PepsiCo: Strong Earnings, But What's The Big Picture?

Summary

• In an investing world that has been ravaged by ongoing conflicts, wrecked supply chains, rising inflation, and upcoming rate hikes, PepsiCo presents itself as a formidable candidate to weather the storm.
• The company came out swinging for its Q1 earnings, beating Wall Street estimates across the board. However, is this truly the case moving forward?
• The dividend growth story might be coming to an end with the payout ratios seemingly hitting all-time highs.
• Valuations have caught up with an otherwise brilliant business as the company's ability to produce more meaningful shareholder value over the course of the next several years comes under question.

AaronAmat/iStock via Getty Images

PepsiCo (NASDAQ:PEP) is an endurable, well-structured, strong moat, free cash flow dividend-oriented machine that's grown to be a long-time investor favorite, especially so among dividend growth investors. The snack and beverage giant has been successful in generating extraordinary shareholder returns over the course of the last decade, generating a total return of 211% accompanied by a 7.84% dividend CAGR for the same period.

In an investing world that has been ravaged by ongoing conflicts, wrecked supply chains, rising inflation, and upcoming interest rate hikes, PepsiCo presents itself as a respectable candidate to weather the ongoing storm. The company came out swinging as it proved the thesis after it successfully weathers inflation and beat Q1 2022 earnings expectations.

The company came out swinging and proved that the thesis is solid after it topped its Q1 2022 earnings expectations today. Still, all of the excellence comes at a hefty price as the pricey valuations have begun to weigh themselves heavily on the future prospects of the company and could spell serious trouble for investors in the years to come.

Negative macroeconomic environment

Broader markets have been in turmoil for the better part of the last three quarters. The Russian invasion of Ukraine has only served to further frighten investors who were already deeply concerned over rising inflation and the announced rate hikes. Many investors are pulling their money out of stocks and moving into safer havens, including bonds, gold, silver, or simply the U.S. dollar.

First, inflation has been ruled as no longer "only transitory" and has become a reality that consumers and companies have to face alike. In fact, the last year has seen the worst consumer price rises in the last 40 years. Secondly, Russia invaded Ukraine on the 24th of February, marking the beginning of the largest conflict in Europe since the Second World War. In response to the invasion, the United States and the European Union have issued unprecedented and never-before-seen sanctions targeting the Russian economy. The sanctions have caused wrecked supply chains and have seen billions of equities simply erased from the markets. Thirdly, reports of historic inflation coming in sparked wide-range speculation predictions that the U.S. Federal Reserve will hike interest rates aggressively this year.

Annual Inflation Rate (TradingEconomics)

Strong Q1 Results Outline Strengths

As a result of the ongoing chaos, the market is down by more than 10.4% year to date. However, PepsiCo does present itself as a reasonable enough candidate to endure the ongoing chaos, at least on the face of things. The nature of the cash flow-oriented, moat-deep, and manageable debt business sees investor returns almost guaranteed with attractive dividends and strong share buy-back programs. PepsiCo has already proven itself quite resilient to the negative macroeconomic environment with the latest earnings report. However, is this truly the case moving forward?

For the first quarter, we delivered strong results which reflect our presence in growing, global categories and the investments we have made towards becoming an even Faster, even Stronger, and even Better company with PepsiCo Positive at the center of everything we do. Given the strength and resilience of our businesses to date, while reflecting higher than expected input cost inflation for the balance of 2022, we now expect our full-year organic revenue to increase 8 percent (previously 6 percent) and we continue to expect core constant currency earnings per share to increase 8 percent. Looking ahead, we will focus on controlling what we can, such as enhancing our focus on productivity and sharpening our revenue management capabilities, while also continuing to make the necessary long-term investments to fortify our businesses and win in the marketplace.

Ramon Laguarta, CEO - Q1 Earnings Release

Q1 2022 Financial Performance (Q1 Earnings Release)

The company came out swinging for its Q1 results with PepsiCo beating Wall Street estimates across the board. They posted core earnings of $1.29 a share, beating estimates of $1.23 a share, while revenue rose more than 9% to $16.2 billion, higher than forecasts for $15.5 billion. Over the last four quarters, the company has surpassed consensus EPS estimates three times.

Pepsi announced first quarter net income attributable to the company of $4.26 billion, or $3.06 per share, up from $1.71 billion, or $1.24 per share, a year earlier. An interesting point was the way the Russia Exit has been reflected in the company reporting. The food and beverage giant reported a $193 million impairment charge as it tries to discontinue or reposition some of its juice and dairy brands in Russia. The charge dragged down its earnings by 14 cents per share. An additional impairment charge of $241 million after taxes related to the Russia-Ukraine conflict weighed on its earnings by 17 cents per share.

The company also reported strong guidance for 2022, once again emphasizing the strength and defensive nature of the company:

• An 8 percent increase in core constant currency EPS;
• A core annual effective tax rate of 20 percent;
• Total cash returns to shareholders of approximately $7.7 billion, comprised of dividends of $6.2 billion and share repurchases of $1.5 billion.

Fortress Balance Sheet

PepsiCo operates as a global food and beverage giant. The company was founded in 1898 and is headquartered in Purchase, New York. PepsiCo's business encompasses all aspects of the food and beverage market. It oversees the manufacturing, distribution, and marketing of its products.

