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Tickers in this Article: PEP, KO, DPS, CBY
Like other international food and beverage firms, snack food and drink giant PepsiCo (NYSE:PEP) is grappling with uncertain global economic growth prospects and volatile commodity costs. As Wednesday, October 17, 2008's third-quarter earnings demonstrated, these factors are making it difficult for Pepsi to manage its businesses, which are usually known for posting steady results. Plus, it's having to deal with challenging prospects in its home market, and these problems aren't going to fizzle out anytime soon.

Unbottling the Quarter
Pepsi proved it's still able to keep top-line growth bubbling along. Total third-quarter sales improved 11% to $11.2 billion on notable strength in the Latin American Foods and Middle East, Africa & Asia operating units, which both grew sales in excess of 20%. Frito-Lay North America also continued to be strong, growing sales by 9%. The American beverage businesses posted flat sales on struggles in the carbonated drink category and saw a surprising 5% fall in North American non-carbonated beverage volume, on weakness in Aquafina water and Propel flavored water. The only unit to post negative sales growth was Quaker Foods North America, due to a flood, which shut down production at a major manufacturing facility in Cedar Rapids, Iowa.

The profit picture can firmly be divided into two camps, with the international businesses posting stellar operating profit growth ranges of 17%-22% as strong demand and the ability to push through price increases in many overseas regions proved sufficient in offsetting raw material cost inflation. The picture was much different at home, as anemic growth, little pricing power, and higher commodity and energy costs all stifled profit expansion.

Pepsi still managed single-digit operating profit growth at Frito-Lay, while insurance proceeds from the Quaker flooding more than offset the sales decline. But the true laggard was the bottling group, where management cited high fuel costs and IT improvement initiatives.

All in all, the operating results were quite decent. The main culprit for the 6.6% drop in diluted earnings to 99 cents per share was the $176 million mark-to-market on commodity hedges, which boiled down to a reversal of the benefits Pepsi had from hedging against rising commodity and energy costs. Just last quarter the benefit was $61 million, and although management was quick to point out that the impact of its hedges tend to even out over time, the unusual macro environment for many of its input ingredients has made it pretty tough for Pepsi to manage its cost structure, which it tried to hammer down for the coming twelve months.

Action Needed at Home
The biggest news of the quarter involved the maturing North American businesses. Pepsi is not standing still and announced a rather significant restructuring initiative, which it projects will bring $1.2 billion in savings over the next three years, but will prove costly in the near term. Management plans $550 million-$600 million in charges in the fourth quarter, with 60% of that in direct cash outlay, and expected to increase capital expenditures. About 45% of the charges relate to North American Beverages, 25% to North America Snacks and Foods, and 25% to international, with plans for layoffs, plant closings and other write-downs all in the cost-reduction cards. (You can learn about gaining from companies' big changes at Cashing In On Corporate Restructuring.)

Arch-rival Coca-Cola (NYSE:KO) is seeing similar challenges stateside, while Dr. Pepper Snapple Group's (NYSE:DPS) stock has really taken a hit, as erstwhile parent Cadbury plc (NYSE:CBY) opted to keep the international beverage rights, leaving Dr. Pepper with the top-line-challenged North American businesses. But still, the region is quite profitable for all - Pepsi posted an impressive third-quarter 22.6% operating margin in its American beverage business. (See more about the effect of materials costs on profits at Analyzing Operating Margins.)

Bottom Line
Pepsi's guidance calls for a 2008 free cash flow of $4.8 billion, which doesn't include the cash costs related to its restructuring announcement. That puts estimated free cash flow per share around $3, or just about one-eighteenth of the latest stock price. That's not a horribly high price-to-cash flow ratio for a business that is certainly as recession-proof as they come, but given the recent hiccups in the domestic business and long-term concerns over fizzy drinks and unhealthy snack foods, Pepsi has work to do in convincing me it can continue to churn out double-digit profit growth.

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