DRIP PORTFOLIO
First-Quarter PEP Talk
Digging into PepsiCo.'s first-quarter results

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By Brian Graney (TMF Panic)
April 26, 2000

It's been a few months since we last made any comments about the food and beverage industry. And judging from our relatively empty e-mail boxes, no one has really seemed to mind all that much. However, rest assured that we haven't forgotten about our industry study from last year (remember that?) or given up on our hopes of picking a possible replacement for current portfolio tagalong holding Campbell Soup (NYSE: CPB).

Here's a quasi-related thought that sums up how Jeff and I currently think about Campbell. With the first-quarter results of mutual funds rolling in recently, investors may have heard the issue of "window dressing" come up. This refers to a fund manager loading up on some "hot" stocks late in the quarter in order to show his boss that he is smartly exposed to the stocks that are currently "working," to use the trading lingo of the day. Our Campbell position is the exact opposite of window dressing. Instead of drapery, it's more like a doormat -- getting trampled regardless of whether the quarter is ending or just beginning.

As for potential Campbell replacements, our two food and beverage finalists (remember them?) recently reported their first-quarter results. We don't have much to say about Wrigley (NYSE: WWY), which reported 5% year-on-year growth in sales and 7% growth in net earnings during the quarter. Do those growth rates sound familiar? They're essentially the reverse of what happened in Q4, when sales grew 8% and earnings grew 4%.

Don't expect us to start jumping up and down about Wrigley's quarterly results unless sales or, more preferably, earnings start to grow regularly at close to a double-digit rate. In the short-term, that may be asking too much. Judging from the company's recent showing, our behinds may be glued to our chairs for a while yet.

On the other hand, PepsiCo. (NYSE: PEP) is threatening to turn itself into a consistent double-digit profit growth performer. For the second quarter in a row, EPS grew greater than 10% year-over-year, rising 13% in Q1 to $0.29. While that's about half the growth rate seen in Q4, it's certainly high enough to catch our attention. And hold onto your hats, because the company has stated for the record that it is comfortable with analysts' estimates for EPS of $0.36 in Q2, which would equate to 16% growth.

"Another solid quarterly performance confirms that we are successfully generating consistent earnings growth, strong cash flow and improving returns on capital,'' said Chairman and CEO Roger Enrico. That's the kind of language we want to hear from PepsiCo., considering our current "show me the money" first, invest later stance toward the company.

As a refresher, our major concern with PepsiCo. from an investing point of view has been whether it can jump over the lofty growth hurdles it has set up for itself, especially given the considerable changes made to the business over the past few years. The Drip Port has been burned once already in its short history by investing in a food company that has over-promised and under-delivered on fast-growth goals. (Uh, can you say "Campbell"?) After 18 months or so aboard the smoldering S.S. Campbell, we've learned our lesson and don't particularly want to get burned again.

The foundation of our investing thesis so far with PepsiCo. is the company's potential to realize higher overall profitability in the years ahead as it wrings efficiencies out of its snack food, cola, and fruit juice businesses and continues to innovate on the product and distribution levels. We saw glimpses of this happening in Q1, with operating profit margins heading up for all foreign and domestic units except one. Flat bottler case sales and higher retail prices hurt Pepsi-Cola North America, where operating profits dipped 8% and margins shrank to 24.7% from last year's 28%. On the flip side, the big winner in the quarter was easily the firm's Tropicana juice unit, which saw operating profits jump 70% and margins ramp up to 11.3% from 7% a year ago.

By our calculations, the firm's quarterly return on invested capital (ROIC) rolled in at around 17% on an annualized basis, up strongly from about 8% in the prior Q1. Since the first quarter is traditionally PepsiCo.'s slowest period -- everybody commits to short-lived diets following the holidays, after all -- it's not surprising to see annualized ROIC slip from Q4's 20% figure, which was higher due to the simple fact that net income was higher in Q4 than in Q1. Over the next three quarters, we should see annualized ROIC rise into the 20% range again, and perhaps even to levels higher than that.

The proposition goes that with higher margins and higher returns on capital, PepsiCo. should fetch a concomitant higher price in the market. So far, that hasn't happened. Despite the company's more focused corporate look and improving profitability, its shares haven't moved all that much since the fall of 1997. Among the folks who are scratching their heads about this are several vocal executives at the company, the 18 or so sell-side analysts that have "buy" ratings on the stock, and the handful of glossy, mass-circulation financial magazine writers that have profiled the company in recent weeks.

This introduces another potential point of contention for Jeff and me, since our natural bent is to look for investment ideas in areas that are maybe being overlooked by others. That's not the case with PepsiCo. right now, although you wouldn't know it by looking at its recent share price performance. On the other hand, an individual investor can only worry so much about what others are thinking at any one moment. So long as our analysis is sound, we believe we will be duly rewarded over the long pull. With PepsiCo., our analysis continues to be ongoing, but we certainly like what we are seeing from the company.

Drip Portfolio

4/26/2000 Closing Numbers
Ticker Company Day Chg % Chg Price
CPBCAMPBELL SOUP-1 9/16-5.39%$27.44
INTCINTEL CORP-4 3/16-3.35%$120.81
JNJJOHNSON & JOHNSON-1 9/16-1.85%$82.75
MELMELLON FINANCIAL CORP-7/16-1.29%$33.50

  Day Week Month Year
To Date
Since
7/28/1997
Annualized
Drip -2.58% 3.31% .30% 15.63% 50.22% 15.96%
S&P 500 -1.09% 1.84% -2.51% -.56% 55.62% 17.46%
S&P 500(DA) -1.09% 1.84% -2.51% -.56% 58.25% 18.17%
S&P 500(DCA) n/a n/a n/a n/a 27.66% 9.29%
NASDAQ -2.19% -.38% -20.62% -10.79% 131.28% 35.67%

Trade Date # Shares Ticker Cost/Share Price LT % Val Chg
9/8/199722.9859INTC45.653$120.81164.63%
11/14/199714.965JNJ78.923$82.754.85%
11/5/199831.5773MEL34.290$33.50-2.30%
4/13/19988.269CPB54.401$27.44-49.56%

Trade Date # Shares Ticker Cost Value LT $ Val Ch
9/8/199722.9859INTC$1,049.37$2,776.98$1,727.61
11/14/199714.965JNJ$1,181.08$1,238.35$57.28
11/5/199831.5773MEL$1,082.79$1,057.84($24.95)
4/13/19988.269CPB$449.84$226.88($222.96)
  Cash: $0.04  
  Total: $5,300.10  


Key
• S&P 500 (DA) = dividend adjusted. Dividends have been added to the total return of the index.

Note
Drip Port launched with $500 on July 28, 1997, adds $100 to invest every month, and the goal is to own $150,000 in stock by August of the year 2017. Due to the slow nature of dollar-cost-averaging and our relatively significant starting costs, we do not expect to seriously challenge the S&P 500 for the first three to five years as we build an investment base. The long-term advantages of dollar-cost-averaging still overcome the short-term disadvantages, however. Final note: our investment in Campbell Soup is frozen due to fees instituted in its investment plan. Click here for a history of all Drip Port transactions.