Wednesday, June 8, 2016

PepsiCo (PEP) is a dividend machine to hold forever

PepsiCo, Inc. (NYSE:PEP) manufactures, markets, and sells various foods, snacks, and carbonated and non-carbonated beverages worldwide. The company operates in four divisions: PepsiCo Americas Foods (PAF), PepsiCo Americas Beverages (PAB), PepsiCo Europe, and PepsiCo Asia, Middle East and Africa (AMEA). The company is a dividend champion, which has increased distributions for 44 years in a row.

The most recent dividend increase was in February 2016, when the Board of Directors approved a 7.10% increase in the quarterly dividend to 75.25 cents/share. PepsiCo's largest competitors include Coca Cola (NYSE:KO) and Dr Pepper Snapple Group (NYSE:DPS).

Over the past decade, this dividend growth stock has delivered an annualized total return of 8.70% to its shareholders.

The company has managed to deliver a 4.40% average increase in annual EPS over the past decade. This figure looks lower than it should be, because of one-time charges of 91 cents/share related to deconsolidation of its Venezuelan business, which depressed ending 2015 earnings. PepsiCo is expected to earn $4.72 per share in 2016 and $5.11 per share in 2017. In comparison, the company earned $3.67/share in 2015.

Share buybacks have resulted in the decrease in outstanding shares from 1,686 million in 2006 to 1,474 million in 2016. A history of consistent share repurchases is helpful, because it shows that the company is willing to help out long-term holders of stock with increased proportional share of earnings and the business over time.

PepsiCo has a wide moat, due to strong recognizable brands it owns, scale of operations, relationships with retailers and having a distribution network of bottlers that will take billions of dollars to create and replicate. Because of the consumer affinity for branded snacks and beverages that PepsiCo makes, they are less likely to switch to a cheaper product. Hence, PepsiCo is part of a sort of unregulated monopoly, which also has some pricing power.

The company has a solid distribution network, a portfolio of strong brand names, and solid relationships with retailers. This portfolio also includes 22 brands with sales of at least $1 billion for each brand. The market dominance in the snack business of Frito-Lay has resulted in higher margins, relative to competitors.

Future growth in earnings will come from international expansion, particularly in emerging markets. The number of servings that consumers abroad consume is much lower than that in North America, which is why I believe there will be years of growth ahead. In addition, I like the fact that the company sells not only beverages, but snacks as well. As an investor, I like to be diversified; hence, I like it when the companies I own are diversified in products and geography. It is estimated that the company achieves significant synergies by operating both a beverage and a snack business.

Earnings can also increase through organic growth for those snacks and beverages, and price increases to offset cost pressures. Strategic cost initiatives to streamline operations, increase productivity and reduce redundancies are another tool to increase shareholder earnings.

Sales of carbonated drinks have been softening, due to increased health awareness by consumers in developed markets. However, PepsiCo has also focused on fast growing non-carbonated soft drinks. The company's innovation in the area has been successful with the introduction of Aquafina, Gatorade and Propel, Lipton teas and Tropicana.

Future earnings growth could also come from synergies associated with the acquisitions of its bottlers, streamlining of operations and cost cutting. The distribution networks of the bottlers acquired could be used to push some of PepsiCo's non-beverage products such as snacks and other foods. Earnings growth could also come from other strategic acquisitions, as well as product innovations in health and wellness food and beverage section.

The annual dividend payment has increased by 10.60% per year over the past decade, which is higher than the growth in EPS.

A 10% growth in distributions translates into the dividend payment doubling every seven years on average. If we check the dividend history, going as far back as 1973, we could see that PepsiCO has actually managed to double dividends every six years on average.

In the past decade, the dividend payout ratio increased from 34.70% in 2006 to a little over 75% in 2015. As we mentioned above, this ratio looks abnormally high due to earnings per share being depressed from a one-time charge. Without this one-time charge, this payout ratio should be under the 60% sustainable ratio I am looking for in a company. A lower payout is always a plus, since it leaves room for consistent dividend growth minimizing the impact of short-term fluctuations in earnings.

The return on equity largely remained between 30% and 40% over the past decade. The decline since 2010 was caused by the acquisition of Pepsi Bottling interests in North America, which require more capital than your regular soda syrup operations. I generally like seeing a high return on equity, which is also relatively stable over time.

Currently, the company is overvalued at 21.70 times forward earnings and yields 2.90%. It is slightly cheaper than Coca-Cola, which sells for 23.40 times forward earnings and has a current yield of 3.10%. The pure play on North American soda is Dr. Pepper Snapple is cheaper at 21.80 times forward earnings and a current yield of 2.20%. I like PepsiCo, but it is selling at the highest point I would be willing to put money at. As a result, I would likely not put money there, unless valuation gets better. However, I do like PepsiCo, and find it to be one of the quality dividend paying cornerstones of my dividend portfolio. Thus, I plan on holding on to this dividend machine, and eagerly wait for drops in the stock price below $94/share.

Full Disclosure: Long PEP, KO, DPS

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