Source: Seeking Alpha
PepsiCo, Inc. (NYSE:PEP)
Q2 2014 Earnings Conference Call
July 23, 2014 08:00 AM ET
Jamie Caulfield – SVP of IR
Indra Nooyi – Chairman and CEO
Hugh Johnston – CFO
John Faucher – JPMorgan
Bryan Spillane – Bank of America
Ali Dibadj – Bernstein
Bill Schmitz – Deutsche bank
Dara Mohsenian – Morgan Stanley
Steve Powers – UBS
Judy Hong – Goldman Sachs
Amit Sharma – BMO Capital Markets
Mark Swartzberg – Stifel Nicolaus
Good morning and welcome to PepsiCo’s Second Quarter 2014 Earnings Conference Call. (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.
Jamie Caulfield – SVP of IR
Thank you, operator. 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 second quarter 2014 performance and outlook, and then we’ll move on to Q&A.
We have kept our comments brief this morning and intend to conclude the call by 08:45, to be respectful of your time during a busy earnings week, and we’ll do our best to get to as many of your questions as we can. Before we begin, please take note of our cautionary statement.
This conference call includes forward-looking statements, including statements regarding 2014 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 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 use when discussing PepsiCo’s financial results, you should 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 today’s results, please keep in mind that our second quarter comprises the 12 weeks ended June 14, for our North American operations in the months of March, April and May for most of our operations outside of North America. As we have mentioned in our earnings release this morning, core operating profit growth rates are impacted by lapping a $137 million gain from the re-franchising of our Vietnam beverage operations in the second quarter of 2013, partially offset by incremental investments of $46 million made in the prior year quarter
Now, it’s my pleasure to introduce Indra Nooyi.
Indra Nooyi – Chairman and CEO
Thank you, Jamie, and good morning, everyone. Thank you for joining us this morning. We are pleased with our second quarter and our first half results. Despite operating and what continues to be a challenging and volatile macro environment, we have been consistently meeting or exceeding our financial goals over the last two and half years. I believe our results reflect the hard work we have done over the last several years to position our business for sustainable success; specifically our investments to strengthen our brands, innovate more effectively, expand our geographic footprint with strategic acquisitions, drive better execution, and operate more efficiently by leveraging our global scale and complementary product portfolio.
Today, these actions and investments are producing consistent tangible results. Based on the strength of our first half results, in our outlook for the remainder of the year, we are increasing our full year core constant currency 2014 EPS growth outlook to 8%.
So let me share with you some of the performance highlights of the second quarter. Organic revenue grew approximately 4%, with global snacks up 5% and global beverages up 2%. We managed the business responsibly achieving three points of effective net pricing to effective price packed revenue management. Each of our four business units delivered organic revenue growth led by high single-digit growth in EMEA and mid-single digit growth in Europe and PepsiCo Americas Foods.
Developing and emerging markets posted solid 8% organic revenue growth led by low double-digit growth in China, high single-digit growth in Brazil and mid single-digit growth in Russia. Innovation continue to play an important role in our topline growth and accounted for 9% of our net revenue.
Core gross margins improved by 60 basis points. Excluding the Vietnam gain, that is incremental investment from the second quarter of 2013, our core constant currency operating profit rose 6%, core operating margin improved by 65 basis points and core constant currency EPS grew 9%. On a rolling four-quarter basis, our core net ROIC improved by 30 basis points and now stands at 16.5%. In the first half of 2014, we returned $4 billion to shareholders in the form of dividends and share repurchases, a 46% increase versus last year. As we previously announced, we expect to return $8.7 billion to shareholders in 2014 in the form of dividends and share repurchases, a 35% increase over our 2013 cash return to shareholders.
Importantly, we achieved our targeted productivity savings in the quarter and remain on track to achieve our full-year target of $1 billion, which represents approximately 3.5% of our operating cost base excluding commodities and A&M expense.
