PepsiCo: A Top Dividend Growth Stock For Long-Term Investors

| About: PepsiCo Inc. (PEP)
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Summary

PepsiCo offers a 2.9% dividend yield, has increased its dividend for 44 straight years, and has potential to deliver mid-to-high-single digit dividend growth going forward.

Carbonated soft drinks are now less than 25% of sales, and PepsiCo's large and growing snack business is a key competitive advantage (and a differentiator compared to Coca-Cola).

PepsiCo's stock offers reasonable value for long-term dividend investors today considering its business quality. In addition to safe dividend income, the stock could deliver double-digit total returns.

PepsiCo (NYSE:PEP) is one of the best dividend growth stocks in the market and a core holding in our Top 20 Dividend Stocks portfolio.

The company has paid dividends for more than 50 years while rewarding shareholders with 44 consecutive dividend increases, making it a member of the exclusive dividend aristocrats list, which can be seen here.

Sporting an above-average dividend yield and solid long-term earnings growth potential, PepsiCo is a dividend growth machine that income investors should familiarize themselves with.

Let's take a closer look at PepsiCo's business and why it is such a special dividend stock.

Business Overview

PepsiCo incorporated in 1919 and is a leading global convenience food and beverage company with about $63 billion in revenue. Snacks account for 53% of revenue, with beverages making up the remaining 47% of sales. Carbonated soft drinks account for less than 25% of total sales.

Some of PepsiCo's most iconic brands are Lay's, Pepsi, Tropicana, Quaker Oats, Gatorade, Naked Juice, Aquafina, Lipton, Doritos, Tostitos, Mountain Dew, Ruffles, Cheetos, and Sierra Mist. Twenty two of PepsiCo's brands generate over $1 billion in annual sales.

By geography, 69% of revenue is derived from developed markets (U.S. 56%), while developing and emerging markets account for the other 31% of sales. PepsiCo is a very global business with operations in more than 200 countries. The company should benefit from growing consumer wealth and consumption around the world.

Business Analysis

PepsiCo's primary competitive advantages are its large scale, balanced product portfolio, extensive distribution network, and well-known brands.

PepsiCo has the largest food and beverage market share in four of its five top markets. Importantly, the company has also been the biggest contributor to retail sales growth in those markets over the last five years, underscoring the importance of its products for retailers.

Source: PepsiCo Investor Presentation

PepsiCo is a critical partner for retailers because its products drive them the most traffic and profit growth of any food supplier. PepsiCo's dual portfolio of snacks and beverages further strengthen its retailer relationships because over half of consumers who buy salty snacks buy liquid refreshment beverages in the same basket, according to IRI. Selling both types of products allows customers to have one point of contact, creating efficiencies.

The company's breadth and depth of retailer relationships, coupled with its powerful brands, makes it practically impossible to be replaced by smaller rivals. As a matter of fact, PepsiCo is about twice the size of the next largest supplier in food and beverage.

PepsiCo's large scale allows it to enjoy economies of scale and invest aggressively in innovation and marketing to stay in touch with consumers' evolving preferences. For example, PepsiCo spent nearly $4 billion on advertising and marketing in 2015 and poured over $700 million into research and development. These investments help it continue to maintain and grow its iconic product lines such as Gatorade, which has been around for more than 50 years.

The amount of brand equity PepsiCo has built up with consumers is nearly impossible to measure, but is extremely valuable. However, it doesn't show up on the company's balance sheet because it is an intangible asset (marketing costs are expensed each year, although they have arguably built a major asset for PepsiCo).

This is one of the reasons why Warren Buffett is invested heavily in consumer staples in his dividend portfolio (click here to see a full analysis of Buffett's dividend portfolio).

PepsiCo, like many other consumer staples, also benefits because its products are in slow-moving industries that enjoy recurring consumer demand, resulting in stable earnings and market share. If a new consumer trend emerges, PepsiCo has the firepower and distribution to develop relevant products itself or acquire new brands that could compete for market.

Even if PepsiCo is a little late to adapt to a new consumer preference, its diversified portfolio and focus on huge markets help mitigate this risk.

For example, the snack market is over $100 billion in the U.S. alone, and PepsiCo only plays in about 15% of that category. The category is growing nicely (projected 5% global growth) as people are snacking more on-the-go with their busy lifestyles (over 40% of food and beverages are purchased outside the home today versus 26% in 1970, according to PepsiCo).

Stepping back, the global foodservice market is roughly $700 billion in size, giving PepsiCo less than a 10% market share. Demand for beverages and snacks is growing at a mid-single digit pace, creating many opportunities for profitable expansion.

Despite numerous opportunities for top line growth, the company is focused on improving its cost structure as well.

PepsiCo targets $1 billion in annual productivity savings through 2019, representing close to 2% of its total global costs. Savings will be made possible by leveraging more global functions and capabilities, using more automation technology, and consolidating global spending.

Continuous productivity initiatives help PepsiCo generate higher margins, grow free cash flow, and increase its return on capital, making it all the more valuable for shareholders. The company has so far delivered on its cost targets, saving $1 billion since kicking off its first program in 2012. Operating margins have increased 195 basis points over the past three years, too.

Overall, PepsiCo has strong competitive advantages, thanks to its balanced portfolio of snacks and beverages, many years of powerful branding investments, critical importance to retailers, and focus on meeting consumers' evolving preferences.

Key Risks

The healthy living trend is usually the biggest risk that comes to mind when investors think about PepsiCo's business. Consumers are becoming more mindful of what they are putting in their bodies each day, and government regulations such as California's soda tax seem to be gaining momentum, potentially serving as a catalyst.

