PepsiCo, Inc. Recommending: Buy NYSE-PEP August 18, Beverages

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1 Analyst: Shane Connor PepsiCo, Inc. Recommending: Buy NYSE-PEP August 18, 2009 Beverages PEP-BUY Current Price $ year Price Target $ Week Range $ Market Cap 88,800m Diluted Shares Outstanding 1,570m Average Daily Volume 9.86m Dividend Yield 3.1% 2008A 2009E 2010E Consensus High Low SIM Est FW P/E Ratio 20.1x* 15x 14.1x *2008 average (in millions) 2009E 2010E FY Sales Est. 43,251 44,361 48,057 Price Sales 2.33* Investment Conclusion-BUY PepsiCo s shares are currently undervalued at 14.8x 2009 EPS. Declining commodity costs, strong international sales, and Frito- Lay should drive earnings. Bottler integration should be seen as a major positive for Pepsi Americas Beverages. Key Points: As the economy recovers, demand should pick up across all business segments.. Strong international growth will continue as PepsiCo leverages its brands and marketing power. Frito-Lay revenue should continue to grow as PepsiCo offers more value to consumer than private labels. Concerns over declining demand for carbonated soda beverages are overstated. Bottler integration should put PepsiCo is the driver s seat. Since PepsiCo successfully operates many of its international bottlers, shareholders should be confident in the company s ability to run U.S bottling operations.

2 Company Profile 1 : PepsiCo's beverage business was founded in 1898 by Caleb Bradham, the pharmacist who first formulated Pepsi-Cola. PepsiCo, Inc. was founded in 1965 when Pepsi-Cola and Frito-Lay merged. Today, PepsiCo (PEP) manufactures, markets, and sells a variety of salty, convenient, sweet, and grain-based snacks; carbonated and noncarbonated beverages; and foods in approximately 200 countries. Their largest operations are found in North America (United States and Canada), Mexico, and the United Kingdom. PepsiCo currently has six business segments: Frito Lay North America (FLNA); Quaker Foods North America (QFNA); Latin America Foods (LAF); Pepsi Americas Beverages (PAB); United Kingdom & Europe (UKEU); and, Middle East, Africa & Asia (MEAA). Business Segments 2 : Frito-Lay North America (FLNA: 29% of 2008 revenue) FLNA manufactures, markets, sells, and distributes branded snacks to independent distributors and retailers. Major brands include: Lay s, Doritos, Tostitos, Cheetos, Fritos, Ruffles, Rold Gold, Sunchips, Grandma s, Cracker Jack, Smartfood, TrueNorth, and several others totaling almost 400 different products within these brands. FLNA comprised 37% of PepsiCo s 2008 operating profits, the highest of the six business segments. Pepsi Americas Beverages (PAB: 25% of 2008 revenue) PAB consists of brands which produce carbonated soft drinks, juices and juice drinks, ready-to-drink teas and coffee drinks, isotonic sports drinks, bottled water and enhanced waters. Major brands distributed by this business segment include Pepsi, Mountain Dew, Gatorade, Tropicana, Sierra Mist, Mirinda, Propel, Dole, Amp, SoBe, Naked, and Izze. PAB comprised 26% of PepsiCo s 2008 operating profits K K 2

3 UK & Europe (UKEU: 15% of 2008 revenue) The UK & Europe segment of PepsiCo manufactures, markets, and sells both snacks and beverages. In addition to Frito-Lay brands, PepsiCo also owns European-specific brands. The most dominant is Walkers, the leading salty snack brand by market share in the United Kingdom. PepsiCo sells most of its domestic beverages plus a few European-specific beverage brands. Last March, PepsiCo acquired 75% of Russian juice maker Lebedyansky. PepsiCo stated Lebedyansky production volumes grew 30- fold from 1999 to 2007 and quadrupled market share in the same period. Unlike U.S. PepsiCo, the UK and European business segment has operated most of its bottlers and distributors for many years. UKEU comprised 10% of PepsiCo s 2008 operating profit. Latin America Foods (LAF: 14% of 2008 revenues) LAF manufactures, markets, and sells both salty and sweet snacks under many of same Frito-Lay North America brand names. LAF PepsiCo uses contracted distributors and manufacturers for its Quaker brands distribution. Pepsi also owns popular Gamesa and Sabritas, snack companies which hold significant market share in Latin America. LAF comprised 11% of PepsiCo s 2008 operating profit. Middle East, Africa, and Asia (MEAA: 13% of 2008 revenue) PepsiCo MEAA markets and sells PepsiCo s branded snacks and cereals. These products are sold to consolidated businesses and non-controlled affiliates. In addition, PepsiCo MEAA markets and sells its beverages to authorized bottlers, independent distributors, and retailers. Similar to UKEU, PepsiCo MEAA owns and operates many of its bottlers and distributors. MEAA comprised 9% of PepsiCo s 2008 operating profit. Quaker Foods North America (QFNA: 4% of revenue) QFNA manufactures (or uses contract manufacturers), markets, and sells cereals, rice, pasta and other branded products. QFNA s products include: Quaker Oats, Life and Cap N Crunch cereals, Aunt Jemima syrups, and Rice-A-Roni. These products are sold through distributors and retailers. QFNA comprised 7% of PepsiCo s 2008 revenues. 3

