Undervalued Dividend Growth Stock of the Week: PepsiCo Inc. (PEP)

I’m going to make a bold proclamation.

Becoming rich is possible for the everyday person. 

However, there’s a caveat to this.

Becoming rich fast is not only unlikely, any “get-rich-quick” scheme you’ll come across is probably only going to lead you to becoming very poor, very quickly.

Of course, it all depends on your perspective regarding time.

I’m a great example of what’s possible within a relatively short period of time.

I was flat broke as recently as 2010. Strike that. I was below broke.

I had far more debt than assets, leading to a negative net worth.

Being almost 28 years old, that was a sad but necessary realization, and it was the catalyst I needed to turn my life around.

I decided to radically alter my lifestyle in order to cut expenses, save more, and generate the excess capital necessary I needed to build wealth and passive income.

That excess capital was steadily fed into my brokerage account, whereby I invested in high-quality dividend growth stocks like those you can find on David Fish’s Dividend Champions, Contenders, and Challengers list.

Hard work, frugality, and dividend growth investing totally changed (and even saved) my life, allowing me to become financially independent in early 2016 (in my early 30s).

I shared the exact steps I took to get to this position in life in my Early Retirement Blueprint, which is a step-by-step guide that just about anyone can use to retire early.

That position in life is this: I control the FIRE Fund, which is my real-life and real-money dividend growth stock portfolio that generates the five-figure and growing passive income I need to cover my basic expenses in life.

I’m wealthy enough to where I don’t need or have a job.

Jason Fieber's Dividend Growth PortfolioSo you can see it took me about six years to go from below broke to rich.

Sure, it didn’t happen overnight.

But it didn’t take that long, either.

And there’s a very important point here.

Investing in high-quality dividend growth stocks is a sustainable path to real and lasting wealth and passive income. 

When you buy a high-quality dividend growth stock, the odds are pretty good that you’re buying equity in a world-class business.

This world-class business is earning enough profit to share a good chunk of it with their shareholders. That sharing occurs via a cash dividend. And as that profit grows, so does that dividend.

The very existence of a lengthy track record of growing dividend serves as great initial evidence of business quality.

All well and good, but keep in mind that I didn’t randomly buy stocks off of Mr. Fish’s list.

One should be doing their due diligence before investment – looking at fundamentals, competitive advantages, and risks.

You want to invest in high-quality businesses.

Arguably even more important, one should be looking at the valuation before investing in any dividend growth stock.

That’s because valuation can impact an investment’s performance to a great degree, especially over the short term.

An undervalued dividend growth stock should present an investor with a higher yield, greater long-term total return potential, and less risk. 

This is all relative to what the same stock might otherwise present if it were fairly valued or overvalued.

These dynamics play out in a straightforward fashion.

Price and yield are inversely correlated; all else equal, a lower price will result in a higher yield.

That higher yield positively impacts total return right from the start, as investment income (via dividends or distributions) is one of two components of total return.

A higher yield should mean more investment income, which should lead to greater long-term total return potential.

In addition, the other component, capital gain, is also given a possible boost via the “upside” that exists between a lower price and higher intrinsic value.

While the market isn’t always all that great at recognizing a stock’s value in the short term, price and value tend to more closely relate to one another over the long run.

If a long-term investor is able to capitalize on any kind of advantageous price mismatch, that could lead to greater capital gain than what would otherwise be available.

And that’s on top of whatever organic capital gain will naturally come about as a company and its stock becomes worth more as it increases its profit.

This should all serve to reduce risk.

That’s due to the margin of safety that one builds into an investment when they buy at an undervalued level.

Maximizing upside simultaneously minimizes downside, meaning you’re less likely to be “upside down” on your investment (having it be worth less than you paid).

Fortunately, these dynamics aren’t that difficult to spot.

You just need to have a system in place that assists you in valuing dividend growth stocks.

One such system has been proposed and shared by fellow contributor Dave Van Knapp.

It’s Lesson 11: Valuation, which is the 11th lesson in his Dividend Growth Investing Lessons.

