Refresh Your Portfolio With Some PepsiCo Inc.

| About: PepsiCo Inc. (PEP)

Summary

Consumer staples companies, Pepsico included, typically strike a good balance between current yield and future growth.

Pepsico is a Dividend Champion with 44 consecutive years of dividend growth.

Checking in on the quality of Pepsico, the company, through the lens of its cash flow.

For many dividend growth investors, myself included, consumer staples are one of the larger sectors within their portfolio. That's for good reason too because companies that fall under the consumer staples sector typically fall within the "sweet spot" of the yield and growth balance while also providing stability to the portfolio. Consumer staples businesses typically aren't as correlated with the health of the economy as a whole which leads to lower volatility in their operations.

A behemoth in the consumer staples sector is PepsiCo, Inc. (NYSE:PEP). One of the reasons that I like the business is that not only do they have diversification within the drinks sector between carbonated soft drinks, juice, tea, coffee sports drinks and much more under their control they also have exposure to some of the best selling brands in the snacks aisle. Think Lays, Ruffles, Doritos, Fritos, Cheetos and much more. PepsiCo also owns Quaker foods giving them access to the breakfast market as well.

It's been a while since I've looked at PepsiCo for a bolt on purchase to my existing position so I wanted to check up on how the company is performing as well as the valuation of the company.

Dividend History

One of the first things I look at to identify quality companies is their dividend history. Low quality companies don't just wander their way into a decades long streak of dividend increases. Rather it takes the combination of a high quality company that can protect and grow their business and a management that is willing to reward investors with cash.

PepsiCo has paid and increased dividends for 44 consecutive years giving them the title of Dividend Champion. The following chart shows PepsiCo's dividend payout history since initiating a dividend in 1972. A full screen interactive version of this chart can be found here.

PepsiCo, Inc. (<a href='https://seekingalpha.com/symbol/PEP' title='PepsiCo Inc.'>PEP</a>) Dividend Payment History

*Image Source: Author / Data Source: PepsiCo Investor Relations

PepsiCo's dividend history is flawless. Since initiating a dividend in 1972 it has been increased every single year. It's one thing for a company to amass a lengthy streak; however, the important aspect is that the growth of the dividend is more than outpacing inflation.

A full screen interactive chart of the following table can be found here.

PepsiCo Rolling Dividend Growth Rates

*Image Source: Author

PepsiCo has amassed a lengthy streak of raising dividends and even more impressive is the rate of growth. Dividend growth from year to year has seen quite a bit of fluctuation; however, expanding the timeline out shows a smoother growth profile.

Quantitative Quality

If a company's dividend history gives me the all clear, I move on to the cash flow statement. I prefer to examine the cash flows rather than the income statement because the cash flows are cold, hard cash that moves through the company.

Pepsico (<a href='https://seekingalpha.com/symbol/PEP' title='PepsiCo Inc.'>PEP</a>) Revenue, Operating & Free Cash Flow

*Image Source: Author / Data Source: PepsiCo SEC filings

PepsiCo has had a tremendous run of growing the top line over the last decade, although recently revenue growth has struggled at least in part due to the strengthening of the US dollar. Overall, revenue has grown 6.7% annually from 2006 through 2015 climbing 79% cumulatively.

Growth of operating cash flow has surprisingly lagged behind revenue growth over the same time period. From 2006 through 2015 operating cash flow grew 74% or 6.3% per year. That's a little discouraging; however, over the last 5 years operating cash flow has continued to grow despite revenues showing slight declines.

Free cash flow growth is the real bright spot among these 3 metrics. Free cash flow has nearly doubled over the same time period improving by 95% in total. Even in the face of the currency headwinds of the last few years, free cash flow has grown 7.7% per year.

PepsiCo's operating cash flow margin has seen a slight decline over the last decade while its free cash flow margin has improved slightly.

