By Debora Tidwell (TMF Debit)
UNION CITY, CA (May 13, 1997)/FOOLWIRE/ --- PepsiCo released their first quarter 1997 earnings on April 29th. Sales grew two percent to $6.7 billion. Reported net income for the quarter grew eight percent to $427 million on top of 23% growth in the prior year. Earnings per share for the quarter were $0.27. They felt it was a good start to the year. They posted 13% EPS growth on top of 20% EPS growth last year. Although the components may be a little different than individual forecasts, the company reported earnings of $0.27 per share. From an operating point of view, the upsides were coming from international beverage and domestic restaurants, relative to most forecasts. The spin-off tasks (for the announced spin-off of the restaurant division) are going very well. Various businesses they indicated they would be selling are either sold or in process so they are on track for the Q4 spin-off. Although they are extremely pleased with the quarter, it is a small quarter and a start for the year. It is a good start, but the year is young yet.
THE BEVERAGE BUSINESS. The domestic beverage business is basically on track for low double-digit growth for the full year. On a two year basis, if you look at what they are rolling over, you can see that what they reported is in line with that for the full year. The market has been very aggressive on pricing, but it is rational. They noted in the press release that fundamentally, their margins were basically flat, so they are taking savings and passing them through to the marketplace and it is not irrational pricing. On a national basis, across channels, their pricing is down about 3%. Some of their volume-driving initiatives actually haven't even kicked in yet. They have a new Diet Pepsi which is just moving into the marketplace now, they haven't really launched it. They are just starting to get vendors in the marketplace and are in the very early stages of that. Their fountain numbers are fine but it is early to see any returns from the efforts they are putting against the fountain business. Their big promotion, Pepsi Stuff 2, has yet to come. So, there is a lot coming ahead in the year and they expect volume will continue to be reasonably aggressive throughout the year. Easter moves into the first quarter and out of the second quarter, but on a full-year basis that doesn't take anything away from their feeling that it is a good start and will be a very exciting year.
INTERNATIONAL BEVERAGE BUSINESS. International beverages was better than most people expected in the quarter. Volume was an improvement over the fourth quarter and they think it was on track with where they hoped they would be. From a profit point of view, they were concerned in their forecasting because it was a turn and may have been a little bit conservative, but fundamentally there is nothing unusual in that number. They knew they were going to come up against a comparison of a prior year quarter that had a lot of concentrate shipments in it, and if volume continued to be negative what would that translate to. As it turned out, everything went on track, they achieved the volume growth. Their volume was down 3% but it would have been flat, excluding the impact of Venezuela, and that is an improvement from the fourth quarter. The improvement is here and there throughout all the regions which they think indicates that the difficulty of getting through the reorganization is starting to be put behind them. They had very aggressive volume growth in India and China and, although Latin America continued to be somewhat soft, the aggressive growth in India and China were getting to the point of largely offsetting what is their largest market -- Latin America accounts for about 40% of their volume. Things are going in the right direction. On a full-year basis for international beverages, they had a range of profits declining between $25-50 million. They still have that range, but would move toward the upper end of that range with some optimism. The first and fourth quarters tend to be relatively small quarters in the international beverage business and not quarters that tend to contribute to profits. What they anticipate is that the third quarter has the highest probability of profits. They do see improvements from here as the year goes on, but there is a seasonality to this business that we haven't really seen before because Canada was rolled into these numbers in prior years and it masked some of the seasonality. For the second quarter, they are hoping for a break-even, but the segment may still lose a little money. It's in a turnaround stage, so they're not worried about that because it is heading in the right direction.
SLICE. The company was asked if they would be developing an alternative to 7Up and how their relationship with Cadbury-Schweppes was going. They responded that they have Slice to address the 7Up and Sprite products. They have not taken the position that Coke has, saying it is a primary strategy to own all of the brands that their bottlers bottle. They have worked in partnership successfully with people for many years and they will continue to do that. It is not easy to build a brand from scratch. They have Slice and feel they would have to have a real reason to change and don't see that right now.
