Company Background (sourced from Yahoo! Finance):
PepsiCo, Inc. operates as a food and beverage company worldwide. The companys PepsiCo Americas Foods division offers Lays and Ruffles potato chips, Doritos and Tostitos tortilla chips, Cheetos cheese flavored snacks, branded dips, and Fritos corn and Santitas tortilla chips; Quaker oatmeal, Aunt Jemima mixes and syrups, Quaker Chewy granola bars, Quaker grits, Capn Crunch cereal, Life cereal, and Quaker rice cakes; Rice-A-Roni, Near East, and Pasta Roni side dishes; Quaker-brand cereals and snacks; and snack foods under Marias Gamesa, Cheetos, Doritos, Ruffles, Emperador, Saladitas, Elma Chips, Rosquinhas Mabel, Sabritas, and Tostitos brands. Its PepsiCo Americas Beverages division provides beverage concentrates, fountain syrups, and finished goods under Pepsi, Mountain Dew, Gatorade, Diet Pepsi, Aquafina, 7UP, Diet Mountain Dew, Tropicana Pure Premium, Sierra Mist, and Mirinda brands; and ready-to-drink tea and coffee products. The companys PepsiCo Europe division offers snacks under Lays, Walkers, Doritos, Cheetos, and Ruffles brands, as well as Quaker-brand cereals and snacks; beverage concentrates, fountain syrups, and finished goods under Pepsi, Pepsi Max, 7UP, Diet Pepsi, and Tropicana brands; ready-to-drink tea products; and dairy products under Domik v Derevne, Chudo, and Agusha brands. Its PepsiCo Asia, Middle East, and Africa division provides snack foods under Lays, Chipsy, Kurkure, Doritos, Cheetos, and Smiths brands; cereals and snacks under the Quaker name; beverage concentrates, fountain syrups, and finished goods under Pepsi, Mirinda, 7UP, Mountain Dew, Aquafina, and Tropicana brands; and ready-to-drink tea products. The company serves wholesale and foodservice distributors, grocery and convenience stores, mass merchandisers, membership stores, and authorized independent bottlers through direct-store-delivery systems, customer warehouses, and distributor networks.
Analysts expect Pepsi to grow earnings 8.20% per year for the next five years and I've assumed they can grow at 2/3 of that, or 5.47%, for the next 3 years and continue to grow at 5.00% per year thereafter. Running these numbers through a three stage DCF analysis with a 10% discount rate yields a fair value price of $95.66. This means the shares are trading at a 15.5% discount to the discounted cash flow analysis.
The Graham Number valuation method was conceived of by Benjamin Graham, the father of value investing, and calculates the maximum price one should pay for a company given the earnings and book value. Pepsi earned $4.25 per share in the last twelve months and has a current book value per share of $14.73. The Graham Number is calculated to be $37.53, suggesting that Pepsi is overvalued by 115.4%.
Average High Dividend Yield:
Pepsi's average high dividend yield for the past 5 years is 3.34% and for the past 10 years is 2.75%. This gives target prices of $67.91 and $82.47 respectively based on the current annual dividend of $2.27. I'm more inclined to think the 5 year average is more realistic over the foreseeable future as the overall growth of the company should slow. So I'll use the 5 year average for my target entry price calculation. Pepsi is trading at a 19.0% premium to this price.
Pepsi's average low PE ratio for the past 5 years was 14.90 and for the past 10 years was 16.65. This corresponds to a price per share of $64.80 and $72.42 respectively based off the analyst estimate of $4.35 per share for fiscal year 2013. Both PE ratios are relatively close so I'll use the average of the two for my target entry price. This corresponds to a target price of $68.61. Pepsi is trading at a 17.8% premium, suggesting that it's overvalued.
Average Low P/S Ratio:
Pepsi's average low PS ratio for the past 5 years is 1.56 and for the past 10 years is 2.01. This corresponds to a price per share of $70.81 and $91.16 respectively based off the analyst estimate for revenue growth from FY 2012 to FY 2013. The price targets don't include effects due to potential share buybacks, rather it's just based off the analyst estimate for revenue and growth to be a bit conservative. Currently, their current PS ratio is 1.89 on a trailing twelve months basis. To be conservative I'll use the 5 year average low P/S ratio in my target entry price calculation. Pepsi is currently trading for a 14.2% premium to this price.
