PepsiCo, Inc. (PEP) 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 (KO) for the soft-drink market, PepsiCo's snack food business diversifies the company. The Frito-Lay North America division takes in more Revenue, and it contributes more to Operating Profit, than the PepsiCo Americas Beverages unit.
In our earlier financial analysis of PepsiCo's 12-week quarter that ended 22 March 2008, we noted that the three business units that operate outside North America registered an average sales gain of 30 percent. Strong international performance, aided by the weak dollar, enabled PepsiCo as a whole to achieve better-than-expected Revenue growth. However, currency changes are something of a double-edged sword, as it increases PepsiCo's raw material (i.e., agricultural commodities) costs. The resulting curb on Net Income and Cash Flow growth led to the second straight Overall gauge score of 23, out of 100 possible, points. Of the four individual gauges that fed into the composite result, Profitability was the strongest at 10, out of 25 possible, points. Value was weakest at 2 points.
The first quarter's 23-point score is near the low end of the historical range for PepsiCo, and share price declines are more likely to occur when the score is weak. We, therefore, shouldn't have been surprised to see the price of PepsiCo shares drop by 12 percent in the second calendar quarter.
Now, with the available data from the June 2008 quarter, our gauges display the following scores:
- Cash Management: 12 of 25 (up from 8 in March)
- Growth: 4 of 25 (up from 3)
- Profitability: 12 of 25 (up from 10)
- Value: 10 of 25 (up from 2)
- Overall: 42 of 100 (up from 23)
Before we examine the factors that affected each gauge, we will compare the latest quarterly Income Statement to our previously announced expectations.
Please note that the table format below, which we use for all analyses, can and often does differ in material respects from company-used formats. A common difference is the classification of income and expenses as Operating and Non-Operating. The standardization is simply for convenience and to facilitate cross-company comparisons.
| ($M) | | June 2008 (actual) | June 2008 (predicted) | (actual) |
| Revenue | | 10945 | 10332 | 9607 |
| Op expenses | | | | |
| | CGS | (5078) | (4753) | (4352) |
| | SG&A | (3664) | (3616) | (3295) |
| | Amortization, etc. | (18) | (15) | (11) |
| Operating Income | | 2185 | 1948 | 1959 |
| Other income | | | | |
| | Equity income | 168 | 173 | 173 |
| | Interest, etc. | (36) | (25) | (15) |
| Pretax income | | 2317 | 2096 | 2117 |
| Income tax | | (618) | (576) | (560) |
| Net Income | | 1699 | 1520 | 1557 |
| | | $1.05/sh | $0.94/sh | $0.94/sh |
| Shares outstanding | 1612 | 1620 | 1665 |
Revenue beat our estimate by 5.9 percent. We expected Revenue to exceed its value in the year-earlier quarter by 7.5 percent, and the actual increase was 13.9 percent. On a year-over-year basis, Revenue grew by 14.0 percent, significantly better than the company's guidance for the year of "high-single-digit" growth.
International operations, aided by the weak dollar, contributed mightily to the sales surge. Revenues at PepsiCo's three business units that operate outside North America grew by an average of 29.4 percent. Revenue at the three other units that operate in North America grew by 4.5 percent. Favorable foreign currency translations, according to the 10-Q, "contributed 4 percentage points to net revenue growth."
We predicted that the Gross Margin would slip to 54.0 percent of Revenue in the first quarter because of rising raw material prices. In actuality, it edged down to 53.6 percent, since the Cost of Goods Sold (CGS) equaled to 46.4 percent of Revenue.
Sales, General, and Administrative (SG&A) expenses were 33.5 percent of Revenue, nicely below our estimate of 35.0 percent. Amortization of intangible assets was $3 million more than we expected.
The greater-than-expected Revenue, with lower SG&A costs, enabled Operating Income, as we define it, to exceed the forecast value by 12.2 percent and to top the year-earlier value by 11.5 percent. The 10-Q indicates that "foreign currency [changes] contributed 3 percentage points to operating profit growth."