THE SNACK FOOD BUSINESS. Domestic snacks is basically on track for profit in the mid-teens, which is what they talked about and what they delivered. They probably should have foreseen the volume growth growing a little slower because they placed an awful lot of racks concurrent with the Baked Lays launch. They placed a lot of "better for you" racks into the marketplace last year and they did not have the same rack configuration this year. But they think they are in good shape. They would expect some tweaking over the balance of the year to get their volume mix where they would like it to be. They don't expect to have major changes in order to drive for share. They will continue to drive for profits this year and will get ready for a volume push next year. The volume will probably be, rather than 6-8%, maybe 5-6% at the low end of that range. The first quarter had one month that was a little light and they bounced back off of it, so they think the 5-6% is a doable objective. Margins showed improvements this quarter but their forecasts for the full year all along has been that this is what would drive the full-year profits. If they are forecasting 12% profit growth from Frito-Lay and something more on the order of magnitude of 5-6% volume growth, clearly 4 points of that growth forecast is going to come out of margin improvement. They are up over a point this quarter, but they are rolling over a relatively easier comparison.
FRITO-LAY PRICING. Frito-Lay took pricing action this quarter due to lower raw material costs and other cost savings. They think raw materials will be relatively favorable this year and that might introduce a bit more pricing to the consumer into the marketplace. Normally they would respond by tweaking more than any wholesale change and that is what they think will happen. Most of their competition out there is in the potato chip category and their potato chip category grew hugely, high single digits driven by Lays. They want to get the tortilla chips moving a little bit again. Tostitos was up but the rest of the category was a little soft. So they will move money around to get the brands going but they don't know specifically what that will translate to. Clearly they are not getting any commodity pressure this year. They take it on a region by region basis because most of their competitors are regional. They think that pricing probably had some impact on volume in the first quarter. They got a reasonable amount of better-for-you volume. They think some of it may have been how they moved the pricing against product lines. They got a lot on regular Tostitos and less on Baked Tostitos, for example. They will be tweaking it around from a mix point of view to try to do their margins. If Frito-Lay's volumes grows 5% instead of 6-8% and they make their profit growth target, Frito is fine with that because they actually have to put their management attention against making sure the logistics in the system are where they want them to be so they are ready for another volume push.
BETTER-FOR-YOU SNACKS. Better-for-you snacks continued to be about 40% of their total growth. It is only about 15% of the volume, but was 40% of the growth. Better-for-you was a key driver. The Lays brand was up significantly and that was Baked Lays although they made the comment about the racks, they were better-for-you racks that had a lot of products on them including Baked Tostitos, but Baked Lays were starting to get the annualization of some additional lines they put on in Q2. Better-for-you is clearly still a major factor in the growth at Frito-Lay.
SARA LEE VENTURE. The Sara Lee joint venture resulted in products that had potential in the marketplace but with the size of Frito-Lay's distribution system, a product has to be pretty big for them to really want to go with it. Frito-Lay has a lot of options right now and the product was attractive to Sara Lee given its size, but wasn't going to make the cut as one of the top two or three things that Frito-Lay wanted to do given the size that they needed to make a real go of it. There has been an orderly transition so that Sara Lee could have the option to pursue what they felt they needed to do and that Frito-Lay could move on with some other ideas that they thought would give them more leverage. That doesn't mean they won't do something in that area, but it isn't a high priority right now.
INTERNATIONAL SNACKS BUSINESS. They are on track for the full year in international snacks. They may be getting there a little differently because they sold the Gerber business, so they have to take out the Gerber profits and put in the gain. When the dust settles on the full year, they will be in about the same place, so they aren't changing their full-year forecasts. They assumed international snacks would be low double-digits at best because they were rolling over some high wheat costs. That happened and they were a little slower than low double-digits taking out Gerber, but are very much on track. For the full year, they are still forecasting Frito-Lay international to grow 20%. They are managing this business like a portfolio of countries. Some are pushing on volume, some are pushing on margin. Mexico continues to recover from the devaluation of the peso, so they have regained volume momentum and have a focus on regaining margin. Some of the other countries are focusing on making sure on a volume basis they do okay. The pieces are all coming together the way PepsiCo would hope.
