For a moment, let's turn back the clock to 2002. Back then, Pepsi (PEP) was cranking out $1.96 in annual profits while shipping off $0.60 of each share to their owners in the form of a dividend. With only 30.61% of the company's profits going towards returning cash to shareholders, Pepsi had a lot of room to buy back shares, invest for future growth, and grow dividends by a rate greater than its earnings for a ten-year time frame. And that is largely what Pepsi did.
The company reduced the share count from 1.722 billion in 2002 to 1.5 billion today, grew earnings per share from $1.96 to $3.92, and grew the dividends faster than the rate at which the profits were growing. Now, the company is paying out $2.27 in profits while generating $3.92 in total profits across its beverage, snack, and breakfast food divisions. That means that 57.90% of the company's profits are going out to shareholders in the form of dividends.
Ten years or so ago, Pepsi was able to retain $0.69 on the dollar to invest in future growth, buy back stock, pay down debt, strengthen its moat, and engage in similar activities designed to reward shareholders over the long term. Now, Pepsi is only retaining $0.42 on the dollar for that same purpose.
Not only does Pepsi have less profit at its disposal to facilitate long-term growth than it did a decade or so ago, but the company has responded to the current period of low interest rates by taking on more debt. As of March 2013, Pepsi had $29.4 billion in total debt, 55% of which is due in the next five years. The company's long-term interest payments are flirting with the $1 billion mark. This debt will be a bit of a drain on the company's future profits, because every dollar that the company puts towards its $30 billion debt burden represents money that is not being spent to grow the business, buy back stock, raise the dividend, and so on.
What explains this change of events for Pepsi shareholders? Well, first of all, Pepsi didn't exactly light the world on fire coming out of The Great Recession. In 2010, Pepsi was pumping out $3.91 in profits per share. By the end of 2012, the company was generating $3.92 per share.
That is because the CEO Indra Nooyi has decided to focus the company's energy and efforts based on what she believes customers should want, rather than what they actually want. People want to eat chips and guzzle soda (63% of the company's total operating profits come from the sale of specialty snacks and beverages in the United States alone). Those are the company's cash cows. Nooyi has decided that Pepsi should position itself to become a healthier company, and therefore, that is where the company is focusing its energies. That is why the company's overall volume growth has been unimpressive since 2010 (the core soda and snack brands have been relatively neglected, and the health brands have not achieved gains commensurate with Pepsi's overall investment energies).
That leads to the question: for income investors, what will Pepsi's dividend growth look like over the next five years? My guess is that the company will be looking at annual dividend growth in the 7-8% annual range over the next five years, and here is why I think that:
When I look at Pepsi's dividend policy over the past several decades, the trend is that the company generally gives investors dividend growth that is superior to earnings growth in bad times, and gives investors dividend growth that is inferior to earnings growth in good times.
For instance, over the past five years, Pepsi has raised its dividend by 11.0% annually. It took care of you during the Great Recession, shipping more and more cash to your household's balance sheet while the credit markets around the world were freezing up. But there is an important catch: even though the dividends grew by 11.0%, the earnings per share only climbed by 5.5%.
Pepsi gives itself the flexibility to do that during troubled times by giving investors slower dividend growth during good times, compared to the earnings growth rate. My guess is that you are going to see Pepsi grow its earnings by about 8-9% annually over the next five years.
My basis for thinking that is the following: Pepsi is cutting costs by about $1 billion per year for the next three years, gaining market share in emerging markets where soda consumption is low by offering competitive prices, and is engaging in a buyback program that will take almost one billion shares off the books by 2017-2018 if (1) the company is able to use at least 80% of its buyback capital towards actually reducing share count, and (2) the company is able to pay no more than 20x earnings at the average time of repurchase, with the estimation that earnings will be 8.5% higher each year.
That is why I think earnings will grow by 8-9% annually over the medium term. But I am also assuming that Pepsi will be using some of those future profits to reduce the $30 billion debt load and try to get the 57.90% payout ratio a bit lower over the long term. That is why I am targeting 7% dividend growth from Pepsi over the next five years, meaning that today's $2.27 dividend should be around $3.20 or so come 2018 based on present known risk factors.