There are Pepsi (NYSE:PEP) machines that dispense your soda in exchange for a $1 bill. But the company's stock is an entirely different sort of Pepsi machine, one whose performance over the past 20 years or so has been nothing short of spectacular. Like clockwork, Pepsi registered yet another solid quarter of results. The company grew sales across all of its business lines, notching a net revenue increase of 9% for the third quarter.
Every once in a while, however, you'll find that the machine has decided to eat your money without dispensing that ice-cold beverage you wanted. Likewise, this period wasn't without hiccups, as costs in certain areas hampered margin expansion efforts; operating margins were down slightly to 20.3% from 20.5% in the year-ago period.
In this edition of Fool on Call, we will examine at two of the key factors currently hitting Pepsi's profits, in addition to taking a look at its rise in capital spending. Using its latest quarterly earnings conference call, we'll look at:
- The impact of escalating orange prices, and Pepsi's response
- The Gatorade impact, and Pepsi's response
- The state of Pepsi's capital spending
The orange squeeze
Both a squeeze from orange produce and a pinch from rising Gatorade expenses are taking a bite out of Pepsi's profits. One of the most pressing concerns management has is the unknowns associated with skyrocketing orange prices. Both Coca-Cola's (NYSE:KO) Minute Maid and Pepsi's Tropicana are still feeling the effects of the storms from hurricane-ravaged Florida.
It was just reported that the U.S. Department of Agriculture is predicting that Florida orange groves would produce 40% fewer oranges in 2007 than their pre-2004 hurricane levels. The report added that juice manufacturers will likely turn to the world's leading orange producer, Brazil, to make up for some of the shortfall. However, Brazilian oranges carry roughly a $0.30-per-gallon tariff, making it an expensive replacement option.
The orange squeeze was the topic of much conversation during Pepsi's latest conference call. CEO Indra Nooyi admitted that earlier in the year management was projecting "orange cost inflation to actually abate somewhat in the back half of the year." Instead, "exactly the opposite happened," as orange costs continued to escalate.
With the realization that current price increases reflect "structural" problems that would not go away anytime soon, the company announced price increases for its Tropicana Pure products. During the question-and-answer portion of the call, management indicated that they have "priced to cover" the changes in the orange market with the latest price increases.
In addition to price increases, Pepsi is looking toward "innovations" and improved efficiencies to its supply chain as other ways to mitigate the escalating costs. Even with the changes, management is keeping a wary eye on the orange market going into 2007, reiterating, "Orange juice is the one [category] that we need to focus on the most."
Gatorade thirst pincher
Beyond oranges, Gatorade also weighed on Pepsi's profits in the quarter. The problem here is that increased demand for Gatorade products over the summer couldn't be met entirely by "Company-owned manufacturing capacity." As a result, Pepsi had to turn to third-party manufacturers to help meet demand, and the costs of going out-of-house put a crunch on margins.
To counter, Pepsi has two new Gatorade plants currently under construction, with the Virginia plant coming online in time for 2007 peak season. The second plant, based out of Oklahoma, will go live for the 2008 season. Together, the new plants will lower "manufacturing and supply chain costs relative to using third-party manufacturing."
Building out the machine
Finally, during the Q&A portion of the call, one analyst asked management to remark on the company's rising capital expenditures, noting that this year CAPEX is estimated to be roughly 6.3% of sales (management's stated goal is to be back around 5 to 5.5% of sales). Nooyi sought to alleviate concerns on this topic by noting that it is natural for capital spending to rise when top-line growth is doing so well, but added that within two years they are hopeful to get capital spending to within 5.5% of net sales.
In the meantime, however, there are vital areas that need additional investment dollars in order to meet increased demand. One, as its snack business expands internationally, the company will "have to add more capacity." Second, as Pepsi moves to bring all Gatorade production in-house, there are costs associated with building the aforementioned manufacturing plants. And third, capacity needs to be ramped up to meet the increased demand for Pepsi's "hot food beverages."
Keep putting your quarters in the Pepsi Machine
Now I must admit, spending an entire article on some of Pepsi's challenges is almost akin to focusing on the birthmark resting on the forehead of Women Management and Ralph Lauren supermodel Valentina Zelyaeva. Yes, it is there, but it does virtually nothing to detract from her overall looks. Folks, even with escalating orange prices, third-party manufacturing costs, and increased capital spending, Pepsi remains a very sexy long-term investment opportunity.
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Coca-Cola is a Motley Fool Inside Value recommendation. To find out why, try a free trial of the newsletter here.
Fool contributor Jeremy MacNealy has no financial interest in any company mentioned. The Motley Fool's disclosure policy will never be affected by oranges.
