PEPSICO VALUATION. 28 April EMON SILA MATT BALLARD

Transcription

1 PEPSICO VALUATION 28 April 2005 EMON SILA MATT BALLARD

2 TABLE OF CONTENTS Executive Summary 2 Business & Industry Analysis 5 Five Forces Model... 6 Competitive Strategy Analysis.. 9 Key Success Factor Accounting Analysis. 13 Key Accounting Policies.. 14 Screening Ratios Ratio Analysis & Forecast Financial 25 Firm Analysis..26 Cross Sectional Analysis Financial Statements Forecasting 46 Valuation Analysis.. 48 Method of Comparables 48 Free Cash Flow..51 Discounted Dividend.53 Discounted Residual Income.54 Long Run Residual Income...56 Abnormal Earning Growth 57 Appendix 60 1

3 Executive Summary I Executive Summary Investment Recommendation: Slightly Overvalued Sell PEP NYSE $ week price range $ Revenue (2004) 29,261 (mill) Market Capitalization 89.99B Shares Outstanding 1.68B Dividend Yield 1.72% 3-month Avg Daily Trading Volume 3,251,909 Percent Institutional Ownership 66.44% Book Value Per Share (mrq) ROE 31.24% ROS 53.68% Cost of Capital Estimates Beta Ke Ke Estimated 5yr Beta % 3yr Beta % 2yr Beta % Published Beta % Kd 3.98% WACC 4.80% Valuation Ratio Comparison PEP Ind Avg Trailing P/E Forward P/E Forward PEG M/B Valuation Estimates Actual Current Price (April 1, 2005) $52.76 Ratio Based Valuations P/E Trailing $49.47 P/E Forward $48.92 PEG Forward $50.80 Dividend Yield $39.72 M/B $37.07 Ford Epic Valuation $71.33 Intrinsic Valuations Discounted Div $43.18 Free Cash Flows $47.90 Residual Income $51.80 Abnormal Earnings Growth $54.13 Long-Run Residual Income Perp $

4 Executive Summary As we mention previously PepsiCo is a world leader in convenient food and beverages, with revenues of about $29 billion in The company consists of the snack business of Frito-Lay North America, PepsiCo Beverage Int l, PepsiCo Beverages North America and Quaker Foods North America. PepsiCo (PEP) shares are traded on the NYSE in the United States. PepsiCo has implemented cash dividends since the corporation was founded. Besides NYSE, this company is also listed on the Amsterdam, Chicago, Swiss, and Tokyo stock exchange ( We have found that the non-alcoholic beverage industry is dominated by three major players which are PepsiCo, Coca-Cola and Cadbury Schweppes. There is tremendous competition within a relatively slowing industry. This industry is known for the rivalry between Pepsi and Coke over the years. PepsiCo currently controls nearly 21% of this industry. On the other hand Frito- Lay controls 60% of the U.S snack-food market. Switching costs are virtually inexistent in this industry. Within the industry there are large economies of scale and it is hard for new entrants in this industry. PepsiCo has done a great job of building a great brand name, rivaling that of Coca-Cola. In PepsiCo s industry there is a considerable threat of product substitution. PepsiCo has a low bargaining power of suppliers because like Coke they own their bottling companies. PepsiCo s competitive strategy is also based on differentiation instead of cost leadership. This means that they have to highly invest in new flavors, formulas, and packaging to compete with their competition. PepsiCo has a flexible distribution network; products are brought to the market through vending distribution networks, direct store delivery, and broker-warehouse. After extensive review of PepsiCo accounting practices we feel highly confident in their financial disclosures. We analyzed several aspects including: key accounting policies, accounting flexibility, accounting strategy, quality of disclosures, potential red flags, and screening ratios. While there were a few discrepancies, the importance of the errors weighted very little on our analysis. By targeting these aspects individually we were able to dissect and examine the underlying procedures of PepsiCo. We determined that their key accounting policies and strategies are directly in line with industry practices. Also, in dealing with account flexibility we determined that there was some flexibility and changes in accounting procedures but these were in line with actions 3

5 Executive Summary of regulation and industry standards. Quality of disclosures was adequate in regards to voluntarily giving information to investors. After review we determined that there were no main causes for alarm. While there were some activities that looked suspicious, after further investigation we determined them to be of minor consequences. Finally, screening ratios were used to determine if there were any potential manipulations. Overall these ratios were fairly consistent over the years. Also, comparing PepsiCo to the industry further supported our decisions, in that they were consistent with that of competitor s ratios. We analyzed PepsiCo using the liquidity, profitability, and capital structure categories of ratios. By doing this analysis we founded that PepsiCo is relatively liquid, has a moderately favorable profitability and that capital structure has a moderately positive analysis. PepsiCo financial statements are reasonably transparent. They are reported on quarterly basis. These financial statements give their shareholders and investors good and clear inside information about PepsiCo. The forecasting that we did for PepsiCo financial statement showed a steady growth for the next 10 years. PepsiCo has an excellent growth potential for the years to come because Frito-Lay, Pepsi-Cola, Quaker Oats, Gatorade, and Tropicana brands all have strong market position in North America. Our forecasted financial statements are free of errors and we don t assume that our forecast it is going to be accurate because as we know the longer the period of forecast the less accurate the forecast will be. We valued PepsiCo based on six valuation models. These models include the following: Method of Comparables, Discounted Free Cash Flows, Discounted Dividends, Discounted Residual Income, Abnormal Earning Growth and Long Run Average Residual Income Perpetuity based on the P/B ratio. Valuation is the process of converting the forecast that we did for the company into an estimate of the value of the firm. To use this method we had to find the Kd, Ke and WACC of the company. We did this by considering the risk of the company and by calculating how much of the firm is financed with debt and equity. In all these models except the abnormal earning growth model, the actual price exceeds our estimated price. These models show that PepsiCo as slightly 4

