July 21, 2017 / 2:20 PM / a year ago

Fitch Affirms PepsiCo's IDRs at 'A/F1'; Outlook Stable

(The following statement was released by the rating agency) CHICAGO, July 21 (Fitch) Fitch Ratings has affirmed the Issuer Default Ratings (IDRs) and the debt ratings of PepsiCo, Inc. (PepsiCo) at 'A/F1'. A full list of rating actions follows at the end of the press release. The Rating Outlook is Stable. PepsiCo's ratings reflect its considerable financial flexibility, substantial cash flow, significant scale, geographic reach, product diversification provided by its high-margin Frito-Lay North America segment, and brand strength as the world's second largest food and beverage company. Rating concerns include increased leverage driven by past domestic borrowing for shareholder initiatives combined with foreign exchange headwinds. Consequently, debt has increased to approximately $39.5 billion at the end of second quarter 2017 compared to $29 billion at the end of 2014. Fitch expects supplemental net leverage to remain within the mid 2x range going forward, which Fitch views as acceptable for the current ratings. KEY RATING DRIVERS Brand Strength, Global Diversity: More than half of PepsiCo's $63 billion in annual net revenue is derived from snacks, and more than 40% of its operating profit is derived from its higher margin Frito-Lay's North America segment. PepsiCo has significant global geographical diversification with approximately 42% of revenues generated outside of the United States. The company's brand strength is demonstrated by its portfolio of more than 20 brands, including Pepsi, Gatorade, Lay's Doritos, and Quaker. Each has more than $1 billion in annual retail sales and is typically No. 1 or No. 2 in their respective categories. Diversification Supports Organic Growth Operationally, PepsiCo is focused on increased brand support to grow volume share, expand its emerging market presence and grow its nutrition business. The company is also reducing overhead and leveraging technology and processes across its organization. Fitch believes PepsiCo's diversified portfolio anchored by its food business, strong brands and good innovation pipeline (high-single digits of sales) should enable core revenue growth of at least 3% during the next couple of years. PepsiCo has been able to use price/mix to offset a significant portion of foreign exchange headwinds, and pricing has remained rational in key developed markets. Consequently, PepsiCo generated core revenue growth of approximately 3.7% in 2016. Fitch expects core revenue growth in 2017 of roughly 3% driven by price/mix benefits. Growing Overseas Cash Continues: PepsiCo generates substantial overseas cash flows due to its international operations. PepsiCo, like other multi-national companies, has been reluctant to repatriate foreign earnings given the tax consequences. Accordingly, foreign cash balances have grown along with debt balances to fund domestic cash requirements for the dividend, U.S. capital investment and share repurchase program. Absent material M&A and tax reform, Fitch anticipates foreign cash levels could grow to approximately $23 billion by 2018. With potential tax reform on the horizon, multi-nationals including PepsiCo would be reluctant to pursue material repatriation until after a new tax plan is implemented. Fitch discounts PepsiCo's foreign cash balances by applying a generic 35% tax haircut and a further 50% adjustment capturing expectations for additional foreign cash balances that could be used for shareholder-friendly actions when determining supplemental net leverage. Mid-2x Supplemental Net Leverage: For U.S. issuers with significant foreign cash balances, Fitch uses a supplemental net leverage ratio as part of our analysis. PepsiCo's supplemental net leverage was approximately 2.6x at the end of the second quarter 2017. Supplement net leverage is expected to be approximately 2.5x for 2017 compared to 2.4x at the end of 2016. Fitch expects gross debt leverage in 2017 of approximately 3.0x. Leverage at the end of the second quarter of 2017 was 3.1x which compares to the low 2x range in 2010. For 2017, PepsiCo has reduced expected shareholder returns to approximately $6.5 billion from $9 billion in 2015, although Fitch anticipates PepsiCo will still need to increase debt by approximately $3 to $3.5 billion to fund their domestic cash requirements. This is based on Fitch's estimate that approximately 45% of CFFO is available for domestic use and does not consider any foreign cash that could be used for