Pepsi's Q1 - Flat At Best: No 'Alpha' Here, And What Looks Better

| About: PepsiCo Inc. (PEP)

Summary

PEP has reported Q1, another down quarter yoy for sales and profits.

This continues a weak multi-year period for sales.

In addition, the company makes it overly difficult to understand its results using generally accepted accounting principles.

This article concludes that while PEP probably won't blow up on you, it's difficult to see any reason for it to profit alpha.

In contrast, I provide my well-known list of companies with secular tailwinds and cheaper valuations, where I expect longer-term alpha to come from.

Introduction

PepsiCo (NYSE:PEP) is the anti-biotech stock. It makes low-tech stuff that's bad for you.

But that's OK as an investment choice, so I'm not anti-PEP on ideological grounds.

The red flag is that it's acting like a stronger version of Valeant (NYSE:VRX) in trying to obscure weak operating results with a blizzard of footnotes and unbusinesslike verbiage.

This is why investors seeking real alpha should in my view fade PEP.

Before showing the problems with PEP, here are two examples of what respectable companies do with their press releases; and it's not that these are cheap stocks. The trucker J.B. Hunt Transport Services Inc. (NASDAQ:JBHT) reports the normal way, which now looks almost quaint:

J.B. Hunt Transport Services, Inc. announced first quarter 2016 net earnings of $100.1 million, or diluted earnings per share of 88 cents vs. first quarter 2015 net earnings of $91.9 million, or 78 cents per diluted share.

Total operating revenue for the current quarter was $1.53 billion, compared with $1.44 billion for the first quarter 2015. Current quarter total operating revenue, excluding fuel surcharges, increased 12.9% vs. first quarter 2015.

Just the facts. These happened to be good results.

Intermediate to PEP we see some not-so-good results from the old-line industrial products distributor W.W. Grainger, Inc. (NYSE:GWW),which reported:

Grainger Reports Results For The 2016 First Quarter Narrows 2016 Sales and EPS Guidance
Quarterly Summary
- Sales of $2.5 billion, up 3 percent
- Reported EPS of $2.98, down 3 percent
- Adjusted EPS of $3.18, up 3 percent

Grainger (GWW) today reported results for the 2016 first quarter ended March 31, 2016. Sales of $2.5 billion increased 3 percent versus $2.4 billion in the first quarter of 2015. There were 64 selling days in the 2016 first quarter, one more than the 2015 first quarter. On a daily basis, sales in the quarter increased 1 percent versus the prior year. Net earnings for the quarter of $187 million were down 12 percent versus $211 million in 2015. Earnings per share of $2.98 declined 3 percent versus $3.07 in 2015.

The first quarter contained the following restructuring items:

Three Months Ended
March 31,

2016

2015

% Change

Diluted Earnings Per Share as reported:

$2.98

$3.07

(3)%

Restructuring (United States)

0.16

Restructuring (Canada)

0.04

Restructuring (Other Businesses)

0.03

Subtotal

0.20

0.03

Diluted Earnings Per Share as adjusted:

$3.18

$3.10

3%

Click to enlarge

"Revenue and share gains are tracking as we expected given the tough economic environment," said Chairman, President and Chief Executive Officer Jim Ryan.

Here, the company is telling the truth pretty clearly. I'm just a bit critical, though, because "restructuring" is an insult to the intelligence of the investor class.

Nonetheless, the company gives you GAAP first and non-GAAP numbers second, in line with the SEC's rules. So, it's legit enough. Business conditions are tough, and they are not hiding it.

PEP has another flattish quarter

Then there are companies like PEP, which reported a weak Q1. It tried to hide it in various ways. The body of the release begins deceptively:

First-Quarter 2016 Performance

Organic/Core1

Reported (GAAP)

Revenue growth

3.5%

(3)%

Gross margin expansion

130 bps

160 bps

EPS

$0.89

$0.64

EPS growth

7%

(21)%

Core constant currency EPS growth

11%

Click to enlarge

PepsiCo, Inc. today reported organic revenue growth of 3.5 percent and 11 percent core constant currency EPS growth for the first quarter of 2016.

What is "organic" revenue growth, I asked myself when reading this? Is it just the parts of the business that did well, excluding the parts that the CEO now wishes she had never heard of?

It's my thesis that companies that do this sort of thing should see their stocks trade at a discount to any guesstimate of fair value, on the theories that A) they are hiding something and B) they should not make us work hard to understand what's going on at the company. After all, while I am not a shareholder (but might be), for the most part, these press releases should be first and foremost intended for consumption by active shareholders. These investors have the right to straight talk, not excuses, obfuscation, and as I will demonstrate, an unusually confusing set of presentations.

