Shares of Pepsico (PEP) have returned 10.34% over the past 12 months. At $68.52 per share, the stock has fallen by 7% from its 52-week high of $73.66 reached in August. Despite the fact that PEP's valuation is not cheap (supported by my value analysis discussed later), I believe the stock still warrants a buy rating, as its dividend would likely provide a solid price floor. My view is based on the following rationales:
PEP's valuation is not cheap relative to the company's financial performance (see table below). Comparing to a peer group consisting of PEP's competitors, such as Coca-Cola (KO), Kellogg Company (K), and Dr Pepper Snapple (DPS), growth potential appears to be the firm's primary issue. Analysts on average predict PEP's revenue, EBITDA, and EPS to grow at 2-year CAGRs of just 1.3%, 0.2%, and 4.4%, respectively, over the current and next fiscal years. Those growth estimates are substantially below the peer averages of 5.7%, 6.2%, and 8.7%, respectively. In addition, PEP's EBITDA margin is expected to shrink by 0.4% over the same period, compared to an average expansion of 0.7% for the peer companies.
On the profit side, PEP only has a mediocre performance. Except for the trailing gross margin, which is above the peer average, all of PEP's other margin measures are below the par. The firm's capital return metrics, such as the ROE and ROIC, are slightly better than the peer average. In terms of leverage and liquidity, PEP assumes an average level of debt, as reflected by the company's higher debt to capitalization ratio, but lower debt to EBITDA rate. PEP's trailing free cash flow margin of 9.3% is above the par, indicating a strong capability of supporting the current dividend growth. Due to the lower EBIT margin, the firm's interest coverage ratio is below the peer average. Both PEP's current and quick ratios are above the group averages, reflecting a fairly healthy corporate balance sheet.
To summarize the financial comparisons, PEP's weak growth prospects should be the primary drag on valuation. As such, it would be reasonable for PEP to trade at a small discount relative to the peer-average valuation. The current stock valuation at 10.2x EV/EBITDA, 19.3x EV/FCF, and 18.2x P/E (all on a trailing basis) represent an average valuation discount of 7.3% to the peer-average trading multiples (see table above), suggesting that the stock is fully priced.
Moreover, PEP's trailing P/E multiple is currently trading very close to its 3-year high (see chart below). Over the past 12 months, the trend of PEP's forward P/E multiple has outperformed the valuation trend of the S&P 500 index (see chart below). From that perspective, PEP's valuation appears to be stretched, given the fact that the company's long-term estimated earnings growth rate of 5.84% (according to Capital IQ) is lower than the average estimate of 7.93% for S&P 500 companies, and thus, PEP's premium valuation over the market seems difficult to justify.
Although the valuation appears to be unfavorable, PEP's decent dividend yield of 3.1% is firmly backed by the company's robust free cash flow and strong commitment to raise the dividend. Over the past decade, the dividend per share had been raised by a 10-year CAGR of 13.4% from $0.58 in FY2001 to $2.03 in FY2011 (see chart below). It should be noted that the annual dividend growth rate had slowed down over the recent years. Additionally, PEP's annual dividend paid historically represented only about a half of the annual free cash flow (see chart below), meaning that there remains an ample capacity to maintain the current pace of dividend growth.
According to the 5-year dividend yield chart shown below, there appears to be a pattern that as long as PEP's dividend yield reached around the 3.5% level, the yield dropped subsequently to close to the 3.0% level. This pattern is likely attributable to the strong demand from the yield-hungry investors in the current low-interest environment. Therefore, assuming a 3.5% dividend yield ceiling, and supposing that the annualized dividend per share (currently at $2.15) would be raised by 5% to $2.26 in the May 2013 payment period, the scenario implies a floor stock price of $64.56, representing only a 5.8% downside from the current stock price. By using the same expected annualized dividend per share of $2.26, and assuming a target dividend yield at 3.0%, the target stock price can be calculated to be $75.32, a 10% upside.
Bottom line, despite the unattractive valuations, PEP's downside is likely limited by the potential dividend growth and the company's strong capability in generating free cash flow. Based on the aforementioned floor price analysis, I recommend establishing a long position in the stock by selling out-of-the-money put options with a strike price close to the calculated floor at $64.56.
Comparable analysis table is created by author, all other charts are sourced from Capital IQ, and all financial data is sourced from Morningstar and Capital IQ.