6 Business & Industry Analysis overvalued by an average of $3.51 per share. In most of these models the change of the growth rate was the most sensitive factor of change, besides the discounted residual income where the cost of equity was the sensitive factor of change. Even though there may be some errors in the models, we feel that PepsiCo stock price is slightly overvalued and we recommend investors to sell this stock. II Business & Industry Analysis PepsiCo was founded in 1919 in Delaware and was reincorporated in North Carolina in Now this company is one of the world leaders in snacks, foods and beverages. ( PepsiCo produces and market different kind of salty, convenient, sweet and grain-based snacks, carbonated and non-carbonated beverages. PepsiCo had revenue of about $29 billion in 2004, 27 billion in 2003 and over 200,000 employees. The company is organized in four divisions which consist of the Frito-Lay North America, PepsiCo Beverage North America (Pepsi-Cola America and Gatorade/Tropicana North America), PepsiCo International, and Quaker Foods North America. The international division operates in around 200 countries. The largest of operations are held in United Kingdom and Mexico ( PepsiCo has emerged as a vast and diverse company, involved in beverages as well as snack foods. PepsiCo s division Frito-Lay holds a significant leadership in the snack industry even though is faced with different competition everyday. The company produces eight of the ten best selling snacks in the nation. Frito-Lay controls 60% of the U.S. salty snack-food market and has the number one position in corn chips, potato chips, tortilla chips and pretzels ( The beverage industry is dominated by three major players which together control the global market. These players are Coca-Cola, PepsiCo, and Cadbury Schweppes (Dr Pepper and Seven Up). For years this industry is known for the war between Coke and Pepsi on the cola principals. Now this war has ended and the industry s giants have been focusing in on creating new product flavors to compete with each other. 5

7 Business & Industry Analysis Five Forces Model Competitive Force 1: Rivalry Among Existing Firms Due to the fact that this industry s growth has had relevantly little growth over the years, there is tremendous competition within the industry. This industry has low concentration. Three major firms account for 80% of the global market. These firms include PepsiCo, Coca-Cola, and Cadbury Schweppes. Coca-Cola has achieved 50% in global market share, while PepsiCo controls 21%, and Cadbury Schweppes maintains 7% ( Competition amongst these firms is not mainly based on price competition but rather product differentiation. Many firms rely on new flavors and have also branched into non-carbonated beverages and snack foods to give there firm a competitive advantage over others. PepsiCo has also been exceeding in this by acquiring Quaker Oats which owns Gatorade. PepsiCo has also added Tropicana, Aquafina, and Lipton into its product line making PepsiCo number one in the non-carbonated beverage industry. Coca-Cola has also entered into this arena by emerging with Nestea, Powerade, and Minute Maid brands to compete in this movement. PepsiCo has also branched into the breakfast and snack food industry with Quaker Oats and Frito-Lay. While PepsiCo has remained at number two in soft drinks, this diversification has helped make up the difference in competition. Switching costs are virtually inexistent in this industry as there are no costs for consumers to switch products. The only costs to switching would be a different taste, appearance, and appeal. This is mainly due to the fact that firms have cooperated to maintain the same price for there products. Consumers are faced with a decision of choosing a product not based on price but rather on style, taste, and other contributing factors. Under these circumstances, companies have spent considerable energy to market there products to achieve brand awareness. There is also a tremendous learning curve for these companies, resulting in extreme barriers to entrance of other emerging companies. Most companies have developed extensive distribution systems and have created relationships with suppliers and buyers. Also there are extensive economies of scale resulting in companies with massive size. This has been created by obtaining extreme amounts of capital and diversifying the company into other markets. 6