To understand what really went on, sadly you need to read the fine print. First, the italicized definition of "organic:"

a Organic results are non-GAAP financial measures that adjust for impacts of acquisitions, divestitures and other structural changes, including the previously announced Venezuela deconsolidation, and foreign exchange translation, as applicable. For more information about our organic results and the impact of the Venezuela deconsolidation, see "Reconciliation of GAAP and Non-GAAP Information" in the attached exhibits. Please refer to the Glossary for the definition of "Organic."

So, yes, that meets my suspicion. "Organic" refers to the stuff that's selling well in parts of the world that PEP likes this quarter.

But that's not all you need to know. You will notice that something called "core" was mentioned in the above presentation. Scrolling down to the nether reaches of the press release, one has to find the Glossary. Who knew a quarterly press release needed a glossary? Here's what "core" means to PEP this quarter:

Core: Core results are non-GAAP financial measures which exclude certain items from our historical results. In 2016, core results exclude the commodity mark-to-market net impact included in corporate unallocated expenses, restructuring and impairment charges and a charge related to the transaction with Tingyi. In 2015, core results exclude the commodity mark-to-market net impact included in corporate unallocated expenses, restructuring and impairment charges, pension-related settlement benefits, a charge related to the transaction with Tingyi, Venezuela impairment charges and a non-cash tax benefit. See "Reconciliation of GAAP and Non-GAAP Information" for additional information.

This is getting confusing. How is "core" different from "organic?"

Ah, with some digging, I see one difference. The PEP lawyers have decided that something called the "transaction with Tingyi" is excluded from core but was not mentioned as being excluded from "organic." Do I have it right?

Anyway, both definitions, of "core" and "organic," guide one to the reconciliation. Unfortunately, if you are still interested, there are 1, 2, 3, many tables of reconciliations. Which one(s) does PEP want you to study to understand their convoluted "accounting" of their poor quarter? They do not say. So here's one that may be relevant, namely Table A-7:

Reconciliation of GAAP and Non-GAAP Information (cont.)

Certain Line Items

12 Weeks Ended March 19, 2016 and March 21, 2015

(in millions except per share amounts, unaudited)

GAAP
Measure

Non-GAAP

Measure

Reported

Non-Core Adjustments

Core (NYSE:A)

12 Weeks
Ended 3/19/2016

Commodity mark-to-
market net
impact

Restructuring and
impairment
charges (NYSE:B)

Charge

related to the

transaction

with Tingyi

12 Weeks
Ended
3/19/2016

Cost of sales

$

5,151

$

18

$

-

$

-

$

5,169

Gross profit

$

6,711

$

(18)

$

-

$

-

$

6,693

Selling, general and administrative expenses

$

5,078

$

28

$

(30)

$

(373)

$

4,703

Operating profit

$

1,619

$

(46)

$

30

$

373

$

1,976

Provision for income taxes

$

442

$

(17)

$

5

$

-

$

430

Net income attributable to PepsiCo

$

931

$

(29)

$

25

$

373

$

1,300

Net income attributable to PepsiCo per common share - diluted

$

0.64

$

(0.02)

$

0.02

$

0.26

$

0.89

Effective tax rate

31.9%

24.7%

Click to enlarge

If you can follow this, basically the company lost a lot of money in its equity in a Chinese company that it refers to as Tingyi. So China's not going so well. Plus PEP has not been smart enough to get out of Venezuela when the getting was good - one of many management failures at the company. So it had deconsolidated results from Venezuela (shown in detail elsewhere in the earnings presentation).

No doubt, these details could have been recognized in any quarter, or if the accountants allowed it, spread over four quarters, etc. But PEP chose (or perhaps had to under the accounting rules) to recognize these losses in Q1, and so it goes.

Anyway, after all the explaining and excusing, the real bottom line is that as it has been quarter after quarter, year after year, PEP is a no-growth dinosaur selling cheap junk food that is losing share in the global economy. Here are the numbers that matter:

PepsiCo, Inc. and Subsidiaries

Condensed Consolidated Statement of Income

(in millions except per share amounts; unaudited)

12 Weeks Ended

3/19/2016

3/21/2015

Change

Net Revenue

$

11,862

$

12,217

(3)%

Cost of sales

5,151

5,503

(6)%

Gross profit

6,711

6,714

-%

Selling, general and administrative expenses

5,078

4,901

4%

Amortization of intangible assets

14

16

(12)%

Operating Profit

1,619

1,797

(10)%

Interest expense

(246)

(211)

17%

Interest income and other

14

15

(8)%

Income before income taxes

1,387

1,601

(13)%

Provision for income taxes

442

370

20%

Net income

945

1,231

(23)%

Less: Net income attributable to noncontrolling interests

14

10

29%

Net Income Attributable to PepsiCo

$

931

$

1,221

(24)%

Diluted

Net Income Attributable to PepsiCo per Common Share

$

0.64

$

0.81

(21)%

Weighted-average common shares outstanding

1,459

1,503

Cash dividends declared per common share

$

0.7025

$

0.655

Click to enlarge

A quick summary of Q1 2016 vs. 2015:

  • revenues declined yoy
  • cost of sales plus SG&A dropped about as much as revenues
  • net interest costs rose (as debt rises)
  • taxes rose

So, nothing tragic, but nothing to justify a 28X multiple that it carries.

