PepsiCo (PEP, Financial) has raised its dividend for 47 consecutive years, elevating it to dividend aristocrat status. PepsiCo has a very secure dividend with room for future increases.
Since it bottomed at the end of last year, the stock has enjoyed an almost breathless 30% rally. As such a steep rally is unusual for this closely-followed, relatively mature stock, the big question is whether the stock remains attractive.
Business overview
PepsiCo is an exceptional company. It has 22 brands that generate more than $1.0 billion in annual revenues, and it is the leader in market share in most of its major markets in the U.S., Canada, U.K. and Russia. It is remarkable that PepsiCo generates approximately 90% of its retail sales from the No. 1 or No. 2 market share position.
While the company sells its products in more than 200 countries, it still generates 69% of its operating profit in North America. As this is a relatively mature market with intense competition, it somewhat limits the growth potential of PepsiCo. Moreover, consumers are becoming increasingly health-conscious year after year. Consequently, the consumption per capita of carbonated drinks has fallen to its lowest level in the last 34 years. Some U.S. states and some foreign countries have also imposed hefty taxes on sweet beverages in order to tighten their budget deficits.
Despite all the above headwinds, PepsiCo has managed to grow its adjusted, currency-neutral earnings per share at a 9% average annual rate since 2012. PepsiCo has reduced its dependence on its Pepsi-Cola trademark, which now generates only 12% of the total revenues of the company. In addition, the beverage giant has offset the declining consumption of carbonated drinks by raising its prices year after year thanks to the inelastic demand for these products and the brand strength of PepsiCo.
Moreover, the primary growth driver of PepsiCo has been its Frito-Lay North America segment. This segment has grown its revenue 5% this year and has ample room to continue growing for several years. Furthermore, PepsiCo has been growing much faster in emerging markets, which are characterized by strong economic and population growth. This helps explain the recent acquisition of South Africa’s Pioneer Food Group by PepsiCo for $1.7 billion. This acquisition, which is the most expensive outside the U.S. in the history of the company, will further enhance the growth of the company in Africa by expanding its production and distribution capacity.
Growth Prospects
Thanks to the sustained growth of Frito-Lay North America and its promising growth prospects in emerging markets, PepsiCo expects to continue growing its organic revenues by 4%-6% per year. Moreover, thanks to economies of scale and cost reductions, management expects to expand the operating margin by 20-30 basis points per year.
As the bottom line will also be assisted by share repurchases, PepsiCo expects to grow its adjusted, currency-neutral earnings per share at a high-single digit annual rate. Nevertheless, due to currency headwinds, we expect the company to grow its earnings per share by 5%-6% per year on average over the next five years.
Valuation
Since it bottomed at the market sell-off at the end of last year, PepsiCo stock has rallied 30%. As a result, it is now trading at a forward price-earnings ratio of 25.1, which is much higher than its 10-year average price-earnings ratio of 18.9. As we expect the stock to revert to its average valuation level over the next five years, we expect the stock to incur a 5.5% annualized drag in its returns due to the contraction of its earnings multiple.
It is important to note that the current price-earnings ratio of PepsiCo is by far the highest of the stock in more than a decade. This rich valuation has resulted from the recent cuts of interest rates by the Fed and its more dovish outlook, which have rendered the dividends of dividend aristocrats much more attractive. However, investors should be well aware of the resultant risk. Whenever the Fed resumes raising interest rates, the earnings multiple of PepsiCo will probably come under great pressure.
Dividend Analysis
PepsiCo is a Dividend Aristocrat that has raised its dividend for 47 consecutive years. The company has achieved this exceptional dividend growth streak primarily thanks to the strength of its brands, which generate reliable cash flows even under the most adverse economic conditions. Its strong brands have also enabled PepsiCo to implement price hikes year after year without dissatisfying its customers.
Moreover, thanks to the strength of its brands, PepsiCo does not need to spend great amounts on capital expenses. It thus enjoys excessive free cash flows, which exceed the distributed dividends by a wide margin. During the last decade, the free cash flows for PepsiCo have averaged about 70% of the operating cash flows of the company.Â
PepsiCo has grown its dividend at an 8% average annual rate over the last decade. This is certainly an attractive growth rate, particularly for a relatively mature dividend aristocrat. Going forward, we expect the company to grow its dividends in line with its historical growth rate thanks to its promising earnings growth prospects and its healthy payout ratio of 69%.
Despite the enviable dividend growth record of PepsiCo, investors should note that the rally of the stock has sent its dividend yield to an almost 10-year low level of 2.8%. During the last decade, the dividend yield of the stock has remained within a markedly narrow range, between 2.6% and 3.4%. We view the almost 10-year low dividend yield of the stock as a signal that the stock is somewhat overvalued right now.
Expected returns
As mentioned above, we expect PepsiCo to grow its earnings per share by 5%-6% per year over the next five years. The stock is also offering a 2.8% dividend yield. However, as it currently has the highest price-earnings ratio in more than a decade, it is likely to incur a 5.5% annualized drag in its returns due to the contraction of its valuation level. Overall, PepsiCo is likely to offer an approximate 2.5% average annual return over the next five years. The relatively low rate of return is due mostly to overvaluation of the stock.
Final thoughts
PepsiCo is an exceptional company, with an impressive business performance record. Thanks to the continuing growth of its Frito-Lay North America division and its promising growth prospects in emerging regions, the company will continue growing its earnings per share and its dividend at a meaningful rate. However, PepsiCo has enjoyed a steep rally, which has led the stock to overvalued territory. As a result, we advise investors to wait for a lower entry point.
Disclosure: No positions in any stocks mentioned.
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