28 March 2009

PEP: Look Ahead to March 2009 Quarterly Results

The GCFR Overall Gauge of PepsiCo (NYSE: PEP) rose from 31 to 47, of the 100 possible points, in the super-sized fourth-quarter of 2008, which consisted of the 16 weeks that ended on 27 December 2008.  Our original and updated analysis reports explained this result in some detail.

The recent tweaks to our gauges bumped up the Overall score by three points to 52.

PepsiCo's fourth-quarter results were adversely affected by the implementation of cost-cutting initiatives and by the stronger U.S. dollar.  Differences in currency exchange rates reduced Revenue growth by 5.5 percent.   A more enduring concern, however, might be the flat performance of PepsiCo's Food and (especially) Beverage operations in the Americas.  These businesses are supposedly more immune than most to economic swings.

Why did our Overall assessment of PepsiCo improve?  The main reason is that the contrarian Value gauge jumped in response to PepsiCo's share price falling from $71.27 to $54.77 during the last three months of 2008.  The lower price made the valuation metrics we track significantly more appealing.  The second explanation is that the Profitability gauge was impelled upward by a higher ROIC, greater Free Cash Flow to Invested Capital, and a lower Accrual Ratio.  The latter metric suggested better quality of earnings.

To look ahead, we've modeled PepsiCo's Income Statement for the 12 weeks that ended on 21 March 2009.  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, 23 April 2009.  GCFR estimates are derived from trends in the historical financial results and guidance provided by company management.

First, we present some background information.

PepsiCo, Inc., 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.

The company is reducing its workforce and number of plants.  This plan, under the banner "Productivity for Growth," led to pretax charges in the fourth quarter of 2008 totaling $543 million.  Additional related charges of $32 to $57 million are expected in fiscal 2009.

The fourth quarter of 2008 was the first to include financial results for the recently acquired potato-chip maker Marbo in Serbia and the juice-maker Lebedyansky in Russia.  The latter was a joint acquisition with Pepsi Bottling Group, Inc. (NYSE: PBG).

For 2009, PepsiCo shuffled some international businesses from one reporting segment to another.  The company also changed how it reports "bottler case sale" volume in North America.  Neither change affect GCFR analyses.

PepsiCo's press release announcing fourth-quarter 2008 results included the following guidance for 2009:

2009 Guidance

PepsiCo is confident in the underlying strength of its business and in its ability to generate solid top- and bottom-line performance in 2009 on a constant currency basis. However, with all of the uncertainties in the current macroeconomic environment, the company believes that it is prudent to offer a much wider range in our guidance than it has in the past. PepsiCo is therefore providing full-year 2009 guidance for both net revenue and core EPS of mid- to high-single-digit growth on a constant currency basis. The company anticipates foreign exchange, at current spot rates, would adversely impact constant-currency core EPS by approximately 8 percentage points.
In 2009, given current market conditions, the company does not anticipate selling shares of its anchor bottlers, The Pepsi Bottling Group (PBG) or Pepsi Americas, Inc. (PAS). PBG and PAS share sales collectively added $0.06 to PepsiCo’s full year 2008 core EPS, and the assumption that shares will not be sold in 2009 has been factored into 2009 guidance.
The company expects the first half of 2009 — and the first quarter in particular — will present the most difficult year-over-year comparisons, in part reflecting commodity costs and foreign exchange rates.
PepsiCo will make a discretionary $1 billion contribution to its pension fund ($640 million after-tax cash impact). Excluding this item, cash from operating activities is expected to be about the same as 2008. The company expects a high-single-digit decrease in net capital spending.
In addition, the company intends, subject to market conditions, to spend up to $2.5 billion repurchasing its shares in 2009. The company expects its full-year reported and core tax rates to be about the same as the core tax rate in 2008.

