Early this year, Pepsico (NYSE:PEP) announced a year-over-year dividend hike of 15%. Over the past 3 months, its share price has returned 6%, slightly outperforming a 4% gain for S&P 500 Index. As many investors wonder whether the company can continue with its double-digit dividend growth, in this article, I will provide readers some perspectives on Pepsico's future cash flow and dividend trends.
I have performed free cash flow forecasts from 2014 to 2016 to gauge the company's capacity for future dividend growth. My analysis started with consensus revenue estimates which project the top line to rise by 4.2% CAGR from $67.2B in 2014 to $72.9B in 2016. Pepsico's operating cash flow margin trended within a tight range in the past 5 years. To be fair, I assumed a flat margin of 14.3% through 2016, which is consistent with its 5-year historical average. It is noted that the consensus view expects a 100 bps EBITDA margin expansion during 2014-2016, which means that my operating cash flow margin assumption is somewhat conservative (assuming a steady trend of EBITDA to operating cash flow conversion). For capital expenditure, I assumed the figure to grow from $3.0B in 2014 to $3.1B in 2016 as the company has not announced any significant spending plans. Based on those assumptions, free cash flow was projected to grow by 5.3% CAGR from $6.6B in 2014 to $7.3B in 2016 (see chart below).
Based on an annual dividend of $2.53 per share for 2014 (assuming quarterly dividend in Q3 and Q4 would be the same at $0.66 per share) and my estimated average share count for 2014 (discussed later), I projected total dividend spending in 2014 to be about $3.8B. As such, the free cash flow dividend payout ratio will increase from 50% in 2013 to 58% in 2014, which is somewhat in line with its historical average during 2009-2012. In order to maintain a steady free cash flow payout ratio such that the dividend payment can be sustained over a longer run, growth in annual dividend spending must be in line with free cash flow growth. Given my projected free cash flow CAGR of 5.3%, I estimated that the dividend spending can grow by 6.0% in 2015 and 5.5% in 2016. In this case, Pepsico would have about $2.7B-$3.0B excess free cash flow in each year which can be used for share buyback (see chart above).
Given my dividend spending estimate of $3.8B in 2014 and management's plan to return a total $8.7B capital to shareholder in the year, share buyback would be about $4.9B in 2014. Assuming that 90% of the excess free cash flow is spent on buying back shares (the other 10% is to account for minor cash acquisitions and/or other corporate purposes) in 2015 and 2016, approximately $2.6B-$2.7B value of shares can be repurchased in each year, which is slightly below the average buyback level of $2.9B in the past 3 years. I then assumed an average share count decrease of 20M in 2014 and 12M in each of 2015 and 2016 based on the average decline of 14M in the past 3 years. As a result, share count will drop to about 1.5B by 2016. Given my dividend spending projections, dividend per share was forecasted to grow by 6.8% CAGR from $2.53 in 2014 to $2.89 in 2016. Comparing with consensus EPS estimates, these forecasts imply that earnings dividend payout ratio will decline slightly from 55.8% in 2014 to 54.5% in 2016. As both the free cash flow and earnings dividend payout ratios will trend steadily under this scenario, I believe my dividend forecasts are at a sustainable level at least over the forecast period (see chart below).
On the valuation side, I believe the current valuation reasonably reflects my dividend per share growth estimate. Based on current annualized dividend of $2.62 per share and 10% cost of equity, the Gordon Growth Dividend Discount Model suggests that the current share price of ~$88 has priced in a dividend growth rate range in between 6.5% and 7.0%, which is in line with my expectation (see chart below).
In conclusion, the 15% dividend hike appears to be a one-time event as a sustainable dividend per share growth would be limited by Pepsico's single-digit free cash flow and EPS growth over the next few years (assuming management plans to maintain a steady free cash flow and earnings payout ratio going forward). One good thing is that the shares are now priced based on a much lower and sustainable dividend per share growth rate.
All charts are created by the author, and historical data used in the article and the charts is sourced from S&P Capital IQ, unless otherwise specified.
Disclosure: The author is long PEP. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.