PepsiCo's Premium Is Too Frothy

Summary

• PepsiCo reported a strong Q4 2019 and recently acquired Be & Cheery.
• The firm has a strong portfolio of billion-dollar brands and an excellent dividend record.
• It is currently overvalued.

PepsiCo's (NASDAQ:PEP) underlying business remains excellent, but nonetheless, this top-tier food snacks and beverage stock is one that I believe is currently trading at a premium to fair value.

Some bulls would argue that a company of PepsiCo's quality should trade at a premium and would cite the recent earnings report, released on 02/13/2020, as evidence for why it should. Non-GAAP earnings per share of $1.45 were in line with estimates, while GAAP EPS missed estimates by $0.13. Revenues of $20.64 billion beat estimates by $400 million. Overall, Mr. Market was bullish enough about these figures, as shares rose 0.63% in the 02/13/2020 pre-market.

Bulls can also point to the growth prospects that PepsiCo can look forward to as a result of its announced acquisition of Be & Cheery. The snack brand is being acquired from its owner, Haoxiangni Health Food, for $705 million. On the benefits that PepsiCo will derive from the acquisition, PepsiCo Greater China CEO Ram Krishnan stated:

Be & Cheery adds direct-to-consumer capability, positioning us to capitalize on continued growth in e-commerce, and a local brand that is able to stretch across a broad portfolio of products, through both online and offline channels...We also expect to leverage Be & Cheery's innovation and consumer insights capabilities to drive innovation in other key PepsiCo growth markets.

All told, the acquisition provides PepsiCo with access to the large Chinese consumer market which, despite present concerns connected to the ongoing coronavirus epidemic, remains a lucrative one long term. PepsiCo has effectively ensured that they will be able to continue generating strong revenue and net income, as they have over the past five years.

Year	Revenue ($)	Net Income ($)
2015	63.05 billion	5.45 billion
2016	62.8 billion	6.33 billion
2017	63.53 billion	4.86 billion
2018	64.66 billion	12.52 billion
2019	67.16 billion	7.31 billion

Click to enlarge

Figures collated from annual reports and SEC filings available on PepsiCo's investor relations page.

This profitability, exemplified by the 15.32% operating margin, accounts for PepsiCo's attractiveness as a prospective investment. The basis for that profitability is PepsiCo's large portfolio of branded food snacks and beverages. Household names such as Frito-Lay, Gatorade, Mountain Dew, Naked, Pure Leaf, Quaker, Sabra, and the Pepsi brand itself all contribute to PepsiCo's bottom line. In total, PepsiCo holds twenty-two brands worth $1 billion each.

PepsiCo's vast food snack and beverage portfolio holds twenty-two brands worth $1 billion each. Image provided by Packaging Digest.

This business model continues to serve PepsiCo's current shareholders well, as evidenced by a 49.92% return on equity (trailing twelve months). Further evidence of how shareholders have benefited from having PepsiCo in their portfolio is the dividend record: PepsiCo has rewarded shareholders with consecutively rising dividends for 47 years, a record that makes it a member of the S&P 500 Dividend Aristocrats index (NOBL). Furthermore, if PepsiCo sustains this record for three more years, it will become a rare Dividend King, which is likely, given the 64.70% payout ratio and free cash flow of $2.31 billion reported for Q4 2019.

That being said, PepsiCo's balance sheet is not as pristine as its dividend record, with long-term debt of $30.27 billion being more than double the firm's net worth of $14.87 billion, and an increase on the previous year's long-term debt figure of $28.3 billion. Short-term finances look better, with total current liabilities of $20.46 billion being offset by total current assets of $17.59 billion, cash on hand worth $5.51 billion, short-term investments worth $230 million, and total accounts receivable of $7.82 billion. Overall, though, Pepsi's strong revenue and net income figures should ensure that the dividend streak will be maintained, and the firm should have no issues covering its liabilities.

Growth is not expected to be rapid for PepsiCo going forward, even with the Be & Cheery acquisition. Earnings per share growth over the next five years projected to be 6.32%, unsurprisingly for a large-cap firm that is already established in most global markets, and also unsurprising considering the debt load. Consequently, while current shareholders will benefit by continuing to hold PepsiCo, prospective investors will require a price closer to fair value lest their total returns suffer. And PepsiCo's current valuation does not inspire confidence that they will get that right now.

Currently, PepsiCo trades in the high-$130 range. Chart generated by FinViz.

At close of market on 03/05/2020, PepsiCo was trading at a share price of $138.10 with a price-to-earnings ratio of 26.59, as earnings per share (trailing twelve months) are $5.19. It also offers a dividend yield of 2.77%. The current P/E is higher than the five-year average P/E of 24.73, and the current dividend yield is lower than the five-year average dividend yield of 2.83%.

The current P/E is also higher than the beverage and tobacco manufacturing sub-sector average of 22.82 and the S&P 500 (SPY) average of 22.41. PepsiCo's price-to-book ratio is also at a premium to the sub-sector average, though its price-to-cash flow ratio is on par with its sub-sector and its price-to-sales ratio is at a discount to its sub-sector. By every metric, however, PepsiCo trades at a premium to the index.

Metric	PepsiCo	Sub-Sector	Index
P/E	26.59	22.82	22.41
P/CF	19.66	20.46	14.07
P/B	12.83	9.43	3.27
P/S	2.82	4.28	2.30

Click to enlarge

Figures collated from Morningstar and TheStreet.

On balance, it appears that PepsiCo is trading at a premium to fair value, raising the question of what fair value for PepsiCo is. In determining fair value, I will first divide the current P/E by the historical market average of 15 to get a valuation ratio of 1.77 (26.59/15 = 1.77) and divide the current share price by this valuation ratio to get a first estimate for fair value of $78.02 (138.10/1.77 = 78.02). Then, I will divide the current P/E by the five-year average P/E to get a valuation ratio of (26.59/24.73 = 1.08) and divide the current share price by this valuation ratio to get a second estimate for fair value of $127.87 (138.10/1.08 = 127.87).

Next, I will divide the five-year average dividend yield by the current dividend yield to get a valuation ratio of 1.02 (2.83/2.77 = 1.02) and divide the current share price by this valuation ratio to get a third estimate for fair value of $135.39 (138.10/1.02 = 135.39). Finally, I will average out these three estimates to get a final estimate for fair value of $113.76 (78.02 + 127.87 + 135.39 3 = 113.76). On the basis of this estimate, the stock is overvalued at present by 21%.

PepsiCo is an excellent business that will continue to serve current shareholders well with its progressive dividend, its Be & Cheery acquisition and its portfolio of billion dollar brands. However, its low growth prospects require an entry point close to fair value for prospective investors, and that is not on offer right now. Consequently, at this time, PepsiCo is a hold, but not a buy.

Analyst’s Disclosure: I/we 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.