The Coca-Cola Company (KO 0.15%) and PepsiCo (PEP -2.97%) need no introduction. Both companies have been around since the late 1800's and have been rewarding their shareholders with dividends and buybacks. But which company offers the safest rewards or the biggest dividend increases to shareholders?
Coke currently has a market capitalization and dividend yield of $185 billion and 2.9%, respectively. Pepsi's market capitalization and dividend yield are $135 billion and 2.9%, respectively. These yields appear quite attractive given the current low yields on US treasury securities. Over the six-year period from 2007-2013, Coke and Pepsi have grown their dividends by compound annual growth rates of 8.67% and 8.07%, respectively. This period encompasses the lead-up to the financial crisis and the most current year-end. Both companies have shown that they can weather the storm of economic uncertainty and still increase their dividends. In fact Coke has increased its dividend for 50 years straight, while Pepsi has done so for 42 years.
When evaluating dividend safety, it helps to be in a stable industry that does not solely rely on the ebbs and flows of economic growth. This is not to say that economic growth does not impact these companies--it does. Basically, people are always going to drink the products that Coke and Pepsi offer consumers, but their sales will not vary as much with economic growth. Investors can quantify dividend safety by looking at the payout ratio, free-cash-flow generation, and coverage ratios. Stock repurchases are another way to reward shareholders, and investors can evaluate them with coverage ratios as well.
Breakdown of the stats
| Coke | 2007 | 2008 | 2009 | 2010 | 2011 | 2012 | 2013 |
| FCF | $5.5 billion | $5.6 billion | $6.2 billion | $7.3 billion | $6.6 billion | $7.9 billion | $8 billion |
| Payout ratio | 52% | 60% | 55% | 34% | 50% | 51% | 58% |
| FCF coverage | 1.1 times | 1.22 times | 1.16 times | 1.04 times | 0.74 times | 0.86 times | 0.82 times |
| Pepsi | 2007 | 2008 | 2009 | 2010 | 2011 | 2012 | 2013 |
| FCF | $4.5 billion | $4.6 billion | $4.7 billion | $5.2 billion | $5.6 billion | $5.8 billion | $6.9 billion |
| Payout ratio | 39% | 49% | 46% | 47% | 49% | 53% | 51% |
| FCF coverage | 0.7 times | 0.63 times | 1.71 times | 0.65 times | 1.0 times | 0.88 times | 1.07 times |
Free cash flow, or FCF, is the cash generated by business operations after investments in capital expenditures. It represents cash available to shareholders that the company can return in the forms of dividends and stock buybacks. Coke and Pepsi have grown their free cash flows at compound annual growth rates of 6.44% and 7.38%, respectively. Pepsi has been increasing its dividend more rapidly than Coke and pays out a lower percentage of dividends from earnings than Coke, which implies that it may have room to increase its payout ratio.
The payout ratio looks at dividends paid as a percentage of net income, but the FCF coverage ratio looks at dividends and stock buybacks as a percentage of FCF. An FCF coverage ratio above one implies that the respective company is earning enough cash after capital expenditures to cover its current dividend and buyback program. A ratio of less than one over a multi-year period implies that the company is likely to reduce its dividend or more than likely its buyback program.
Coke's coverage has been hovering below one for the past three years. This can be traced back to its decision to continually increase its stock buyback program which has matched its dividend payments on a dollar basis. With Coke's ratio of less than one, we should not be surprised if it reduces its buyback program in the future. Investors can see Coke's dividend as safer than its buyback program because investors are generally more favorable toward dividends.
Investors can view stock buybacks as a vote of confidence from management that indicates it sees the stock as undervalued and a good investment. Pepsi, like Coke, conducts stock buybacks that closely match its dividend payments on a dollar basis. Pepsi's FCF coverage for the past three years has been higher than that of Coke, but not by much. Investors should be wary about whether Pepsi's buybacks will continue at the same clip.
Foolish takeaway
Investors who are looking for income in their portfolios would be wise to give Pepsi a closer look. Pepsi has a long history of dividend increases that are supported by healthy financials. Pepsi's steady FCF growth should help support its long-term dividend growth of 8.07%. Coke's higher payout ratio indicates that Pepsi has room to pay out more of its earnings to be in line with its peers. It's noteworthy that Pepsi's coverage ratio of below one probably signals that its buyback rate will not continue at its past levels, but its dividend increases seem sustainable.
