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What It Would Take to Make PepsiCo a Buy


Has the company found a normalized earnings base?

PepsiCo (PEP) gave, what was for it, a big cut in year ahead earnings guidance in the fourth quarter report. Consensus fell from $4.55 to $4.09 after Pepsi management guided to an 8% earnings decline in FY '12 versus a flattish result with '11, which had been Street expectation.

Pepsi management said that there would be a step up in ad and promo spending of $600-700 million mostly for North American beverages, where the companies had been losing market share to Coca Cola (KO). This was to be funded by a 3% reduction in the workforce and other initiatives.

Pepsi has lost two points of market share to a Coke that has been resurgent following its acquisition of the US operations of Coca Cola Enterprises. Pepsi does not want to lose any market share to Coke, especially given their competitive history. But many, including myself, see no great economic reason why they're fighting so hard for incremental volume in the clearly mature business of US carbonated soft drinks. Pepsi's ad-to-sales ratio in North American beverages had declined, but they will be picking it up in the next few years.

Pepsi management also said that it will be working harder for more cost savings within the company because it could not keep on raising prices on a troubled consumer at anywhere near the rate of commodities price increases the company has had to absorb. (The company also can't continue losing market share to private label, which was left unsaid.)

So, at least some sell-side analysts are hopeful that Pepsi will gain back some market share domestically from Coke, and that earnings will have a stable base from which to grow, and obviously from which to value that stock. At $63, with consensus EPS of $4.09 and $4.46 for years '12 and '13 respectively, the stock discounts a 2% five-year growth rate and 1% terminal growth. If an investor could expect just a 4% five-year rate and 2% terminal growth, the stock is a buy, with 22% appreciation potential by my discounted EPS model. And that 4% growth rate is well below management's HSD (high single digit) percentage long-term growth algorithm that they continue to stand by (assuming a more normal environment). That is tempting for a value investor that is willing to be early on the stock.

But I think that the normalized earnings level for Pepsi is lower than $4.09. And I think that any normalized earnings level will have to be proven to investors, rather than discounted in advance, given the experience since the 2008 economic crash. Further, I have not seen one mainly US staples company that has staunched market share losses to private label competitors (see my previous article on private label; I believe that it's the biggest issue for consumer staples companies) to the extent that an investor could have faith attaching a growth rate to their presently reported EPS.

For now I will give them some credence that their moves in North American beverages will establish a defensible, believable earnings level, but only some credence. Consider this: The latest 12-week Nielsen's show Pepsi's 5% pricing led to a 3% sales decline on a 7% volume decline versus private label at 4% pricing, resulting in a 6% sales increase, as volume advanced 2% (all numbers rounded, Cokes' result akin to Pepsi's). However I think that Frito Lay's North American prices need to come down.

Salty snack numbers for 2011; results by quarter:

Implied Prices Increase %
Quarter 1 2 3 4
Frito (1.2) 1.4 4.9 6.5
PrL (.6) .9 2.2 3.2

Unit Volume Increase
Frito .3 .4 (2.9) (2.9)
PrL 8.9 4.3 7.4 9.1

SOURCE: Information Resources International

Adjusting revenue down for a 10% price decrease on this IRI-reported segment volume is a $.44 hit to EPS to $3.65. Using this as an earnings base, a 3% growth rate is implied by the $63 price. Believing that the consumer will be hurting more, a 15% price cut is a $.66 hit, implying a 4.5% growth rate from a $3.43 EPS. Realizing that we are in uncharted territory on consumer behavior changes, if this recession recovery/slow growth situation continues, I wouldn't give much credence to Pepsi management's HSD percentage long-term EPS growth rate. But a 7% growth rate off of a $3.65 number could justify over 20% upside. So, I think that a quarter or two's results could indicate that the stock is a buy.

Finally, I believe that the idea of splitting the company into snack and drinks segments makes no sense. The company is hurting because of the consumer environment, not because management does not sufficiently concentrate on its two businesses. Readers might want to see my recent article about Kraft (KFT) for a breakup perspective that also applies to Pepsico.
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