Dr Pepper Snapple Group (DPS) Larry D. Young on Q2 2016 Results - Earnings Call Transcript

| About: Dr Pepper (DPS)

Dr Pepper Snapple Group, Inc. (NYSE:DPS)

Q2 2016 Earnings Call

July 27, 2016 10:00 am ET

Executives

Heather Catelotti - Vice President-Investor Relations

Larry D. Young - President, Chief Executive Officer & Director

Martin M. Ellen - Chief Financial Officer

Analysts

Ali Dibadj - Sanford C. Bernstein & Co. LLC

Stephen R. Powers - UBS Securities LLC

Judy E. Hong - Goldman Sachs & Co.

Amit Sharma - BMO Capital Markets (United States)

Vivien Azer - Cowen & Co. LLC

Bill Schmitz - Deutsche Bank Securities, Inc.

Caroline Levy - CLSA Americas LLC

Kevin Grundy - Jefferies LLC

Brett Cooper - Consumer Edge Research LLC

Operator

Good morning, and welcome to the Dr Pepper Snapple Group Second Quarter 2016 Earnings Conference Call. Your lines have been placed on listen-only until the question-and-answer session. Today's call is being recorded, and includes a slide presentation, which can be accessed at www.drpeppersnapple.com. The call and slides will be also available for replay and download after the call has ended.

It is now my pleasure to introduce Heather Catelotti, Vice President Investor Relations. Heather, you may begin.

Heather Catelotti - Vice President-Investor Relations

Thank you, Maria, and good morning, everyone. Before we begin, I would like to direct your attention to the Safe Harbor statement and remind you that this conference call contains forward-looking statements, including statements concerning our financial and operational performance. These forward-looking statements should also be considered in connection with cautionary statements and disclaimers contained in the Safe Harbor statement in this morning's earnings press release and our SEC filings. Our actual performance could differ materially from these statements, and we undertake no duty to update these forward-looking statements.

During this call, we may reference certain non-GAAP financial measures that reflect the way we evaluate the business, and which we believe provide useful information for investors. Reconciliations of these non-GAAP measures to GAAP can be found in our earnings press release and on the Investors page at www.drpeppersnapple.com. This morning's prepared remarks will be made by Larry Young, President and CEO; and Marty Ellen, our CFO. Following our prepared remarks, we will open the call for your questions.

With that, let me turn the call over to Larry.

Larry D. Young - President, Chief Executive Officer & Director

Thanks, Heather, and good morning, everyone. Once again, we posted another solid quarter as our teams continued to relentlessly focus against our strategy. We're on track with driving integrated communications and execution across our priority brands, and RCI continues to permeate throughout the organization and drive sustainable financial benefits.

For the quarter, bottler case sales increased 1% on almost four points of positive mix and price. Volumes grew across our portfolio, with CSDs increasing by 1% and non-carbs increasing by 2%. Brand Dr Pepper decreased 1% in the quarter, as continued strong growth in our fountain foodservice business was more than offset by declines in diet. Our Diet Dr Pepper business continues to significantly outperform the diet category, declining at about half the rate of all diets, driven by the strength of our Lil' Sweet campaign.

Our Core 4 brands also declined 1%, as over 5% growth in Canada Dry was more than offset by declines in 7UP, A&W and Sunkist soda. Crush and Schweppes grew 4% and 9% respectively on increased activation at a large retailer. Squirt grew 8% on strong growth in both Mexico and the U.S., and Peñafiel grew 4%. All other CSD brands decreased 2% in the quarter. In non-carbs, Snapple declined 2% as growth from product innovation was more than offset by the effect of a year ago of liquidating certain Snapple inventories. As a reminder, Snapple growth in the second quarter last year was 11%.

Hawaiian Punch decreased 5% as expected, driven primarily by price increases on single-serve packages. Mott's was flat in the quarter, as growth in sauce was fully offset by decreases in juice driven by price increases on single-serve packages. Clamato grew 14% in the quarter, reflecting continued strong growth across Mexico, the U.S. and Canada. Our water category grew 25% on growth in our allied brand portfolio, particularly Bai and FIJI, and continued growth in Aguafiel. All other non-carb brands decreased 10% in the quarter, almost entirely due to our exit of the Country Time business.