With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to be undervalued right now…

PepsiCo Inc. (PEP)

PepsiCo Inc. (PEP) is a global manufacturer and distributor of a variety of non-alcoholic beverages, foods, and snacks.

PepsiCo Inc. operates across the following segments: North American Beverages (33% of FY 2017 revenue); Frito-Lay North America (25%); Europe Sub-Saharan Africa (17%); Latin America Foods (11%); Asia, Middle East, and Africa (10%); and Quaker Foods North America (4%).

I write about the power of brands a lot. Quality brands that people enjoy and identify with typically provide their parent companies with immense pricing power over the long run.

Well, PepsiCo is about as emblematic of that as it gets.

They have 22 different billion-dollar brands.

Let’s just run through a few of them.

Pepsi, Lay’s, Mountain Dew, Gatorade, Doritos, Quaker, Lipton, Tostitos, Aquafina, Tropicana.

I could go on. But you get the point here.

People enjoy snacks. And people literally have to consume food and liquid in order to survive.

This was true 200 years ago. It’ll be true 200 years from now.

PepsiCo has positioned itself incredibly well in terms of providing quality and enjoyable products available at a low price point.

When it comes to non-alcoholic beverages and snacks, there’s no other company that offers that kind of one-two punch. This collection of brands is unparalleled.

What’s almost as unparalleled as their brands is the company’s track record for dividend raises.

They’ve increased their dividend for 46 consecutive years.

That time frame stretches through multiple wars, numerous economic calamities, and stock market crashes.

But people have to eat and drink. Recession or not, people are going to buy food and beverage products.

The 10-year dividend growth rate is sitting at 8.9%.

Impressive in and of itself, it’s particularly notable that there’s been no marked deceleration here.

Furthermore, the most recent dividend increase, for the Q2 2018 dividend, was over 15%!

That growth rate is on top of a very appealing yield of 3.82%.

That yield isn’t only much higher than the broader market, but it’s also more than 100 basis points higher than the stock’s own five-year average yield.

The only possible drawback regarding the dividend is the payout ratio, which is at 71.3% right now (using TTM EPS that factors in core earnings for Q4 2017).

But I simply view PepsiCo as a fairly mature business that is returning the majority of its profit back to shareholders via a big and growing dividend – and there are worse situations to be in as a shareholder.

The stock is basically a cash cow. And that’s why it’s a major position in my FIRE Fund.

In order to get a feel for exactly what that dividend cash flow might look like going forward, we’ll next take a look at top-line and bottom-line growth for PepsiCo.

Building an expectation for future dividend growth relies on building an expectation for future profit growth. And that involves looking at not only what a company has done over the long haul, but also what it might do going forward.

So we’ll first look at PepsiCo’s growth over the last decade (using that as a proxy for the long term), before comparing that to a near-term forecast for profit growth.

Blending a known past and professional estimate of the future should tell us a lot about what PepsiCo is capable of.

The company grew its revenue from $43.251 billion in fiscal year 2008 to $63.525 billion in FY 2017. That’s a compound annual growth rate of 4.36%.

Mid-single-digit top-line growth is right in line with what I’d expect from a company like this.

Meanwhile, the company’s earnings per share advanced from $3.21 to $5.32 over this period, which is a CAGR of 5.57%.

Notably, I used Core EPS for FY 2017, which factors out a massive non-cash adjustment the company took to GAAP EPS due to the US Tax Cuts and Jobs Act of 2017.

That’s a bit below what I’d like to see, but it’s not so far off to be disappointed with the business. Moreover, keep in mind the last decade (which includes the Great Recession) is about as challenging for a business as it can get.

Also keep in mind that PepsiCo kept paying and growing its dividend straight through the financial crisis. That shows the strength and durability of the business model.

That said, the dividend has grown faster than EPS over the last decade, leading to a payout ratio that is a touch high. As such, I wouldn’t expect outsized dividend growth to continue.

