PepsiCo's CEO Discusses Q1 2014 Results - Earnings Call Transcript

PepsiCo Inc. (PEP) Q1 2014 Earnings Conference Call April 17, 2014 8:00 AM ET

Executives

Jamie Caulfield - Senior Vice President, Investor Relations

Indra Nooyi - Chairman and Chief Executive Officer

Hugh Johnston - Executive Vice President and Chief Financial Officer

Analysts

Bryan Spillane - Bank of America

John Faucher - JPMorgan

Judy Hong - Goldman Sachs

Dara Mohsenian - Morgan Stanley

Bill Schmitz - Deutsche Bank

Caroline Levy - CLSA

Steve Powers - UBS

Mark Swartzberg - Stifel

Bonnie Herzog - Wells Fargo

Operator

Good morning and welcome to PepsiCo's first quarter 2014 earnings conference call. (Operator Instructions) It is now my pleasure to introduce Mr. Jamie Caulfield, Senior Vice President of Investor Relations. Mr. Caulfield, you may begin.

Jamie Caulfield

Thanks, Jackie. 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 first quarter 2014 performance and outlook, and then we'll move on to Q&A.

In an effort to get to as many analyst questions as possible within the hour, we're going to have a one-question limit, so we should be able to get through the full queue of analysts, when we get to the Q&A.

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 first quarter comprises the 12 weeks ended March 22 for our North American operations and the months of January and February for the vast majority of our operations outside of North America.

Now, it's my pleasure to introduce Indra Nooyi.

Indra Nooyi

Thank you, Jamie, and good morning, everyone. Thank you for joining us this morning. We are very pleased with our first quarter results. Organic revenue grew 4% overall, with global snacks up 5% and global beverages up 3%.

Core gross margins improved by 40 basis points and core operating margins improved by 50 basis points. Core constant currency operating profit grew 7% and core constant currency EPS grew 10%. We achieved our targeted productivity savings in the quarter and remain on track to achieve our full year target of $1 billion.

On a rolling four-quarter basis, our core net ROIC improved by 110 basis points and now stands at 16.5%, and we returned $2.1 billion to shareholders in the form of dividends and share repurchases, a 47% increase versus last year. And as we previously announced, we expect to return $8.7 billion to shareholders in 2014 in the form of dividends and share repurchases, which represents a 35% increase over our 2013 cash return to shareholders.

Now, we all know that the world continues to be a volatile and uncertain place and we certainly saw indications of this in the first quarter. The heavy lifting we've done to transform our portfolio and capability is yielding results. I believe, our results reflect the power of our portfolios of products and brands and the strength of our geographic footprint.

Additionally, the investments we made to strengthen our brand, innovate more effectively, drive better execution and operate more efficiently by leveraging our global scale and portfolio complementarity are all beginning to pay off. As a consequence, we've been consistently meeting or exceeding our financial goals, and more importantly, we have increased confidence in the future prospects for our business.

Today, we believe our business is well-positioned to deliver top-tier return in the current volatile environment, as a result of the very deliberate steps we've taken and the investments we've made over the years.

First, the balance and diversity of our product portfolio, ranging from fun-for-you to good-for-you products across snacks and beverages, gives us the ability to manage through issues in any individual business. Together, these businesses have an attractive growth rate in the mid-single digits.

Second, investments we made to enhance the equity of our $22 billion brand are all translating to success in the marketplace. These powerful brands account for more than 70% of our annual retail sales, in fact our brands hold the number one or number two position in many of our markets, and several of our brands like Mountain Dew, Doritos, Gatorade, Lays and Quaker Oats virtually define their categories.

Looking across our largest markets, we have the leading position among top brands with nine of the top 40 packaged food and beverage trademarks in the U.S., which is most of any CPG company. We have nine of the top 50 packaged food and soft drink brands in Russia, which is again most of any CPG company. We have seven of the top 50 in Mexico and six of the top 50 in the U.K., and again in both countries we are leaders.

The strength of our brands is clear in our ability to achieve consistent net price utilization. In 2013, beverages and snacks each achieved 4 points of net pricing. In the first quarter of 2014, beverages and snacks achieved 2 points and 4 points of net pricing respectively.

Third, we stepped up our focus on differentiated innovation. Our annual R&D investment is up more than 25% since 2011. We have also created unique linkages between consumer and shopper insights and product development, using the signs of our demand space as framework. As a result, 2013 was one of PepsiCo's best years ever for innovation with PepsiCo products accounting for nine of the top 15 new food and beverage introductions across all measured U.S. retail channels.

