15 August 2010

PEP: Financial Gauge Analysis for the June 2010 Quarter

PepsiCo (NYSE: PEP) earned $0.98 per diluted share on a GAAP basis in the fiscal 2010's 12-week second quarter, which ended on 12 June.  Earnings per share declined 7 percent when compared to the $1.06 PepsiCo made in the same quarter of 2009.

Core earnings, however, rose from $1.02 to $1.10 per share in the second quarter.  Core earnings exclude acquisition-related and other unusual items.

A previous article examined PepsiCo's Income Statement for the June quarter. 

We have now updated the various financial metrics we use to analyze Cash Management, Growth, Profitability and Value.  This post reports on the metrics for PepsiCo and the associated financial gauge scores.  The metrics were calculated using data from PepsiCo's current and historical financial statements, including the latest 10-Q.

Before getting into the details, we will take a step back to introduce the subject of today's analysis.

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 company's $7.8 billion acquisitions of Pepsi Bottling Group, Inc., and PepsiAmericas, Inc., made PepsiCo one of most valuable consumer staple firms in the U.S.  The company claims that the integration of the bottlers will "help create a more fully integrated supply chain and go-to-market business model, to improve the effectiveness and efficiency of the distribution of our brands and to enhance our revenue growth."

Additional background information about PepsiCo and the business environment in which it is currently operating can be found in the look-ahead.

After a major corporate reshaping, such as PepsiCo's bottler acquisitions, the gauge scores can be volatile for several quarters.  Caution (and patience) is necessary.  Until the transformed company gets a year or so under its belt, financial changes that are indicative of long-term performance are likely to be obscured by transient conditions.

With this important caveat, PepsiCo's latest quarterly results produced the following changes to the gauge scores:

The current and historical values for the financial metrics that determine the gauge scores are listed below, with some brief commentary.  Readers are encouraged to verify these figures and calculate others as they see fit using the filings available at the SEC's web site and elsewhere.

Cash Management12 Jun 201020 Mar 201013 Jun 20095-Yr Avg
Current Ratio1.
LTD to Equity98.4%92.1%58.6%36.2%
Debt/CFO (years)
Inventory/CGS (days)48.649.650.246.3
Finished Goods/Inventory44.0%44.3%41.5%45.6%
Days of Sales Outstanding (days)42.342.644.141.2
Working Capital/Revenue6.5%7.4%6.0%5.5%
Cash Conversion Cycle Time (days)-45.4-47.4-49.7-52.1
Gauge Score (0 to 25)10101413

The Cash Management gauge held its moderate 10-point score as positive changes in some metrics relative to the March figures were balanced my negative changes in others. 

The most substantial changes involve PepsiCo's long- and short-term debt.  Long-term Debt soared nearly 140 percent, from $8.2 billion in June 2009 to $19.6 billion this year.  The new debt was used to finance the bottler acquisitions and other corporate activities.  Short-term obligations also surged, from less than $500 million when 2010 began to $4.5 billion in June.  The extent of the added Balance Sheet leverage, relative to Shareholders' Equity and Cash Flow from Operations, can be seen above.  The leverage increase is significant but not especially worrisome for a company with PepsiCo's resources.

Relative to June 2009, the Inventory level decreased modestly, which we consider favorable, but the proportion of Finished Goods in the Inventory increased, which we do not.  The addition of bottler Inventory to the mix might explain the latter's rise.

The small decrease in Days of Sales Outstanding hints at a possible cash efficiency improvement.  The amount of Working Capital, relative to Revenue, has returned to its normal range after a small spike in the first quarter.

Growth12 Jun 201020 Mar 201013 Jun 20095-Yr Avg
Revenue Growth13.4%2.7%2.5%9.8%
Operating Profit Growth3.3%4.8%10.1%11.2%
CFO Growth23.0%17.5%-11.4%24.4%
Net Income Growth21.5%21.7%-13.0%15.1%
Gauge Score (0 to 25)1212110
Revenue, CFO, and Net Income growth rates compare the last four quarters to the four previous quarters.
The Operating Profit rate is the annualized rate of growth in Operating Profit after Taxes over the last 16 quarters.

The Growth gauge also remained steady, although there were some significant positive changes in the underlying metrics.  It's certainly encouraging to see Revenue, Cash Flow from Operations, and Net Income growth rates that were tepid or negative a year ago now with double-digit positive figures.  In time, it will become clearer whether the growth can be sustained when not propelled upward by acquisitions.

The amount of Revenue relative to Assets is less than last year because of the Balance Sheet expansion, but the 5.7 percent rise in the last quarter is promising.

Profitability12 Jun 201020 Mar 201013 Jun 20095-Yr Avg
Operating Expense/Revenue84.2%83.4%83.6%82.4%
Free Cash Flow/Invested Capital18.1%17.8%19.7%21.6%
Accrual Ratio7.4%7.9%7.1%4.1%
Gauge Score (0 to 25)991113

The Profitability gauge was adversely affected by the weaker Operating Margin (i.e., higher expenses), but this downward pressure was offset by slight improvements in returns -- both earnings and cash flow -- on Invested Capital in the last three months.

These percent returns are, however, less than they were last year.  More debt has increased the denominator, Invested Capital.

The Accrual Ratio increased in part because of the cash used in the bottler acquisitions.  In other circumstances, this would trigger a warning about Earnings Quality,

Value12 Jun 201020 Mar 201013 Jun 20095-Yr Avg
P/E vs. S&P 500 P/E
Enterprise Value/Cash Flow (EV/CFO)15.917.114.416.7
Gauge Score (0 to 25)65146
Share Price ($)$63.56$66.56$53.65-

The Value gauge benefited, ever so slightly, from the 4.5 percent decrease in PepsiCo's price per share during the June quarter of 2010.  However, the shares were still trading at a much higher price than they were in mid-2009.  This kept the gauge score in check.

The share price is back over $65.

The P/E multiple has been temporarily inflated by merger and integration costs, which were $464 million in the first 24 weeks of fiscal 2010.

Overall12 Jun 201020 Mar 201013 Jun 20095-Yr Avg
Gauge Score (0 to 100)34324740

The second quarter's results did not lead to any significant gauge score changes.  Value rose a point, and the others stayed the same.

The two large bottler acquisitions that closed during the first quarter have skewed some of the financial ratios and obscured changes in business fundamentals.  As we mentioned three months ago, conclusions need to deferred until the integration is more mature and the ultimate financial structure of the new, bigger PepsiCo is more apparent.

Full disclosure: Long PEP at time of writing.

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