Although Pepsi's (PEP) stock went up last month in response to the company's announcement that it will buy back $10 billion worth of its own stock over the next three years, I am not cheering.
To explain why, I'd like you first to take a look at Warren Buffett's explanation of a sound buyback policy that he outlined in his most recent letter to shareholders of Berkshire Hathaway (BRK.B) that came out a short while ago:
The third use of funds - repurchases - is sensible for a company when its shares sell at a meaningful discount to conservatively calculated intrinsic value. Indeed, disciplined repurchases are the surest way to use funds intelligently: It's hard to go wrong when you're buying dollar bills for 80¢ or less. We explained our criteria for repurchases in last year's report and, if the opportunity presents itself, we will buy large quantities of our stock. But never forget: In repurchase decisions, price is all-important. Value is destroyed when purchases are made above intrinsic value.
I put that last line bold, because it cannot be overstated enough: with share buybacks, price means everything. They are much different from dividends: with dividends, a company only has to determine how much money it needs to reinvest in the business, and from there, it's up to the shareholder. The individual investor gets to decide if he wants to spend the cash payout, reinvest it into the same business, or use it to fund other business opportunities.
With stock buybacks, the relationship between the amount of money devoted to the repurchase and the repurchase price is what determines whether value gets created or destroyed. Based on the current market prices, I am not at all excited about Pepsi's latest buyback announcement.
When you run the numbers, you can see that Pepsi is currently trading at $77.20 per share and generating $3.92 per share. That is a P/E ratio of 19.69. According to Value Line, Pepsi is fairly valued when it trades at 19-20x earnings. This is the valuation that Pepsi traded at from 2005-2008 before the financial crisis hit. Based on Pepsi's eight-year history of normal P/E ratios and analyst predictions, it looks like Pepsi is trading at the upper end of its fair value right now.
And that's why I'm not excited about this latest buyback announcement. As Buffett mentioned in the first sentence of the quote explained above, a buyback is sensible for a company when its shares sell at a meaningful discount to conservatively calculated intrinsic value. Pepsi management has given no indication as to why it believes that the current repurchase trades at a meaningful discount to conservatively calculated intrinsic value. Most likely, that is because the company isn't cheap right now. It is trading at intrinsic value!
I find this bothersome, because a good buyback program should be structured so that, at best, it creates a lot of value, and at worst, has a so-so effect on creating value for shareholders. Based on the fact that Pepsi normally trades around 20x earnings, and given that the company is currently trading just shy of 20x earnings, it seems that Pepsi management is setting itself up so that this buyback program turns out to be so-so at best but could be value destructive at worst. Because of this, I do not believe that the $10 billion set aside for stock buybacks is in the best interests of shareholders.
What I find odd about Pepsi's $10 billion buyback declaration is that the company has many other uses for that capital that seem to be much more intelligent than merely buying the stock at the upper end of fair value. For instance, Pepsi has $28 billion in debt as of January. Almost $5 billion of that debt is not low-interest debt that has been refinanced for the long term. It would be nice if the company paid that off.
Or Pepsi could use some of that $10 billion to cover its pension shortfall. The company has $14 billion in pension obligations, but currently has $11 billion pension assets.
And lastly, Pepsi's dividend has nosedived a bit these past two years. Over the past decade, Pepsi has rewarded shareholders with 13% annual increases. This was quite nice while it lasted. Unfortunately, it seems that Pepsi's dividend has become less of a priority these past two years. Last year, Pepsi only raised its dividend 4%. And last month, Pepsi management announced that this year's dividend increase will only be 5.6%. Both of these dividend increases are quite unimpressive in relation to Pepsi's historical averages that investors have come to expect.
By the way, I want to make it clear that my objection is solely to Pepsi's buyback program, not its underlying business. Personally, I hope to own a large block of Pepsi shares someday that I never sell. When I study economic recessions, it's usually the food companies that are among the best performers. This includes the Great Depression, the 1973-1974 meltdown, and the 2008-2009 financial crisis. Pepsi is on the short list of companies you can pull off owning for life.
Nevertheless, I remain unimpressed with the company's decision to spend $10 billion on share buybacks when all indications seem to point to the fact that the company is fairly valued, using traditional P/E metrics to make that determination. I would much rather see the company pay down some of its debt or give investors dividend hikes that are more in line with traditional averages. It's becoming clear that Pepsi is engaging in stock buybacks at the expense of dividend growth. I can make peace with that when the company is undervalued, but I'm not going to cheer along when a megacap stock announces a buyback program while trading at almost 20x earnings.