Pepsico contributed a larger proportion of gross revenues, however, Frito Lay had higher operating income than Pepsico, indicating that the profit margins were higher on Frito Lay. Therefore, on a free cash flow basis, it is Frito Lay product lines that currently contribute the highest returns. The four segments however display very different characteristics. Frito Lay, Pepsico N. Am., and Quaker N. Am., all display the characteristics of mature markets. With the notable exception of Quaker, the other two segments display similar growth in revenue and operating income, which are circa 5.9% in revenues and 6.1% for Frito Lay in operating income, while Pepsico N. Am., has only 3.6% growth in operating income… Quaker demonstrates far lower growth in both metrics. Revenue growth is 4.1% and operating income is only 2.8%.
Using a common-size analysis of the financial statements, the information provided by this analysis allows questions 7 & 8 to be answered. Gross margins during the 2005/07 period are deteriorating, the cost of goods increasing during 2005/07 by 12.8%, as compared to Revenues increasing by +10.1%. This is due to “pricing pressures” (Schilit 2002, pg. 202) This trend continues into 2007/08 with 12.8% and 9.6% changes respectively. The result of this gross margin compression is that operating income and net income decline in 2007/08 by (-3.1%) and (-9.5%) respectively.
Continuing the analysis using the Balance Sheet, it is possible to identify one of the possible drivers of this gross margin compression. In the 2005/07 period, inventories grew by 16.3%. This significantly exceeded the growth in revenues at 10.1%. Schilit states “the Company may have failed to charge the cost of sales, on some sales” (Schilit 2002, pg. 201). It would suggest that the gross margin compression is due to an inability to pass onto consumers, the increased manufacturing costs of products. This may be across aggregate product lines or specific product lines.
An analysis of gross revenues to the product portfolio reveals the following information. In the 2005/07 period, the highest growth was achieved by Pepsi Int. This division grew sales at a 17.8% rate. The slowest growth in revenues was by Quaker N. Am. which only grew sales at 4.1%. These figures were confirmed in the operating income line entry. Pepsi Int. grew Operating Income by 18.2% while Quaker N. Am. grew Operating Income by 2.8%. High commodity prices in this period for raw foodstuffs, make it likely that the margin compression was caused by these high prices (Economic Research 1967-2012). Frito Lay, which has the highest profit margins, which should make it the first choice for increased capital allocation, has slower growth than Pepsico Int. This may well be due to a saturated home market share, and it has become difficult to grow home market share due to competition. International growth would seemingly be the logical area to expand the business. Here, however, Frito Lay products, especially in Asia and Africa, may encounter cultural resistance to these foodstuffs, which simply is not a barrier to Pepsico Int. water-based products.
For current Shareholders, the portfolio as it exists in 2008 needs to be restructured to offer attractive returns. I would suggest that Management would need to restructure in the following manner. Capital expenditures should be reallocated away from the under-performing division Quaker N. Am. to the outperforming division on an international growth basis, Pepsi Int. Management can also, depending upon market conditions, add value to existing Shareholders through purchasing common stock if it falls below the average price of $57.66. (Yahoo Finance 2008). At this average price, the earnings yield is 8.1%. This return exceeds the 6-month money market rates that fell between 4.2% and 2.2% during 2008. (Economic Research 2008) Dividends should only be increased if there are no attractive investment opportunities. With Pepsi Int. growing Revenues at 17.8% and Operating Income at 18.2%, clearly this is a more attractive investment.
References
Economic Research, Federal Reserve Bank of St Louis, [Image] (2008). Line 1: 6-Month Certificate of Deposit: Secondary Market (CD6M). Web.
Economic Research, Federal Reserve of Bank St. Louis, [Image] (1967-2012). Producer Price Index: Crude Foodstuffs & Feedstuffs (PPICFF). Web.
Schilit, Howard. (2002). Financial Shenanigans New York, United States America: R.R.Donnelly & Sons Company, McGraw Hill.
Yahoo Finance: PepsiCo, Inc. (PEP). (2008). Web.