PepsiCo (PEP) is one of the best dividend growth stocks in the market and a core holding in our Top 20 Dividend Stocks portfolio.

The company has paid dividends for more than 50 years while rewarding shareholders with 44 consecutive dividend increases, making it a member of the exclusive dividend aristocrats list.

Sporting an above-average dividend yield and solid long-term earnings growth potential, Pepsi is a dividend growth machine that dividend growth investors should familiarize themselves with.

Let’s take a closer look at Pepsi’s business and why it is such a special dividend stock.

Business Overview
Pepsi incorporated in 1919 and is a leading global convenience food and beverage company with about $63 billion in revenue.

[ad#Google Adsense 336×280-IA]Snacks account for 53% of revenue, with beverages making up the remaining 47% of sales.

Carbonated soft drinks account for less than 25% of total sales.

Some of PepsiCo’s most iconic brands are Lay’s, Pepsi, Tropicana, Quaker Oats, Gatorade, Naked Juice, Aquafina, Lipton, Doritos, Tostitos, Mountain Dew, Ruffles, Cheetos, and Sierra Mist.

22 of Pepsi’s brands generate over $1 billion in annual sales.

By geography, 69% of revenue is derived from developed markets (U.S. 56%), while developing and emerging markets account for the other 31% of sales.

PepsiCo is a very global business with operations in more than 200 countries. The company should benefit from growing consumer wealth and consumption around the world.

Business Analysis
Pepsi’s primary competitive advantages are its large scale, balanced product portfolio, extensive distribution network, and well-known brands.

Pepsi has the largest food and beverage market share in four of its five top markets. Importantly, the company has also been the biggest contributor to retail sales growth in those markets over the last five years, underscoring the importance of its products for retailers.

Source: Pepsi Investor Presentation

PepsiCo is a critical partner for retailers because its products drive them the most traffic and profit growth of any food supplier. Pepsi’s dual portfolio of snacks and beverages further strengthen its retailer relationships because over half of consumers who buy salty snacks buy liquid refreshment beverages in the same basket, according to IRI. Selling both types of products allows customers to have one point of contact, creating efficiencies.

The company’s breadth and depth of retailer relationships, coupled with its powerful brands, makes it practically impossible to be replaced by smaller rivals. As a matter of fact, Pepsi is about twice the size of the next largest supplier in food and beverage.

Pepsi’s large scale allows it to enjoy economies of scale and invest aggressively in innovation and marketing to stay in touch with consumers’ evolving preferences. For example, Pepsi spent nearly $4 billion on advertising and marketing in 2015 and poured over $700 million into research and development. These investments help it continue maintaining and growing iconic product lines such as Gatorade, which has been around for more than 50 years.

The amount of brand equity Pepsi has built up with consumers is nearly impossible to measure but is extremely valuable. However, it doesn’t show up on the company’s balance sheet because it is an intangible asset (marketing costs are expensed each year, although they have arguably built a major asset for Pepsi). This is one of the reasons why Warren Buffett is invested heavily in consumer staples in his dividend portfolio.

Pepsi, like many other consumer staples, also benefits because its products are in slow-moving industries that enjoy recurring consumer demand, resulting in stable earnings and market share. If a new consumer trend emerges, Pepsi has the firepower and distribution to develop new relevant products itself or acquire new brands that could be a threat.

Even if Pepsi is a little late to adapt to a new consumer preference, its diversified portfolio and focus on huge markets help mitigate this risk.

For example, the snack market is over $100 billion in the U.S. alone, and Pepsi only plays in about 15% of that category. The category is growing nicely (projected 5% global growth) as people are snacking more on-the-go with their busy lifestyles (over 40% of food and beverages are purchased outside the home today versus 26% in 1970, according to Pepsi).

Stepping back, the global foodservice market is roughly $700 billion in size, giving Pepsi less than a 10% market share. Demand for beverages and snacks is growing at a mid-single digit pace, creating many opportunities for profitable expansion.

Despite numerous opportunities for top line growth, the company is focused on improving its cost structure as well.

Pepsi targets $1 billion in annual productivity savings through 2019, representing close to 2% of its total global costs. Savings will be made possible by leveraging more global functions and capabilities, using more automation technology, and consolidating global spending.

Continuous productivity initiatives help Pepsi generate higher margins, grow free cash flow, and increase its return on capital, making it all the more valuable for shareholders. The company has so far delivered on its cost targets, saving $1 billion since kicking off its first program in 2012. Operating margins have increased 195 basis points over the past three years, too.

Overall, Pepsi has strong competitive advantages thanks to its balanced portfolio of snacks and beverages, many years of powerful branding investments, critical importance to retailers, and focus on meeting consumers’ evolving preferences.

Key Risks
The healthy living trend is usually the biggest risk that comes to mind when investors think about Pepsi’s business. Consumers are becoming more mindful of what they are putting in their bodies each day, and government regulations such as California’s soda tax seem to be gaining momentum, potentially serving as a catalyst.

Carbonated soda is arguably the category that is under the most pressure. Fortunately for Pepsi, however, this category accounts for less than a quarter of the company’s total sales. This is not the case for Coca-Cola (see our analysis of Coke here).

By changing product packaging, pricing, and promotion (the three P’s of marketing), I expect carbonated beverages will remain a cash cow for now, albeit with little to no growth.

Pepsi and other snack and beverage giants are doing their best to adopt their products to changing consumer preferences. From introducing new health and wellness brands to investing in more research and development ($754 million last year) to take out sugar, fat, and salt, meaningful efforts are underway.

