pepsico

Analysis of PepsiCo

Report by Valanium Analysts: Aziz Hassanali, Rami Musa, Jordan Rubin

Investment Recommendation: MARKET OUTPERFORM 3 December, 2001

PEP – NYSE (11/30/01) $ 48.63 52 week range $40.25 - $ 50.46 Sales (TTM) $ 25.4B Market Capit alization $ 85.1B Share Outstanding 1.75B Dividend Yield 1.19 % Average Daily Trading Volume* 3.54M Book Value per Share (12/01) $ 4.75 Return of Equity (ttm) 32.20 % Return on Assets (ttm) 13.08 % Est. 5 Years EPS Growth Rate (‘01-‘05) 11.70 % Industry: BEVERAGES — NON-ALCOHOLIC

Earnings per Share actual estimate 1999 2000 2001 2002 $1.75 $1.51 $1.75 $1.97 Ratios PEP Industry Average

Forward P/E 29.2 26.71 Forward PEG 2.25 2.00 M/B 2.03 3.71 P/Sales 3.22 2.60 Valuation Predictions

Current Market Price $ 48.63 P/E Valuation $ 46.74 PEG Valuation $ 41.30 M/B Valuation $ 17.62 P/S Valuation $ 39.23 DCF Valuation $ 52.34 EBO (Abnormal Earnings) Valuation $ 51.85 Performance of PEP

Trailing 3 mo. 12 mo. 36 mo. Return on PepsiCo 3.8% 16.2% 8.7% Return on S&P 500 2.5% 28.5% 8.2% Return on Industry 6.6% 39.5% 19.6%

• Assigning a rating of market outperform on PepsiCo on its current price of $48.63 and a year end target price of $52 (based on DCF and EVA valuations).

• Though ratio analysis yields a lower price, DCF and EVA valuations provide a more reliable price target as PepsiCo's financial data is reliable (high quality of earnings) and its business varies from its competitors.

• PepsiCo has the top brand in each of the juice, water, sports drink, iced tea, coffee-style, and new age beverage segments of the non-alcoholic beverage industry.

• Frito-Lay, PepsiCo's largest subsidiary by sales and by operating profit, is the number one producer of snack foods worldwide.

• Recent merger with Quaker Oats is expected to provide upside potential for PepsiCo due to operating synergies.

• A poor economic climate would be less of a drain on PepsiCo than the market average.

Rating System: BUY: A strong purchase recommendation with above average long-term growth potential. MARKET OUTPERFORM: A purchase recommendation that is expected to marginally outperform the return of the market. MARKET PERFORMER: A recommendation to maintain current positions with returns to match that of the market. SELL: A recommendation to sell the security (or short the security) as it is expected to decrease in price in the medium term.

Valanium Associates PepsiCo (PEP)

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Business Summary CORE BUSINESS The core business of PepsiCo consists of non-alcoholic beverages and snack foods. PepsiCo’s primary business units are Pepsi-Cola, Frito-Lay, Tropicana, and Quaker Foods. A list of popular brands produces by PepsiCo includes Pepsi, Diet Pepsi, Mountain Dew, Lays, Doritos, Tostitos, Tropicana, Gatorade, and Aquafina.

In fiscal 2000, 25.11% of PepsiCo sales came from the Pepsi-Cola business unit, 63.02% from Frito-Lay, and 11.87% from Tropicana. Quaker Oats was a separate firm until August 2001, thus not a subsidiary of PepsiCo in 2000.

Pepsi-Cola holds a share of approximately 32% of the domestic soft drink market. Pepsi-Cola is the second largest food brand in U.S. supermarkets, behind only Coca-Cola. Frito-Lay holds an approximate share of 58% of the US market for snack chips.

PepsiCo products have international appeal with Pepsi-Cola and Frito-Lay marketing products worldwide. The brands that these two business units sell internationally are both brand-specific towards individual countries and regions, as well as global brands. More than 20% of PepsiCo’s operating profit is generated from foreign operations.

CORPORATE INFORMATION Company History & Overview

PepsiCo was founded by Donald M. Kendall and Herman W. Lay in 1965 with the merger of Pepsi-Cola and Frito-Lay. Kendall, president and CEO of Pepsi-Cola, became president and CEO of the merged company. Lay, president and CEO of Frito-Lay became chairman of the Board of Directors of PepsiCo.

Pepsi-Cola was created by pharmacist Caleb Bradham in the late 1980s. The 1961 merger of the Frito Company and the H.W. Lay Company formed Frito-Lay. Elmer Dool in founded the Frito company in 1932; Lay founded the H.W. Lay company in the same year.

In the last five years, PepsiCo has been involved in a number of significant business transactions. Four of the largest and most significant transactions for PepsiCo’s operations are below.

• Spin-off of Tricon Global Restaurants PepsiCo bought Pizza Hut in 1977, Taco Bell in 1978, and Kentucky Fried Chicken in 1986. In 1997, the three fast-food outlets were spun off as Tricon Global

Restaurants, Inc. PepsiCo shareholders received one share of the new company for every ten shares they held in PepsiCo stock.

