PepsiCo Inc (PEP) — Q2 2015 Earnings Call Transcript

Thank you and good morning. Joining me on the call today are Indra Nooyi, PepsiCo's Chairman and CEO; and Hugh Johnston, PepsiCo's CFO. We'll lead off the call this morning with prepared remarks, and then turn to Q&A. As we begin the call, it's important to note the following. We will make forward-looking statements on this call. Any forward-looking statement inherently involves risks and uncertainties that could cause our actual results to differ materially from current predictions and expectations. Information on such risks can be found in today's earnings release and our most recent Form 10-K and subsequent SEC filings. In addition, we will discuss results using non-GAAP measures and you can find the GAAP to non-GAAP reconciliations on our website under the Investors section in the Events and Presentations tab. Beginning with the third quarter of 2015, PepsiCo will realign certain of its reportable segments as you saw in this morning's press release. Within the next 30 days, PepsiCo expects to provide reclassified summary segment reporting for 2013 and 2014 and the first two quarters of 2015 to reflect the company's new structure. And now it's my pleasure to introduce Indra Nooyi.

Thank you, Jamie, and good morning everyone. We are very pleased with our performance in the quarter. Organic revenue grew 5.1%, with Global Snacks up 8% and Global Beverages up 2%. Core gross margin improved 115 basis points. Core constant currency operating profit grew 8% and core constant currency EPS grew 11%. Based on the strength of the quarter, our overall first half results and our outlook for the remainder of the year, we are increasing our full year core constant currency 2015 EPS growth outlook to 8%. Our businesses are performing well, both at the top line and the bottom line. PepsiCo America's beverages had an outstanding quarter. 3% organic revenue growth translated to 10% core currency operating profit growth. Frito-Lay North America delivered another quarter of very strong results, with organic revenue up 3% and core constant currency operating profit up 7%. Our developing and emerging markets delivered 11% organic revenue growth in the quarter, despite the ongoing volatility in many regions of the world. Looking across some key D&E markets, our businesses continue to prove resilient. Turkey and Saudi Arabia achieved double-digit organic revenue growth. China, Egypt, and the Philippines achieved high single-digit organic revenue growth, and Mexico achieved mid-single-digit organic revenue growth. Now, I assume you have had a chance to read the release this morning, so rather than go through the numbers in detail by segment or country, what we will do in this call and going forward is to give you an update and provide a bit more detail on each of our big initiatives to drive performance, namely innovation supported by sensible brand management, flawless execution, self-sustaining productivity, prudent capital allocation, and talent renewal in management. But today we will focus primarily on innovation and touch briefly on the others. Our innovation success today is the result of significant investments in and changes to our innovation research and development capabilities and processes that began about eight years ago. At that time, we were in an extremely decentralized organization, operating as a loose confederation of geographic business units, each largely driving its own development agenda and establishing their own processes. Development was focused largely on product line extension, and that structure, while effective in its time, led to less efficient use of resources, with redundant projects often being undertaken in different parts of the world and suboptimal resource allocation to the most promising ideas. As a result, much of our innovation lacked staying power. To address these opportunities, we undertook a major transformation to improve our R&D function and innovation capabilities. Specifically, we established global category groups charged with coordinating global innovation. This resulted in a more focused innovation agenda, a greater emphasis on development platforms rather than product line extensions only, and more efficient allocation of development resources. We globally adopted the proprietary Demand Moments framework, originally developed at Frito-Lay North America. This created a stronger linkage between consumer and shopper insights in the R&D functions, and has led to our innovation being more incremental to top-line growth. We implemented a common discipline-staged gear process to gain better visibility into multi-year pipeline of R&D projects, to allocate resources to the most promising ideas and new platforms, and to ensure a better balance of refresh, reframe, and breakthrough innovation. We have increased our investment in R&D, starting in 2008. In fact, from 2011 to 2014 alone, our investment in R&D has increased almost 40%. More recently, we established a design capability, tapping world-class design talent. Increasingly, they are involving design in the early stages of innovation, to create memorable experiences for our consumers. Lastly, we are using reverse engineering, leveraging our learnings and developments in emerging markets, to yield benefits from holistic thinking about low-cost design of new products. We are pleased with the progress we have made and the tangible results we see. Innovation as a percentage of total revenue reached 9% in 2014, an improvement of over 150 basis points compared to two years ago. Three of our products received the 2015 Nielsen Breakthrough Innovation Awards, which recognizes the most successful and enduring new CPG products launched in the U.S. in 2013. Over the past three years, we have introduced numerous new products that have achieved or are on pace to achieve more than $100 million each in annual retail sales, including Tostitos Cantina, Mountain Dew Kickstart, Doritos-Cheetos fun multipack mix, and Gatorade Fierce Blue Cherry and Frost Glacier Cherry. More recently, we are using premium innovation to capture more price realization. We have relaunched Caleb's Kola and launched DEWshine, a craft premium soda inspired by Mountain Dew's brand roots in the backwoods of Tennessee. We are also innovating in packaging, capitalizing on the success of our consumer-engaging Lay's Do Us A Flavor campaign. We launched Lay's Summer Days campaign, encouraging fans to create custom digital packs of Lay's potato chips for sharing on social media. Adding excitement to this experience, 10,000 lucky fans will receive a real-life customized bag of Lay's Classic Potato Chips featuring the photo they digitally submitted, offering personalized packaging for the first time in the brand's history. We are capitalizing on consumer health and wellness demand. As consumers embrace almond milk and other plant-based proteins as an alternative to traditional dairy milk, Naked Juice has launched two new nut milks, Berry Almond Nut Milk and Peachy Almond Nut Milk. In Quaker Foods North America, our new Quick Cook Steel Cut innovation has propelled us to the number one market position in the growing Steel Cut Oatmeal segment. We are launching a new line of craft soft drinks called Stubborn Soda. The Stubborn lineup includes unique flavors like Black Cherry Tarragon, Lemon Berry Acai, Agave Vanilla Cream, and Pineapple Cream, all made with natural flavors and fair-trade certified sugar. We have continued refreshing our key brands to maintain consumer engagement and excitement. Innovation has also contributed to strong market share performance in the second quarter in the U.S. We held value share while delivering strong net price realizations. Gatorade's share of sports drinks surpassed 80%. Mountain Dew gained value share. Our innovation is driving growth for our retail partners. In the second quarter, PepsiCo was again the largest contributor to U.S. retail sales growth among food and beverage manufacturers.

