14 October 2008

PEP: FInancial Analysis through September 2008

We have analyzed the financial statements included in PepsiCo's press release announcing third-quarter earnings.

The results were disappointing, as explained below, and they caused PepsiCo shares to lose 12 percent of their value on Tuesday.  The share price is now 32 percent below the 52-week high.  PepsiCo responded to challenging economic conditions with plans to cut 3300 jobs and close 6 plants.  These actions, under the banner "Productivity for Growth," will lead to a pretax charge in the fourth quarter between $550 and $600 million.

PepsiCo, Inc., (NYSE: PEP) is a leading global purveyor of beverages and snacks.  The company is well regarded for good management, steady growth, significant international exposure, and the defensive characteristics of the food industry.  While famously locked in a battle with Coca-Cola (NYSE: KO) for the soft-drink market, PepsiCo's snack food 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 PepsiCo's second quarter, which consisted of the 12 weeks ending 14 June 2008, our analysis determined that the company held the line on expenses, despite rising raw material (i.e., agricultural commodities) costs.  This performance, combined with a lower stock price, pushed up the GCFR Overall gauge to 42 (later recalculated at 46) of 100 possible points.  Total Revenue increased by 14.0 percent year-over-year, and Revenue growth at PepsiCo's three business units that operate outside North America averaged 29.4 percent.

Now, with the available data from the September 2008 quarter, our gauges display the following scores:

  • Overall: 30 of 100 (down from 46)

Before we examine the factors that affected each gauge, we will compare the latest quarterly Income Statement to our previously announced expectations.

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.

($M) September 2008
September 2008
September 2007
Revenue 11,24411,300 10,171
Op expenses
CGS (5,268)(5,220) (4,627)
SG&A (3,979)(3,842) (3,467)
(13)(17) (15)
Operating Income 1,9842,220 2,062
Other income
Equity income 201210 218
Interest, etc. (59) (35)
Pretax income 2,1262,395 2,224
Income tax (550) (647)
Net Income 1,5761,748 1,743
Shares outstanding1,5931,6001,651

Third-quarter Revenue was only 0.5 percent below our estimate.  We figured Revenue would be 11.1 percent more than in the year-earlier quarter, and the actual increase was 10.5 percent.  On a year-over-year basis, Revenue grew by 13.7 percent.  This is consistent with the company's guidance last Summer to expect "low-double-digit" Revenue growth.   PepsiCo stated that "foreign exchange added 3 percentage points to revenue growth."

International operations contributed mightily to the sales increase.  Revenue at PepsiCo's three business units that operate outside North America grew by an average of 20.8 percent.  Revenue at the three other units that operate in North America grew by 3.8 percent.

The Gross Margin in the third quarter was lower than we expected.  We anticipated the margin would slip to 53.8 percent of Revenue, but it actually declined to 53.1 percent.  The Cost of Goods Sold (CGS) equaled to 46.9 percent of Revenue.

Sales, General, and Administrative (SG&A) expenses were 35.4 percent of Revenue, substantially above our estimate of 34.0 percent.  It's possible that the increase is attributable to a $176 million "mark-to-market losses on commodity hedges" in the quarter.  However, it's possible these losses are reflected elsewhere on the Income Statement.

The charge for Amortization of Intangible Assets was $4 million less than expected.

The lower-than-expected Gross Margin, combined with much higher-than-expected SG&A costs, led to Operating Income, as we define it, missing the forecast value by 10.6 percent.  Operating Income was 3.8 percent below that in last year's third quarter. 

We don't normally do very well predicting the erratic "Bottling equity income," which includes gains from selling shares in Pepsi Bottling Group, Inc. (NYSE: PBG).  However, we were only $9 million off in the third quarter.  Net Interest Expense was a substantial $24 million more than we expected, due greater debt. 

The Income Tax Rate was 25.9 percent, up from 22.3 percent in the year-earlier quarter, but below our 27 percent expectation for the current period.   PepsiCo benefited last year from a "favorable resolution of certain foreign tax matters."  The lower-than-anticipated tax rate for the September 2008 quarter was not enough to prevent Net Income missing our prediction by 10 percent.  Net Income was also 10 percent less than in the September 2007 quarter.

Cash Management. This gauge decreased from 12 points in June to 11 points now.

3 mos.
12 mos.
Current Ratio1.21.41.2
LTD/Equity 40.7%36.3%18.2%
Debt/CFO  1.2 yrs0.9 yrs0.4 yrs
Inventory/CGS 46.5 days51.4 days45.3 days
Finished Goods/Inventory 43.5%45.3%43.3%
Days of Sales Outstanding (DSO)44.8 days44.9 days43.2 days
Working Capital/Market Capitalization  1.3%3.1%1.5%
Cash Conversion Cycle Time-45 days-41 days-56 days

The increase in debt is the most noticeable change.  Long-term debt rose $2.3 billion this year, during which time PepsiCo spent $4.2 billion to repurchase its shares.  We would prefer that debt, if necessary, be used for capital investments that will spur growth and profitability.

Inventory, something we watch very closely, is up a day from the comparable period last year.

Growth. This gauge decreased from 14 points in June to 10 points now.

3 mos.
12 mos.
Revenue growth13.7%14.0%8.8%
Revenue/Assets 121%122%117%
CFO growth-8.0%12.4%25.5%
Net Income growth -8.6%-2.0%26.4%
Growth rates are trailing four quarters compared to four previous quarters.

Revenue grew when the dollar was weakening, but the Revenue growth rate might now have topped out.  The drops in Cash Flow and Net Income are disturbing, but a portion of the earnings decline is due to last year's income tax rate increase being abnormally low.

Profitability. This gauge decreased from 12 points in June to 10 points now.

3 mos.
12 mos.
Operating Expenses/Revenue 82.5%81.8%81.1%
ROIC 25.0%27.2%34.6%
Accrual Ratio7.4%2.9%3.8%

Operating Expenses have risen significantly.  PepsiCo's returns on investment remain impressive, but have weakened a little.  The big rise in the Accrual Ratio, which suggests lower earnings quality, indicates that less of the company's Net Income is due to Cash Flow from Operations (CFO), and, therefore, more is due to changes in non-operational Balance Sheet accruals.

Value.  The gauge, which takes a contrary view of share prices, had risen to 10 points by the end of June.  From the beginning of July to the end of September, PepsiCo's stock price rebounded from $63.59 to $71.27.  Early October's market crash knocked the price to about $60, and the disappointing third-quarter results brought the share price under $55.  Using the 30 September price, per GCFR standard practice, the Value gauge score is 4 points.  Using the 14 October closing price, the gauge would be 11 points higher.   This suggests that the shares may have been punished more than warranted by fundamentals. 

3 mos.
12 mos.
P/E 20.017.519.4
P/E to S&P 500 average P/E 119%96%114%
Enterprise Value/Cash Flow (EV/CFO)18.615.017.4
PepsiCo's valuation ratios can be compared with other companies in the Processed & Packaged Goods industry.

PepsiCo's domestic businesses, especially beverages have stagnated.  Most of the company's Revenue growth has been due to international operations.  However, the recent rebound in the dollar may change this dynamic in the fourth quarter.  Higher operating costs (e.g.,due to higher agricultural commodity prices) have swallowed up sales increases, leading to disappointing earnings and declining Cash Flow. 

The use of debt to defray the costs of share repurchases is not a strategy we would endorse, although we appreciate the desire to return profits to shareholders.

These negative conditions explain the big drop in the Overall Gauge score, which reversed a once-promising increase in the second quarter.

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