PepsiCo Earnings – Behind The Headlines
Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
When companies like PepsiCo (NYSE: PEP) report earnings, investors don't really expect a lot of surprises. This comes from the fact that the company operates in multiple countries and has several divisions. Investors might just read the headlines and move on with their lives. There is a lot you can learn from a company's quarterly report. I've made it my job to go through the company's earnings report to try and pull out any trends or issues that might not be obvious on the surface. Let's see what investors could have missed from PepsiCo's most recent report.
The headline numbers were: revenue up 4.1% and EPS was flat. While this EPS performance was actually good enough to beat expectations by 3%, there are a few things investors should know. First, cost of sales caught my eye, as this line item was up 8.1%. When a company's cost to sell their product rises at nearly twice the rate of sales, that is a problem. In addition, part of the reason the company beat estimates is they retired shares to the tune of 1.3% versus last year. Without these share repurchases, EPS would have still beaten estimates but by a lesser amount.
A second item that stuck out like a sore thumb was operating cash flow. Reported operating cash flow dropped to negative $690 million. However, this was primarily due to a $1.1 billion contribution to the company's pension and medical plans. Without these two contributions, the company's operating cash flow would have been up nearly 8% to about $410 million. A concern for shareholders should be the level of capital spending. With $316 million in capital spending, and $816 million in dividends paid, there is clearly an issue with the level of cash flow the company produces. In plain english, even without the pension and medical plan contributions, the company's free cash flow payout ratio of the dividend would have been 868%! With only $94 million in free cash flow, paying $816 million in dividends is a challenge unless you do something with your balance sheet.
Where the company's balance sheet is concerned, they did have to go into more debt to handle their cash needs this last quarter. The company issued $2.7 billion in new long-term debt to repay short-term debt, and to pay dividends. This isn't a problem if it happens once in a while, but as I've written before, Pepsi has already seen its long-term debt increase by 178% in the last three years. While a lot of this was for the company to buy its bottling business, PepsiCo's cash and investments net of long term debt is negative $16.73 billion. When you compare this to the fact that Coca-Cola (NYSE: KO) sits on a positive $8.40 billion in net cash & investments, you can see that PepsiCo is competing at a disadvantage.
PepsiCo operates in basically four major divisions. Each division did relatively well for a company this size. The Frito-Lay division in North America saw revenue up 4%, Latin America's foods revenue was up 11%, and PepsiCo Europe, South Africa and Asia all showed revenue growth in the double digits. There were two lagging divisions. PepsiCo America Beverages (think Pepsi and the like sold in North America) showed revenue down 2%, but profit was down 9% from higher commodity costs. This was similar to the 9% drop in adjusted income Coca-Cola showed in their North American division in the most recent quarter. Both companies have to either deal with increased costs or raise their prices to try to restore net income growth.
The other lagging division was Quaker Foods North America. This division saw revenue down 3%, volume down 5%, and profit down 10%. This isn't the first time that Quaker has disappointed PepsiCo investors either. In 2010 revenue for the division was down 1%, in 2011 revenue was flat. Given this historical underperformance, I would suggest that PepsiCo management look to shop this division to a company already in the breakfast business. Quaker Foods North America is really about oatmeal and a few cereal brands. This really doesn't fit well within the Frito-Lay division, it doesn't drive sales of Pepsi's beverages, and just seems to be the odd man out. With just $623 million in revenue compared to the over $3 billion in revenue Frito-Lay North America produced, this is a small enough division that the company could sell it, and use the proceeds to shore up the company's previously mentioned balance sheet issues. The two companies that come to mind as potential acquirers would be Kellogg (NYSE: K) and General Mills (NYSE: GIS). With Kellogg producing over $1 billion in free cash flow last year, and General Mills producing about $900 million in free cash flow, it seems both companies could afford this division. This would allow either company to broaden their breakfast offerings, and their knowledge of the breakfast industry would allow them to grow the brand. In addition, the Quaker name brand and oatmeal flavors could be incorporated into either company's existing breakfast cereal offerings. It seems like a much more natural fit for these two companies, than for PepsiCo.
Overall, PepsiCo and to a lesser extent Coca-Cola seem destined to raise prices in the North American region to combat higher commodity prices. Pepsi needs to rid itself of Quaker so it can focus on its faster growing Frito-Lay and Pepsi franchises. I know the crown jewel of Quaker Foods was Gatorade, but now that Gatorade has been incorporated into PepsiCo Beverages this connection doesn't exist. Pepsi is already lagging Coca-Cola when it comes to growth, they can't afford any of their divisions to slow them down.
MHenage has no positions in the stocks mentioned above. The Motley Fool owns shares of The Coca-Cola Company and PepsiCo. Motley Fool newsletter services recommend PepsiCo and The Coca-Cola Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.