• Acquisition Tropicana PepsiCo acquired Tropicana Products, including the Dole global juice business from the Seagram Company in 1998. Tropicana is the most popular brand of orange juice in the United States. Tropicana also produces Dole brand fruit juices.

• IPO of Pepsi Bottling The $2.3 billion public offering of the Pepsi Bottling Group is completed in 1999. The new firm, the world’s largest bottler of Pepsi trades on the New York Stock Exchange under the symbol PBG. With holdings of 38% of outstanding PBG stock, exclusive ownership of PBG class B stock and other interests in subsidiaries of PBG, PepsiCo holds an economic ownership of approximately 42% of the combined operations of PBG. Thus PepsiCo uses the equity method for accounting purposes.

• Merger with Quaker Oats PepsiCo completed its merger with the Quaker Oats company in the summer of 2001. The Gatorade division of Quaker Oats produces the world’s leading sports drink. This makes PepsiCo the world’s largest producer of non-carbonated beverages.

PepsiCo’s business strategy focuses on growth via product innovation, consumer base expansion, and mergers and acquisitions.

PepsiCo has an active research and development department, improving existing products as well as creating new products. Recent trends have seen consumers seeking “add-on supplements” and “all-natural ingredients.” In the past, “reduced fat” and “low sodium” labels had been popular amongst consumers. PepsiCo’s R&D has been able to meet this market demand.

PepsiCo’s marketing effort is amongst the most aggressive for any company. Advertisements for Pepsi, Mountain Dew, and Doritos are aired on network and cable programming, including prime time and other premium air times. Under Quaker Oats, Gatorade had an extensive marketing campaign. This can be expected to continue after the merger. PepsiCo is noted for using high profile celebrities (Michael Jackson, Larry Bird, Brittney Spears) in ad campaigns.

PepsiCo has been active in M&A activity to create operating synergies and increase firm value. The recent Quaker Oats merger is expected to create $400M of synergies for the merged


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firm. PepsiCo also acquired a controlling interest of the South Beach Beverage Company in January 2001. The signature product of that firm, SoBe is a niche, high-margin beverage that features fortified vitamins and herbal enrichments as well as a new age appeal. PepsiCo currently has 10% more market share than Coca-Cola in the non-carbonated beverage market — this can be attributed to merger activity.

Management Team This past May, the PepsiCo board of directors elected Steven S Reinemund chairman of the board and chief executive officer, and Indra K. Nooyi president and chief financial officer. Nooyi was also selected to sit on the board. Reinimund, formerly PepsiCo’s president and chief operating officer, succeeded Roger Enrico as chairman and CEO.

PepsiCo’s active strategy in the M&A arena require a high-caliber management team. PepsiCo’s managers and board of directors have consistently added to the value of the firm through purchasing and selling asset bases.

OPPORTUNITIES FOR GROWTH PepsiCo has shown the ability to produce profit growth and returns on its assets. PepsiCo has growth potential in all four of its main subsidiaries.

Table 1

Sales % of

PepsiCo % of Total Pepsi-Cola $5,131 25.11% 20.16%

Frito-Lay $12,881 63.02% 50.61% Tropicana $2,426 11.87% 9.53%

Quaker Oats $5,014 N/A 19.70% Table 1: Sales of PepsiCo in 2000

Table 2

Oper. Profit

% of PepsiCo % of Total

Pepsi-Cola $981 27.63% 22.51% Frito-Lay $2,344 66.03% 53.79%

Tropicana $225 6.34% 5.16% Quaker Oats $808 N/A 18.54%

Table 2: Operating profits of PepsiCo in 2000

Tables 1 and 2 show sales and operating profit, respectively, for PepsiCo in 2000. Within the new conglomerated PepsiCo, most of the assets and operations of Quaker Oats fall within two business units of PepsiCo, namely, Tropicana and Quaker Foods. Gatorade, formerly a subsidiary of Quaker Oats, will

operate as within the Tropicana subsidiary. The expected breakdown of the firm’s operating profits by subsidiary for 2001 is shown in chart 1.

Chart 1

Chart 1: Expected percentage of operating profits by division in 2001

As noted before, consumer trends are likely to shift within the realm of beverages and snack foods. PepsiCo is in a good position to react to these shifts in consumer preferences due to a large R&D team. The R&D team inherited from Quaker Oats is of equal quality and will aid the PepsiCo R&D team.

Product innovation by PepsiCo has been successful despite setbacks. PepsiCo is willing and able to take risks in developing new products. Not all of these products find success within the market. The Frito-Lay division has seen a higher rate of successful new products because the consumer is more willing to adapt to new snack foods as compared to new beverages.

Furthermore, consumer shifts within the snack food market are more easily determined and PepsiCo is the clear leader in that field. The recent shift for consumers to search for “enhanced” products rather than “reduced-harm” products was noticeable as low-fat and low-sodium products were declining in sales by percentage. PepsiCo countered this by introducing new flavors of Doritos and baked chips.

