I'm at a point where I need to decide what is going to happen to my holdings of Dr Pepper Snapple Group (DPS).
I've been long the company since this past September and added to my position at the start of February. 2014 has started off as a very strong year for DPS and already I'm looking at an over 12% gain on my cost basis.
January and February have been much less kind to Dr Pepper's larger peers, however, as both Coca-Cola (KO) and Pepsi (PEP) have fallen more than the broader market. Below a the 6-month price chart of the three companies that makes Dr Pepper's relative outperformance since the start of the new year very apparent:
Now of course, as a shareholder, I'm very pleased with DPS' performance, but after its run up I have to reconsider my positioning here. The reason I invested in DPS to begin with was certainly not because of high growth prospects, but because it's a cash cow that returns a ton of its free cash flows to its investors. While the same is true of its larger peers, because they command higher multiples the cash return is less effective--higher payout ratios result in smaller dividend yields, larger share buybacks retire a smaller percentage of the float.
It seems to me that DPS share price has gone a bit too high too fast. One way to think about it: "what has changed for Dr Pepper in the last 6 months that makes it worth 14% more today?" I think looking at the stock from this perspective would leave one struggling to justify its performance.
Price Divergence Is a Red Flag
Let's take a look at the year-to-date return of DPS again, this time comparing it to the broader S&P index as well as its peers:
Again, DPS is handily beating out its peers and the broader market in the short term. My concern is that historically DPS has had a very high correlation to its peer group and that this divergence will ultimately be closed--either by DPS slumping in price or PEP and KO running up to meet it.
Using this calculator, I found the correlation between DPS and KO since the start of 2011 to be a very high 0.94 and between DPS and PEP to be 0.93. Since the start of 2014, however, DPS has been negatively correlated with both KO and PEP (who've maintained a 0.86 correlation to one another). Add to that DPS is currently hitting the overbought range on its RSI (over 70), and there should be some real concerns for the short term performance of the stock.
But Are There Good Reasons for the Price Pop?
Price comparisons and RSI readings never paint a full picture of any security--maybe the company's recent performance justifies the stock's gains.
Looking at Dr Pepper Snapple's Q4 2013 results filed on February 12, there was a 1% decline in net sales year over year to $1.46 B on weaker sales volume. But earnings were strong, with a 19% increase in EPS year over year to $0.97 for the quarter, beating consensus estimates of $0.85. These are welcome results relative to Coca Cola whose net sales slipped 4% and EPS came in in-line and just 2% higher year over year at $0.46. SA contributor Seth Golden has written a good summary article on DPS' latest earnings report here and the SA transcript for the conference call can be found here for any looking for further details.
While the earnings beat and strong margins in the latest quarter are encouraging, I am skeptical that DPS can continue to meaningfully grow its earnings with weakening sales volume. DPS does not have as significant access to strong growth markets abroad to help offset weakness in the US market as PEP and KO. Its presence is limited to North America and the Caribbean. Coke's lackluster results actually came on the back of a 1% increase in global sales volume as Dr Pepper's declined.
The push back against both sugar filled sodas and now also their artificially sweetened diet counterparts by health conscious consumers and, in some places, local governments, is the main cause of slipping sales volume. Of course DPS is not sitting idly on this front. Several new, naturally sweetened products will be pushed out and DPS can leverage their Mott's brand to appeal to changing consumer preferences. But Coke and Pepsi can and will do the same within their drink portfolios--and have much more marketing muscle to back up their efforts.
It seems that DPS' share price is responding very favorably to the announced dividend increase from $0.38 to $0.41 quarterly and relatively better earnings performance, but the fundamentals of the business going forward don't give much reason for confidence.
Even After the Run, Valuation Remains Below Peers'
DPS still trades at a discount relative to its peers, but that discount has been shrinking as you can see from its historical P/E chart below:
The table below shows some other metrics for comparison between the three companies taken from Yahoo.
DPS is still the least expensive by its price to sales and price to earnings ratios and has a slightly lower payout ratio as well. Therefore, even after its recent run higher and PEP and KO's slump, it is still a relative value and very competitive on the dividend front.
Even though I think that DPS is due for a pullback I don't like KO or PEP much either as I believe they are still too expensive. I may take some profits or liquidate my position on DPS if the divergent performance continues, but I would currently call it a hold. I would not recommend initiating a position in DPS at this time.
I would always like to see a company I own stock in perform well. But in this case, I believe that DPS is seeing its multiples expanding, which will actually make cash returns to shareholders less effective. Let's see if earnings can manage to keep pace.