Building our brands continue to be a critical element of our overall strategy and success, and we've got another strong calendar of programming that is targeted against our consumer insights for the back half of the year. Our regular Dr Pepper 20-ounce program highlights 150 unique labels that allow consumers to choose their favorite bottle that represents their individuality. Though it's early on, we're seeing recent upward trends in our convenient and gas business and our consumers are showcasing their love for the bottles on social platforms such as Instagram and Twitter. You can also even purchase your preferred bottle on eBay.

As I mentioned earlier, our diet Lil' Sweet campaign continues to drive impressive results for the brand, and we'll start college football off strong with heavy media across TV and digital platforms, and activation in large national accounts. And new this year, Larry Culpepper will be tailgating across the country to bring Dr Pepper to every football gathering in his own Dr Pepper Van.

Our Dr Pepper Cherry push is bringing new users into the franchise, and consumers are enjoying A&W Root Beer floats at their summer parties. Core 4 is bringing back monster-themed mini-cans for Halloween, with an app that will bring the monsters to life on their smart device. Canada Dry will continue to capitalize on growth in the ale category with increased media throughout the rest of the year, and will activate against Schweppes sparkling waters, honing in on the growing mixer occasion.

Snapple will remind consumers to make time for Snapple with quirky new Real Facts ads, and will once again bring news to the tea aisle with red-blue election themed LTOs. Clamato has partnered with an authentic Mexican beer to spice up outdoor gatherings as the original Michelada. You may have seen our Mott's Secret Life of Pets packaging in market. And just in time for back-to-school, Mott's will support schools with bonus pop-top (06:56) for education. As you can see, we've got a tremendous amount of activity lined up that engages our consumers and gives our customers and partners programs to rally behind.

Now, let me turn the call over to Marty to walk you through our financial results and our 2016 guidance.

Martin M. Ellen - Chief Financial Officer

Thanks, Larry. Let me start with a high-level financial summary of the quarter, which, as Larry just said, reflected solid performance. Sales volume increased 1%, with reported net sales up 2%. Core operating income was up 6%, and core operating margin was 22.8%, up 70 basis points. Core EPS was up 11% in the quarter. On a currency-neutral basis, net sales were up 4%, core operating income was up 8%, and core EPS was up 12%.

Now, let me provide some further details. Reported net sales increased 2% on about 2.5 points of favorable product and package mix, just over one percentage point of price realization, and a 1% increase in sales volumes. Reducing this net sales growth was just over 1.5 point of foreign currency translation and almost one point of unfavorable segment mix, as concentrate sales were relatively higher this year. Reported gross margins increased 120 basis points in the quarter, increasing from 59.3% last year to 60.5% this year, of which 90 basis points was driven by the favorable effect of unrealized mark-to-market commodity changes.

Lower commodity costs, primarily PET and aluminum, increased gross margins by 60 basis points, and continued productivity benefits, including those from RCI as well as certain other packaging and ingredient cost reductions, increased gross margins by another 50 basis points. The impact of positive net pricing also increased gross margins by 50 basis points. The effective mix, mostly from products purchased from others, reduced gross margins by 100 basis points. And finally, foreign currency reduced gross margins in the quarter by 30 basis points, as Mexico sources certain inputs in U.S. dollars and finished products sold in Canada are sourced from the U.S.

For the quarter, SG&A, excluding depreciation, increased by $4 million on inflationary and certain other increases in operating expenses, including a one-time $4 million cost associated with the transition of a certain employee benefit program. These increases were partially offset by favorable foreign currency translation, a reduction in transportation costs driven by lower fuel prices, and $7 million of lower marketing investments year-over-year due to timing shifts of brand campaigns.

Depreciation and amortization declined $2 million in the quarter. Below the operating line, net interest expense increased $5 million, primarily reflecting an overall higher debt balance and higher rates from our fourth quarter 2015 refinancing. Other income increased by $23 million in the quarter as a result of a $21 million gain on the extinguishment of a multi-employer pension plan withdrawal liability. This gain has been excluded from our core results. Our reported effective tax rate was 35.3%, compared to 35.5% last year.