Looked at in the big picture, in 2011, PEP revenues were $66.5 B. In 2015, revenues were $63.1 B.

In 2006, the company's working capital was $2.27 B and long-term debt was $2.55 B (Value Line data).

In 2015, working capital was $2.7 B and LT debt was $25 B (Value Line data from near year-end).

When one works through the reduction in shares outstanding and dividends, basically the company has taken on tons of debt to reward shareholders.

This is not normally worth 25-30X EPS.

When I go to Yahoo! Finance (NASDAQ:YHOO) and compare the performance of PEP versus a plain vanilla long-term Treasury bond ETF (NYSEARCA:TLT) for the past 10 years, PEP has beaten TLT by just about the amount that I estimate TLT has beaten it in yield. In other words, after all the non-GAAP "reporting," PEP has been the most boring financial asset possible, a long-term Treasury bond in essence.

My own opinion is that if I want a bond, I'll just own a bond, not a financial engineering play that tracks a bond.

The importance of PEP as a paradigm for today's markets

Unfortunately, this situation is rife. The total return of the overall larger-cap market (NYSEARCA:SPY) over the past 10 years has actually lagged that of TLT. The price of SPY is up just about 7% more than TLT, but its dividend yield has lagged more than that.

Most non-GAAP results are just distractors, like those far-out choices on multiple choice tests that are designed to weed out the clueless test-takers.

My own view is that there is no prospective alpha from these consumer product companies at 25X multiples, or utilities (NYSEARCA:XLU) at 20X multiples. When looked at objectively, they are just bond substitutes.

If one is "into" high P/E companies, Novo Nordisk (NYSE:NVO) at 27X has immense potential in its pipeline as well as business with real "organic" growth even before its next wave of products hits.

With the exception of the still-young Regeneron (NASDAQ:REGN), all the large-cap biotechs I follow have much more attractive valuations than PEP or its peers. For readers who don't follow me, these include Gilead (NASDAQ:GILD) at about 8X EPS up to Celgene (NASDAQ:CELG) at around 22X likely 2016 GAAP EPS. In between in valuation are Amgen (NASDAQ:AMGN), Biogen (NASDAQ:BIIB) and AbbVie (NYSE:ABBV). Then there is Apple (NASDAQ:AAPL), which only reports GAAP EPS, has lots of net cash and sells at less than half PEP's P/E with lots of secular growth ahead.

I think that for a combination of secular growth trends plus more attractive valuations, all these names are better buys for yours truly for total returns than PEP, Coke (NYSE:KO), and various household products companies that also sell consumables, such as P&G (NYSE:PG).

Concluding thoughts - staying with growth

Stocks of companies that try to hide their factual operating results are in my view stocks that are not good ways to seek alpha.

Also, seemingly stable consumer products companies that have negative sales growth over a several-year period at a time when many other companies have been seeing sales and profit growth are not ones I seek out. Yes, if one has a mining company and the field has been devastated, that's one thing. But PEP sells food. Food never goes out of style. But junk food might. So might Aquafina. How sustainable are profits from selling tap water?

To be clear, I'm neutral on PEP. It can survive and prosper in a rising rate environment when TLT might easily give negative total returns. It's a strong marketer. Etc. Not that this is real-world, but sure, give me PEP or cash for the next 25 years, I would expect PEP to beat cash and to beat TLT (which is like cash as the government pays its bills by having the Fed print money, really).

But that's not the point of this website.

The title, Seeking Alpha, implies identifying future outperformance. Unless one's goal is simply to beat TLT if and when rates move upward, PEP is not it - all this opinion is of course "in my humble opinion." I think PEP has:

  • too much debt
  • overly weak results for too many years
  • too high gross margins, inviting competition
  • too little innovation
  • unhealthy products (litigation/regulatory risk down the road?)

For the equity part of my portfolio, I continue to prefer shares of strong companies with major product innovation, with cheaper valuations than PEP carries, and that are helping to shape what I view as a better world. With patience, I believe that it's in those stocks that future alpha will best be found.

Disclosure: I am/we are long NVO,REGN,GILD,AAPL.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Not investment advice. I am not an investment adviser.