8 Business & Industry Analysis In this type of industry there are relatively few exiting barriers which have left only a few companies to compete in. Competitive Force 2: Threat of New Entrants Within this industry there are large economies of scale. This results in an extreme amount of capital to propel the company. Using capital for manufacturing isn t much of a concern as there are generic brands which cost less. Much capital is used to market and advertise there products to achieve brand awareness and differentiate there products from others. PepsiCo has done a tremendous job by creating a household name rivaling that of Coca-Cola s. Such common household names are Pepsi, Mountain Dew, Gatorade, Tropicana, Lipton, and Quaker and Frito-Lay products. New companies trying to emerge into the industry have a distinct disadvantage due to the fact that the top companies have already developed such traits. This has caused new companies to not be able to compete head on with rivals. Also companies within the industry have developed extensive arrangements and relationships with manufactures and distributors. PepsiCo for example has Pepsi Bottling Group. This independent entity makes, sells, and distributes Pepsi brands around the world. Competitive Force 3: Threat of Substitute Products In PepsiCo s industry there is a considerable threat of product substitution. Products offering the same qualities and features at a lower price can initiate customers to substitute. In this day of age of health consciousness, new products have been developed to meet this trend. To meet this concern many of the companies offer healthier alternatives that ultimately cut into their other brands profits. Brands such as Pepsi One, Diet Pepsi, and Coca-Cola s C2, and Diet Coke have been developed to meet this concern head on. Another concern is that of generic brands such as grocery store brands. The relative concern is based on price. For example most grocery stores have their own brands of soda, juices, breakfast, and snack items. While the top companies have there 7

9 Business & Industry Analysis own distinct image, these generic brands offer a similar taste but at a much lower price. This industry s main concern is if customers become price conscious and stray away from popular brands such as PepsiCo products. As long as consumers place value on these companies products there shouldn t be that much of a concern. Competitive Force 4: Bargaining Power of Buyers PepsiCo is more sensitive to price due to the fact that there are low switching costs involved in producing their products. Because the total cost of manufacturing their product comes from packaging, PepsiCo is more apt to search for the lowest price of their raw materials being that are readily available and are a common material (i.e. plastics and aluminum). Being that PepsiCo is such a large producer enables them to hold a strong bargaining position. Since they buy so many raw materials they are able to get lower prices for them buying in such bulk. Also the number of readily available materials to PepsiCo increases their bargaining power due to the fact if a specific supplier can not match a price or does not have the material available; it is not difficult to find it quickly and inexpensively. However these packaging and distribution expenses are taken by Pepsi Bottling Group which is a separate entity of PepsiCo and became publicly traded in early Even though PBG is a separate company; PepsiCo owns 40% of PBG s equity interest. ( Competitive Force 5: Bargaining Power of Suppliers There are many different suppliers in PepsiCo s industry. These suppliers are the bottlers and metal can suppliers. PepsiCo is in a unique position in which it used to own Pepsi Bottling Group. In 1999, Pepsi Bottling Group became independent and in which PepsiCo retains 40% of its shares. Because of this suppliers of bottlers have a relatively low bargaining power relative to PepsiCo because they are a continued vested interest of PepsiCo. This makes PepsiCo able to have a distinct advantage over other competitors in production and distribution. Pepsi Bottling Group also provides other 8

10 Business & Industry Analysis ingredients that are used in the food and beverage businesses, these include: almonds, cocoa, corn, flavorings, flour, juice, oranges, potatoes, and different kind of fruits.( This gives PepsiCo the chance to produce low cost products over competitors. PepsiCo also employs specialists to secure the best suppliers that are in the market for many of these items in order to produce quality products too. Competitive Strategy Analysis The beverage and snack industry is very competitive. Their competitive strategy is based on differentiation instead of cost leadership. This means that the giants of the business like PepsiCo should explore new formulas, flavors and appearances to compete with each other. This is what PepsiCo is already doing by introducing two different lime flavor drinks by the end of this month. PepsiCo is known for producing a variety of salty, sweet and grain-based snacks, carbonated and non-carbonated beverages and foods. They invest many resources to produce superior products and in marketing for brand awareness. This is one of the reasons that PepsiCo has been one of the leaders in the beverage and snack industry. Another competitive advantage that PepsiCo has is its non-carbonated beverage. PepsiCo has lost the war against Coke for the carbonated beverages, but they are the leader in the non-carbonated beverages category. They have done this by adding Gatorade s 73% share of the sports drink market to its Tropicana and Lipton tea holdings. ( This means that PepsiCo is not only focusing on competing with Coke on the carbonated beverages but they are looking to win battles in other competitive areas. This is going to make PepsiCo maintain a competitive advantage over a wider array of its competitors. Another competitive advantage of PepsiCo is their flexibility of their distribution network. PepsiCo products are brought to the market through direct-store delivery, vending distribution networks and broker-warehouse. This distribution system is 9

11 Business & Industry Analysis developed in a way to satisfy customer needs and to show product characteristic. By having a flexible distribution network PepsiCo is going to maintain their great reputation and their product are going to satisfy their customers. The last competitive advantage that PepsiCo has is its capital. PepsiCo is number one in the snack industry, number two in the non-alcoholic industry and they have revenue of about $29 billion. This means that they have excess money to spend on advertising, quality of products and differentiation. PepsiCo by having such great capital provides advertising, sales and promotional support to their beverage and food customers. That s why PepsiCo has some of the most-recognized advertising in the world. By having such extensive capital PepsiCo is making some research and development to find new flavors and to produce an even higher quality product. In conclusion PepsiCo believes that their capital, differentiation, flexibility of their distribution network and their non-carbonated beverage is going to allow them to compete efficiently. Key Success Factor Strengths: One of the biggest strengths of PepsiCo is its Officers and Directors. They are a master of being honest, having analytical assessment and they have no shyness in terms doing what needs to be done. Minority Business News names PepsiCo Chairman and CEO Steve Reinemund Executive of the Year. ( It is because of them that the PepsiCo is one of the best companies in the beverage and food industry. Another strength of this company is their division Frito-Lay which has surpassed companies of all sizes through a combination of restructuring, new products, and lower prices. While Coke is synonymous with soda, so are Frito-Lay s Fritos is with corn chips demonstrating its product-name association. Like James Stack an editor of InvesTech Research says, While the company trails Coca Cola on the soft-drink industry, in the snack foods, Frito-Lay which controls 60% of the U.S. salty snack-food market, has the number one position in corn chips, potato chips, tortilla chips and pretzels. They are the 10

