Friday, August 2, 2013

Dr. Pepper Snapple Group (DPS): A Cheap Stock with Dividend Growth Potential

Dr Pepper Snapple Group (DPS) was spun off from Cadbury Schweppes in 2008. It initiated a dividend in 2009, and has managed to consistently raise it, while repurchasing stock.

Analyst expectations are for the company to earn $3.08/share in 2013 and $3.29/share by 2014. I initiated a position in the stock in the prior week,

The company operates under three segments:

Packaged Beverages

This segment is responsible for primarily manufacturing and distribution of packaged beverages and other products, including DPS brands, third party owned brands and certain private label beverages, in the U.S. and Canada. This segment accounts for approximately 73% of sales, but 40% of operating profits.

Latin America Beverages

The Latin America Beverages segment reflects sales in the Mexico and Caribbean markets from the manufacture and distribution of concentrates, syrup and finished beverage. This segment accounts for approximately 7% of sales, but 4% of operating profits.

Beverage Concentrated

This segment is responsible for manufacturing and selling beverage concentrates to customers in US and Canada. Most of conentrates are produced in St Louis, Missouri, which is a risk in and of itself, in case of a natural disaster. This segment accounts for approximately 20% of sales, but 57% of operating profits.

One of the warning signs that I identified from reading the annual report was that 67% of Dr Pepper volumes are distributed through the Coca-Cola affiliated and PepsiCo affiliated bottler systems. I also found out that PepsiCo (PEP) and Coca-Cola (KO) are the two largest customers of the Beverage Concentrates segment, and constituted approximately 30% and 18%, respectively, of the segment's net sales during 2012. The Beverage Concentrates segment's operations generate a significant portion of the company’s overall segment operating profit. On the other hand, using the distribution networks of Coca-Cola & PepsiCo bottling groups could be an advantage, because it could require less investment from Dr. Pepper Snapple Group's part to build out those relationships. This could mean more money for shareholders either through higher dividends or share repurchases.

It is interesting that no one talks about this arrangement, as I could see a lot of issues arising from it. First of all, it looks like an arrangement where the wolf is put in charge of the herd. In other words, a potentially cancelation of one or both contracts could result in a 25% - 30% drop in profits for Dr. Pepper. In addition, failure to properly distribute Dr Pepper products in order to sell their own products, could be another scenario where Coca-Cola and Pepsi can steal market share away from the company.

In 2010, the company made 20 year licensing deals with PepsiCo and Coca-Cola that paid the company $900 and $715 million dollars respectively. As a result, it is recognizing $64.60 million in annual revenue over 25 years. The company used this cash for buybacks and debt reductions.

On the other hand, the 20 year contract with both companies might be too expensive to break by Coke or Pepsi, which could result in a relatively peaceful 18 years for DPS. In addition, I wouldn’t be surprised if either giant decides to try and acquire Dr Pepper Snapple, in order to tap into this cash machine. The only factor preventing this might be the US government’s distaste for monopolies. A cash rich private equity group however, might be able to do just that however. In addition, both agreements could very easily be extended for another 20 years around 2030, and they require that both PepsiCo and Coke meet certain performance conditions.

I view Dr Pepper Snapple Group’s management as very shareholder friendly ones. They are utilizing their steady cash flows to repurchase stock and regularly hike dividends. This is because it has strong brands such as Dr Pepper & Snapple, which have a fiercely loyal customer base. At some point however, I would like to see them expand by adding new products in segments it is not represented, and in other countries.

I also view the company as a very stable consumer staple, which has strong brand names that consumers like. I would say it has competitive advantages, and should continue to churn out plenty of free cash flows for the next 20 years.

The largest portion of revenues are derived from carbonated soft drinks. This segment is not particularly popular with investors, given the declines in consumption over the past decade, in addition to stagnant sales volumes expected due to health concerns by customers. The company is trying to be responsive by introducing low calorie beverages like Dr Pepper 10, 7 UP 10 etc. Given the stable nature of the business brands, I believe that the firm can achieve solid total returns for shareholders, even with anemic growth in the future. They are also increasing the amounts they are spending on advertising, in order to create buzz about the product and maintain the brand, which should bode well for revenues.

