05 May 2007

PEP: Analysis through March 2007

PepsiCo (PEP), a leading global purveyor of beverages and snacks, filed a 10-Q with the SEC for the 12 weeks ending on 24 March 2007. We updated our analysis to address certain details in this formal submittal that were not available in the original press release. Our results, adjusted to account for the new information, are reported in this post.

PepsiCo is known for good management, steady growth, the defensive characteristics of the food and beverage industries, and significant international exposure. While famously locked in a battle with Coca-Cola for market share, PepsiCo's snack food business results in a more diversified company. In the North American markets, the Frito-Lay division takes in more revenue and contributes more to operating profit than the Pepsi Bottling division.

When we analyzed PepsiCo after the results from December 2006 became available, the Overall score was a modest 39 points. Of the four individual gauges that fed into this composite result, Growth was the strongest at 19 points. Cash Management was weakest at 3 points.

We observed that the recent 10-Q filing modified the income statement for the quarter ending 25 March 2006. Revenue was reduced from $7.205 billion to $6.719 billion. Net Income was reduced from $1.019 billion to $0.947 billion. The modification isn't directly explained in the 10-Q, but there is a Note indicating that the reporting calendar for some international units was revised. We're less concerned about the change than the likelihood that revenue and expenses were shifted, in amounts not publicly announced, to other quarters. These shifts, if they occurred, will add errors to our year-over-year comparisons. We seemingly have no recourse other than to wait for subsequent 10-Q filings to learn if other 2006 quarters were revised.

With the available data from the most recent quarter, our gauges now display the following scores:

Cash Management. This gauge held at 3 points from December. The Current Ratio is now 1.16, down from 1.3 in December, but the same as March 2006. PepsiCo keeps this value lower than many other companies. Long-Term Debt/Equity is a minimal 12 percent, down from 17 percent the previous quarter. The debt ratio was 16 percent one year ago. Inventory/Cost of Goods Sold rose to 48 days from 45 days at the end of the prior quarter and 47 days in March 2006. The percentage of Inventory that is product ready for sale (i.e., Finished Goods) is now 49 percent, compared to 48 percent at the end of the prior quarter and 51 percent in March 2006. The inventory levels suggest sales met, or were at least close to, expectations. Accounts Receivable/Revenues equal 43 days. This is a couple days more than the value one year ago, but it is within the normal variability for this parameter.

Growth. This gauge increased 3 points from December. Revenue growth was 8 percent year over year (aided by the restatement of last year's results?), down from 10 percent a year ago. Net Income growth is an eye-opening 39 percent, up from -4 percent a year ago. The increase benefited greatly from a change in the income tax rate from 36 to 19 percent. CFO growth is an impressive 24 percent, up from a tepid 4 percent a year ago. Revenue/Assets is 118 percent; it has been trending up. It indicates that the company is becoming more efficient at generating sales. The $3 billion per year spent repurchasing common shares, reducing assets, might also be a non-operational explanation for the increase.

Profitability. This gauge increased 1 point from the prior quarter. ROIC grew to an impressive 31 percent from 21 percent a year ago. FCF/Equity jumped up to 29 percent from 23 percent. Operating Expenses/Revenue were 81 percent; these expenses have been within 1 percent of 81 percent for the last six years. The Accrual Ratio, which we like to be both negative and declining, moved in the wrong direction from +2 percent to +4 percent. This tells us that less of the company's Net Income is due to cash flow, and, therefore, more is due to changes in non-operational balance sheet accruals.

Value. PepsiCo's stock price rose from $62.55 at the end of December to $63.56 at the end of March. The Value gauge, based on the latter price, is a so-so 8 points, compared to 8 and 1 points three and twelve months ago, respectively. The P/Eat the end of the quarter was 18.6, down its historic median value in the low 20's. The decrease suggests the shares have become less expensive, even though the share price has risen. The average P/E for the Non-alcoholic Beverages industry is 22. To remove the effect of overall market changes on the P/E, we note that the company's current P/E is at a 17 premium to the average P/E, using core operating earnings, for stocks in the S&P 500. Historically, the company's P/E has had a 28 percent premium to the market, as expressed by this measure. Companies tend to trade at a premium when their growth rates are greater than average, particularly when the growth rates seem more likely to be sustained. The PEG ratio of 0.5 is indicative of a bargain stock. It has been decreasing (i.e., suggesting greater value). The Price/Revenue ratio, which is less affected by the one-time factors that cause wide swings in earnings, has been stable at 3.0. The average Price/Sales for the Non-alcoholic Beverages industry is 3.9.

Now a moderate 42 out of 100 possible points, the Overallgauge has been inching up. Net income, Cash Flow, and ROIC are all very good, and Operating Expenses are under control. The stock price is not excessive by normal measures. Yet, we're troubled by the possibility that the income gains were more due to tax adjustments than sustainable operations. As mentioned above, we're also concerned that the restatement of 2006's first-quarter results might have thrown of our comparisons.

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