12 Business & Industry Analysis best-run company in the food business. For the twelve months ended Sept, 4, 2004 PepsiCo earned $3.93 billion on sales of $16.49 billion. This shows that company is very profitable, has a good financial footing, and is continuing to grow. While the soft drink segment is, as ever, PepsiCo is number 2, but is an extremely strong number 2. They control 21% of the soft-drink market. It is going to be hard to compete with Coke in the soft drink industry but PepsiCo is not just staying and accepting defeat. The company s purchase of The Quaker Oats Company and its Gatorade brand show that they are still highly competitive. Weaknesses: Pepsi maybe is one of the weaknesses of PepsiCo due that is really far from the leader Coca-Cola in the international market. Coke is three times Pepsi's size in fountain sales and has more than ten times as many salespeople as Pepsi. In the U.S., Pepsi's market share lags behind Coke's by the widest margin in over two decades. The net sales of PepsiCo had increase in the past years but it is important to notice that this increase is only because of sales in USA. Internationally, Pepsi's drink business was a mess. They still haven t figured out a way to increase their sales in the international market. But lately they have improved internationally and especially after Coke have lost a lot of sales in Europe. But PepsiCo has showed difficulties in the past in the international market and they are trying very hard to improve these weaknesses. Another weakness is their historically late entrance into carbonated beverage industry. Coca-Cola entered the market in 1886 while Pepsi emerged in 1919 giving Coca-Cola a three decade head start.( Regardless of PepsiCo s size, diversification, business acumen or bottom line, consumers still see the company as only Pepsi, a product. While Coke has fans (collector s clubs, items, Christmas tree ornaments, etc.), Pepsi has purchasers. Opportunities: 11

13 Business & Industry Analysis There are still some undeveloped markets in the world that PepsiCo should try to penetrate. They need to look for these markets and get established there before their competitors. PepsiCo traditional carbonated soft drinks and salty snacks continue to symbolize the company and it is going to do so for a long time. But you have to be risky to succeed in business and to beat your competition. PepsiCo is thinking about taking a risky strategy to make at least half of its new-product offering nutritious ( We know that we live in a society where many people are worried about their nutrition. We hear about this topic through the media and we read it in magazines all the time. New good-for-you products from PepsiCo are going to include soon dairy products, more whole-grain items in its Frito-Lay line of salty snacks, products based on olive oil and a soy-enhanced Tropicana orange juice. This is going to be a great opportunity for PepsiCo to make healthier product and to expand its market. The key for the beverage companies is differentiation. The giants of the industry have different formulas and appearances. PepsiCo for being one of these giants has the opportunity to make better formulas and appearances for their customers so they can beat their competition. PepsiCo is going to introduce a lime-flavored soda that is going to compete with a similar offering of their rival Coca-Cola. By using a better formula and appearance and a great advertising plan in these new drinks, they have the opportunity to beat Coca-Cola. Threats: The prices of the items that PepsiCo purchase are subject of fluctuation. For example the increase the prices of the raw materials or the fuel can cause an increase of the costs of the production of their product, and in the business environment that PepsiCo operates, it is not possible to increase the product price because they are part in a very competitive environment. In the marketing department the PepsiCo brand image is very much linked to Pepsi image, which has label of second best brand. This can still give them the label of loser, linking its image to the rest of firm s company. This can give them a bad brand image in their markets. They need to improve in their marketing 12

14 Accounting Analysis department through advertising campaigns where they are appeared together with other PepsiCo Brands. Conclusion: PepsiCo has established itself as a very stable and profitable company in North America and all over the world. As we mentioned above they are number two in the nonalcoholic beverage industry and number one in the snack industry by owning Frito-Lay. PepsiCo, Inc operates four major businesses: Frito-Lay North America, 34% of the sales and 41% of operating profit; PepsiCo Beverages 29% of sales and 30% of operating profit; Quaker Food 5% of sales and 9% of operating profit; PepsiCo Int l 32% of sales and 20% of operating profit. (Value Line) All these brands have a strong market position in North America and because of these PepsiCo has a growth potential for the years to come. III Accounting Analysis The next process of analyzing PepsiCo was to look at their accounting activities. The following sections contain both the qualitative and quantitative methods to evaluate the credibility of PepsiCo financial statements. The qualitative method consists of five steps: key accounting policies, potential accounting flexibility, strategy analysis, quality of disclosures, and potential red flags. Based on our analysis we did not undo any accounting distortions. After our evaluation of the financial statements and footnotes, we feel confident that PepsiCo s accounting practices are not misleading or distorted. The quantitative method consists of evaluating ratios to see the reliability of PepsiCo financial results. 13