Carbonated soda is arguably the category that is under the most pressure. Fortunately for PepsiCo, however, this category accounts for less than a quarter of the company's total sales. This is not the case for Coca-Cola KO.

By changing product packaging, pricing, and promotion (the three Ps of marketing), I expect carbonated beverages will remain a cash cow for now, albeit with little-to-no growth.

PepsiCo and other snack and beverage giants are doing their best to adopt their products to changing consumer preferences. From introducing new health and wellness brands to investing in more research and development ($754 million last year) to take out sugar, fat, and salt, meaningful efforts are underway.

As PepsiCo's business mix continues evolving, the risk posed from soda should continue declining. PepsiCo has seen especially strong growth in its teas, coffees, sports drinks, and water portfolio.

Currency exchange rates are another risk given PepsiCo's high mix of international business. The dollar has been strong this year, weighing on PepsiCo's reported results. However, I don't expect this factor to impact PepsiCo's long-term earnings potential.

Otherwise, given PepsiCo's balanced portfolio and global presence, it's hard to identify many risks that could really harm the business. Perhaps the biggest challenge facing management is the task of continuing to deliver solid earnings growth for a company as big as PepsiCo.

Dividend Analysis: PepsiCo

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

Our Dividend Safety Score answers the question, "Is the current dividend payment safe?" We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

PepsiCo's Dividend Safety Score of 99 indicates that the company's dividend payment is one of the safest in the entire market. PepsiCo's excellent dividend safety begins with the company's payout ratio.

PepsiCo's dividend has consumed just 56% of its free cash flow over the last four quarters. This is about in line with the company's historical payout ratios, which have remained between 40% and 60% for more than a decade. Such stability is usually the sign of a steady business with reliable earnings and dividends, and PepsiCo is no exception.

PepsiCo PEP Dividend Stock

Source: Simply Safe Dividends

Speaking of business stability, another factor helping PepsiCo's strong Dividend Safety Score is its performance during the last recession. PepsiCo's sales were roughly flat in 2009, and the company's free cash flow per share managed to grow each year.

Consumers keep buying the company's products even when times are tough. PepsiCo's stock also outperformed the S&P 500 by 11% in 2008, highlighting its defensive qualities.

PepsiCo PEP Dividend Aristocrat

Source: Simply Safe Dividends

Free cash flow generation is another important factor that impacts dividend safety. Without positive free cash flow, a business is not able to sustainably pay dividends without depending on capital markets to issue debt and equity.

My favorite dividend stocks reliably generate positive, growing free cash flow each year. PepsiCo certainly checks that box. Its free cash flow per share has steadily climbed from $2.46 in 2005 to $5.33 in 2015, more than doubling. PepsiCo's economies of scale and powerful brands make it a cash flow machine, fueling safe and steady dividend growth.

PepsiCo PEP Dividend Stock

Source: Simply Safe Dividends

A company's balance sheet is another very important factor impacting a dividend's safety because companies will always meet their debt obligations before paying dividends.

Fortunately, PepsiCo has a great balance sheet with nearly $15 billion in cash compared to $29 billion in debt. The company could cover its total debt using cash on hand and just 1.5 years' worth of earnings before interest and taxes (EBIT).

Not surprisingly, PepsiCo maintains an "A" credit rating from Standard & Poor's. The company has plenty of flexibility to continue paying dividends, reinvesting for growth, and acquiring new brands.

Source: Simply Safe Dividends

Overall, PepsiCo's dividend is extremely safe. The company has a healthy payout ratio, generates consistent free cash flow, performs well during recessions, and maintains a strong balance sheet.

Dividend Growth Score

Our Growth Score answers the question, "How fast is the dividend likely to grow?" It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

PepsiCo's Dividend Growth Score is 71, which indicates that the company's dividend growth potential is above average.

PepsiCo has increased its dividend for 44 consecutive years and last raised its dividend by 7.1% in July 2016. The company has paid uninterrupted dividends since 1965 and is a member of the dividend aristocrats list.

As seen below, PepsiCo has consistently delivered annual dividend growth in the high-single to low-double digits.

PepsiCo PEP Dividend Stock

Source: Simply Safe Dividends

PepsiCo's future dividend growth will likely remain between 6% and 9% annually. Solid future dividend growth is supported by the company's healthy payout ratio (56% of free cash flow) and outlook for high-single digit earnings growth.

Valuation

PepsiCo's shares trade at a forward-looking P/E ratio of 19.8 and offer a dividend yield of 2.9%, which is slightly higher than the stock's five-year average dividend yield of 2.8%.

PepsiCo targets mid-single digit organic revenue growth and core, constant currency earnings per share growth in the high-single digits. I believe these targets are achievable given its track record, the underlying growth rates of its large markets, and its moderate global market share.

Under these assumptions, PepsiCo's stock appears to have potential to deliver annual total returns of 9-12% (2.9% dividend yield plus 6-9% annual earnings growth). The stock's current multiple (19.8) isn't a bargain, but it appears reasonable to me considering PepsiCo's excellent stability, great business quality, and opportunities for long-term growth.

Conclusion

Unlike many large cap consumer staples companies, PepsiCo's outlook for long-term earnings growth is quite positive. While the consumer health trend should continue being watched, PepsiCo's diversified snack and beverages portfolio, more limited exposure to soda, investments in innovation, and exposure to international markets help mitigate these concerns.

While the stock doesn't appear to be cheap today, I think it offers reasonable value for long-term investors building a high quality dividend growth portfolio.

Disclosure: I am/we are long PEP.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.