Moving on to cash flow, cash from operating activities was $407 million, net of the $35 million payment of the multi-employer pension plan liability. Cash from operating activities was up $58 million compared to last year, primarily driven by timing of certain working capital amounts and the increase in net income adjusted for non-cash items. Capital spending was $68 million compared to $42 million last year, as we've spent incrementally to further support our growth in Mexico. Our new mineral water plant north of Mexico City should be operational in the fourth quarter of this year. For the first six months, total distributions to our shareholders were $493 million, with $303 million in shares repurchased and $190 million in dividends paid.

Before I move on to guidance, let me give a quick update on Rapid Continuous Improvement. Our 2016 Lean tracks are in full swing. We've already had over 75 kaizen events across the organization, and we're seeing wins across the board. I'll share a few now. In our Orlando DSD site, driver turnover has been reduced by 44%, driven by improved recruiting, onboarding and performance management processes. Through this lean track nationally, we're also learning from our drivers' other elements of waste that will enable us to further improve the effectiveness of our route delivery system.

A job role safety playbook, developed by our front-line employees, is driving a 25% recordable injury reduction year-over-year in the second quarter, helping drive 12-month trend rates down almost double digits. We've closed over 2,000 voids on Dr Pepper's smaller CSD packages in a large retailer through a similar process we used to close voids on other brands. And certain allied brands are experiencing both double- and triple-digit growth rates partially as a result of our track specifically focused on allied brand distribution and availability. As I've mentioned before, we have a tremendous amount of RCI activity going on throughout the business in addition to our Lean tracks. Branch managers in our central business unit gained 10 hours per week of additional customer facing time by adopting the RCI principle of standard work, and our Mexican team has improved Peñafiel distribution with our third-party distributors by creating standard work for trade management and point-of-sale.

We have great urgency to improve the performance of brand 7UP. Our Lean track is underway. And while there is still a great deal of work to do, the team had diligently focused on the components of brand messaging and execution in local markets. Supporting this is a deep inspection of pricing, packaging, channel, and geographic competitive trends alongside those of 7UP. These insights should enable us to begin implementing certain changes in the balance of 2016. There is definitely more to come on 7UP. Again, these are just a very few examples of the vast improvement initiatives taking place across our entire business every day.

Now, let me move on to 2016 guidance. We continue to expect reported net sales to be up approximately 2%, inclusive of a foreign currency translation headwind of about 1%. Given our first half performance, we are increasing our full-year core EPS guidance. We now expect core EPS to be in the $4.27 to $4.35 range. This is inclusive of what we now expect to be about a 3% headwind from both foreign currency translation and transaction combined, versus the 2.5% that we had expected previously. We continue to expect total company sales volume to be about flat. Similar to our previous guidance, we expect CSDs to be about flat, while we expect non-carbs to be up slightly. Remember that our non-carb volume performance is being tempered this year by pricing actions taken across several of our warehouse direct brands. However, we still expect continued growth from other non-carb brands such as Snapple, Clamato and our allied brand portfolio.

On a total company basis, we expect combined price and mix to be up about 3%. Our January 1 concentrate price increase will drive about 40 basis points of this increase, and price increases on our warehouse direct brands will drive an additional 20 basis points. The remainder will come from mix as a result of stronger growth from smaller CSD packages and brands such as Snapple, Clamato and our allied brand portfolio.

Moving on to cost of goods, given our hedged positions and current market prices for our unhedged positions, we now expect packaging and ingredients to be about 1% deflationary on a constant volume mix basis. This expectation still reflects deflation in commodities such as PET and aluminum, and as we have previously said, a headwind on corn driven primarily by increases in tolling fees and unfavorable pricing of corn co-products from which we derive our net corn price. For modeling purposes, remember that growth from some of our non-carb portfolio and allied brands will also increase the dollar value of cost of goods. And also remember that cost of goods is negatively impacted by foreign currency transaction, as I mentioned a moment ago. Collectively, all of the factors I mentioned above should result in roughly similar gross margins in 2016.

Moving to SG&A, we now expect an increase of approximately $15 million in health and welfare and other insurance costs versus the original $20 million that we had previously expected. We also still expect general inflation in our field labor costs to increase operating expenses by approximately $20 million. That said, we believe we will be able to achieve productivity benefits from RCI that will help offset a portion of these increases, and we are also now expecting favorability from lower fuel costs of about $10 million, more than half of which we have already experienced. We continue to expect marketing to be about 7.5% of sales for the year. This implies a significant uptick in the back half of the year, mostly in the third quarter.