The overall domestic market for snack foods is growing. There has been a steady trend for Americans to snack more. As the leader in snack food production, Frito-lay has seen a large benefit as a result of this steadily increasing demand. This trend is expected to continue indefinitely as Americans spend more time “on-the-run” and a culture of snacking (versus sit-down meals) settles into the American culture.

With an expected $400M in operating synergies, the merger between PepsiCo and Quaker Oats is filled with opportunities

Quaker Foods 8%

Frito-Lay

51%

Pepsi-Cola21%

Tropicana20%


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for growth. The distribution system of Tropicana, as well as Pepsi-Cola, should expand the market and consumer base for Gatorade. Gatorade has grown rapidly since its introduction to the market. PepsiCo’s beverage distribution mechanism should allow Gatorade to continue its rapid growth.

Chart 2

Chart 1: Distribution of Tropicana & Pepsi-Cola

Including Gatorade in fountain drink packages will provide a marketing tool for PepsiCo to add to market share within restaurants. The addition of Gatorade to vending machines will provide a real growth opportunity for PepsiCo. Tropicana’s military sales will likely benefit from the ability to sell Gatorade products. And with more than half of PepsiCo beverage distribution going to supermarket and other retail outlets, there will necessarily be a synergy for Gatorade with regards to sales to Supermarkets.

The Frito-Lay division has PepsiCo’s highest potential for international growth. Frito-Lay is the largest producer of snack foods worldwide. Internationally, there is potential for growth in the market for snack foods. Half of PepsiCo’s Latin American sales are in Mexico. This market is expected to grow. The success of the Sabritas brand of potato chips in penetrating

the market in Mexico shows the potential for further consumer base growth in Latin America. Opportunities for establishing a significant operation in Brazil may be realizable as the Brazilian economy settles.

Expansion of the European market will provide growth opportunities for Frito-Lay as well. The European consumer is expected to spend more money on snack food in the near future. PepsiCo is in a good position to take advantage of this increase in demand.

PepsiCo innovation yields growth potential within the non-carbonated juice market as well. PepsiCo produces the leading domestic brands in orange juice (Tropicana Pure Premium), water (Aquafina), iced tea (via a partnership with Lipton), bottled coffee (Frapuccino via a partnership with Starbucks), sports drink (Gatorade), and new age drink (Sobe). There is potential for innovative product for all of these products, as well as many other non-carbonated beverages under the Pepsi-Cola and Tropicana portfolios of assets.

Within the carbonated beverage market, prospects are good, though not as bullish as for snack foods and non-carbonated beverages. Particularly within the cola arena, potentials for growth are not as readily apparent

The recent induction of China and Taiwan into the WTO might provide Pepsi-Cola with a real growth opportunity. Pepsi-Cola’s recent success in Thailand suggests that there is a potential for further growth in the Asian market.

RISK ANALYSIS Consumption & Demand

Variation in the consumption patterns of beverages and snack foods adds a risk to PepsiCo. If fewer individuals were to buy snack foods, the Frito-Lay division would see it’s growth potentials erode.

The effects of the terrorist attacks on September 11 are unclear. There is a genuine possibility for a real change in consumption patterns as a result of those unfortunate events.

Reports have shown that Americans have turned to food as a mechanism to deal with the tragedy. This would imply an increasing in snacking in the U.S. Another effect, however, is that people have been spending more time with family. The result of this fact may be a shift from the “eat-and-run” mentality of many Americans. Individuals may be slowing the pace of their daily lives and thus eating larger meals and snacking less. This could have a negative effect on Frito-Lay revenues. There is no way to know the real effects of the

Supermarkets 66%

Mass Merchandise/ Club/Military/Drug 14%

Convenience/Direct Store Delivery/Dairy 12%

Foodservice 8%

Supermarket/ Other Retail 48%

Convenience/Gas 12%

Vending 11%

Fountain/ Restaurant 21%

Mass Merchandise/ Club/Drug Stores 8%

TROPICANA PEPSI-COLA


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attacks on PepsiCo sales, but we should recognize the increase in variance of expected sales.

Commodity Prices Rises in commodity prices would reduce operating profits for PepsiCo by increasing the cost of goods sold. PepsiCo engages in activities in order to hedge its commodity risks. Shortages in the commodities that act as inputs to PepsiCo’s production process could occur due to a bad year in agricultural output. PepsiCo does not fully hedge its risks with regard to commodity prices, so there is a real risk that the firm faces. (The cost of a complete hedge for PepsiCo would be prohibitive to the management’s goal of increasing shareholder value. PepsiCo’s hedging activities are appropriate.)

PepsiCo enters futures contracts in primary oil, corn, fuel, and juice concentrates. Futures contracts are not a significant portion of PepsiCo’s commodity transactions. PepsiCo also works to hedge commodity risk with fixed-price purchase orders, pricing agreements, and geographical diversity.

