The market is currently taking some of the fizz out of Pepsi Bottling's (NYSE:PBG) stock price, sending the shares down over 6% as of this afternoon. The company raised the low end of its full-year guidance, but the entire range was below what analysts had been projecting. Beside this short-term development, what's the long-term picture for Pepsi's (NYSE:PEP) major bottler?
Total sales for the quarter grew 7.7%, while net income was only up 1%. However, diluted earnings grew almost 5%, even though last year's quarter included a nickel gain because of a corn syrup litigation settlement. Particular strength was seen in Europe as the region saw 14% top-line growth and a 36% advance in operating income. Europe accounted for 16% of sales for the quarter. The U.S. and Canada accounted for the highest percentage of quarterly sales at 74% and saw sales advance 7%, although operating income fell 10%. Mexico, the third and final region, saw a 5% advance in both sales and operating income.
Management attributed U.S. and Canadian top-line growth to non-carbonated brands such as Lipton, Starbucks (NASDAQ:SBUX) Frappuccino, and energy drinks. Unfortunately, higher costs hit earnings, and certain analysts project that higher corn syrup and aluminum prices will continue to hurt the bottom line. Management highlighted European strength and characterized Mexico as a work in progress as it endeavors to energize sales growth. In the conference call, however, profitability trends were described as solid.
For the entire 2006 fiscal year, the company expects total global volume growth of 4% and diluted earnings of $1.90-$1.93, which includes $0.18 of stock option expenses and $0.05 from a benefit because of an income tax change. Analysts were targeting a couple of cents higher.
As I detailed last quarter, Pepsi Bottling generates robust operating cash flow, but because of the high levels of capital intensity from the factories and vehicles that come with bottling and distributing beverages, free cash flow is pretty low. Additionally, Pepsi Bottling has a history of snapping up other bottling companies. During the conference call, management characterized the industry as still highly fragmented, with further opportunities to make acquisitions and gain market share.
In addition, the company has high debt. While it does generate stable cash flow, interest expense ate up 16% of operating income for the quarter. Pepsi Bottling's net margins are also razor thin, another characteristic of operating in the bottling industry. In spite of the tough industry, Pepsi Bottling has done an excellent job of maintaining high-single-digit top-line growth, although the bottom line has advanced only about 5% over the past three years on a trailing 12-month basis. Nonetheless, the stock has nearly doubled since April 2003, when it traded as low as $18.
Pepsi Bottling should be able to continue to consolidate the bottling space, but it may be a better bet to invest directly in Pepsi or Coca-Cola (NYSE:KO) if you can find a good entry point. Pepsi and Coke have much higher margins and growth profiles. Plus, there's exposure to their respective bottlers (Pepsi Bottling and Coca-Cola Enterprises (NYSE:CCE) are the two primary ones), as they own just enough to control them but not enough to have to consolidate the bottling operations into their own financials. That financial arrangement best illustrates that low margins and capital intensity are best avoided if possible. Pepsi and Coke can't avoid the bottlers because they're instrumental in bringing their products to market, but fortunately, investors can.
For more fizzy Foolishness:
- Pepsi Bottles Another Quarter: Fool by Numbers
- The Little Beverage Company That Could
- Emerging Market Musings: Mexico
Coca-Cola is a Motley Fool Inside Value pick, and Starbucks is a Motley Fool Stock Advisor recommendation. Whatever your investing style, The Motley Fool has a newsletter right for you.
Fool contributor Ryan Fuhrmann is long shares of SBUX but has no financial interest in any other company mentioned. The Fool has an ironclad disclosure policy. Feel free to email him with feedback or to discuss any companies mentioned further.
