PepsiCo, Inc. (PEP) Q3 2013 Earnings Conference Call October 16, 2013 8:00 AM ET
Jamie Caulfield - Senior Vice President, Investor Relations
Indra Nooyi - Chairman and Chief Executive Officer
Hugh Johnston - Chief Financial Officer
Bryan Spillane - Bank of America Merrill Lynch
John Faucher - JPMorgan
Ali Dibadj - Bernstein
Dara Mohsenian - Morgan Stanley
Caroline Levy – CLSA
Judy Hong - Goldman Sachs
Amit Sharma - BMO Capital Markets
Good morning and welcome to PepsiCo’s Third Quarter 2013 Earnings Conference Call. Your lines have been placed on listen-only until the question-and-answer session. (Operator Instructions) Today’s call is being recorded and will be archived at www.pepsico.com.
It is now my pleasure to introduce Mr. Jamie Caulfield, Senior Vice President of Investor Relations. Mr. Caulfield, you may begin.
Thanks, Jacky. With me today are Indra Nooyi, PepsiCo’s Chairman and CEO and Hugh Johnston, PepsiCo’s CFO. We’ll lead off today’s call with a review of our third quarter performance and 2013 outlook and then we’ll move on to Q&A. In an effort to get to as many analyst questions as possible within the hour, we have kept our prepared remarks relatively short this morning, and we are going to have a one question limit, so we should be able to get through the full queue of analysts when we get to the Q&A.
Before we begin, please take note of our cautionary statement. This conference call includes forward-looking statements, including statements regarding 2013 guidance and our long-term targets based on currently available information. Forward-looking statements inherently involve risks and uncertainties that could cause our actual results to differ materially from those predicted in such forward-looking statements. Statements made on this conference call should be considered together with cautionary statements and other information contained in today’s earnings release and in our most recent periodic reports filed with the SEC.
Unless otherwise indicated all references to EPS and total operating profit growth are on a core basis. In addition, references to organic revenue results in this call exclude the impact of acquisitions and divestitures, structural changes and foreign exchange translation. To find disclosures and reconciliations of non-GAAP measures that we may use when discussing PepsiCo’s financial results, please refer to the glossary and other attachments to this morning’s earnings release and to the Investors section of PepsiCo’s website under the Events & Presentations tab. As we discuss our results today, please keep in mind that our Q3 reporting period reflects the 12 weeks ended September 7 for our North America businesses and the months of June, July and August for the vast majority of our businesses outside North America.
Now, it’s my pleasure to introduce Indra Nooyi.
Thank you, Jamie and good morning everyone. I am pleased to report good results for the third quarter despite significant volatility experienced in a couple of our AMEA region markets. From a top line perspective, our business largely maintained the top line momentum we saw in the first half and our year-to-date and expected full year organic revenue growth is right in line with our long-term mid-single-digit growth target.
Our organic revenue growth reflected each of the four business units achieving positive net price realization in the quarter and we had particularly good organic revenue growth at Frito-Lay North America, which was up mid-single-digits and Latin America foods, which was up double-digits. And this was both in the quarter and year-to-date as well as in key developing and emerging markets such as China, where we had strong double-digit organic revenue growth both in the quarter and year-to-date; Brazil, where we had 9% organic revenue growth both in the quarter and year-to-date and Turkey, where we had 7% organic revenue growth in the quarter and 9% organic revenue growth year-to-date. Snacks volume grew 3% and our beverage volume grew 1% on an organic basis globally both in the quarter and year-to-date.
Our international beverage volume growth was strong, up 4% on an organic basis in the quarter and 5% year-to-date. Operating performance was solid. We had good gross profit flow through with core gross margins improving 70 basis points in the quarter. We improved core operating margin even as we continued to invest in A&M with A&M as a percent of sales up 40 basis points and we made incremental marketplace investments of almost $30 million as part of the incremental investment program we announced last quarter. In addition our three year productivity program remains on track; we project delivering $900 million of productivity in 2013 and expect to deliver the full 3 billion three year target by year end 2014.
Our productivity is funding our growth initiative and is contributing to our operating margin improvement. We’re reaping productivity from across the value chain through the acceleration of global procurement initiatives and coordination of our global supply chain which in turn is enabled by the investments we have made over the past decade in our SAP platform.
Year-to-date in 2013 PepsiCo, organic revenue grew approximately 4%, core gross margins improved by 1.5 basis points, A&M as a percent of sales increased 50 basis points and operating margins expanded by 65 basis points. Core constant currency EPS is up low double digits year-to-date and we continue manage cash flow exceedingly well. Year-to-date management operating cash flow excluding certain items was $5.5 billion, a 12% increase of the comparable 2012 period.
