Refresh Your Portfolio With Some PepsiCo Inc.

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. (NASDAQ: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.

*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.

*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.

*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.

*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%.

*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 (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.

*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 (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.

*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.

*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.

Analyst’s 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.

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.

Comments

[Awayk]

PIP - I agree with your analysis and buy-points. I picked up some PEP (1/4 position) when it dipped below $100 recently. Also bought MDLZ (1/4) and SJM (1/2) and added to HRL (now ~4/5) all for what I think are decent values. Some quick cap gains are nice but the real value in paying attention to valuation is more shares, better yield and let it compound away! MKC still eludes me but if it heads back near $90 I'll buy some because of the slow and steady growth. Thanks for all your work.

[Pursuit 2 Freedom]

I really like how you perform this analysis. I'm also interested in the MARR analysis. Can you tell me where I can find more details about how to calculate this exactly? I understand the big picture, but details would be nice.

About PEP, I think it's to expensive for me right now. Also, I'm in doubt if it would fit my goals. I still have 25 years to go to retirement and I'm only just beginning to build up my portfolio. PEP could function as a defensive stock, but the valuation would have to be better I think. I do like the company for it's diversity and consistent growth.

[Vlae Kershner]

If you buy Pepsi now and reinvest dividends, you can almost guarantee being happy you did in 25 years. It's so stable as to be almost the ultimate get-rich-slow stock.

[cheesepep]

I won't buy in at these prices. As much as I like PEP, I'm going to be buying more KO at these prices.

[Passive Income Pursuit]

cheesepep,

It's definitely not a discount to fair value, but I personally see PEP's share price pretty close to the middle of the fair value range. If you're itching to get some capital to work in a high quality business then PEP is okay, but I don't blame you for wanting a better value which I think KO is offering at this time too although I do see more headwinds fro them than PEP. But that's my own take on it.

[CeGe]

I've owned Pep since 1983. It's done very well and has weathered many market scenarios. I'm still investing in it because eventually, that split is coming; and for me it will be the mother-load. Everyone has their opinion, but I'm here to tell the tale - lol. Go long and you can't go wrong.

[Passive Income Pursuit]

CeGe,

I'm sure you're looking at some excellent returns now on PEP. Unfortunately my position only dates back a few years but eventually it'll get up to 10 and then 20...

[Bear84]

As I've stated before owning PEP has been a license to print money . Since last year when we hit 100 I've been hoping for a 3/1 or a 4/1 split because now new investors need in excess of $10,000 to buy 100 shares . Think of all the new fellow shareholders who would be able to increase our value as we go from 700 shares to 2100 or 2800 shares . The last time we had a 3/1 split the stock moved upward as many more new investors helped PEP go up,up,up .

[Passive Income Pursuit]

Bear84,

Personally I don't want to see a stock split if only for the fact that if the the share price opens up more investors and it pushes the valuation higher I won't be able to buy shares on the cheap.

[Bear84]

Let me explain ; example ; if the stock was 99 and a 3/1 split reset the price at 33 , people who couldn't afford $99 could buy in at $33 .
these new buyers would push the stock up . let us say the stock went
to $38. The $5/share would be $15/share for those who owned before the the split. If you owned 500 shares you now owned 1500 shares and the math is on your side .

[bigjuicy]

long PEP but would still like to see some effort to lower debt with interest rate hikes on the horizon

[Passive Income Pursuit]

bigjuicy,

As renanulrich mentioned the net debt/cash position hasn't really changed much at least over the last 5 years. See my previous reply for the numbers. So it's not quite as bad as it seems on the surface but I agree I'd like to see the debt load start moving lower.

[DiscoBlair]

Todd,they are doing very well with flavored waters...of all things & then you have those fabulous salty snacks. Long PEP, but hoping to buy more @ around $100.00.

[Passive Income Pursuit]

DiscoBlair,

I'd love to the see the $100 mark although I'll likely sell puts to collect enough premium and hopefully then have shares put to me.

