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Is It Too Late to Buy PepsiCo?

- By Ben Reynolds

PepsiCo (PEP) is one of the 10 favorite stocks of Kevin O'Leary, or "Mr. Wonderful," as he is known on TV. O'Leary is also chairman of O'Shares Investments, which invests primarily in high-quality dividend stocks.

The stock has rallied 23% in less than five months and is thus now trading at an all-time high. Consequently, while this is a stock with several attractive characteristics, it is only natural to wonder whether it is too late to buy.


Business overview

PepsiCo is a gigantic food and beverage company, with a market capitalization of $183 billion and $66 billion in annual sales. Its product portfolio includes 23 brands that generate more than $1 billion in annual sales each.

PepsiCo has been facing some negative secular trends in recent years. First, consumers have become much more health-conscious lately. This has taken its toll on the per-capita consumption of carbonated drinks, which has fallen to its lowest level since 1985. Moreover, as many U.S. states and some countries are trying to limit their budget deficits, they have resorted to sizeable tax hikes on sweet beverages, primarily because this is a tax measure that does not upset many voters.

PepsiCo has taken a series of steps to address these developments. The company has diversified its product portfolio so much that its percentage of revenues generated from the Pepsi-Cola tradmark has dropped to 12%. In addition, it has a series of offerings named "Better for You," which are much healthier options for consumers than the well-known legacy products. PepsiCo has also addressed the issues of declining soda consumption per capita and increased taxes by implementing meaningful price hikes year after year. Thanks to the price-inelastic character of its products, the benefit from price hikes clearly outweighs the small decrease in consumption that results from the price hikes. A very similar trend is witnessed in the tobacco industry -- major tobacco companies keep growing their earnings despite the declining percentage of the smoking population.

It is remarkable that PepsiCo is the No. 1 brand in market share in most of its major markets, such as the U.S., Canada and U.K., and generates 90% of its revenues from the No. 1 or No. 2 market share position. This dominant position offers a significant competitive advantage to PepsiCo, giving it strong pricing power with vendors.

Growth prospects

While PepsiCo sells its products in more than 200 countries, it still generates almost 70% of its operating profit from North America. Given the mature status of this market and the headwinds facing the beverage business mentioned above, it is only natural that some investors worry about the growth prospects of PepsiCo.

However, the company has consistently grown its earnings per share in eight of the 10 last years. More precisely, it has grown its earnings per share at a 4.6% average annual rate in the last decade.

The main growth driver has been its Frito-Lay North America segment, which generated 25% of the total revenues and 44% of the operating profit of the company last year. Moreover, the company grows at a much faster rate in international markets than in the domestic market. To provide perspective, in 2018, PepsiCo grew its operating profit by 13% in Latin America and 9% in Asia, Middle East and North Africa. Since these regions contribute less than 20% of the total operating income right now, they do not have a huge effect on the total results yet, but they are likely to grow in importance in upcoming years.

Further, the food and beverage giant has reduced its operating expenses by approximately $2 billion per year since 2012 thanks to its cost-cutting initiatives. As a result, it has steadily enhanced its operating margin, to 15.9% now from 13.9% in 2012. The margin expansion has amplified the effect of sales growth on earnings.

According to the long-term guidance of management, PepsiCo expects to grow its organic sales by 4-6% per year, expand its operating margin by 20 to 30 basis points per year and grow its currency-neutral earnings per share at a high single-digit annual rate. Given the aforementioned historical growth rate of the company, the guidance of management seems somewhat ambitious. Nevertheless, even if the company does not manage to live up to its own guidance, it will almost certainly continue growing its earnings per share at a mid-single digit rate for the foreseeable future thanks to sales growth, margin expansion and share repurchases.

Dividend

Due to the strength of its brands, PepsiCo needs to spend minimal amounts on capital expenses. As a result, it enjoys excessive free cash flows. In other words, almost all of its earnings is available for shareholder distributions. Thanks to its excessive free cash flows and the strength of its brands, which secure resilient cash flows, PepsiCo has an exceptional dividend growth record. It has raised its dividend for 47 consecutive years and thus belongs to the group of dividend aristocrats.

PepsiCo currently offers a 2.9% dividend yield. Given the promising growth prospects and its healthy payout ratio, which currently stands at 69%, it is safe to expect the company to keep raising its dividend for several more years. In reference to the most likely future dividend growth rate, PepsiCo has raised its dividend at an 8.0% average annual rate over the last decade. Last year, the company raised its dividend by 15%, but this year, it raised by only 3%. The lackluster dividend hike of this year should probably be attributed to the ongoing restructuring program, which will result in $800 million charges this year and another $1.7 billion until 2023.

Overall, given the current reasonable payout ratio, investors should expect the future dividend growth rate to be in tandem with the earnings-per-share growth rate. Therefore, investors should expect PepsiCo to raise its dividend at a mid-single digit average annual rate for the foreseeable future.

Valuation

Since it bottomed in the Christmas sell-off, PepsiCo has rallied 23%. This is an exceptionally steep stock price move for this slow-moving stock. As a result, the stock is now trading at an all-time high and at a forward price-earnings ratio of 23.6, which is the richest valuation level of the stock in more than a decade.

On one hand, PepsiCo has historically traded at a premium valuation most of the time on the strength of its brands and the resultant reliable and growing cash flows and dividends. On the other hand, because PepsiCo is a relatively mature stock, which grows its earnings at a mid-single digit annual rate, the stock seems to be overvalued right now. It is thus prudent for investors to put this high-quality stock on their radar but wait for a more attractive entry point.

Disclosure: I am not long any stock mentioned.

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This article first appeared on GuruFocus.