PepsiCo, Inc. (PEP) has just released Q2 2019 results and reaffirmed FY2019 guidance. In its July 9, 2019 Earnings Release, PEP's Chairman and CEO indicated efforts are being made to make PEP a faster, stronger and better company by building new capabilities, strengthening brands, adding capacity to grow and transforming the culture.

I view PEP as a company that will merely continue to plod along.

Summary

  • In my April 23rd article I disclosed that I had written October 2019 $130 covered calls and my reasons for such a decision.
  • I view PEP as a company which just 'plods' along and which is currently overvalued.
  • It is not my intent to liquidate my PEP holdings but I currently have no intention of adding to my position other than through the automatic reinvestment of dividends.

Introduction

With the release of PepsiCo, Inc.'s (PEP) Q2 results for the 24 week (just under a full half year)  period ending June 15, 2019 (the 15th is not a typo) and the surge in PEP's share price subsequent to me writing October 18, 2019 $130 covered calls I thought this would be an opportune time to quickly look at PEP; click on the following links to access my two previous PEP posts (February 17, 2018 post and April 23, 2019 post).

Interestingly, PEP's Chairman and CEO indicated in the July 9th Q2 2019 Earnings Release that:

'We are also pleased with the progress on our priorities to make PepsiCo a faster, stronger and better company by building new capabilities, strengthening our brands, adding capacity to grow and transforming our culture. Our performance for the first half and the progress we are making on our strategic priorities give us increased confidence in achieving the 2019 financial targets we communicated earlier this year.'

I understand his position given his leadership role in the company but when I look at PEP's brand portfolio and see how an increasing number of people are beginning to pay closer attention to the nutritional value of the products they consume, I can't say that I view PEP as a company that will do much more than 'plod' along.

I know PEP devotes a section of its website to 'Nutrition' but when I look at the products PEP deems to be nutritional it appears that we have a difference of opinion. I never buy PEP products but I will go down the aisles in the grocery stores where its products are displayed for interest sake. When I look at the 'expiry date' on PEP’s products I KNOW I don't even have to look at the list of ingredients to know that stuff is in PEP’s products are not on the 'good for you' list.

Having said this, I will readily admit that I am not the world’s 'most ethical investor'. Were I the 'world’s most ethical' investor I probably would not have retired in my mid 50s as I would have likely passed on investing in many companies within our portfolio; you can probably find something with just about every publicly traded company that a 'purely ethical investor' would deem as a reason not to invest. I have, in essence, tried to find a healthy balance….invest in decent companies that do their best not to run afoul of the law and which do what they can to make the world a little better.

I digress….

When I wrote my April 23, 2019 post, PEP shares were trading at ~$127. At the time of that article I wrote:

As per the Q1 2019 Earnings Release, guidance calls for 2019 adjusted core EPS of $5.50 which is a 3% decrease compared to 2018 adjusted core EPS of $5.66. Reported diluted EPS for FY2018 was $8.78 but if you look at page 6 of 7 in this document you will see various adjustments.

I also note that the mean adjusted FY2019 EPS estimate based on estimates from 25 analysts is $5.52. Another source from which I access earnings estimates reflects a consensus estimate of $5.67.

If we use the current ~$127 share price and the consensus earnings estimate reflected above we arrive at a forward adjusted PE range of ~22.4 - ~23. Using management's guidance we get a forward PE of ~23.

I view PEP as currently being fairly valued based on the above forward adjusted PE levels.

Based on management's guidance, current market conditions, and my opinion on PEP's valuation at the time, I decided to initiate a covered call on some of our underlying PEP shares. My rationale for writing covered calls was to:

  • collect cash income at the time of the trade;
  • generate a small amount of downside protection if PEP's stock price declined.

In the portion of the article viewable by subscribers I disclosed the covered call option strategy I had decided to employ. NOTE: When employing covered calls you must own the underlying shares.

I decided to sell 4 October 2019 $130 covered calls as opposed to a shorter expiry to generate more time premium. In addition, I chose the $130 strike price which was slightly higher than the current market price to allow for a potential slight uptick in PEP's stock price. I could have written a covered call with a $135 strike price but I would have received less of an upfront premium.

In exchange for writing the October 2019 $130 covered calls I received $3.50/share or $350 per contract (excludes nominal service charges).

Although the book value of my PEP shares is less than half the current market value I always look at my breakeven point at being the strike price plus the premium I received.

In presenting potential outcomes regarding the covered call options I had sold, I provided the following outcomes using different stock prices.

  • If shares are trading below $130 then I retain the premium I collected AND my shares. Nobody in their right mind would buy PEP shares at $130 if they could acquire shares on the open market for less than $130.
  • If shares are trading at $131 and the buyer of the calls exercises their right to buy shares from me at $130 then I would be ahead $2.50/share ($131 – ($130 + $3.50)).
  • If shares are trading at $132 and the buyer of the calls exercises their right to buy shares from me at $130 then I would be ahead $1.50/share ($132 – ($130 + $3.50)).
  • If shares are trading at $133.50 and the buyer of the calls exercises their right to buy shares from me at $130 then I breakeven ($133.5 – ($130 + $3.50)).
  • If shares are trading at $140 and the buyer of the calls exercises their right to buy shares from me at $130 then I would be down $6.50/share ($140 – ($130 + $3.50)).

I indicated that it was not my intent to part with my PEP shares so I indicated I would need to determine what course of action to take based on where PEP would be trading in mid-October 2018.

So….what has happened subsequent to my April 23, 2019 article? Well, in these crazy market conditions PEP's share price has appreciated and it briefly exceeded $135 (late June). The share price, however, has subsequently retraced slightly and as I compose this article I see shares are trading at ~$131. I still have over 3 months before the covered calls expire and anything can happen between now and then. As for now, however, my option trade is profitable.