15 Accounting Analysis Key Accounting Policies PepsiCo is a manufacturing company that must compete in research and development, product defect after the sale and product quality and innovation. PepsiCo key accounting policies are revenue recognition, brand and goodwill valuations, income tax expense and accruals, stock compensation expense, and pension and retiree medical plans. These policies require management to make difficult judgment about uncertainties and these results may significantly impact their financial results. PepsiCo needs to focus on these key accounting policies to maintain a competitive advantage over it competition. One of the most important key accounting policy for PepsiCo is revenue recognition. They recognize revenue upon delivery to their customers in accordance with written sales agreements that do not allow for a right of return. PepsiCo wants to maintain a high reputation for its superior products. This is achieved by implementing a policy for direct-store delivery with chilled fresh products, to remove and replace damaged and out-of-date products. This ensures that their customers receive the highest of quality and freshness from their products. Another key accounting policy for PepsiCo is brand and goodwill valuations. Many of their brand names have been developed by PepsiCo management. They believe that a brand has an indefinite life if it has significant market share in a stable economic environment, and a strong revenue and cash flow performance. Brands that don t meet these criteria are amortized over their expected useful lives. PepsiCo purchases brands and goodwill in acquisitions in which are not amortized. They are recorded annually to ensure that estimated future cash flows continue to exceed their relative book value. As of December 27, 2003 PepsiCo had $4.7 billion of perpetual brands and goodwill, of which nearly 75% related to Tropicana and Walkers. 14

16 Accounting Analysis Income Tax Expenses and Accruals is another key accounting policy for PepsiCo. They determine their annual tax rate based on their income, tax planning opportunities, statutory tax rates, and significant judgment. Their annual tax rate was 28.5% in The annual tax rate reflected in PepsiCo financial statements is different from that reported in their tax return. Also due to tax laws, timing differences that create deferred tax assets and liabilities must be shown. Stock Compensation Expense is another key success factor for PepsiCo. PepsiCo believes that rewarding employees based on there performance will ensure a more productive workforce. At the end of 2003, PepsiCo board put in effect a new compensation program, which makes the link between pay and individual performance stronger. They achieved this by varying the amount of long-term compensation for each employee based on individual performance and responsibility. This new program provided employees with the choice of being granted stock options or restricted stock units (RSUs). This new program is expected to reduce the stock compensation expense for 2004 from $407 million in 2003 to $360 million. The last key accounting policy for PepsiCo is pension and retiree medical plan expenses. Their pension plans cover employees in USA and certain international employees. They measure their annual pension and retiree medical expense based on many assumptions. These include: the interest rate used to determine the present value of liabilities, the expected return on plan assets, the rate of salary increases of plans where benefits are based on earnings. Also they use certain employee-related factors such as: turnover, retirement age, mortality, retiree medical benefits, and health care cost trend rate. In 2003 PepsiCo s pension and retiree medical expense was $157 million and $116 million respectively. In 2004 they are estimated to be $245 million and $120 million. 15

17 Accounting Analysis Accounting Flexibility: For PepsiCo there are a few recently adopted new accounting standards, but are not expected to have a material impact on the bottom line of the consolidated financial statements. This company has historically implemented accounting methods that make their financial statements to reflect the truest economic reality possible. PepsiCo products are sold for cash or on credit terms. The credit terms require that the payments arrive within 30 days of delivery and awards discounts to customers for early payments. Revenue is recorded at the time of delivery to customers. PepsiCo management develops their own brand name and they also purchase brands through acquisitions. The brands developed costs are expensed as incurred, and the purchase price of brands is allocated under identifiable assets and liabilities based on estimated fair value. Any remaining purchase price is recorded as goodwill. If brands meet the criteria, they have an indefinite life. If a brand cannot live up to the set of standards, it is amortized over its expected useful life. Goodwill and perpetual brands are not amortized; they are assessed for impairment. A perpetual brand is impaired if its book value exceeds its fair value. On the other hand, goodwill is impaired if the book value of its reporting unit exceeds its fair value. If the fair value of an evaluated asset is less than its book value, the asset is written down to fair value based on its discounted future cash flow. PepsiCo recently changed methods to account for employee stock options. Under the intrinsic value method, they did not recognize any stock compensation expense because they grant their stock options at the current stock price. So at the end of 2003, PepsiCo changed their way of measuring employee stock options. They adopted the fair value method for accounting for stock options as described in SFAS 148, Accounting for Stock-Based Compensation- Transition and Disclosure. Now the accounting procedure recognizes stock compensation expenses from the date of grant to the vesting date. Under this method, the expected value that employees will receive from the options is 16

