PepsiCo (PEP, Financial) is a core holding in our dividend portfolio for Beginner Investors because of its extremely safe dividend (97 Safety Score), above average dividend growth prospects (75 Growth Score), and reasonable dividend yield (2.8% yield is in the 56th percentile of all current dividend yields).
The stock was added to the Beginner Investors portfolio on July 10 at a price of $95.55 (the stock closed at $98.79 on Aug. 13).
Business Overview
PEP is a global food and beverage company that grossed nearly $67 billion in sales last year, including $1 billion or more from 22 of its largest brands (Frito-Lay, Gatorade, Pepsi-Cola, Quaker, Tropicana, and more). A little over 50% of sales are in North America, which is split roughly 50/50 between snacks and beverages. In general, snacks carry higher margins than beverages.
Stock Performance
PEP has performed well over the last year, returning 11%. However, the stock has not quite kept up with the overall market over the last 3- and 5-year periods, trailing by several percentage points but still generating nice absolute returns. The weaker performance coincides with a slowdown in revenue growth, which saw total reported sales decline 2% in FY12, rise 1% in FY13, and remain roughly flat in FY14.
Source: Simply Safe Dividends
Dividend Analysis
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. PEP's long-term dividend and fundamental data charts can all be seen here.
Dividend Safety Score
Our Safety Score answers the question, "Is the current dividend payment safe?" We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.
PEP scored a very high Safety Score of 97, meaning its dividend is safer than 97% of all other dividend stocks.
As seen below, PEP has maintained EPS and FCF payout ratios between 40-60% over the past decade, suggesting there is reasonable cushion to continue paying and growing the dividend, even in the event of an unexpected decline in the business.
Source: Simply Safe Dividends
Like many other consumer staples businesses, most of PEP's products are in slow-moving industries and benefit from recurring consumer demand, adding further stability to the business and dividend. To reinforce this point, PEP's sales grew 10% in fiscal year 2008 and were roughly flat in fiscal year 2009. Perhaps even more impressive, free cash flow per share has grown every single year since fiscal year 2006. Talk about durability!
Unlike some of its salty snacks, PEP's balance sheet is healthy. As seen below, the company generated $7.8 billion in free cash flow last year, equivalent to over half of the company's net debt of $13.5 billion. Other credit metrics look really good, too - net debt / EBIT is a low 1.4x, and interest coverage (EBIT / Interest Expense) exceeds 10x. PEP's balance sheet and free cash flow generation further support the safety of its dividend.
Dividend Growth Score
Our Growth Score answers the question, "How fast is the dividend likely to grow?" It considers many of the same fundamental factors as the Safety Score, but places more weight on growth-centric metrics like sales and earnings growth and payout ratios.
PEP's Growth Score is 75, placing it in the top quartile of the 2,700+ dividend stocks we monitor for forward-looking dividend growth prospects.
As seen below, PEP has grown its dividend at an 11% annual clip over the past decade and increased its dividend by 13% and 6% in 2014 and 2015, respectively.
Source: Simply Safe Dividends
Yield Score
Our Yield Score simply ranks a stock's current dividend yield against all of the other dividend yields in the market. A score of 50 means the stock's yield is right in the middle of the pack. A score of 100 means it has the highest yield.
PEP's Yield Score is currently 56, placing it approximately in line with the market's average dividend yield. I view this favorably because, unlike the "average" stock in the market, PEP is a much higher quality business with arguably above average growth prospects going forward.
Competitive Strengths
PEP is truly a fantastic business. $100 invested in PEP in 1965 would be worth nearly $43,000 today with dividends reinvested. That type of growth cannot occur unless a company is doing something right (or getting extremely lucky…for decades at a time). So, why has PEP been such a chugger, and can this type of persistent growth persist?
PEP sits on some of the most valuable real estate of any public company. No, not land or developed commercial property.
I am talking about shelf space, perhaps the most important real estate in any store. In many categories, as much as 80% of purchase decisions are made at the point of sale (i.e. the shelf). While pricing, promotional activity, and packaging are all important drivers, shelf space often trumps all.
If you were a grocery or convenience store owner, wouldn't you get rid of what doesn't sell and make more room for the highest gross profit items that do sell, giving them your best shelf space?
PEP has many "must have" brands that consumers expect to find in stores, and many of PEP's retail customers are highly dependent on PEP's merchandise. Within North America, PEP is about twice the size of its next-largest supplier in food and beverage. Importantly, PEP plays in product categories with some of the highest turnover rates in the food and beverage market. Within those categories, PEP's product turnover is also well above the average, meaning it is moving its branded products out the door much faster than its competitors. In other words, PEP is the biggest contributor to cash flow for almost any customer it does business with, an extremely valuable partner that has arguably more than earned its premium shelf space.
