11 July 2007

PEP: Looking Forward to 2Q Results

PepsiCo (PEP) will report second-quarter earnings on 24 July. Our assessment of PepsiCo after the first quarter was generally positive, but we also raised two cautionary flags. We pointed out that gains in net income were inflated by a favorable tax settlement, which lowered last year's effective tax rate. Second, we were concerned that financial data reporting changes (involving international operations) were skewing then-and-now comparisons.

By most accounts, PepsiCo is one of the better managed companies in the country. Their shares have been advancing steadily for almost three years, from below $50 to almost $70 before falling back a few points. The company has also paid a dividend of about 2 percent. We've noticed a strange anomaly with our gauge scores for PepsiCo. The figures never get very high and make the company appear weak. However, the scores over a seven-year period (28 quarters) actually correlate well (corr. coefficient = 0.65) with future stock price gains. In other words, rising scores have presaged price increases; the gauges just don't seem to rise very high. The overall gauge peaked at 43 points in September 2002, when the stock price was in the mid $30s. Shares sold in the mid $40s a year later, and you know the rest of the story.

As usual, prior to the release of another quarter's earnings, we want to establish expectations to which we can compare the new results.

We start with information published by the company itself. In February, PepsiCo provided guidance for 2007 indicating "the Company expects mid-single-digit volume and net revenue growth, with revenue growth outpacing volume growth." With this in mind, we're looking for second-quarter revenues of $9.3 billion. This figure would equate to 7 percent year-over-year revenue growth and an 8 percent increase over the June 2006 quarter.

The gross margin for PepsiCo always seems to be about 55 percent of revenue, so we're comfortable estimating the cost of goods sold at $4.2 billion. Similarly, SG&A expenses are usually right around 36 percent of revenue, so our assumption for these costs in the second quarter is $2.6 billion. We'll also assume a flat $52 million charge for amortization of intangible assets.

Bottler equity income is usually more significant. Unfortunately, we don't see any particular quarter-to-quarter pattern in the results. Therefore, we have simply chosen the 10-quarter average of $133 million for our estimate of this income in the second quarter. Similarly, a $20 million charge for net interest expenses seems reasonable given recent history.

The income tax rate presents another complication. The company indicated that tax rate volatility will continue, but they are assuming that the average for year will be 27.7 percent. Since the rate in the first quarter came in somewhat below this target, we will assume 28 percent for the second quarter, or $513 million.

Rolling up these estimates, we're looking for net income of $1.319 billion ($0.79) for the quarter. As you can see, we're not looking for much more that a flat quarter. However, we have to note that our net income prediction is much less than the estimates of professional analysts. The difference might be the result of our tendency to be conservative with our numbers. However, the magnitude of the difference is surprising because PepsiCo's operating expenses are fairly constant as a percentage of revenue, and we have some guidance from the company concerning the revenue. Amortization expenses and bottler equity income are the values of which we are most unsure. We used historic averages for these figures, but, perhaps, the professional analysts have better information at their disposal.



Op expenses

CGS 4196

SG&A 3356

Amortization 52
Op income

Other income

Equity income

Interest, etc.
Pretax income

Income tax

Net income



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