Pepsi Could Plausibly Deliver 9% Annual Dividend Growth

| About: PepsiCo Inc. (PEP)


Although the recent 15% dividend hike was welcome news for Pepsi shareholders, most of this was the result of an increasing payout ratio as actual growth was only 8%.

Pepsi is on pace to grow core earnings by 7.5%-8.5% over the coming 5-10 years, and is also receiving 1.5% earnings per share growth from a share buyback program.

Given that the Pepsi Board does not have much room to increase the payout ratio further, it seems likely that the long-term dividend growth rate will mirror core profit growth.

This June 30th, Pepsi (NYSE:PEP) shareholders will be the recipients of a welcome surprise: they will be receiving a quarterly dividend of $0.655 per share instead of the $0.5675 received in June 2013. This annual dividend increase of over 15% has surely got some long-term holders of the soda giant (as well as prospective investors) wondering, "Is Pepsi back?"

The answer is yes, but not entirely.

First, the bad news: this nice dividend hike was not entirely supported by a growth in profits. Pepsi has managed to grow its profits per share by 8% in the past year, which is nice, but significantly below the amount of the most recent dividend hike. Some of this has been the result of payout ratio creep, as the company's dividend payout ratio has risen from 40% in the pre-recession year of 2007 to 53% today. The growth rate of the dividend has outpaced the growth of profits for the past five years, and that is why the current dividend growth rate is somewhat illusory (it's not that Pepsi is advancing its business operations by 15%, but rather, the Pepsi Board of Directors has chosen to advance its payout ratio by thirteen percentage points in the past 6-7 years).

The other concern is that the company has been using debt to meet its obligations -- although the company's balance sheet has grown stronger as Pepsi's earnings power has improved, it has grown weaker in the sense that the company carries a significant debt burden and does not have a fully funded pension. For instance, Pepsi currently carries $32 billion in debt ($8 billion of which is not being carried long term), and requires $800 million in interest payments alone. The pension has seemingly gone neglected as the pension fund has over $15 billion in obligations, yet is only carrying $7 billion in assets on its balance sheet to meet them.

Now, for the good news.

First of all, Pepsi seems to have finally burst out of its slowing sales growth rut. The reason why Pepsi's profits felt "stuck" there for a little while (e.g. profits of $3.98 per share in 2011 actually declined to $3.92 per share in 2012) was because the company's sales per share were stuck in the $42 range for a few years until finally breaking free in 2013 by posting sales per share of $43.44. Once a snack and soda company starts experiencing a few percentage points of sales growth, it becomes doable to turn that sales growth into 8-10% annual earnings per share growth.

Secondly, Pepsi is starting to get serious about reducing its share count again. From 2008 to 2010, Pepsi was actually diluting its shareholders rather than using a buyback program to actually reduce the share count. More specifically, the share count of 1.553 billion in 2008 increased to 1.565 billion in 2009, and then increased yet again to 1.581 billion in 2010. Since then, Pepsi has been reducing its share count by a little over 20 million shares per year, indicating that Pepsi's current buyback program will add 1.5% annually to the earnings per share figure.

On the core metrics front, Pepsi is humming along nicely. Operating margins come in at 19.5% (the best year in the past five), the net profit margin is holding steady at 10.5% (which has generally remained constant in the past five years), and the returns on shareholder equity remain in line with historic norms at 27.5% (slightly worse than last year, but in line with its five-year performance). Additionally, Pepsi has begun a $5 billion cost savings program, with management indicating that all the money from cost cuts will go directly to buybacks and dividends once realized. And, of course, Pepsi has increased its cash on hand from $6 billion in 2012 to over $9 billion today.

The bogeyman with Pepsi is that people are concerned that carbonated beverages will be on the decline in the coming years, weakening the broad appeal of the Pepsi-Cola brands and making long-term growth difficult. I don't buy into that conventional wisdom. That kind of analysis regards Pepsi as only a North American soda manufacturer, without realizing that a quarter of PepsiCo's overall profits come from Pepsi-Cola's international arm, and 40% of PepsiCo's profits come from the Frito-Lay division. Furthermore, a 2% or so annual decline in Pepsi is not a significant issue when you have Gatorade and Aquafina there to pick up the slack, as well as international beverages and a snacking division that dwarf the long-term performance of the Pepsi brand in North America.

I think a more appropriate, and accurate, take-home message for PepsiCo shareholders would be this: sales are starting to increase by 2-4% across the entire snack and beverage portfolio. Because PepsiCo is reducing its costs by $5 billion and achieving high international growth with the Frito-Lay division, it is reasonable that the sales growth will translate into 7%-8% core earnings growth. Furthermore, Pepsi is retiring 1.5% of its share count per year, which means that the actual earnings per share figure will increase by 8.5%-9.5% over the coming five to ten years. Given that Pepsi likely won't increase its payout ratio further because it has already increased thirteen percentage points over the past seven years, it seems likely that the long-term dividend growth rate will roughly mirror the 8.5%-9.5% earnings per share growth of the corporation. For those reasons, it seems plausible that Pepsi shareholders will collect dividends growing by around 9% in the coming five to ten year stretch.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.