For the sake of full disclosure, the last time I ranked all my holdings and the respective weighting of each holding within the overall portfolio, PEP was my 30th largest holding. I am not about to perform this exercise again at this time but following a brief review of all our holdings held in multiple accounts, it appears that PEP is no longer one of our top 30 holdings.

Q2 2019 Financial Results and FY2019 Guidance

The supporting material related to PEP’s Q2 2019 Earnings Release can be accessed here; FY2019 guidance can be found on page 4 of 18.

Credit Ratings

The following provides a history of PEP's Senior Unsecured Foreign Currency credit ratings history.

Moody’s continues to assign an A1 rating to PEP's long-term debt and Standard & Poor’s continues to rate PEP's long-term debt A+.

I don't particularly like to see rating downgrades but the current A1 and A+ levels are satisfactory for my purposes.

Dividend and Dividend Yield

PEP's dividend history can be accessed here.

When I wrote my April 23rd article, I indicated that PEP's dividend history had not been updated to reflect the 15.2% increase in PEP's quarterly dividend ($0.805/quarter to $0.9275/quarter which was declared May 1, 2018). Looking at historical Press Releases related to PEP's dividend, however, I knew that investors were receiving a $3.71/share annual dividend which provided them with a ~2.93% dividend yield based on the current ~$127 stock price.

Subsequent to my April 23rd article, PEP declared a sub 3% dividend increase on April 30th ($0.9275/quarter to $0.955/quarter). PEP investors who had grown accustomed to annual dividend increases which outpaced the rate of inflation certainly received a rude awakening.

Despite this weaker than anticipated dividend increase, PEP's share price has appreciated to the current ~$131. With the dividend now being $3.82, investors are receiving a dividend yield of ~2.91%....not great but certainly not completely out of line with historical dividend yields.

Valuation

Using PEP's Q1 2019 Earnings Release for my April 23rd article I noted that guidance called for 2019 adjusted core EPS of $5.50 which was a 3% decrease compared to 2018 adjusted core EPS of $5.66. Reported diluted EPS for FY2018 was $8.78 but when we looked at page 6 of 7 in this document we saw various adjustments.

I also noted that the mean adjusted FY2019 EPS estimate based on estimates from 25 analysts was $5.52 and another source from which I access earnings estimates reflected a consensus estimate of $5.67.

At the time of my April 23rd article, PEP was trading at ~$127/share and using the consensus earnings estimates reflected above I arrived at a forward adjusted PE range of ~22.4 - ~23. Using management’s guidance of $5.50 I arrived at a forward PE of ~23.

With the release of Q2 2019 results we see the net income attributable to PEP per diluted common share generated in the first half of FY2019 was $2.44 ($2.21 for the same timeframe in FY2018). On an adjusted basis, PEP generated $2.52 versus $2.58 in FY2018 (refer to page 14 of 18 in this document).

With the release of Q2 earnings we see that PEP has reiterated its $5.50 FY2019 adjusted core EPS estimate.

I now see that the consensus estimate from 24 analysts has been lowered from the previous $5.67 to $5.54 with quite a disparity in projections ($5.49 - $5.75). The $5.75 estimate is a real outlier and the guidance from the vast majority of the analysts is clustered in the $5.49 - $5.53 range.

If we use the current ~$131 share price and the projected $5.50 FY2019 adjusted core EPS we get a forward adjusted PE of ~23.82. This valuation is slightly higher than when I wrote my April 23rd article.

In my previous article I viewed PEP as currently being fairly valued based on the above forward adjusted PE levels and on that basis I chose to write $130 covered calls. I don't think PEP is grossly overvalued but I think a price below $130 is more representative of PEP's current value and I stand by my April 2019 decision to write $130 October 2019 covered calls; I think PEP will be below this level as we approach expiry.

Final Thoughts

PEP is certainly not a company that is at the forefront of my mind. To be perfectly honest, I consume only their 'Sabra' hummus as all their other products are not products I deem to have any nutritional value; I used to consume a lot of Tropicana orange juice until I realized there is very little that is healthy about the product (my opinion).

I certainly did not acquire PEP shares many, many years ago (and KO shares too) from an ethical perspective. I simply acquired PEP shares and have periodically added to my position because I viewed the shares as being attractively valued (aka. inexpensive/cheap). I can't say the same thing now.

I have mentioned in several other articles that I am being cautious in this environment and am only adding to my position when I think a decent company has fallen temporarily out of favor with the broad investment community; PEP currently does not strike me as such a company.

I have no intention of adding to my PEP position at this point in time (other than through the automatic reinvestment of dividends). I am cautiously optimistic PEP's share price will continue to retrace from its recent ~$135 high posted in late June and will close below $130 come the expiry of my October 2019 calls.

I fully recognize you can make money from companies, such as PEP, which just ‘plod’ along. In my opinion, however, there are far better companies in which to invest (look at page 47 of 162 in the 2018 Annual Report and you will see this is not a ‘Growth’ company). It is, therefore, not my intent to acquire additional PEP shares other than through the automatic reinvestment of dividends.

I hope you found this article helpful and wish you much success on your journey to financial freedom.

Thanks for reading!

Note: I sincerely appreciate the time you took to read this article. Please send any feedback, corrections, or questions to [email protected].

Disclaimer: I have no knowledge of your individual circumstances and am not providing individualized advice or recommendations. I encourage you not to make any investment decision without conducting your own research and due diligence. You should also consult your financial advisor about your specific situation.

Disclosure: I am long PEP and KO.

I wrote this article myself and it expresses my own opinions. I am not receiving compensation for it and have no business relationship with any company whose stock is mentioned in this article.