PepsiCo Inc. (PEP) Earnings Preview: 2Q Profit Hurt By Higher Commodity Costs, Restructuring Efforts

PepsiCo, Inc. (NYSE:PEP), which reports earnings Wednesday before the markets open, is expected to post a profit of $1.1 per share, down 9.5 percent from a year ago when PepsiCo reported earnings of $1.21 per share, according to analysts polled by Thomson Reuters.

Revenue is projected to come in at $16.66 billion for the quarter, one percent below the year-earlier total of $16.83 billion.

PepsiCo didn't give quarterly guidance but reaffirmed its operational 2012 outlook on June 19. It is forecasting that adjusted net income would fall by 5 percent, with an incremental $500 million in marketing spending in 2012.

PepsiCo also took down currency guidance to negative 3 percent, or about $300 million pretax, from negative 2 percent previously.

For the full year, PepsiCo expects an additional 9 percent hit to earnings per share from commodity inflation, which amounts to somewhere in the neighborhood of $850 million.

Given that the Purchase, N.Y.-based company revised its full-year guidance as recent as in June, analyst don't envision anther change when PepsiCo reports earnings results on July 25.

Investors will look to Wednesday's call for commentary around the early results from the step up in marketing as well as any color on the rollout of Pepsi Next and additional flavors. Interest will also relate to the structure of the company and current management's roll going forward.

Management is likely to reiterate that it is progressing as it expected, but caution that PepsiCo will continue to invest in the business brick by brick and could take some time before a tangible improvement could be visible.

As for milestones, management had indicated that it would provide semi-annual updates on brand equity scorecard results -- including brand health, brand share, coincidence of snack and beverage purchase, and cost and capital efficiency -- during the second quarter earnings call.

Analysts expect commentary to focus on general directional trends of North American beverages' progress on brand health scores as well as progress on the $500 million of productivity savings planned for 2012.

PepsiCo will likely point to positive trends in small-format channels as an early indicator of improving momentum, and highlight the organizational, marketing and strategic changes at PepsiCo America's Beverages segment.

For the first three months of the year, PepsiCo said it earned $1.13 billion, or 71 cents per share. That compares with $1.14 billion, or 71 cents per share, in the same period last year. A reduced number of average outstanding shares in the quarter lifted the latest per-share results. Not including one-time items, the company said it earned 69 cents per share, which topped Wall Street expectations for 66 cents per share.

Commodity Costs

PepsiCo has been trying to pass along rising commodity costs for items such as corn, juice, potatoes, aluminum and plastic without losing customers.

Commodity inflation totaled $300 million in the first quarter and PepsiCo said it expects commodity costs to increase this year by about $1.5 billion, or roughly 7 percent.

We expect that the rate of (commodity) inflation in the first quarter will be the highest of the year, with the rate of inflation abating somewhat each quarter as we work our way through the year, PepsiCo Chief Financial Officer Hugh Johnston said during a conference call with analysts in April.

Commodities make up about 30 percent of sales for PepsiCo and only about 70 percent to 80 percent of PepsiCo's commodities costs are currently hedge-able, according to Johnston.

PepsiCo management has increased prices for many of its products over the past several months to account for higher commodity prices.

PepsiCo has taken measures such as putting fewer chips in a bag to control costs. It also pushed up prices by 5.5 percent in the latest quarter.

Despite the price increases, PepsiCo still saw operating margins decline in each of its segments compared to the first quarter of 2011.

Higher commodity prices forced cost of goods sold 9.1 percent higher year-over-year, which pressured gross margin.

Despite slightly lower selling, general, and administrative expenses as a percentage of revenue, earnings still fell from the previous year.

Chief Financial Officer Hugh Johnston said in a conference call with investors that additional price hikes should continue to drive up revenue in the months ahead, but warned that there might be lower volume as a result.

So far, the consumer seems to be accepting that pricing and understanding that there's inflation, Johnston said.

Restructuring

PepsiCo lost market share in the U.S. carbonated beverage market to the Coca-Cola Company (NYSE: KO) from 2008 through 2010, according to Beverage Digest, an industry newsletter. Over the past decade, Coca-Cola has invested more in marketing than PepsiCo as a percentage of its net sales.

To breathe new life into its brands, PepsiCo announced in February a restructuring plan that includes plowing money into advertising drinks like Pepsi and Mountain Dew in North America.

The company warned that its profit will fall 5 percent this year as it targets $1.5 billion in new cost savings by 2014, including 8,700 job cuts.

We made substantial progress against our productivity plans in the first quarter, CEO Indra Nooyi said during the company's first-quarter earnings conference call in April. Because most of the restructuring actions began in mid-first-quarter, the financial benefits of the restructuring will accelerate in the second quarter and as we move through the year.