4 Figure 1 PepsiCo s Major Name Brands 4

5 Macro Economic Factors Figures 2.1, 2.2, 2.3 PepsiCo is part of the consumer staples sector which tends to perform well even when the country is viewed to be in a recession. Most economists agree the U.S. is returning to growth and positive GDP should be reported sometime later this year. A recent Wall Street Journal survey indicates many economists feel that GDP could turn positive as early as this quarter. I believe PepsiCo will benefit from an improving macro picture and GDP PEP Revenue Line Fit Plot % 0.00% 10.00% 20.00% PEP Revenue 6.00% 4.00% 2.00% 0.00% -2.00% -4.00% -6.00% -8.00% PepsiCo Line Fit Plot GDP Revnue lower commodity costs. GDP growth is an obvious positive economic sign. I think PepsiCo will undoubtedly benefit from this growth. To understand the extent of PepsiCo s GDP 6.00% 4.00% 2.00% 0.00% -2.00% -4.00% -6.00% -8.00% -2.0% 0.0% 2.0% 4.0% 6.0% GDP PepsiCo Volume correlation with the GDP, I ran a series of PepsiCo regressions. The sample size was comprised of the past ten quarters. I chose this sample to determine how PepsiCo is performing in the current environment. First, I ran a regression comparing GDP and PepsiCo revenues. The correlation was PAB Line Fit Plot positive, but was not very strong (.64). Next, I ran regressions using volume as this excludes price increases and foreign exchange. My results were surprising. GDP and PepsiCo volume growth GDP -8.0 % -6.0 % -4.0 % -2.0 % 6.00% 4.00% 2.00% 0.00% -2.00% -4.00% -6.00% -8.00% 0.0% 2.0% 4.0% GDP PAB Volume showed a correlation of.84. I thought this PAB quite high considering PepsiCo is regarded as a consumer staple. 5

6 Lastly, I ran a regression comparing GDP and PAB volume growth. I did this as I believe PAB is not only struggling due to increased competition in the beverage industry, but also due to a macro slowdown. The correlation between GDP and PAB volume was.87. This supports my conclusion that PAB problems can also be attributed to the economy. Figure 4 GDP PEP Revenue PepsiCo Volume PAB Volume GDP 1 PEP Revenue PepsiCo Volume PAB Volume PepsiCo will benefit from the fall in commodity prices in the latter part of No commodity represents more than 10% of PepsiCo s COGS, but together they represent a significant portion. PepsiCo enters into futures contracts in order to hedge themselves against commodity prices. During conference calls, management indicated many of these contracts were entered into last summer. I believe PepsiCo will benefit when these contracts expire and they will be able to enter into new contracts at much lower prices. Figure 5 shows the significant drop off in commodity prices since last year. Figure 5 (Source USDA) 6

7 Overall, PepsiCo s input costs should decrease in the second half of this year. I believe food commodity prices should remain low as the supply side reports good outputs. According to the USDA, estimated corn crop production is billion bushels. Providing this estimate is accurate, it would be the second largest recorded corn crop. Continued low commodity costs will increase PepsiCo s margins. Sector Outlook Consumer Staples have underperformed the S&P 500 by 8% YTD. Much of this can be attributed to investors moving funds out of defensive sectors and into more cyclical sectors. Investors are more willing to take on risk in anticipation of an economic recovery. In Figure 6 different valuation metrics are shown on an absolute basis. Figure 6 Absolute Basis High Low Median Current Analyst Opinion P/Trailing E Undervalued P/Forward E Undervalued P/B Undervalued P/S Undervalued P/CF Undervalued Source: Thompson Baseline Currently, all of the valuation metrics seem to undervalue consumer staples. This can be expected due to the recent movement to more cyclical sectors. In Figure 7 the same valuation metrics are shown relative to the S&P 500. This shows that Consumer Staples appear to be more inline with historical valuation. Figure 7 Relative to SP500 High Low Median Current Analyst Opinion P/Trailing E Undervalued P/Forward E Undervalued P/B Inline P/S Inline P/CF Inline Source: Thompson Baseline 7

