ALEXANDRIA, VA (Jan. 15, 1998) -- Yesterday we looked at the annualized return on equity at PepsiCo (NYSE: PEP). After adjusting return on equity for the fact that the third quarter was the only quarter that was truly free of the recent Tricon Global Restaurants (NYSE: YUM) spin-off, we discovered that PepsiCo's annualized return on equity was 21%. Modifying return on capital so that it takes the return in the third quarter and annualizes it (we will spare you the math this time around) we discover that it is 19.0%, slightly below the average. However, because of the distortion involved in the Tricon property, return on invested capital may well be understated even on an annualized basis.
Overall, PepsiCo still does not seem tremendously cheap relative to its adjusted historical financials. The company trades at approximately 2.7 times sales, 25.7 times annualized earnings per share, and at 26.3 times current fiscal 1998 earnings estimates. The only problem with those estimates is that some of them may not have been adjusted for the recent divestiture of the restaurant business. As a result, it is incumbent on individual investors to cut through the statements, make sure that they are looking at revenues from the continuing operations, and try to figure out what earnings might really be next year.
Looking at PepsiCo's recent 10-Q filing for the third quarter, we discover that revenues for the soda and snack food business for that quarter were $5.362 billion, while operating earnings were $929 million. This puts operating margins at 17.3% for the business, a great deal higher than the 11.3% the company shows on a historical basis. This 17.3% is higher than the 13.2% average for the twenty companies we have looked at and actually ranks PepsiCo number five, behind Coca-Cola, Campbell Soup, Anheuser-Busch, and Tootsie Roll.
Assuming that PepsiCo maintains its 40% historical tax rate, this 17.3% operating margin would translate into 10.4% profit margins. If we know the profit margins that we can reasonably expect over the next year, all we need to do is figure out the potential revenues, divide by the shares outstanding, and we can come up with our own estimate of earnings per share. In the last quarter, revenues for both businesses were $5.362 billion, up 3.9% from year ago levels. A flat year in soda due to the loss of one of the company's major South American bottlers and pricing pressure in the U.S. drove down the 7% gain in snack foods.
Using these numbers and some conservative growth estimates, we can imagine what earnings might be next year. Should soda revenue increase 2% next year and snack foods revenue grow by 7%, then the total revenue for the third quarter will be $5.594 billion. Assume that PepsiCo can do that revenue for all four quarters and maintain the 10.4% profit margins and you have net profits of $2.327 billion. As the company uses excess cash flow to buy in shares, we can imagine shares outstanding might be around 1.51 billion, meaning that the company could bring in $1.54 per share. If you increase the profit margin slightly to 10.7% to assume some benefit from cost cutting, earnings would be $1.60 per share. Either of these numbers would be much higher than the $1.37 per share analysts are currently expecting. So given the possibility of higher-than-expected share buybacks and margin improvements, should the company grow revenues even in the mid-single digits it could post significant earnings surprises. PepsiCo is certainly a strong contender for our Drip dollars, but we will have to look at our other two finalists next week before making the final decision.
Tomorrow, we wrap up the week with our normal Touchstone Friday. See you then.