PepsiAmericas Q2 2007 Earnings Call Transcript

Jul.25.07 | About: PepsiAmericas, Inc. (PAS)
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PepsiAmericas, Inc. (PAS)

Q2 2007 Earnings Call

July 25, 2007, 11:00 AM ET

Executives

Sara Zawoyski - VP of IR

Robert C. Pohlad - Chairman and CEO

Alexander H. Ware - EVP and CFO

Kenneth E. Keiser - President and COO

Analysts

Lauren Torres - HSBC

Andrew Sawyer - Goldman Sachs

Presentation

Operator

Good day everyone and welcome to the PepsiAmericas Incorporated Second Quarter 2007 Earnings Conference Call and Webcast. This call is being recorded. At this time, for opening remarks and introduction, I would like to turn the call over to Ms. Sara Zawoyski. Ms. Zawoyski, please go ahead ma'am.

Sara Zawoyski - Vice President of Investor Relations

Thank you, Rufus. Good morning and thank you all for joining us today to discuss our second quarter 2007 results. On this morning's call are Bob Pohlad, our Chairman, and CEO; Ken Keiser, our President and COO; and Alex Ware, our CFO. Our call is being recorded and will be available for playback on our website at www.pepsiamericas.com.

Please note that throughout our call this morning, we will be presenting certain forward-looking statements of expected future performance including expectations regarding anticipated earnings per share as well as other matters. These forward-looking statements reflect our expectations and are based on currently available data. However, actual results are subject to future risks and uncertainties which could materially affect our performance. We undertake no obligation to update any such forward-looking statements, and we wish to advise you that the risks and uncertainties that could affect our actual performance are set forth in the cautionary statements found in our annual report on Form 10-K for the fiscal year ended December 30th, 2006.

We will also reference certain non-GAAP financial measures in our call this morning. Reconciliations of these items to GAAP financial measures are included in our earnings release, as well as on our website. Please note that our comments today also include results on a constant territory basis. Constant territory refers to results of operations excluding the acquired territories in Romania and Moldova which we acquired the remaining interest in and consolidated beginning in the third quarter of last year.

And with that, let me turn the call over to Bob.

Robert C. Pohlad - Chairman and Chief Executive Officer

Thanks Sarah, and good morning everyone, and thanks for joining us and for you interest in PepsiAmericas. We had a good quarter that builds off our good start in Q1. This performance is a direct result of our plans, our execution, and discipline against three strategic initiatives: first, our U.S. business executed its pricing strategy and managed mix offsetting cost of goods sold increases; second, progress continues on our initiatives to add capability, efficiency and flexibility; and third, our international strength continued increasing operating profits of over $21 million.

Cost increases, price sustainability and anticipated innovation warranted caution coming out of Q1. Our Q2 adjusted EPS from continuing operations of $0.60 reflects good performance against those challenges, and consequently we are raising our full year outlook to an adjusted EPS of $1.55 to $1.60 which is a 17% to 21% increase over last year.

With that as our starting point then, let me give you some context around each of these strategic initiatives, and I will begin with our U.S. business. Like last quarter, pricing, single serve and innovation worked for us as we expected it would. Those things helped to offset higher COGs in our most difficult SD&A cost lap to roughly breakeven in operating profit which I believe is a significant achievement.

Our revenue strategy is working with domestic revenues up 4.2% driven by net price increasing 7.3% though volume did decline 3.3%. Coming into Q2, we knew where we had to be on pricing and volume because of the difficult volume and cost lap from a year ago. We discussed this with you on our Q1 call. And while we came in a bit better than we expected on both the balance between volume and pricing still needs to improve, and it will as we get passed in holiday lapping issues. This is an important element to our long-term performance going forward.

Because 7.3% pricing is a big increase, let me break it down. First, we were lapping flat pricing from a year ago. When viewed over two-year more normalized period, pricing is up just over 3%. Second is timing, the holiday shift contributed roughly a point and half of pricing in the quarter as two weeks of promotional pricing in the year ago quarter was shifted out of Q2 this year. What did surprise us, however, was mix which contributed over 1 percentage point to pricing, roughly twice the impact we anticipated, due to stronger single serve performance and lower take-home water volume, both of which we will talk about in a moment.