Pepsico (<a href='https://seekingalpha.com/symbol/PEP' title='PepsiCo Inc.'>PEP</a>) Cash Flow Margins

*Image Source: Author / Data Source: PepsiCo SEC filings

Both operating and free cash flow margins have been relatively flat over the last decade. Operating cash flow margins have seen a slight decline from 17.3% in 2006 to 16.8% for 2015 and the TTM period. Free cash flow margins have expand slightly rising from 11.4% in 2006 to 12.4% during 2015.

Cash flow margins represent the amount of cash generation for every dollar of revenue that PepsiCo brings in. An alternative view of PepsiCo's profitability is to use the free cash flow return on equity and total capital invested in the business. Ideally both of these values would be above 10%.

Pepsico (<a href='https://seekingalpha.com/symbol/PEP' title='PepsiCo Inc.'>PEP</a>) Free Cash Flow Return on Equity and Capital

*Image Source: Author / Data Source: PepsiCo SEC filings

PepsiCo's free cash flow returns haven't enjoyed the same success as the free cash flow margin. Free cash flow return on equity has seen a huge increase especially in the last 2 years; however, that is fueled by a declining equity stake as opposed to the growth of free cash flow.

The free cash flow return on equity is only a useful metric in the case where the capital structure of the company is relatively static. Unfortunately that's not been the case for PepsiCo as they've been increasing their debt load over the last decade while equity has been falling. Despite free cash flow nearly doubling over the last 10 years the free cash flow return on invested capital has declined from 22% in 2006 to just 17.3% in 2015. PepsiCo's debt to capitalization ratio stood at just 15% in 2006, but had climbed to 74% for 2015.

Considering the fairly stable and consistent nature of PepsiCo's business they can afford a more aggressive capital structure; however, debt can quickly become a burden and it's something I'll be looking for in the earnings release this week.

Free cash flow is vital to any company. Unlike earnings it's cold, hard cash that is in the company's coffers. Free cash flow represents the excess cash that the company generates above and beyond the capital expenses to both defend and grow the business. In order to understand how PepsiCo uses their free cash flow I examine 3 variations of the metric.

  1. Free Cash Flow (NYSE:FCF) - The traditional calculation of operating cash flow less capital expenditures.
  2. Free Cash Flow after Dividend (FCFaD) - FCF less the total cash spent on dividend payments.
  3. Free Cash Flow after Dividend and Buybacks (FCFaDB) - FCFaD less net cash used on share buybacks.

The reason I use these 3 variations is that it gives me a glimpse into the way that PepsiCo uses its cash as well as whether they can self fund the capital allocation process. If a company generates more cash than is needed to run the business then management can move down the capital allocation chain and pay dividends, repurchase shares or build up their balance sheet. Ideally companies would still show positive FCFaDB since that means the company produces more cash than is needed throughout capital allocation chain without having to access the capital markets which leaves room for future dividend increases.

Pepsico (<a href='https://seekingalpha.com/symbol/PEP' title='PepsiCo Inc.'>PEP</a>) Free Cash Flow Variations

*Image Source: Author / Data Source: PepsiCo SEC filings

As we saw earlier PepsiCo nearly doubled free cash flow from 2006 to 2015 with increases every single year. Although the TTM period currently shows a slight decline from 2015's total. With positive free cash flow management is free to move down the capital allocation chain.

FCFaD has also been positive every year. The dividend is well covered by free cash flow with an average payout ratio around 53% over the last decade. The positive FCFaD signifies that PepsiCo has room to further increase the dividend payment as well as employ a share buyback program.

Negative FCFaDB for any given year doesn't concern me if the company is increasing buybacks to take advantage of cheap valuations of their shares. However, a consistently negative FCFaDB is something to watch out for since it can't go on forever. Management has either been using cash reserves or increasing debt in order to fund the buybacks.

PepsiCo's FCFaDB has been negative 6 of the last 10 years. Cumulatively, management has spent $4.85 B more cash than the company has generated internally. This partially explains the rise in debt levels over the last decade. Eventually that party will have to come to an end with debt currently accounting for 74% of the capital structure. Share buybacks will need to decrease to the FCFaD level or less or management will be forced to take on more debt and potentially put the company at risk.

Buy, Hold or Sell?

