Pepsi Buys Quaker Oats in a Highly Publicized Food Fight

On June 26, 2000, Phillip Morris, which owned Kraft Foods, announced its planned $15.9 billion purchase of Nabisco, ranked seventh in the United States in terms of sales at that time. By combining Nabisco with its Kraft operations, ranked number one in the United States, Phillip Morris created an industry behemoth. Not to be outdone, Unilever, the jointly owned British–Dutch giant, which ranked fourth in sales, purchased Bestfoods in a $20.3 billion deal. Midsized companies such as Campbell’s could no longer compete with the likes of Nestle, which ranked number three; Proctor & Gamble, which ranked number two; or Phillip Morris. Consequently, these midsized firms started looking for partners. Other companies were cutting back. The U.K.’s Diageo, one of Europe’s largest food and beverage companies, announced the restructuring of its Pillsbury unit by cutting 750 jobs—10% of its workforce. PepsiCo, ranked sixth in U.S. sales, spun off in 1997 its Pizza Hut, KFC, and Taco Bell restaurant holdings. Also, eighth-ranked General Mills spun off its Red Lobster, Olive Garden, and other brand-name stores in 1995. In 2001, Coca-Cola announced a reduction of 6000 in its worldwide workforce.

As one of the smaller firms in the industry, Quaker Oats faced a serious problem: it was too small to acquire other firms in the industry. As a result, they were unable to realize the cost reductions through economies of scale in production and purchasing that their competitors enjoyed. Moreover, they did not have the wherewithal to introduce rapidly new products and to compete for supermarket shelf space. Consequently, their revenue and profit growth prospects appeared to be limited.

Despite its modest position in the mature and slow-growing food and cereal business, Quaker Oats had a dominant position in the sports drink marketplace. As the owner of Gatorade, it controlled 85% of the U.S. market for sports drinks. However, its penetration abroad was minimal. Gatorade was the company’s cash cow. Gatorade’s sales in 1999 totaled $1.83 billion, about 40% of Quaker’s total revenue. Cash flow generated from this product line was being used to fund its food and cereal operations. Gatorade’s management recognized that it was too small to buy other food companies and therefore could not realize the benefits of consolidation.

After a review of its options, Quaker’s board decided that the sale of the company would be the best way to maximize shareholder value. This alternative presented a serious challenge for management. Most of Quaker’s value was in its Gatorade product line. It quickly found that most firms wanted to buy only this product line and leave the food and cereal businesses behind. Quaker’s management reasoned that it would be in the best interests of its shareholders if it sold the total company rather than to split it into pieces. That way they could extract the greatest value and then let the buyer decide what to do with the non-Gatorade businesses. In addition, if the business remained intact, management would not have to find some way to make up for the loss of Gatorade’s substantial cash flow. Therefore, Quaker announced that it was for sale for $15 billion. Potential suitors viewed the price as very steep for a firm whose businesses, with the exception of Gatorade, had very weak competitive positions. Pepsi was the first to make a formal bid for the firm, quickly followed by Coca-Cola and Danone.

By November 21, 2000, Coca-Cola and PepsiCo were battling to acquire Quaker. Their interest stemmed from the slowing sales of carbonated beverages. They could not help noticing the explosive growth in sports drinks. Not only would either benefit from the addition of this rapidly growing product, but they also could prevent the other from improving its position in the sports drink market. Both Coke and PepsiCo could boost Gatorade sales by putting the sports drink in vending machines across the country and selling it through their worldwide distribution network.

PepsiCo’s $14.3 billion fixed exchange stock bid consisting of 2.3 shares of its stock for each Quaker share in early November was the first formal bid Quaker received. However, Robert Morrison, Quaker’s CEO, dismissed the offer as inadequate. Quaker wanted to wait, since it was expecting to get a higher bid from Coke. At that time, Coke seemed to be in a better financial position than PepsiCo to pay a higher purchase price. Investors were expressing concerns about rumors that Coke would pay more than $15 billion for Quaker and seemed to be relieved that PepsiCo’s offer had been rejected. Coke’s share price was falling and PepsiCo’s was rising as the drama unfolded. In the days that followed, talks between Coke and Quaker broke off, with Coke’s board unwilling to support a $15.75 billion offer price.

After failing to strike deals with the world’s two largest soft drink makers, Quaker turned to Danone, the manufacturer of Evian water and Dannon yogurt. Much smaller than Coca-Cola or PepsiCo, Danone was hoping to hype growth in its healthy nutrition and beverage business. Gatorade would complement Danone’s bottled-water brands. Moreover, Quaker’s cereals would fit into Danone’s increasing focus on breakfast cereals. However, few investors believed that the diminutive firm could finance a purchase of Quaker. Danone proposed using its stock to pay for the acquisition, but the firm noted that the purchase would sharply reduce earnings per share through 2003. Danone backed out of the talks only 24 hours after expressing interest, when its stock got pummeled on the news.

Nearly 1 month after breaking off talks to acquire Quaker Oats because of disagreements over price, PepsiCo once again approached Quaker’s management. Its second proposal was the same as its first. PepsiCo was now in a much stronger position this time, especially because Quaker had run out of suitors. Under the terms of the agreement, Quaker Oats would be liable for a $420 million breakup fee if the deal was terminated, either because its shareholders didn’t approve the deal or the company entered into a definitive merger agreement with an alternative bidder. Quaker also granted PepsiCo an option to purchase 19.9% of Quaker’s stock, exercisable only if Quaker is sold to another bidder. Such a tactic sometimes is used in conjunction with a breakup fee to discourage other suitors from making a bid for the target firm.

With the purchase of Quaker Oats, PepsiCo became the leader of the sports drink market by gaining the market’s dominant share. With more than four-fifths of the market, PepsiCo dwarfs Coke’s 11% market penetration. This leadership position is widely viewed as giving PepsiCo, whose share of the U.S. carbonated soft drink market is 31.4% as compared with Coke’s 44.1%, a psychological boost in its quest to accumulate a portfolio of leading brands.
-Do you think PepsiCo may have been willing to pay such a high price for Quaker for reasons other than economics? Do you think these reasons make sense? Explain your answer.

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