Valuation Of PepsiCo Inc. - The Long Case Looks Strong

Last week management of PepsiCo. Inc. (NASDAQ:PEP) announced earnings for 4Q and full year 2013. The results were fairly mixed with revenue increasing around 1% over 2012. North American soda consumption continues to be a drag on the growth of the company as international beverage and snacks show solid growth. The Board of Directors also announced a huge 15.4% increase in the quarterly dividend from $0.5675 to $0.655, although the new dividend rate doesn't start until the June payment. PepsiCo, Inc. was trading around $78.00 on Thursday, February 20th giving a forward yield of 3.36% based on the new dividend rate.

DCF Valuation:

Analysts followed by Yahoo!Finance expect PepsiCo to grow 7.86% per year over the next five years and I've assumed they can grow at 6.29% (75% of 7.86%) for the next 3 years and at 4.50% per year thereafter. Running these numbers through a three stage DCF analysis with a 9% discount rate yields a fair value price of $111.09. This means the shares are trading at a 29.8% discount to the discounted cash flow analysis.

Graham Number:

The Graham Number valuation method was conceived of by Benjamin Graham, the father of value investing, and calculates the maximum price one should pay for a company given the earnings and book value. PepsiCo, Inc. earned $4.32 per share in fiscal year 2013 and ended with a book value per share of $15.96. The Graham Number is calculated to be $39.39, suggesting that it is overvalued by 98.0%.

Average High Dividend Yield:

PepsiCo, Inc.'s average high dividend yield for the past 5 years is 3.27% and for the past 10 years is 2.91%. This gives target prices of $80.24 and $89.93, respectively, based on the current annual dividend of $2.62. PepsiCo is currently trading at an 8.3% discount to the average of two high dividend yield models.

Average Low P/E Ratio:

PepsiCo Inc.'s average low P/E ratio for the past 5 years is 14.92 and for the past 10 years is 16.66. This corresponds to a price per share of $67.44 and $75.3, respectively, based off the analyst estimate of $4.52 per share for fiscal year 2014. I'll use the average of the two low P/E ratio models, $71.37, in my target entry price calculation. PepsiCo is currently trading at 9.3% premium to this price.

Average Low P/S Ratio:

PepsiCo's average low P/S ratio for the past 5 years is 1.57 and for the past 10 years is 2.02. This corresponds to a price per share of $67.76 and $87.05, respectively, based off the analyst estimate for revenue growth from FY 2013 to FY 2014. 2014 revenue per share is estimated at $43.16 based off only the analyst estimate for growth of 1.30%. Currently, PepsiCo's P/S ratio is 1.80 on a trailing twelve months basis. Once again I'll use the average of the two P/S ratio models, $77.40, in my target entry price calculation. PepsiCo Inc. is trading at a 0.8% premium to this price, or essentially at the target price.

Gordon Growth Model:

The Gordon Growth Model is a quick way to calculate the fair value of a company using the current dividend, the expected dividend growth rate, and your required rate of return or discount rate. Assuming a constant 6.00% dividend growth rate and a discount rate of 9.00%, the GGM valuation method yields a fair price of $87.33. PepsiCo Inc. is trading for a 10.7% discount to this price.

Dividend Discount Model:

For the DDM, I assumed that PepsiCo will be able to grow dividends for the next 5 years at the lowest of the 1, 3, 5 or 10 year growth rates or 15%. In this case that would be 7.67%. After that I assumed they can continue to raise dividends for 3 years at 80% of 7.67%, or 6.14%, and in perpetuity at 6.00%. The dividend growth rates are based off fiscal year payouts and don't necessarily correspond to quarter-over-quarter increases. To calculate the value, I used a discount rate of 9%. Based on the DDM, PepsiCo is worth $77.10, meaning it's overvalued by 1.2%.

P/E Ratios:

PepsiCo Inc.'s trailing P/E is 18.1 and its forward P/E is 16.0. The PE3 based on the average earnings for the last 3 years is 19.1. I like to see the PE3 be less than 15 which PepsiCo is currently well over. Compared to its industry peers, PepsiCo is undervalued against The Coca-Cola Company (KO) 19.2 and overvalued against Dr. Pepper Snapple Group (DPS) 16.5. Comparisons are on a TTM basis. PepsiCo is trading at a PEG ratio of 2.17 and is trading on par with Dr. Pepper Snapple Group (2.17) and is undervalued versus The Coca-Cola Company (3.38). None of the companies are trading at a discount based on the PEG ratio where 1 is generally considered fair value.