18 Accounting Analysis going to be based on a number of assumptions like interest rate, employee exercises, PepsiCo stock price, and dividend yield. Pension and retiree medical plans are other areas that show flexibility. These plans are recorded as long-term liabilities for PepsiCo. The pension or retiree medical benefits that are expected to be paid are expenses that are based on estimates. These estimates include: factors such as the expected return on assets in their funded plans, the rate of salary increase for plans where benefits are based on earnings, how long a person will live after they retire, and on the interest rate used to determine the present value of liabilities. If these estimates are not done accurately, the company will have an overstated or understated net income. Evaluating Accounting Strategy: In order to assess if PepsiCo s accounting strategies reflect true economic reality, we had to evaluate the accuracy of their accounting policies. By comparing PepsiCo s policies with that of other firms in the industry, we were able to determine the differences in strategies that could mean potential distortions. After careful review we determined that PepsiCo s implemented accounting policies are within the standards of the current industry. PepsiCo s accounting policies are very similar in many aspects to other industry competitors such as Coca-Cola and Cadbury Schweppes. One policy similarity is revenue recognition, in which all companies recognize revenue when product titles are transferred upon delivery. Also, the credit terms which require payment within 30 days of delivery, are created in accordance with industry practices. This credit term policy is a good business transaction that PepsiCo uses to collect money from their customers in a short period of time. Another important similarity is brand and goodwill valuations. Interestingly, PepsiCo and Coca-Cola use the same three criteria for evaluating goodwill and other intangible assets. These include that assets with indefinite lives not be 17

19 Accounting Analysis amortized, and that definite intangible assets are subject to amortization. They also implement the same procedures to test for impairments that may result from a change in future operations, economic downturns, or conditions present to indicate that carrying value may not be recoverable. Pension and retiree medical plans are very similar to the industry as well. They each use estimations of the plan s expected returns and risk characteristics. They adjust these estimations based on the interest rate used to calculate the present values of the plan liabilities, estimations of the maturity of the benefits, and increases in salary. Also, advertising, marketing, and research and development are crucial to this industry. Even though future value is created in these expenditures, all costs associated with these ventures are expensed appropriately. Finally, the last policy reflects the treatment for stock option via the fair value method. Coca-Cola, Cadbury Schweppes, and PepsiCo Inc all have established the fair value method to account for employee stock options. PepsiCo policies and estimates have been mostly realistic, but the company did have a mistake in the earning release for the fourth quarter in They revised the 2002 and 2003 earning per share because of overstatements for stock option expenses. This was something that does not normally occur in this company, but they explained that is was a computational error. The revision increased the previously reported earnings per share for 2003 by $0.04 to $2.05 and for 2002 by $0.02 to $1.68. This revision did not have any impact on the company s previously reported cash flow or division operating profit because stock option expense is a non-cash charge. Even though such mistakes can easily happen, erroneous financial reporting can overstate or understate earnings. The firm made some changes in it accounting policies during One of these changes was measuring employee stock options. Until 2003, they were using the intrinsic value to measure this expense. The method that they were using measured the stock compensation expense as the amount by which the market price of the stock on the date of grant exceeds the exercise price. By using this method, they were not recognizing any stock compensation expense because they granted their stock option at the current 18

20 Accounting Analysis stock price. So by the end of 2003, they changed their method from intrinsic value to fair value method of accounting for stock options. Under this method, they measure the stock option expense at the date of the grant using the Black-Scholes valuation model. This model estimates the expected value that the employees will receive based on different assumptions such as interest rate, employee exercises, stock price and dividend yield. The firm also restated their results using the fair value method. The impact of this change is going to be recorded as unallocated expenses in each of the years presented. Refer to Table 1 to see how the restatements affected the firm. Table Operating Profit Net Income Net Income per common share $0.16 $0.17 $0.14 Quality of Disclosure: PepsiCo provides to its investors and analysts adequate disclosures to assess the firm s business strategy. The quality of financial statements, accounting methods, and information disclosed provided by the firm gives a true picture about their business. Reports have shown that carbonated soft drink growth has been slowing overall and that the brand name PepsiCo was declining during PepsiCo did not show adequate information to its investors to explain these declines. They wrote a brief paragraph in the Letter to the Shareholders to inform analysts and investors about this current information. The paragraph though did not give any explanation or any remedies 19

21 Accounting Analysis for this discouraging information. Instead, they disclosed information regarding the fact that the firm has been growing in the past and is expected to grow in the future. The letter talks about commitments to growth and in what sectors PepsiCo has achieved growth. They also give a good description of the firm s industry condition, environment, and competitive positioning, but they did not disclose relevant information to their investors about bad news. PepsiCo discloses economic factors that affect the company. For example, some of these factors include the exchange rate and political conflict. PepsiCo s operations outside of the United States generated approximately 35% of their net revenue of which almost 20% comes from Mexico, United Kingdom, and Canada. The other 15% comes from the rest of the world. By operating worldwide, the company is exposed to foreign currency risks and political unrest. To prevent any losses and reduce the effect of the foreign exchange rate, PepsiCo enters into primarily forward contracts with terms of no more than two years. In 2002, PepsiCo hedged $2.1 billion Mexican pesos related to their net investment in Pepsi-Gemex which resulted in a $5 million gain upon the disposal of this investment. PepsiCo does a job showing disaggregated performance information based on their business segments. In there footnotes they present each segments accounting information and address their strengths and weaknesses. Also, PepsiCo thoroughly explains the reason why performances in certain segments have increased or declined. For example, in the Frito-Lay division managers give relative information regarding what products have performed good/bad and give adequate reasoning for both. In the footnotes, managers also adequately explain the key accounting policies and assumptions logically. For example when there are some significant changes in the firm s policies the footnotes give a good explanation for the reason of these changes. Potential Red Flags: 20

