09 June 2010

PEP: Look Ahead to June 2010 Quarterly Results

This post describes our model of PepsiCo's (NYSE: PEP) Income Statement for fiscal 2010's 12-week second quarter, which will end on 12 June 2010.

The purpose of the model is to establish a baseline for identifying surprises, positive or negative, in the quarterly results the company will report.  Estimates for each line of the Income Statement are derived from management's guidance, the company's historical financial results, and other publicly available data.

The model for the second quarter is particularly uncertain because of PepsiCo's recent acquisitions of its two largest bottlers.

First, we present 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

Food and Beverage companies can be considered defensive investments because they are relatively less affected by economic slumps.

On 26 February 2010, PepsiCo completed acquisitions for $7.8 billion of Pepsi Bottling Group, Inc., and PepsiAmericas, Inc.  These simultaneous deals made PepsiCo one of largest consumer staple firms in the U.S.  The company's market capitalization is now around $100 billion.

PepsiCo then hiked its annual dividend by 7 percent, from $1.80 to $1.92 per share.

The newly combined company would have earned $6.75 billion ($4.09 per diluted share) on a pro forma basis in fiscal 2009 on Revenue of $57.5 billion.  The pro forma results eliminate the transactions that occurred between the three entities.  The acquisitions effectively added $800 million (13.6 percent) to PepsiCo's annual Net Income and $14.2 billion (33 percent) to Revenue.

As a result of the acquisitions, Pepsico asserted during its last conference call (transcript made available by Seeking Alpha) that it now has "one vertically integrated value chain [for beverages] just like [the] snacks business."  It will be "making decisions which benefit the total system without concern as to how the cost and benefits are shared between the brand and bottling operations."

PepsiCo changed its organizational structure to accommodate the bottlers.  For financial data reporting, PepsiCo now has six main divisions.

  • Frito-Lay North America
  • Quaker Foods North America
  • Latin American Food
  • PepsiCo Americas Beverages
  • PepsiCo Europe
  • PepsiCo Asia, Middle East and Africa.
While famously locked in a battle with Coca-Cola (NYSE: KO) for the soft-drink market, it is important to recognize the importance of PepsiCo's other product lines.  Frito-Lay North America had Revenue in 2009 of $13.2 billion, which was 30.6 percent of PepsiCo's total revenue prior the bottler acquisitions and 23 percent of total revenue afterward.

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 selections 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 earned $0.89 per diluted share on a GAAP basis in the 12-week quarter that ended 20 March 2010.  PepsiCo made $0.17 more per share, 23 percent, than the $0.72 it earned in the March 2009 quarter.  "Core earnings" increased from $0.71 to $0.76 per share.

Core earnings is a non-GAAP measure that provides insight into the company's fundamental financial performance, especially in an unusual quarter such as the last one.   Core earnings exclude the acquisition-related gains and expenses, inventory valuation adjustments, the effect of Venezuela's currency devaluation, and several other special gains and losses.

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

When the company announced its first quarter results on 22 April 2010, it articulated its expectations for the year's second twelve-week quarter and the year as a whole.

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, with about 6 percent growth in core constant currency EPS in the first half of the year, which includes a charge of approximately $40 million related to the Patient Protection and Affordable Care Act (PPACA) — which was signed into law in the second quarter of 2010 — and mid-teens core constant currency EPS growth in the second half of the year. Based on current spot rates, foreign exchange translation would represent a one percentage point unfavorable impact on the company’s full-year, core constant currency EPS.
This guidance for core earnings growth is consistent with statements made 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.
PepsiCo is 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.

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.

Before we can use a percent growth rate to estimate PepsiCo's Revenue in 2010's second quarter, we need to establish a year-earlier amount.  Unfortunately, PepsiCo did not provide quarterly pro forma results (only annual) reflecting the impacts of the recent acquisitions.

In the second quarter of 2009, PepsiCo reported Revenue of $10.6 billion, PBG reported Revenue of $3.5 billion, and PAS reported 13-week Revenue of $1.27 billion.  We will exclude 18.2 percent of PBG's Revenue and 22.5 percent of PAS's Revenue -- these percentages are estimates based on annual data -- as inter-party transactions.

2Q-2009 Pro forma Revenue estimate = $10.6 billion + [(1 - 0.183) * $3.5 billion] + [(12/13)*(1 - 0.225)*$1.27 billion]

    = $14.4 billion

To approximate Revenue in the second quarter of 2010, we will take the 2009 estimate and assume 4 percent growth.  The result is $15 billion.

We will assume that the Gross Margin in the second quarter will be near 2009's pro forma margin of 53.6 percent.

Our Revenue and Gross Margin estimates would translate into a projection for the Cost of Goods Sold of (1 - 0.536) * $15.0 billion = $7.0 billion.

Similarly, by looking at data from 2009, we expect the SG&A expense to be 36 percent of Revenue, or 0.36 * $15.0 billion = $5.4 billion.   We also added the $40 million health care charge mentioned in the guidance to this amount.

We're also estimating a $40 million charge for amortization of intangible assets, based on historical data.

These assumptions lead to Operating Income, as we define it, of $2.56 billion.  Note that this estimate does not include Productivity for Growth charges, mark-to-market commodity hedge costs, nor acquisition costs.

With the completion of the bottler acquisitions, Bottler equity income should become insignificant.  We're assuming interest expenses a little more than the first quarter's $150 million.

Applying a 25 percent effective income tax rate to pretax income of $2.4 billion would result in a tax provision of $600 million. 

Rolling up these figures, we obtain an estimate for Net Income of $1.8 billion, about $1.09 per share.

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.