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When an iconic brand like Pepsi has a meaningful correction, investors are intrigued and mostly desire to buy some shares. While some investors crave dividends, others crave meaningful price appreciation. Interestingly, I have found that investors fail to recognize and appreciate the nuances of the company's stage in the business cycle. Now, Pepsi is a mature, well-established company. However, there are different kinds of mature companies. For instance:
Late-stage company heading towards winding up or bankruptcy.
A company with established assets, generating consistent cash flows, but with newer assets that propel its future growth.
A company with low revenue growth - equal to or less than GDP growth - leveraging operational efficiencies and enhancements to continue to deliver EPS growth much greater than revenue growth.
Pepsi squarely and unequivocally belongs in the #3 category. Consider the following conversation from the Q3 2024 Earnings Call:
If I could just follow up on that with the – other than the details, if organic revenue growth does indeed stay in the sort of low-single-digit or 1% range, can you still deliver 8% on EPS?
I think we have a very large productivity set of tools that we'll keep deploying systematically. At the same time, we don't think our category will grow at 1% long term. We think our category with investments that we're putting back into the business and the help of our brands and the innovation that we have in place for this year and next year will deliver much more than 1%. So, we're not considering that scenario in our kind of planning.
I don’t get any prizes for being nice here. That is plain gobbledygook. You don’t have to trust my judgment, look at the stock price - that is the end all and be all of it. Hence, we can assume 2025 will be another flattish revenue growth year with operational levers helping it maintain its EPS growth rate.
That said, there is light at the end of the tunnel for Pepsi. Irrespective of how the structural pressures of higher operating costs, and consumer behavior play out, 2026 looks set to be a blockbuster year for EPS growth. Why? Here is why:
The 2019 Productivity Plan, publicly announced on February 15, 2019, leverages new technology and business models to further simplify, harmonize and automate processes; re-engineers our go-to-market and information systems, including deploying the right automation for each market; and simplifies our organization and optimizes our manufacturing and supply chain footprint.
To build on the successful implementation of the 2019 Productivity Plan, in 2022, we expanded and extended the plan through the end of 2028 to take advantage of additional opportunities within the initiatives described above. As a result, we expect to incur pre-tax charges of approximately $3.65 billion, including cash expenditures of approximately $2.9 billion.
Plan-to-date through September 7, 2024, we have incurred pre-tax charges of $2.3 billion, including cash expenditures of $1.7 billion. For the remainder of 2024, we expect to incur pre-tax charges of approximately $300 million and cash expenditures of approximately $200 million. These charges will be funded primarily through cash from operations.
We expect to incur the majority of the remaining pre-tax charges and cash expenditures through 2025, with the balance to be incurred through 2028.
Source: Q3 2024 10Q - PDF Page 45
So, what levers are available to Pepsi to boost EPS if revenues falter? While the productivity plan ends in 2028, most of the restructuring expenses will be covered by the end of 2025. In one quarter, if things turn south, they can just turn the tap off and record fewer restructuring charges. There is nothing illegal here; it is just a tool they have.
Now, if everything goes according to plan, the “Restructuring Charges” line item in the Income Statement starts becoming smaller meaningfully in 2026, and hence, as I said earlier, in 2026 Pepsi will see a meaningful boost to EPS. As they say, it is a feature, not a bug.
Now that we have the narrative and framework to work with, let’s take a shot at valuing Pepsi using a few methodologies.
Intrinsic Value
Oh, the horrors of numbers and assumptions!!! Let me try to simplify it as much as possible. As for the experts, feel free to roast me on X. Given that, the first step is to derive the cost of capital for Pepsi.
Cost of Capital Calculation
Debt Ratio = 0.4, Marginal Tax Rate = 37%
Cost of Capital = 0.6 * Cost of Equity + 0.4 * (1 - 0.37) Cost of Debt
Cost of Equity = Risk-Free Rate + Beta * Equity Risk Premium
= 4.6% + 0.54 (4%) = 6.76%
Cost of Debt = Risk-Free Rate + Default Spread (Based on Rating)
= 4.6% + 0.92% = 5.52%
Cost of Capital = (0.6) 6.76% + (0.4) (1 - 0.37) 5.52% = 5.45%
As we had previously established, Pepsi is a stable mature firm with a current growth rate of 1% (g). Let’s now calculate the value of Pepsi’s Operating Assets.
Value of Operating Assets Calculation
LTM FCF = 6,201 million
Value of Operating Assets = (FCF (1 + g)) / (Cost of Capital - g)
= (6,201 * (1 + 0.01)) / (0.0545 - 0.01) = 97,101 million
Now that we have the Value of the Operating Assets of Pepsi, let’s calculate the value of Pepsi’s Equity.
Value of Equity Calculation
Cash = 8,051 million, Debt = 45,014 million
Value of Equity = Value of Operating Assets + Cash - Debt
= 97,101 + 8,051 - 45,014 = 60,138 million
All that remains now is to calculate the value per share.
Value per Share
Weighted Average Shares Outstanding Diluted = 1,379.3 million
Value per Share = Value of Equity / Weighted Average Shares Outstanding Diluted
= 60,138 / 1,379.3 = 43.6
MOMMY, but the current share price is 152.06!!! Let’s all calm down. Let’s determine if there were any inconsistencies in my assumptions.
Reconciling Return on Capital
Reinvestment Rate = (CAPEX - Depreciation + Change in Working Capital)/After-Tax Operating Income
= (5,831 - 3,483 + (-7,474)) / 11,279 = -45.45%
Implied Return on Capital = g / Reinvestment Rate
= Don’t even bother with a -ve Reinvestment Rate
I was trying to figure out whether my growth assumptions were wrong but, looky what I ended up finding. A negative Reinvestment Rate. That should scare the bejesus out of any investor. I believe there is a serious Reinvestment Risk with Pepsi. Simplistically, there is a possibility that Pepsi may not be able to reinvest cash flows at a rate comparable to its current rate of return. Now even mommy is freaking out.
However, since I promised I would go through a couple of valuation models, let’s plug along.
Dividend Growth
Assuming Pepsi doesn’t have cash flow problems, the simplest way to arrive at the value of equity per share is via observable cash flow: dividends. Over the last 5 years, Pepsi has grown its dividends by 7% and has already raised it by 7% for next year. So, this is an easy layup.
Calculating Value of Equity per Share using Dividend Growth
Value of Equity per Share = Expected Dividends per Share / (Cost of Equity - g)
= 5 (1.07) / (0.0676 - 0.01) = 92.88
You may play around with the growth rate and figure out whether you trust Ramon and how much topline growth Pepsi can achieve.
Verdict
Pepsi has a PEG ratio of 2.89. Pepsi doesn’t deserve that based on its growth profile. How much lower should the P/E be? Let the market decide.
The Reinvestment Risk scared me. I would avoid Pepsi and look for better things to do in life. Maybe in 2026, I may come back and have another look, but for now, I am running for the hills.
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