[HolmesDepot]

This is really a solid piece of analysis. I can't pick apart the author's observations on the details. My only concern is whether any company which is heavily into sugary drinks is a growth area any longer. Yes, yes, I know there are many diet versions available but many people are avoiding them too going for the "all natural" stuff. That is my sole preoccupation when considering PEP which otherwise is an exceptional company. I use their products minus the sodas. I think many people are increasingly thinking that way also.

[Vlae Kershner]

They should change their name to Frito-Pepsico so people won't associate them first with soda anymore.

[Passive Income Pursuit]

Todd68,

Thanks for the compliment and glad you enjoyed the analysis.

One of the reasons I like PEP to KO is because of their diversification to snacks as well as drinks. That's a big plus in my book to help combat the sugar fight.

[User 286]

Thanks for a good article on PEP. I've owned PEP for about 2 1/2 to 3 years, and other than the dividend, it's been pretty flat. I will continue to hold another year or two to see if it can pick up a head of steam. I like the CEO, balance sheet, strategy and vision, diversified product portfolio and the dividend. But I can't sit in limbo forever.

[TMWSIY]

February 10, 2014 the price was 78.09. That's almost a 25% gain.

[Passive Income Pursuit]

User 286,

Personally I'm not concerned about that. If anything you should be happy the share price has just kind of sat here recently because it gives an opportunity for business fundamentals to improve, decrease the valuation and then spring the returns forward when PEP comes back in favor.

PEP is one of the largest consumer staples in the world with great product diversification. So I would need to be pretty hard pressed to give up my shares just because the share price has been flat. Several years back JNJ's share price went no where for about 2 years staying in the $50-60 range, then the market got back on JNJ and it was revalued up to $90 really quick. So just focus on the fundamentals and as long as they are still good then stick with the investment. That's my $0.02.

[Ron Burgundy’s Hair]

Fed bias is to raise rates & strengthening dollar.

Avoid consumer staples & beverage stocks.

[brasscop]

"Avoid consumer staples & beverage stocks."

I don't agree with blanket avoidance of a class of equities. It's a "market of stocks.." etc. For those with a medium to long-term horizon, there will be convincing opportunities to buy all classes of so-called interest sensitive issues including REITS and utilities. As always, individual investor needs and goals trump generalized, pan-market nostrums.

[Passive Income Pursuit]

Boomer#12,

A dollar that continues to strengthen is definitely a concern for the multinationals especially if they don't have adequate cash flow generation. The problem is that I have no idea if the dollar will continue to strengthen, stay here, or weaken. Everyone was piling on the bullish dollar trade at the end of 2016 and the USD had it's weakest January ever. Also the Fed was supposed to give 4 rate hikes in 2016 and we got one. So we'll see if we get the 3 they say they'll do in 2017.

All that is to say that I'm not concerned about the dollar fluctuations rather I try to focus on business fundamentals and PEP is still going strong on that front. Growth might be kind of blah while the dollar is strong/strengthening but whenever it does start to weaken those multinationals will get a tailwind in reported numbers.

[Passive Income Pursuit]

brasscop,

I have to agree with you on that one. Sectors fall in and out of favor so as an individual investor you just have to be ready to scoop up the deals du jour.

[renanulrich]

Thanks for the review,
But instead of looking only for the debt, look also for the cash position accumulating in the company. Net debt was fairly constant in nominal terms in the last few years, different from what happened to KO... Long PEP

[Passive Income Pursuit]

renanulrich,

I do track that in my spreadsheet, but I rarely report on it because the articles are already quite long. PEP's net debt position has been fairly consistent despite the increase in debt (-$16.1 B in 2011 -$17.2 B in 2015). LTD to cash/STI is improving to 4.6 in 2011 and 2.4 for 2015. So the rising debt isn't a big burden, but if does make the FCF ROE essentially a useless metric with the capital structure changing. For consumer staples I'm okay with a more aggressive capital structure but my preference is always for a more conservative one. Also it's important to see why the company is increasing debt to make sure it's necessary and can lead to better future growth.

Thanks for the comment.