Finance Research Paper

Whether you are on a relaxing on sandy beach or sitting behind a desk, when reaching for a crisp and refreshing beverage, you are likely to think of Pepsi. PepsiCo, a Fortune 500 company, is a purveyor and manufacturer of snacks, carbonated and noncarbonated beverages, dairy products, and other foods worldwide. The company operates in four divisions: PepsiCo Americas Foods (PAF); PepsiCo Americas Beverages (PAB); PepsiCo Europe; and PepsiCo Asia, Middle East, and Africa (AMEA). In this competitive industry, the company relies on accurate and timely forecasts to make strategic decisions. To build our valuation analysis of PepsiCo, we will first look at sales projections, ten year pro forma, and finally an interpreted firm valuation. Understanding the firm’s sales first takes an understanding of the firm’s macro environment. When it comes to macroeconomic trends, the most pressing issue is the global economic recession. Over the past couple of years, companies, industries, and individuals have been impacted decreased incomes and consumer spending.  For PepsiCo, this immediately translated into a loss of sales. However, ever since the economic downturn in 2008, the major economies of the world have been on a path of slow recovery.  With all other political and tax factors assumed to stay at the status quo, PepsiCo is looking at a market that in the next ten years is to recover and support business growth. Through understanding this macro-environment, we can begin understanding the direction of the industries that PepsiCo operates in. With subsidiaries in Frito-Lay North America, Quaker Foods North America, Latin America Foods, PepsiCo Americas Beverages, United Kingdom and Europe, and many others, PepsiCo is a company that operates in a variety of dynamic industries. To maintain its competitive edge, PepsiCo has to be the figurative dancing bear, large and flexible.  But for simplicity, the two biggest factors that the company has to react to are Frito-Lay North America and PepsiCo Beverages. Representing the snack and beverage industries, these divisions make up more than 50% of PepsiCo’s revenues. To build a sales forecast that will accurately portray the firm’s potential; an investor would need to looker closer at these two industries.   According to Global Industry analysts, the snacks and sweets industry is predicted to grow to a 335 billion dollar industry by 2015. Snack foods are claiming an expanding portion of the food market as a result of busier lifestyles. Of these snacks, the key trend is the focus on eating healthier. We see companies adapting by offering healthy options including such things as fat-free snack foods or 100-calorie packs. Some key market segments that will drive this growth are chocolate, artificial sweeteners, nuts, and fruit snacks, of which, PepsiCo is well positioned. Most importantly, PepsiCo is not aiming to change its business model into asset-light model, which will significantly reduce its cost, inventory turnover and capital expenditure. At the very mature and developed stage of a business circle, this asset -light business model will definitely grand PepsiCo some strong competitiveness over other industry participants. Understanding both of these macro-environment and industry prospects, we can now interpret PepsiCo’s positioning and potential. Frito-Lay, the primary snack subsidiary of PepsiCo, commands a large share of the U.S. market, accounting for around 37% of domestic snack food [TNB4] sales. A diverse portfolio of snack products gives the company a competitive edge. Looking more specifically at the portfolio and current market branding of Frito-lay, we are expecting to see the company hold and expand market.

In 2010, PepsiCo made headlines that it had officially lost the Cola war with Coca-Cola Company. However at ~37% [TNB5] market share, the company is fighting hard to maintain and grow against strong competitors and a tough market. PepsiCo’s Beverages division strengths include its current market position, brand portfolio, and economies of scale. Leveraging these make the company competitive and well positioned to adapt to changes in consumer tastes and shifts in demand. While it might be easiest to apply to historical sales growth as our future rate, we realized that these numbers are inflated by numerous acquisitions. Ruling future acquisitions out of our forecasts, we look to three key indicators for sales growth: population growth, consumer consumption, and GDP. As a food company, sales are tied to the number of consumers and amount of consumption. Intuitively, neither the number of consumers, as reflected by population growth and food consumption will vary dramatically. As a result, we perceive that there will be no expected super growth in sales. If we were to look for a numerical metric for this, GDP would be a good indicator. For the first three years, we predict a 1% growth rate that reflects not only our three factors but as well the effects of the economic recession. But following this, we expect to see the growth rate increase to around 1.5% to reflect the healing macroeconomic environment.

Subsequently, these sales forecasts allow us to build a sales-driven pro forma. For investors, this becomes a tool to assess credit, strategic, and planning worthiness. It will also become a structural part of the model from which cash flows can be derived. To give context to our final valuation, the following will explain how we plotted our operating expenses, assets and liabilities, and plug. With all other items filled, we turn to choosing our plug. Amongst many choices, we felt that using Long Term Debt as the plug was the most appropriate in this model under the criteria that it reflects an increasingly crucial factor for business operations. Analysis of PepsiCo’s Long Term Debt shows that in the recent years, this account has increased dramatically to support expansion in numerous areas. It is our assumption that Long Term Debt will continue to play a critical role for PepsiCo on its path of continued growth.

Using the income statement and balance sheet, we will be able to discover what free cash flows PepsiCo is able to grow from our predictions and assumptions. The three factors of free cash flows are Operating Cash Flows, Capital Expenditures, and changes in Operating Net Working Capital. Initially, we were concerned with the cash flows because theoretically the company would be taking on a lot of debt and capital expenditures at very low sales growth to maintain and expand the business. Some key assumptions for this section involve revenues on the income statement, especially our interest and taxes. For interest income, we applied the short term borrowing rate of treasury, which historically was 3-5%, so in choosing 2% we feel that it reflects a balanced and realistic rate of return. But after finding very high net incomes and in factoring in the present value of potential profits past year 10 in our terminal value, we ended up with our positive NPV. Although it would be easy to say market conditions for this project seem optimistic for success, the ultimate deciding factor in the decision for pursuing the online project is net present value which is based upon the growth these cash flows and our WACC. Two key assertions in our model regarding the WACC are the risk free rate and firm Beta. While current sources report risk free rate as 1.16%, we forecasted it at 5%.  We believe that we should use average the Nominal 20 year annual IS 5.48% rather than short term rate because PEP is a long term investment. For our choice of firm Beta, the same logic applies as current sources report a .48 beta but rather we would prefer using .7 betas. Over the last 5 years with the market crash in 2008 and 2009, investors flocked into “safe” and defensive stock as PEP or Coca Cola, lowering their beta even more. Similar to short term interest rates, we are forecasting for the long haul, so we should use long term risk score as Beta. If you look at 2006 level, before the market crashed in 2008 and 2009, PEP’s Beta was in the .7-.75 range. The combination of these two assumptions result in our final firm value was $139,074 million, which is indicative that the company is undervalued. If anything, this is a clear positive sign for the long-term potential of the project.

With a final valuation of $ 289,636 million, the resulting share price should be, given our assumptions, $182.54 per share. To present further evidence of our belief that the stock is undervalued, we need to determine how a change in sales will impact our valuations under our given set of forecast assumptions. Assessing a change of sales in increments of 10%, we see that the firm’s valuation price varies by at most 20 cents or 22% when testing against 80% to 120% change in our predicted sales growth. Notably, this range of share prices remains above the current market price for PepsiCo, supporting the claim that this stock is undervalued in the market. For investors, this difference reflects a profit potential.   After integrating our research, we believe PepsiCo is undervalued. Through our construction of our sales forecasts, ten-year pro-forma, and valuation assumptions, we have shown that PepsiCo has a net present value of $289,636 million and a suggested share price of $182.54 per share. Ultimately, whether or not you are a fan of Pepsi, these numbers translate into an understanding that PepsiCo is a firm that deserves a second look when evaluating competitive firms in the snack and beverage industry.