Gordon Growth Model:
The Gordon Growth Model is a quick way to calculate the fair value of a company using the current dividend, the expected dividend growth rate, and your required rate of return or discount rate. Assuming a constant 5.00% dividend growth rate and a discount rate of 10.00%, the GGM valuation method yields a fair price of $45.40. Pepsi is currently trading at a 78.0% premium to this price.
Dividend Discount Model:
For the DDM, I assumed that Pepsi will be able to grow dividends for the next 5 years at the lowest of the 1, 3, 5 or 10 year growth rates or 15%. In this case that would be 5.00%. After that I assumed they can continue to raise dividends for 3 years at 75% of 15.00%, or 3.74%, and in perpetuity at 3.50%. The dividend growth rates are based off fiscal year payouts and don't necessarily correspond to quarter over quarter increases. To calculate the value I used a discount rate of 10%. Based on the DDM, Pepsi is worth $36.85, meaning it's overvalued by 119.4%.
Pepsi's trailing PE is 19.04 and it's forward PE is 17.13. The PE3 based on the average earnings for the last 3 years is 20.45. I like to see the PE3 be less than 15 which Pepsi is currently well over. Compared to it's industry, PEP seems to be overvalued versus DPS (15.01) but undervalued versus KO (19.89), MDLZ (23.39) and the industry as a whole (25.20). All comparisons are on a TTM basis. Pepsi's PEG for the next 5 years is currently at 2.27 which has them undervalued versus KO (2.44) but overvalued against DPS (1.90) and MDLZ (1.71) and the industry as a whole (1.81). A lower PEG ratio is better because it means you're paying less for every dollar of growth the company achieves.
Pepsi's gross margins for FY 2011 and FY 2012 were 56.4% and 56.1% respectively. They have averaged a 57.7% gross profit margin over the last 10 years. Their net income margin for the same years were 9.7% and 9.5%. Since 2003 their net income margin has averaged 12.6%. I typically like to see gross margins greater than 60% and at least higher than 40% with net income margins being 10% and at least 7%. Their gross margin is very close to the 60% level so I'm not concerned with that at all. While their average net income margin over the last 10 years is above the 10% threshold, the trend has been negative. It's still above the 7% minimum, but I'd like to see the trend start to turnaround. Since each industry is different and allows for different margins, I feel it's prudent to compare PEP to its industry. For FY 2012, Pepsi captured 100.9% of the gross margin for the industry and 81.2% of the net income margin. On the gross margin front their tracking with the industry, but when it comes to the bottom line of the income statement, Pepsi is lacking by a big margin. I have a feeling this is due to their snack business not being as high margin as their cola business which is a drag on their overall margin levels.
Pepsi's management generally purchases shares to reduce the share count. The shares outstanding have declined in all but two years since FY 2002. Overall they've bought back 8.5% of their shares for an average annual decline of 0.89%. When we examine the cash flow later you'll see that management wasn't all that prudent with their buybacks as they had some of their largest buyback years leading up to the "Great Recession" and couldn't capitalize on the cheap prices over the subsequent years. This is why share buybacks can be useful, but only if management is prudent with that capital.
A negative number for the % change value means shares were bought back by the company and a positive value means the shares outstanding increased.
Pepsi is a dividend champion with 41 consecutive years of dividend increases. That's quite an impressive streak for any company. They have increased the dividend at a 4.99%, 5.92%, 6.67%, and 13.55% rate over the last 1, 3, 5, and 10 year periods respectively. Dividend increases are based off fiscal year payouts and don't necessarily correspond to annual payouts. Their payout ratio based off EPS has averaged 42.3% over the last 10 years, but was 53.7% in FY 2012. Their payout ratio has been increasing over time which has allowed them to grow their dividend faster than EPS. Dividend growth has been trending down which is a little worrisome; however, analysts do expect for earnings to grow over 8% per year over the next five years which could allow management to increase dividends in the 7-8% range while lowering their payout ratio. I wouldn't expect 10%+ growth rates unless the outlook for the company changes significantly.