The remaining roughly 4.5 points represents our underlying rate increases in the market. This is consistent with our Q1 exit rate and where we expected it to be. At the same time, customer alignment and disciplined execution positively contributed to our pricing. And importantly, the strength of our brands and the breadth of our portfolio continued to provide the flexibility to effectively manage through the higher cost environment while still providing good consumer value and generating continued retailer interest.

Volume, on the other hand, was down 3.3% as we cycled through our most difficult lap of a plus 3.6% last year. This reflects roughly 2 percentage drag from the holiday shift as we lapped heavy promotional volumes in both Easter and July 4. Again when viewed over a two-year period, our volume was off just 0.1%.

Package mix was positive this quarter. We're particularly pleased that our single-serve volume was up 1%. Within that, our single-serve CSD performance improved from past trends with the new look of Diet Pepsi and our limited time offers contributing to the performance. The launch of Diet Pepsi Max is fully in the market behind great execution that's evidenced by over 90% distribution in only two weeks. And we are leading the Pepsi system in share.

Innovation plans in the second half includes the trade... include trademark Dew which will have a limited time offer called Mountain Dew Game Fuel to tie in with the Microsoft's Xbox game launch of Halo 3. Dew innovation was always strong for PepsiAmericas given our high share Dew market. Building off the success last year, Sierra Mist Cranberry Splash will return in Q4 and importantly will be available in Diet this year.

Our non-carb category development also continues and now accounts for 22% of our total U.S. volume. Non-carb growth, excluding water, was up 23% and this is the sixth consecutive quarter of double-digit growth.

In tea, our Lipton brands continue to significantly outpace the category growing more than 50% in the quarter. Noticeably, trademark Aquafina was down 4% as we lapped significant distribution and promotional gains of the year ago. Despite its volume decline gross profit grew as we executed our pricing initiatives and took costs off the production cycle. The balance of the year, water trend should be more reflective of the growth we saw in the first quarter and in line with the category. So at the mid point of the year, our plans have been effective, our execution strong and our initiatives are taking hold, all of which is driving our performance.

Now I want to talk about those initiatives for a moment. A couple of years ago, every chance we had in these kinds of calls we talked about Nextgen to the point of those who followed PepsiAmericas probably tired of hearing about it. Well now we are doing the same thing with both customer alignment and CO3. So, both of these along with manufacturing initiatives improved the strength of our infrastructure. We are in make, sell and deliver business and how well we do each of these will directly and significantly affect our performance and our success.

Customer alignment, which is our new organization structure, brings a strategic focus on each channel. It's all about specialized expertise. We truly have one voice with our customer demand, promotions, new products, everyday pricing and service. Specifically about promotional activity, customer alignment brings clarity and consistency and it certainly is contributing to our 1% growth in single-serve.

In addition to the top-line opportunities there are significant benefits in reallocating our people and resources to those areas of greatest opportunities. Few of three of the initiatives built around, first, improving our demand planning and forecasting accuracy; second, driving warehouse efficiencies and loading accuracy; and third, building additional selling effectiveness through a new hand-held technology. We are making great progress on the first two while the third piece of field, really the in-store... in-store ordering will be completed next year.

We've rolled out demand planning and forecasting tools at about two-thirds of our domestic locations but we are in the rollout phase of our warehouse processes. Results continue to be very positive. Where we've rolled that out we improved forecasting accuracy roughly 30 percentage points. We cut our warehouse out of stock almost in half but we are now achieving 99.9% accuracy in taking orders. These initiatives improve the core of what we do, which is getting the right product to the right customer at the right time.

The development and success of our international business, its growth and profit contribution, and our expansion in scale and geography is truly remarkable. At the end of 2007, we expect our international market to generate over 1 billion in sales and over $90 million in operating profit. It should be the most important source of our top line and profit growth well into the future.

In Q2 Central Europe recorded its strongest volume performance ever. Volume was up 11% over the prior year on top of volume gains of 11% last year. This marks the fifth consecutive quarter of double-digit volume gains.