PEP also has the drawstrings to maintain its shelf space. Given the competitiveness of the industry, slotting fees are commonly paid to retailers for shelf space. Payments are also required for in-store displays and merchandising (i.e. brand building), distribution of new products, and occasional promotional discounts. In 2014, PEP spent $35.8 billion alone on these sale incentives. Good luck competing with that!
Beyond shelf space, PEP's combination with Frito-Lay in the 1960s continues to pay dividends in other ways. According to IRI, 54% of consumers who buy salty snacks buy liquid refreshment beverages in the same basket. There are many synergies between PEP's snack and beverage brands, and selling both types of products is preferable for customers because they only need one point of contact.
If you questioned PEP's importance to most retailers' businesses, look at its Q2 results. Organic sales grew 5%, and the company was the largest contributor to retail sales growth in the US among all food and beverage manufacturers. With such a slow moving economy, these results are a testament to the strength of PEP's brands and product portfolio.
Finally, PEP's global scale (operates in over 200 countries) and free cash flow generation ($7.8 billion in FY14) allow it to organically develop or acquire new brands and plug them into its massive distribution network relatively quickly to achieve rapid growth. This helps its mix continue to diversify into growth categories, reducing its dependence on carbonated soft drinks
One of the quickest ways to assess the strength of a business model is to evaluate the level and durability of a company's return on invested capital. As seen below, PEP has generally maintained a return on invested capital in the teens or higher for the past decade, a durable and consistent business. The drop from FY09 to FY10 was driven by acquisitive growth (higher intangible assets counted in the "invested capital" number).
The strength of PEP's business model is also reflected in its growing free cash flow per share:
Source: Simply Safe Dividends
Given PEP's size and the generally stable nature of the markets it serves, organic growth seems unlikely to exceed a mid-single digit pace. Occasional acquisitions seem likely to periodically boost overall growth, especially since PEP has the benefit of being able to plug in acquired brands to its global network to expand their reach quickly.
Until currency headwinds subside, reported sales growth is likely to remain negative through the rest of this year. Thinking longer-term, however, foodservice is a $700 billion global market that is forecasted to grow around 4% per year going forward. While $67 billion is a lot of revenue, it still represents less than 10% of the overall foodservice pie. With continued product innovation, brand additions, and global expansion, it isn't hard to see how PEP could continue growing in the low-single digits for decades to come.
Source: Simply Safe Dividends
Key Risks
Like other multinationals, PEP is dealing with unfavorable currency movements that are impacting reported growth. Take Q2 results, for example. Reported sales fell 6% compared to the prior quarter, but organic sales grew 5%. These headwinds are likely to persist the rest of this year but should ultimately subside.
Longer-term, PEP's greatest risks seem to be consumer health preferences for healthier snacks and beverages, the threat of private label taking share from branded goods, and moderate customer concentration in North America.
Never bet against the "obesification" of Americans, but their awareness of what they are eating and drinking does seem to be increasing. While PEP's mix is becoming increasingly healthier, the majority of its products are still arguably biased towards the "junk food" category. Continued mix improvements will help (did you know Mountain Dew's Kickstart has coconut juice in it and 60% less sugar than regular Mountain Dew? Yes, I am still not interested in it either), and PEP is also working on shifting some of its "junk food" products into smaller packaging that comes with much higher margins. Smaller products would make PEP less dependent on the 12-pack and 2-liters while making more money. Regardless, it would be shocking to see a rapid decline in "junk food" sales given their addictive nature.
Private label is another fear, as rock-bottom prices can lure less loyal customers to trade down. PEP's strong brands help combat this risk, and private label accounts for a small share of the liquid refreshment beverages ("LRB") and salty snack categories relative to the broader food and beverage market. Here is an image provided by the company:
From a customer concentration perspective, PEP's top five retail customers represented 31% of its FY14 North American revenue, with Wal-Mart representing 18%. The importance of PEP's brands and its increasingly diversified operations by product type and geography help mitigate this risk.
Conclusion
PEP is a wonderful business (97 Safety Score, 75 Growth Score) trading at a reasonable dividend yield (56 Yield Score - PEP's yield basically in line with the market's average dividend yield). The company's strong brands, premier shelf space, snack and beverage synergies, and dominant position in a $700 billion large and growing market make PEP an attractive stock for long-term dividend investors.
