22 March 2011

PEP: Financial Gauge Analysis for the December 2010 Quarter

We have updated the various financial metrics we use to analyze PepsiCo's (NYSE: PEP) 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-K.

A previous GCFR article examined in some detail PepsiCo's Income Statement for the December-ending fourth quarter of fiscal 2010.  The company earned $0.85 per diluted share on a GAAP basis, 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.  Core earnings surpassed our target by $0.01 per share.

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 currently 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 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 paid $3.8 billion for 66 percent of Wimm-Bill-Dann, and it has offered to purchase the remaining shares.  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.

Now we turn to the financial gauges.  The latest quarterly results produced the following changes to the scores:
  • Overall: 34 of 100 (down from 36)
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.

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 Management25 Dec 201004 Sep 201026 Dec 20095-Yr Avg
Current Ratio1.
LTD to Equity93.1%91.1%42.4%44.5%
Debt/CFO (years)
Inventory/CGS (days)44.446.248.646.5
Finished Goods/Inventory47.2%44.3%45.0%45.3%
Days of Sales Outstanding (days)39.541.641.141.4
Working Capital/Revenue4.2%5.1%6.9%5.4%
Cash Conversion Cycle Time (days)-47.4-46.8-54.4-50.9
Gauge Score (0 to 25)11101413
The Cash Management gauge edged up a point after three consecutive quarters at 10 points.

PepsiCo's debt soared in 2010 when the company issued securities to finance the two bottler acquisitions.  The ratio of Long-term Debt to Shareholders' Equity more than doubled over the last year.  Total debt (long- and short-term) relative to Cash Flow from Operations increased by a factor of 2.5 (3 years vs. 1.2 years).

The additional debt increased Current Liabilities and, as a result, reduced the Current Ratio below its historical average.

The Inventory level decreased modestly, which we consider favorable, compared to last quarter and last year.  But, the proportion of Finished Goods in the Inventory increased, which we do not.

The decrease in Days of Sales Outstanding hints at improved cash efficiency.  The decrease in the amount of Working Capital, relative to Revenue, tells a similar story.

Growth25 Dec 201004 Sep 201026 Dec 20095-Yr Avg
Revenue Growth33.8%24.2%0.0%13.3%
Operating Profit Growth4.5%3.0%7.9%7.8%
CFO Growth24.3%21.3%-2.9%7.6%
Net Income Growth6.3%22.1%15.6%3.3%
Gauge Score (0 to 25)913611
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 slipped as the Net Income growth rate declined.

It's important to understand that the bottler acquisitions in early 2010 inflated the Revenue growth rate relative to 2009.  Pro forma revenue growth was much more modest 3.7 percent. 

Although Revenue increased, the ratio of Revenue to Total Assets declined.  In other words, Assets grew faster than Revenue, which is not the ideal situation.

Cash Flow from Operations during the last four quarters also expanded significantly.  The bottler acquisitions were responsible for most of the growth, but changes in Working Capital also helped.

Net Income did not match this robust growth rate.  Earnings growth was hampered by merger and integration charges, inventory adjustments, and a currency devaluation in Venezuela.

Robust sales growth rates will be harder to achieve after the one-year anniversary of the bottler acquisitions.  However, the earnings may get a boost as synergies are realized and integration expenses wane.

Profitability25 Dec 201004 Sep 201026 Dec 20095-Yr Avg
Operating Expense/Revenue85.4%84.5%81.2%82.6%
Free Cash Flow/Invested Capital17.0%18.9%23.8%23.7%
Accrual Ratio8.1%7.2%3.9%4.1%
Gauge Score (0 to 25)9101513

The Profitability gauge lost recently gained point on relatively minor changes to relevant financial metrics.

The weaker operating margin (i.e., higher expenses per revenue dollar) weighed on the gauge score.  Special acquisition-related expenses probably deserve most of the blame.  Higher commodity costs in some areas might have also been a factor, but the company's hedging activities makes this harder to determine.

 Returns -- both earnings and cash flow -- on Invested Capital are not as robust as last year.   Higher debt levels inflate the denominator, which puts pressure on the percent returns.

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.

Value25 Dec 201004 Sep 201026 Dec 20095-Yr Avg
P/E vs. S&P 500 P/E
Enterprise Value/Cash Flow (EV/CFO)14.715.214.815.7
Gauge Score (0 to 25)77117
Share Price ($)$65.69$65.57$60.96-

The Value gauge was steady in the December quarter at the modest 7-point score.  The negligible gain in the share price contributed to this stability.

The Price/Earnings multiple was remained near 16, not much higher than it was a year earlier.

Sales growth resulting from the bottler acquisitions pushed down the Price/Sales ratio.

The Enterprise Value to Cash Flow ratio was also remarkably steady.

The gauge score is hurt by our version of PEG ratio being too high.  Acquisition expenses pulling down the earnings growth rate have had a negative effect on the PEG ratio.

Overall25 Dec 201004 Sep 201026 Dec 20095-Yr Avg
Gauge Score (0 to 100)34364840

The Growth gauge was the one most affected by PepsiCo's fourth-quarter results, and it lost 4 points.  It was pressured by the decline in the earnings growth rate.

The two large bottler acquisitions that closed during the first quarter of 2010 have skewed some of the financial ratios that determine the gauge scores, obscuring changes in business fundamentals.  Conclusions need to deferred until the acquisitions are more better integrated.  Bottom-line earnings should benefit from future operational efficiencies and the end of merger/integration spending ($800 million in 2010).

Full disclosure: Long PEP at time of writing.

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