Interest Rates & Currency Exchange PepsiCo hedges effectively against fluctuations in interest rates. A centrally managed debt and investment strategy is used to minimize tax consequences while avoiding interest rate risk. PepsiCo uses interest rate swaps in this effort. PepsiCo’s portfolio to deal with interest rates includes primarily cash equivalents and short-term marketable securities. In recent years, PepsiCo has realized a negative interest expense (thus a gain) on its income statement. PepsiCo is engaged in currency swaps as well.

As PepsiCo realizes more than 20% of its operating profit from international operations, currency exchange has the potential to change the earnings of the firm. The exchange rates that expose PepsiCo to the most risk are the Mexican peso, British pound, Canadian dollar, and Euro. This is due to the large amount of operations an revenue generated in Mexico, the United Kingdom, Canada, and continental Europe. PepsiCo’s currency risk will necessarily increase as it enters into different countries with significant operations.

PepsiCo engages in forward currency contracts, but these contracts do not have a material effect on the financial status of the firm.

COMPETETIVE LANDSCAPE Rationale for Choosing Non-alcoholic Beverage Industry

We examine firms in the non-alcoholic beverage industry rather than the snack food industry because PepsiCo’s business

practices have more similarities with the non-alcoholic beverage companies when examining accounting practices, business strategies, and product management. For example, PepsiCo’s nearest competitor in the snack chip business is Proctor & Gamble, which is mainly in the personal and household products industry. Kraft Foods, Incorporated and RJR Nabisco are two leaders in the production of brand-name food items. Kraft Foods was spun off from the Philip Morris Companies in 2001, so there is limited financial data on the firm. RJR Nabisco is not publicly traded, and is also has a core interest in the cigarette business. (Cigarette producer Philip Morris currently retains 84% of Kraft Foods.) In the near future, Kraft Foods may be included in the competitive landscape for PepsiCo for the purpose of financial analysis . However this year it is not appropriate as the firm has yet to produce an annual report

Non-Alcoholic Beverage Industry Competitors with PepsiCo in the non-alcoholic beverage industry include the Coca-Cola Company; Cadbury Schweppes, PLC; the Triarc Company, the National Beverage Company, and the Hansen Natural Corporation. Table three displays these companies in decreasing order of their market capitalization.

Table 3 Company Name Ticker Exchange

Stock Price

Market Cap.

Coca-Cola Co.

KO NYSE $46.96 $116.8B

Cadbury Schweppes

CSG NYSE $25.25 $12.9B

Triarc Co. TRY NYSE $23.40 $523.6M National Beverage Co.

FIZ NYSE $11.20 $203.4M

Hansen Natural Corp.

HANS NASDAQ $4.00 $40.2M

Table 3:Five of PepsiCo’s main competitors

The main competitor of PepsiCo is the Coca-Cola Company. Coca-Cola Classic is the leading brand in American supermarkets. Of the competitors, Coca-Cola is the most similar to PepsiCo when comparing market capitalization and market share. Coca-Cola’s market capitalization of $116.8B is larger than PepsiCo’s $85.1B, but they are more in line with each other than the next competitor’s $12.9B. Furthermore, Coca-Cola and PepsiCo have similar marketing strategies. Coke and Pepsi operate as basically a duopoly in the cola market.

Cadbury Schweppes is another competitor in the field of non-carbonated beverages and snack foods. The consolidated assets of Cadbury Schweppes are similar to PepsiCo in the fact that


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the two firms are diversified in similar markets. The snack foods sold by Cadbury Schweppes are weighted more towards confectionary items whereas PepsiCo’s snack business is centered on salty snacks.

The Triarc Company produces soft drink concentrates, which are sold under brand names.

The National Beverage Company holds a portfolio, which includes standard sodas, including Shasta, as well as specialty and new age beverages.

Hansen National Corp produces a wide variety of alternative and new age beverages, as well as nutritional bars.

PepsiCo, Coca-Cola, and Cadbury Schweppes, the three non-alcoholic beverage firms with billion-dollar market capitalizations, produce various types of beverages. A listing of beverage types produced or distributed by these three firms can be found in table 4.

Table 4 Style of

Beverage PepsiCo Coca-Cola Cadbury

Schweppes

Cola Pepsi Diet Pepsi

Coca-Cola Cl. Diet Coke –

Non-Cola Soda

Mountain Dew Sierra Mist

Sprite Diet Sprite

Schweppes

Bottled Water Aquafina Dasani –

Enhanced Water

Propel – –

Sports Drink Gatorade PowerAde – Energy

Drink KMS SoBe

Amp –

Juice Drinks Dole

Tropicana FruitWorks

Minute Maid Fruitopia

Hawaiin Punch Snapple

Country Time Refrigerated

Juices Tropicana

Dole Minute Maid Simply Juice –

New Age SoBe Mad River Mistic Iced Tea Lipton Nestea Snapple

Coffe Style Drink Frapuccino Planet Java –

Table 4: Sampling of beverage brands by type of beverage for three main firms

PepsiCo’s brands are leaders in a number of these categories. PepsiCo is in a good position within the competitive landscape with its beverage products. As consumers slowly shift away from drinking cola, they move into categories where PepsiCo’s relative strength is just as strong. Though the markets for many of the non-cola beverages do not act as duopolies, the margins on the sales of these products are high for PepsiCo. PepsiCo has the ability to increase its market share in all beverages while it struggles to maintain its market share in the Cola business.