In the first quarter of 2014, products launched over the past three years made up 8% of our total net revenues. The good news is that our innovation is becoming more incremental and is contributing to positive price mix.

Fourth, the investments we made to expand our footprint in developing and emerging market are fueling our growth. As a group, D&E markets grew organic revenue 9% in the first quarter, following 10% growth for the full year in 2013.

In the first quarter, Russia and Brazil led the way with double-digit organic revenue growth, followed by India which delivered high-single digit organic revenue growth. Our broad array of food and beverage products range from value to premium-priced products and enabling us to earn sales from consumers across the economic spectrum.

Fifth, we are delivering on all our productivity targets and significantly lowering the cost base of the company. By leveraging our global scale, eliminating duplication and deploying new technologies, we are driving the highest level of productivity in our company's history.

We are on track to achieve our three-year $3 billion productivity program in 2014 and we are poised to begin executing on our next major productivity program, targeting $5 billion over five years, beginning in 2015, focused on increasing automation, deploying more shared services model, optimizing our manufacturing footprint and optimizing our go-to-market systems.

Since 2011 we've increased our core net revenue per employee by 9%, increased our core EBIT per employee by 5%, reduced net capital spending as a percentage of net revenue by 80 basis points from 4.9% for full year 2011 to 4.1% over the past four quarters, and improved our average cash conversion cycle by 33% to 24 days in 2013 from 36 days in 2011 and we continue to look in every area of our business for sensible ways to do even more.

And finally, we are executing better, faster and more efficiently within our operating segments and then further benefiting through increased coordination across our product and geographic portfolios. And let me just give you a few recent examples of our complementary portfolio and our execution capabilities at work.

Our Super Bowl execution demonstrated outstanding delivery of print, outdoor, mobile, digital and in-store programming. PepsiCo delivered a united effort to leverage our NFL partnership and drove unprecedented national and local impact with both consumers and customers.

Each business executed the property very effectively and PepsiCo's combined activation was one of our most compelling expressions of better together, with coordinated advertising, promotions and merchandizing across our snacks and beverage portfolios, which helps drive incremental sales and share gains.

Second, building on the growing consumer appetite for ridged cut chips and the strong performance of Lay's Deep Ridged chips in the U.S., U.K. and Spain in 2013, we'll offer versions of Lay's Deep Ridged potato chips in over 20 markets around the globe in 2014 with additional markets planned for 2015.

Our global execution leverage is common product specifications, branding, hedged graphics and ad copy. At the same time, we've built on our beverage partnership with Buffalo Wild Wings by introducing Ruffles Deep Ridged Classic Hot Wings flavored potato chips inspired by Buffalo Wild Wings. So what we are doing is leveraging our global category structure and getting new products to market faster across more geographies, more cost effectively and in more channels.

Third, during the quarter we kicked off the 2014 Pepsi soccer campaign, our largest global football marketing effort to date. Over 100 markets will be executing and locally adapting the campaign around the world. Our global superstar football squad brings together an unprecedented wealth of international talent that spans five continents and includes 19 of the world's greatest players, including the great Lionel Messi.

The campaign unites the worlds of football, music and art, reaching fans with distinctive packaging, point of sale, out-of-home communication and engaging content. This program drives higher consumer awareness and regard, allows us to leverage our global scale of product complementarity and gives us the flexibility for targeted local execution.

Next, our highly successful Lay's Do Us A Flavor campaign represents a great blend of global brand building elements. This campaign now expands more than 15 countries and is an excellent example of how we lived and shift best practices around the world. Breakthrough digital and mobile engagement is embedded in every single touchpoint, all the way to shelf.

This year in the U.S., we've increased consumer engagement by inviting consumer to choose both flavor and type of chip. As part of this year's contest, a judging panel will narrow down the contest submissions to four finalist flavors and then these four finalist flavors will be fully developed at Frito-Lay culinary experts and unveil this summer.

The winning flavor is determined by fan votes, will be revealed in November with a grand prize winner taking home $1 million. This program has driven high levels of consumer engagement and is an extremely efficient marketing tool because of the massive earned media benefit that begun on each of the markets where we launched it. And finally, we have accelerated productivity best practices across the organization.

For example, as our global enterprise system or GES continues to rollout across Frito-Lay North America, we are beginning to apply the same concepts and tools to our North American beverage business and in some international markets. And these initiatives will maximize asset utilization by reducing distribution centers, leveraging automation, deploying fleet and route trucks more efficiently, and reducing inventory, while improving service and product freshness.