Great, thank you, Indra and good morning everyone. Turning directly to guidance; as Indra mentioned, based on the strength of our first half results and our outlook for the remainder of the year, we have increased our full year core constant currency EPS growth target to 8% from 7% previously. Our other targets remain unchanged. For the full year 2015, we continue to expect mid-single digit organic revenue growth, core operating margin expansion, as organic top line growth and productivity should offset negative geographic mix and commodity inflation. Below the division operating line, we continue to expect corporate costs to be lower, a core tax rate of approximately 25%, and a reduced share count. We expect foreign exchange translation to negatively impact net revenue and core earnings per share by approximately nine and 11 percentage points respectively, based on current market consensus rates. Taking our 2014 core EPS of $4.63 and applying our guidance in current market consensus of foreign exchange impact, implies 2015 core EPS of approximately $4.49. Should circumstances dictate the use of a higher rate, this would also negatively impact our U.S. dollar results. From a cash flow perspective, we continue to expect full year free cash flow of more than $7 billion. We expect our capital allocation discipline to continue to drive core ROIC improvement. This is built on the progress we have made in ROIC, with core net ROIC up 310 basis points to 18.4% since 2012. We expect to return between approximately $8.5 billion and $9 billion to shareholders in 2015 through dividends and share repurchases. Our previously announced 7% dividend per share increase commenced with the June payment, which represents the 43rd consecutive year of annual dividend increases. To summarize; our core constant currency earnings outlook for 2015 has improved, and free cash flow, disciplined capital allocation and returning cash to our shareholders remain top priorities for the company.