Revenues grew 34% on a constant territory basis. ForEx obviously provided the tailwind this quarter but Central Europe revenues still grew 13% on a currency neutral basis. Our strategy has been consistent and simple. Build out our product portfolio in quite... in increased frontline resources and capability and invest behind our brands through advertising and marketing.

Our juice and juice drinks portfolio has expanded with Tropicana and Toma. We continue to innovate in tea with Lipton, and water is now contributing positively in Hungary with the addition of a low mineral water. We continue to add and reallocate selling resources to those channels with the most opportunity, specifically on-premise and small format. And we have significantly increased our advertising and marketing.

The strategy is working for us with single-serve up 22%. CSDs were up 3%. Water was up 20%, juice up 26%, tea up 32%. In Romania, performance continues to be exceptionally strong as we executed similar strategy there optimizing our package portfolio, innovating with Lipton and finding new distribution opportunities. We expect Romania to contribute over a half of our total international profits this year.

But the success in Europe brings both the requirement and opportunity for reinvesting in our business to ensure we continue that growth. We will do that this year and into next year while we continue to invest in strategic on-premise opportunities in the U.S.

Investment and capability in geography in Central and Eastern Europe is very attractive. It builds for us a portfolio of developing and emerging economies, higher beverage category growth rate, big populations in current or recent accessions into the EU. It began with our base CEG market, then with Romania and we will continue with our recently announced deal in Ukraine. We continue to be disciplined and aggressive in this strategy.

With that, I'll turn it to Alex who will take you through more details on the financial.

Alexander H. Ware - Executive Vice President and Chief Financial Officer

Thank you, Bob. Good morning everyone. Our Q2 results were strong with both the U.S. and Central European operating performance exceeding our expectations. Worldwide revenues grew 13%, up 7% on a constant territory basis. Operating profit increased 16% led by Central Europe with all markets growing organically in addition to the lapping benefit of Romania.

Worldwide operating margins improved with the expansion of 30 basis points. All-in adjusted EPS from continuing operations increased $0.10 from last year and reaching $0.60.

Now let me take you through the specifics and how these trends relate to the back half of the year. These comparisons reflect constant territory performance and include the impact of ForEx which added roughly 1.5 percentage points to revenue, 1 point to COGs, 1.5 points SG&A and 3.5 points to operating profit.

Worldwide net selling price was ahead of our full year guided range of up 4% to 5% ending up 7.4% in the quarter. In the U.S. our net pricing increased 7.3% lapping nearly flat pricing from a year ago. Importantly, mix and holiday shifts contributed 2.5 percentage points, as Bob just went through, with the remainder of roughly 4.5% representing our underlying rate increase in the quarter.

For the full year, we expect all-in U.S. net pricing to grow in the 4.5% to 5% range, as the July 4th pricing falls into Q3 and we lap the price increases and strong single-serve performance in Q4.

Bottom line we feel very good about our pricing which enabled us to cover the higher COGs and expand U.S. gross margins by 50 basis points. Worldwide COGs per unit was up 5.1% in line with our guided range of plus 5. U.S. COGs per unit was up 5.4% reflecting higher ingredient costs as well as the impact of our non-carb development.

With year-to-date worldwide COGs per unit up 5.7%, our full year guidance of plus 5 anticipates that cost increases will moderate in Q4 as we begin to lap last year's significantly higher sweetener costs.

Turning to the SG&A line, worldwide costs were up 11% lapping a notably low 0.3% including last year and generally in line with our expectations. In the U.S. SG&A costs increased 8.5% as we lap compensation and healthcare favorability of a year ago. Our guidance anticipated this U.S. increase but ForEx and marketplace reinvestment are driving us closer to a plus 6% to 7% range in the constant territories balance of year, or full year excuse me.

On our last call, I spent some time discussing fuel expense and the impact of our hedge. The net impact in Q2 was minimal. Therefore, the 3.5 million favorability which we discussed in Q1 will reverse out and be reflected in higher balance of year costs. As a reminder, the favorable fuel hedge impact is embedded in and not incremental to on full year guidance.