So with all this as a backdrop, let's take a look at how the business has performed, starting with our North American businesses. Frito-Lay North America delivered another quarter of very strong results. Organic revenue grew 4% and core constant currency operating profit grew 6%. The U.S. salty snacks category continues to grow retail sales at a mid-single digit rate and Frito-Lay's delivering a good balance between volume growth and price realization.

Revenue growth in the quarter was led by good performance across our five largest brands, Lay's, Tostitos, Doritos, Cheetos and Ruffles, and each grew between low and mid-single digits. We continue to execute product and packaging innovation, targeted incremental macro snack occasions, including the launches of Rold Gold Pretzel Thins, Twistos Snack Bites, Lay's Air Pops, Lay's Kettle Cooked Lattice Cut Chips and our ready-to-go market pack that offers a broad assortment of macro snacks.

Quaker Foods North America delivered positive organic topline in the quarter and gained value share at retail in each of its core categories, hot cereals, ready-to-eat cereals and snack bars.

Turning to North American Beverages. We are really encouraged with the continued progress we are making. In the quarter, we held U.S. liquid refreshment beverage value share and achieved positive net price realization at retail, ahead of the category and our primary competitor.

Notably, PepsiCo has held or gained relative U.S. LRB value share in measured channel versus our closest competitor in each of the last four quarters. And we continue to manage the business responsibly with consistent pricing across carbonated and non-carbonated beverages.

Within the LRB category, we held or gained value share across a number of important subcategories, including CSD, sports drinks and ready-to-drink tea and coffee. And we grew retail sales in measured channels in the U.S. for regular colas and Mountain Dew, both within CSD and for Gatorade, Lipton Tea, Starbucks Coffee and Naked Juice within our non-carb portfolio.

We are investing in R&D to drive sustainable innovation and we are off to a good start, beginning with the first quarter launches of Brisk Half and Half, Gatorade Fierce Blue Cherry, and Kickstart Black Cherry and Limeade to name a few. In addition, we continue to expand our package offerings and we are seeing good success with strong double-digit growth in mini cans and we have more than doubled the sales of our 12 ounce glass bottles in Q1.

These practices enable us to realize new price-packed revenue benefits, while providing flexibility to maintain price competitiveness. So that's the North American story. Our other developed markets in Western Europe also performed well, but organic revenue for these markets are up 3.5% in the first quarter.

Let me now turn to developing and emerging markets. In Mexico, we are managing through the new taxes on certain foods and beverages that were enacted recently. We've taken pricing in snacks and our bottle has taken pricing in beverages to pass the taxes through to the consumer.

In the quarter, the elasticities and volume declines in Mexico was in line with what we expected. And we have been dealing with the situation throughout the year and expected to continue to depress consumer demands, but results so far are consistent with our planned assumptions.

In Venezuela, we are managing through high inflation, political unrest, supply chain disruptions and continued uncertainty regarding the applicable exchange rate. But given all these challenges our businesses in Venezuela performed well in the quarter with organic revenue up strong double-digits across both snacks and beverages.

Brazil delivered double-digit organic growth, revenue growth, led by organic revenue growth in snacks. In Russia, organic revenue rose double digits, and double-digit growth in snacks and high-single digit growth in beverages. And we saw strong organic growth in a number of other East European markets, including double-digit organic revenue growth in Poland, high-single digit organic revenue growth in Turkey.

Moving across to our Asia, Middle East, Africa businesses. Organic revenue growth was led by Pakistan, a strong double-digit organic revenue growth, followed by Egypt and the Philippines, which also grew double-digits and India which grew high-single digits.

China organic revenue declined low-single digits in line with our expectations. Performance was muted, given strong high-single digit comparisons from Q1 of 2013 and some business disruption related to our bottlers restructuring in Q1 of 2014 to drive increase efficiency through greater integration.

We expect the business to return to its normal trajectory as we enter Q3. We remain committed to the developing and emerging markets as they have a long runway for growth, driven by increasing demand for a convenient, on trend affordable products, supported by a rapidly growing middle-class and we are well-positioned to capitalize on these opportunities.

Let me conclude my comments by saying we are off to a good start in 2014, with the pieces of our portfolio working together to generate healthy topline and bottomline performance. Clearly, there are a 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 through the current environment.

So with this, let me turn the call over to Hugh Johnston.

Hugh Johnston

Thank you, Indra, and good morning, everyone. Let me spend a few minutes discussing the quarter and our outlook for 2014, which is in line with the full year guidance issued in mid-February. Overall, the quarter came in largely as expected with pricing actions, commodity inflation and productivity, all in line with our expectations.