This year we successfully complete the three-year $3 billion productivity program we launched in 2012 and we are now focused on our next generation’s five-year 5 billion productivity programs for 2019 announced earlier this year which is really centered on four key areas.
First, embedding more automation in our operations replace labor with capital. Second, expanding shared services, including global financial shared services for the handling of routine back office transaction processing. Third, restructuring, manufacturing to optimize our global manufacturing footprint. And fourth, restructuring our go-to-market systems to optimize our distribution network.
As a result of these initiatives, we expect to see continued improvement in net revenue and core earnings before interest and tax as per employee, as well as margin expansion and returns on invested capital.
So with all this as a backdrop, let’s take a look at how the business has performed, starting in North American. The North American consumer picture continues to be weak with retail sales among the top, the food and beverage manufactures roughly flat in the quarter, a slight deceleration from the first quarter.
In this challenging environment, PepsiCo grew sales at retail across each of its North American snacks and beverage businesses and was a largest contributed to retail sales growth among the top 30 manufactures.
Frito-Lay North America performed well with organic growth of 2% and core constant currency operating profit growth of 5%. Net price utilization was somewhat mutual in the quarter, as we benefitted from commodity cost deflation.
Core operating margins expanded 80 basis points despite an increase in advertising and marketing and affected savings from our productivity efforts. Our top-line growth is driven by strength across most of our largest trademarks, with Lays, Doritos and Cheetos each posting revenue growth in the low to high single digits.
Our broader macro-snack offering were also doing well with strong performance in shelf stable dips, crackers, our line of Smartfood snack and the Sabra line of refrigerated hummus, dips and spread. As we look to the second half, we are encouraged by the strength of our innovation and consumer engagement program leveraging some of our biggest brands.
In April, we launched Doritos Jack mystery flavors with nationwide distribution. Consumers voted for their favorite mystery flavor online. Earlier this month, we revealed the three flavors, Spicy Street Taco, Chocolate Chipotle Bacon and Caribbean Citrus Jerk. Spicy Street Taco was a consumer voted favorite and we launched it this fall as a permanent Jack flavor.
We also brought back the U.S. the highly successfully Lay’s Doritos flavor campaign. We’ve received more than 14 million consumer submissions, nearly four times a submissions we received for last year’s campaign.
On July 17, we announced the four finalist among consumer submitted flavors, Cappuccino, Cheddar Bacon Mac & Cheese, Mango Salsa and Wasabi Ginger. And these products are now hitting store shelves. Our consumers will now have the opportunity to vote for their favorite new Lay’s flavor. And we are especially excited about the progress we’re making in food service innovation.
On July 2, we launched Doritos Loaded exclusively at more than 5500, 7-Eleven stores nationwide. Doritos Loaded is a delicious hot snack served with melted Nacho Cheese and encrusted with Doritos. Our launch of loaded created a great deal of tradition and social media buzz generating more than 750 million impressions to-date. And it has also featured on Jimmy Kimmel live.
Each of these programs has a strong demonstration of how we are leveraging our Culinary center to create unique great tasting new products and driving excitement in the vendors to create a consumer engagement.
Turning now to Quaker Foods North America, despite continued challenges across most central store food categories, we gained value share at retail in each of Quaker’s key categories, hot cereals, ready-to-eat cereals and snack bars both in the quarter and year-to-date. Core constant currency operating profit growth rose 5% of the quarter with operating profit margins expanding 155 basis points.
We are pleased with the performance of our recent innovation in 2014. We launched Quaker Express Cups which provides Quaker Instant Oatmeal in the convenient on-the-go cup. We also introduced the first of its kind hot cereal; Quaker Warm & Crunchy Granola which delivers both the wholesale goodness of Quaker Oatmeal and the satisfying crunch of market grain granola.
And finally, we are continuing to build in the success of our Real Medleys platform this time in a ready to eat cereal form. In North American beverages, we’re encouraged for the continued progress we’re making. In the second quarter and in the first half, we gained U.S. LRB value share and achieved positive net price realization at retail.
