Idea of the Week: Will Pepsi’s Earnings Go Flat?

The third quarter of 2016’s earnings season is approaching and the S&P 500 is currently expected to post its fifth consecutive earnings decline, an estimated  -0.8% from the prior year (visit our latest S&P 500 Earnings Dashboard here).

History shows that analysts tend to become more bearish as earnings season approaches; however, the majority of companies beat estimates. As a result, earnings growth rates tend to improve throughout the reporting period. This could be the quarter that breaks the streak.

In this article, we take a look at food and beverage company PepsiCo Inc. (PEP.N), which is expected to report earnings on Sept. 29, to find out if its earnings are expected to be fizzy or flat and reveal the company’s strength.

Exhibit 1: Pepsi Earnings Quality History

Source: Eikon/StarMine

High quality

Quality control is crucial to food and beverage companies and the quality of earnings is an essential metric of sustained performance. Those companies whose earnings come from sustainable sources are likely to generate better financial results over the longer term. Pepsi has a StarMine Earnings Quality (EQ) score of 99 on a scale of 1 to 100, with 100 representing the highest quality earnings. Pepsi has consistently ranked among the top decile of North American companies over the past eight quarters. This bullish signal indicates that Pepsi’s operations are among the highest caliber.

Exhibit 2: Pepsi T4Q Cash Flow from Operations, Free Cash Flow, and Net Income

Source: I/B/E/S data

Cash is king

Companies in the consumer staples sector are often viewed as safety assets; therefore, the ability to sustain cash flow is a crucial metric of the group. Strong cash flows are also a sign of earnings quality. Due to the cyclical nature of Pepsi’s business we’ll look at trailing four quarter (T4Q) performance. Pepsi’s T4Q cash flow from operations (CFO) and free cash flow have exceeded net income for seven straight quarters and the trend is expected to continue.

Pepsi’s StarMine Cash Flow Component score of 91 (on a scale of 1 to 100) places it in the top decile of North American companies and is highlighted by a 31.4% T4Q CFO to average net operating assets (ANOA). This compares to a cash flow component score of 77 and 15.6% T4Q CFO/ANOA for the beverages industry median.

Exhibit 3: Pepsi vs. Beverages Industry T4Q Return on Average Net Operating Assets

Source: Eikon/StarMine

Formula boost

The management team at Pepsi has the right formula to boost operational efficiency. As a result, StarMine’s Operating Efficiency Component score for Pepsi is 90 (on a scale of 1 to 100), which is well above the beverage industry median of 61.

Over the past 14 quarters, Pepsi’s T4Q return on average net operating assets (RANOA) has consistently outperformed the beverages industry. Year-over-year (YOY) T4Q RANOA has continued to improve over the past 11 quarters. Pepsi’s latest T4Q RANOA of 28.8% is a YOY improvement of 3.6 percentage points (ppts) and is 9.5 ppts above the beverages industry’s median. This demonstrates management’s ability to select and execute the right strategies.

SmartEstimates help to better predict future earnings and analyst revisions with estimates that place more weight on recent forecasts by top-rated analysts. T4Q RANOA derived through SmartEstimates shows that Pepsi is expected to continue this trend into the next quarter with a YOY gain of 2.0 ppts.

Exhibit 4: Pepsi vs. Beverages Industry T4Q Average Net Operating Asset Turnover

Source: Eikon/StarMine

Low calorie diet

Asset turnover measures how efficiently a company uses its assets to generate revenue, and our model measures both the absolute level and the rate of change in asset turnover. YOY T4Q average net operating asset turnover (ANOAT) for Pepsi has consistently improved over the past seven quarters. SmartEstimates show this trend is expected to continue into the next quarter with YOY T4Q ANOAT expected to increase by 2.2 ppts.

StarMine’s Accruals Component score of 72 vs. the beverages industry median score of 29 highlights the Pepsi’s effective management of net operating assets. Pepsi improved T4Q ANOAT in the presence of declining revenues, which have seen six straight quarters of declines. Improvement is the result of management’s ability to effectively lower T4Q ANOA. Over the past seven quarters YOY T4Q ANOA has fallen, with double digit declines in the past five quarters.

Inventory management has improved and benefited from lower commodity costs in North American divisions, which is reflected by seven quarters of YOY declines in average days inventory. Management consistently reduced PP&E, YOY PP&E/T4QANOA declined in each of the past 15 quarters. Pepsi has also continued to extend average days accounts payable over the past 13 quarters, with double digit increases in five out of the last seven interim periods.

Exhibit 5: Pepsi Segments

Source: Eikon/StarMine

Healthy snacks

Frito-Lay North American is the underlying operating strength of Pepsi and has been adding new lines of premium and healthier snack brands to its product mix. Revenue growth, cost reductions and lower commodity costs have helped the segment’s T4Q operating profit contribution grow 7.7 ppts over the prior year to 41%. This profitable division only accounts for 24% of T4Q Revenue and 8% of T4Q average total assets.

YOY T4Q operating profit margin (OPM) for the segment has improved consistently over the past 13 quarters and is now at 29.9%. However, the highlight of the division is its utilization of assets. T4Q operating return on average total assets has steadily increased and is current at an impressive 81.8%. Analysts expect this trend to continue, which is supported by Mike Esterl of the WSJ’s Sept. 21 report that U.S. salty-snack sales rose 3.5% in the four weeks ended Sept. 10.

Analysts’ sentiment towards Pepsi-Cola North America (North American beverages) is bubbling up as well. The largest division by total assets, representing 41% of T4Q average total assets, has improved T4Q OPM to 13.8% with both T4Q revenue and operating profit growth in each of the past four quarters. Lower commodity costs have contributed to improvements in OPM and offset the impacts of volume declines. Operating profit growth is expected to continue with strength in sports drinks, bottled water, and juice.

Troubles abroad

While the North American segments have seen improvements in T4Q operating profit, foreign segments have declined over the past four quarters. Combined, these segments represent 15% of Pepsi’s T4Q operating profit. Increased strength in the U.S. dollar along with higher commodity prices affected all three groups. Additionally, deconsolidation of Venezuelan business has deeply impacted Latin America’s operating profit, contributing to a 126.6% YOY decline in T4Q operating profit for the division. However, there is some bright news, at least in Europe. Analysts expect Pepsi to take market share from rival Coca-Cola Co. (KO.N).

Health Monitor

The Q3 2016 earnings report from Pepsi will be closely monitored as it is likely to set the tone for the food and beverages industry as it is among the first of its peers to report. North American segments are expected to continue positive performance. However, Pepsi is likely to remain impacted abroad.

Overall, analysts estimate YOY revenue will decline by 3.2% to $15.8 billion. However, they expect to see net income pop by 2.1% to $19.2 billion. Additionally, analysts anticipate a 16.4% YOY gain in free cash flow of $2.8 billion.

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