Moving to items below the operating line, interest was in line with our expectations totaling $26.1 million. In the back half of the year, acquisition borrowing for the anticipated Sandora closing will have $7 million of additional interest partially offset by lower CP borrowings and rates driving our full year estimate to roughly $109 million.

We recently issued 300 million of 5-year notes essentially pre-funding the anticipated closing in late Q3. A change in our estimated effective tax rate added $0.02 to EPS in Q2 and we'll add nearly $0.02 in the back half of the year. We established a new legal entity structure for our international business enabling more efficient cash management resulting in taxation at lower local rates. As a result, this lowers our effective tax rate to 35% in 2007 and further reduces our estimated 2008 rate to 34%.

And lastly, in discontinued operations we recorded an after-tax charge of $2.1 million or $0.02 EPS for legal and environmental costs. There are also a couple of items impacting net income comparability beyond the 900,000 in special charges related to our U.S. reorganization.

Most notably we recorded a $6.3 million gain on the sale of legacy railcars in the other income and expense line. In addition, we wrote down to market the Northfield Labs investment by $2.5 million leaving a remaining investment there of $2 million. We have excluded these, each of these items netting to $0.03 from our adjusted EPS.

A strong operating performance drove meaningful improvements in our adjusted ROIC, delivering a 40 basis-point increase from the first quarter to reach 7.5%, while outperforming our full year target of 7.2. All in, we followed a good Q1 results with a strong Q2 performance.

As Bob mentioned, our adjusted EPS outlook is now $1.55 to $1.60. This new guidance reflects U.S. net pricing improvements of 4.5% to 5% full year, worldwide SD&A increasing to 9% to 10 % and continued momentum in Europe.

We now estimate operating profit to be in the 12% to 15% range, up from 4 to 7%. Also, baked into the EPS build is the $0.02 to $0.03 dilution anticipated with the Sandora purchase based on a late Q3 close. We will provide the specific impact of this acquisition upon closing.

With our strong operating performance, we anticipate reinvesting some of our cash flow improvements to accelerate capacity additions in Central Europe. We expect to be on the high end of our $190 million to $200 million adjusted operating cash flow guidance which would represent over 15% improvement from last year.

In closing, we have good momentum as we start the second half. Lots of work remains and we are eager to make it happen.

Now, I'll hand it back to Bob.

Robert C. Pohlad - Chairman and Chief Executive Officer

Thanks Alex. And before we take your questions, I want to return to where we are today. We've got two good quarters. But as you know we are always cautious about getting too far ahead of ourselves. The second half has its challenges.

In the U.S. we still have key selling months ahead of us. Contribution from our international business has been significant, and we need to keep that momentum going while at the same time, we face a sizable integration effort with Sandora.

That being said, I am very confident in our organization's ability to keep that momentum going and achieving our revised full year guidance. So with that operator, we are ready to take questions.

Question And Answer

Operator

[Operator Instructions]. And for our first question, we go to Lauren Torres with HSBC.

Lauren Torres - HSBC

Good morning.

Robert C. Pohlad - Chairman and Chief Executive Officer

Good morning, Lauren.

Lauren Torres - HSBC

I am not sure if I missed this in your prepared remarks, but how much did acquisitions help you out on the net incline [ph] in the quarter?

Alexander H. Ware - Executive Vice President and Chief Financial Officer

Lauren, it's Alex, good morning. Acquisitions for us in the quarter, we had, Romania contributed roughly $0.05 of our growth year-over-year on acquisitions.

Lauren Torres - HSBC

And also two just quickly, I think you touched upon single-serve. What was the balance there for the U.S. in the quarter single-serve versus take-home?

Alexander H. Ware - Executive Vice President and Chief Financial Officer

Well Lauren, our single-serve business as Bob mentioned was up 1%, our take-home business was down 4%.

Lauren Torres - HSBC

All right. And also just more generally speaking, I was hoping you could talk about your thoughts behind your raised guidance. And obviously we saw a benefit in the quarter from acquisitions and currency, and just a good pricing environment. But I was hoping if you could just generally more talk about it with respect to your longer term outlook. You mentioned a better balance between volume and pricing in the U.S. I was just hoping if you could kind of elaborate on that a bit as far as how we plan to get there from where we are today?