domestic funding requirements. Debt increased $2.5 billion during the first half of 2017. Productivity Underpins Earnings Expansion: PepsiCo's five-year $5 billion productivity cost savings program to be completed by 2019 remains on track and provides the company with significant flexibility to expand margins and drive increased earnings over the longer term. PepsiCo is using a portion of these savings to bolster brand strength by increasing media, innovation and R&D spending combined with cost reductions that strongly support future growth in revenues and operating profit. Consequently, Fitch views PepsiCo's long-term mid-single-digit profit before tax financial targets as achievable. Despite the past effects of foreign exchange translation due to the strong dollar that has negatively affected EBITDA, benefits of productivity efforts and working capital gains have resulted in stable cash generation. Cash flow from operations (CFFO) and free cash flow (FCF) averaged $10.5 billion and $3.6 billion respectively for the past three years. Fitch expects PepsiCo's CFFO and FCF to be approximately $10 billion with FCF less than $3 billion in 2017. Beverage Category Headwinds: PepsiCo's challenges include global concern with health and wellness trends, increased excise taxes on its beverage products in certain markets, evolving consumer shopping habits and the maturity of its categories in developed markets. Several of PepsiCo's developed markets have stagnant or declining per capita carbonated soft drink (CSD) consumptions trends and low population growth. Weak CSD volume trends in developed markets place more dependence on increases with price/mix. However, exposure to CSDs continues to decline at less than 25% of revenues, and PepsiCo has good growth offsets from its non-carbonated portfolio due to Gatorade (low to mid-single digit volume growth) and water (double-digit). Developing and emerging markets have experienced more volatility and pressure in the past with growth and local cost inflation. Even so, growth in these markets was 6% in Q2 2017 compared to 2% in developed markets driven by Mexico and Russia, although certain pockets remain weak including Brazil, Argentina and the Middle East. DERIVATION SUMMARY PepsiCo's significant scale, geographic reach, distribution, product diversification including strong margins in its Frito-Lay North America segment, and brand strength as the world's second largest food and beverage company strongly positions the company relative to its peers. Consequently, PepsiCo's ability to execute on innovation and price/mix strategies has leveraged consumer trends in the snack food segment, resulting in greater U.S. retail growth than other larger competitors. With less than 25% of its beverage portfolio carbonated soft drinks, PepsiCo has much less exposure than The Coca-Cola Company ('A+'/ Outlook Negative) that is in excess of 70% of its beverage portfolio. PepsiCo has a weaker presence in higher growth developing/emerging markets than Coca-Cola with lower brand equity, resulting in less pricing power across its international footprint. Consequently, PepsiCo's consolidated operating margins are also much lower due to its lower margin beverage segment, in the mid-teen range, when compared to Coca-Cola in the mid 20% range. However, PepsiCo's Frito-Lay North American segment generates industry leading operating margins at approximately 30% versus Mondelez ('BBB'/Outlook Stable) North American segment at approximately 20% and Kellogg's ('BBB'/Outlook Stable) US Snacks segment at approximately 12%. PepsiCo's financial policies have been aggressive during the past several years with increased shareholder returns, similar to Coca-Cola, which has resulted in higher domestic borrowing given the reluctance to repatriate foreign earnings. Given the increases in leverage for both companies, Fitch expects moderating shareholder returns with PepsiCo's long-term supplemental net leverage in the mid 2x range compared with Coca-Cola's long-term supplemental net leverage that is expected to decline to less than 2x. Fitch does expect PepsiCo will return a higher level of cash to shareholders than Coca-Cola during the medium-term, particular in the event of tax reform. KEY ASSUMPTIONS Fitch's key assumptions within our rating case for 2017 and 2018 for PepsiCo include: --Underlying revenue growth in the 3% range; Fx impact of approximately 2% in 2017; --Modestly improving margins over the time period as productivity benefits accrue; --$10 billion of cash flow