PepsiCo: 47 Years of Dividend Growth From This Predictable Aristocrat

Pepsi (PEP) traces its roots back to 1898 when its original formulation was created by North Carolina pharmacist Caleb Bradham. PepsiCo was formed by the 1965 merger of Pepsi-Cola and snack food giant Frito-Lay (founded in 1932).

Today, Pepsi boasts 22 iconic brands with more than $1 billion in annual sales, including Lay’s, Pepsi, Tropicana, Quaker Oats, Gatorade, Naked Juice, Aquafina, Lipton, Doritos, Tostitos, Mountain Dew, Ruffles, Cheetos, and Sierra Mist.

While the company is perhaps best known for its name brand sodas, high-margin snacks comprise over half of Pepsi's sales, with the Frito-Lay and Quaker brands generating more than 40% of total operating profits. (For comparison, soda accounts for nearly 70% of Coca-Cola's unit sales.)

By geography, about 57% of Pepsi's sales are derived from the U.S. and another 20% from emerging markets. However, North America still remains its most profitable region, accounting for approximately 75% of operating income. 

With 47 consecutive years of dividend increases, Pepsi is a dividend aristocrat and will become a dividend king in 2022.

Business Analysis

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

The company's dual portfolio of market-leading snacks and beverages sets Pepsi apart from rival Coca-Cola. Whereas the majority of Coca-Cola's sales are from soda, Pepsi's product line is much more diversified, making the company better positioned as consumer preferences change.

Impressively, Pepsi has the largest food & beverage market share in four of its five top geographic markets, according to a 2016 investor presentation. The company has also been the largest contributor to sales growth in those markets, underscoring the importance of its products for retailers.

By selling both snacks and beverages, Pepsi also provides retailers an efficient means of sourcing much of what their customers want. Over half of consumers who buy salty snacks buy liquid refreshments in the same basket, according to analyst firm IRI.

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

Not surprisingly, 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 routinely spends about $4 billion on advertising and marketing (over 6% of sales) and pours around $700 million into research and development each year (about 1% of sales).

The amount of brand equity Pepsi has built with consumers is extremely valuable but nearly impossible to measure. In the past, brand strength alone has made it possible to fend off private label competition and offset rising input costs by increasing prices.

Pepsi also benefits from operating 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 financial firepower and distribution necessary to develop relevant new products or acquire brands that pose a long-term threat.

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

Going forward, Pepsi's long-term growth ultimately depends on its continued success in shifting its product mix to evolve with changing consumer sentiment. For now, that means focusing on healthier foods and faster-growing drink segments.

Pepsi has invested significantly in what it refers to as "Guilt-Free" products, meaning low sodium snacks or drinks with 70 calories per serving or less. Today, Guilt-Free products account for 45% of Pepsi's sales.

Furthermore, 28% of the company's revenue is earned from "Everyday Nutrition" products such as grains, fruits, and vegetables, or protein, plus those that are naturally nutritious like water and unsweetened tea. These are products with positive nutritional value that consumers are demanding more of as they become increasingly health conscious.

Even Frito-Lay chips are undergoing innovation, with Pepsi creating natural and organic versions under its new "Simply" label. These lower fat, lower sodium, and natural ingredient formulations of classic Frito Lays products are now in Walmart, Target, Costco, Kroger, and Whole Foods.

Initiatives like these represent not only Pepsi's attempts to increase its market share in the U.S. snack foods market, but also compete in the global healthy foods market.

Additionally, the company is investing in e-commerce and generates over $1 billion in retail sales online. While overall penetration of online food and beverage shopping remains relatively low compared to other categories (clothes, books, etc), Pepsi is ensuring it will remain a force no matter where its products need to be sold.

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. Pepsi is far more than a beloved soda brand today and appears positioned to continue rewarding dividend growth investors for many years to come.

Key Risks
The healthy living trend is usually the biggest risk that comes to mind when investors think about Pepsi’s business. People are becoming more mindful of what they are putting in their bodies each day, and government regulations such as California's soda and Seattle's sugar taxes could further catalyze the healthy-eating trend.

Carbonated soda is arguably the category that is under the most pressure, especially in North America. U.S. soda sales have declined over the last decade, and it would be unsurprising if soda consumption were to continue dropping over time as people in developed countries become more health conscious.

Fortunately, Pepsi's business is well diversified beyond soda. Pepsi also has a number of levers to pull (smaller packaging, price increases, promotion) to ensure that its soft drinks business remains a cash cow, albeit with little growth.

In addition, as Pepsi’s product mix continues evolving to include healthier options, the risk posed from soda should continuing declining. Pepsi has seen especially strong growth in its coffees, sports drinks, and water portfolio.

However, the company will need to find the right balance between experimenting with new brands and products while not alienating its still large, core base of consumers who continue drinking soda and indulging on less healthy snacks.

Diversifying into foods has helped Pepsi continue to grow despite challenges in soda markets, but this benefit shouldn't be overstated. After all, salt and fat, primary components in many of Pepsi's snack foods, are often perceived as unhealthy as well.

If consumers accelerate their adoption of healthier food and beverage choices, the company could face increased pressure to launch more new products and acquire faster-growing rivals with trendier brands. The problem is that for a company of Pepsi's size, needle-moving investments need to be large, increasing risk.

Besides opting for healthier products, more consumers are also warming up to cheaper private-label goods in many food and beverage categories. Costco's Kirkland Signature brand is the shining example, with revenue hitting $39 billion in 2018. For context, that's approximately 60% of Pepsi's total sales and nearly 30% of Costco's total business.

Online shopping has also made it easier for store brands and upstart products to quickly gain visibility and direct-to-consumer distribution, bypassing the traditional retailer relationships that helped many of Pepsi's products become so popular with households.

To combat this constant threat, Pepsi will need to continue achieving success with its product innovation and marketing investments, protecting the value perception of its brands.

Finally, Pepsi, like most global consumer staples companies, faces commodity price and currency exchange rate risks. Volatile input costs and a stronger U.S. dollar can weigh on the company's profits over the short term. However, these headwinds shouldn't affect Pepsi's long-term earnings potential.

Overall, given Pepsi’s balanced portfolio, global presence, and track record of adapting to the times, it’s hard to identify many risks that could really harm the firm's long-term outlook. Perhaps the biggest challenge facing management is the task of continuing to deliver solid earnings growth for a company as big as Pepsi.

Closing Thoughts on PepsiCo
Unlike many large consumer staples companies, Pepsi’s long-term prospects appear positive. While the consumer health trend should be monitored, Pepsi’s diversified snack and beverages portfolio, more limited exposure to soda, investments in innovation, and exposure to international markets help mitigate concerns.

The company has paid uninterrupted dividends since 1965, including 47 consecutive years of payout increases, and shows no signs of slowing down anytime soon.

While the food and beverage industry's growth challenges will be something that Pepsi must address over the coming years, Pepsi appears to remain a dependable long-term dividend growth stock for conservative income growth portfolios.