Notably, PepsiCo has held or gained relative U.S. LRB value share in major channel versus our closest competitor in each of the last five quarter. In the quarter, we also achieved greater net price realization retail and our primary competitor and the category overall.
Within the LRB category, we held or gained value share across a number of important sub-categories including CSDs, sports drinks, ready to drink tea and chilled juice and we grew retail sales in major channels in the U.S. for regular CSDs led by trademark Mountain Dew just up mid-single digits and with our non-carb portfolio for Gatorade, Lipton Tea, Starbucks Coffee and Naked Juice.
In the quarter, PAB grew both organic revenue in core constant currency operating profit with core operating profit margin expanding by 25 basis points. We’re also excited about the progress we’re making on the innovation front. In the second quarter, we introduced PEPSI SPIRE, our state-of-the-art beverage dispensers which allows consumers to create more than 1,000 customized beverages with a touch of screen while providing our food service partners flexible, cost effective, reliable equipment that best fits their needs.
PEPSI SPIRE is currently available in select U.S. locations and will continue to roll out for the rest of the year. On May 5, we also brought Mountain Dew Baja Blast to the shelves for a limited time, leveraging on the success of the fountain brand ahead of Taco Bell. Mountain Dew Baja Blast is a second largest and fastest growing fountain beverage sold at Taco Bell and may now expand the reach of the fan favorite brand.
And concurrent with the launch of the Doritos Loaded, we introduced Solar Flare, our tropical punch take on Mountain Dew exclusively at 7-Eleven. We are leveraging of the high purchase coincidence of Dew and Doritos with joint advertising, point-of-sale communication and promotion. And we are pleased with the performance of our expanded package offerings with strong double-digit growth in mini cans as well as 12 ounce glass bottle from the second quarter.
These new packages have enabled us to realize new price packed revenue benefits while maintaining flexibility for price competitiveness. So that’s another American story. Western Europe performed well with organic revenue 3% in the second quarter in a difficult retail and competitive environment.
Turning now to developing and emerging markets. In Mexico, we continue to navigate for the new the new taxes on certain foods and beverages. And as a reminder, we’ve taken pricing in snacks and our bottler has taken pricing in beverages to pass the taxes through to the consumer.
In the quarter, in Mexico, our volume decline in snacks moderated sequentially while beverage volume returned to growth as consumers began to adjust to the higher prices and our systems drove beverage share gains through improved market sales execution. We’d dealing with the tax driven price increase throughout the year and expect some quarterly volatility to continue, our results so far are in line with our expectations.
In Venezuela, we are managing through high inflation, political unrest, supply chain disruptions and continued uncertainty regarding the applicable exchange rate. Despite all the challenges, our businesses in Venezuela performed very well in the quarter with revenue up strong double-digits across both snacks and beverages.
Brazil delivered high single-digit organic revenue growth, led by double-digit organic revenue growth in beverages and high-single-digit organic revenue growth in snacks. We did a particularly effective job leveraging our global soccer properties in this market during the time when soccer was very much top of mind. Our integrated campaign featured an impressive roster of the world’s premium soccer players and included television advertising as well as digital, out-of-home, in-store and point-of-sale marketing.
In Russia, organic revenue rose mid-single digits with double-digit growth in snacks and low-single digit growth in beverages. And we saw strong organic revenue growth in a number of other East European markets, including high single-digit growth in Turkey and low double-digit growth in Poland.
Moving across EMEA. Organic revenue growth was led by Thailand, which pronged double-digit organic revenue growth, followed by Egypt and the Philippines, which also grew double-digits.
China organic revenue grew low double-digits driven by strong growth in our snacks business. The productivity restructuring program initiated by our bottling partner in the first quarter has achieved solid progress. Our partner has taken a well-planned deliberate approach to execute the program to ensure that our entire system is positioned to capture its full long-term efficiency and effectiveness benefits.