8 In conclusion, I think Consumer Staples are a necessary part of any portfolio given current uncertainty in equity markets. Consumer Staples could also perform very well in a growing global economy as emerging markets begin to spend money on more on staples. The beverages industry is a good example of an industry which could benefit from a growing global economy. Beverages Industry Figure 8 (Source: S&P industry survey) Historically, the beverages industry has been one of the more cyclical industries within Consumer Staples. It trades at higher valuation multiples since beverage companies offer more growth than most other Consumer Staples. A major concern for the industry is declining demand for carbonated soft drinks (CSDs). Consumers have been opting for healthier options such as water and energy boosting drinks. Figure 8 shows CSDs consumption declined 3.1% in 2008 compared to Flavored and enhanced water and energy drinks had the greatest gains. This data appears to confirm a consumer shift from CSDs. If the trend continues, beverage companies will be forced to come up with innovative new products to spur demand. A major risk for the beverage industry is the proposed soda tax. Lawmakers are debating the idea of a soda tax to help pay for healthcare reform. Early reports indicate the tax could be as much as three cents per twelve ounces. Currently, the soda tax is simply one of a hundred different ideas to pay for healthcare reform. However, if passed, it would constitute a major disadvantage to the beverages industry. 8

9 Company Analysis The Deal On August 4, 2009, PepsiCo struck a deal to buy its two largest bottlers. The acquisition of Pepsi Bottling Group and Pepsi Americas will give PepsiCo control of 80% of its U.S. beverage distribution. The deal will cost PepsiCo $7.8bn and shareholders will have the option to choose cash or PepsiCo stock. This may be confusing to some as ten years ago PepsiCo completed a spin-off of these two companies. In 1999, PepsiCo divested it two largest bottlers but continued to hold minority shares in both. PepsiCo felt this would increase shareholder value as profits came primarily from fountain beverages and concentrated sales. PepsiCo believed bottling was too capital intensive and the margins were not large enough. After the divestiture, PepsiCo s operating margins and ROIC increased. Coke followed Pepsi s lead and divested its bottlers as well. However, the beverage industry went through a change the years after the spin off. There were new small niche companies (vitamin water), more juices, teas, and energy drinks entering the market. In addition, CSD (carbonated soft drink) demand was weakening as consumers looked for healthier alternatives. PepsiCo responded by developing healthy alternatives, but often lagged behind in bringing these products to market. The lag was caused by bottlers who relied on heavy volumes to make a profit and did not want to experiment with niche products. Without a competitive presence from PepsiCo or Coke, many companies easily entered the industry and were able to carve out significant market share. PepsiCo quickly realized that in order to grow in the beverage industry it would need to offer new products. An initial offer of $6bn by PepsiCo was turned down by the bottlers. Pepsi Bottling Group stated the deal undervalued the potential $750-$850 million in synergies. In the initial offer PepsiCo estimated synergies of only $200 million. PepsiCo now says that there should be $250 million in synergies. Is this a positive? Only time will tell, but I believe bottler integration is necessary to grow PAB (Pepsi Americas Beverages). 9

10 Benefits PepsiCo, through Frito-Lay, has many of the same distribution channels as its bottlers Duplicate jobs can be eliminated PepsiCo can now experiment with niche products and package innovation Integration should improve PepsiCo s ability in bring new products to market PepsiCo may be able to offer bundled items Gatorade and Aquafina water 24pk Risks Unanticipated charges or poor performance relating to the integration and operation of Pepsi Bottling Group and Pepsi Americas PepsiCo has owned its international bottlers since it expanded to those markets. I believe PepsiCo should be able to leverage this operational knowledge to efficiently integrate and operate its U.S. operations Business Segment Analysis Figure 9 3 Frito-Lay North America (FLNA) Analysis PepsiCo holds a 39% market share in the U.S. savory food snacks market 4. In the last three years FLNA has delivered high single digit revenue growth and low single digit volume growth. In mid-2008, PepsiCo passed price increases through to consumers due to higher commodity costs. Subsequently, revenue continued to grow but volume decreased as the economy 3 Company Reports 4 Company Reports 10

