PEP: Financial Analysis through December 2007

We have analyzed PepsiCo's (PEP) preliminary financial results for the quarter that ended on 29 December 2007. Our evaluation will be updated after the company formally submits a complete 10-Q report to the SEC.

PepsiCo is a leading global purveyor of beverages and snacks. The company is known for good management, steady growth, significant international exposure, and the defensive characteristics of the food and beverage industries. While famously locked in a battle with Coca-Cola for the soft-drink market, PepsiCo's snack food business results in a more diversified company. In the North American markets, the Frito-Lay division takes in more revenue and contributes more to operating profit than the Pepsi Bottling division.

When we analyzed PepsiCo after the September quarter, the Overall score was a modest 39 points. Of the four individual gauges that fed into this composite result, Growth was the strongest at 23 points. Value was weakest at 3 points.

Now, with the available data from the December 2007 quarter, our gauges display the following scores:

• Cash Management: 8 of 25
• Growth: 5 of 25
• Profitability: 11 of 25
• Value: 0 of 25
  

• Overall: 22 of 100
  

Before we examine the factors that affected each gauge, let's compare the latest quarterly Income Statement to our previously announced expectations.

($M)		Dec 2007 (actual)	Dec 2007 (predicted)	Dec 2006 (actual) (1)
Revenue		12346	10951	10570
Op expenses
	CGS	(5784)	(4928)	(4830)
	SG&A	(4811)	(4271)	(4097)
	Amortization, etc.	(21)	(60)	(54)
Operating Income		1730	1692	1589
Other income
	Equity income	95	140	113
	Interest, etc.	(28)	(25)	(4)
Pretax income		1797	1807	1698
Income tax		(535)	(501)	(128)
Net Income		1262	1307	1826
		$0.77/sh	0.79/sh	1.09/sh

1. Restated


Revenue soared in the December 2007 quarter. The reported figure was 12.7 percent above our estimate and 16.8 percent greater than in the year-earlier quarter. Revenue growth at PepsiCo International was especially strong, up 26 percent. The weak dollar contributed to the sales surge, but the company also reported gains in both volume and pricing.

We thought the Cost of Goods Sold (CGS) would be 45 percent of Revenue, and the actual value was 46.8 percent. As shown in the figure, this is a relatively high percentage for PepsiCo; it probably reflects the rise in commodity prices. Sales, General, and Administrative (SG&A) expenses were 39.0 percent of Revenue, matching our prediction. SG&A costs are always higher in the fourth quarter than the others. One of these entries, CGS or SG&A, includes a $102 million restructuring charge. Amortization of intangible assets was $39 million less than we expected.

The Revenue and CGS values far above expectations nearly canceled each other out. Operating Income was only 2.25 percent above the forecast value.

Non-operating income was $48 million less than expected. The Income Tax Rate was 29.8 percent, instead of the predicted 27.7 percent. The higher rate was enough to pull Net Income below our prediction, despite the fabulous top-line Revenue figure, by 3.4 percent.


Cash Management. This gauge decreased from 13 points in September to 8 points now.

The measures that helped the gauge were:

• LTD/Equity = 24.2 percent, up from 16.6 percent a year ago, but an easily managed level
• Cash Conversion Cycle Time (CCCT) = -59.6 days, up from -64.3 days; we're not sure what to make of a negative value for this measure of efficiency.
• Debt/CFO = 0.6 years, easily affordable, although slightly higher than previous levels.
  

The measures that hurt the gauge were:

• Current Ratio =1.3; weaker than we like, but close to the norm for this company
• Inventory/CGS = 42.7 days, compared to 45.3 and 42.0 days 3 and 12 months ago, respectively.
• Finished Goods/Inventory = 47 percent, up from 43 percent last quarter (this increase had the greatest negative effect on the score.)
  
• Days of Sales Outstanding (DSO) = 37.5 days, greater than the 36.4 days calculated one year earlier
• Working Capital/Market Capitalization = 1.9 percent, down from 2.1 percent
  

Growth. This gauge decreased substantially, from 23 points in September to 5 points now.

The measures that helped the gauge were:

• Revenue growth = 12.7 percent year-over-year, up from 7.6 percent in a year.
• CFO growth = 14 percent year-over-year, up from 4 percent in a year
  

The measures that hurt the gauge were:

• Revenue/Assets = 114 percent, down from 117 percent one year earlier; sales efficiency is improving
• Net Income growth = 0.6 percent year-over-year, down from 38 percent in a year
  

Earnings growth was hurt by an increase in the income tax rate from 19.3 to 25.9 percent.

Profitability. This gauge slipped from 13 points in September to 11 points now.

The measures that helped the gauge were:

• ROIC = 26 percent, wonderful, but down from 32.3 percent in a year
• Accrual Ratio = +3.3 percent, down from +5.4 percent in a year. The Cash Flow contribution to earnings increased.
  
• FCF/Equity = 26 percent, unchanged from 2006
  

The measure that hurt the gauge was:

• Operating Expenses/Revenue = 81.7 percent, up from 81.1 percent.
  

Value. PepsiCo's stock price rose from the end of September to the end of December from $73.26 to $75.90. Given that the price was in the low $60's only a year ago, it's not surprising the Value gauge has bottomed out.

None of our measures helped the gauge:

• Enterprise Value/Cash Flow = 18.3, up from 17.3 in December 2006 and a five-year median of 17.8
• P/E = 22.1, up from 18.7 last year, but a little below the five-year median of 22.6
  
• P/E to S&P 500 average P/E = 30 percent premium, a little above than the five-year median premium of 28 percent
• Price/Revenue ratio = 3.2, above the five-year median of 3.0.
  

The average P/E for the Non-alcoholic Beverages industry is currently a more expensive 22.7. The average Price/Revenue for the industry is currently 3.8.

A rising stock price, increasing costs, and slowing income growth knocked down PepsiCo's Overall Gauge score to 22 out of 100 possible points. Last year had more substantial non-recurring tax benefits, which skews the comparisons. However, we're worried more about the decreasing Gross Margin, which swallowed up seemingly impressive (and hard to sustain) Revenue Growth.