Pepsi: More Downside Than Upside Potential And Slowing Dividend Growth

| About: PepsiCo Inc. (PEP)
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Firms that are undervalued on both a DCF and on a relative valuation basis, and are showing improvement in timeliness indicators score highly on the Valuentum Buying Index.

Pepsi is a global food/beverage company with a plethora of respected brands. We're huge fans of its business quality, but shares speak of more downside than upside potential at present.

We're not calling for a dividend cut at Pepsi, but its Valuentum Dividend Cushion score doesn't leave much room for future growth in the dividend.

As part of the Valuentum process, we perform a discounted cash flow (DCF) valuation, a relative valuation versus industry peers, as well as an assessment of technical and momentum indicators for each firm in our coverage universe. For example, firms that are undervalued on both a DCF and on a relative valuation basis, and are also showing improvement in technical and momentum indicators score highly on our scale. We think this approach, which we call the Valuentum Buying Index, represents the best way to identify the most attractive stocks at the best time to buy. Take a quick view of this video (click here) on how we think about equity investing, and then come back to see how PepsiCo (NYSE:PEP) stacks up on our process in this article.

Great, you're back. Now before we get started, and in the spirit of transparency, we wanted to show you how the Best Ideas Newsletter portfolio, our flagship product, has performed since inception, applying the Valuentum Buying Index rating system. We think it is important to understand how we use the Valuentum process. Not all highly-ranked firms are added to the portfolio, and not all firms that score poorly are entered. As with any portfolio, the management team has the final say on which firms enter and exit the portfolio. One wouldn't expect a value investor to own every single undervalued stock on the market, for example. We only add the cream of the crop of ideas to the portfolio.

Let's now dig in. PepsiCo posts a VBI score of 5 on the Valuentum Buying Index, reflecting our "fairly valued" DCF assessment of the firm, its neutral relative valuation versus peers, and neutral technicals. For a relative value comparison, we use non-alcoholic beverage peers Coca-Cola (NYSE:KO), Dr. Pepper Snapple (NYSE:DPS), and Monster Beverage (NASDAQ:MNST), though we note that any relative valuation assessment is imperfect. However, many investors make decisions about a company's attractiveness on the basis of its price-to-earnings ratio relative to its own history, its peers/competitors, or to a market median/average. Therefore, a good relative value assessment cannot be ignored within the context of the Valuentum process, even if a robust intrinsic value-derived fair value estimate forms the backbone of the methodology.

Our Report on PepsiCo

Investment Considerations

Investment Highlights

  • PepsiCo's business quality (an evaluation of our ValueCreation™ and ValueRisk™ ratings) ranks among the best of the firms in our coverage universe. The firm has been generating economic value for shareholders with relatively stable operating results for the past few years, a combination we view very positively.
  • Pepsi is a global food/beverage company with a plethora of respected brands. Its portfolio includes the namesake Pepsi, Mountain Dew, Gatorade, Lay's, Doritos, Cheetos, Tostitos, Ruffles, Quaker oatmeal, Aunt Jemima, among others.
  • PepsiCo has a good combination of strong free cash flow generation and manageable financial leverage. We expect the firm's free cash flow margin to average about 11.2% in coming years. Total debt-to-EBITDA was 2.4 last year, while debt-to-book capitalization stood at 56%.
  • Though we're huge fans of Pepsi's brand portfolio, competition remains fierce. Coca-Cola is its primary beverage competitor, while food and beverage rivals include Nestlé, Danone, Kellogg, General Mills, and Mondelēz.
  • We're not calling for a dividend cut at Pepsi, but its Valuentum Dividend Cushion score doesn't leave much room for future growth in the dividend. What is the Valuentum Dividend Cushion? Click here.

Business Quality

Economic Profit Analysis

The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. PepsiCo's 3-year historical return on invested capital (without goodwill) is 20.1%, which is above the estimate of its cost of capital of 9.1%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

Cash Flow Analysis

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. PepsiCo's free cash flow margin has averaged about 8.7% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures, and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at At PepsiCo, cash flow from operations increased about 0% from levels registered two years ago, while capital expenditures fell about 17% over the same time period.

Valuation Analysis

Our discounted cash flow model indicates that PepsiCo's shares are worth between $58.00-$88.00 each. Clearly, this range speaks of more downside than upside at current prices. The margin of safety around our fair value estimate is driven by the firm's LOW ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $73 per share represents a price-to-earnings (P/E) ratio of about 18.6 times last year's earnings and an implied EV/EBITDA multiple of about 11.7 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 3.1% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 14.8%. Our model reflects a 5-year projected average operating margin of 15.9%, which is above PepsiCo's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.9% for the next 15 years and 3% in perpetuity. For PepsiCo, we use a 9.1% weighted average cost of capital to discount future free cash flows.

Margin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $73 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets, as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety, or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for PepsiCo. We think the firm is attractive below $58 per share (the green line), but quite expensive above $88 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

We estimate PepsiCo's fair value at this point in time to be about $73 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of PepsiCo's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $89 per share in Year 3 represents our existing fair value per share of $73 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

Pro Forma Financial Statements

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.