Fundamentals:

PepsiCo's gross margins for FY 2012 and FY 2013 were 52.2% and 53.0%, respectively, and they have averaged a 53.1% gross profit margin over the last 5 years. Their net income margin for the same years were 9.5% and 10.2% with a five year average of 10.8%. I typically like to see gross margins greater than 60% and at least higher than 40% with net income margins being 10% and at least 7%. PepsiCo doesn't hit the 60% mark on gross margins but it's still comfortably above the 40% level. On the net income margin level, PepsiCo is hanging around the 10% threshold which is good to see. I feel it's prudent to make a company to company comparison as well, as each industry allows for different margins. Over the TTM, Dr. Pepper Snapple Group's gross margin was 58% and The Coca-Cola Company's gross margin was 60%. For net income margin, Dr. Pepper Snapple Group was at 10.4% while Coca-Cola Company was at 18.5%. PepsiCo is trailing its two main competitors in both gross margin and net profit margin. I'm not too surprised since the snack food business is a bit more sensitive to commodity prices and therefore margins are typically a bit lower. I'd like to the see the gap close some but I don't expect to see PepsiCo surpass either of their less diversified competitors.

Share Buyback:

Since FY 2003 ended, PepsiCo has done a pretty good job with reducing the share count. The decreases would have been great except for the two years of increases (2006, 2010). Overall management has been able to reduce the share count by 8.5% over the last 10 years for an average annual decrease of 0.88%. During the earnings release last week, management announced an increase in the buyback program of $5 billion which is approximately 4% of the market cap.

A negative number for the % change value means shares were bought back by the company and a positive value means the shares outstanding increased.

Dividend Analysis:

PepsiCo Inc. is a dividend champion just announcing its 42nd consecutive year of increasing the dividend. The dividend has been increased at a 13.1%, 8.4%, 7.7%, and 12.5% rate over the last 1, 3, 5, and 10 year periods respectively. Dividend increases are based off fiscal year payouts and don't necessarily correspond to annual payouts. The increases had been fairly steady over the last few 4 fiscal years all being around the 6% mark, but during the earnings release management announced a huge 15.4% increase in the quarterly dividend from $0.5675 to $0.655. The new rate won't go into effect until the June payment which follows the normal increase schedule. This will be approximately a 60% payout ratio which management is targeting. Over the last 5 years, the payout ratio has averaged 49.3%, so the dividend is well covered by earnings.

PepsiCo's management has done a wonderful job in regards to cash flow. Operating cash flow has increased from $4.33B in FY 2003 to $9.69B in FY 2013 with an average annual increase of 8.4%. Capital expenditures have increased along the way from $1.35B in FY 2003 to $2.80B in FY 2013. Free cash flow has increased from $2.98B in FY 2003 to $6.89B in FY 2013. That's an average annual increase of 8.7%. I like to calculate the free cash flow after paying the dividend as well. While it hasn't grown at quite the levels of operating cash flow or free cash flow it has still increased by 6.1% on average from $1.91B in FY 2003 to $3.46B in FY 2013. Dividends are paid from cash so it's important to check the payout ratio based off free cash flow. Over the last 5 years the FCF payout ratio has averaged 56.4% which is a little bit higher than the EPS payout ratio, but is still comfortably covered. I'm more concerned that the total shareholder payout, buybacks plus dividends, has been eating up almost all of the free cash flow. While I love to see the companies I own buyback shares, I wouldn't mind a bit larger of a cushion in free cash flow after backing out the buybacks and dividends.

Return on Equity and Return on Capital Invested:

PepsiCo Inc.'s ROE has averaged a solid 32.3% over the last 10 years while their ROCI has averaged 21.8%. Its ROE and ROCI have been stuck in a downward trend though since FY 2008; both with ROE declining around 15% and ROCI declining around 12%. I was hoping to see at least flattening of the ROE and ROCI and PepsiCo was able to scrape out an increase on both fronts from FY 2012 to FY 2013. The gap in ROE and ROCI has widened recently due to a large increase in debt levels starting in FY 2010. Long-term debt has almost increased by a factor of 10 since FY 2004 ended and consequently the LT debt-to-capitalization ratio has increased from 12.5% to 50.0% at the end of FY 2013. Equity levels since FY 2004 has only increased by 80% over that time leading to a large increase in the debt-to-equity ratio. The long term debt-to-equity ratio has increased from 0.18 in FY 2004 all the way to an even 1.00 for FY 2013. Debt levels aren't at burdensome levels but I'd like to see them flatten out going forward to allow for more cushion. As debt levels increase, the overall debt service will increase leading to less cash available to reward shareholders.

Revenue and Net Income:

Since the basis of dividend growth is revenue and net income growth, we'll now look at how PepsiCo Inc. has done on that front. Their revenue growth since the end of FY 2004 has been solid with an 8.5% annual increase growing their revenue from $26.97B to $66.42B in FY 2013. Their net income growth has lagged behind by a significant margin leading to about a 30% reduction in the net income margin from 14.4% to 10.2%.