We don't normally do very well predicting the erratic "Bottling equity income," which includes gains from selling shares in Pepsi Bottling Group, Inc. (PBG). However, we were only $5 million off in the second quarter. Net Interest Expense was $11 million more than we expected, due to higher level of debt.
The Income Tax Rate was 26.7 percent, instead of the 27.5 percent indicated in management's guidance. Rate changes can have a significant effect on reported income. The lower rate helped Net Income beat our prediction by 11.8 percent.
Cash Management. This gauge increased from 8 points in March to 12 points now.
| June 2008 | 3 mos. ago | 12 mos. ago | |
| Current Ratio | 1.4 | 1.3 | 1.3 |
| LTD/Equity | 36.3% | 29.2% | 20.5% |
| Debt/CFO | 0.9 yrs | 0.9 yrs | 0.6 yrs |
| Inventory/CGS | 51.4 days | 44.8 days | 50.8 days |
| Finished Goods/Inventory | 45.3% | 47.0% | 44.1% |
| Days of Sales Outstanding (DSO) | 44.9 days | 40.3 days | 43.7 days |
| Working Capital/Market Capitalization | 3.1% | 2.0% | 2.0% |
| Cash Conversion Cycle Time | -41 days | -45 days | -46 days |
PepsiCo has taken on significantly more debt, but the level remains affordable. The added debt has bolstered Working Capital to enable capital investments and, perhaps, additional share repurchases. Inventory, something we watch very closely, is up a day from the comparable period last year. We're keeping in mind that PepsiCo gears up every spring for the high-demand summer season. Similarly, the small rise in Days of Sales Outstanding isn't a concern at this time, but it bears watching.
Growth. This gauge increased from 3 points in March to 4 points now.
| June 2008 | 3 mos. ago | 12 mos. ago | |
| Revenue growth | 14.0% | 13.1% | 8.7% |
| Revenue/Assets | 114% | 113% | 115% |
| CFO growth | 12.4% | 4.5% | 20.0% |
| Net Income growth | -2.0% | -1.4% | 39.1% |
Revenue has grown as the dollar has weakened, but Net Income growth has fallen. We need to remember that the drop in Net Income is mostly due to an increase in the Income Tax Rate from 18.6 percent to 26.1 percent. [One-time factors led to an abnormally low tax rate last year.] A healthy increase in Cash Flow relieves one of our concerns from the first quarter.
Profitability. This gauge increased from 10 points in March to 12 points now.
| June 2008 | 3 mos. ago | 12 mos. ago | |
| Operating Expenses/Revenue | 81.8% | 81.8% | 81.1% |
| ROIC | 26.8% | 25.8% | 30.5% |
| FCF/Equity | 27.2% | 26.1% | 26.6% |
| Accrual Ratio | 2.9% | 6.1% | 2.7% |
We're impressed that Operating Expenses haven't edged up more than they have. PepsiCo's returns remain impressive. The recent drop in the Accrual Ratio indicate that more of the company's Net Income is due to Cash Flow from Operations (CFO), and, therefore, less is due to changes in non-operational Balance Sheet accruals.
Value. PepsiCo's stock price slid from $72.20 to $63.59 during the second three months of 2008. The drop was enough to increase this gauge from 2 to 10 points from March to June.
| June 2008 | 3 mos. ago | 12 mos. ago | |
| P/E | 17.5 | 20.6 | 18.1 |
| P/E to S&P 500 average P/E | 103% | 120% | 110% |
| Price/Revenue | 2.5 | 2.9 | 2.9 |
| Enterprise Value/Cash Flow (EV/CFO) | 15.0 | 17.8 | 17.4 |
PepsiCo's international operations have boosted Revenue substantially, and the company is doing a very good job managing its costs in a challenging economic environment. With this operational performance, the drop in the price of PepsiCo shares pushes up the Value gauge. This situation is reflected in the Overall Gauge score rising from 23 to 42 points. Scores in the 40's for PepsiCo have sometimes been omens of future share price gains. We should also acknowledge that management is returning profits to shareholders via increased dividends and share repurchases.
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