In my quest to fill out a DGI portfolio of twenty stocks inside my 401(k), of course I looked at the duopoly of Coca-Cola (NYSE:KO) and Pepsi (NYSE:PEP). There is just something intrinsically intriguing to me about companies that have raised their dividends longer than I’ve been alive.
But the more I looked into the space, the more I realized that the company with the longest runway may very well be Dr Pepper Snapple Group (NYSE:DPS).
Flagships at Half Mast
To the surprise of no one, sales of carbonated soft drinks (CSDs) have been on a steady decline for over a decade now. Couple this with the trend that bottled water consumption has been in a near-perfect uptrend since 1977, and bottled water sales have now surpassed that of CSDs. Whether it is consumers realizing organically that sodas are not the greatest of drink options, or being assisted in coming to that realization by our benevolent and altruistic overlords, the horse is galloping fast and it is hard to imagine it being put back in the barn.
With it being obvious to every consumer, it is also obvious to the affected companies. Both Coca-Cola and Pepsi have taken numerous steps to try to stem the tide of soda sales. For Coke’s part, there have been acquisitions of vitaminwater and smartwater, an equity stake in Monster Beverage (NASDAQ:MNST), acquiring Honest Tea and launching (insert drink name) Zero products. For Pepsi, there has been a dip into the probiotic market, reacquiring bottlers, an acquisition of Izze Beverage Company, and bolstering their food products arm in Latin America and Europe – not to mention making the right decision in not spinning off Frito-Lay.
As a result, although the revenue trend is a bit discouraging for both, things are decidedly less poignant at Pepsi as one can really see the benefits of their diversification efforts.
It would appear that Coca-Cola provides at least a faint rhyme to my Gilead (NASDAQ:GILD) holding – so much share of revenues coming from one specific product line, that when this line slows down, growth from other areas is not enough to pick up the slack.
However, it is a little surprising that against this backdrop, Dr Pepper Snapple Group has increased sales every year since 2009.
DPS has made a number of acquisitions as well – $1.7 billion for Bai Brands, LLC (expected to add $425 million in sales in 2017 and be accretive to EPS in 2018), as well as rolling up a few bottlers. However, DPS’s acquisitions are providing a greater impact to their top line than the Big Two. This, coupled with incremental market share growth, means that the company that quietly holds the #1 root beer brand (A&W) in the US, the #1 Ginger Ale brand (Canada Dry) in the US and Canada, the #1 orange carbonated brand (Sunkist) in the US, and the #1 apple juice and applesauce brand (Mott’s) in the US has increased revenues by over 7% since 2012 – the same period of the declines for Pepsi and Coca-Cola above.
The needed beverage company transformation is coming at fortuitous timing for DPS, as they have less sales in a year than KO has in a quarter, meaning that acquisitions, market share gains and margin improvements can have a greater impact.
Rapid Continuous Improvement
In February 2011, Dr Pepper embarked on a plan called Rapid Continuous Improvement (or RCI inside the company, and for the rest of this article). There is an RCI group that goes step by step throughout the company, organizing teams to look at processes to see what could be done better or cheaper. What has happened gradually as a result of these “Kaizen events” is that Dr Pepper’s margins are starting to sneakily look like the vaunted margins of Coca-Cola:
As a result, Dr Pepper has progressively earned higher returns on both their assets and their invested capital:
And come to think of it, this is all the more impressive because unlike the other two, Dr Pepper relies quite a bit on third-party bottling companies.
Contrasting Coca-Cola and Pepsi, who seem to be ubiquitous everywhere but Antarctica (Coke is Santa’s official drink, after all), Dr Pepper is unique in that 90% of 2016 sales came from the US, while 7% came from Mexico and the Caribbean, and 3% came from Canada.
Part of this is unredeemable, unfortunately. For instance, back when Dr Pepper wasn’t a public company, the rights to the mothership outside of North America were sold to Coca-Cola, and the international rights to multibillion-dollar 7UP (one of Dr Pepper’s “Core Four” brands now) were sold by Philip Morris to Pepsi in 1986 for $246 million.
International represents a really good chance for growth for Dr Pepper, and they have started to move towards that regard. Clawing back distribution in parts of Asia of Snapple and other beverages from Mondelez represents a good start.
While international growth would certainly be a feather in the cap into the future, most of the growth near-term will come from their Allied Brands portfolio.
Providing only 5% of the net volume at this point, these allied brands are responsible for roughly 50% of sales growth. Sometimes smaller is better!
Absolutely no one could legitimately argue against the income supremacy of Pepsi and Coca-Cola in this space. However, Dr Pepper Snapple Group is quickly gaining a reputation for returning cash to shareholders.
Not only this, but Dr Pepper has reduced over 26% of its outstanding share count since 2007:
There are of course risks to owning shares in Dr Pepper Snapple. First would be the elephant in the room. Following are two more that are minimally to moderately troublesome.
The first would be deterioration of their third-party bottler relationships. Dr Pepper is in a rather unique position of being a direct competitor of the very companies who distribute a lot of their product. From the outside looking in, the relationships seem to be fine, but if they were to deteriorate, then Dr Pepper could be in for a decrease in value post haste. However, further purchasing of third-party bottlers could help alleviate this should the need ever arise.
Lastly and most troublesome is the debt picture. Understandably with rates as low as they have been, more debt has been taken on by the Beverage Oligopoly. However, as of now, Dr Pepper’s liabilities total almost 80% of the assets on its books.
On the flip side of this, however, just the cash and cash equivalents on the balance sheet at year-end 2016 was almost a full 40% of all of its long-term debt. Secondly, the debt is staggered in such a way that no significant portion of it comes due in a single year:
Lastly, operating cash flow has been at or above 20% of all the principal amount of notes every year since 2013. All of this has me thinking it’s manageable.
If you have had your eye on initiating a position in Dr Pepper, in my personal view shares are a bit overvalued (like practically everything else but dumpster fires) at this point. Simply Wall St very attractively presents the fair value as right around here,
while Morningstar has attached a fair value of $80, and S&P Capital IQ estimates $93.40. Lastly, assuming a dividend growth rate of 8% and a discount rate of 10%, a dividend discount model would come in at $116, which in light of the above looks a little stretched.
Moreover, over the course of its journey as a public company, shares bought now will lock in almost the lowest yield there has ever been:
Given the average of the above targets, fair value would be around $97. However, if you were to give yourself around a 5% margin of safety, your starting yield would move to 2.5%. And of course, the closer you move towards an 8-10% margin, the starting yield would move up from there, with the latter coming in around 2.65%, the highest since 2014.
While it is nowhere near impossible, it is hard for me to imagine a scenario where Coca-Cola or Pepsi return to the prodigious growth of before. For my own sake, multiple years of declining revenues are a bit disconcerting.
However, if you are intent on being in this space and have a couple of decades for a time horizon, it could very well be that Dr Pepper Snapple Group will provide you with a better growth opportunity going forward.
Disclosure: I am not a professional investor, and as such, the companies and/or positions mentioned and any associated analyses are related to my own personal experience and expertise, and is not intended to be a recommendation to buy or sell. As everyone has their own risk tolerance, goals and needs, it is important that you perform your own due diligence.
Disclosure: I am/we are long GILD.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.