PEP reported quarterly results last week, beating expectations and reinforcing the key reasons why we have like the stock. We continue to believe PEP has a clearer and, as of today, brighter future than Coca-Cola (KO). The ongoing trends that drove PEP’s strong quarter suggest that the strategic differences between PEP and KO will only become more important going forward. For these reasons, PEP remains one of our favorite dividend stocks.
Before we get into another PEP vs KO debate, let’s quickly review the points from PEP’s quarter that stood out to us. PEP’s organic sales grew more than 7% (compared to 5% growth last quarter), with strength in both snacks (+10%) and beverages (+5%). Earnings per share, excluding currency effects, grew 14% compared to the prior year’s third quarter.
While both companies are one of the 52 dividend aristocrats, recall that PEP is quite different from KO as it relates to its mix of carbonated beverages (<30% of volume vs 70%+ of KO’s volume) and snacks (30-40% of PEP’s sales vs 0% for KO). PEP also has 22 brands with sales greater than $1 billion compared to KO’s 20 billion-dollar plus brands.
PEP noted that beverage volumes were up 3% in Q3. However, carbonated soft drinks volume was down 1.9%, and non-carbonated beverages saw volumes rise nearly 10%. PEP’s CEO stated, “Clearly the big story here is non-carbs and the non-carbs are really what’s driving all of the growth in the whole industry…Regarding North American beverages, today more than ever, the portfolio is shifting to non-carbs. Innovation is becoming more fragmented and the life cycle of innovation is being shorter and the trade becoming more and more complex.”
Clearly PEP is seeing and responding to the strengthening consumer trend away from carbonated soft drinks and toward “healthier” beverages. While many perceive the beverage industry to be slow-changing, we found PEP’s comment that “the life cycle of innovation is being shorter” especially interesting. The CEO’s remark on how to analyze the beverage market’s growth really drove these points home:
“I think focusing just on [carbonated soft drinks] is actually a thing of the past and I would strongly suggest everybody looks at total [liquid refreshment beverages], because that’s the right way to look at the market going forward.”
With no snacks and less than 30% of its global volume coming from non-carbonated beverages, KO has much more work to do if it wants to continue growing its earnings. KO has the global distribution network, brand, and financial firepower, but its massive size also slows down the rate at which it can profitably diversify into products more aligned with secular beverage trends. The company will continue throwing off mountains of cash flow for decades to come, but we question the sustainability of its 21x forward earnings multiple if profit growth stalls over the next five years.
On the other side of the fence, PEP has been pushing all of the right buttons. The company noted it gained value share across ready-to-drink tea and water (large non-carbonated beverage categories), and its Frito-Lay snack business grew organic sales by 2%, topping expectations.
Once again, PEP was the largest contributor to US retail sales growth among all food and beverage manufacturers with over $400 million of retail sales growth in all major channels. This was double the next largest contributor to growth! As we highlighted in our original thesis on PEP, the company is an extremely important vendor for most of its customers for several reasons.
According to IRI, 54% of consumers who buy salty snacks buy liquid refreshment beverages in the same basket. Selling both types of products, like PEP does, is preferable for customers because they only need one point of contact. PEP plays in product categories with some of the highest turnover rates in the food and beverage market. Within those categories, PEP’s product turnover is also well above the average, meaning it is moving its branded products out the door much faster than its competitors. In other words, PEP is the biggest contributor to cash flow for almost any customer it does business with, an extremely valuable partner that has arguably more than earned its premium shelf space.
Beyond the quarter, the long-term future looks bright for PEP. Foodservice is a $700 billion global market that we believe will continue to around 3-4% per year going forward. While the $67 billion PEP generated in sales last year is a big number, it still represents less than 10% of the overall market and leaves plenty of room for expansion.
From a dividend perspective, nothing has changed – PEP’s dividend continues to score an extremely high Safety Score (99) and an above-average Growth Score (66). As a refresher, we evaluate payout ratios, balance sheets, profitability trends, sales growth, industry cyclicality, and more to generate our scores.
PEP has increased its annual dividend for 43 consecutive years, growing its dividend per share at a compound annual growth rate of about 10% over the last decade and maintaining its status as one of the strongest dividend aristocrats. With a free cash flow payout ratio of about 50% and solid business growth, there is plenty of room for additional dividend increases in the years ahead.
PEP trades at about 22x forward earnings. Hardly a bargain, but we think the stock is an example of a “wonderful company trading at a reasonable price.” We are happy to hold our position for many years to come and would opportunistically add on pullbacks. Compared to KO at 21x forward earnings, we think PEP is the relatively more attractive investment opportunity. From a dividend yield perspective, PEP yields 2.8% and KO yields 3.1%, perhaps reflecting the market’s recognition of PEP’s clearer growth strategy.