Pepis has done a decent job at managing their cash flow. Over the last 5 years they've been able to turn 65.2% of their operating cash flow into free cash flow and 27.6% of their operating cash flow into free cash flow after paying the dividend. Their free cash flow has grown from $3.190B in 2002 to $5.765B in 2012, good for a 6.1% annualized increase, while their free cash flow after dividends has grown from $2.149B to $2.460B over the same time for a 1.4% annual increase. The free cash flow payout ratio has averaged 49.5% over the last 10 years, but has been trending higher and was 57.5% in FY 20012. As the dividend has been increasing faster than overall growth of the company, the FCF payout ratio has been expanding. Once again, signs point to just average dividend growth in the 5-8% range if the growth of the company doesn't increase much faster.
Return on Equity and Return on Capital Invested:
Pepsi's ROE has averaged a solid 33.4% over the last 5 years and 32.6% over the last 10 years. Pepsi's ROCI has averaged 19.0% over the last 5 years and 23.0% over the last 10 years. Their ROE and ROCI have been great over the last 10 years although they have been trending down. I'd like to see both of these at least reverse trend and start increasing again, although they are both still at great levels. Their overall debt level was great through most of the last 10 years, but since FY 2010 it has increased significantly. Their total debt level has increased to the point that their debt to equity and debt to capitalization ratio has soured. Between FY 2003 and FY 2009 their debt to equity level averaged 0.34 with an average debt to capitalization ratio of 20.7%. However, as I mentioned starting in FY 2010 their debt levels have increased significantly compared to their equity with average debt to equity levels of 1.24 and debt to capitalization ratios of 49.8% over the last three fiscal years.
Revenue and Net Income:
Since the basis of dividend growth is revenue and net income growth, we'll now look at how Pepsi has done on that front. Their revenue growth since the end of FY 2002 has been excellent with a 10.0% annual increase while their net income growth has lagged with only a 6.5% annual growth rate. This has led to the net profit margin deteriorating down to 9.5% in FY 2012. Although a good sign is that over the last twelve months the net income margin is back up over 10%.
The average of all the valuation models gives a target entry price of $60.40 which means that Pepsi is currently trading at a 33.8% premium to the target entry price. I've also calculated it with the highest and lowest valuation methods thrown out. In this case, the DCF and DDM valuations are removed and the new average is $58.05. Pepsi is trading at a 39.2% premium to this price as well.
Assuming that Pepsi can grow their earnings and dividends at the rates that I assumed, you're looking at average returns over the next 10 years. In 2023, EPS would be $7.97 and slapping an average PE of 16.49 gives a price of $131.42. Over the next 10 years you'd also receive $29.33 in dividends for a total return of 198.88% which is good for a 7.12% annualized rate if you purchase at the current price. If you purchase at my target entry price of $60.40, your projected 10 year total return jumps to 266.15% for an annualized return of 10.28%.
According to Yahoo! Finance the 1 year target estimate is at $90.67 suggesting about 12% upside from Friday's trading. Morningstar has Pepsi rated as a 4 star stock suggesting that it's trading below their fair value estimate.
I really like the company and would love to own the other half of the cola duopoly and the snack business is just a plus. While I don't think it's a steal at current prices, it is around the fair value using the average P/E, P/S and dividend yield models with a target fair value price of $82.84. Management is clearly committed to the dividend as well as increasing it as they've done so for the past 41 years. I expect some muted dividend growth going forward, but still well above inflation at 4-8% annual increases so that management can get their payout ratios back in better shape. Although I can still live with 4-8% annual increases. If the share price pulls back to the mid to upper $70's I'd be very tempted to purchase some shares.
The main concern with Pepsi is that there's been a bigger push towards health concerns over their cola and snacks business. Over the last 10-15 years, there's been declining demand for carbonated drinks and junk food. If this trend continues then Pepsi could see declines in the the company. However, in 2010 they started an initiative to increase "good for you" products to $30 billion annually from $10 billion over the next decade. There's still plenty of recognizable brands under Pepsi's control so they should do just fine. How they manage the switch to a more health conscious consumer will determine how fast they can grow in the future.
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What do you think about PepsiCo. as a DG investment? How do you think the long-term dividend growth prospects are?