As Pepsi’s business mix continues evolving, the risk posed from soda should continue declining. Pepsi has seen especially strong growth in its teas, coffees, sports drinks, and water portfolio.

Currency exchange rates are another risk given Pepsi’s high mix of international business. The dollar has been strong this year, weighing on Pepsi’s reported results. However, I don’t expect this factor to impact Pepsi’s long-term earnings potential.

Otherwise, given Pepsi’s balanced portfolio and global presence, it’s hard to identify many risks that could really harm the business. Perhaps the biggest challenge facing management is the task of continuing to deliver solid earnings growth for a company as big as Pepsi.

Dividend Analysis: PepsiCo
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their track record has been, and how to use them for your portfolio here.

Pepsi’s Dividend Safety Score of 99 indicates that the company’s dividend payment is one of the safest in the entire market. Pepsi’s excellent dividend safety begins with the company’s payout ratio.

Pepsi’s dividend has consumed just 56% of its free cash flow over the last four quarters. This is about in line with the company’s historical payout ratios, which have remained between 40% and 60% for more than a decade. Such stability is usually the sign of a steady business with reliable earnings and dividends, and Pepsi is no exception.

Source: Simply Safe Dividends

Speaking of business stability, another factor helping Pepsi’s strong Dividend Safety Score is its performance during the last recession. Pepsi’s sales were roughly flat in 2009, and the company’s free cash flow per share managed to grow each year.

Consumers keep buying the company’s products even when times are tough. Pepsi’s stock also outperformed the S&P 500 by 11% in 2008, highlighting its defensive qualities.

Source: Simply Safe Dividends

Free cash flow generation is another important factor that impacts dividend safety. Without positive free cash flow, a business is not able to sustainably pay dividends without depending on capital markets to issue debt and equity.

My favorite dividend stocks reliably generate positive, growing free cash flow each year. Pepsi certainly checks that box. It free cash flow per share has steadily climbed from $2.46 in 2005 to $5.33 in 2015, more than doubling. Pepsi’s economies of scale and powerful brands make it a cash flow machine, fueling safe and steady dividend growth.

Source: Simply Safe Dividends

A company’s balance sheet is another very important impacting a dividend’s safety because companies will always meet their debt obligations before paying dividends.

Fortunately, Pepsi has a great balance sheet with nearly $15 billion in cash compared to $29 billion in debt. The company could cover its total debt using cash on hand and just 1.5 years’ worth of earnings before interest and taxes (EBIT).

Not surprisingly, Pepsi maintains an “A” credit rating from Standard & Poor’s. The company has plenty of flexibility to continue paying dividends, reinvesting for growth, and acquiring new brands.

Source: Simply Safe Dividends

Overall, Pepsi’s dividend is extremely safe. The company has a healthy payout ratio, generates consistent free cash flow, performs well during recessions, and maintains a strong balance sheet.

Dividend Growth Score
Our Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

Pepsi’s Dividend Growth Score is 71, which indicates that the company’s dividend growth potential is above average.

Pepsi has increased its dividend for 44 consecutive years and last raised its dividend by 7.1% in July 2016. The company has paid uninterrupted dividends since 1965 and is a member of the dividend aristocrats list.

As seen below, Pepsi has consistently delivered annual dividend growth in the high-single to low-double digits.

Source: Simply Safe Dividends

Pepsi’s future dividend growth will likely remain between 6% and 9% annually. Solid future dividend growth is supported by the company’s healthy payout ratio (56% of free cash flow) and outlook for high-single digit earnings growth.

Valuation
Pepsi’s shares trade at a forward-looking P/E ratio of 19.8 and offer a dividend yield of 2.9%, which is slightly higher than the stock’s five-year average dividend yield of 2.8%.

[ad#Google Adsense 336×280-IA]Pepsi targets mid-single digit organic revenue growth and core, constant currency earnings per share growth in the high-single digits.

I believe these targets are achievable given Pepsi’s track record, the underlying growth rates of its large markets, and its moderate global market share.

Under these assumptions, Pepsi’s stock appears to have potential to deliver annual total returns of 9-12% (2.9% dividend yield plus 6-9% annual earnings growth).

The stock’s current multiple (19.8) isn’t a bargain, but it appears reasonable to me considering Pepsi’s excellent stability, great business quality, and opportunities for long-term growth.

Conclusion
Unlike many large cap consumer staples companies, Pepsi’s outlook for long-term earnings growth is quite positive. While the consumer health trend should continue being watched, Pepsi’s diversified snack and beverages portfolio, more limited exposure to soda, investments in innovation, and exposure to international markets helps mitigate these concerns.

While the stock doesn’t appear to be cheap today, I think it offers reasonable value for long-term investors building a high quality dividend growth portfolio.

Brian Bollinger
Simply Safe Dividends

Simply Safe Dividends provides a monthly newsletter and a comprehensive, easy-to-use suite of online research tools to help dividend investors increase current income, make better investment decisions, and avoid risk. Whether you are looking to find safe dividend stocks for retirement, track your dividend portfolio’s income, or receive guidance on potential stocks to buy, Simply Safe Dividends has you covered. Our service is rooted in integrity and filled with objective analysis. We are your one-stop shop for safe dividend investing. Brian Bollinger, CPA, runs Simply Safe Dividends and previously worked as an equity research analyst at a multibillion-dollar investment firm. Check us out today, with your free 10-day trial (no credit card required).

Source: Simply Safe Dividends