PepsiCo Changchun Joint venture analysis

While PepsiCo was already involved in seven joint ventures in the People’s Republic of China, this proposal would be one of the first two green-field equity joint ventures with PepsiCo control over both the board and day to day management. Every investment project at PepsiCo had to go through a systematic evaluation process that involved using capital budgeting tools such as net present value (NPV) and internal rate of return (IRR). The final decision would be made after a presentation to the PepsiCo Asia Pacific president. Mr. Hawaux wondered if the proposed Changchun joint venture would be sufficiently profitable based on the information he had collected. The carbonated soft drink business had in recent years become increasingly competitive as Western markets matured and multinational firms began increasing global operations as a means to continue growth.

The former USSR, Latin America, and Asia were pinpointed by both Coca-Cola international and PepsiCo international as prime areas for expansion. Historically, the early mover into a white market (an area with no previous distribution of coke or Pepsi) continued to hold the majority of market share as the market matured. Thus, it was seen as critical to enter new markets as soon as they became politically and economically accessible. The carbonated soft drink (CSD) industry in the People’s Republic of China (PRC) was highly fragmented and composed of a multitude of regional players. For its Guilin CJV, PepsiCo had supplied 80% of the capital, yet received only 17% of the profits. In 1993, Premier Deng Xiaopeng introduced a series of reforms in order to make the Chinese market more attractive to foreign investors.

Cooperative joint ventures fell out of favor and a new form of enterprise, the equity joint venture (EJV) was established. Under the new rules, a foreign CSD company could enter into a joint venture with SOEs appointed by the PRC government and hold a maximum of 60% ownership share in the entity; the remaining 40% had to be held by mainland Chinese interest. The profit would be distributed in line with the ratio of capital injected. In the past 10 years real per capita GDP growth rates had ranged 8 to 12% annually, and the forward momentum in per capita wealth was expected to continue. Total beverage consumption was expected to more than double by the turn of the century from the current consumption of 13 eight ounce servings per capita.

More established demand centers, such as Beijing and Shanghai had already greatly exceeded this estimate; Beijing’s per capita consumption was 84 eight ounce servings, while Shanghai’s was 90. PepsiCo defined the total Chinese beverage industry as all non-alcoholic beverages, including bottled water, teas, Asian drinks, and both concentrated and non-concentrated juices. This total basket of drinks was then divided into carbonated soft drinks and non-carbonated soft drinks. 2 billion; of whom Mr. Hawaux estimated, only 50% had ever heard of Pepsi or coke, the PRC still held a significant potential for development. Pepsi’s strategic goals were articulated through a platform known within the firm as vision 2000. Essentially, vision 2000 articulated two overarching: to close the gap with CCI before the turn of the century and to leverage this into industry leadership beyond the year 2000.

The proposed site for the next PCI bottling plant was in Changchun, the capital city of Jilin province, located in the North East region of the PRC. Many residents of Changchun had already heard of either coke or Pepsi and were eager to experience a product closely tied to the Western lifestyle. In developed demand centers, it was found that many residents purchased coke or Pepsi for a relatively small portion of their disposable income, to buy into and emulate the enticing, fascinating and sexy American dream. Both PepsiCo and CCI had found this phenomenon in the former USSR and Easter European countries as well. Coke’s presence in the Changchun market was relatively insignificant, limited quantities, sourced from CCI’s bottling plants in Shenyang, Beijing, and Tianjin, were found in certain hotels and restaurants.

CCI had no production facilities for its flagship brands and as per their MOU, couldn’t until 1997. 5 % interest in the JV, which would be named Changchun Pepsi-Cola Beverage Company limited. The Second Food Factory would hold 37. 5% and Beijing Chong Yin would hold the remaining 5%. The agreement would span 50 years, the maximum allowable under Chinese law. Capital infusions from the two Chinese partners would be in cash and or fixed assets at their fair market value, and would be injected in accordance with the ownership ratio of the JV PepsiCo’s capital would be composed of fixed assets, mainly production lines and cash in U. PepsiCo would appoint the general manager while the Chinese partners would be responsible for appointing the deputy general manager.

While PepsiCo would initially staff the upper management with expatriates, the firm hoped to develop local management talent overtime. Common to all large PepsiCo capital requests, a 12 year NPV projection, with sensitivities was computed by the finance department. The head office in the United States determined discount rates for projects in different countries which included country risk premiums. Currently, PepsiCo used 13% as its weighted average cost of capital. After discussions with colleagues working on the JV, Mr. Hawaux estimated that sales in 1995 (year 1) would be $4. 9 million. Depreciation of fixed assets was included as part of the costs of goods sold (COGS). Operating expenses, which included sales and distribution, marketing, distributors’ commissions and general administration expenses, also contained an allowance for the amortization of intangible assets.

The taxes imposed on the JV were projected to remain at these levels for future years. PRC loss also stipulated that companies must set aside 15% of their net earnings as a statutory reserve. The reserve was created so that companies were prohibited from distributing all of their earnings. Reserves could be used to offset losses in future periods but could not be distributed to shareholders. The JV partners would commit considerable capital in the initial years to build up the facility (see exhibit 3). Exhibit 8 provides an estimate of net working capital changes over the 12 year projection period. Bottles and shells were part of the fixed asset investment for the JV. Distributors would provide the bottling plant with a bottle and shell deposit for using this containers.

In assessing the financial impact of the proposal, Mr. Hawaux understood that there would be two sets of financial projections to analyze: those of the JV, and those of PepsiCo. While PepsiCo had impressed upon them the long term nature of the project, the partners would still be eager for dividends in the short term. PepsiCo planned to apply for the maximum operation period, 50 years, allowed under the current PRC law governing foreign investments. According to the present stipulations, the JV would be liquidated in 50 years, but many believed that as the economy further liberalized, the JV partners would be allowed to apply for further extensions. Mr. Hawaux felt that a reasonable estimate of the terminal value of the JV beyond the 12 year projection period could be calculated with a commonly used capitalization formula; Terminal value = (cash flow (1+growth rate)/ (discount rate-growth rate) He believed that a long term growth rate (beyond year 12) of 5% annually was a conservative estimate.