10 February 2011

PEP: Income Statement Analysis for the December 2010 Quarter

PepsiCo (NYSE: PEP) earned $0.85 per diluted share on a GAAP basis in the 16-week, December-ending fourth quarter of fiscal 2010, down 6 percent from $0.91 in the same three months of 2009. 

Core earnings, which exclude certain items, increased from $0.90 to $1.05 per share.  The Core figures are intended to provide better insight than the reported GAAP results into the company's fundamental financial performance.  The differences between GAAP and Core results were significant in the latest quarter.  The most significant differences were a $0.13 per share charge for merger and integration costs and a $0.07 per share charge for debt repurchase expenses.

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 $0.19 less than our $1.04 EPS estimate, but the truer comparison is that Core earnings surpassed our target by $0.01 per share

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

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 over $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 in 2010 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."

PepsiCo changed its organizational structure after it acquired its 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.

In fiscal 2010, which included about 10 months of the acquired bottlers' operations, PepsiCo earned $6.3 billion on revenue of $57.8 billion.

In December 2010, PepsiCo reached an agreement to buy Wimm-Bill-Dann Foods (NYSE: WBD), a Russian dairy and juice firm.  PepsiCo will pay $3.8 billion for 66 percent of Wimm-Bill-Dann, and it will offer to purchase the remaining shares at a later date.  PepsiCo separately acquired Russian juice-maker Lebedyansky in 2008.

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.

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

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 December quarter rose an acquisition-enhanced 36.5 percent, from $13.3 billion last year to $18.2 billion in the last three months. 

Because the bottler acquisitions in 2010 inflate the Revenue growth rate, we made a separate growth-rate calculation that attempts to make the 2009 and 2010 periods more similar.   On this basis, the Revenue growth rate was closer to 5 percent.  Readers are cautioned that this pro forma rate is dependent on other estimates and assumptions.

Revenue in the latest quarter surpassed our $18.0 billion target by 0.7 percent, a trivial amount.  Revenue growth was relatively unaffected by currency exchange rate fluctuations.

The following table lists PepsiCo Revenue growth by division.

Revenue ($M)4Q 20104Q-2009% change
Frito-Lay North America$3,891 $3,888 0.1%
Quaker Foods North America566585-3.2%
Latin American Food2,2522,0629.2%
PepsiCo Americas Beverages6,2962,754128.6%
PepsiCo Europe3,0832,26436.2%
PepsiCo Asia, Middle East and Africa2,0671,74418.5%
Total$18,155 $13,297 36.5%

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 $8.36 billion, pretty close to the value we expected.  CGS was 46.0 percent of Revenue, which translates into a Gross Margin of 54.0 percent.  The Gross Margin was 130 basis points more profitable in the latest quarter than in the equivalent year-earlier period.

The Gross Margin surpassed our 53.5-percent target for the fourth quarter by 50 basis points. 

PepsiCo spent $7.53 billion, which was 41.5 percent of Revenue, on Sales, General, and Administrative expenses.  The reported figure for SG&A exceeded our $7.21 billion estimate by $315 million.  Of this difference, $263 million was due to non-core, pre-tax merger and integration costs. 

In other words, SG&A adjusted to exclude the non-Core expense was fairly close to expectations.

The $39 million operating charge for amortization of intangible assets was just under our $40 million estimate.

Subtracting the various GAAP operating expenses from Revenue yields GAAP Operating Income of $2.23 billion, up 9.7 percent relative to last year's fourth quarter. 

Non-GAAP Core Operating Profit was $2.49 billion, which beat our equivalent estimate by 3.8 percent.  Better-than-expected Revenue explains most of the difference.

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

Division Operating Profit ($M)4Q 20104Q-2009% change
Frito-Lay North America$1,027 $956 7.4%
Quaker Foods North America175190-7.9%
Latin America Foods38830128.9%
PepsiCo Americas Beverages73452240.6%
PepsiCo Europe218259-15.8%
PepsiCo Asia, Middle East and Africa614632.6%
Total$2,603 $2,274 14.5%

Turning to non-operating items, the recent acquisitions have made Bottling equity income a relatively insignificant item, as anticipated.

The Net Interest Expense was $366 million, much more than the $175 million we expected.  Much of the extra expense was due to a non-Core $178 million charge associated with a debt repurchase.  The interest expense was $230 million if the special charge is excluded. 

The greater-than-expected interest expense also reflects higher debt balances required to acquisitions and other purposes.

The quarter's effective income tax rate of 27.3 percent was more burdensome than the 25 percent rate we had estimated.

GAAP Net Income was $1.37 billion ($0.85 per share), compared to $1.43 billion ($0.91 per share) in last year's fourth quarter. 

Core earnings were $1.69 billion ($1.05 per share).  Our estimate for the quarter was $1.67 billion ($1.04 per share).

In summary, assessing the results of the December 2010 quarter was made more difficult by large acquisitions and by special charges.  However, Core results, which excludes special items, were mostly close to our expectations from the top to the bottom of the Income Statement.  Core EPS beat our equivalent target by $0.01.

Going forward, Pepsico commented that increasing commodity costs are likely to be a "major headwind" in 2011.  Margins will be under pressure because competitive concerns, at least in some markets, will limit the company's ability to raise prices.  Productivity improvements might make up some of the difference.

Full disclosure: Long PEP at time of writing.

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