We have returned $4.6 billion to shareholders to the first three quarters in the form of dividends and share repurchases and we’re on-track to return $6.4 billion by the end of this year right in line with the target we set at the beginning of the year.
As you all know the macro environment continues to be challenging. Developed markets remain sluggish and emerging markets are volatile particularly those experiencing political and civil unrest. In challenging times such as these it's especially important to stay focused on execution and that’s really what we’re doing, focusing on the fundamentals to drive good, sustainable performance. Additionally, we have performed well because our portfolio of brands are extensive and strong, our products are on trend and relatedly diverse. And we have a broad geographic footprint, let me talk to each. Our brand portfolio as you know has been well architected. We have a great line-up of iconic brands that cover everything from treat to healthy eats. Our brands worldwide stands for safety, quality, taste and affordability. We’re investing appropriately behind our brands and our increased investments have resulted in even stronger brand equity scores.
More importantly the strength of our innovation, design capabilities and revenue management skills which are all foundational building blocks are applied across our categories to sustain top-line growth and profitability. Just to give you some examples, in innovation we had six of the top 25 new food and beverage product introductions across all measured U.S. retail channels year-to-date and we have seven new products this year that are on pace to achieve $100 million each in annual retail sales in the United States, Mountain Dew KickStart, Tostitos Cantina, Quaker Medleys platform which has been expanded to ready-to-eat cereals and bars, Starbucks Iced Coffee, Lipton Pure Leaf Tea, Muller Quaker Yogurt and Gatorade Frost Glacier Cherry. We continue to see positive results from my investments in innovation. Innovation as a percentage of net revenue is more than 8% year-to-date, a 100% basis point improvement year-over-year. We have recently opened our innovation design center and they are looking to increase the pace and incrementality of innovation with more reframed and breakthrough innovation as we move forward.
In addition our geographic footprint allows us to fully capitalize in the diversity of our portfolio including the solid top-line performance, high margins, high returns and healthy cash flows of our developed market with a high top-line growth and future marginal return expansion potential of emerging and developing markets as we drive greater scale by fully capitalizing on the related diversity of the portfolio.
In many markets including the U.S., Russia, Mexico, we’re either the largest or the number two food and beverage supplier and this scale is so important in today’s environment where retailers competition for share of the shoppers basket and manufacturers competition for share of retail sales is intensifying. The scale, ubiquity and related velocity of our categories make us an essential partner for retailers and consequently we relied upon to drive a large share of our retail partner’s growth. And our retail partners increasingly seek us out for joint business planning activities to explore mutual creative ways to drive our respective businesses. So all the benefits of our scale and product and geographic portfolios enable us to deal with headwinds and capitalize on the tailwinds within categories and across geographies.
So with that as a background, overall our business is on track and we are pleased with the progress we have made strengthening our competitive position across our key developed, developing and emerging markets. We have managed the business as a portfolio and we have remained highly disciplined in our approach leveraging our combined scale and capabilities to build sustainable value rather than overreacting to short-term pricing pressures or local value brand initiatives. As a result over the past six quarters in both salty snacks and beverages, we have seen increases in aggregate market share for our top strategic international markets that account for approximately 80% of our total international business. And year-to-date in the United States, we have grown value share at Frito-Lay and sequentially improve the value share in beverages even as we have outpaced the industry in net price realization at retail.
Let me comment now on our individual operating segments. Each of our businesses performed well financially and the marketplace in Q3. Just to give you some highlights. At Frito-Lay North America, we generated 3% volume growth and mid-single-digit organic revenue growth with 2 points of net price realizations and the performance was very balanced with volume and revenue performance positive across each major U.S. channels. We gained value, volume and unit share in salty snacks in the quarter and year-to-date. We expanded core operating margins by about 25 basis points in the quarter and 35 basis points year-to-date even as we increased advertising and marketing expense.
Our advertising initiative was focused on our core brands, for example, Doritos’ For the Bold integrated marketing campaign was executed across TV, digital and social media and was supported by new Doritos logo and updated packaging. And our Lays 75 and Sunny campaign sort of celebrated 75 summers of Lays and we continued to capitalize on a highly successful consumer driven Do Us a Flavor campaign with a winner Cheesy Garlic Bread launched at retail in Q3. And our innovation continues to perform well led by Tostitos Cantina, Doritos Jacked Ranch Dipped Hot Wings, Cheetos Mix-Ups, as I mentioned Lays Do Us a Flavor. So that’s Frito-Lay North America.
