29 November 2008

PEP: Look Ahead to December 2008 Quarterly Results

The GCFR Overall Gauge of PepsiCo (NYSE: PEP) fell from 46 to 30 of the 100 possible points in the third quarter, which consisted of the 12 weeks ending 6 September 2008. Our original and updated analysis reports explained this result in some detail.

All of the gauges were down in the third quarter, even the contrary Value measure. Revenue growth decelerated, and the Gross Margin was lower than expected. In addition, Sales, General, and Administrative expenses were substantially above projections, possibly because of $176 million "mark-to-market losses on commodity hedges" in the quarter. Net Income was 10 percent less than in the September 2007 quarter.

Disappointing third-quarter results, along with macroeconomic factors, caused PepsiCo shares to drop significantly in October. PepsiCo responded with a program to cut 3300 jobs and close 6 plants. This plan, under the banner "Productivity for Growth," will lead to pretax charges in the fourth quarter between $550 and $600 million.

To look ahead, we've modeled PepsiCo's Income Statement for the super-sized, 16-week December 2008 quarter. The intent of this exercise was to produce a baseline for identifying any deviations, positive or negative, in the actual data that the company will announce on, or about, 5 February 2009. GCFR estimates are derived from trends in the historical financial results and guidance provided by company management.

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.

During the third quarter, PepsiCo and Pepsi Bottling Group, Inc. (NYSE: PBG) closed on their joint acquisition of 81 percent of Lebedyansky, a Russian juice company, for $1.5 billion. The purchase was announced in March 2008. PepsiCo owns 75 percent of this stake. Both companies have offered, in accordance with Russian law, to buy the remaining shares of Lebedyansky. PepsiCo's Cash Flow Statement includes $297 million of cash restricted for use in future acquisitions, which "primarily relates" to the Lebedyansky deal.

PepsiCo's press release announcing third-quarter earnings included the following update to the company's outlook for the year:
The company expects that the recent surge in the U.S. dollar will likely have an adverse impact on fourth-quarter earnings. At current rates, the incremental impact would be about $0.04-$0.05 per share. As a result, the company would expect to report full-year core 2008 earnings per share in the range of $3.67 — $3.68 (excluding any commodity mark-to-market impact and Productivity for Growth costs), versus our prior EPS guidance of $3.72. The company expects full-year 2008 performance of 3 percent to 5 percent volume growth and low-double-digit net revenue growth (including acquisitions and foreign exchange). The company has revised its 2008 guidance with respect to cash provided by operating activities to be approximately $7.3 billion and capital spending to be approximately $2.5 billion, excluding Productivity for Growth costs.
Due to the unpredictability of future changes in commodity prices, the company is not able to provide guidance on 2008 projected EPS including the impact of mark-to-market gains/losses on commodity hedges.
[emphasis added]

To establish a fourth-quarter Revenue target, we will interpret "low-double-digit" growth as 12 percent. In the full year of 2007, Revenue was $39.5 billion. Therefore, we expect annual Revenue in 2008 to be $39.5 billion * 1.12 = $44.2 billion. In 2008's first three fiscal quarters (a total 36 weeks), Revenue equaled $30.5 billion. This leaves $13.7 billion for the long fourth quarter.

PepsiCo's Gross Margin has averaged 53.4 percent in the last four quarters, with a slight downward bias. We estimate it will be 53.3 percent in the current quarter. In other words, we're projecting the Cost of Goods Sold to be (1 - 0.533) * $13.7 billion = $6.4 billion.

SG&A expenses average around 36 percent of Revenue, but the ratio tends to be a few points higher in the fourth quarter. For the current period, 39 percent is probably a better estimate. Therefore, our assumption for these costs is 0.39 * $13.7 billion = $5.3 billion.

We'll assume a $18 million charge for amortization of intangible assets. This estimate is based on the prior charges scaled for the longer quarter.

These assumptions would lead to Operating Income, as we define it, of $1.9 billion. This would be a 12.1 percent increase over the equivalent figure in the year-earlier quarter. Note that this estimate for Operating Income does not include Productivity for Growth, nor mark-to-market commodity hedge costs -- see below for more detail.

In 2008, Bottler equity income has been down about 6 percent from 2007. Assuming a similar result in the fourth quarter, we will set a $90 million target for Bottler equity income.

A $55 million charge for net Interest Expense seems reasonable given recent history. This would result in pre-tax income of $2.0 billion.

We're using 27 percent for the fourth-quarter income tax rate, which is consistent with the company's full-year guidance. This rate would result in an a tax provision of $530 million. The rate can be volatile from quarter to quarter.

Rolling up these figures, we're looking for Net Income of $1.44 billion ($0.91/share). The absolute and per-share figures are 14.2 and 18.2 percent, respectively, more than in the December 2007 quarter.

Neither restructuring nor commodity "mark-to-market" costs were included in the preceding discussion. With respect to the former, PepsiCo provided the following guidance:

As a result of the [Productivity for Growth] program, the company expects to incur a pre-tax charge of approximately $550 million — $600 million in the fourth quarter of 2008, comprised of: approximately $275 million of severance and other employee-related costs; approximately $200 million for asset impairments (substantially all non-cash) resulting from plant closures and related actions; and approximately $100 million for other costs. The company expects that approximately $325 million — $375 million of this charge will result in cash expenditures during the fourth quarter of 2008 and into 2009. The company currently expects to complete the productivity program during the first quarter of 2009.

The table below includes a speculative column that includes our interpretation of this guidance regarding restructuring costs. Since PepsiCo can't predict the "mark-to-market" costs, we know it would be fruitless for us to try.

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.


December 2008
(predicted, 1)
December 2008
(predicted, 2)
December 2007
Op expenses

CGS (6,393)

SG&A (5,614) (5,339) (4,811)

Operating Income
Other income

Equity income

Interest, etc.
Pretax income

Income tax

Net Income

Shares outstanding


(1) Includes a speculative distribution of "Productivity for Growth" costs; does not include commodity hedge mark-to-market cost.

(2) Includes neither "Productivity for Growth" costs, nor commodity hedge mark-to-market costs. This column is the one discussed in the narrative.

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