19 October 2010

PEP: Financial Gauge Analysis for the September 2010 Quarter

PepsiCo (NYSE: PEP) earned $1.19 per diluted share on a GAAP basis in the fiscal 2010's 12-week third quarter, which ended on 4 September.  Earnings per share were 9.5 percent greater than the $1.09 PepsiCo made in the same quarter of 2009.

Core earnings, which exclude certain items, increased from $1.08 to $1.22 per share in the third quarter.

A previous article examined in some detail PepsiCo's Income Statement for the September quarter. 

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

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, which has a market value of approximately $110 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. 

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 Management04 Sep 201012 Jun 201005 Sep 20095-Yr Avg
Current Ratio1.
LTD to Equity91.1%98.4%48.6%40.3%
Debt/CFO (years)
Inventory/CGS (days)46.248.649.646.5
Finished Goods/Inventory44.3%44.0%41.1%45.5%
Days of Sales Outstanding (days)41.642.343.641.3
Working Capital/Revenue5.1%6.5%5.9%5.4%
Cash Conversion Cycle Time (days)-46.8-45.4-52.7-51.4
Gauge Score (0 to 25)10101513

The Cash Management gauge held its moderate 10-point score for the third straight quarter.  Positive and negative changes to the metrics since the last quarter balanced each other out. 

The most substantial change involved the amount of debt on PepsiCo's Balance Sheet, which had soared earlier this year when the company needed to finance the bottler acquisitions.   In the latest quarter, roughly $1 billion of debt shifted from the long-term account to the short-term account for debt due within the next year.  The ratio of  Long-term Debt to Shareholders' Equity was reduced by more than 7 percent, from 98 percent to 91 percent.  But, total debt (long- and short-term) barely changed relative to Cash Flow from Operations.

Relative to September 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 to the upside in the first quarter.

Growth04 Sep 201012 Jun 201005 Sep 20095-Yr Avg
Revenue Growth24.2%13.4%-0.5%11.6%
Operating Profit Growth3.6%3.3%9.3%11.5%
CFO Growth21.3%23.0%5.0%24.5%
Net Income Growth22.1%21.5%-8.0%11.3%
Gauge Score (0 to 25)1312411
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 the bottler acquisitions added considerable fuel to growth rates listed above.

Revenue, Cash Flow from Operations, and Net Income in the last four quarters (i.e., trailing year) are each 20-percent greater than they were in the four previous quarters.  The growth rates are dramatically better than they were last year.

The growth rates will moderate when the one-time boost fueled by the bottler acquisitions fades in significance.  Business fundamentals will then have to drive growth.

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

Profitability04 Sep 201012 Jun 201005 Sep 20095-Yr Avg
Operating Expense/Revenue84.5%84.2%82.9%82.4%
Free Cash Flow/Invested Capital18.9%18.1%21.9%22.7%
Accrual Ratio7.2%7.4%1.6%3.7%
Gauge Score (0 to 25)1091413

The Profitability gauge picked up a point as small improvement in the returns -- both earnings and cash flow -- on Invested Capital outweighed the slightly weaker Operating Margin.

Percent returns, although improving, are weaker than they had been in the past.   More debt has inflated the denominator, Invested Capital.

The Accrual Ratio has been made less relevant because so much cash was used in the bottler acquisitions.  In other circumstances, a rising Accrual Ratio would trigger a warning about Earnings Quality.

Value04 Sep 201012 Jun 201005 Sep 20095-Yr Avg
P/E vs. S&P 500 P/E
Enterprise Value/Cash Flow (EV/CFO)15.215.914.116.6
Gauge Score (0 to 25)76126
Share Price ($)$65.57$63.56$57.54-

The Value gauge benefited slightly as PepsiCo's Revenue and earnings outpaced the 14 percent increase in the company's share price over the last year.

The gauge score hasn't risen further because our version of PEG ratio is high and because further increases in Cash Flow are needed to get the EV/CFO ratio down.

Overall04 Sep 201012 Jun 201005 Sep 20095-Yr Avg
Gauge Score (0 to 100)36344940

The third-quarter results led to one-point improvements, not especially significant, in three of the gauge scores.   Two of the points made it to the bottom-line Overall score.

The two large bottler acquisitions that closed during the first quarter have skewed some of the financial ratios and obscured changes in business fundamentals.  Conclusions need to deferred until the integration is more mature and the ultimate financial structure of the new, bigger PepsiCo is more apparent.  Earnings should benefit from operational efficiencies resulting from the acquisitions.  The end of merger/integration spending ($536 million in the first 36 weeks of the year), money that is being spent to realize these efficiencies, will also help the bottom line.

Full disclosure: Long PEP at time of writing.

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