25 March 2010

PEP: Look Ahead to March 2010 Quarterly Results

This post describes our model of PepsiCo's (NYSE: PEP) Income Statement for the 12-week first quarter of fiscal 2010, which ended on 20 March.

The intent of our look-ahead exercises is to produce a baseline for identifying surprises, positive or negative, in the reported data.  GCFR estimates are derived from guidance provided by company management, when available, and the company's historical financial results.

In this case, the model is especially uncertain because PepsiCo is in a state of transition, as described below.

First, we set the stage with some background information about PepsiCo and the business environment in which it is currently operating.

PepsiCo, Inc., is a leading global purveyor of beverages and snacks.  The company is well regarded for good management, steady growth, and significant international exposure.  The Food and Beverage industries are considered defensive investments because they are relatively less affected by economic slumps.

The company's $7.8 billion acquisitions of its two largest bottlers -- Pepsi Bottling Group, Inc. (NYSE: PBG) and PepsiAmericas, Inc., (NYSE: PAS) -- closed on 26 February 2010.  Limited pro forma financial information the combined company was included in the prospectus dated 12 January 2010.  

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, prior to the bottler acquisitions, took in more Revenue, and it contributed more to Operating Profit, than the PepsiCo Americas Beverages unit.

The rising number of health-conscious consumers are both a challenge and an opportunity for PepsiCo and its rivals.  There has been less demand for carbonated beverages in the U.S., but bottled water, tea, and juice have become profitable alternatives.  Similarly, snacks with excessive salt, sugar or fat are publicly criticized, but there is a growing market for selection that are more nutritious or organic.  PepsiCo recognizes this opportunity:  the company has established a series of goals for improving the the nutritional content of its products.

PepsiCo has cut recurring costs through workforce reductions and plant closures.  This plan, under the banner "Productivity for Growth," led to pretax charges in the fourth quarter of 2008 totaling $543 million and smaller charges in fiscal 2009.

On 12 March 2010, PepsiCo hiked its annual dividend by 7 percent, from $1.80 to $1.92 per share.

Now, we are ready to look ahead to PepsiCo's results for the March 2010 quarter.

PepsiCo's initial guidance for fiscal 2010 was included in the press release, issued 11 February 2010, announcing fourth-quarter and 2009 results.

Fiscal 2010 Guidance
For fiscal 2010, the company is targeting an 11 to 13 percent growth rate for core constant currency EPS off of its fiscal 2009 core EPS of $3.71. This guidance assumes the company will close the bottling transactions by the end of February. The earnings guidance also reflects roughly 8 to 9 percent growth from “base” PepsiCo, with additional growth coming from a combination of financial and accounting accretion from the bottling transaction plus year-one synergies (totaling about 5 points of growth) partially offset by strategic investment spending. As a result of its recent integration planning efforts, the company is now targeting pre-tax annualized synergies from the proposed bottler acquisitions of approximately $400 million once fully implemented by 2012, with one-time costs of about the same amount. Synergies to be realized in 2010 are expected to total approximately $125 to $150 million. ...

This guidance for core earnings growth was confirmed on 22 March 2010 at the first day of PepsiCo's Investor Meeting for 2010.

PepsiCo, Inc. (“PepsiCo” or “we”) today confirmed its guidance of 11-13% core constant currency EPS growth for 2010 and low-double-digit core constant currency EPS growth for 2011 and 2012.

It's important to understand that "core" earnings exclude the following:
  • Commodity mark-to-market expenses,
  • Integration costs related to the mergers with PBG and PAS.
  • The gain or loss on previously held equity interests in PBG and PAS,
  • The post-merger one-time impact of fair value adjustments to acquired inventory,
  • The one-time charge related to hyperinflationary accounting and devaluation in Venezuela,
  • A contribution to the PepsiCo Foundation, Inc.,
  • Any additional restructuring or impairment costs and transaction costs related to the mergers with PBG and PAS.

Interestingly, PepsiCo was unable to reconcile core constant currency earnings guidance to reported GAAP results ...

because we are unable to predict the 2010-2012 full-year impact of foreign exchange or the mark-to-market net gains or losses on commodity hedges due to the unpredictability of future changes in foreign exchange rates and commodity prices. Additionally, with respect to our mergers with PBG and PAS, we are unable to predict the amounts or timing of any additional restructuring or integration costs. Therefore, we are unable to provide a reconciliation of this measure.

PepsiCo's acquisition of the two bottlers closed about three weeks prior to the quarter.  In other words, PepsiCo operated as the combined company for only 25 percent of the period.

The guidance quoted above does not address Revenue, but PepsiCo said at the recent Investor's Conference they are targeting "mid to high single digit" Revenue growth over the next three years on a constant currency basis.

Our Revenue estimate for the first quarter of 2010 is three percent growth relative to PepsiCo's Revenue in the first quarter of 2009  ($8.263 billion), plus 25 percent of PBG's Revenue ($2.507 billion), plus 25 percent of PAS's Revenue ($1.058 billion). 

This totals to:

(1.03 * $8.263 billion) + (0.25 * $2.507 billion) + (0.25 * $1.058 billion)
=$9.402 billion

To estimate the Gross Margin for the first quarter of 2010, we assume each operating unit will achieve the margin it achieved over the course of fiscal 2009.  The Gross Margins for PepsiCo, PBG, and PAS were, respectively, 53.5 percent, 44 percent, and 40 percent of Revenue.  Weighting these margins based on expected Revenue contribution yields an estimated Gross Margin for the first quarter of 52.5 percent.

Our Revenue and Gross Margin estimates would translate into a projection for the Cost of Goods Sold of (1 - 0.525) * $9.4 billion = $4.5 billion.

Similarly, by looking at data from 2009, we expect the SG&A expense to be around 35 percent of Revenue, or 0.35 * $9.4 billion = $3.3 billion.

We're also estimating a $15 million charge for amortization of intangible assets, based on historical data.

These assumptions lead to Operating Income, as we define it, of $1.63 billion.  Note that this estimate does not include Productivity for Growth charges, mark-to-market commodity hedge costs, nor acquisition costs.

We are assuming a relatively light $50 million for Bottler equity income because this category became irrelevant during the quarter.  We're assuming interest expenses will be greater than normal because of the acquisition expense.

We're using a 28 percent effective income tax rate, which would result in a tax provision of $443 million. 

Rolling up these figures, we're looking for Net Income of $1.14 billion.  We're uncertain how many shares will be outstanding, so our EPS estimate is a shaky $0.70.

Please click here to see a full-sized, normalized depiction of the projected results next to PepsiCo's quarterly Income Statements for the last couple of years.  Please note that our organization of revenues, expenses, gains, and losses, which we use for all analyses, can and often does differ in material respects from company-used formats.  The standardization facilitates cross-company comparisons.

Full disclosure: Long PEP at time of writing.  No position in any other security mentioned.

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