11 weakened and consumers traded down to private labels. In 2009, PepsiCo has pulled back somewhat on the price increases they implemented in 2008, and have introduced the 20% more campaign promoting more chips per bag. Consumers were quick to recognize the added value as FLNA reported a 3% volume growth and more than an 8% revenue growth in 2Q09. I believe this is PepsiCo s most important business segment. Brands such as Frito-Lay, Doritos, and Ruffles are household names which offer strong, predictable demand. PepsiCo distributes these products through its Direct Store Delivery (DSD) network a system that delivers Frito-Lay products directly to retailers. PepsiCo works with individual retailers to improve inventory management and reduce costs. This unique relationship is a best-in-industry practice that PepsiCo should be able to effectively leverage when they begin distributing their own beverages. Pepsi Americas Beverages (PAB) Analysis Figure 10 5 PAB is often perceived as PepsiCo s problem child due to decreasing sales volume. These declines can be primarily attributed to a more health conscious consumer and increased competition in the beverages space. Health conscious consumers have been gravitating more towards water, low calorie beverages, teas, and juices. PepsiCo has responded by introducing low calorie alternatives as well as by acquiring smaller beverage companies (i.e. Naked Juices) that compete in this space. A secondary reason for volume decline is increased competition in the beverage industry. The industry now includes several niche products e.g., energy drinks, enhanced waters, teas, and specialty 5 Company Reports 11

12 juices. PepsiCo has tried to bring similar products to market, but has not been very successful. Forestalling their efforts was their relationships with the bottlers who rely on large volume production that niche products generally cannot deliver. I believe PepsiCo s recently announced acquisition of the Pepsi Bottling Group and Pepsi Americas will enable them to restore long term growth in this segment. Within Pepsi American Beverages the Gatorade product has struggled most, down an estimated -18% 6 in second quarter volume. Gatorade is a premium priced product which depends on consumer activity. During the second quarter conference call CEO Indra Nooyi noted construction workers were no longer buying multiple bottles of Gatorade on the way to work as they did prior to the recession. This is a good example of the product s dependence on consumer activity. Furthermore, with high unemployment, premium priced products like Gatorade tend to struggle. PepsiCo recently rebranded Gatorade as G. Initial reactions have been mixed but PepsiCo has stated this is a long term strategy. In addition, I believe Gatorade or G will be one of the benefactors of the bottler s integration. PepsiCo will be able to bring to market more flavors, bottle sizes, and bottle styles. Overall, I think Gatorade s weakness will be short lived. As consumer activity recovers and new products come to market, Gatorade will return to strong growth. United Kingdom & Europe (UKEU) Analysis In 2008, snack volume was up 6% compared to the previous year. Walkers had low single digit volume increases in most regions and acquisitions added to the volume increase. UKEU beverage volume was up 17% compared to the previous year. Newly acquired Lebedyansky contributed 16% growth and carbonated soft drinks achieved modest volume gains. These results clearly illustrate the international growth PepsiCo is experiencing. I believe PepsiCo is unfairly classified as a mature company. PepsiCo investors receive consistent domestic performance, but are also exposed to PepsiCo s growing international franchise. 6 Beverage Digest 12

13 PepsiCo is committed to international growth both organically and though acquisitions. Pricing, brand recognition, and distribution power enable PepsiCo to enter new markets and immediately become the leader. I believe UKEU will continue to outpace other segments as PepsiCo enters fast growing emerging markets where population and growth are increasing. Latin American Foods (LAF) Analysis The LAF business is currently experiencing slower growth than MEAA and UKEU because PepsiCo been in the LAF market much longer. This segment reported a 3% increase in volume, primarily coming from an acquisition in Brazil. Mid single digit declines for Sabritas was offset by mid single digit increases for Gamesa. I believe PepsiCo has less room for distribution growth than it once had and as a result will now focus on small acquisition growth, new product offerings, and market growth. For example, PepsiCo announced this month it was acquiring Brazil s top coconut water company. Middle East, Africa, and Asia (MEAA) Analysis MEAA is PepsiCo s fastest growing segment. Double digit volume growth has been recorded in the past three years. In 2008, double digit and mid digit growth was recorded by China and India, respectively. PepsiCo s expansion into these markets came much later than rival Coke; however, PepsiCo s brands have been very well received. This relative underexposure will allow PepsiCo to increase market share by simply increasing distribution. Further growth will come as acquisitions are made and brand awareness increases. Quaker Foods North America (QFNA) Analysis Although QFNA is PepsiCo s smallest segment by revenue, it is a stable performer. In 2008, QFNA reported a 1.5% volume decline compared to the previous year. This was 13

14 largely due to lower sales of Quaker Oatmeal and ready-to-eat cereals. This segment is not as susceptible to major volume swings and seems to chug right along without much attention. PepsiCo is more concentrated on its international growth businesses than QFNA. I believe QFNA has serious potential and could be one of the only segments that can take advantage of a more health conscious consumer. New product offerings under a powerful brand name like Quaker would be very successful. It s not just a battle over taste PepsiCo (PEP) vs. Coke (KO) The battle between Pepsi and Coke is not just over taste but also over investor dollars. When building a portfolio, investors and portfolio managers must determine which company offers better value. For example, when PepsiCo reports its earnings, Coke must either match or beat Pepsi s earnings and vice versa. If either falls short, it often times negatively impacts their stock price. This is a fairly unique situation as there are very few industries where such large market shares are at stake. In Figure 11, I have determined who is better positioned for long term success. 14