For further perspective on what we should expect moving forward, CFRA believes PepsiCo will compound its EPS at an annual rate of 8% over the next three years.

This would be a nice acceleration off of what’s transpired over the last decade. Pricing increases, productivity improvements, and a tax benefit from the aforementioned change in corporate tax structure should all benefit PepsiCo moving forward.

But even if the company were to fall a bit short of this forecast, there’s still room for mid-single-digit dividend growth. Combining that with a yield near 4% is awfully attractive when considering the low-risk business model.

The company’s balance sheet is moderately leveraged, but I don’t find it to be particularly concerning.

While the long-term debt/equity ratio, at 3.1, looks high, that’s only because common equity has been reduced by treasury stock.

The interest coverage ratio, however, is over 9. That indicates no issue with the company’s ability to cover its liabilities.

Profitability is fairly robust, although ROE is boosted by the lack of common equity.

Over the last five years, PepsiCo has averaged annual net margin of 9.25% and annual return on equity of 39.37%.

Both averages were negatively impacted by the hit to FY 2017 GAAP numbers relating to the tax change.

Overall, there’s not much to dislike about owning a slice of a business like this.

There’s competition, sure.

But the risks are few and far between.

And you weigh that against extremely high odds that people are going to still enjoy consuming products like potato chips and orange juice hundreds of years into the future.

As long as that remains true, PepsiCo should continue to do well. More people consuming more of those products, at higher prices, bodes well for the business and its shareholders.

The only aspect that should ever really discourage a long-term dividend growth investor from buying and holding this stock is valuation.

However, after falling from the low $120s earlier this year to below $100 now, the valuation now looks quite compelling…

The P/E ratio (factoring out the one-time tax hit in Q4 2017) is sitting at 18.68 right now. That’s below the broader market by a wide margin. And it’s  also well below the stock’s own five-year average P/E ratio of 23.2.

While that isn’t totally an apples-to-apples comparison because we’re looking at adjusted EPS to GAAP EPS, the fact is that you have to go back almost two years before you see this price and valuation on this stock.

And the yield, as noted earlier, is substantially higher than its own recent historical average.

If it’s compelling, how compelling might it be? What might a reasonable estimate of intrinsic valuation look like? 

I valued shares using a dividend discount model analysis.

I factored in a 10% discount rate and a long-term dividend growth rate of 6.5%.

That DGR Is low when held against the demonstrated long-term dividend growth, as well as the forecast for future EPS growth.

However, I’m also considering the company’s 10-year EPS growth rate, which has led to an inflated payout ratio.

This seems like a rational, if a bit conservative, look at PepsiCo’s future dividend growth potential.

The DDM analysis gives me a fair value of $112.89.

The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.

The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.

It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.

I find it to be a fairly accurate way to value dividend growth stocks.

My analysis and valuation wasn’t aggressive, yet the stock still looks undervalued here. It’s not often in this market that you find a high-quality business like this available at a valuation below what’s likely fair.

But I readily admit my perspective is but one of many, which is why we’ll also look at what two select professional analysts have to say about this stock and its valuation.

Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system.

1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.

Morningstar rates PEP as a 4-star stock, with a fair value estimate of $123.00.

CFRA is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line.

They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.

CFRA rates PEP as a 5-star “STRONG BUY”, with a 12-month target price of $120.00 (TP used in lieu of missing fair value).

We all agree that this stock is worth more than it’s selling for, although I came out the most conservative. Averaging the three numbers out gives us a final valuation of $118.63, which would indicate the stock is potentially 22% undervalued here.

Bottom line: PepsiCo Inc. (PEP) is a high-quality company across the board, with more than 20 different billion-dollar brands. This company produces the products that people all over the world love to buy and consume. Almost 50 consecutive years of dividend raises, a yield closing in on 4%, a recent dividend increase of over 15%, and the possibility shares are 22% undervalued means this is one of the most compelling long-term opportunities for dividend growth investors in the market today.

— Jason Fieber

Note from DTA: How safe is PEP’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 96. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, PEP’s dividend appears safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.

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