Now, before I go into the Pepsi America’s beverage performance let me give you some perspective in the North American beverage industry, which is much watched and much talked about. First, the beverage category in North America remains the largest category in food and beverages here in the United States at over $90 billion at retail and it is very profitable. It’s very relevant to retailers and is one of the first categories retailers look to when overall growth slows. As many of you know, the LRB category has slowed and the shift from the CSDs to non-carbonated beverages has accelerated. CSD is now comprised approximately 40% of the U.S. LRB category volume versus approximately more than 50% a decade ago. We have a competitive position in CSDs and we have a very strong leadership position in the faster growing non-carbonated beverages. This advantage enables us to hold or grow overall measured channel LRB value share as we manage the challenges of the CSD category in a responsible and sustainable way. Our strategy is to compete on the basis of innovation and marketing and to manage the business responsibly and profitably. We are convinced this is the right strategy to increase shareholder value given category realities. And as we have said in the past, we continued to explore the potential for structural changes in our North American beverage business to create further value. So we continued to achieve attractive net price realization as we simultaneously invest in brands and R&D.
So with this as the backdrop, let me now talk about our performance at Pepsi America’s beverages in the quarter with the focus on North America. We achieved another quarter of solid net price realization with net price realization up 3 points. In the U.S. our LRB value share slightly out performed our primary competitor and measured channels lead by our advantage non-carb portfolio with value share gains and ready to drink sports drink and chilled juice. Our retail pricing in LRB and in CSDs led overall pricing in those categories and our key new product launches are performing very well. Mountain Dew KickStart, a product targeting morning energy needs of Millennials is expected to significantly exceed a $100 million in the first year retail sales. Capitalizing and momentum of the morning platform, we will be expanding Kickstart as an evening energy occasion in early 2014. Lipton Pure Leaf Premium Tea continues to perform well and has reached a 9% value share and ready to drink tea and is also on track to exceed a $100 million in retail sales in its first year. Tropicana Farmstand is a delicious chilled 100% juice of one serving of fruit plus one serving of vegetables in every glass and that’s doing well and Starbucks Iced Coffee is performing ahead of expectations, it has reached a 7.5% value share position ready to drink coffee and is on pace to achieve approximately a $100 million in retail sales in it's first year.
And of course our businesses, we continue to sharpen how we leverage our scale and capabilities to drive incremental value. As a focus and integrated food and beverage company we are able to better serve our consumers and retail customers by providing unique value to them through powerful properties like the NFL. Our partnership with the NFL continues to be among PepsiCo’s most successful sports sponsorship. This year we’re taking our partnership to the NFL to a new level with NFL activations that include Pepsi, Gatorade, Tostitos, Quaker, Tropicana, Aquafina and Sabra brands.
Let me now move on to developing and emerging markets, organic revenue grew 9% in the quarter. Most of our developing and emerging market continue to perform well. As we build our business by driving greater penetration. Organic snacks volume increased 4% in developing and emerging markets in the quarter led by particularly strong growth in China which is our 15%, Pakistan of 23%, and Turkey which grew 11% just to name a few. Year-to-date organic snacks volume in developing and emerging markets also grew 4% led by double digit growth in China and Pakistan and high single digit growth in Egypt, Turkey, South Africa and India. And again we’re managing the business in a sustainable and responsible way by focusing on profitable growth in segments where brands and quality matter.
Organic beverage volume grew 4.5% in developing and emerging markets led by double digit growth in China, Philippines, Pakistan, Poland and South Africa. Year-to-date organic beverage volume in developing and emerging markets grew 5.5% led by double digit growth in China, Philippines, Pakistan and Poland to name a few. We’re encouraged by our performance in these important markets and excited by the long term growth prospects they present. We have built extremely strong businesses across every important developing and emerging market, in large part by leverage the presence of the beverage businesses we established decades ago. So for example today we have an integrated food and beverage business in Ukraine with sales approaching $0.5 billion. We’re the number one food and beverage business in the Middle-East and along with our partner Tingyi has the number one beverage business in China. As we continue to drive greater consumer penetration frequency in these markets we build scale which makes us more efficient. This allows us to continue to invest in these markets and at the same time increase our operating margins. However as we mentioned in our earnings release there was a meaningful slowdown in the third quarter in our businesses in Egypt and India which accounts for the deceleration of organic revenue in AMEA from the double digit rate of growth we saw in the first half of the year.
Egypt’s performance was impacted by the political turmoil and India reflected unusually aggressive industry pricing. In each case we’re pleased to note early trends in Q4 have improved. The potential for volatility especially in developing and emerging markets is in part why we provide annual but not quarterly targets. The important thing to remember is that we fully expect to achieve a mid-single digit organic revenue growth goal for full year 2013 and as we look beyond 2013 we believe we’re positioned well to deliver our long-term financial goals, which we believe will translate to top tier total shareholder return on a sustainable basis.
With that, let me turn the call over to Hugh. Hugh?