15 Figure 11 Battle Grounds Pepsi Coke Advantage Forward P/E 15.1x 16.1x ROE 36.20% 27.20% P/S 2.7x 3.6x Dividend Yield 3.05% 3.60% Efficiency Product Diversification International Exposure WINNER Inventory Turnover- 7.8, Asset Turnover 1.2, Average Collection Period (days) PepsiCo has stong snack, food, and beverage brands. Its strongest brands might be in snacks (Frito-Lay) International sales are approximately 40% of revenues Inventory Turnover- 4.7, Asset Turnover-.76, Average Collection Period (days) Coke is strictly beverages International sales are approximately 70% of revenues Source: S&P Data Insight (OSU Libraries) 15

16 Income Statement and Segment Revenue (Appendix 1,2) PepsiCo s revenue over the last five years has been growing at a compounded annual growth rate of 10.4%. This impressive performance has been mainly driven by organic growth not acquisitions. (PepsiCo s last major acquisition was Quaker Oats in 2001) Going forward, I forecasted 2.57%, 8.33%, and 7.58% revenue growth in years 2009, 2010 and 2011, respectively. Company guidance for 2009 was 6-9% revenue growth excluding currency. In the second quarter, PepsiCo stated that 2009 revenue would be negatively affected by currency due to the strong dollar in the first half of the year. Therefore, I believe that my forecast (2.57%) is within reason. Operating margins should move higher in 2009 as PepsiCo s existing commodity contracts expire. This should boost operating margins in the second half of this year. These effects are taken into account on a per segments basis in my forecasts. Balance Sheet Analysis (Appendix 4) After analyzing the balance sheet no major red flags were found. The big jump in debt from 2007 to 2008 could be attributed to the anticipated acquisition of Pepsi Bottling Group and Pepsi Americas. Other acquisitions in 2008 (Lebedyansky) were also funded partially though debt. I believe debt should not be a concern as PepsiCo sill maintains a Net debt/ebitda ratio of.6. PepsiCo is also able to borrow at very attractive rates given their A+ S&P rating. 16

17 Valuation Analysis I utilized three different valuation techniques to determine a price target for PepsiCo (PEP): (1) Discounted Cash Flow model; (2) Historical valuation multiple model; and (3) Forward EPS estimate. (1) DCF Valuation (Appendix 3) Assumptions 10% discount rate used, which is relatively high for a consumer staple 3.5% terminal growth as it represents historical GDP Long term revenue growth remains around 8% due to strong international demand; it eventually reverts back to 3.5% terminal rate 17.5 % operating margin represents the 5 years average 3.8 % depreciation and amortization represents historical average Working capital gradually decreases as revenue growth slows I came up with an intrinsic value of $72.82 using the discounted cash flow model. Additionally, I performed a sensitivity analysis to determine the effects of using different discount rates and terminal growth rates. Figure 12 Sensitivity Analysis- Implied Equity Value ($) Terminal Discount Rate Terminal FCF 9.00% 9.50% 10.00% 10.50% 11.00% 11.50% 12.00% 12.50% 3.00% % % % % Sensitivity Analysis- Upside (%) Terminal Discount Rate Terminal FCF 9.00% 9.50% 10.00% 10.50% 11.00% 11.50% 12.00% 12.50% 3.00% 45.1% 33.2% 23.0% 14.2% 6.5% 0.0% -6.3% -11.6% 3.50% 53.7% 40.2% 28.7% 19.0% 10.5% 3.1% -3.4% -9.1% 4.00% 63.9% 48.4% 35.4% 24.5% 15.1% 7.0% -0.1% -6.3% 4.50% 76.5% 58.2% 43.3% 30.9% 20.4% 11.4% 3.6% -3.2% 5.00% 92.2% 70.3% 52.8% 38.4% 26.5% 16.4% 7.8% 0.3% 17

