Income investors are always asking me about the safety of dividends. To answer the question I always look at the competitive landscape to give people an answer. Pepsico (PEP) has announced its results for the first quarter of 2012. There was a 4% growth in total revenues to $12.4 billion largely due to strong growth at Frito-Lay North American (FLNA), the Asia-Pacific and the Middle East as well as the benefits of the acquisition of Wimm-Bill-Dann. The net income was flat at $1.13 billion and Pepsi reaffirmed its guidance which indicates a 5% drop in the EPS for the full year to $4.40 a share. Pepsi earned $0.69 per share which is slightly above the consensus estimate but down from $.74 from the same quarter in the previous year.
The year 2012 is seen as critical for Pepsi as it devotes more attention to the beverages business and lays off 8,700 workers in a bid to control spiraling costs. Gross margins for the company as a whole declined by 1.8% to 52.6% when compared to the same quarter in the previous year. Carbonated soft drinks declined 4% in volume and Pepsi plans to spend $600 million in 2012 to boost its marketing effort and place greater focus on soft drinks. It is expected to maintain its market share in the U.S. market because of the strong relationship between soft drink sales and advertising and marketing spends.
Frito-Lay North American was a standout performer clocking up a 4.5% increase in revenues to $3 billion on a year to year basis. A 2% decline in volume was more than compensated for by a 6% increase in price and, as a result, operating profit rose 2% to $788 million. Latin American Foods (LAF) reported an 11% increase in revenues to $1.23 billion on the back of acquisitions in Germany and Brazil. Frito-Lay's market share in the market for international snacks has been steadily increasing with the introduction of new products as well as acquisitions in developing countries.
Pepsi is a global food and beverages company that operates in more than 200 countries. Pepsi has four main business units. Pepsico Americas Foods (PAF) includes Frito-Lay, Quaker foods and the Latin American food businesses. Pepsico Americas Beverages (PAB) contains the entire beverages business in North America as well as Latin America. PepsiCo Europe includes all beverage, food and snack businesses in Europe while Pepsico Asia, Middle East and Africa (AMEA) consists of beverage, food and snack businesses in that region. The company owns a huge portfolio of brands which is well known in the snack foods and beverages markets.
Here is my take on the prospects of the company and its future as a potential investment. The main problem that all global food and beverage companies face is to manage the rising costs of inputs as well as prices so that a steady and stable volume of business is maintained. I believe that Pepsi should stay focused on improving margins and operating cash flows instead of being distracted by its traditional rivalry with Coca-Cola (KO). The first quarter results have more or less been expected, except for the volumes at Quaker, which are a little disappointing.
It is clear that Pepsi needs to improve the performance of its beverages business when you look at the decline in North American revenue growth and compare it to the increase at Coke. Performance in the snack food business has been good, especially when you consider the performance of competitors such as Kellogg (K). Kellogg has made a pricey acquisition of Pringles from Procter & Gamble (PG) and will be looking to boost its snack business. Given the commanding market share of Pepsi (almost 40% in the broad American snack market and growing shares in Europe and Latin America), I don't believe that Pepsi would be too concerned about the competition from Kellogg.
Pepsi has not been particularly kind to its shareholders over the past few years. Even though the dividend yield which is in excess of 3% is satisfactory, its stock price has been relatively flat over this period. The snack foods businesses make up about half of Pepsi sales and this is expected to reach 55% in the course of time. It is not difficult to conclude that Coke has done more for its shareholders though the best performer has been Dr Pepper Snapple (DPS) ever since it was spun off to stand on its own. However, the discount at which Pepsi quotes when compared to Coke is not substantial.
If you were a potential investor, one thing that would concern me is the amount of goodwill and intangible assets that Pepsi carries on its books. They amount to over $33 billion which is well over 40% of the total assets. Moreover, if you look at the tangible asset valuation of the company, it is a negative value of more than $12 billion. Normally, goodwill comes from acquisitions and do not pose a problem if the acquisitions perform to expectations. However, the goodwill can evaporate overnight if the acquisitions do not create the anticipated value. You just have to remember the fiasco in the case of AOL Time Warner where massive goodwill write-offs over a few months sent the stock price plunging by more than 60%. As long as Pepsi continues to perform reasonably and has relatively low leverage and an increasing cash flow, there should be no real cause for worrying about the financial strength of the company.
I am neutral on the stock and would recommend a hold on any existing investment that you may have. In my opinion, the dividend is safe. A 51% payout ratio is reasonable. If the company is successful in executing its strategy and improving the beverage business, it may be a possible buy. After all, the company is not going to go away overnight and there is time to evaluate its future performance before making an investment decision. Meanwhile, the acceptable dividend yield helps in holding onto your investment.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.