Alexander H. Ware - Executive Vice President and Chief Financial Officer

Sure. Lauren, it's Alex, I'll take that. I think one of the simple way to look at this is, is taking our growth from where we ended 2006 through to the end of 2007. And if you run to the middle of our revised guidance roughly $1.58 that's a $0.26 improvement versus last year's $1.32. In Q1 we were up $0.05, in Q2 we were up $0.10, so that leaves $0.11 for the balance of the year for us to drive that growth.

We expect a majority of that growth to come on the international side with Romania and CEG contributing meaningfully to that. Expect the U.S. business to be slightly softer than that. In addition, we have the negative impact of the hedge which drives $0.02 downside which effectively will offset the tax upside of $0.02 that we'll see balance of year. And then we have a $0.02 to $0.03 dilution from Ukraine. So the combination of those factors is how we expect to be able to deliver the $0.11 growth versus prior year.

Lauren Torres - HSBC

And I guess, this is for Bob, just thinking a longer term in nature in getting to that balance volume, pricing growth that you mentioned, how do we get there?

Kenneth E. Keiser - President and Chief Operating Officer

Lauren, this is Ken. Clearly as we go through the... if you look at where we are, through the midpoint of the year, I mean our volume is essentially flat and our pricing is up... our price is up about 5%. So in the long term we think that in the U.S. appropriate... appropriate balances, volume is going to... in the U.S. probably be somewhere between flat and plus 1. And probably seeing a little bit softer lower cost of goods sold environment we think a 3.5% to 4% pricing ranges is a good healthy balance in the U.S.

And again as our mix shifts out of CSDs into non-carbs as it is doing and it's now 22% of our mix we believe that it will be much... it will be much easier to get to that volume and price balance.

Lauren Torres - HSBC

And just a last question, the shift we are seeing to non-carbs now that you are at a 22% level, where would you like that number to go?

Kenneth E. Keiser - President and Chief Operating Officer

WellI am not sure if we have any... I don't think if we have any specific formula but clearly as the... we want to make sure that particularly I guess non-carbs that we are growing faster than the non-carb category and that will take us to wherever the lines might intersect.

Alexander H. Ware - Executive Vice President and Chief Financial Officer

I think Lauren just to add to that point I think the build... if the current momentum continues we are looking to 20 to 30 basis points a year of improvement to our non-carb mix.

Lauren Torres - HSBC

Great. That helps. Thank you.

Operator

And for our next question we go to Andrew Sawyer with Goldman Sachs.

Andrew Sawyer - Goldman Sachs

Hey guys. I was just wondering if we could talk a little bit about Europe and I guess from a starting point we saw EBIT margin in the quarter go from something like 7 to 14. I was wondering if you could talk a little more granularity about the drivers of that and I guess what the outlook would be going forward?

Alexander H. Ware - Executive Vice President and Chief Financial Officer

It's Alex, Andrew I will take that. So as we look at that margin build, we did improve from the 7 to 14. If we look on a constant territory basis Central Europe was responsible of about 2.5 points of that improvement with the balance coming from Romania which does operate at materially higher margins than our base CEG market.

Andrew Sawyer - Goldman Sachs

All right. And then I guess kind of turning back to Romania, I guess if I look at it today you spent a total of $150 million to buy that entity and you just said that EBIT is going to be roughly half of international which is I guess presumably $40 or $50 million this year. Am I correct in thinking you guys are winding up paying three to four times '07 EBIT for it?

Robert C. Pohlad - Chairman and Chief Executive Officer

Pretty good payback on the purchase.

Andrew Sawyer - Goldman Sachs

So my math is correct there?

Robert C. Pohlad - Chairman and Chief Executive Officer

Yes.

Andrew Sawyer - Goldman Sachs

Then I guess my last question is kind of turning to free cash flow, on the first, I guess that will make potentially [ph] European margins first, and you are now I think for the full year it looks like you are talking about something on order of an high single digit maybe even pushing 10% EBIT margin. I mean how much ups... I mean that's similar to what we see for mature bottlers. I guess how much upside is there to that figure?