[emphasis added in text]

To establish a Revenue target for the first quarter of 2009, we start with the company's guidance for a Revenue percentage growth rate for the year, on a constant currency basis, in the mid- to high-single digits.  This is suggestive of a range between, say, 5 and 9 percent.  The statement that the first quarter will be particularly challenging lowers our sights towards the bottom half of the range, although commodity costs will degrade Earnings more than Revenue.

The effect of foreign exchange on Revenue is a major concern because PepsiCo's operations outside of the U.S. generated 48 percent of Revenue in 2008.  PepsiCo, of course, operates in many different currencies.  The company also takes certain steps to reduce its exposure to exchange rate changes.

We can't possibly model this complexity, so we will make the crude assumption that the Euro can stand as a proxy for the various currencies handled by the non-U.S. half of PepsiCo.  The Euro's 14 percent decline (OANDA was especially helpful in determining this figure) from the first quarter of 2008 to the first quarter of 2009 would, in this construct, cut PepsiCo's Revenue by about 7 percent.

Given the expectation for constant-currency Revenue growth of 5 to 7 percent (i.e., the bottom half of the range above), PepsiCo's overall Revenue growth could be flat to minus 2 percent.  We'll pick minus 1 percent as our target.

In the first fiscal quarter of 2008, PepsiCo's Revenue was $8.33 billion.  Our estimate for the first 12 weeks of 2009 is, therefore, 0.99 * $8.33 billion = $8.25 billion.

PepsiCo's Gross Margin has averaged 52.9 percent in 2008, down 1.35 percent from 2007.  We estimate it will be 52.5 percent in the first quarter of 2009.  In other words, we're projecting the Cost of Goods Sold to be (1 - 0.525) * $8.25 billion = $3.9 billion. 

In the first fiscal quarter of the last five years, SG&A expenses averaged 36.4 percent of Revenue.  Therefore, our assumption for these costs is 0.364 * $8.25 billion = $3.0 billion.

We'll assume a $15 million charge for amortization of intangible assets.  This estimate is based on quarterly charges in the last couple of years.

These assumptions would lead to Operating Income, as we define it, of $1.3 billion.  This would be a 15.5 percent below 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.

Bottler equity income will probably be down given that the company indicated that it would not be selling shares in its bottling operations.  We will set $50 million target.

A $75 million charge for net Interest Expense seems reasonable given recent history.  This would result in pre-tax income of $1.3 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 a tax provision of $350 million.  The rate can be volatile from quarter to quarter.

Rolling up these figures, we're looking for Net Income of $940 billion ($0.60/share).  The absolute and per-share figures are -18 and -14 percent, respectively, less than in the March 2008 quarter.

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.



  1. Great analysis!
    Is there a way to find companies that are in the green part of the overall gauge? I am interested to see which companies fit the bill.

  2. Jae,

    Thank you very much for the kind words. I'm a fan of your work at Old School Value http://www.oldschoolvalue.com

    A second thank you for including GCFR posts in your Recommended Reading lists.

    Unfortunately, there is no easy way at the current time to identify companies with high (or low) gauge scores. However, this might change soon.

    The choke point in my approach today is that I manually enter detailed Balance Sheet, Income Statement, and Cash Flow data for 20 or more quarters into a separate spreadsheet for each company. While doing so, I adjust the reported data to conform to normalized presentation formats.

    While I have automated major parts of the work required to compute GCFR gauges scores, I haven't found it productive to automate data importation because every company uses a unique presentation format for their financial statements. Also, companies change formats frequently and without warning.

    The good news is that the ongoing transition to XBRL should eventually make manual data entry unnecessary. I haven't yet figured out how to exploit XBRL, but I have been studying the problem.

    If you want to try to compute the gauge scores yourself, some of the earliest GCFR posts describe the methodology. I need to update some older posts to reflect changes to some weighting factors, but there is enough there in the record for someone to get started.

  3. Thanks for the detailed response. In the meantime, I'll have to go through your past reports in search of some great companies.