22 September 2007

PEP: Looking ahead to September Results

PepsiCo (PEP) will report third-quarter earnings on 11 October.

A look at a stock chart indicates that the late-Summer market downturn barely affected PepsiCo, and the shares are now trading near a 52-week high. The weak dollar increases the attractiveness of companies with significant overseas operations, which is certainly the case for PepsiCo. Also, in an uncertain economy, investors are drawn to blue-chip cash generators and industries satisfying the steady, predictable demand for food and beverages. But the PepsiCo 's appeal is not a simply a recent phenomenon: PEP shares have been advancing steadily for almost three years, from below $50 to over $70. The company also pays a dividend of about 2 percent.

Our assessment of PepsiCo after the second quarter was generally positive. Revenue was higher than we forecast, and many expenses were lower. As a result, Operating Income was 14 percent above the predicted value, and Net Income exceeded our forecast by 18 percent.

The Overall gauge score in June of 42 seems weak, but that is misleading. The gauge for PepsiCo is now at the top of its historic range. For whatever reason, the score for PepsiCo never gets very high, but the trend (i.e., increasing scores, as is currently the case) is more important than the absolute level. We've observed that future increases in PepsiCo's stock price correlate fairly well with increases in the Overall score. In other words, rising scores have presaged price increases. With 28 quarters of data, the degree of correlation coefficient between these two parameter is 63 percent.

As usual, prior to the release of another quarter's earnings, we find ourselves wondering if the good times at PepsiCo will continue. By most accounts, they are one of the better managed companies in the country. What is reasonable to expect?

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 third-quarter revenues of $9.74 billion. This figure would equate to 8 percent year-over-year revenue growth and almost a 9 percent increase over the September 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 0.45 * $9.74 billion = $4.38 billion. Similarly, SG&A expenses are usually right around 36 percent of revenue, so our assumption for these costs in the third quarter is 0.36 * $9.74 billion = $3.51 billion. We'll also assume a flat $40 million charge for amortization of intangible assets.

Bottler equity income is both significant and erratic. However, income in the September quarter tends to be strong. Since bottler equity income was $173 million in the June quarter, we think it is reasonable to expect an income of $220 million in the third quarter.

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 27.3 percent. We've used this full-year estimate for the third quarter.

Rolling up these estimates, we're looking for net income of $1.46 billion ($0.89) for the quarter. As you can see, we're not looking for much more than a flat quarter. However, we have to note that our net income prediction is much less than the estimates of professional analysts. We tend 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. We've also been tripped up in the past by the company restating the year-earlier results, which changes the baseline for out growth predictions.


Sept 2007
Sept 2006

Op expenses

CGS (4383)

SG&A (3506) (3063)

Amortization (40)
Op income

Other income

Equity income

Interest, etc.
Pretax income

Income tax

Net income



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