Investment Thesis
Pepsi (NASDAQ:PEP) had a wonderful 2019 as the company saw its revenue increased 3.9% year over year. The company’s elevated marketing and advertising expenses will likely be resulted in operating margin compression in the near-term, but should help drive customer brand awareness. This should help improve its revenue growth outlook in the long-term. The company has recently increased its quarterly dividend by 7%. Its dividend yield of 2.8% is towards the low end of its yield range in the past 10 years. In addition, its current forward P/E ratio is higher than its historical average. Therefore, we only project a total return of 5.2% by the end of 2021. A pullback will provide a better opportunity.
Data by YCharts
Recent Developments: Q4 2019 Highlights
Pepsi delivered a solid Q4 2019 and ended its 2019 with strong results. The company saw its revenue increased by 5.7% year over year to $20.6 billion in Q4 2019. Its 2019 revenue reached $67.2 billion (or an increase of 3.9% year over year). Growth was mostly broad-based across different platforms. As can be seen from the table below, except its Quaker Foods North America (“QFNA”), its Frito-Lay North America (“FLNA”) and PepsiCo Beverages North America (“PBNA”) saw their revenues grew by 3% and 4% respectively. Outside of North America, growth was also broad-based. As can be seen from the table, LatAm (Latin America), Europe, AMESA (Africa, Middle East and South Asia), and APAC (Asia Pacific, Australia and New Zealand and China) also grew year over year.
Source: Q4 2019 Earnings Release
Growth and Earnings Analysis
Productivity savings and investments should continue to drive gross margin expansions
Pepsi has done well in 2019 to expand its gross margin. In fact, the company’s gross margin has expanded for 5 consecutive quarters (on a year-over-year basis). As can be seen from the chart below, the company’s Q4 2019 gross margin of 54.79% was an improvement of 54 basis points from Q4 2018.
Source: Created by author
Looking forward, we think Pepsi has the potential to continue to expand its gross margin as the company continues to introduce innovative products that has higher gross margin. In addition, omnichannel capabilities (e.g. e-commerce) also helps to improve its gross margin. Pepsi has been working on cost management initiatives such as water use efficiency, and plastic content reduction. This should also help support its gross margin expansion in the long-term.
Operating margin compression due to higher marketing and advertising expenses
Pepsi saw its operating margin contracted 60 basis points year over year to 15.8% in Q4 2019. This was primarily due to advertising/marketing investments especially in several of its brands (e.g. Gatorade, Pepsi, Mountain Dew). In addition, productivity charges to harmonize business processes also dragged down its operating margin. Although these expenses have dragged its operating margin in the near-term, it should help strengthen its brand and drive future sales. Management specifically mentioned in the conference call that marketing and advertising expenses in 2020 will continue to grow, but at a slower pace. In fact, management believes that growth will likely only be slightly in excess of the rate of its sales growth.
Valuation Analysis
Pepsi estimates its 2020 EPS to be $5.88 per share. This is an increase of about 6% from 2019’s EPS of $5.53 per share. We estimate its 2021 EPS to grow by another 6%. This means that its EPS will grow to $6.23 per share in 2021. The company is currently trading at a price to 2020 EPS ratio of 22.45x. This is higher than its 5-year forward P/E ratio of about 20.85x. Given its better growth outlook than last year, we think the market may be willing to give it a higher P/E ratio than its historical average. Therefore, we will use a forward P/E ratio of 22x to calculate or price target. Using this ratio, we derive our price target of $129.36 per share by the end of 2020 and $137.06 by the end of 2021. This means a total return of only about 5.2% by the end of 2021.
A growing 2.8%-yielding dividend
Pepsi currently pays a quarterly dividend of $0.955 per share. This is equivalent to a forward dividend yield of 2.8%. In the past 10 years, its trailing 12-month dividend yield is in the range of 2.4% and 3.3%. Its current dividend yield of 2.8% is in the middle of its 10-year yield range.
Data by YCharts
Risks and Challenges
Foreign exchange risk
Pepsi’s top and bottom lines can be impacted by unfavourable foreign exchange rates as a large portion of its revenue derives from region outside of the U.S.
Inflation risk
Unlike its competitor Coca-Cola (KO), Pepsi faces higher inflation risk as the company is more exposed to raw material inflation (e.g. agricultural materials) than Coca-Cola that focuses primarily on beverages.
Investor Takeaway
We like Pepsi’s growth outlook but not its valuation right now. Investors may want to wait patiently on the sidelines.