We remain committed to the developing and emerging markets as we believe they have a long runway for growth driven by increasing demand for our convenient on trend affordable products supported by rapidly growing middle class.
We believe we are well positioned to capitalize on these opportunities. So to conclude, we are off to a terrific start in 2014 with the pieces of our complementary portfolio working together to generate healthy top line and bottom line performance as we also step up the terms on investments and cash returns to shareholders.
Clearly, there are number of challenges around the globe but the shape and resilience of our portfolio combined with strong execution and aggressive productivity should enable us to navigate successfully to the current environment. Let me now turn the call over to Hugh. Hugh?
Hugh Johnston – CFO
Thank you, Indra and good morning everyone. Let me spend a few minutes discussing the quarter and our upwardly revised core constant currency earnings per share outlook for 2014. First for Q2, organic revenue grew 3.6%. On a reported basis, net revenue was up 0.5 point versus a year ago, reflecting 3 points of unfavorable foreign exchange translation and a slight negative structural impact primarily from the refranchising of our Vietnam bottling operation. Commodity cost had low single-digit inflation. Our core gross margins improved about 60 basis points and core operating margins rose 10 basis points.
Core operating margin rose 65 basis points when excluding the gain from refranchising Vietnam net of incremental investments from last year. Core constant currency operating profit grew 3% and approximately 6% excluding the Vietnam gain and investments from last year. Our quarter effective tax rate was 26.3, 2 percentage points above Q2 2013.
Our fully diluted share count declined 2%, reflecting the benefits of our ongoing share repurchase program. And core constant currency EPS grew 3% and 9% when excluding the Vietnam gain and investments from last year. And we returned $4 billion to shareholders in the first half in the form of dividends and share repurchases which was 46% above year ago levels and reflective of our commitment to return cash for shareholders.
Now turning to guidance. As Indra mentioned, based on the strength of our first half results and our outlook for the balance of year, we’ve increased our full year core constant currency EPS growth target to 8%, up from 7% previously. Our other targets remain unchanged. We expect mid single-digit organic revenue growth, low single-digit commodity inflation and productivity savings of approximately $1 billion.
Below the division operating profit line, we expect corporate cost efficiency driven by our productivity initiatives, a core effective tax rate of approximately 25% and a reduced share count from our share repurchase program.
Foreign exchange is expected to negatively impact net revenue by 3 percentage points and core earnings per share by 4 percentage points for the full year 2014, based on current market consensus rates. Taking our 2013 core EPS of $4.37 and applying our guidance implies 2014 core EPS of approximately $4.54.
As many of you know, the foreign exchange picture in Venezuela is very dynamic at the moment with three different exchange rates and the possibility for a converged mechanism. Our second quarter results were translated to U.S. dollars at VEB6.3 to the U.S. dollar. Our current FX forecast, which is based on current market consensus rates, assumes a blended rate of approximately VEB9 to the U.S. dollar for the balance of the year.
As you model out for third quarter, I’d ask you to consider the following. We expect foreign exchange translation to have an approximate 2 point unfavorable impact on both third quarter revenue and third quarter EPS based on current market consensus rates. We do expect to ramp up advertising and marketing expense in the quarter and below the division operating profit line, net interest expense is expected to increase in the third quarter versus last year, primarily reflecting higher debt balances and higher rates.
From a cash flow perspective, we continue to expect full-year free cash flow excluding certain items of more than $7 billion. We will continue to drive cash flow through efficient working capital management and continued tight controls over capital spending. Net capital spending should approximate $3 billion, which is well within our long-term target of less than or equal to 5% of net revenue. We expect to return approximately $8.7 billion to shareholders in 2014, a 35% increase over 2013 through a combination of $3.7 billion in dividends and $5 billion in share repurchases.
So to summarize, we’ve increased our core constant currency EPS growth outlook for the full-year 2014 to 8% from 7%. We expect to drive improved full-year margins and net ROIC and discipline capital allocation and returning cash to our shareholders, remain top priorities for the company.
With that operator, we will take the first question.
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