Alexander H. Ware - Executive Vice President and Chief Financial Officer

Well our belief going forward is that those margins will hold but really take advantage of the top line than opportunities in the marketplace. Again the strong macros in the Central European economies give us great confidence going forward on overall LRB growth.

Andrew Sawyer - Goldman Sachs

Okay. And then just on the cash flow side, it does... you guys are just talking to the high end of the range. I think if I am not mistaken, you took your CapEx guidance up. Can you talk about what the incremental spending is going against or why that number is going up more?

Kenneth E. Keiser - President and Chief Operating Officer

Sure. We have seen a lot of growth. A lot of our growth in Central Europe has been in the tea and juice arena. So we need to be adding capacity against that business in order to provide for future growth. So we are going to accelerate some of our investments to be able to go for that capacity.

Andrew Sawyer - Goldman Sachs

All right. Well thank you very much guys.

Operator

[Operator Instructions]. We will go next to Bonnie Herzog with Citigroup.

Unidentified Analyst

Hi guys it's actually Helena Lee [ph] for Bonnie. Just on the SG&A costs for that quarter, how much of the growth is driven by marketing spend and what's your outlook on marketing and for the remainder of that year?

Alexander H. Ware - Executive Vice President and Chief Financial Officer

Within our Central European markets we have seen a sizeable increase to our marketing spend consistent with the strategy that we have been rolling out there over the last year and half or so. So it's increased speed on the street as well as trade spend and advertising. So, all of those factors have been areas of investment for us in Central Europe. Domestically the levels of marketplace spend have really not changed year-over-year.

Unidentified Analyst

Great, thanks. And then just on your revised guidance, can you just speak about the hedges that you have in place on currency and how much that is embedded in the guidance for the remainder of '07?

Robert C. Pohlad - Chairman and Chief Executive Officer

I amsorry. I think you're breaking up a bit there in the end but I think your question is related to any hedging that we were doing on currencies, is that correct?

Unidentified Analyst

Right. During the quarter and then how much of that is in the guidance for '07?

Robert C. Pohlad - Chairman and Chief Executive Officer

Yes we currently do not deploy hedging programs on the currency side. So there is no impact to our guidance related to that.

Operator: And with a follow-up question we return to Andrew Sawyer with Goldman Sachs.

Andrew Sawyer - Goldman Sachs

Pepsi talked a lot yesterday about its broadening out their hydration strategy and particularly leveraging Gatorade, Propel and then the SoBe Life Water as part of that. And how are you guys thinking about potentially increasing your role in the Pepsi system in the broader hydration segment. What kind of discussions are you having with Pepsi in that regard?

Kenneth E. Keiser - President and Chief Operating Officer

Well Andrew, this is Ken. As you suggest and as you heard yesterday, clearly we're excited about the re-launch of the repositions, SoBe Life Water which is in our system today. And as we do know that Propel, Nice Tonic [ph] and Gatorade has always been a healthy debate within our system. But we'd like to think as, as this new Gatorade opportunity has developed and as the new Propel position develops that we might find an avenue to participate with that in someway evolving system.

Andrew Sawyer - Goldman Sachs

I guess kind of building on that, I guess if my memory is correct when that Quaker deal closed, I thought, was there a 10-year moratorium on you guys participating in the Gatorade trademark in most channels. Am I correct in thinking on that?

Andrew Sawyer - Goldman Sachs

There were some conditions I think that were made with the Federal Trade Commission on that, but I don't think that would prohibit or prevent us having an additional relationship with Gatorade.

Andrew Sawyer - Goldman Sachs

Okay. Thank you very much guys.

Operator

And with that ladies and gentlemen, we have no further questions on our roster. Therefore Mr. Pohlad, I will turn the conference back over to you for any closing remarks.

Robert C. Pohlad - Chairman and Chief Executive Officer

Thank you, and thank you everyone for your continued interest in PepsiAmericas. And we look forward to you speaking with you again and sharing hopefully a continuation of the momentum we got going now on our third quarter call. Well thank you.

Operator

And ladies and gentlemen this does conclude the PepsiAmericas Incorporated second quarter 2007 earnings conference call and webcast. We do appreciate your participation and you may disconnect at this time.

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