Will Pepsi Be a Rule Maker?

For review, the 11 criteria that Rule Maker companies must possess are (bolded criteria have already received the thumbs up regarding Pepsi):

1. Dominant brand
2. Repeat-purchase business
3. Convenience
4. Expanding possibilities
5. Your familiarity and interest
6. Sales growth of at least 10%
7. Gross margins of at least 50%
8. Net profit margins of 7% or greater
9. Cash no less than 1.5x total debt
10. Flow Ratio below 1.25
11. Cash King Margin of at Least 10%

We continue today from sales growth.

Sales growth of at least 10%. Measuring relevant sales growth at Pepsi is difficult due to a recent restructuring, including a spin-off of three restaurant chains. In fact, when you look at past financial results, sales have declined the last five years. The only relevant results, however, are those of the "new" Pepsi.

In the most recent quarter, sales grew 8% year-over-year. In the quarter before that, sales rose 6%. The quarter before that, 6% again. Prior to that, 5%. Finally, in the first quarter of 1999, sales jumped 17%. We don't have much else to go on. So far, however, the new Pepsi has not regularly topped 10% sales growth year-over-year, and sometimes it has not even been close. Frito-Lay has performed well, but the soda division has been a drag. Pepsi misses the mark on this criteria.

Gross margins of at least 50%. Pepsi doesn't have any trouble here. The last three years, gross margins were 58.9%, 57.3%, and 58.3%. Gross margin stood even higher at 59.9% in the most recent quarter. Selling snacks is a high-margin business for Pepsi.

Net profit margins of 7% or greater. No trouble here, either. Profit margins in 1999 were 10.0% and last quarter they were 10.0%. If we're lucky, they should start to rise modestly.

Cash no less than 1.5x total debt. As of March, Pepsi had $2.9 billion in long-term debt and $520 million in cash and equivalents, so the company fails on this account. However, we're not as strict as Rule Maker investors when it comes to a company holding some debt. Debt in moderation can represent smart leverage in a business, as long as the cost of the capital is lower than the return earned on the capital. However, Pepsi simply fails on this Rule Maker criteria.

Flow Ratio below 1.25. Measuring cash flow efficiency, Tom Gardner's formula for the Flow Ratio is:

                  (Current Assets - Cash)
Flow Ratio = -------------------------------

             (Current Liabilities - ST Debt)

The information needed to run the Flow is found on a company's balance sheet, which is best found in SEC filings available at http://quote.fool.com. Pepsi's most recent results showed a Flow Ratio of 1.01, well below 1.25 and therefore very respectable. Chalk up a victory for the Chee-tos guy.

Cash King Margin (CKM) of at Least 10%. The final Rule Maker criterion measures how much cash a company is clearing from operations much more accurately than does the net profit margin. It is this:

                   (Operating Cash Flow -
                    Capital Expenditures)
Cash King Margin = ------------------------
                           Sales 

Pepsi's most recent CKM (which we measured last month) was 9.37%, only slightly below the benchmark. However, we do expect Pepsi's CKM to rise above 10% soon, given the trajectory of the business, so this isn't much of a concern.

Conclusion. Pepsi passed all five of the qualitative Rule Maker criteria with flying colors on Wednesday, but it failed two of the six quantitative measures -- sales growth and debt levels -- and it just missed on a third, the Cash King Margin.

To pass the test completely, Pepsi will need to grow sales 10% annually, lower its debt-to-cash ratio, and increase its Cash King Margin. The latter two improvements are likely to occur. However, 10% sales growth is a challenge for such a large company. In fact, Rule Maker holding Coca-Cola (NYSE: KO) has failed miserably on this measure.

Your Turn. Having passed about 8.8 of the 11 Rule Maker criteria, is Pepsi close enough to Rule Maker status for your satisfaction? Vote in our Poll.

Rule Maker Criteria Summary for Pepsi
(Bold passed, italics failed, #11 is lukewarm close.)

1. Dominant brand
2. Repeat-purchase business
3. Convenience
4. Expanding possibilities
5. Your familiarity and interest
6. Sales growth of at least 10%
7. Gross margins of at least 50%
8. Net profit margins of 7% or greater
9. Cash no less than 1.5x total debt
10. Flow Ratio below 1.25
11. Cash King Margin of at Least 10%

Fool on!