It is a good time to be a PepsiCo (PEP) shareholder. I admit to being unsure how shares of the New York-based giant would fare heading into the environment of last year. I had no qualms on the business side of things; PepsiCo was also going to be relatively well-positioned to deal with inflationary conditions. It was the stock’s valuation where I had my reservations.
So far at least it is the former sentiment that has been winning out. PepsiCo shares have outperformed the S&P 500 by around 16ppt since the start of last year (inc. dividends), throwing down what looks to me like a very impressive set of numbers on the business side of things in the process.
I’m a bit more torn on the valuation. There has always been a lot to love about the simplicity of PepsiCo’s business; heck, almost 15% of it consists of selling Pepsi, Doritos, Quaker Oats and so on to Walmart. That’s before we get into profitability (mid-20s ROIC and a fat, double-digit net margin), capital returns ($85bn shuffled off via dividends and buybacks these past ten years if my math is good, with dividend growth now running at 50-plus consecutive years) and the all-round reliability of its cash flows.
With that, fair value at the current share price probably works on long-term mid-single digit revenue growth and high single-digit EBIT growth. PepsiCo is arguably good for that, but with T-Bills yielding 5% I appreciate why folks would be less inclined to chase this right now.
Snack Business Now The Core
PepsiCo Beverages North America (“PBNA”) may be the reportable segment that represents the genesis of the PepsiCo empire, but these days it is the snacks operation that seems like the real core of the firm. Indeed, Frito-Lay North America (“FLNA”) is a gem of a business that currently generates over $6b in operating income for the firm on the back of around $11b in assets.
The domestic snacks business has also been growing quite nicely, with FLNA revenue increasing at a circa 6% annualized clip over the past decade. Of that, around 2ppt has come from pound volume growth and the rest from pricing. Segmental EBIT has likewise put in a CAGR of around 5% over the past decade, with margin landing in the mid-to-high 20s area.
In contrast, elements of the legacy drinks business have been softer. PBNA revenue has increased at a 3% CAGR over the past decade, with core EBIT (i.e. excluding last year’s gain on the sale of Tropicana, Naked and other juice brands) basically flat in that time. Domestic carbonated soft drinks (“CSD”) volume has been the main drag there, declining at a rate of around 2-3% per annum.
Elsewhere, Quaker Foods North America (“QFNA”) has been pretty quiet, while the consolidated non-US numbers look similarly lackluster in USD but much better on a currency-neutral basis, with organic net sales growth averaging somewhere in the mid-to-high single-digit per annum region.
Knocking It Out The Park
There has been a lot to chew on from a macro perspective in recent quarters, with supply chain issues, war, the effect of COVID stimulus and all the rest of it leading to the highest inflation numbers in years. PepsiCo would have naturally been high on many folks’ list of firms to deal with all of that given its pricing power, high margins and so on, and so far at least the company appears to be knocking it out of the park.
With that, organic revenue growth was up 14% last year on the back of flat organic volume. All of the company’s reporting segments delivered double-digit organic top-line growth, with pricing up anywhere between 6-17 points. Core EBIT was up 8% on 2021 to $12.3b (up around 16% on pre-COVID 2019), with core margin down a touch year-on-year but still solid at 14.2%. In an environment where much focus has been on commodity costs, flat-ish 2022 gross margin of 53% looks pretty darn solid.
What Does The Market Think?
PepsiCo stock trades for $176.01 at time of writing, putting it at 25.9x 2022 core EPS of $6.79 and 24.4x FY23 core EPS guidance of $7.20. The forward dividend yield is a shade under 2.9%. That’s based on the annualized payout of $5.06 per share effective June this year (with the quarterly payout increasing 10% from $1.15 per share previously).
I like to ‘value’ PepsiCo using a simple reverse DCF model and reverse DDM. Basically I try to see what kind of growth assumptions underpin the current share price and whether they look okay, with all that relative to my estimate of PepsiCo’s cost of capital. It’s all a bit finger in the air but remember that unless you are dealing with a declining business most of the value is usually found in the ‘terminal’ part of these models, and who the heck can predict that far out? Indeed, that explains why these kinds of stocks have done so well historically. Folks back then just never thought PepsiCo would be growing at a high-single-digit clip this far out.
With that, I think annualized ten-year core EBIT growth in the high-single-digit range works okay here in terms of a DCF. Lo-and-behold that chimes with C-suite targets, which include 4-6% long-run annualized organic revenue growth, 20-30bp of annual EBIT margin expansion and high single-digit per annum core constant currency EPS growth. Some of my own assumptions include a 7.2% WACC (including a personal 8% cost of equity for PepsiCo), a sustainable ex-goodwill ROIC in the mid-20s range, a 20% tax rate and circa 2% terminal growth.
In terms of a simple dividend discount model, an 8% hurdle rate requires around 5.1% long-run annualized growth to work. Again that doesn’t strike me as overly aggressive. I base that on PepsiCo’s current payout ratio, ROIC profile and growth prospects.
The softest part of PepsiCo’s business is domestic (and European) CSDs, and even that is being offset by growth in non-carbonated beverage volume. Beverage volume growth elsewhere looks more robust and also tends to be higher margin as most of PepsiCo’s company-owned bottling operations are located in the US and Europe. That should be a good tailwind for the firm-wide margin. International snacks volume growth likewise looks healthy, and a nice growth runway in emerging markets will similarly support margins.
Summing It Up
“Buy and hold” has perhaps become an overused phrase in recent times, but in Pepsico I feel like we are dealing with a stock for which it was truly intended. These shares may not look cheap based on the headline numbers, but with the firm knocking it out of the park operationally and targeting impressive levels of growth I do think you can make a solid case they are fair value. Whether that is going to cut it now that you can pick up T-Bills at near-enough a 5% yield is a different matter, and I accept some folks will be happy enough on the sidelines right now.
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