18 The results (Figure 12) show the downside risk is not present until a 12% discount rate is used. I believe my 10% rate is very conservative and should provide a good margin of safety. When I determined my discount rate I started at a rate of 9%. I then added 50 bps for risks associated with the bottler integration. I also added an additional 50bps for risks associated with a declining beverage demand. A 10% discount rate is much higher than the rate the CAPM determined. (2) Comparable Valuation Multiple Model From the comparable valuation multiple model analysis I determined the value of PEP is $ This results in a 21% upside from the PEP s current share price. I arrived at this price by averaging the target multiples for each valuation metric. I tried to show mean reversion when choosing my target multiples. I also considered the various risk and rewards associated with PepsiCo. Additionally, as the economy recovers and investors move back into the market, multiples will gradually increase. I feel these multiples are realistic over a one year time period. Figure 13 Absolute Valuation High Low Median Current Target Multiple E, S, B, etc/share Target Price A. B. C. D. E. F. G. H. P/Forward $65.80 E P/S $81.71 P/B $55.71 P/EBITDA $65.31 P/CF $68.00 Average $67.31 As of 8/3/09 Source: Thompson Baseline (3) Forward Price/Earnings 18

19 Finally, I wanted to come up with a value for PEP that would include the bottler integration. PepsiCo stated the bottler integration would result in $250 million in synergies and be.15c accretive to EPS by I feel synergies will be greater and occur sooner than stated. (Pepsi Bottling Group said there was $750-$850 in synergies.) However, I cannot blame PepsiCo for being conservative given integration uncertainty. I arrived at my target price of $70.53 by adding.10c onto my 2010 EPS and applying a 17.5x P/E multiple. This price target should be included in my 1- year target since investors will consider PepsiCo s future earning power. Figure 14 Forward Multiple Price Target 2010 EPS Accretive EPS 2010 EPS Target Multiple Price Target $ c = $ 4.00 x 17.5x $ Valuation Recap DCF price target: $72.82 Comparable Valuation Multiple Model: $67.31 Forward Price/Earnings: $70.00 I averaged all three price targets to arrive at a one year of $ The implied upside for using this price tag and adding in the dividend yield is 27%. Risks to Price Target Unanticipated charges relating to the integration of Pepsi Bottling Group and Pepsi Americas Continued weak demand for carbonated soft drinks Enactment of soda tax Foreign Currency and commodity price volatility 19

20 Executive Summary I am assigning a BUY rating with a $ year target price. This target price implies 27% upside including the dividend. I believe PepsiCo s shares are currently undervalued and will offer good, long term appreciation. PepsiCo currently trades at 14.8x my 2009 EPS estimates. This represents a 34% discount compared to their historical forward P/E of 19.8x. In addition, PepsiCo s Price/Sales, Price/EBITDA, and Price/Cash Flow all trade at a discount to their respective historical medians. My DCF model values PepsiCo s shares at $72.58 which implies an upside of 28%. I included all risk factors, consumer trends, and macro economic factors when generating forecasts. My estimates are conservative and earnings upside is very possible. Some may argue current valuation is warranted given the weak demand for soft drinks. However, I perceive this concern to be overstated and believe bottler integration within PAB will mark a turning point for this business segment. Short term projections: PepsiCo will benefit from a macro recovery. My research shows a positive correlation between PepsiCo s volume and the GDP. Therefore, as GDP begins to rebound, PepsiCo s volume should pick up. PepsiCo will also benefit from lower commodity costs. I anticipate this margin expansion to occur in the second half of this year as previous commodity contracts expire and PepsiCo is in a position to renegotiate them at lower prices. PepsiCo remains an attractive investment despite the record rally from March lows. Since March, the S&P 500 is up almost 50%, but PepsiCo is up only 9%. PepsiCo is well positioned, therefore, to be a beneficiary as investors hunt for remaining bargains. Long term projections: A majority of PepsiCo s growth will come from two sources: (1) international growth and correlating market penetration, (2) Pepsi Americas Beverages, and (3) Frito-Lay North America 20

21 PepsiCo s low international exposure relative to Coke is as an opportunity for the company to aggressively expand and grow international sales by leveraging its brands and marketing power. In addition, international acquisitions, e.g., Lebedyansky, and market penetration, especially in the MEAA business segment, should offer long term growth. Pepsi Americas Beverages will become a long term growth vehicle for the company. After the acquisition of Pepsi Bottling Group and Pepsi Americas, PepsiCo will be on course to level the playing field with its smaller niche competitors. PepsiCo will have the ability to develop and produce products that can go head-to-head with these competitors who have been eroding market share. Frito-Lay growth should continue as PepsiCo is able to leverage its dominant brand names. Private label penetration has been a concern but PepsiCo has regained the upper hand by offer 20% more per bag. This campaign should not significantly cut into PepsiCo s margins because of lower commodity costs. In addition, price increases implemented in 2008 will benefit PepsiCo. Finally, I would not discount Quaker Foods North America (QFNA). If PepsiCo targets the health conscious consumer and cleverly markets / leverages the popularity of the brand as well as its products, this could be a business segment that brings PepsiCo long term, sustainable growth. 21

