“Now look at stories we’re following on The Closing Bell ticker tonight. PepsiCo net income rose to $1.7 billion. It beat Wall Street expectations due to the cost cutting efforts. The sales fell by a larger than expected 1.5% to $11.1 billion in revenue. The company is cautioning it does not expect a big increase in consumer spending next year… As you will see, the third quarter, the earnings up and the stock finished down nearly 1%.” –CNBC’s The Closing Bell 10/8/2009

PepsiCo (PEP) reported net income rose to $1.72 billion or $1.08 per share in the third quarter, compared to $1.58 billion or $.99 a year ago.  This earnings number came in five cents ahead of analysts’ estimates helped by increased sales volume of snacks and continued emphasis on reducing costs.  Also, a lower effective tax rate helped boost the result.  As opposed to the previous two quarters, we believe it will take more than topping analysts’ expectations to push stocks higher this earnings season.  The stock finished Thursday trading day down more than 1% down. 

The reason for the decline, on a day that equities were generally higher after positive retail sales results, is because revenue came in a little bit lighter than hoped.  Revenue fell 1.5% to $11.08 billion, while analysts had called for sales to be just about flatPepsi’s soft drink sales were weak in the Americas falling 6%, but the international segment picked up some of the slack rising 9%.  Furthermore, management does not expect major growth in consumer spending in the coming year.  Pepsi CEO Indra Noori said their research shows the “age of thrift” in the U.S. and Western Europe is here to stay through 2010.  The company reaffirmed earnings guidance through the rest of the year but guidance for 2010 exceeded analysts’ expectations. PEP

The fact is that the market has grown weary of the “less bad” results, where companies can beat profit expectations by trimming costs.  The market needs to see the ability to grow sales this quarter, and Pepsi failed in that respect.  The market needs to see sustained improvement in order to hold the exceptional returns seen in many sectors over the last seven months.

One wildcard for Pepsi is its acquisition of its two largest North America bottling operations; both of these deals are expected to close in late 2009 or early 2010.  The move consolidates 80% of Pepsi’s North American bottling into one organization, and should lead to $300 million of cost savings.  Ms. Noori did not offer specifics over how much the mergers of Pepsi Bottling Group (PBG) and PepsiAmericas (PAS) would affect the bottom line, but she did say that they expect company-wide earnings to grow by 11% to 13% in 2010.

We continue to believe that PepsiCo is Undervalued and it trades below its historically normal valuation ranges of price-to-cash earnings and price-to-sales at the current price.  However, we believe that this case exemplifies what corporations can expect going into third quarter earnings.  Investors have grown tired of the cost cutting as a means to beating earnings estimates.  What is going to be received much more favorably are companies that can beat earnings through the ability to grow sales.  A substantial amount of fundamental improvement has been priced in during this rally, and investors will justifiably be slightly tougher to please.

Pepsi Sets the Tone for Earnings Season