22 Accounting Analysis Based on our accounting analysis that we performed, we did not find anything alarming for potential severe distortions in their accounting policies. We also felt very confident in their reported numbers. We looked into the firm s financial statements to assess any unexplained changes in accounting policies. There has been a steady increase in accounts receivable and accounts payable that most likely has been caused by the steady increases in sales. There was also a large decrease in cash and cash equivalents, but this could have resulted from the increase in short-term investments. Also, they have been very consistent with valuing the amortization of there intangible assets. Although, there was one fourth-quarter adjustment during 2003, this was due to a computational error and was corrected immediately. There isn t much cause of alarm since there hasn t been a history of errors in the past five years for this company. Another item that might be concerning is the fact that PepsiCo has certain accounts on their financial statements missing. This hindered us from calculating certain screening ratios in the following section. Although this may be alarming, we still feel comfortable in PepsiCo s accounting methods. After careful review, we also believe that these numbers are accurate and reflect the truest economic value possible. Screening Ratios Sales Manipulation Net Sales/Cash from Sales Net Sales/Net Account Receivables Net Sales/Inventory Net Sales/Unearned Revenue NA NA NA NA NA Net Sales/ Warranty Liabilities NA NA NA NA NA Core Expense Manipulation Declining Asset Turnover CFFO/Operating Income Pension Expense/SGA Expense NA CFFO/Net Operating Assets NA NA NA NA NA Total Accruals/Change in Sales NA NA NA NA NA Other Employment Exp/ SG&A NA NA NA NA NA 21

23 Accounting Analysis In order to account for any possible manipulations of PepsiCo s information we calculated several screening ratios. The first three ratios test for sales manipulation with in their accounting practices. The first ratio, net sales/cash from sales, indicates a slight rise over the five-year period inferring that PepsiCo must be collecting less cash or is increasing its account receivable form sales. The second ratio, net sales/net accounts receivable, indicates a drastic drop in 2000 due to the fact that PepsiCo abandoned its bottling operations when Pepsi Bottling Group was formed. Since 2000, accounts receivable ratio has steadily decreased. This means accounts receivable has actually increased in size, corresponding to the first ratio (net sales/cash from sales). The last ratio, net sales/inventory, shows a slight decrease since 2000, which correlates with the formation of the Pepsi Bottling Group in Other ratios were also selected to evaluate PepsiCo s accounting practices. These included net sales/ unearned revenues and net sales/ warranty liabilities. Though, due to lack of information in the financial statements these ratios could not be calculated. This may mean for a cause of alarm due to the fact that PepsiCo could have purposely done this. One thing though that elevates this concern is the fact that in PepsiCo s sales agreements they do not allow for return which would negate the net sales/ warranty liabilities. Another set of ratios were analyzed to assess core expense manipulations. The three ratios include: declining asset turnover, changes in cash flow from operations divided by operating income, and pension expense in relation to selling and general administration expenses. The declining asset turnover indicates a general level trend since the formation of Pepsi Bottling Group that explains that assets are being used the same relative to the sales generated. The next ratio is the change in cash flow from operations divided by operating income. Pass levels were above one but in 2004 it fell below; this indicates that PepsiCo s accounts receivables are not being collected as 22

24 Accounting Analysis quickly as they have previously been. This correlates with the sales screening ratios as previously discussed. The last ratio is the pension expense in relation to the selling and general administration expenses. On average since 2001, this has been on an upward trend, although 2004 forecast are expected to decrease significantly. This is due to the Medicare Prescription Drug Improvement and Modernization Act of 2003 (late December 2003), which is forecasted to reduce pension liability by nearly $50 million. As in the case of sales manipulation screening ratios, there were some ratios that could not be calculated do to lack of information in the financial statements. This could also mean a cause for alarm as well. One thing though is that PepsiCo actually might not have these kinds of expenses in their financial statements. By also looking at these key screening ratios compared to other competitors gave a good description and benchmark of their accounting policies. By comparison of the same ratios listed above to Coca-Cola we found some consistency in the numbers. The reason for viewing only Coca-Cola was due to the fact that they are more highly correlated with PepsiCo. This could be in size, operations, sales, and other factors associated with their company. Coca-Cola Sales Manipulation Net Sales/Cash from Sales Net Sales/Net Account Receivables Net Sales/Inventory Core Expense Manipulation Declining Asset Turnover CFFO/Operating Income Pension Expense/SGA Expense