Now, moving below segment operating profit, our net interest expense will be around 4.5% on our $2.9 billion of debt, which implies an increase of approximately $15 million, driven primarily by our fourth quarter 2015 debt refinancing. Our full-year core tax rate is still expected to be approximately 35.5%. And we continue to expect capital spending to be approximately 3% of net sales, even with the spending for our new plant in Mexico. We also continue to expect to repurchase approximately $650 million to $700 million of our common stock in 2016, subject to market conditions. Now let me highlight a couple of additional phasing items that will help you update your models.

First, as previously mentioned, while we expect commodities to be deflationary for the full year, the deflation has already been experienced and our trends are expected to turn flat to slightly up for the balance of the year, due to the year-over-year timing of a certain commodity-related rebate. And second, based on timing of prior-year true-ups, both the third quarter and fourth quarter will experience an increase in health and welfare and other insurance costs.

With that said, let me turn the call back over to Larry.

Larry D. Young - President, Chief Executive Officer & Director

Thanks, Marty. Before we open the lines for questions, let me leave you with a few brief though consistent thoughts. Once again, we posted solids results in the quarter. We're continuing to focus on driving integrated communication, innovation and execution across our key priority brands, while also selectively adding to our allied brand portfolio to capture fast-moving consumer trends. We're continuing to embed RCI further into our culture and we're seeing meaningful improvements in growth and productivity across the company. And importantly, we've remained committed to returning excess free cash to our shareholders over time.

Operator, we're ready for our first question.

Question-and-Answer Session

Operator

Thank you. Our first question comes from Ali Dibadj of Bernstein.

Ali Dibadj - Sanford C. Bernstein & Co. LLC

Hey, guys. Just a couple things, and both on the Packaged Beverages business. Obviously they're a little bit less than certainly we in consensus had it at, and it's attributed to lower contract manufacturing volumes. Can you help us quantify the impact of that? You mentioned in your comments it's Country Time. Is at all Country Time? And then, you remember, we heard back about this in 2010, 2011 I think it was roughly that at that point you were getting rid of or deemphasizing some of your contract manufacturing. How much more of that is left? And I think that both from a volume impact perspective, but also from a potential of improving your margins in that segment.

Martin M. Ellen - Chief Financial Officer

Ali, it's Marty. Good morning. So contract manufacturing volume was down a little bit in the quarter. Probably an overall impact of maybe one point on overall volume in Packaged Beverages. I would say actually we're not – as a matter of strategy, in terms of helping us use excess capacity in our plants, it's still our strategy. Business comes and goes in that arena. There are competitors there. And it's very geographic. We're only going to be effective dealing with retailers on their private label, for example, in the geographies where our plants are, and assuming those plants have the capacity to do their volumes. Otherwise transportation makes it sort of a nonstarter. And we're still going to aggressively pursue volumes in our plants where it makes sense to do so. At the same time, we still do some co-packing around the energy category, and that business continues.

Ali Dibadj - Sanford C. Bernstein & Co. LLC

Okay. So, this is not as it was in 2010, 2011, where you were getting rid of less profitable businesses? This is just the tides (22:16) sometime of business in that sector. That's what it sounds like.

Martin M. Ellen - Chief Financial Officer

Correct.

Larry D. Young - President, Chief Executive Officer & Director

Correct.

Ali Dibadj - Sanford C. Bernstein & Co. LLC

And then within that context from an allied brands perspective, is it still driving more than half of your volume and revenue this quarter? I think that's what you've said over the past couple quarters, just wanted to touch base on that. And would you ever put that into your contract manufacturing or is that just not part of the cards technologically, or just to your point a moment ago, given where you need the volume to be and where the retailers are and your capacity is?

Larry D. Young - President, Chief Executive Officer & Director

I think a lot of our – as we bring on these allied brands, when we first bring them in, a lot of them have agreements already with some people on the contract pack. As it's available and make sense, we always look at it. We have great relationships with all our allied brands, and we always look at it together and say, you know, if it makes sense for us to do it, we'll look at it. If not, we're fine with the arrangements we have right now.

