An Ode to Pepsi Stock

In 1994 you were finally mine. But then as I aged, you remained young. You were too fast for me; I could not keep up with the pace. By 2000 our value systems bore no resemblance and we parted ways; you represented growth, I value. Since then, I have watched you grow; I have yearned for you; I made a mistake, will you ever take me back?

Pepsi (PEP) is what I see as a classic mistake I made. I bought the shares during 1994 and exited during 2000. I am a cycle investor, but I tend to book capital and let the profits ride. With Pepsi, in 2000 I took a full exit and I lost a great company, with good defensive characteristics, which help limit the pain during cyclical contractions.

In 2000, the stock had gone as far as it would; I had a rock solid profit and felt I would buy it back at a good value later. I patted myself on the back until early 2004; the stock went nowhere but it never came to a level which I considered good value, and I never buy unless I see good value.

The lesson I learned was that while cyclical stocks (typically stocks in financials, discretionary, energy, materials, industrials and IT sectors) will almost always reach what I define as fair value during the course of an economic cycle, defensive plays in (typically stocks in staples, utilities, healthcare, sectors) will make you wait much longer for a value entry point. Once you buy a good defensive at great value, it is worth holding long term, instead of trading it through the cycle. Not being able to buy it back later in the cycle, might cause a deterioration in portfolio quality; and for defensive plays, the higher the quality the better the defense characteristics.

I have been watching Pepsi with intent since 2000 and I am still waiting. I am patient, but my patience is wearing thin. I think I missed an opportunity when Pepsi traded in the late $40s earlier this year; I missed it because it was still higher than what I call fair value. I did not get a chance to look specifically at PEP because it never fell to fair value - I was more focused on acquiring cyclical stocks; and strangely enough, several defensive stocks gave good value opportunities as the market got hammered.

Please visit "The Quant Report" and link through to the PEP report for a decade’s worth of historic data and the various valuation metrics applied in arriving at below referred indicative out values.

Pepsi is an exceptionally well managed company. It has a great portfolio of products and access to all major growth markets; both in terms of product and in terms of geographically. Since the year ended 1999 through the year ended 2008, earnings grew at an annualized rate of 11.25%; dividends grew at over 12%. 2008 was a trough earnings year for Pepsi as earnings fell from $3.34 in 2007 to $3.21 in 2008; during 2009 earnings expectations are at an achievable $3.6. The six year median earnings have also grown at a stable rate of over 11% annualized. The year on year change in earnings has been strong with median earnings growth rising at over 11%; this stability in earnings is remarkable; since 1999, the year on year change has been negative only during 2003 and 2008.

On The Quant Report, on a cycle basis, Pepsi earnings expectations for 2009 are shown at normal risk levels; a low risk level would be indicated if earnings expectation for 2009 were more than one standard deviation below median levels and a very low risk would be indicated if earnings expectation for 2009 were more than two standard deviations below median levels. High/Very High earnings risk would be indicated if earnings expectation for 2009 were more than 1 and 2 standard deviation above median levels.

For 2008 and 2009, earnings risk is rated as high and very high, but these can be ignored because history suggests that Pepsi has been able to deliver consistent earnings growth over long periods of time – as a consequence it is unlikely that a single or forward year will ever indicate normal or low earnings risk levels.

Pepsi’s dividend provides a yield of 3% with a payout ratio of 48%; this compares with a long term median payout ratio of just shy of 38%. In my view the dividend is safe. There is less scope for dividend growth at the same pace as historic dividend growth rates, until earnings growth reduces the payout ratio to levels consistent with historic median levels. We would need to see earnings hit near $4.7 before high growth in dividends can be expected to resume.

I love this stock and I hate it too; it has tested my patience too long and has pushed me to a point when I am desperate to buy. On the rare occasion, I do buy in desperation, but the relationship has not always been a happy one.

I would gladly buy PEP at $38; but I doubt that price point will be achieved; $45 would have been a good entry point, but I missed it. I would buy at $51, but even that seems unlikely. I expect the share to trade at $70 this year and $80 next year. By 2014, in my view the stock should trade at $110. Buying at $60 would give a return expectation of near 13% plus the dividend. This is good, but below what I can expect from cyclical opportunities.