Forecast:

This chart shows the historical high and low prices since 2001 and the forecast based on the low, average, and high P/E ratios and the expected EPS values. I have also included a forecast based off a P/E ratio that is only 75% of the average low P/E ratio. I like to buy at the 75% low P/E price or lower to provide for a larger margin of safety, although this price doesn't usually come around very often. In the case of PepsiCo Inc., the target low P/E is 15.8 and the 0.75 * low P/E is 11.8. This corresponds to an entry price of $71.37 based off the expected earnings for FY 2014 of $4.52, with a 75% target price of $48.34. Currently PepsiCo is trading at a $23.28 premium to the 75% low P/E target price and a $0.79 premium to the low P/E price. If you look at the chart you'll notice that the current price line intersects the average forward P/E line around the end of 2014. That's good news for long-term investors and could mean that shares are currently trading at an average valuation as you're not paying for future growth at current prices.

Conclusion:

The average of all the valuation models gives a target entry price of $78.40 which means that PepsiCo is currently trading at a 0.5% discount to the target entry price. I've also calculated it with the highest and lowest valuation methods thrown out. In this case, the DCF and Graham Number valuations are removed and the new average is $79.66. PepsiCo is trading at a 2.1% discount to this price as well.

Assuming that PepsiCo Inc. can grow their earnings and dividends at the rates that I assumed, you're looking at average returns over the next 10 years at current prices. In 2023, EPS would be $8.30 and slapping an average P/E of 17.6 gives a price of $146.16. Over the next 10 years you'd also receive $38.97 per share in dividends for a total return of 87.4% which is good for a 9.03% annualized rate if you purchase at the current price.

According to Yahoo!Finance, the 1 year target estimate is $89.56 suggesting that the share price has about 14.8% upside over the next year. Morningstar's fair value estimate is $88.00 suggesting about 12.8% upside and has it rated as a 4 out of 5 star stock meaning it's under their fair value estimate.

PepsiCo Inc. is one of the highest quality companies out there in the consumer staples market. With a product lineup including sodas, juices, teas, sports drinks, potato chips, cereals, oatmeal and a whole list of other products, they provide plenty of options for anyone looking for food or drink. North American soda sales continue to decline much like Dr. Pepper Snapple Group and Coca-Cola. Thanks to their diversification among beverage types as well as with snack foods, the impact from declining soft drink sales is muted through growth of non-soda beverages and the various snack foods. PepsiCo has the number one ready to drink tea and coffee as well as sports drink.

PepsiCo's key markets are emerging (China, India), developing (Russia, Mexico, Brazil), and developed (U.S., U.K.). In the developed markets, PepsiCo expects revenue growth to be rather slow and the main drivers of higher profit to come from improved margins and taking market share. For the developing markets, PepsiCo expects moderate revenue growth, margin expansion, and frequency of product use to fuel higher profits. PepsiCo is willing to sacrifice margins in the short-term in the emerging markets in order to penetrate the faster growing companies with their products to establish and improve market share. Revenue growth will be the biggest driver of growth out of the emerging markets. For fiscal year 2013, PepsiCo has a solid mix of revenue sources with 48% of revenue coming from beverages and 52% from snacks. Across the geography, approximately 65% of revenue was generated from developed markets, with the remaining 35% from developing and emerging markets.

The snack food, and especially the soda business, has been under intense scrutiny in the United States with the increase in obesity among the population. I don't want to debate the merits or causes of what's led to the increase in obesity because no one factor is to blame. However, PepsiCo has started a Better-for-You and Good-for-You campaign in order to improve the healthiness of their product lineup.

From an operations/capital use standpoint I'd like to see debt levels come down or at least remain steady at current levels. The biggest question I have is why management is expecting $7B in free cash flow in 2014 but planning on allocating $8.7B between share buybacks and dividends. That would be approximately $1.7B in excess capital return than the free cash flow can support on its own. The current cash hoard is quite large over $9B so cash on hand can cover the excess and still leave plenty of cash in the coffers.

Overall I feel that PepsiCo Inc. offers real good value at current levels. Management is targeting mid-single digit organic revenue growth which will provide the earnings and cash flow for continued growth. The dividend remains well covered by both earnings and free cash flow and with a 42 year history of increased dividends is not in jeopardy. I like the diversification between beverages and snack foods as well as the geographical spread. If one area is down, others are usually up. With the plans for expansion in both developing and emerging markets, earnings are expected to grow around 7% per year for the next five years. If PepsiCo continues to buy back approximately 1% of the outstanding shares each year that will allow the dividend to grow over 8% per year and keep the payout ratio constant.

What do you think about PepsiCo Inc. as a DG investment? How do you think the long-term dividend growth prospects are?

Disclosure: I am long PEP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I may add to my position in the next 72 hours. All charts/images are sourced from my personal stock analysis spreadsheet, Morningstar, or PepsiCo, Inc.'s Investor Relations page.