Ali Dibadj - Sanford C. Bernstein & Co. LLC

And on the – yeah, go ahead.

Martin M. Ellen - Chief Financial Officer

Let me give some color on that. So across all of our allied brands, the entire portfolio, this quarter, I will tell you they collectively were less than 2% of our volume and less than 4% of our SOP in total for all of them. And if you're curious as to, like, case growth rates, it was probably 0.5 million total cases of growth in there – 0.5 million to 1 million cases of total growth in there year-over-year in the second quarter.

Ali Dibadj - Sanford C. Bernstein & Co. LLC

Okay. Okay. And just to follow-up on one of those, you mentioned that we've good relationships with them, Larry. There's always discussion about some of the protection we have now, that we own pieces of these companies.

Larry D. Young - President, Chief Executive Officer & Director

Right.

Ali Dibadj - Sanford C. Bernstein & Co. LLC

There's stuff in the press out there about how much you own. Can you give us a little bit more detail about how much of these companies you own? It doesn't sound like it's a majority stake by any stretch of the imagination. Press stuff suggests, kind of, low single-digit type ownership. Can you give us anything about how to think about the protection you actually have in the ownership stakes? Thanks.

Larry D. Young - President, Chief Executive Officer & Director

Well, you know, the percentages we own are small, but we also have contracts in there that we have buyouts and certain things like that. We don't ever disclose how all of them are put together, but we continue to feel very protected on those. But I think the biggest thing that protects us is the performance we do for them. I mean, you look at the kind of growth we're getting there and the relationships we have, I don't think we will lose too much sleep. I mean, it could happen, but if it does, we're covered. It's happened in the past and we always recovered. We brought something else in. That's why we constantly look at them.

Martin M. Ellen - Chief Financial Officer

Yeah, Ali, it's Marty. Let me go back to looking at numbers. So the growth, probably worth a half point of growth this quarter. I may have understated the number a little bit. But let me follow on Larry's point. I mean, we've talked openly about the strategy. And at some point, given all these companies are run by entrepreneurs, the successful ones will look to monetize at some point. That's not a secret. As I've said before, we have a long pipeline of opportunities. In fact, I'll be heading to a meeting right after this call to do a review of that again.

And, of course, monetarily, we have small pieces of equity, and, of course, buyout agreements and our distribution agreements with our – which is worth a reasonable sum of money. Should we lose the distribution, I don't want anyone on this call to think, though, that because one or more of these may change hands, that we necessarily lose the distribution either. There aren't too many other companies – there are a couple, but not many more, that have the platform that we have in terms of our coverage and our relationships and our ability to work with the other large bottlers that today are part of our network. So, as Larry said, we bring a lot of value to them, and we think there's a lot of future opportunity, given some of the brands that we're now seeing presenting themselves to us to do similar kinds of distribution activities with.

Ali Dibadj - Sanford C. Bernstein & Co. LLC

Okay. Thanks very much for the dialogue there.

Operator

Our next question comes from Steve Powers of UBS.

Stephen R. Powers - UBS Securities LLC

Great. Thanks, guys. A couple of quick ones, if I could, first on fountain, second on 7UP. Just the fountain business is running a good bit ahead year-to-date of your historical growth. And I'm just curious as to whether we should expect that to continue in the second half or should we expect correction, normalization in the back half? And then on 7UP, as you called out the RCI initiative to improve that, is that something we should expect to see some movement on in the second half or is that 2017?

Martin M. Ellen - Chief Financial Officer

Hey, Steve. Morning, it's Marty.

Stephen R. Powers - UBS Securities LLC

Morning.

Martin M. Ellen - Chief Financial Officer

Let me take that one on 7UP. We're doing a lot of work, as I said. We're finding some insights. My comment earlier about the phasing of marketing – 7UP is part of that because, through our strategy work and our consumer insight work, we are changing the messaging on the brand, and that's going to roll out in the second half. And you'll see probably some activation – you may not see them, but the market will see some changes in activation at retail. There are some new and different thoughts that have arisen that we're going to try here in the second half of the year. It's a lot of work in progress. We're encouraged by it. Obviously, it is the weak spot in the Core 4. Everything else actually is performing fairly well. So more to come on that. Well, I can't remember what the first half of that question was...

