ALEXANDRIA, VA (Jan. 14, 1998) -- Today we sit down and take a long, hard look at PepsiCo (NYSE: PEP). Fair warning -- this report will push the boundaries of security analysis for many of you, so be prepared to read it more than one time through. The simple fact is that detailed analysis of the company's financials has been made difficult by the recent spin-off of Tricon Global Restaurants (NYSE: YUM). In many ways, the historical information is not 100%, forcing us to dig deeper in the analytical tool bag in order to assess the company's intrinsic quality and the current valuation. Drip investors should not be too upset about this unfortunate development, as it is because the financials are not crystal-clear that we have the opportunity to make what could be an attractive investment in two global franchises -- Pepsi Cola and Frito-Lay.
The holding company known as PepsiCo is currently one half Pepsi Cola and one half Frito Lay. Although Pepsi Cola is certainly a solid business, the real opportunity I perceive here is the investment in Frito Lay. In our initial look at PepsiCo back on December 30th, I waxed poetic about the perfection I see in the business known as Frito-Lay. Simply put, the beauty of Frito-Lay is that it is one of the few companies in the world that absolutely dominates a market in a product that you can make for a penny and sell for a dollar. With the collapse of Anheuser-Busch's (NYSE: BUD) Eagle Snacks unit in 1996, the only global competitor to Frito-Lay in any of their product categories right now is Procter & Gamble's (NYSE: PG) Pringles potato chips. Soda is great and all, but salty snack foods is something that I think is quite a bit greater.
The first tool we will use to look at PepsiCo is return on equity. In fact, the bulk of this report will consist of our analysis of the return on equity at PepsiCo, as it has been made complicated by the Tricon spin-off. As we described in the look at return on equity in Monday's report, return on equity is a measure of how much income was generated relative to the net dollars invested in company assets, or shareholder's equity. Now, read this slowly: As shareholder's equity is total assets less total liabilities, return on equity is simply the return generated on all of the assets left over after all liabilities are paid. Return on equity is simply one tool used to measure how efficiently a company is at generating money relative to the money that is put into the business. If a company has a return on equity of 50%, that means for every net $1 invested in assets, $0.50 in income is generated. According to the recently released book "Buffettology," the average return on equity for American industry over the past forty years has been around 12%. I use this as a benchmark to separate the great from the mediocre.
Before I launch into PepsiCo's return on equity, I want to stress one thing about how I am calculating return on equity that I forgot to mention on Monday. As we discussed last Wednesday when we introduced the Branded Food Spreadsheet, the shareholder's equity that we are using to determine return on equity has been adjusted to negate the effect of any share repurchases. You see, in American accounting when you repurchase shares and retire them, you must subtract the value of the shares repurchased from the shareholder's equity. This has the secondary effect of making companies that repurchase shares seem to have higher returns on equity than companies that do not.
Although repurchasing shares is certainly not a bad idea, if the choice is between buying a competitor at a very low valuation and repurchasing extraordinarily expensive shares, you can see that repurchasing the shares is ipso facto not the better move. Thus, to level the playing field between the branded food companies and make the return on equity comparisons legit, I added back to the shareholder's equity the value of any shares repurchased. If you are trying the calculation at home and cannot get the right answer, this is probably why. So...
From the Pepsico 1997 Q3 Balance Sheet: Shareholders' Equity (in millions) Capital stock, authorized shares 29 Capital in excess of par value 1,305 Retained earnings 10,366 Currency translation adjustment (1,035) ---------- 10,665 Less: Treasury Stock, at Cost: 9/97 - 209 shares, 12/96 - 181 shares (4,320) Total Shareholders' Equity 6,345
You can see above where PepsiCo's shareholder's equity would have been $10,665 million, but instead $4,320 million was subtracted from it due to share repurchases, so we end up with $6,345 million. All I have done is added the $4,320 back, doing the same with each company we are looking it, in order to have a similar number to compare. On this basis, the return on equity at PepsiCo has been an unimpressive 13.3%, well below the 17.6% average for the twenty branded food companies we looked at in our survey.
As we mentioned above, though, things are not always as they seem. Given the massive divestiture of Tricon Global Restaurants, the net assets invested in PepsiCo have changed considerably in the past few months. You see, accounting is more of an art than a science. This is particularly true when you are retroactively trying to figure out what a company would have spent or what assets it would have had if it had been separate instead of part of a larger company. In the case of PepsiCo, Tricon was an asset and capital hog that required a lot of money to be pumped into it to generate adequate returns. As a separate business, PepsiCo is going to have a higher return on equity than it had when combined with Tricon. Thus, we have to try to imagine what the real return on equity for the "new" PepsiCo is, instead of blindly relying on what the historical financials say.
In this case, we reach into our analytical toolkit and pull out the "annualizing" wrench. You see, while we don't have four quarters worth of data for PepsiCo without Tricon, we do have one quarter. What we can do is annualize the income from the one quarter in order to figure out what the return on equity might have been for the entire year. The only thing we have to keep in mind is that if PepsiCo has a seasonal benefit in the third quarter, we may be overstating their returns. Because the third quarter has two of the summer months, this is possible, although the second quarter with one summer month and the fourth quarter with the holidays would seem to have an equal bias.Now, the formula for straight return on equity
is quite simple: 12 Months Net Income Return On Equity = ------------------------------ Average Shareholder's Equity
To modify the formula to get annualized return on equity, we need to make two adjustments. The first is to change the "12 Months Net Income" into "3 Months Net Income X 4." If we multiply one quarter's income by four, we get the annualized equivalent of a full year's income. Since we are looking at the third quarter, the income we are going to annualize is the third quarter's net income.
The second modification is to the denominator. We get the average equity by averaging the amount of equity at the beginning of the period and at the end of the period. Normally, this is the equity in one year averaged with the equity in the next year. In this case, because we are looking at one quarter, we need to average the equity at the end of the second quarter (the beginning of the third quarter) with the equity at the end of the third quarter. Thus, we need to look up the shareholder's equity in the 10-Q for the second quarter and the 10-Q for the third quarter.Our adjusted formula is as follows: 3 Months Net Income X 4 Return On Equity = ---------------------------- (Q2 Shareholder's Equity + Q3 Shareholder's Equity)/2
Using this formula, we can determine that the annualized return on equity 21.0%. We take the net income from the "new" PepsiCo of $551 million for the quarter, multiply by four, and divide by the average of $10,665 million and $10,317 million. As you can see, the annualized returns are much higher than the historical returns, putting the company above the newly adjusted 18.0% average return on equity for the group of twenty. (As we increased the return on equity at PepsiCo, the average for the twenty companies consequently had to be increased.)
Now, we need to compare this and several other factors to our other top choices. More tomorrow.