Last week PepsiCo (PEP) reported its Q4 earnings. Within the report the company stated they delivered an EPS of $1.05, which beat the consensus estimates of $1.01. The company's revenue of $20.12 billion missed estimates of $20.16 billion by ~$4 million while net income for the quarter increased 5% from the same quarter last year.
As these results were decent, Pepsi stated that it will maximize shareholder value by retaining the North American beverage business in its current structure. They also announced they will raise the dividend to $2.62 a share and raise its buyback program to close to $5 billion.
Even though the company reported decent earnings and presented some positive catalysts for investors in the form of dividend increases and share buybacks, PepsiCo's stock price failed to break out of the sideways trading pattern that it has been locked in for the past year or so.
Some of the questions that come to mind are: At current levels what is the valuation? What are some of the issues that the company is facing? and where is it going from here?
EV/EBITDA = Enterprise Value/Earnings Before Interest, Taxes, Depreciation and Amortization
In the next section, I will use the EBITDA to calculate the EV/EBITDA. The adjusted EBITDA takes into account foreign exchange and share-based payment expenses. The EV/EBITDA ratio is one of the most commonly used valuation metrics, as EBITDA is commonly used as a proxy for cash flow available to the firm. Retail (Special lines) stocks typically have an EV/EBITDA ratio that trades in the 10.0x to 12.0x trading range.
Enterprise Value or EV = Market Capitalization + Total Debt - Cash and Cash Equivalents.
- EV - $121.04 + $29.639 million - $9.375 billion = $141.304 billion
- EV = $141.304 billion
- EBITDA = $12.368 billion
- EV/EBITDA = 11.42
As the Beverage (non-alcoholic) sector often trades in the 13.95 trading range, an EV/EBITDA ratio of 11.42 indicates at current levels the stock is trading just fair value compared to other companies in its sector.
Other metrics that indicate the stock is undervalued are: PepsiCo has a P/B of 5.34, which is below with the industry average of 4.8, a P/S of 1.84, which is below the industry average of 2.37 and a P/FCF of 12.18, which is below the industry average of 14.51.
The preceding valuation metrics indicate that PepsiCo is currently undervalued. As we have determined that the company is undervalued what are some of the investor concerns that are causing this undervaluation.
Even though Globally PepsiCo had a strong quarter, there was some weakness within the overall picture. In the latest report, the PepsiCo American Beverages (PAB) segment stated:
"organic revenue declined 1% driven by an organic volume decline of 3%, partially offset by 3% points of effective net pricing."
As sales for Pepsi, Diet Pepsi, and Gatorade within North America are on the decline, this is increasing investor concerns. PepsiCo along with its competitors Coca-Cola (KO) and Dr.Pepper (DPS) are struggling against strong social headwinds that make avoidance of these high sugar drinks an increasingly popular choice. Due to these social headwinds there are questions and debates regarding a possible spin-off of the North American Beverages segment.
As the decline in sales for sugary drinks is not a new issue for the company, PepsiCo has diversified. As the North American Beverages segment is the largest part of the company contributing
$21.068 billion in sales for 2013 which represented ~32% of overall sales, other segments are showing strength. The largest growth in 2013 was the Latin foods segment that increased by 7% in revenue and 17% in operating profit. As other segments of the company are increasing this will cushion the effects of the declining North American Beverage segment.
As PepsiCo met or exceeded expectations in organic revenue, cash flow, productivity, core operating margins, constant currency EPS, and ROIC targets they are poised for growth and dividend increases. In their latest report they state:
"Our financial targets for 2014 are consistent with our long-term goals. As a reflection of our positive outlook for the business and our expectation for consistent, strong cash flow generation, we intend to increase our cash returns to shareholders in 2014 to $8.7 billion through both higher dividends and share repurchases."
As the company is expecting to "increase their cash returns to shareholders in 2014 to $8.7 billion through both higher dividends and share repurchases." lets look at a few profitability ratios that indicate how profitable PepsiCo is regarding their investments. This will give us an indication of how well management is investing their capital thus increasing profitability and securing future cash flow.
Return on capital employed = EBIT / (Total Assets - Current Liabilities)
This ratio indicates the efficiency and profitability of a company's capital investments. The higher the percentage the better.
ROCE should always be higher than the rate at which the company borrows otherwise any increase in borrowing will reduce shareholders' earnings, and vice-versa. A good ROCE is one that is greater than the rate at which the company borrows.
- 2011 = $9.633 billion / $54.728 billion = 17.60%
- 2012 = $9.112 billion / $57.549 billion = 15.83%
- 2013 = $9.705 billion / $59.639 billion = 16.28%
According to the list above, all of PepsiCo's calculated return on capital employed ratios is much higher than the rate at which it has borrowed. As compared to the current WACC 3.64% this indicates that the company is making substantial profits on the capital invested.
Return on Invested Capital = Net Income - Dividends / Total Capital
This ratio assess a company's efficiency at allocating the capital under its control to profitable investments. The higher the percentage the better.
The return on invested capital measure gives a sense of how well a company is using its money to generate returns. Comparing a company's return on capital with its cost of capital (OTC:WACC) reveals whether invested capital was used effectively.
- 2011 = $6.443 billion - $3.157 billion/ $41.272 billion = 7.96%
- 2012 = $6.178 billion - $3.305 billion/ $45.961 billion = 6.25%
- 2013 = $6.740 billion - $3.434 billion/ $48.742 billion = 6.78%
As compared to the current WACC 3.64% this indicates that the company is making substantial return on the invested capital.
As these ratios are very important regarding profitability this will be a strong indicator regarding of dividend sustainability, share buybacks and future growth. Currently, as both ratios are well above the WACC this indicates that the company is generating sufficient cash on their investments.
The ROCE and the ROIC ratios above indicate PepsiCo is creating substantial profits on the capital they have invested. This is utmost importance to the investor as they are profitability indicators that enables the company to pay for dividends and purchase share buybacks.
At current levels PepsiCo offers a 2.90% yield which equates to a payout of $2.27. As stated earlier in the article the company plans to increase the dividend payout to $2.62 which equates to a yield of ~3.36%. As the payout ratio is 52.00% this indicates that the company is not overpaying based on their income.
As the chart above reveals PepsiCo's share price has been inline with the S&P 500 over the past 10 years. Having stated that, As PepsiCo has a solid history of dividend increases the investor has significantly outperformed the market over the past 10 years.
Forward P/E to create a target
To create a target price for PepsiCo. I will use PepsiCo's forward P/E ratios with estimated earnings to find a target. Currently, PepsiCo has a forward P/E of 15.38 and FY 2017 high earnings projected at $6.08. These two metrics lead to a target price of $93.51.
As of February 20th, PepsiCo was trading at $77.10. Using the forward P/E model, this indicates that the stock has a 21.28% potential upside from this point.
In the latest report PepsiCo reported decent results. Of concern in this report was the continuing lack of growth in the North American Beverages segment. As PepsiCo has diversified and is looking to grow in other markets this growth is should cushion the effects of the declining North American Beverage segment.
From a fundamental point of view PepsiCo is making significant cash from the capital they have invested. This bodes well for the future as these investments will drive future cash flow that will in turn drive future divided increases and share buybacks. At current levels using the valuation metrics above, I have concluded that PepsiCo is currently trading at a discount, offers an increasing dividend and has capital appreciation potential based on market growth outside N.A.