In our final lap around the track in pursuit of an investment decision, we've set up an earnings growth model for PepsiCo. (NYSE: PEP) to get a handle on what the company will need to do over the next 15 years in order to meet our objective for a 15% compounded annual return. We crunched the numbers for three different scenarios, all of which assume different combinations of earnings per share and price-to-earnings (P/E) multiple growth:
Scenario 1 Assumes both earnings and P/E multiple growth
Scenario 2 Assumes earnings growth and P/E multiple decline
Scenario 3 Assumes earnings growth and constant P/E multiple
You merely need Excel spreadsheet to view our model scenarios. The tabs at the bottom of the document take you to our three different models.
Scenario 1 is the model that Jeff and I hope is most likely to unfold, if any of our imaginary scenarios are actually to occur at all. These are just models after all. They should not be taken as gospel by anyone including ourselves.
Each scenario assumes that four main growth levers, as Jeff likes to call them, will be pulled by Pepsi year after year. We'll consider these one by one.
1. Annual sales growth
This is the main lever at Pepsi's disposal. The most obvious way to grow sales is to sell more products year after year, whether it's good old-fashioned case volume growth of Pepsi-Cola, new flavors of Doritos, or higher sales of Tropicana Pure Premium orange juices. Hopefully, there will be sustained unit growth at all three of the firm's divisions, both in domestic and international markets.
On top of the unit growth, it's important to remember that Frito-Lay is one of the few branded food companies out there that can legitimately claim some sort of pricing power. That's a major competitive advantage in our minds and it should help the company achieve predictable sales growth of around 5%. Our preferred scenario assumes sustained 6% top-line growth.
2. Annual expense growth slower than annual sales growth
This driver is also called "operating leverage," which is different from "financial leverage" or debt. This will be a key element if Pepsi is to attain its long-term goal of double-digit operating profit growth. Top-line growth alone will not cut it; the firm will need to regularly eliminate costs and effectively do more with less. In our view, Pepsi's efficient and much-admired distribution system is a major asset here.
Over time, operating leverage should translate into higher returns on capital and higher operating margins. Under Scenario 1, we're projecting operating margins to hit a very Coke-like 27.5% in 15 years, up from 16.5% last year. This can be achieved with an annual expense growth rate a mere one percentage point lower than the sales growth rate.
3. Consistent decline in annual interest expense
Lowering interest expense on its long-term debt is where financial leverage comes into play. With a much less asset-intensive business model, Pepsi should easily be able to fund its operations through its operating cash flow without taking on new debt. In addition to that, keeping annual capital expenditures in line with depreciation and amortization charges should free up enough cash for the company to pay down debt and lower its annual interest expense.
4. Consistent decline in annual sharecount
Some of the cash that's left over can be used for share repurchases, returning value to shareholders and boosting earnings per share. As of April, the company had already repurchased $2 billion worth of stock under a three-year, $3 billion share buyback plan instituted last year.
When compared to the first two levers, the effects from the interest expense and share buyback should be small in percentage terms. In all three of our profit growth scenarios, we are assuming 2% annual declines in both interest expense and sharecount from last year's levels. This is no small feat on the sharecount front.
All told, the pulling of these four "levers" gets us to 12.7% annual EPS growth under our preferred Scenario 1. To get us over the 15% return hump, we'll need to rely on a rise in Pepsi's price-to-earnings multiple, a lower-than-current-market-price cost basis, or an annual dividend growth kicker. Quite possibly, we'll need all three of these things.
At this point, we'll hand off the baton to Jeff to wrap up our study by early next week. We may be out of breath as our long study ends, but we'll certainly have enough energy left to share our final investment decision with you very soon.
To discuss our earnings scenarios for Pepsi and ask us questions, visit us on the Drip Companies board. Have a great weekend.