PepsiCo will spend an additional $500 million to $600 million to market a dozen core brands in 2012. Last year PepsiCo reported $66.5 billion in annual sales and spent $3.5 billion globally marketing its brands.

For the year, PepsiCo plans to push up advertising from 5.2 percent of net revenue to 5.7 percent of net revenue. PepsiCo increased media spending in the U.S. by 25 percent in the first quarter, which shows it is committed to its reinvestment initiatives in North America.  A slate of major ad campaigns is also in store for the coming months.

We would be very disappointed if any over-delivery from sales growth, cost deflation or productivity savings was not completely reinvested back into marketing, advertising and R&D, Barclays Capital analyst Michael Branca wrote in a July 17 note. He rates PepsiCo a BUY with a stock target of $69.6.

The company is embarking on a demanding fix of its global beverage business, and though we are gaining confidence that PEP is taking the rights steps, a notable turnaround will take both focused investment and time, Branca added.

The last thing investors want is another misguided EPS beat head-fake, Branca said. Instead, investors will be assessing the underlying performance indicators for early signs that PepsiCo is on the path toward revitalizing its North America beverage business and improving the company's long-term prospects.

Consumer Trends

Profound changes are underway, both due to the aging population and significant pressure from external sources for consumers to change their lifestyles and to get healthier.

Blue-can Pepsi gave up 0.3 percent in market share and 4.8 percent in volume last year, and the carbonated-soft-drink category has been declining for seven straight years, according to Beverage Digest.

Since joining PepsiCo in 2006, Nooyi has been working to decrease the company's reliance on sugary carbonated beverages and snacks by developing new products and retooling old ones to increase their nutritional quality.

PepsiCo released new products such as its Pepsi Next, which uses a blend of sweeteners to deliver half the calories of a standard Pepsi.

The company has also start selling yogurt in the Northeast and mid-Atlantic states in July through a joint venture with Germany's biggest diary company sTheo Muller Group.

The partnership was announced in March and is seen as Pepsi's first step towards entering the U.S. dairy market.

Yogurt sales in the United States this year will add up to roughly $7 billion, according to the consumer research firm Mintel, an increase of 9 percent over last year - when sales increased by 7.5 percent.

PepsiCo is not new to the diary business. The company already sells dairy products outside U.S.

In September last year, PepsiCo acquired Russia's largest dairy company, Wimm-Bill-Dann. It also has a joint venture with Almarai, Saudi Arabia's largest dairy company, since 2009.

Emerging Market

With sales slowing at home, PepsiCo is racing to strengthen its foothold in the emerging markets that will be critical for its long-term growth.

Between 2006 and 2011, emerging and developing market revenue has grown from $8 billion to $22 billion, with the mix increasing from 22 percent of revenues to 34 percent of the revenues over that same time frame.

Speaking at the Consumer Analysts Group of New York's annual conference in February, PepsiCo's CEO Indra Nooyi said, More than ever, any company's growth is going to be defined to the extent to which they have a presence in developing and emerging markets. And I believe this trend will continue into the future as developed markets' growth rates slow down and developing and emerging markets pickup.

Emerging markets revenue growth was particularly strong in the first quarter, up 13 percent on a constant-currency basis, led by strong double-digit organic revenue growth of 21 percent in India, 13 percent in Brazil, 33 percent in Saudi Arabia and 26 percent in Egypt, just to name a few.

Stock Performance

PepsiCo has paid consecutive quarterly cash dividends since 1965, and 2012 marks the company's 40th consecutive annual dividend increase.

Since the start of 2002, PepsiCo has returned more than $50 billion to shareholders in the form of dividends and share repurchases. The company expects to return more than $6 billion to shareholders in 2012.

PepsiCo has started slowly on its plan to repurchase $3 billion of stock in 2012, spending only $142 million in the first quarter. While this quarter's figure will likely be higher, we still expect buyback activity to be skewed towards the second half of 2012, Branca said.

PepsiCo's major competitor, the Coca-Cola Company (NYSE:KO), reported its second-quarter profit that topped analysts' estimates helped by higher pricing.

Other competitors include: Dr. Pepper Snapple Group Inc. (NYSE:DPS) and Monster Beverage Corp. (NASDAQ:MNST).

PepsiCo, Inc. (NYSE:PEP) closed at $69.34, down 0.88 percent, in Monday's trading. Year to date, the stock gained 4.51 percent in value.

Retail sales data has shown no signs of a turnaround, yet the stock price seems to be reflecting increased optimism. We believe a clearer sign of fundamental turnaround is needed for PepsiCo shares to outperform, Goldman Sachs analyst Judy Hong wrote in a July 11 note to clients.