In part 28 of the 54 part Dividend Aristocrats In Focus series, I take a look at the competitive advantage and future growth prospects of PepsicCo (PEP). PepsiCo sells non-alcoholic beverages under brand names including: Pepsi, 7 Up, Gatorade, Tropicana, Pure Leaf, and Mountain Dew. The company now generates over 50% of its revenue from its snack division which controls the following brands (among others): Cheetos, Lays, Sun Chips, Quaker, and Doritos.
PepsiCo is the second largest beverage company in the world based on its market capitalization of $142 billion. The company has a long history of success including 42 consecutive years of dividend increases. The section below gives an overview of the company’s operating segments so readers get a better feel for the company as a whole.
PepsiCo operates in 6 distinct business segments. Each segment is listed below along with the percentage of revenue and operating profit generated for the company through the first nine months of PepsiCo’s fiscal 2014.
- Frito-Lay North America (FLNA): 22% of revenue, 34% of operating income
- Quaker Foods North America (QFNA): 4% of revenue, 5% of operating income
- Latin America Foods (LAF): 12% of revenue, 11% of operating income
- PepsiCo Americas Beverages (PAB): 32% of revenue, 26% of operating income
- Europe: 20% of revenue, 13% of operating income
- Asia, Middle East & Africa (AMEA): 10% of revenue, 11% of operating income
The company’s highest margin business is its Frito-Lay North America business. Nelson Peltz of activist investment firm Trian Partners issued a proposal for PepsiCo to split its snack business from its beverage business earlier this year. You can read the full critique and presentation here. PepsiCo’s management quickly squelched spin-off rumors. For now, the company will continue to operate as one business.
PepsiCo’s competitive advantage comes from its global operating scale and its strong brands. The company’s competitive advantage is extremely durable due to the slow changing nature of the snack and beverage industry. As a diversified business, PepsiCo can benefit by taking cash flows generated in the profitable but slow growing soda business and reinvesting them into the quicker growing salty snack business throughout the world.
PepsiCo’s 40+ year history of consecutive dividend increases and stable cash flows are a direct result of its strong brands. Several of the company’s more well known brands were in the introduction of this article. The company supports its brands through large advertising and marketing spending. PepsiCo spent $3.9 billion, or 5.9% of total revenues on advertising and marketing in its full fiscal 2013. The company is likely to spend about 6% of revenue on advertising and marketing again in 2014 to build brand awareness. PepsiCo’s ability to spend billions of dollars on advertising each year is a competitive advantage that smaller competitors simply cannot enjoy. As a result, the company’s brands are widely known and purchased throughout the world.
In total, PepsiCo has 22 brands that generate over $1 billion per year in revenues. The image below shows all 22.
Source: PepsiCo Brand Explorer
Future Growth Prospects
PepsiCo has grown revenue per share at over 10% a year over the last decade. This is the 3rd fastest of any dividend aristocrat. PepsiCo’s strong 10 year growth has been driven by organic growth and share repurchases. On average, the company has repurchased about 1% of its shares outstanding each year over the last 10 years. PepsiCo’s future growth potential comes from greater expansion into developing markets and continued single digit positive growth in the developed world.
PepsiCo’s earnings guidance projects 9% constant currency EPS growth for fiscal 2014. The company saw 11% constant currency growth for its most recent quarter. The company’s revenue growth by segment in the third quarter is emblematic of PepsiCo’s future growth potential. The company’s segments can be grouped into two categories: fast growth, and slow growth or negative growth.
The ‘fast growth’ category is made up of the company’s EMEA and LAF segments. These segments both have exposure to quickly growing developing markets. For the third quarter of 2014, EMEA organic revenue grew 11%, and LAF organic revenue grew 9%.
The ‘slow or negative growth’ category includes the FLNA, QFNA, PAB, and Europe segments. The future growth prospects for each segment within this overall category are varied. FLNA has the best growth prospects. Salty snack sales continue to be strong in North America. The FLNA segment reported 3% organic revenue growth for the 3rd quarter of fiscal 2014. Low to mid single digit revenue growth is likely for the FLNA division going forward. The QFNA segment saw organic revenue decline 2% in the most recent quarter. The Quaker brand has performed poorly for PepsiCo for years now and is outside of the company’s core “salty snacks and non-alcoholic beverages” circle of competency. The QFNA segment has poor growth prospects ahead and is an excellent candidate for divestiture from PepsiCo. Finally, the PAB and Europe segments reported flat and 1% organic revenue growth for the quarter, respectively. These divisions are both weighed down by stagnant soda sales as consumer preferences switch away from carbonated beverages and toward non-carbonated beverages. The future growth prospects for these divisions is in the low single digits.
Overall, PepsiCo has strong growth prospects due to emerging market growth and its strong brands. The company will likely grow EPS at a compound rate of between 8% and 10% over the next several years. This combined with the company’s strong dividend yield of about 2.8% gives shareholders an expected return of 10.8% to 12.8% per year going forward.
As mentioned above, PepsiCo has a solid dividend yield of 2.8%. The company currently has a payout ratio of about 60%. As a result, PepsiCo will likely grow its dividend payments in line with EPS growth going forward. Fortunately for shareholders, PepsiCo is still experiencing strong EPS growth. If the company can grow its dividend payments at 10% per year (which I believe is likely over the next several years), the company will have the following yield on cost in the future:
- Current Yield: 8%
- Yield in 3 Years: 7%
- Yield in 5 Years: 5%
- Yield in 10 Years: 3%
PepsiCo currently trades at a PE multiple of about 20.4. Historically, PepsiCo has traded at a 1.1x premium to the S&P500’s PE ratio. This makes sense, as the company has very stable and predictable cash flows coupled with solid growth prospects. The S&P500 currently trades at a PE ratio of around 19, implying a fair valuation multiple of PepsiCo of about 20.9. At current market prices, PepsiCo appears fairly valued. If the S&P500 reverts to its historical PE ratio of 15, the fair valuation multiple for PepsiCo will be about 16.5.
PepsiCo has performed well during recessions. The company’s EPS are shown below throughout the Great Recession of 2007 to 2009 to show the company’s stability through recessions:
- 2007 EPS of $3.34
- 2008 EPS of $3.21
- 2009 EPS of $3.77
As you can see, the company only experienced a minor EPS dip during the last recession. PepsiCo is extremely well insulated from global economic turndowns because it sells low cost branded food products that are popular regardless of the economic climate.
PepsiCo is a high quality business with a long history of strong growth and solid future growth prospects. The company’s underlying businesses remain healthy, and the stock does not appear to be overvalued at current levels. PepsiCo is a Top 10 dividend growth stock based on The 8 Rules of Dividend Investing due to its strong growth history, high yield, and extremely low price standard deviation of under 18%. The company is a low risk investment with double-digit return potential.