Geographic Mix (CAGNY 2021 Investor Presentation)

Some of the more famous brands the company owns include Pepsi, Cheetos, Doritos, Lay’s, Fritos, Gatorade, Mountain Dew, 7up, Miranda, Tropicana, and many others. The complete brand line is estimated to be worth more than $23 billion.

PepsiCo Brand Portfolio Overview (CAGNY 2021 Investor Presentation)

As per the latest quarterly filing, we can see that the company is carrying some hefty but still manageable debt. As it stands, PepsiCo has $40.04 billion of total debt and $33.48 billion in net debt. The company is also facing $25.82 billion in current liabilities and almost $78 billion in total long-term liabilities. Even though the debt looks slightly unattractive on paper, the reality is that the company's financials are sound and that it should not represent a significant issue down the road.

The estimated net debt/EBITDA ratio of x2.15 for 2022 seems to indicate that debt should be more than manageable. Even with the expected rise in the cost of debt and cost in the maintenance of debt, the current interest expense of $1.79 billion and x8.88 EBITDA interest coverage seems to solidify the point.

PepsiCo Debt (TIKR Terminal)

The company's main focus on generating shareholder value was more oriented toward its dividend program. Still, the company has been also operating a generous share buyback program for years. Management was successful in generating significant shareholder value by buying back almost 13% of the shares outstanding of the company since 2010.

The intensity of the share repurchase program has slowed down over the course of the past couple of years, partially due to the premium PepsiCo started to command. More meaningful buyback programs seem to have been put to the side. PepsiCo management has extended the next year's repurchase program but limited it to $1.5 billion. Even if commendable, the buyback will prove ultimately insignificant against the 238.13 billion market cap.

Shares Outstanding (TIKR)

PepsiCo shares today can be acquired for $173.59 per share, which is resulting in a relatively modest 2.54% dividend yield. As stated previously, the company has been a long-time favorite among income investors, especially dividend-growth investors as the company managed to generate an attractive 8% dividend CAGR over the course of the last decade.

The company is still pushing the dividend growth story. As we recall, the company announced a 7% increase in the annualized dividend back on Feb. 10, 2022, increasing the annualized dividend to $4.60 per share from $4.30 per share. This means that the company is currently committed to paying out $6.2 billion in dividends yearly.

Dividend Growth (TIKR)

PepsiCo does have a formidable history of growing its dividends. They went all the way from paying out a quarterly $0.45 back in 2010 to paying out $1.15 per quarter today. The dividends have effectively more than doubled over the course of the last 10 years. However, we might argue that the dividend growth story might be coming to an end. Clearly negative tendencies can be witnessed when taking a look at the growing payout ratio, making it clear that the company will be hitting the top in terms of fundamentals in the upcoming years.

Payout Ratio (TIKR Terminal)

Here's where I arrive at a major concern with PepsiCo. Even if the company is finding itself in a brilliant position to handle inflation and push price hikes down to the consumers, I find that the dividend is unlikely going to grow significantly over the next couple of years. The relatively modest dividend yield accompanied by rising interest rates and subsequent rising treasury yields makes me doubt that the company has much future upside potential.

10y Treasury Note (CNBC)

Risks to keep in mind

If you plan to invest in the company, there are several things that you should keep in mind:

• With both the company and the market seemingly reaching the top, the upside does seem to be rather limited.
• The company is already close to overreaching when it comes to dividends. One should not look upon the previous history of dividend increases and hope for the same in the days to come.
• The debt is still manageable but investors should keep an eye on how the situation will develop, especially with the debt becoming "more expensive."
• Management cutting back on the buyback programs leads me to believe they are aware the company remains slightly overpriced.

Final thoughts and conclusions

Pepsi is probably one of the most beloved dividend stock picks that's on its way to becoming a "Dividend King." The company is more than capable of delivering on the dividends, but given the current financial situation, I find that the company is going to have a hard time keeping up with the history of steady dividend increases. In the end, I believe it all comes down to valuation. For the income-focused conservative investor who cares little about keeping up with the market, the snack and beverage giant might still be a formidable investment. But as things stand, most active investors should most likely stay clear of PepsiCo and wait for valuations to start making some more sense.

Unfortunately, I would have to conclude that valuations have caught up with an otherwise brilliant business. Arriving at fair value for the company is somewhat difficult. The current market sentiment seems to value PepsiCo close to 18.00x EV/EBITDA for 2022, which I find somewhat of a stretch. I'm questioning the company's ability to produce some more meaningful shareholder value over the course of the next several years, at least until they are able to deliver on some bottom-line growth and free cash flow expansion. I find something in the area of 15.00x EV/EBITDA much more appropriate given the situation. This would indicate a roughly 20% downside for the stock if the company stock fails to hold its premium.

The company has been overbought to the point that even after distributing more than $6 billion of dividends, the dividend yield hovers around 2.5%. The dividend is currently taking up 41% of EBITDA and 78% of free cash flow. This combined with the expected slowdown in dividend growth brings the investment into question. As 10-year bonds are slowly creeping up past the 3% mark, the dividend yield offered by the company at this point might prove simply not attractive enough to investors. With the valuations in mind, the upside does seem to be rather limited, and unless management can generate some significant top and bottom-line growth, the dividends seem to be locked in place for the foreseeable future.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.