08 September 2010

PEP: Look Ahead to September 2010 Quarterly Results

This post describes our model of PepsiCo's (NYSE: PEP) Income Statement for fiscal 2010's 12-week third quarter, which ended on 5 September 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.

We begin by reviewing 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, which has a market value of approximately $100 billion, is well regarded for good management, steady growth, and significant international exposure

Businesses, such as PepsiCo, that sell consumer staples are considered defensive investments because they are relatively less affected by economic slumps.  These firms also tend to pay generous dividends, and this is true for PepsiCo.  The company hiked its annual dividend this year by 7 percent, from $1.80 to $1.92 per share.

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.

On 26 February 2010, PepsiCo completed acquisitions of Pepsi Bottling Group, Inc., and PepsiAmericas, Inc., for $7.8 billion in total.  These transactions give PepsiCo, according to statements made during a conference call, "one vertically integrated value chain [for beverages] just like [the] snacks business." PepsiCo 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."

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.

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.

The rising number of health-conscious consumers is 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 $0.98 per diluted share on a GAAP basis in the fiscal 2010's 12-week second quarter, which ended on 12 June.  The reported EPS amount was 7 percent lower than the $1.06 PepsiCo made in the same quarter of 2009.

Core earnings increased from $1.02 to $1.10 per share in the second quarter.  Core earnings exclude acquisition-related gains and expenses, inventory valuation adjustments, and other unusual gains and losses.  (The exclusions from the GAAP figures are intended to provide better insight into the company's fundamental financial performance.)

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

When the company announced its second-quarter results on 20 July 2010, it updated its expectations for fiscal 2010 Core earnings:

For fiscal 2010, the company is targeting an 11 to 13 percent growth rate for core constant currency EPS from its fiscal 2009 core EPS of $3.71. Based on current spot rates, foreign exchange translation would represent a one percentage point unfavorable impact on the company’s full-year, core EPS. As a result, growth in core EPS for the year is expected to be in the 10 to 12 percent range.
This guidance for Core earnings growth is consistent with statements made on 22 March 2010 at PepsiCo's Investor Meeting.

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.

PepsiCo has not provided guidance for its GAAP-compliant results.  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.

The guidance quoted above does not address Revenue.  PepsiCo said at the Investor's Conference they are targeting "mid to high single digit" Revenue growth over the next three years on a constant currency basis.  However, Revenue earlier this year has been less than that goal.

Before we can use a percent growth rate to estimate PepsiCo's Revenue in 2010's third 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 bottler acquisitions.

In the third quarter of 2009, PepsiCo reported Revenue of $11.1 billion, PBG reported Revenue of $3.6 billion, and PAS reported 13-week Revenue of $1.13 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.

3Q-2009 Pro forma Revenue estimate = $11.1 billion + [(1 - 0.182) * $3.6 billion] + [(12/13)*(1 - 0.225)*$1.13 billion]

    = $14.86 billion

To approximate Revenue in the third quarter of 2010, we will take the 2009 estimate and assume 3.5 percent growth as in the second quarter.  The result is $15.4 billion.

We will assume that the Gross Margin in the third quarter will be 54 percent, which is a little less profitable than the second quarter's 54.4 percent

Our Revenue and Gross Margin estimates would translate into a projection for the Cost of Goods Sold of (1 - 0.54) * $15.4 billion = $7.0 billion.

By reviewing previous third quarters, we expect the SG&A expense to be 34 percent of Revenue, or 0.35 * $15.4 billion = $5.4 billion.

We're also estimating a $25 million charge for amortization of intangible assets, based on historical data.

These assumptions lead to estimated Operating Income, as we define it, of $2.9 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 similar to the second quarter's $170 million.

Applying a 25 percent effective income tax rate to pretax income of $2.73 billion would result in a tax provision of $680 million. 

Rolling up these figures, we obtain an estimate for Net Income of $2.04 billion, about $1.24 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.

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