RATIOS & INDICATORS (FY2000) Profitability Ratios

ROA:13.08% ROE: 32.20 %

Market Ratios P/E Ratio: 33.5 PEG Ratio: 2.86 M/B Ratio: 11.2 P/S Ratio: 3.44

Turnover Ratios Accounts Receivable Turnover: 11.36

Inventory Turnover: 8.78 Fixed Asset Turnover: 1.49 Short-Term Liquidity

Current Ratio: 1.17 Quick Ratio: Oper. Cash Flow/Curr. Liab.: .994

Long-Term Solvency & Bankruptcy Test Long-term Debt Ratio: .245

Debt/Equity: .324 Liabilities/Assets: .605 Interest Coverage: not applicable as PepsiCo incurs an interest expense which is negative Altman Z-Score: 6.76 which indicates that bankruptcy is very unlikely.

Quality of Earnings Analysis

QUALITY OF SALES The analysis of PepsiCo's sales and accounts receivable (A/R) information, starting January 1995 through the second quarter of 2001, shows no apparent threats to the health of the company's sales. There are no worrisome trends in the growth level of sales compared to that of A/R.

As shown in Table 5 below, the annualized percentage change in quarterly reported A/R and sales for PepsiCo vary by a reasonable amount. The standard deviation on A/R growth is about half that of sales growth with a correlation of about 29.6%. This is a reasonable effect resulting from accrual accounting. The difference between A/R and Sales therefore does not appear to pose a threat to the future revenues and cash flows of PepsiCo.

Table 5

Sales Sales

Growth AR AR

Growth Average 5557 -1.8% 2280.4 -3.9% Standard

Dev. 1325.9 30.2% 416.3 16.2%

Table 5: Sales and A/R quarterly data analysis


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NET INCOME vs.

CASH FLOW FROM OPERATIONS A basic comparison between the net income (NI) and cash flow from operations (CFO) for the past 6 years shows that CFO grows on average faster than NI. This indicates a healthy business. The average CFO growth in the past 6 years is about 129% and the growth in NI is about 64% for the same period.

VOLATILITY OF EARNINGS & HEDGING A comparison of PepsiCo's operating income before depreciation (OIBD) with cash flow from operations (CFO) confirms that the company is not engaged in aggressive booking of sales to boost net income numbers. In addition, the results, summarized below, reflect that PepsiCo is engaged in hedging activities to smooth out earnings. Table 6

PEP KO CSG

OIBD: St. Dev./Avg. 0.48 0.15 0.25

CFO: St. Dev./Avg. 1.07 0.61 0.81

Ratio 0.45 0.25 0.32

Table 6:Ratios of STDEV of OIBD to that of CFO

The measure used in this analysis is the ratio of the standard deviation of OIBD to that of CFO after normalization (after dividing by the respective average). The results for PepsiCo and two of its competitors, shown in Table 6 above, indicate that a relatively low ratio is the industry standard. This confirms that Pepsi is in line with its peers. In addition, a ratio of less than one indicates it is unlikely that PepsiCo is involved in any of cooking the books.

The surprisingly low ratio for PepsiCo can be attributed to the company's hedging activities. PepsiCo is an international firm with exposure to several risks including foreign exchange, interest rate and raw-material prices risks. The effects of hedging are captured in CFO but not in OIBD and this can lead to a low ratio.

PepsiCo's hedging activities include the use of various derivative financial instruments such as currency swaps and forward contracts as well as commodity instruments related to necessary raw materials. All derivative instruments seem to protect against an underlying exposure. PepsiCo does not seem to hold any derivative instruments for trading or speculative purposes.

NET INCOME vs. EARNINGS PER SHARE Comparing the change in earnings per share (EPS) of PepsiCo in 2000 with the change in net income (NI) in the same year shows no dramatic variation. The change in EPS was 7.14% and the change in NI was 6.49%. This suggests that there is little EPS manipulation in relation to the net income.

Extraordinary Items: The comparison was extended to check for any manipulation related to extraordinary items (IE). Both EPS values for PepsiCo, including EI and excluding EI, show no significant variation at all. EPS in both cases was 7.14%.

Number of Shares Outstanding: PepsiCo's EPS is also free from manipulation related to changes in shares outstanding. EPS could misrepresent trends in earnings due to significant changes in the shares outstanding (shares used to calculate basic EPS) across periods. For Pepsi this does not occur. A summary of this comparison is available in Table 7 below. Table 7

Average Shares Outstanding EPS (2000)

1999 1467 1.48

2000 1454 1.50

Table 7: EPS 2000 using shares outstanding from 1999 and 2000

ASSET WRITEDOWNS In recent years, PepsiCo has been involved in restructuring activities specially related to their bottling operations. These operations dictated a number of asset impairment charges to be incurred. Changes in asset holdings seem to be accounted for appropriately. Abandoned and disposed assets are written down in the period they become of no use to PepsiCo's operations. In addition, several assets have been written down recently to their fair market values based on recent purchases of similar assets. This shows that PepsiCo's handling of its assets seems to be appropriate. There does not seem to be any too early or too late writing down of abandoned assets.