Great, thanks Indra. I will spend just a minute covering the financial results and guidance in a little more detail and then we will open up the lines to your questions. For Q3, organic volume grew 3% in snacks and 1% in beverages. Organic revenue grew 3.3%. Commodity inflation was up low single-digits. Our core gross margins improved by about 70 basis points and we increased A&M expense by 8%. Core constant currency operating profit grew 3%. Incremental investments totaled $28 million pre-tax in the quarter. Excluding the impact of incremental investments, core constant currency operating profit grew 4%.
Our core effective tax rate was 25.5%, approximately 80 basis points below Q3 2012. And core constant currency EPS grew 5% and 6% excluding the incremental investment. So between core constant currency division operating profit growth of 3% and core constant currency EPS growth of 5%, we got about 1.5 points of leverage including nearly a point of de-leverage from higher net interest expense, 1 point of leverage from a lower tax rate which will reverse in the fourth quarter as we are forecasting the full year core effective tax rate to come in at approximately 27% and 1 point from weighted average share count, which was down 1% year-on-year. Overall, the quarter came in largely as expected with pricing actions, commodity inflation and productivity all in line with our expectations.
On a reported basis, net revenue was up 1.5% reflecting over a 1 point drag from foreign exchange and about a 0.5 point negative impact from the Vietnam refranchising. We generated over $6.6 billion in cash flow from operations year-to-date, an improvement of $1.5 billion versus last year. This was driven by lower pension contributions and strong working capital improvements. Year-to-date management operating cash flow excluding certain items was approximately $5.5 billion, an increase of approximately 12% year-over-year reflecting the growth in earnings, disciplined capital expenditure investment and continued improvement in working capital management. And we returned $4.6 billion to shareholders year-to-date in the form of dividends and share repurchases.
Now, turning to guidance, consistent with what we have said throughout this year, for the full year 2013, we expect core constant currency EPS growth of 7% off of a core 2012 base of $4.10. And consistent with our previous guidance, we expect mid-single-digit organic revenue growth, core constant currency operating profit growth of approximately 6%, approximately 1 point of leverage below the operating profit line driven by share repurchases and we expect our core effective tax rate to be approximately 27% for the full year. Within these expectations, we assume positive price mix, low single-digit commodity inflation and productivity of $900 million. Our productivity assumption is completely in line with the three-year $3 billion program that we launched last year and the savings will be used to help offset inflation as well as provide funding for investment back into the business.
And as we mentioned on the last conference call, you should also take into account that we intend to incrementally invest the balance of the Vietnam gain in the balance of year, which will impact operating profit growth and margins. Regarding foreign exchange based on current market consensus, we anticipate foreign exchange translation to have approximately a 2 point negative impact on our net revenue and at least a 2 point negative impact on operating profit and EPS for the full year including the impact of the Venezuela devaluation. As we anticipate structural changes driven by China and Vietnam, we’ll have a negative impact of approximately 1 point on our full year net revenue growth. As a reminder the world remains a volatile place as evidenced in our AMEA region this quarter. Despite the volatility we continue to expect investments in long term value building initiatives such as advertising, innovation, and in emerging markets growth capacity. As you model out the fourth quarter these are our expectations, foreign exchange translation should have an appropriate three point unfavorable impact on fourth quarter revenue and upto a four point unfavorable impact on fourth quarter EPS based on current market consensus rates. Revenue in the fourth quarter will have an estimated 1.5 of a percentage point negative impact from structural changes due to the Vietnam we’re franchising. Division operating profit will be impacted by higher sequential commodity cost inflation as we had expected, incremental investments funded by the Q2 Vietnam gain increasing A&M expense and negative foreign exchange. Below the division operating profit line corporate cost in Q4 will be above prior year levels based on the timing of investments primarily in R&D.
Net interest expense will increase versus last year primary reflecting higher rates. And our tax rate will be significantly higher in Q4 as we approach our full year estimated rate of approximately 27%. From a cash flow perspective we expect full year core management operating cash flow excluding certain items of more than $7 billion. We will continue to drive cash flow through an even more efficient working capital management and continued tight controls over capital spending. And for the full year 2013 we expect to see continued improvement in our key working capital metrics and to manage net capital spending to approximately $3 billion which is well within our long term target of less than or equal to 5% of net revenue.
As a result we will continue to return strong cash flow to our shareholders. In total we expect to return approximately $6.4 billion to shareholders in 2013, $3.4 billion in dividends and 3 billion in share repurchases. Net our outlook for 2013 is unchanged from our last call and it's consistent with our long term targets for net revenue, operating profit and core constant currency EPS. We expect to drive improved full year margins and net ROIC and disciplined capital allocation coupled with returning cash to our shareholders remained a top priority for the company. With that operator we will take the first question.
Earnings Call Part 2:
- Consumer Discretionary
- Company Earnings
- basis points
- North America
- Indra Nooyi