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PepsiCo (NYSE: PEP) recently reported earnings for the super-sized, 16-week quarter that ended on 27 December 2008. This post provides the GCFR analysis of this period, which was the fourth quarter of fiscal 2008.
The income statement for the quarter included an unusual number of items that make it hard to compare current and historic results. These items, and some faulty assumptions on our part, led to significant differences between PepsiCo's actual results and our model. In the paragraphs below, we identify the specific line-by-line differences and our errors.
PepsiCo, Inc., is a leading global purveyor of beverages and snacks. The company is well regarded for good management, steady growth, significant international exposure, and the defensive characteristics of the food industry. While famously locked in a battle with Coca-Cola (NYSE: 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.
After reporting disappointing third-quarter results in October 2008, PepsiCo announced it would cut costs by eliminating 3300 jobs and closing six plants. This plan, under the banner "Productivity for Growth," led to pretax charges in the fourth quarter totaling $543 million. Of this amount, $212 million was attributed to employee-related costs, $149 to asset impairments, and the remaining $182 million was deemed "other costs." Another $32 to $57 million in related charges are expected in fiscal 2009.
The fourth quarter was the first to include financial results for the recently acquired potato-chip maker Marbo in Serbia and the juice-maker Lebedyansky in Russia. The latter was a joint acquisition with Pepsi Bottling Group, Inc. (NYSE: PBG).
Last fall, the GCFR Overall Gauge of PepsiCo fell from 46 to 31 of the 100 possible points. Our original and updated analysis reports on the third quarter, which consisted of the 12 weeks ending 6 September 2008, explained this result in some detail.
All of the gauges were down in the third quarter, even the contrary Value measure. Revenue growth decelerated, and the Gross Margin was lower than expected. In addition, Sales, General, and Administrative expenses were substantially above projections, possibly because of $176 million "mark-to-market losses on commodity hedges" in the quarter. Net Income was 10 percent less than in the September 2007 quarter.
Now, with the available data from the December 2008 quarter, our gauges display the following scores:
- Cash Management: 10 of 25 (down from 11 in September)
- Growth: 1 of 25 (down from 10)
- Profitability: 16 of 25 (up from 10)
- Value: 12 of 25 (up from 4)
- Overall: 47 of 100 (up from 31)
Before we examine the factors that affected each gauge, we will compare the latest quarterly Income Statement to our earnings model that included neither restructuring, nor commodity "mark-to-market" costs.
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.
http://sheet.zoho.com/public/ncarvin/pep-income-statement?mode=html
We overestimated fourth-quarter Revenue by 7.5 percent, a substantial error. We took the company's guidance of "low-double-digit" Revenue growth in 2008 and assumed a growth rate of 12 percent. As it turned out, Revenue in 2008 was only 9.6 percent above that in 2007.
Revenue in the December 2008 quarter was a mere 3.1 percent greater than in the December 2007 quarter. PepsiCo explains this weak result by indicating that changes in currency exchange rates reduced Revenue growth in the fourth quarter by 5.5 percent.
Our estimate would have been much more accurate had we considered foreign exchange. The point to remember is that a strengthening dollar significantly weakens Revenue for a multinational. The opposite situation, which was the case not long ago, is also true. While we don't know the exact proportion of PepsiCo's Revenue generated outside the U.S., the PepsiCo International and Latin America Foods business segments were responsible for 41 percent of total Revenue.
The Cost of Goods Sold in the quarter equaled 48.5 percent of Revenue, which translates into a Gross Margin of 51.5. Our estimate for the Gross Margin was 53.3 percent.
If non-"core" expenses are excluded, CGS would have been $6.084 billion, and the Gross Margin would have been 52.2 percent. Either way, the quarter was not as profitable, by this measure, as we had expected.
Sales, General, and Administrative (SG&A) expenses were 41.8 percent of Revenue, substantially above our estimate of 39.0 percent. Many of the non-"core" expenses were in theSG&A category. If they are excluded, SG&A would have been 36.5 percent of Revenue.
The charge for Amortization of Intangible Assets was $3 million more than expected.
Lower-than-expected Revenue and higher-than-expected costs led to Operating Income, as we define it, missing the forecast value by 37.4 percent. Operating Income was 29.9 percent below that in last year's fourth quarter.
If the non-"core" expenses are excluded, our estimate for Operating Income would only have been off by about 2 percent.
