When the broader stock market falls, some investors get scared and flock to safe names -- those that have been around, standing the test of time. One of those safe names is snack and beverage giant PepsiCo (PEP -0.41%). The company sells some of the most popular food and drink brands in the world. It's a cash generator and the company has paid and raised its dividend for 49 consecutive years.
This article isn't here to make the case that PepsiCo is a bad company or a horrible investment. But it does seem that the stock has become quite popular, pushing the share price to all-time highs. Before following the crowd into PepsiCo, consider these three reasons why the stock could be a disappointment at the moment.
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1. Popular stocks are rarely cheap
There are many reasons to like PepsiCo; its products, like Pepsi, Doritos, and Gatorade, are popular. Of the dozens of brands it markets, 23 generate $1 billion or more each in revenue every year. This kind of revenue generation means plenty of profits to share with investors. The company is about to become a Dividend King, and raising a dividend annually for 50 consecutive years is not something weak companies can pull off.
But picking the right company is only part of the equation in investing; the price you pay can matter just as much. PepsiCo's valuation has steadily risen over time; the stock now has a price-to-earnings (P/E) ratio of 29, which is comfortably higher than its average P/E of 23 over the past decade.
PEP P/E ratio. Data by YCharts.
When a stock's valuation runs higher like this, there are two potential outcomes. The stock's fundamentals can justify the high valuation and eventually generate the growth or higher profits needed to bring the valuation back to the norm, or the valuation eventually goes back down as investors lose interest in a stock under-performing. In PepsiCo's case, does the stock deserve this higher valuation?
2. Growing large numbers is tough
PepsiCo is having a great 2021 fiscal year. The company's most recent quarter, the third, showed that revenue grew 11.6% year over year and is up 13.2% year over year when combining the first three quarters. The company's beverage volume is up 11% year over year for the first three quarters combined, which makes sense considering that lockdowns in 2020 closed many gathering places like restaurants, where PepsiCo sells its concentrates for fountain drinks.
The company is having a great year, but is the outlook as rosy? PepsiCo has grown revenue an average of 2% per year over the past decade, and analysts are already looking for it to revert lower, calling for 4% revenue growth in 2022. Matching strong 2021 results will be difficult.
PepsiCo isn't a software company that can rapidly acquire customers or a smartphone company that sells many big-ticket items. It generated its $54 billion in overall revenue through three quarters of 2021 by selling millions of small items for between $1 and $5 each. Consumers tend to eat and drink the same amount on a month-to-month basis. It's harder to move the needle with this business model. When you factor in its $241 billion market cap, the ability to generate big increases year to year becomes more difficult the bigger PepsiCo gets. It's already one of the largest food and beverage companies on earth.
We're seeing a rebound year after lockdowns impacted the business in 2020, but that doesn't change PepsiCo into a growth stock. It's a massive and mature business likely to grow modestly in the future.
3. The balance sheet is slowly sliding
PepsiCo returns a lot of cash to shareholders, not only through its annual dividend raises but also through buying back stock to help grow its earnings per share. Its dividend payout ratio is a high 86%, which doesn't leave a lot of money left over. The company occasionally borrows money to fund its buybacks or make an acquisition (it bought energy drink brand Rockstar for $3.85 billion in 2020).
The company's balance sheet has slowly taken on water over the past 10 years. Its ratio of debt to EBITDA (earnings before interest, taxes, depreciation, and amortization), which compares its debt to its profits before noncash adjustments, has risen from less than 2.4 to 3.0.
PEP financial debt to EBITDA (TTM). Data by YCharts. TTM = trailing 12 months.
I don't think that this means that PepsiCo is in financial trouble. It could always sell some of its many brands if it needed the cash for debt servicing, but it could mean that its financial flexibility is diminishing. A tighter balance sheet could result in lower dividend raises, fewer buybacks, and fewer acquisitions.
Investor takeaway
PepsiCo is a blue-chip stock, but investors should be cognizant of the headwinds that are developing for the company. The stock is expensive, and investors need to justify this higher valuation against the possibility of slowing growth and a weaker balance sheet.
It's likely a safe stock in that the company will probably be around for years to come. But is it the safest place to invest today? If you're aiming for strong investment returns, you might want to reconsider investing in PepsiCo.
