11 December 2007

PEP: Look Ahead to December 2007 Results

PepsiCo (PEP) shares, as shown here, have repeatedly established new 52-week highs. With the dollar weak, PepsiCo's significant overseas operations are attractive. Also, with uncertain economic growth, investors are drawn to defensive, non-cyclical industries, such as food and beverages.

Our assessment of PepsiCo after the third quarter was generally positive. Revenue was higher than we forecast, and PepsiCo did a good job controlling expenses in spite of increases in raw material costs. As a result, Operating Income was 14 percent above the predicted value, and Net Income exceeded our forecast by 19 percent. The latter result was aided by a $115 million favorable resolution of foreign tax matters.

The Overall gauge score of 39 in September might seem weak, but that is misleading. The gauge for PepsiCo is now just a few points below the top of its historic range. For whatever reason, the score for PepsiCo never gets very high. Nevertheless, the Overall score correlates fairly well with future increases in PepsiCo's stock price. With 28 quarters of data, the correlation coefficient between the score and one-year price growth is 62 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 fourth-quarter revenues of $10.95 billion. This figure would equate to 9.3 percent year-over-year revenue growth and a 5.5 percent increase over the December 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 * $10.95 billion = $4.93 billion. Similarly, SG&A expenses have recently been around 35 percent of revenue, but tend to be several points higher in the fourth quarter. Our assumption for these costs in the fourth quarter is 0.39 * $10.95 billion = $4.27 billion. We'll also assume a $60 million charge for amortization of intangible assets and restructuring charges. (The company issued guidance to expect restructuring charges of about $0.03 per share in the fourth quarter.)

Bottler equity income is both significant and erratic. It tends to be relatively weak in the December quarter. Since bottler equity income was $218 million in the September quarter, we think it is reasonable to expect an income of $140 million in the fourth quarter.

A $25 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 no more 27.7 percent. We've used this full-year estimate for the fourth quarter.

Rolling up these estimates, we're looking for net income of $1.31 billion ($0.79) for the quarter. The quarter appears weaker than the year-earlier period because the latter benefited from an unusually low tax rate.


Dec 2007
Dec 2006
Op expenses

CGS (4928)

SG&A (4271) (4072)

Operating Income
Other income

Equity income

Interest, etc.
Pretax income

Income tax

Net Income


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