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Valuation Analysis SUMMARY OF VALUATION TECHNIQUES We determined the target price for PepsiCo using a variety of valuation methods. Our valuation methodology is based on 5-year Discounted Cash Flow Model (DCF) and an Economic Value added Model (EVA). In addition we used relative P/E, PEG and M/B analysis comparing PepsiCo relative to the industry in arriving at our 12-month price target.

In order to employ any of these valuation methodologies, however, it is important to accurately forecast the future earnings of the firm. We therefore, arrive at forecasted earnings numbers by extrapolating the present income statement for PepsiCo by analyzing previous numbers and also studying the 2000 annual report and general market indicators (please see appendix for detailed assumptions).

DISCOUNTED CASH FLOW MODEL (DCF) The DCF method uses forward FCF estimates discounted by the cost of capital to arrive at a share price for a firm. The FCF method is used because future earnings are the best determinant of the share price of a firm. The accuracy in the estimate of the share price, therefore, lies in two fundamental variables: the FCF’s and the cost of capital. The Free Cash Flow (FCF) is derived by the following relationship:

FCFt = Net Incomet – ? Working Capital Accrualst + Depreciationt – Capital Expenditurest

The cost of capital ( eR ) was determined primarily using the Capital Asset Pricing Model (CAPM): )( fmfe RRRR −+= β

We determine the most appropriate β by performing regressions using the three-factor model: )()()( HMLDistressSMBSizefmfe RRRRRR βββ ++−+=

We compared our estimate of β = 0.70 to the Yahoo estimate of 0.79, which seemed about right. The cost of capital was then determined as below. Re = 3.14% + 0.70*8.68% = 9.22%

This cost of capital was used in calculating the appropriate share price, after conducting sensitivity analysis to account for the slight variation in beta estimates and other non-captured abnormal factors.

ECONOMIC VALUE ADDED MODEL (EVA) This model assumes that the current book value of equity truly captures the firm value with the exception of unforeseen or abnormal future earnings. The investor is compensated for bearing this additional risk and therefore the model predicts the share price to be the sum of the previous year’s book value and the net present value of future abnormal earnings discounted at the cost of capital.

∑∞

=− +

+=ti

ii

tt rAE

BookValueeEquityValu)1(1

In most cases it is assumed that competitive market forces will tend abnormal earnings to converge to zero.

P/E, PEG, M/B & P/S ANALYSIS The above four metrics are based on the same principle, which is determining the respective industry averages of each of the benchmarks and then applying them to the earnings numbers or book values of PepsiCo to arrive at a crude estimate of the share price. The industry average is based on the respective ratios for five of Pepsi’s most significant competitors.

Though these estimates are not as rigorous as the DCF or EVA they provide a fair gauge of where the stock should be trading relative to its peers assuming that it it is very similar to them. However, PepsiCo is fairly diversified in comparison to its competitors, which could account for lower estimates. This is particularly, significant for M/B estimate where KO and CSG are the only perhaps true competitors.

The respective growth rates, earnings forecasts and ratios were obtained from Yahoo Finance, Morgan Stanley Research and credit Suisse First Boston Research.


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FORWARD P/E VALUATION

Competitor Current

Share Price Forward EPS Forward P/E Coca Cola (KO) 47.99 1.57 30.57 Hansen National Corp (HANS) 3.95 0.29 13.62 Triarc Co Inc (TRY) 22.75 0.45 50.56 Cadbury Schweppes (CSG) 24.94 2.06 12.11 National Beverage Company (FIZ) 10.94 N/A N/A Mean: 26.71

PEG VALUATION

Competitor Forward P/E Long Term

Growth Rate PEG Coca Cola (KO) 30.57 12.00 2.55 Hansen National Corp (HANS) 13.62 N/A N/A Triarc Co Inc (TRY) 50.56 18.50 2.73 Cadbury Schweppes (CSG) 12.11 17.00 0.71 National Beverage Company (FIZ) N/A N/A N/A Mean: 2.00

M/B VALUATION

Competitor Current

Share Price BV/Share

M/B Coca Cola (KO) 47.99 4.46 10.76 Hansen National Corp (HANS) 3.95 2.47 1.60 Triarc Co Inc (TRY) 22.75 14.53 1.57 Cadbury Schweppes (CSG) 24.94 8.31 3.00 National Beverage Company (FIZ) 10.94 6.67 1.64 Mean 3.71

P/S VALUATION

Competitor Current

Share Price Sales/Share P/S Coca Cola (KO) 47.99 8.13 5.90 Hansen National Corp (HANS) 3.95 8.64 0.46 Triarc Co Inc (TRY) 22.75 6.67 3.41 Cadbury Schweppes (CSG) 24.94 8.82 2.83 National Beverage Company (FIZ) 10.94 26.07 0.42 Mean 2.60