25 Accounting Analysis First looking at net sales/ cash from sales indicates that PepsiCo is receiving more cash from their sales than Coca-Cola. Although these numbers are substantially different, on trend they seem very stable in comparison. Also net sales / net accounts receivable seems very consistent as well. The show that both companies have had tremendous decreases in their ratio s over time. Another fairly good comparison is CFFO/ Operating Income. By comparison both companies have very consistent ratios with both gradually decreasing over time. This indicates that operating income is beginning to increase relative to the cash flow from operations. By looking at these ratios across the industry both companies seem very consistent with their accounting numbers. This evidence further supports our claim that PepsiCo s accounting methods are consistent with industry practices. Conclusion and Discussion: After extensive review of PepsiCo accounting practices we feel highly confident in their financial disclosures. We analyzed several aspects including: key accounting policies, accounting flexibility, accounting strategy, quality of disclosures, potential red flags, and screening ratios. While there were a few discrepancies, they were of minor concern. By targeting these aspects individually we were able to examine the underlying procedures of PepsiCo. We determined that their key accounting policies and strategies are directly in line with industry practices. Also, in dealing with account flexibility we determined that there was some flexibility and changes in accounting procedures but these were in line with actions of regulation and industry standards. 24

26 Financial Analysis & Forecast Financials Quality of disclosures was adequate in regards to voluntarily giving and posting information to investors. After review we determined that there were no main causes for alarm. While there were some activities that looked suspicious, after further investigation we determined them to be of minor consequences. Finally, screening ratios were used to determine if there were any potential manipulations. Overall these ratios were fairly consistent over the years. Also, comparing PepsiCo to the industry further supported our decisions, in that they were consistent with that of competitor s ratios. III. Financial Analysis and Forecast Financials In this next phase of evaluating PepsiCo, we have computed financial ratios to assess the performance of the company. We are going to forecast the financial statement of the company for the next 10 years. From the financial ratio analysis we are going to be able to benchmark against our competition in the non-alcoholic beverage industry as well as compute the industry average. This step is very crucial since it can be used to evaluate the company on an individual basis, or compare it against competitors. Another implication is that is can address the company s performance compared to the industry as a whole. By establishing financial ratios we are able to get a more in depth look into the company s profitability, liquidity, and capital structure. This type of analysis is very important to investors and shareholders because it going to show them more in depth the strengths and weaknesses of PepsiCo. 25

27 Financial Analysis & Forecast Financials Firm Analysis Liquidity Ratios Current Ratio Quick Asset Ratio Inventory Turnover Days Supply of Inventory Receivables Turnover Sales Outstanding Working Capital Turnover Profitability Ratios Gross profit margin 53.68% 53.56% 53.67% 59.46% 60.46% Operating Expense Ratio 35.20% 35.07% 33.94% 43.10% 44.68% Net Profit Margin 14.40% 13.23% 13.19% 9.88% 10.68% Asset Turnover Return on Asset 15.05% 14.09% 14.11% 12.26% 11.90% Return on Equity 31.24% 30.15% 35.81% 30.76% 30.11% Capital Structure Ratios Debt to Equity Ratio Times Interest Earned Debt Service Margin Liquidity: In order to assess the liquidity of PepsiCo several ratios were determined and examined. Also by looking at the current year and past years we were able to get a clear 26

28 Financial Analysis & Forecast Financials picture of the changes PepsiCo has faced. After careful examination of these ratios we determined that PepsiCo is relatively liquid. We first examined the Current Ratio. Overall PepsiCo had a favorable current ratio. This is shown by an increase from 1.17 in 2000 to 1.28 in This implies that current assets have grown more in relation to its current liabilities. Although this picture looks good overall, PepsiCo has hit some speed bumps along the way. This is shown in the decrease from 1.17 in 2001 to 1.06 in This was the result of an increase in current liabilities by 21.1% with a relative minor increase in current assets of 9.6%. An alternative ratio that captures a firm s liquidity is the Quick Ratio. This ratio analyzes the company s ability to meet current obligations based on higher liquid assets. Overall, the quick ratio has improved over the past five years from.80 in 2000 to.95 in This indicates a favorable trend in which PepsiCo has utilized more liquid assets relative to current liabilities, indicating that they can now meet upcoming obligations quicker than in previous years. One factor constraining liquidity is the declining Receivable Turnover of the past five years. This number has decreased from in 2000 to 7.97 in The reason of dramatic increase in 2001 of was the result of the enormous increase in sales relative to the increase in accounts receivables. Looking forward from 2001 shows how the ratio has declined in other years, indicating that PepsiCo is collecting far less cash on sales than in previous years. As a result this also indicates that PepsiCo has had reduced capability of turnover in sales of credit. Seemingly, we were able to determine the Days Supply of Receivable; which measures the performance of collecting receivables. Comparing past and present performance also entails discouraging news for PepsiCo since the number of days until accounts receivable are collected has steadily increased from in 2000 to in This can indicate that PepsiCo has had problems in credit terms and collecting cash from customers. Another ratio implemented was Inventory Turnover, which has increased slightly over the years. This number increased from 7.87 in 2000 to 9.76 in 2004 indicating that PepsiCo is more productive in using inventory. The major reason for the decrease in 2001 to 7.51 was attributable to the tremendous increase in inventory which increased an astonishing 44.75% from the previous years. This might have occurred because of a increase in the estimate of expected sales for Corresponding to inventory turnover is Days Supply of Inventory. This number has decreased rather 27