Dr Pepper Snapple Group does not have any energy drinks, nor does it have any bottled water to offer. This could be an opportunity for diversifying away from carbonated drinks, and could also provide the company with the ability to expand internationally. This could likely cost a lot of money however, which is why being smart with the shareholder money and not expanding at all costs would be preferred.

The company currently operates in mostly three countries – US, Canada and Mexico ( also Caribbean). This is because the company was acquired by Cadbury Schweppes in 1995. Back in 1999, the parent sold a large part of international distribution rights to Coca-Cola for 155 countries. As a result, the company would be unable to expand internationally, unless it buys back those licensing rights.

While the US represents half of the global soft drinks market, Europe is second at slightly over one-third. Asia Pacific represents about 12%, although it could result in higher growth over time.

Several months ago, DPS purchased the rights for distribution of Snapple in key markets such as China, Japan, Australia, South Korea, Malaysia, Hong Kong and Singapore. This is the right strategy to pursue, in order to capitalize on long-term growth in the emerging markets. The rights to Dr Pepper drink internationally are owned by Coca-Cola or Mondelez International (MDLZ).

The allure behind the growth story of Coca-Cola (KO) and PepsiCo (PEP) is in the expected growth in emerging markets such as China, India, Russia, Brazil, Turkey and many others. As millions of consumers become middle class in those emerging markets, they would be able to spend their increasing discretionary incomes on items such as sodas, snacks and other purchased beverages.

Overall, I like that Dr. Pepper is shareholder friendly, and manages to distribute a lot of its excess cash flows to shareholders through dividend increases and share buybacks. However, I do not like the fact that the company is dependent on its main competitors Coca-Cola and PepsiCo for a large portion of its revenues and operating income. This is mitigated by its long-term licensing contracts with these two giants, and could be a positive because it provides a lot of cash flows with a limited need for a lot of capital to build a distribution system. In addition, I do not like the fact that Dr Pepper Snapple group is limited to only a select few countries for its operations, and has to purchase this right with shareholder cash. The company is trying to create new healthier beverages, and to expand internationally, which could be very beneficial in the long run.

The reason why had not purchased Dr Pepper till this moment is because I was already invested in the largest two “soda” companies in the world – Coca-Cola (KO) and PepsiCo (PEP) ( although I realize that PepsiCo has a substantial snack operation, I am looking at it from a soda company perspective here). In addition, its operations are mostly limited to North America for legacy brands as it cannot expand abroad. The company does not have a long history of dividend increases, which is mitigated by the fact that it was listed for only five years.

At this time, Coca-Cola (KO) and PepsiCo (PEP) are trading above 20 times earnings, which prevent me from adding money to those positions today. The stock of Dr. Pepper Snapple Group  is much cheaper at 16.30times earnings and yielding 3.20%. I also believe that the company would be able to grow cashflows and earnings well over the next 20 years, especially if it manages to expand in Europe, Asia – Pacific and South America.. Long-term growth of Dr Pepper Snapple over the next 20 -30 years would likely be slightly higher than that of its two largest rivals, due to its small relative size.

I recently purchased a very small starting position in the company, because I find it easiest to monitor an investment when you own it. It is difficult to find quality at a cheap price these days, which is why Dr Pepper Snapple Group sounded like an overlooked play. While I am not very happy with the reliance on Coke & PepsiCo mentioned above, or the lack of exposure outside of North America, and the heavy reliance on carbonated drinks, I think there is plenty of opportunity. There is a strong brand name, and opportunities for very good total returns over the next 20 years through stable revenues and earnings, share repurchases and dividend growth. If the company introduces new products to compete in new niches, manages to expand internationally by tapping the cash cow business behind Dr. Pepper and Snapple brands, it can probably achieve a dividend champion status one day. Even if it simply uses excess cashflows to repurchase stock and raise dividends, Dr Pepper Snapple Group should do well for shareholders.

Full Disclosure: Long KO, PEP, DPS, MDLZ

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