Thanks. Good morning.

Good morning John.

Two quick questions here; one, can you just give us a little bit of the rationale in terms of the merger at the Latin American Food and Beverage businesses? Secondly, can you talk about the Frito volume, which was a little bit light relative to trends? Anything in particular going on there? Thanks.

Let me talk a bit about the Latin American merger. We have seen success in Europe and AMEA with all of the power of one management of those regions. We are able to get more productivity takeout costs, and especially with volatile economies, we have to get more and more agile and creative about how to take out costs. It's not just costs within our system, John; I think even with our bottling partners, there is an opportunity to cooperate and figure out how not to duplicate efforts between the two companies. We are seeing those initiatives pay off in AMEA and Europe, and we decided now is the time to do it in Latin America. We are in the middle of a major productivity program in Latin American Foods, and integrating Latin American beverages with foods gives us that much more of a cost base to work with. Lastly, given the volatility of those economies there, it is very important to become a lean mean machine to take the sales and reinvest it to grow the top line. So that's Latin America. Second is on the Frito volume. Again, we watch Frito performance carefully as does Tom Greco and the Frito team. In our potato chip business, we are going through a revenue management program that is yielding good revenue growth and improving top-line growth and profitability for our retailers. Unfortunately, the revenue management program impacts volume because the price architecture shifts some of the volume to certain bag sizes, affecting volume in the short term. However, over the long term, it’s the right thing for the business. So I'd let it play out through the balance of the year, then look at our results in 2016.

Hi, good morning everyone.

Good morning Bryan.

Two quick ones; first, in terms of exchange rate, Hugh, you mentioned Venezuela; and if you were to move to the SIMADI rate, what would the impact for that be on the year, and how will that affect the guidance that you have given for currencies?

Hugh is going to take that.

Happy to do that, Bryan. As you all know, we have provided pretty extensive disclosures in our 10-Qs and 10-K about this issue. In the Q that we intend to file after today's market close, consistent with past filings, you will see that Venezuela represents approximately 2% of our revenue and operating profit. We also have net monetary assets of approximately $335 million, and non-monetary assets of approximately $725 million. If we were to take all of that and go to SIMADI, Venezuela would then represent 0% or very slightly above 0% of our revenue and operating profits. Therefore, it's roughly a 2% hit on both revenue and operating profit. We have a charge of approximately $325 million related to the net monetary assets, and it will likely lead to an impairment of our non-monetary assets. However, from an economic standpoint, this would not significantly impact PepsiCo, as Venezuela is largely a self-sufficient operation. We are not putting any capital to speak of in the country, and we have not been able to redeploy any of our Venezuela cash.

So that 2% effect on operating income would be above and beyond the guidance that you have given this morning?

That's correct. Right now, we assume for the balance of the year on Venezuela is 12.8, as that was the recent SICAD option. However, if we move to SIMADI, the impact would be even more significant. I think there are three key considerations at play here. First, the back half, particularly Q4 -- both Q3 and Q4 are more challenging than the first half overlap. So we are facing an uphill growth battle in the second half. Second, commodities are more of a headwind in the second half of the year. Finally, the world remains very volatile. We have major businesses in the Middle East and Russia. We incorporate this volatility into our guidance, ensuring we do not assume perfect conditions moving forward.

Hi, good morning.

Good morning.

Is there a price war going on in snacks, especially in the U.K.? It seems like the categories are under a lot of pressure, and I wonder how far that travels across Europe, and what the competitive response has been?

I wouldn't call it a price war. The retail environment in the U.K. remains interesting. High street retailers are facing challenges, and the entry of discounters is reshaping the competitive situation. In the short term, we did lose some share, but we have plans to recover that share and navigate these retail environment changes. As we see significant changes in retail, short-term dislocations are likely, but we have to adjust our business model carefully.

Hey, good morning.

Good morning.

Could you provide an update on market trends specifically leading into the July 4th holiday, and how your beverage and snacks portfolio performs in terms of volume and pricing?