For Q1, organic volume grew 2% in snacks and was even versus the prior-year quarter in beverages. Organic revenue grew 4%. On a reported basis, net revenue was even versus year ago, reflecting 3 points of unfavorable foreign exchange translation and nearly 0.5 point negative impact, primarily from the franchising of our Vietnam bottling operation.

Commodity inflation was up low-single digits. Our core gross margins improved about 40 basis points and core operating margins increased 50 basis points. Core constant currency operating profit grew 7% in the quarter. Our core effective tax rate was 23.7%, approximately 80 basis points below Q1 2013.

Our fully diluted share count declined 1.5%, reflecting the benefits of our ongoing share repurchase program and core constant currency EPS grew 10%.

So between the core constant currency operating profit growth of 7% and core constant currency EPS growth of 10%, we achieved about 3 points of leverage, driven by lower interest expense or lower tax rate and share repurchases. And we returned $2.1 billion to shareholders year-to-date in the form of dividends and share repurchases during the quarter, which is 47% above year ago levels and reflective of our commitment to return cash to shareholders.

Turning to guidance. The world does remain a volatile place as evidenced in places like Mexico, Venezuela and Eastern Europe. So even with the strength that we saw in the first quarter, our full year guidance remains unchanged.

Consistent with what we said back in February, for the full year 2014 we expect mid-single digit organic revenue growth and core constant currency EPS growth of 7% and we expect 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 tax rate of approximately 25% and a reduced share count from our share repurchase program.

Foreign exchange is expected to negatively impact net revenue and core earnings per share for the full year 2014 by approximately 3% and 4% respectively, based on current market consensus rates. Taking our 2013 core EPS of $4.37 and applying our guidance implies 2014 core EPS of approximately $4.50, consistent with our prior guidance.

As many of you know, the foreign exchange picture in Venezuela is very dynamic at the moment. Our first quarter results were translated to U.S. dollars at 6.3 bolivars to the U.S. dollar. Our current FX forecast, which is based on current market consensus rates assumes a blended rate of approximately 9 bolivars to the U.S. dollar for the balance of the year.

To help you with the FX sensitivities on Venezuela, for the full year 2013, Venezuela generated approximately 1% of our net revenues and 2% of our operating profit.

In addition, as of the end of our international Q1, which includes January and February, we have approximately $380 million of net monetary assets in Venezuela, valued at 6.3 bolivars to the U.S. dollar, which would be subject to revaluation, if there is a change in the exchange rate we use. As we did in 2013, we would expect to treat any revaluation of the net monetary assets as a non-core charge.

As you model out the second quarter, I'd ask you to consider the following. First, our EMEA division will face very difficult operating profit comparison due to the following: A, a $137 million gain recorded in Q2 2013 related to the re-franchising of the company's bottling operation in Vietnam; and B, 27% year-over-year core constant currency operating profit growth in Q2 2013, when excluding the above mentioned gain.

Second, foreign exchange translation should have an approximate 4 point unfavorable impact in the second quarter revenue and approximate 5 point unfavorable impact on second quarter EPS, based on current market consensus rates. Revenue in the second quarter will have an estimated 15 basis point of negative impact from structural changes due to the Vietnam re-franchising.

Below the net operating profit line, net interest expense is expected to increase in the second quarter versus last year, primarily reflecting higher debt balances and higher rates. And our tax rate is expected to be higher in the second quarter of 2014 versus both, the second quarter of 2013 and the first quarter of 2014.

Finally, our stepped up share repurchase activity will occur throughout the year, but is expected to have a more pronounced impact in the second half of 2014 and into 2013. From a cash flow perspective, we continue to expect full year free cash flow excluding certain items of more than $7 billion. We'll 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 for shareholders in 2014, a 35% increase over 2013, through a combination of $3.7 billion in dividends and a $5 billion share repurchase program.

And as a reminder, our previously announced 15% dividend per share increase will commence with the June payment. This represents the 42 consecutive year of an annual dividend increase and an approximate 60% payout ratio based on 2013 core EPS. At yesterday's closing stock price, it represents a 3.1% yield and will bring our 10-year annualized dividend per share compound annual growth to 11%.

So to summarize, our 2014 outlook is unchanged from our last call. We expect to drive improved full year margins and net ROIC and discipline capital allocation and returning cash to shareholders remain top priorities for the company.

With that operator, we'll take the first question.

Earnings Call Part 2:

• Q&A with PepsiCo Inc. CEO