07 October 2010

PEP: Income Statement 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.  The reported EPS amount was 9.5 percent greater than the $1.09 PepsiCo made in the same quarter of 2009.

Core earnings, which exclude certain items items, increased from $1.08 to $1.22 per share in the third quarter.  Core earnings adjusted to exclude currency fluctuations were $1.24 per share in the latest period.  The Core figures are intended to provide better insight than reported GAAP results into the company's fundamental financial performance.

This post examines PepsiCo's Income Statement for the quarter and compares the entries on each line to our "look-ahead" estimates.  Reported earnings were $0.05 less than the $1.24 we had forecast for the third quarter, but core constant-currency earnings matched our target.

The principal sources for this review were the earnings announcement, the ensuing conference call presentation slides [pdf] and transcript [pdf], and the formal 10-Q report.

In a second article, we will report PepsiCo's scores as measured by the GCFR financial gauges.  The follow-up post will also provide the latest figures for the various financial metrics we use to analyze Cash Management, Growth, Profitability and Value.

Before getting into the details, we will take one 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.  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 acquisitions make it more challenging to compare PepsiCo's recent and historic results.

Please click here to see a normalized depiction of the actual and projected results for the just-concluded quarter, as well as the 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.

Revenue in the September quarter rose an acquisition-enhanced 40.0 percent, from $11.1 billion last year to $15.5 billion in the last three months.  Revenue growth was relatively unaffected by currency exchange rate fluctuations.

Revenue in the latest quarter surpassed our $15.4 billion target by 0.7 percent, a relatively minor amount.  We had estimated a 3.5 percent increase over estimated pro forma Revenue, and the actual rise was about 4.4 percent.

The following table lists PepsiCo Revenue growth by division.

Revenue ($M)3Q 20103Q-2009% change
Frito-Lay North America $3,244$3,1981.4%
Quaker Foods North America 407418-2.6%
Latin American Food 1,5421,39610.5%
PepsiCo Americas Beverages 5,7922,656118%
PepsiCo Europe 2,7621,87447.4%
PepsiCo Asia, Middle East and Africa 1,7671,53814.9%

The surge in PepsiCo Americas Beverage revenue was primarily due to the bottler acquisitions.  The 100+ percent gain is not a pro forma comparison.

The Cost of Goods Sold
in the quarter was $7.0 billion, or 45.2 percent of Revenue.  This ratio translates into a Gross Margin of 54.8 percent, which is 160 basis points more profitable than the 53.2 percent Gross Margin in last year's third quarter.

The Gross Margin surpassed our 54.0-percent target for the third quarter by a healthy 80 basis points. 

PepsiCo spent $5.68 billion, which was 36.6 percent of Revenue, on Sales, General, and Administrative expenses.  The latest amount includes $69 million for PBG/PAS merger and integration costs. 

The reported figure for SG&A exceeded our $5.39 billion estimate by a worrisome 5.3 percent. 

The $30 million operating charge for amortization of intangible assets was a little more than our $25 million estimate.

Subtracting the various GAAP operating expenses from Revenue yields Operating Income of $2.8 billion.  Operating Income increased 25.4 percent when compared to last year's third quarter.  Although Revenue and the Gross Margin were both better than we expected, higher SG&A costs resulted in Operating Income 3.5 percent below our $2.9 billion target for the third quarter.

Another perspective is gained by looking at Operating Profit by Division.

Core Operating Profit ($M)2Q 20102Q-2009% change
Frito-Lay North America $907$82210.3%
Quaker Foods North America 126131-3.8%
Latin America Foods 23819919.6%
PepsiCo Americas Beverages 1,01760767.5%
PepsiCo Europe 42331833.0%
PepsiCo Asia, Middle East and Africa 244297-17.8%

Turning to non-operating items, the recent acquisitions have made Bottling equity income a relatively insignificant item, as anticipated.  Income declined from $146 million to $10 million for this item.

The Net Interest Expense was $151 million, up substantially from last year's $70 million.  The increase was due to higher debt balances required to complete the bottler acquisitions. The interest expense was less than the $170 million we budgeted.

The quarter's effective income tax rate of 27.4 percent was more burdensome than the 25 percent rate we had used for our estimate.  PepsiCo continues to expect a full-year reported tax rate of 23 to 24 percent.

Net Income was $1.92 billion ($1.19 per share), compared to $1.72 billion ($1.09 per share) in last year's third quarter.  Our estimate for the latest quarter was $2.04 billion ($1.24 per share).

Core earnings of $1.97 billion ($1.22 per share) was closer to our estimate. Core earnings rose 16 percent, from $1.705 billion ($1.08 per share).

Full disclosure: Long PEP at time of writing.

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