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Dr. Pepper Snapple Group (NYSE:DPS) is a favorite of ours in the integrated carbonated and non-carbonated beverage and soft-drink space. Spun off from Cadbury back in 2008, the company has been growing market share in the U.S., Canada and particularly Mexico.

During a recent visit to their plant in Baja California, we were impressed with progress being made in their Grupo Peñafiel operations. Logistics has been a focus of management’s attention, but our takeaway was that the company’s Rapid Continuous Improvement efforts were bearing fruit, particularly in the distribution and brand awareness for Peñafiel mineral water, Squirt, Clamato and Aguafiel brands.

DPS also will be distributing Vita Coco, a packaged coconut water product experiencing rapid growth in the healthy lifestyle beverage category.

However, we are seeing some deterioration in the quality of earnings being presented by DPS and believe the shares are overvalued at current levels. Below is a summary of our analysis for the seven quarters ending March 31, 2011.

Q1 2011 e-p-s was $0.50 vs. $0.49 in Q4 and $0.16 more than the $0.34 reported in the similar period last year. Sales declined -5.7% in Q1 vs. Q4 and well below the average 31.7% quarterly sales growth for the seven quarters ending March 31, 2011.

Other than the high debt (currently about $2.5B and 106% of equity) we do not see any significant deterioration to the balance sheet per se. One exception might be an 11.1% increase in accounts payable in the latest period. This rise in AP is notable as it is the largest increase for all seven periods reviewed and almost twice the average change. Maybe a temporary issue, but worth keeping an eye on going forward.

Cash-Flow: Based on the Merriam Report’s dual cash-flow model, operating cash-flow (as defined in our screen) has deteriorated significantly in the last two quarters ending Q1 at -$1,514.0 ($ millions) as compared to an average -$1193.7 OCF for all periods.

OPerating Cash-flow trend
(Click to enlarge)

In contrast, balance sheet cash-flow trends accelerated during the past two quarters ending March 31, 2011 at $5,578.9 (millions) and greater than the average $4,809.3 for all seven quarters.

The concern to our cash-flow analysis is that although DPS generates ample and significant cash from operations, the earnings in the past two periods have been largely supported by balance sheet maneuvering rather than “paying customers.”

Accruals: Our accrual analysis also reveals some weakening in the earnings quality for DPS. Up until Q4 2010, the accrual ratio had been bullish. In the recent Q1, our accrual reading turned neutral with a bearish bias. We also note the latest figure of +1.84 is the most extreme reading of all periods reviewed.

Dual Cash flow ratio, accruals and Capital Productivity
(Click to enlarge)

Revenue Metrics: Cost of Sales and S/G/A expenses (as a % of sales) rose in the latest period modestly, offset by significant improvement in accounts payable.

Capital Productivity: Costs for income producing assets (per dollar of sales) also rose dramatically in the latest quarter, particularly with accounts receivable and property, plant and equipment.

Goodwill: Although we view DPS as a dynamic growth story, the rising trend in goodwill both as percent of assets and equity is a concern. Rapid increases in goodwill also raise the chance of potential writedowns or asset impairment charges in the future. Although impairments are non-cash charges, they do reduce equity.

Dr. Pepper Snapple Goodwill Trends
(Click to enlarge)

There is a lot to like about DPS. However, shares look to be trading at a 18% premium to our estimated fair-value of $36. Traders might find opportunity in the $39-41 area. Investors with a longer term horizon might consider waiting for a pull-back to the $37 area to take partial positions and full positions up to $35. DPS will report Q2 earnings on July 25th.

View the full DPS analysis here (pdf)

Source: Dr. Pepper Snapple Group: A Lot to Like but Slightly Overvalued