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Ben Reynolds
Ben Reynolds
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PepsiCo: Strong Brands Lead to Long-Term Dividend Growth

The Dividend Aristocrat has raised its dividend for over 40 consecutive years. A huge portfolio of billion-dollar brands is a major reason for its success

July 01, 2020 | About:

With the potential for a second coronavirus wave, as well as concerns over a recession amid an unprecedented macroeconomic outlook, many investors are looking for stocks with a consistent track record of delivering positive returns. One such stock is PepsiCo Inc. (NASDAQ:PEP).

The company has an outstanding track record of 48 years of consecutive dividend increases, displaying a resilient business that can withstand and even keep growing throughout adverse economic conditions.

PepsiCo is a global food and beverage company that generates around $70 billion in annual sales. The companys products include well-known brands like Pepsi, Mountain Dew, Frito-Lay chips, Gatorade, Tropicana orange juice and Quaker foods. It has 23 invidividual billion-dollar brands, which each generate $1 billion or more in annual sales.

With a proven strategy of managing its brands, we believe PepsiCo is a great stock to own for reliable, long-term returns.

Recent earnings and dividend analysis

Being a consumer staples company, PepsiCos sales are way less volatile than other sectors since households are likely to keep consuming the companys products despite economic conditions. Everyday consumables like Quaker and Lipton are mostly recession-proof. As a result, the company has been able to grow its earnings consistently. Earnings per share has grown from $3.81 in fiscal 2010 to an estimated $5.64 for 2020. With such consistent profitability, PepsiCo has keep increasing its capital returns as well.

Dividends per share have had a compounded annual growth rate over the past decade of 7.8%. This is very impressive for a company the size of PepsiCo. The company has been rewarding long-term shareholders greatly. Such dividend growth is way larger than the sector average, which mostly sees increases that slightly beat inflation. The stock is currently yielding 3.12%, nearly at a decade high, which presents a juicy income option in this low-rate environment.

Moreover, the dividend is well-covered with a payout ratio close to 73%, which leaves enough retained earnings for the company to acquire more brands in the future and buy back its own stock.

Speaking of stock buybacks, a significant driver of the companys earnings per share growth as well as its share price appreciation has been repurchasing its own stock. Over the past four quarters, the company has performed $2.73 billion worth of share buybacks. Buybacks are a tax-efficient way to return capital back to stockholders and lift shares higher when management feels that the companys stock is undervalued. Over the past two decades, PepsiCo has been consistently doing so, retiring around 23% of its total shares outstanding.

We believe PepsiCos business model is very constant and reliable. As a result, the company can keep generating attractive earnings and dividend per share growth in the medium term and extensively in the long term.

Valuation and expected returns

Over the past several years, PepsiCo has seen a valuation expansion. Prior to 2015, investors could buy the stock at around 20 times earnings, and potentially lower. However, as uncertainty in the market has increased, reliable businesses like PepsiCo have had a great attraction. As a result, shares are currently trading at a price-earnings ratio of around 25 and a forward price-earnings ratio of 24.3. We believe that shares are indeed a bit overvalued. We estimate a fair price at around $107 should shares experience a return toward their historical valuation.

However, as long as uncertainty surrounds equities and investors keep on buying robust, dividend growth businesses, it is likely that a discount on PepsiCo will not appear anytime soon. Shares briefly traded at around $100 during the coronavirus selloff, but that opportunity only lasted so long. Being prudent, we believe that a valuation multiple contraction could hurt the total return potential of the company in the medium term. Still, at its current valuation, PepsiCo remains a rock-solid income option.

Potential risk factors

PepsiCos quality characteristics are no secret. Its long-term shareholder return track record is one of the most pristine in the market. However, every investment has risks attached, and PepsiCo is no different.

The most worrying qualitative risk is that PepsiCo products are heavy in sugar and additives, and are certainly not healthy. With a massive global trend toward healthy foods, likely long term, the companys products will gradually lose their appeal. Thats not to say that their consumption will stop, but it could definitely slow down. Thankfully, with its huge experience in acquisitions and its world-class balance sheet, PepsiCo can keep adjusting its portfolio products and pivoting toward profitable brands, as it has done in the past.

Another potential concern is the companys long-term debt, which currently sits at an all-time high of $35.36 billion. In order to fund acquisitions and share buybacks, the company has accumulated billions in debt. Debt is not necessarily bad. Since the company can achieve a higher return on investment on its debt than its actual cost of interest, it would be doing a disservice to shareholders by not taking on more of it.

Moreover, interest is covered by around 6.63 times the companys operating cash flow, which highlights its financial solvency. However, the debt position remains a risk should the companys sales, and in turn earnings, take a hit in the long term.

Investor takeaway

PepsiCo is one of the sleep-well-at-night stocks in the current market environment. Despite economic conditions, its products will probably keep being consumed around the world daily. As a result, the company should keep on returning capital to shareholders at a consistent pace. We believe the stock provides an excellent income opportunity.

While the dividend yield is not massive, the dividends safety is well-assured, and its growth is excellent. Shares are definitely not cheap, but considering the companys quality, combined with the non-stop buybacks, investors may find it hard to purchase PepsiCo at a discount.

Some risks indeed remain, but the companys proven business model has come out a winner during multiple recessions in the past. The future total return potential may be limited, but the stock presents a rock-solid investment case, with a diversified revenue stream of top-quality brands.

Disclosure: No positions in any stocks mentioned.

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About the author:

Ben Reynolds
I run Sure Dividend, a website that finds high quality dividend stocks for long term investors using the 8 Rules of Dividend Investing.

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