But I want some defense soon, so I might buy anyway. I am undecided, but if the stock trades down to $51, I will buy; $51 is my estimate of Graham’s intrinsic value.

Disclosure: No holdings.

Comments

[Gravity404]

PEP is my oldest holding. I bought and forgot. I have done very well with it as a part of a balanced portfolio.

In addition to the divys, it has provided shareholder value with the massive spin off of YUM and multiple buy backs and splits.

Also, they typically split around the 60-70 range. Then after the split it dips for a month or so, then heads back up, steadily. That may be a good opportuntiy to get back in.

Having said that, as a long term holder of PEP, I am very concerned about the new target painted on this industry. Be it soft drinks of potato chips, when the Pelsoi party secures their talons in the backs of American, they feel as if they need to protect people against themselves. As you know, people are inherently stupid so we need big governement to control us; what we eat and drink. America is fat and they are targeting soft drinks and snack foods; rather than promoting a balanced diet and exercise.

Last year it was "BIG EVIL OIL" and this year its "BIG EVIL JUNK FOOD." I believe NY is thinking of a special tax on "junk food."

That concerns me.

2009 Oct 08 11:42 AM

[Adonis]

Unfortunately it isn't just NY, the federal government is looking at tax on soft drinks. However, I still like PEP, especially with them vertically integrating by buying Pepsi Bottling and Pepsi Americas.

2009 Oct 08 12:26 PM

[Wolfhounds]

Excuse me, but what exactly are you complaining about? A stock that will only return 13%, according to your calculations, for the next five years. I'm really crying. I wish every stock I bought had that return - nearly twice the expected return of the S&P.

2009 Oct 09 09:22 AM

[David Van Knapp]

Pepsi is a superb company. I own it as part of a dividend portfolio, so am less concerned with its price du jour. On the dividend front, it just keeps kicking out those checks every quarter like clockwork, and they've been increasing for decades.

I have faith in Pepsi's management. Even if healthcare worries and/or regulations cause people to turn away from heretofore core products, I believe that Pepsi has the foresight and agility to develop healthier products ahead of the curve and maintain its leadership in snacks. I've been eating Baked Lays for years based on my own health concerns, and they are great. Just a small anecdotal example of what Pepsi can do with its franchise, including its unmatched distribution network.

Shiv, sorry you jumped off the gravy train. I don't quite follow your reasoning for selling in 2000, nor for being unable to find enough value for 4 years to buy back even though the stock went nowhere. Personally, I find no value in categorizing stocks as "cyclical" or "growth" or "defensive," so such labels never play a role in my investment decisions. It sounds like those labels hurt you here with Pepsi.

2009 Oct 09 09:23 AM

[Shiv Kapoor]

well trying to be too clever. My capital tripled and I reckoned I would sell and buy back cheaper. I never did! One of my bad calls.


On Oct 09 09:23 AM David Van Knapp wrote:

> Pepsi is a superb company. I own it as part of a dividend portfolio,
> so am less concerned with its price du jour. On the dividend front,
> it just keeps kicking out those checks every quarter like clockwork,
> and they've been increasing for decades.
>
> I have faith in Pepsi's management. Even if healthcare worries and/or
> regulations cause people to turn away from heretofore core products,
> I believe that Pepsi has the foresight and agility to develop healthier
> products ahead of the curve and maintain its leadership in snacks.
> I've been eating Baked Lays for years based on my own health concerns,
> and they are great. Just a small anecdotal example of what Pepsi
> can do with its franchise, including its unmatched distribution network.
>
>
> Shiv, sorry you jumped off the gravy train. I don't quite follow
> your reasoning for selling in 2000, nor for being unable to find
> enough value for 4 years to buy back even though the stock went nowhere.
> Personally, I find no value in categorizing stocks as "cyclical"
> or "growth" or "defensive," so such labels never play a role in my
> investment decisions. It sounds like those labels hurt you here with
> Pepsi.

2009 Oct 09 10:00 AM