PepsiCo Forecasted Price Mean Industry Forward P/E * PepsiCo Forward EPS

26.71*1.75 = $46.74

PepsiCo Forecasted Price: PepsiCo 5yr Growth Rate * PepsiCo Forward EPS * Mean Industry PEG Ratio

11.8*1.75*2.00 = $41.30

PepsiCo Forecasted Price: Mean Industry M/B * PepsiCo Book Val. Per Share

3.71 * 4.75 = $17.62

PepsiCo Forecasted Price: Mean Industry P/S * PepsiCo Sales Per Share

2.60*15.09 = $39.23


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DISCOUNTED CASH FLOW MODEL 2001 2002 2003 2004 2005

NOPAT 3,414,757 3,882,516 4,085,370 4,561,833 4,938,246 Change in WC (16,000) 209,000 177,000 193,000 215,000 Depreciation15 1,246,600 1,621,577 1,757,790 1,905,444 2,065,501

Capital Expenditures 1,387,100 1,525,810 1,602,101 1,650,164 1,755,000

Operating FCF 3,290,257 3,769,283 4,064,059 4,624,113 5,033,747 Terminal Value

(Growth Rate = 4.50%) 106,647,190 Discounted FCF

(Cost of Capital = 9.22%) 3,290,257 3,451,092 3,406,871 3,549,130 78,482,054

Value of Equity 92,179,405

2001 Shares 1,761,000

Share Price $52.34

Sensitivity Analysis on DCF Valuation: Terminal Growth

50.94 4.0% 4.5% 5.0% 5.5%

8.0% $62.5 $70.0 $80.0 $94.1 8.4% $57.0 $63.0 $70.8 $81.3 8.8% $52.4 $57.3 $63.5 $71.7

9.2% $48.4 $52.6 $57.7 $64.1 Co

st o

f C

ap

ital

9.6% $45.1 $48.6 $52.8 $58.0

ECONOMIC VALUE ADDED MODEL 2001 2002 2003 2004 2005

Book Value 7,828,920 8,459,148 9,144,339 9,889,603 10,700,550 Abnormal Earnings 3,752,115 2,924,690 3,879,370 4,278,833 4,559,246

Terminal Value (Growth Rate = 4.50%) 96,594,194

Discounted AE (Cost of Capital = 9.22%) 3,752,115 2,677,797 3,252,047 3,284,118 71,084,018

Value of Equity 91,299,095

2001 Shares 1,761,000

Share Price $51.85

Sensitivity Analysis on EVA Valuation: Terminal Growth

50.94 4.0% 4.5% 5.0% 5.5%

8.8% $51.86 $56.34 $61.99 $69.36 9.2% $48.32 $52.04 $56.65 $62.51

Co

st o

f C

ap

ital

9.6% $45.28 $48.42 $52.24 $57.00


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Income StatementIn $000's (Except Per Share Data)

1996 1997 1998 1999 2000CAGR '96-'00 2001E 2002E 2003E 2004E 2005E

CAGR '01-'05 R

ef. #

____________________ __________ __________ ______________________________ __________ __________ __________ __________ __________

NET SALES 20,337,000 20,917,000 22,348,000 20,367,000 20,438,000 0.1% 26,569,400 28,216,703 29,994,355 31,913,994 33,988,403 6.3%Sales Growth 6.7% 2.9% 6.8% -8.9% 0.3% 30.00% 6.20% 6.30% 6.40% 6.50% 1

COST OF GOODS 8,452,000 8,525,000 9,330,000 8,198,000 7,943,000 -1.5% 10,707,468 11,371,331 12,147,714 12,988,995 13,867,269 6.7%COGS /Sales 41.6% 40.8% 41.7% 40.3% 38.9% 40.3% 40.3% 40.5% 40.7% 40.8% 2

GROSS PROFIT 11,885,000 12,392,000 13,018,000 12,169,000 12,495,000 1.3% 15,861,932 16,845,372 17,846,641 18,924,998 20,121,135 6.1% 3

SELL GEN & ADMIN EXP 9,063,000 9,241,000 9,924,000 9,103,000 9,132,000 0.2% 11,291,995 11,568,848 12,297,686 12,765,598 13,595,361 4.8%SG&A/Sales 44.6% 44.2% 44.4% 44.7% 44.7% 42.5% 41.0% 41.0% 40.0% 40.0% 4

INC BEF DEP & AMORT 2,822,000 3,151,000 3,094,000 3,066,000 3,363,000 4.5% 4,569,937 5,276,523 5,548,956 6,159,401 6,525,773 9.3%

AMORT 206,000 199,000 222,000 183,000 138,000 -9.5% 149,592 162,158 175,779 190,544 206,550 8.4%Amort/PPE 2.1% 2.0% 1.9% 2.3% 1.6% 1.7% 1.8% 1.9% 1.9% 2.0% 5

NON-OPERATING INC (485,000) (165,000) (214,000) 1,136,000 206,000 19.3% 148,000 161,000 181,000 208,000 279,000 17.2%% Growth 203.1% -66.0% 29.7% -630.8% -81.9% -28.2% 8.8% 12.4% 14.9% 34.1% 6

