15 March 2008

PEP: Financial Analysis through December 2007 (Update)

We previously posted an analysis of PepsiCo's (PEP) preliminary financial results for the quarter and fiscal year that ended on 29 December 2007. The company subsequently submitted more detailed financial statements in a 10-K annual report filed with the SEC.

The additional data in the 10-K did not significantly alter the analysis. However, one of our gauge scores ticked up a point because of an adjustment we've made to the GCFR scoring algorithms.
In our earlier analysis report, we remarked that the scores were adversely affected by a rising stock price, increasing costs, and slowing income growth. To be fair, 2006 featured substantial non-recurring tax benefits, which skewed the 2007 vs. 2006 comparisons. The decreasing Gross Margin, which swallowed up seemingly impressive (and hard to sustain) Revenue Growth, was probably affected by increasing commodity prices that don't appear to be waning.

Readers are alerted that the Value gauge score listed above reflects PepsiCo's $75.90 stock price at the end of December. PEP shares now trade for $68.45. With the lower share price, the Value gauge would rise to 5 points, and the Overall gauge would lift by seven points to 30. The higher figures are still rather weak, although our scores for PepsiCo in the best of times don't get above the 40's.

As can be seen in the chart, which is based on seven years of data, PepsiCo shares tend to rise more in the following year when the Overall score gets over 35 points, and they are probably best avoided when the Overall score is below 30. There are counter examples on both sides showing that that this tendency is not a certainty.

The 10-K includes some interesting information tidbits. Here are a few:

1. 12 percent of Net Revenue during 2007 is associated with Wal-Mart.

2. Sales incentives and discounts, which reduce Revenue, were 27.3 percent of Revenue in 2005, 29.3 percent of Revenue in 2006, and 28.6 percent of Revenue in 2007. This must be indicative of the competitiveness of the beverage and snack food businesses.

3. Distribution costs, which include the costs of shipping and handling, were $5.1 billion in 2007, or 35.9 percent of SG&A expenses. Are higher energy costs going to push this up in 2008?

4. PepsiCo is able to defer only $42 million of last year's $2 billion income tax provision. However, lower taxes on foreign results reduces the effective tax rate by 6.5 percent. 44 percent of Net Revenue is generated outside the U.S.

5. It's a sign of shareholder-friendly corporate governance that PepsiCo requires shareholder approval to reprice (i.e., reduce) the exercise price of previously issued stock options. This has not occurred.

6. When projecting its U.S. pension liability, PepsiCo assumes a 7.8 percent annual return on pension plan assets. The company assumes a long-term return on equity assets (targeted at 60 percent assets) of 9.3 percent per year, and a long-term return on on fixed-income investments of 5.8 percent.

7. Approximately 3 percent of securities in the investment portfolio of the U.S. pension plans were in subprime mortgage holdings at the end of 2007.

8. PepsiCo has been aggressively converting short-term debt to long-term debt. $1.4 billion in debt was reclassified from short-term to long-term in 2007. (Long-term debt to equity rose from 17 to 24 percent.)

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