08 September 2008

PEP: Look Ahead to September 2008 Quarterly Results

In our earlier financial analysis of PepsiCo's second quarter, which consisted of the 12 weeks ending 14 June 2008, we noted that Revenue grew 14.0 percent year-over-year.  This performance, enabled by the company's international operations, clearly surpassed PepsiCo's original guidance for the year of "high-single-digit" growth.  Revenue growth averaged 29.4 percent at PepsiCo's three business units that operate outside North America.

Despite pressure from rising raw material (i.e., agricultural commodities) costs, the company managed to hold the line on other expenses.  Net Income in the second quarter was 9.1 percent greater than in the quarter ending June 2007.

Good operating performance combined with a lower stock price pushed up PepsiCo's Overall gauge score to 42 of 100 possible points.  By historical measures, this is a pretty good score for PepsiCo, and it would have been a few points higher if recent tweaks to our scoring algorithms had been in effect.

PepsiCo, Inc. (NYSE: PEP) is a leading global purveyor of beverages and snacks.  The company is one of the most admired, and it is known for steady growth, significant international exposure, and the defensive characteristics of the food and beverage industry.  While famously locked in a battle with Coca-Cola (NYSE: KO) for the soft-drink market, PepsiCo's snack business diversifies the company.  The Frito-Lay North America division takes in more Revenue, and it contributes more to Operating Profit, than the PepsiCo Americas Beverages unit.

In early October 2008, PepsiCo will report its results for the 12 weeks ending 6 September.  In anticipation of this report, we've modeled PepsiCo's Income Statement for the quarter.  The intent of this exercise was to produce a baseline for identifying any deviations, positive or negative, in the actual data.  GCFR estimates are derived from trends in the company's historical financial results and guidance provided by company management.

When announcing its second-quarter results, PepsiCo updated its full-year outlook as follows:

The Company expects full-year 2008 performance of three to five percent volume growth, low-double-digit net revenue growth (including acquisitions and foreign exchange) and EPS of at least $3.72 excluding the impact of any mark-to-market gains/losses. The Company is not able to provide guidance on the 2008 projected EPS growth including the impact of the mark-to-market gains or losses on commodity hedges due to the unpredictability of future changes in commodity prices.
Cash provided by operating activities is expected to be approximately $7.6 billion and capital spending about $2.7 billion. In 2008, the Company intends to repurchase at least $5.3 billion of its shares, subject to market conditions. This represents an increase of at least $1 billion from its previously announced intention to spend $4.3 billion in share repurchases in 2008. As of the end of the second quarter, the Company spent $2.9 billion repurchasing its shares in 2008.

The guidance for Revenue growth changed from "high single digit" in earlier remarks to "low-double-digit" in the statement above.  The EPS target didn't change, but the exclusion of "mark-to-market gains/losses" on commodity hedges was new.

To establish a Revenue target for the third quarter of 2008, we will interpret "low-double-digit" growth to mean 13 percent.  Total Revenue in 2007 was $39.5 billion, so Revenue for the current year is expected to be about $39.5 billion * 1.13 = $44.6 billion.  In the last five years, the September quarter contributed an average of 25.4 percent of the year's Revenue.  Therefore, our Revenue target for the September 2008 quarter is 0.254 * $44.6 billion = $11.3 billion.  (Given the resurgent dollar, we were tempted to shave this to $11 billion even.)

We expect to see continued pressure on PepsiCo's Gross Margin.  The margin in the September 2007 quarter was 54.5 percent, and we'll estimate it will come down to 53.8 percent.  In other words, we're projecting the Cost of Goods Sold to be (1 - 0.538) * $11.3 billion = $5.2 billion. 

SG&A expenses are typically around 35 percent of Revenue, but the ratio tends to be lower in the third quarter of each year.  For the current quarter, we think 34 percent is a better estimate.  Therefore, our assumption for these costs is 0.34 * $11.3 billion = $3.8 billion. 

For amortization of intangible assets, we'll assume a $17 million charge.  This has been the average charge over the last four quarters.

These assumptions would lead to Operating Income, as we define it, of $2.2 billion.  This would be a 7.7 percent increase over the equivalent figure in the year-earlier quarter.

Bottler equity income is both significant and erratic.  We've noticed that it tends to reach its high-water mark for the year in the third quarter.  So far in 2008, equity income has been down a few percent from 2007.   For these reasons, we will set a target of $210 million for the September 2008 quarter.  The target is 3.7 percent below the equity income in the year-earlier quarter.

A $35 million charge for net Interest Expense seems reasonable given recent history.

We're using 27 percent for the third-quarter income tax rate, which balances the company's full-year guidance and earlier experience.  The rate can be volatile from quarter to quarter, which throws earnings estimates out of whack.

Rolling up these figures, we're looking for Net Income of $1.748 billion ($1.09/share).  It is eerily close to the $1.743 billion that PepsiCo earned in the year-earlier quarter.  How did a 7.7 percent increase in Operating Income turn into a zero increase in Net Income?  The  income tax rate was only 22.3 percent in the September 2007 quarter.

Our estimate for Net Income translates into $1.09 per share, matching the consensus analyst estimate.

Please note that the table format below, which we use for all analyses, can and often does differ in material respects from company-used formats.  A common difference is the classification of income and expenses as Operating and Non-Operating.  The standardization is simply for convenience and to facilitate cross-company comparisons.


September 2008
September 2007
Op expenses

CGS (5,220)

SG&A (3,842) (3,467)

Operating Income
Other income

Equity income

Interest, etc.
Pretax income

Income tax

Net Income

Shares outstanding


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