22 Appendix 1 Pro Forma Income Statement PepsiCo Income Statement FY2011E FY2010E FY2009E FY2008 FY2007 FY2006 FY2005 FY2004 Net Revenue 51,700 48,057 44,361 43,251 39,474 35,137 32,562 29,261 Cost of Sales SG&A Amort. of intangible Segment Operating Profit 9,561 9,154 8,436 7,942 7,923 7,240 6,764 6,098 Corp- net impact of mark-mkt on commodity hedges Corp-Other Operating Profit 8,370 8,222 7,781 6,935 7,170 6,502 5,984 5,259 Operating Profit Margin 16.19% 17.11% 17.54% 16.03% 18.16% 18.50% 18.38% 17.97% Bottling equity income Interest Exp Interest Inc Income before Taxes 8,344 8,198 7,737 7,021 7,631 6,989 6,382 5,546 Provision for Taxes ,304 1,372 Net Income 6,008 5,902 5,803 5,142 5,658 5,642 4,078 4,174 Net Income per Common Share Basic w/o bottlers Diluted w/o bottlers Consensus

23 Appendix 2 Segment Revenue and Operating Profit FY2011E FY2010E FY2009E FY2008 FY2007 FY2006 FY2005 PepsiCo Americas Foods Frito-Lay North America 15,318 14,588 13,508 12,507 11,586 10,844 10,322 Quaker Foods North America 1,979 1,959 1,921 1,902 1,860 1,769 1,718 Latin America Foods 6,644 6,095 5,541 5,895 4,872 3,972 PepsiCo Americas Beverages PepsiCo Americas Beverages 11,022 10,598 10,390 10,937 11,090 10,362 9,146 PepsiCo International 11,376 UK/Europe 8,551 7,635 6,757 6,435 5,492 4,750 - Middle East/Africa/Asia 8,186 7,181 6,244 5,575 4,574 3,440 - Total Revenue 51,700 48,057 44,361 43,251 39,474 35,137 32,562 PepsiCo Segment Profit PepsiCo Americas Foods Frito-Lay North America 3,676 3,574 3,309 2,959 2,845 2,615 2,529 Quaker Foods North America Latin America Foods 1,096 1, PepsiCo Americas Beverages PepsiCo Americas Beverages 2,094 2,014 2,026 2,026 2,487 2,315 2,037 PepsiCo International 1,661 UK/Europe 1, Middle East/Africa/Asia 1, Operating Profit 9,561 9,154 8,436 7,942 7,923 7,240 6,764 Sales Growth (YOY) PepsiCo Americas Foods Frito-Lay North America 5.00% 8.00% 8.00% 7.95% 6.84% 5.06% 7.97% Quaker Foods North America 1.00% 2.00% 1.00% 2.26% 5.14% 2.97% 12.58% Latin America Foods 9.00% 10.00% -6.00% 21.00% 22.66% - - PepsiCo Americas Beverages PepsiCo Americas Beverages 4.00% 2.00% -5.00% -1.38% 7.03% 13.30% 10.02% PepsiCo International 15.35% UK/Europe 12.00% 13.00% 5.00% 17.17% 15.62% - - Middle East/Africa/Asia 14.00% 15.00% 12.00% 21.88% 32.97% - - Total Revenue 7.58% 8.33% 2.57% 9.57% 12.34% 7.91% 11.28% Guidance ex. Currency 6-9% Operating Margin PepsiCo Americas Foods Frito-Lay North America 24.00% 24.50% 24.50% 23.66% 24.56% 24.11% 24.50% Quaker Foods North America 30.50% 32.50% 30.50% 30.60% 30.54% 31.32% 31.26% Latin America Foods 16.50% 16.50% 16.00% 15.22% 14.66% 16.49% - PepsiCo Americas Beverages PepsiCo Americas Beverages 19.00% 19.00% 19.50% 18.52% 22.43% 22.34% 22.27% PepsiCo International 14.60% UK/Europe 12.25% 12.50% 13.00% 12.60% 14.09% 14.74% - Middle East/Africa/Asia 12.75% 13.50% 12.00% 11.96% 11.70% 11.66% - Operating Profit 18.49% 19.05% 19.02% 18.36% 20.07% 20.61% 20.77% 23