Being able to find and recognize quality companies is only part of the investment process. The rest comes from investing in them whenever you find the market price trading at fair value or less.

One method that I like to use to identify price targets for an investment is the minimum acceptable rate of return analysis. This requires estimating the future earnings and dividend payments for the company and applying a reasonable future valuation.

On average analysts expect PepsiCo to announce full year earnings for 2016 of $4.80, $5.16 for the current fiscal year and to grow earnings 6.5% per year through 2022. For the sake of being conservative I've assumed that earnings growth will slow to 4.5% for the following 5 years.

The annual dividend payment for fiscal year 2016 amounted to $2.96 which represents a 62% payout ratio based on the mid-point of the analyst estimates. I've assumed that PepsiCo will grow dividends at the same rate as earnings per share growth in order to maintain a 62% payout ratio. Dividends will be paid and increased at PepsiCo's historical norms.

It's said that "history doesn't repeat, but it does rhyme" and I think we can use history as a guide for what market participants will be willing to value PepsiCo at in the future. As you can see in the following chart market participants are currently valuing PepsiCo near the highest levels of the last 10 years. That's likely due to various reasons such as lower than normal valuations coming out of the financial crisis, the stability of the company and the search for yield due to the ZIRP environment of the last decade or so.

PEP Normalized PE Ratio (<a href=

PEP Normalized PE Ratio (TTM) data by YCharts

By examining the above chart a reasonable range for expected valuation would likely be in the area of 15x to 22.5x earnings. That jives with my own fair P/E ratio calculation of 20.6x using PepsiCo's growth profile and stability.

The next step in a MARR analysis involves setting up your desired rate of return. I'd be willing to accept a lower annual return for a company as large as PepsiCo with less fluctuations based on the strength of the economy. The initial MARR that I will use is 8%.

The following table shows the price targets for a purchase on February 14th using the grow assumptions from above and an 8% minimum acceptable rate of return. Returns are calculated as internal rates of return through the end of 2022 and 2027, respectively.

Pepsico 8% MARR Price Targets

*Image Source: Author

The price targets show the most that you could pay per share in order to generate an 8% internal rate of return through the end of calendar 2022 and 2027, respectively, at the varying future valuations.

At the time of writing the share price is sitting around $106. In order to generate an 8% rate of return from PepsiCo, including dividends, the current share price supports a future valuation around 20x through both 2022 and 2027, respectively. Based on historical valuations and my fair P/E ratio calculation the valuation would be at a reasonable level and PepsiCo would currently be fairly valued.

Since some investors, myself included, have varying return requirements depending on the investment I've re-run the calculations at a higher MARR of 10%. Intuitively this decreases the price targets for the same given future valuation. The revised price targets can be found in the following table.

Pepsico 10% MARR Price Targets

*Image Source: Author

By requiring a higher rate of return we're in effect building in a margin of safety for an investment in PepsiCo. In this scenario we see that the current share price around $106 would only be achieved should PepsiCo's valuation remain at elevated levels. By the end of 2022 the valuation would need to be around 22.5x and at the end of 2027 the valuation would need to be at a lofty 25x.

Conclusion

The current share price of PepsiCo is reasonable as long as your expectations are kept in check. If you expect double digit annual returns you're likely to be disappointed if you buy shares at the current level. After all "price is what you pay; value is what you get".

The fact is that PepsiCo is a behemoth in a relatively slow growing industry. Since PepsiCo currently makes up approximately 3% of my overall portfolio I'm willing to be a bit more patient before adding more shares to my portfolio. Ideally I'd like to pick up shares at a sub-$100 level. A purchase at those prices, based on the above assumptions, would provide a 10% rate of return assuming the valuation stays around the 20x level and while still providing an 8% return should the valuation contract over time to sub-20x levels.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am not a financial professional. Please consult an investment advisor and do your own due diligence prior to investing. Investing involves risks. All thoughts/ideas presented in this article are the opinions of the author and should not be taken as investment advice. In addition to owning shares in PepsiCo I am also currently short a $104 put expiring 2/24.

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