Which is Better, Pepsi (PEP) or Coke (KO)? This long running beverage dispute doesn't have a clear answer, but when it comes to stocks, these beverage giants not only have to compete against each other, but also against some other compelling beverage arena investments.
In the last few years, a lot has changed in the non-alcoholic beverage industry with the entrance of new players like Monster (MNST) and SodaStream (SODA), as well as Coke and Pepsi's changes to their bottling groups. Yet for all of this change, PEP and KO remain solid long-term investments. At this stage though, I don't think they offer investors the best mix of risk and reward. Instead, I think that title should go to another firm.
Let's take a look at some firm metrics across the space and see what stands out.
National Beverage Corp.
Coca-Cola Enterprises Inc
Coca-Cola Bottling Co. Consolidated
Dr Pepper Snapple Group Inc.
The Coca-Cola Company
Cott Corporation (USA)
Monster Beverage Corp
Sodastream International Ltd
First and foremost, it's important to note that many of the stocks in this category are relatively safe and over the long term, the majority of these companies are likely to be solid investments (though obviously MNST and SODA are more speculative). But in looking at this chart, it should be obvious that one firm appears to have fallen out of favor with the markets for no obvious reason. That company is Dr Pepper Snapple (DPS).
Basically, mostly, these firms fall into three categories; the giants Coke and Pepsi as well as Coke's semi-affiliated firms Coca-Cola Enterprises (CCE) and Coca-Cola Bottling (COKE), the small cap names trying to break into the space including National Beverage (FIZZ) and Cott Corp. (COT), and the speculative firms looking to shake up the industry including Monster and SodaStream.
Only DPS with its 9-10B market cap doesn't fit neatly into one category. At a little less than $10B, it is certainly a big company, but not compared with $100B plus giants like Pepsi and Coke, nor is its business or size risky enough to warrant placing it in a category with MNST and SODA, or COT and FIZZ. Instead, of all of the non-alcoholic beverage makers in the US, DPS stands out as the only company whose size might make the firm an attractive take-over target for a multinational food or consumer goods company like Unilever (UN), Kraft (KRFT), Mondolez (MDLZ), Nestle, or even Proctor & Gamble (PG). For that matter, the firm is just about the right size for a large private equity takeover as well.
DPS was spun off of Cadbury Schweppes in 2008, and includes brands ranging from Dr Pepper and Seven Up to Snapple and Yoo-hoo. Given the large stable of brands across both the carbonated and non-carbonated sector, one would think that DPS would trade at a premium to many of its peers. Yet, as the table above shows, the firm has the lowest P/E ratio, and it trades at low levels of Price-to-Sales, Price-to-Book, and Price-to-Cash Flow compared with its peers.
Part of the reason for this discount is probably that DPS has grown more slowly than peers over the last couple of years, and analysts are concerned this trend will continue. Consensus forecasts put DPS' next year EPS growth at 7.5%, while PEP and KO are both expected to grow by 8-9%, MNST is expected to grow EPS by 16%, and SODA by a whopping 29%. Expected revenue growth for the firm tells a similar story with DPS only expected to grow its top-line numbers by about 3% in the next 12 months.
Yet, analysts may be overly pessimistic in Dr Pepper Snapple's case, and if they are, the company's stock could have significant upside potential. While Pepsi and Coke have cut their advertising and marketing budgets as a percentage of sales over time, DPS has raised its budget since it became independent of Cadbury Schweppes. Where DPS was spending only ~6.25% of its sales on advertising in 2008, the firm has boosted that figure to 8% since then. In contrast, Coke and Pepsi have gone from spending 9.5% and 6.75% of sales on ads respectively in 2008 to 7% and ~5% today. Of course, cutting costs is good for the bottom line in the short-run, but in the medium term, these cost cuts may enable DPS to pick up market share.
What's more, DPS has begun a program to upgrade its technology systems and has identified improved efficiencies that should lead to 50bps on increased gross margin over the next three years.
Further, one long held concern of bears in DPS (and for that matter KO and PEP) is that the firm's portfolio of brands is fairly heavily focused on carbonated soft drinks (CSDs). While Coke's US sales are roughly 75% CSDs and Pepsi's sales are 65% CSDs, DPS' sales are ~90% CSD. This is a concern because CSDs have slowly been losing favor in the US as consumers drink more water, tea, juices, and other non-CSDs.
Yet one factor bears appear to be overlooking is that while CSDs as a whole are losing market share, flavored CSDs are actually taking market share from the more traditional colas. And while DPS' US portfolio is about 90% CSDs, virtually all of this comes from flavored CSDs. Thus these two trends - market share loss for CSDs as a whole, and gains for flavored CSDs vs. traditional colas, are helping to balance each other out. The efforts by DPS to promote its new low calorie CSD should help with this issue as well, as concerns over calorie counts by consumers are one of the core drivers that has led to the 20% fall in consumption of CSDs per consumer over the last decade (from roughly 53 gallons per person per year in 2003 to 43 gallons per person per year in 2013).
While the current media scrutiny over the safety of energy drinks like Monster's will probably help slow the conversion of consumers from CSDs to non-CSDs, it is unlikely to reverse the trend entirely. But DPS' TEN program should help the company with these issues immensely. The company's new TEN drinks are supposed to mimic the flavor and sweetness of traditional CSDs while containing only 10 calories and thus limiting concerns over drinking flavored CSDs. Similar efforts by Coke to create low calorie colas have borne fruit in the last few years while the general concerns over calorie counts have led Diet Coke to surpass Pepsi-Cola as the second most popular cola in the country (behind only Coca-Cola).
Even if this situation does not yield benefits for DPS, the stock still looks attractive at these levels based on a 3% dividend yield and the ability of investors to capture additional income through covered calls. The firm has paid down debt substantially over the last few years with debt load falling from 3x EBITDA in 2008 to 2x EBITDA today. This reduced debt load should enable the firm to return even more cash to shareholders now that debt/EBITDA is below management's 2.25x target.
At a recent stock price of ~$46-47, DPS trades about 10% below consensus fair value estimates of $52.50, but even this likely undervalues the firm given its growth, portfolio advantages, and takeover chances. Instead, looking at the P/E of the firm's closest competitors, Coke and Pepsi, the average P/E is roughly 21.5x ttm EPS. Given DPS's ttm EPS of $2.20, a comparable ratio on the firm implies a stock price of ~$65 /share, a 35% premium over current levels. This seems justified given the advantages of DPS's business discussed above. Further with a yield of 3%, Dr. Pepper Snapple pays investors to wait for the firm's multiples to come in line with peers. Given these figures, even if the firm were only to partially close the P/E gap over the next year, this still implies returns in excess of 25%.
In summary, while all of the non-alcoholic beverage companies should benefit from the slowly improving US economy and increased consumer discretionary power, Dr Pepper looks better positioned than most to weather the secular trends shifting the industries landscape. Trading around 15x ttm EPS, the firm looks like a reasonable value in spite of the vast improvements the company has made to its financial health and product stable over the last few years.