24 Appendix 3: DCF Model DCF Valuation 8/16/2009 Ticker: PEP Terminal Discount Rate = 10.0% SHANE CONNOR Terminal FCF Growth = 3.5% Forecast Terminal Year 2009E 2010E 2011E 2012E 2013E 2014E 2015E 2016E 2017E 2018E 2019E Value Revenue 44,361 48,057 51,700 56,094 60,862 65,123 69,681 73,862 78,294 82,208 85,497 % Growth 8.33% 7.58% 8.50% 8.50% 7.00% 7.00% 6.00% 6.00% 5.00% 4.00% Operating Income 7,781 8,222 8,370 9,816 10,651 11,396 12,194 12,557 13,310 13,975 14,534 Operating Margin 17.54% 17.11% 16.19% 17.50% 17.50% 17.50% 17.50% 17.00% 17.00% 17.00% 17.00% Interest and Other- net Interest % of Sales 0.75% 0.70% 0.70% 0.60% 0.60% 0.60% 0.60% 0.60% 0.60% 0.60% 0.60% Taxes 1,934 2,295 2,336 2,834 3,075 3,290 3,521 3,629 3,846 4,039 4,200 Tax Rate 24.9% 27.9% 27.9% 27.9% 27.9% 27.9% 27.9% 27.9% 27.9% 27.9% 27.9% Bottling Equity Income % sales 0.65% 0.65% 0.65% 0.90% 0.90% 0.90% 0.90% 0.90% 0.90% 0.90% 0.90% Net Income 5,803 5,902 6,008 7,658 8,283 8,842 9,440 9,722 10,288 10,788 11,208 % Growth 2% 2% 27% 8% 7% 7% 3% 6% 5% 4% Add Depreciation/Amort 1,664 1,802 1,939 2,104 2,282 2,442 2,613 2,770 2,936 3,083 3,206 % of Sales 3.75% 3.75% 3.75% 3.8% 3.8% 3.8% 3.8% 3.8% 3.8% 3.8% 3.8% Plus/(minus) Changes WC (204) (110) (105) (67) (73) (78) (84) (89) (94) (99) (103) % of Sales -0.46% -0.23% -0.20% -0.12% -0.12% -0.12% -0.12% -0.12% -0.12% -0.12% -0.12% Subtract Cap Ex 2,100 2,218 2,643 2,805 3,043 3,061 3,136 3,324 3,132 3,288 3,420 Capex % of sales 4.73% 4.62% 5.11% 5.0% 5.0% 4.7% 4.5% 4.5% 4.0% 4.0% 4.0% Free Cash Flow 5,163 5,377 5,199 6,890 7,449 8,145 8,834 9,080 9,998 10,484 10,892 YOY growth 4% -3% 33% 8% 9% 8% 3% 10% 5% 4% Terminal 173,430.4 P/E 15.5 NPV of free cash flows $47, % EV/EBITDA 10.3 NPV of terminal value $66, % Free Cash Yield 6.28% Projected Equity Value 114,326.6 Free Cash Flow Yield 4.52% Shares Outstanding 1,570 Current Price Implied equity value/share Upside/(Downside) to DCF 28.7% 24

25 Appendix 4 (Source: S&P Market Insight) Current Balance Sheet ANNUAL BALANCE SHEET ($ MILLIONS) PEPSICO INC SIC: 2080 (Beverages) 700 Anderson Hill Rd GICS: (Soft Drinks) Purchase, NY S&P Long-Term Issuer Credit Rating: A+ Ticker: PEP S&P Short-Term Issuer Credit Rating: Extremely Strong (A1) Fiscal Year: 12 Latest Q Jun09 Dec08 Dec07 Dec06 Dec05 Dec04 ASSETS Cash & Short-Term Investments 2, , , , , , Net Receivables 5, , , , , , Inventories 2, , , , , , Prepaid @CF Other Current Assets 1, , Total Current Assets 11, , , , , , Gross Plant, Property & Equipment 23, , , , , , Accumulated Depreciation 11, , , , , , Net Plant, Property & Equipment 11, , , , , , Investments at Equity NA 3, , , , , Other Investments NA Intangibles NA 6, , , , , Deferred Charges NA 1, , , Other Assets 13, , TOTAL ASSETS 37, , , , , , LIABILITIES Long Term Debt Due In One Year Notes Payable NA , Accounts Payable 7, , , , , , Taxes Payable Accrued Expenses NA 2, , , , , Other Current Liabilities , , , , , Total Current Liabilities 8, , , , , , Long Term Debt 8, , , , , , Deferred Taxes , , Investment Tax Minority Interest Other Liabilities 5, , , , , , TOTAL LIABILITIES 23, , , , , , EQUITY Preferred Stock - (97.000) (91.000) (79.000) (69.000) (49.000) Preferred Stock - Nonredeemable ( ) Total Preferred Stock ( ) (97.000) (91.000) (79.000) (69.000) (49.000) Common Stock Capital Surplus Retained Earnings 27, , , , , , Less: Treasury Stock 13, , , , , , Common Equity 14, , , , , , TOTAL EQUITY 13, , , , , , TOTAL LIABILITIES & EQUITY 37, , , , , ,