THE RESTAURANT BUSINESS. Restaurants was another surprise. Domestic restaurants was significantly better than they had forecast and it is largely because of extraordinarily good performance at Taco Bell. KFC was good and on track. They thought Pizza Hut would be down and they delivered according to that plan as they rolled over the introduction of Triple Decker pizza last year. Taco Bell did a spectacular job. They leveraged the Star Wars promotion better than any other restaurant in PepsiCo's portfolio, but they also did a lot of things to improve speed of service, introduced combo meals, and did some other things that appear to have legs beyond Star Wars because they are still running positive same store sales. They started the quarter with negative same-store sales and peaked up in double-digit same store sales to get up to that average number of 4%. It looks like they will be able to hang onto some positive growth this quarter. Pizza Hut is basically on track. They launched a new product called the "totally new pizza." David Novak's original initiatives at KFC were centered on quality of a core product, relaunching that and then doing some other things and that is basically what they are doing at Pizza Hut. It is a "significantly upgraded basic pizza product" with fresh, better toppings. They think the Taco Bell upsides will flow through for the full year and they are sticking to their plans for the balance of the year but have reason to believe they may get more optimistic as the year moves on. International restaurants is on track, no particular surprises there.
REFRANCHISING EFFORTS. The refranchising gains are on track. They were forecast to be a little lower this quarter than last year, which is a calendarization issue and they have no problems with it. They don't use refranchising gains to support their forecasts for growth either. They went down a full percentage point in ownership on a year-over-year basis. At year end they were at 45% ownership and are down to 44% now, so the balance continues to shift very aggressively toward franchisees. On the international side, the franchisees are growing the system aggressively in addition to normal same store sales growth. Franchisees and royalty income is a real driving force behind the margin improvement.
HIGHER TAX RATE RISK. The beverage business looks okay, international is a little bit better and domestic is basically on track. The snack business looks okay. Restaurants looks okay with the domestic a little bit better. They have not changed their full-year forecast because they have a real risk that the tax rate will be 36% for the balance of the year because they are unbundling a number of tax entities to effect the spin. They have a lot of tax entities, something like 80 foreign countries, that they will be looking at. They think that is something they can do something about over time but right now the workload is such that they believe it is a significant risk, so they have rolled it into their forecast.
SHARE REPURCHASE. Below the operating profit line they have been repurchasing shares very aggressively. They repurchased 11.7 million shares in the quarter and they have repurchased an additional 9 million shares since the quarter closed. They are going at a very aggressive pace. They were not even able to begin their share repurchase program in a meaningful fashion until after the year-end earnings release because they had the spin announcement in January. So, over a 3-month period they have repurchased almost 21 million shares of stock. Their goal for the full year was to repurchase $2 billion worth of stock and they think they will at least do that. It could be more, but that will depend on how much cash they get out of some of the asset sales they are talking about. Long term share repurchase will still remain a priority, but they don't have a long-term forecast on how much they will continue to repurchase because they will be a different company after the spin-off, but philosophically they will be in the same place. In the year after the spin, if they get a big dividend as a part of the spin and that has to be used to repay debt, that may create an opportunity to use some of that financing opportunity for different purposes including share repurchase, but they don't know that will happen.
THE UPSIDE REPRESENTED REAL IMPROVEMENT. The upside in the first quarter was real. It's not borrowed from another quarter. They do expect it largely to flow through to the full-year numbers but they are moderating the impact of that somewhat by some caution on the tax rate. They think it is a good start to the year and it feels good to be able to deliver the results they did. They also think it feels good that they got there basically the way they thought they would get there, without any huge surprises.
INTEREST INCOME VARIANCE. The interest income variance was because last year they had a higher balance in some of their overseas investments which they have brought down. It was due to the repatriation of some of their 936 law portfolio in Puerto Rico. Looking at first quarter 1996, they had a higher balance of cash and cash equivalents than this time last year.
CAPITAL SPENDING PLANS. Capital spending plans haven't changed. They still expect roughly 40% of their capital spending, or just under $1 billion to go into the snack business. Frito-Lay is taking a healthy piece of that, but given its size and its initiatives getting ready for a launch of an olestra-based product and some new plants they are bringing onstream, probably 3/4 of that money goes on the domestic side and the rest on the international side.
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