From our perspective, our numbers look fine. We have good price utilization. Though there were some weather-related issues in parts of the country, overall, we feel good about our results.

Absolutely Bill. There is certainly some bifurcation between what's happening in the center of the store and on the perimeter. Overall, we see good growth across our categories, with the exception of center of the store, which saw a slowdown in the Quaker category. Most of our categories are robust and saw good growth in the quarter.

Hey, good morning.

Good morning Kevin.

Can you discuss North American carbonated soft drinks and the implications of the recent pricing discipline? How does this change your view on North American carbonated soft drink profit pools and the sustainability of mid-single digit growth?

We've discussed disciplined pricing for some time, and I'm glad to see it's manifesting in the marketplace now. We will focus on disciplined pricing, revenue management, and innovations in the CSD segment. Ultimately, our profit pool depends on competitive dynamics. We believe this approach is appropriate for such a significant segment. Regarding Diet Pepsi, we are providing an aspartame-free option that will be available at the end of August for consumers seeking an alternative. Those who still prefer aspartame will have access as we work to ensure availability online.

Great. Thank you very much.

Good morning.

Could you give a bit more granularity on the impact to the topline, both in terms of volume and price mix that you're getting from innovation?

Our innovation has allowed us to achieve much better price realization, which is critical in today's environment. Our focus on packaging innovation and revenue management is driving this. We see this across categories, and our innovations are yielding significant revenue and profitability improvements.

Good morning. Thank you.

Good morning Caroline.

Are there increased regulatory risks to your food or beverage business globally, and specifically in Russia?

We recognized this risk early on and have been adjusting our portfolio. We are ensuring we have a diverse portfolio capable of withstanding regulatory actions. In Russia, our diverse portfolio enables us to navigate challenges, and our business remains strong despite geopolitical issues.

Good morning, Indra. Good morning, Hugh. I was wondering if we could talk a little bit more about procurement specifically in that larger $5 billion productivity aim.

Hugh, go ahead.

The $5 billion productivity aim does not include procurement savings. Productivity focuses on our operating costs, while we report procurement savings as net commodity inflation. The $5 billion does not cover savings from procurement.

Yes hi, good morning. I was hoping you could discuss the personnel and segmentation decisions announced alongside today's results.

We analyzed our global operations and clustered them into eight segments for more effective management. North America remains separate due to its size and uniqueness. The segmentation changes were made to streamline our strategies. Regarding personnel changes, we focus on elevating top talent and ensuring we have the right leaders in critical roles. We believe our talent management processes are working effectively.

Thank you. Good morning.

Good morning Judy.

I have two questions. One, looking at your global snack business, how do you plan to accelerate top-line and profit growth?

In global snacks, we aim to expand beyond savory categories. We recognize growth opportunities in dips and are focusing on taking share from other macro-snack categories. We are leveraging our snacks to generate sales opportunities in beverage retail outlets. Regarding global e-commerce, we are exploring opportunities ranging from click-and-collect models to direct delivery in markets like China. We're also tailoring products to suit e-commerce consumer needs, which allows us a more direct relationship with consumers.

Hey guys.

Hey Ali.

What's the status of Frito volume and is there potentially an end in sight there? Also, could you quantify where the remaining cost savings will come from?

We are monitoring Europe keenly and assessing our response to cost-saving measures, though nobody enjoys cost cutting. Our aim is to balance any productivity efforts with top-line growth. We seek to reduce inefficiencies through automation and shared services without compromising innovation or growth.

Yes, good morning everyone and congrats Hugh.

Thank you.

Could you share your perspective on zero-based budgeting within the business?

We look for every opportunity to tighten our operations. However, I believe knee-jerk, zero-based budgeting can harm growth efforts. We focus on smart, targeted spending that allows for operational efficiency without hurting growth potential. To conclude, we are pleased with our financial performance for the first half of 2015. Clearly, there are macro challenges; however, we believe we have the right strategies to navigate successfully through this environment. Our balanced portfolio provides a natural hedge against global volatility, boosting our confidence in reaching our financial targets.