INTEREST EXPENSE 565,000 478,000 395,000 363,000 221,000 -20.9% 183,000 75,000 25,000 75,000 100,000 -14.0%Interest Expense/Debt 6.9% 9.7% 9.8% 12.9% 9.4% 9.4% 8.4% 6.4% 6.4% 7.4% 7

INCOME BEFORE TAX 1,566,000 2,309,000 2,263,000 3,656,000 3,210,000 19.7% 4,534,937 5,362,523 5,704,956 6,292,401 6,704,773 10.3%

PROV FOR INC TAXES 624,000 818,000 270,000 1,606,000 1,027,000 13.3% 1,451,180 1,716,007 1,825,586 2,013,568 2,145,528Effective Tax Rate 39.8% 35.4% 11.9% 43.9% 32.0% 32.0% 32.0% 32.0% 32.0% 32.0% 8

NET INC BEF EX ITEMS 942,000 1,491,000 1,993,000 2,050,000 2,183,000 23.4% 3,083,757 3,646,516 3,879,370 4,278,833 4,559,246

EX ITEMS & DISC OPS 207,000 651,000 NA NA NA N/A N/A N/A N/A N/A 9

NET INCOME 1,149,000 2,142,000 1,993,000 2,050,000 2,183,000 17.4% 3,083,757 3,646,516 3,879,370 4,278,833 4,559,246 10.3%

OUTSTANDING SHARES 1,545,000 1,502,000 1,471,000 1,455,000 1,446,000 1,761,000 1,849,050 1,756,598 1,721,466 1,669,822 -1.3% 10

% Growth -2.0% -2.8% -2.1% -1.1% -0.6% 21.8% 5.0% -5.0% -2.0% -3.0%

EPS $0.74 $1.43 $1.35 $1.41 $1.51 $1.75 $1.97 $2.21 $2.49 $2.73 11.7%

Total Equity 6,623,000 6,936,000 6,401,000 6,881,000 7,249,000 2.3% 7,828,920 8,459,148 9,144,339 9,889,603 10,700,550 8.1%% Growth 4.7% -7.7% 7.5% 5.3% 8.0% 8.1% 8.1% 8.2% 8.2% 11

Book Value / Share 4.29 4.62 4.35 4.73 5.01 4.45 4.57 5.21 5.74 6.41 Sales/Share 13.16 13.93 15.19 14.00 14.13 15.09 15.26 17.08 18.54 20.35

Capital Expenditures 1,630,000 1,506,000 1,405,000 1,118,000 1,067,000 -10.1% 1,387,100 1,525,810 1,602,101 1,650,164 1,755,000 6.1% 12

% Growth -7.6% -6.7% -20.4% -4.6% 30.0% 10.0% 5.0% 3.0% 6.4%Working Capital Changes 265,000 706,000 (3,740,000) (423,000) (147,000) (16,000) 209,000 177,000 193,000 215,000 91.5% 13

Debt 8,174,000 4,946,000 4,028,000 2,812,000 2,346,000 -26.8% 1,946,809 892,857 390,625 1,171,875 1,351,351 -8.7% 14


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INCOME STATEMENT TABLE OF ASSUMPTIONS Please refer to Income statement for respective references

Reference Assumption

1 Consistent Growth beyond 2001; in 2001 the purchase of Quaker Oats will affect revenues dramatically. Though the economy is expected to undergo a recession over the next few years, beverage sales should not be hampered drastically.

2 Costs will increase due to the merger with Quaker and then stabilize according to previous trends, marinating a mean 6% increase

3 CAGR (Compounded Annual Growth Rate) considerably higher than past five years mainly due to potential of acquisitions, by about 4.8%

4 SG&A will be lower due to synergies, but roughly the same as previous years

5 Depreciation will not change considerably and will maintain a similar trend only increasing marginally

6

This income is mainly derived from the bottling operations. It is not expected to continue to be a major source of revenue of the next few years and therefore, is increased by less than 10% in future years. Also, Pepsi sold many of its bottling operations this year accounting for the approximate 30% write down.

7 Pepsi has a tendency to maintain little debt and is expected to payoff much of it by 2005. Thus a linearly decreasing schedule is applied.

8 The effective tax rate is capped at 32.0%, a rough average of previous levels and the median corporate tax rate.

9 No extraordinary income is expected to be generated over the next 5 years, another means of marinating earnings in check.

10 Total number of shares increased after merger, increases by 5% in'02 but then declines dude $2Bn share buy back program

11 The Equity value is said to be consistent and hover around the 8% level in line with previous 5-year estimates

12 CAPEX is expected to decrease linearly after 2001, however, because of the Quaker acquisition, major future investments are expected and therefore a 30% increase in 2000 levels is anticipated. Nonetheless, for forward years, the levels decrease in line with peers

13 Debt levels are expected to decrease

14 WCACC are based on annual report analysis

15 Amortization is expected to be 10% of total depreciation

pepsico

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