from operations (CFFO) in 2017; increasing to the mid $10 billion range in 2018. Fitch estimates approximately 45% of CFFO is available for domestic use; --Free cash flow (FCF) in the $2.6 billion to $2.7 billion range, increasing to approximately $2.8 to $2.9 billion in 2018; --Absent cash repatriation, Fitch anticipates foreign cash levels could grow to approximately $19 billion and $23 billion in 2017 and 2018 respectively; --Total debt increases by roughly $3 billion annually to fund domestic cash requirements; --Capital spending in the $3 billion range; --Share repurchases in the $2 billion range; --Gross leverage of approximately 3x and net supplemental leverage of approximately 2.5x. RATING SENSITIVITIES Future Developments That May, Individually or Collectively, Lead to Positive Rating Action While a positive ration action is not anticipated, the following would lead to an upgrade: --A public commitment by Pepsi to maintain a more conservative financial strategy related to debt levels and cash returned to shareholders; --Supplemental net leverage as calculated by Fitch below 2x and/or gross leverage in the 2.5x range or less; --Better than expected organic growth and operating metrics. Future Developments That May, Individually or Collectively, Lead to Negative Rating Action --A significant increase in debt due to M&A activity and/or share repurchases; --Weaker than expected organic growth and operating metrics; and/or --Supplemental net leverage sustained above the mid 2.5x; and/or gross leverage sustained materially above 3.0x. LIQUIDITY Liquidity, Maturities and Guarantees: PepsiCo maintains good liquidity. The company's cash and short-term investments totaled $17.2 billion at the end of the second quarter 2017, of which $16.3 billion was offshore. This compares to $15.2 billion at the end of 2016. PepsiCo has a combined capacity of $7.5 billion under its 364-day and five-year revolving credit facilities maturing in 2018 and 2022 respectively that remain undrawn. Upcoming maturities of long-term debt include $3.4 billion in 2017 and $2.5 billion in 2018. Commercial paper (CP) balances as of June 17, 2017 were approximately $1.8 billion. During the second quarter of 2017, PepsiCo issued $3.0 billion of U.S. dollar denominated senior notes and $750 million of Canadian dollar denominated senior notes with net proceeds used for general corporate purposes, including the repayment of CP. PepsiCo guarantees all of the senior notes at its bottling subsidiary, Pepsi-Cola Metropolitan Bottling Company (PMBC), which is wholly owned by PepsiCo. While PMBC's notes are structurally superior to the notes issued by PepsiCo, Inc., Fitch has chosen not to make a distinction in the ratings at the single 'A' level as default risk is very low. FULL LIST OF RATING ACTIONS Fitch affirms the ratings for PepsiCo and its subsidiaries as follows: PepsiCo --Long-term Issuer Default Rating (IDR) at 'A'; --Senior unsecured debt at 'A'; --Bank credit facilities at 'A'; --Short-term IDR at 'F1'; --Commercial paper program at 'F1'. Pepsi-Cola Metropolitan Bottling Company, Inc. (Operating Company/Intermediate Holding Co.) --Long-term IDR at 'A'; --Guaranteed senior notes at 'A'. The following rating has been withdrawn since all of the debt at the bottling subsidiary has been repaid: Bottling Group, LLC (Operating Company) --Long-term IDR 'A'. The Rating Outlook is Stable. Contact: Primary Analyst Bill Densmore Senior Director +1-312-368-3125 Fitch Ratings, Inc. 70 W. Madison Street Chicago, IL 60602 Secondary Analyst Carla Norfleet Taylor, CFA Senior Director +1-312-368-3195 Committee Chairperson Monica Bonar Senior Director +1-212-908-0579 Summary of Financial Statement Adjustments - Financial statement adjustments that depart materially from those contained in the published financial statements of the relevant rated entity or obligor are disclosed below: --Historical and projected EBITDA is adjusted to add back non-cash stock based compensation expense and restructuring as reported in financials. --Supplemental adjusted net leverage ratio is determined by reducing foreign cash balances by applying a generic 35% tax haircut and a further 50% adjustment capturing expectations for additional foreign cash balances that could be used for shareholder-friendly actions to accommodate PepsiCo's relatively aggressive policy for share buybacks. Media Relations: Alyssa Castelli, New York, Tel: +1 (212) 908 0540, Email: alyssa.castelli@fitchratings.com. 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