We rarely do well at predicting the erratic "Bottling equity income," and this quarter was no exception. Our target was income of $90 million, and the actual figure was a $65 million loss. Much of the difference is due to restructuring and impairment charges of $138 million at Pepsi Bottling Group, Inc. (NYSE: PBG).
Net Interest Expense was a substantial $80 million more than we expected. Expenses were higher as the result of hedging investment losses and additional debt.
The Income Tax Rate was 29 percent, down from 29.8 percent in the year-earlier quarter, but above our 27 percent expectation.
Net Income in the quarter was 43 percent below that in the year-earlier period. On a core basis, Net Income was up 6.3 percent. Earnings per share were down 40.6 percent, but coreEPS was up 11.4 percent.
Core Net Income was 3.7 percent below our estimate.
| Cash Management | December 2008 | 3 months ago | 12 months ago |
| Current Ratio | 1.2 | 1.2 | 1.3 |
| LTD/Equity | 64.9% | 40.7% | 24.4% |
| Debt/CFO | 1.2 yrs | 1.2 yrs | 0.6 yrs |
| Inventory/CGS | 43.2 days | 46.5 days | 42.7 days |
| Finished Goods/Inventory | 44.6% | 43.5% | 47.0% |
| Days of Sales Outstanding (DSO) | 38.3 days | 44.8 days | 37.5 days |
| Working Capital/Market Capitalization | 2.1% | 1.3% | 1.9% |
| Cash Conversion Cycle Time | -59 days | -45 days | -60 days |
| Gauge Score (0 to 25) | 10 | 11 | 8 |
The increase in long-term debt is the most noticeable change. Debt rose from $4.2 billion to $7.9 billion during 2008, during which time PepsiCo spent $4.7 billion in cash to repurchase its common shares. We would prefer that debt, if necessary, be used for capital investments that will spur growth and profitability.
Inventory, something we watch very closely, is up 0.5 days from December 2007. However, the lower proportion of finished goods in the Inventory eases our concern.
| Growth | December 2008 | 3 months ago | 12 months ago |
| Revenue growth | 9.6% | 13.7% | 12.3% |
| Revenue/Assets | 123% | 121% | 122% |
| CFO growth | 0.9% | -8.0% | 14.0% |
| Net Income growth | -9.1% | -8.6% | 0.3% |
| Gauge Score (0 to 25) | 1 | 10 | 15 |
The Revenue growth rate weakened as the recession took hold and as the dollar strengthened against other currencies. In addition, restructuring expenses added to the fall in Cash Flow and Net Income.
| Profitability | December 2008 | 3 months ago | 12 months ago |
| Operating Expenses/Revenue | 84.0% | 82.6% | 81.8% |
| ROIC | 28.1% | 24.7% | 28.0% |
| FCF/Equity | 31.0% | 23.9% | 27.6% |
| Accrual Ratio | 2.3% | 7.4% | 7.1% |
| Gauge Score (0 to 25) | 16 | 10 | 12 |
Operating Expenses, which had been very stable, have now risen significantly. Nevertheless, PepsiCo's returns on investment remain impressive. The big drop in the Accrual Ratio, which suggests improving earnings quality, indicates that more of the company's Net Income is due to Cash Flow from Operations (CFO). A lower percentage of Net Income is due to changes in non-operational Balance Sheet accruals.
| Value | December 2008 | 3 months ago | 12 months ago |
| P/E | 16.8 | 20.0 | 22.1 |
| P/E to S&P 500 average P/E | 125% | 112% | 124% |
| Price/Revenue | 2.0 | 2.6 | 3.2 |
| Enterprise Value/Cash Flow (EV/CFO) | 13.2 | 18.6 | 18.3 |
| Gauge Score (0 to 25) | 12 | 4 | 0 |
The value metrics became more appealing as PepsiCo's stock price dropped from $71.27 to $54.77 from the end of September 2008 to the end of December 2008.
PepsiCo's valuation ratios can be compared with other companies in the Processed & Packaged Goods industry.
| Overall | December 2008 | 3 months ago | 12 months ago |
| Gauge Score (0 to 100) | 47 | 31 | 26 |
PepsiCo's fourth-quarter results were adversely affected by the implementation of cost-cutting initiatives and by the stronger U.S. dollar. The former should quickly improve profitability, and the latter may have run its course. Along with a much lower share price, these are the reasons to feel bullish about PepsiCo.
The big concern, however, is the flat performance of PepsiCo's Food and (especially) Beverage operations in the Americas. It's often claimed that these businesses are more immune than most to economic swings. Has this relationship been broken, or is PepsiCo having problems competing?
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