Heather Catelotti - Vice President-Investor Relations

Fountain.

Martin M. Ellen - Chief Financial Officer

Oh, fountain.

Stephen R. Powers - UBS Securities LLC

It was the Fountain business.

Martin M. Ellen - Chief Financial Officer

Yeah, fountain. Look, we've done reasonably well in fountain. We've had historic growth rates 1% to 2% for a while. We continued to gain valves. Our team is doing a good job. We're increasingly selling in the regional strength of our brands, all of you know, in regions of the country. That's an advantage for us. And the Freestyle business that we have with Coke has seemed to improve, and so we're selling more syrup into cartridges going into Freestyle machines. But that's of course good for Dr Pepper.

Stephen R. Powers - UBS Securities LLC

Yeah. Okay. And then just stepping back. In May we had the FDA announce new packaged food and beverage labeling requirements with more focus on both calorie disclosures as well as, importantly, the added sugar disclosures. Just given your portfolio skewing towards full calorie CSDs and full sugar beverages generally, I'm just curious how you're approaching that change? And do you have any clarity on the timeline to implement it? And then any guesses on the impacts to your business? Any mitigation efforts you're doing, whether it be more accelerated portfolio shifts or more accelerated investments in smaller pack sizes, that kind of thing? Just how you're thinking about the pending changes?

Larry D. Young - President, Chief Executive Officer & Director

Well, on the changes, I mean, we will follow the guidelines. And as far as the sweetened beverages, we've been seeing growth come back into the sugared beverages. So I don't see us changing anything there. I think, we're glad to see that it's going to be more of a federal labeling instead of having 20 different ones out there to where it really drives the cost up of packaging and then distribution. So we were happy with that. And we think the FDA and our guys all did a great job there on helping get that through. But I don't see any significant impacts that I'm too concerned about on.

Stephen R. Powers - UBS Securities LLC

Does that – does it roll into the market in the second half? Or is that 2017?

Martin M. Ellen - Chief Financial Officer

It's later.

Larry D. Young - President, Chief Executive Officer & Director

I think, it's going to be later in 2017.

Stephen R. Powers - UBS Securities LLC

Okay. Okay. Fair enough. Thanks.

Operator

Our next question comes from the line of Judy Hong of Goldman Sachs.

Judy E. Hong - Goldman Sachs & Co.

Thank you. Good morning.

Larry D. Young - President, Chief Executive Officer & Director

Good morning, Judy.

Judy E. Hong - Goldman Sachs & Co.

So first on Snapple, just wanted to get a little bit more color just in terms of how much that the inventory issue impact volume in the quarter. And then maybe taking a step back, Snapple obviously has been a pretty good growth driver for you guys, and key categories seems to be growing. But the consumer seems to be trading up to more of a premium tea, and Snapple seems to be lagging the category growth a little bit. So just wanted to better understand what the strategy is to kind of accelerate Snapple's growth going forward?

Larry D. Young - President, Chief Executive Officer & Director

Yeah, I mean – you know, as I said in my remarks, we've got a lot of good new advertising we've done with Snapple. We've got more LTOs laid out. You know, in the quarter, again, like I said, it was up 11% a year ago. And then we had some inventory that we had to move because we've been telling people all along we started deemphasizing the value, so there was a lot of factors for the second quarter that made the difference on that. I think you'll going forward with the programs we have in place that Snapple will get more of a clearer message out there of what Snapple is and where we play and what the consumer wants.

I don't know if everybody's really trading up to a premium, or if – it's kind of – you've got flavored teas out there and you have regular teas. And I think that's the big place where you're seeing kind of the shifts. We see a lot of the tea drinkers – we have straight up tea, but they don't take anything away from the Snapple drinker. That flavored drinker on Snapple and flavored teas, they like that flavor, they're going to stay there. So we continue with our strategy on our flavored teas and our Snapple juices, and then we continue to put distribution out there on our straight up tea.

Judy E. Hong - Goldman Sachs & Co.

Okay. And then, Larry, just – in just kind of looking at the broader CSD shelf space, and obviously with the category, I think, it's seeing a bit of a decline in terms of shelf space broadly over the last few years. You obviously have many brands in the portfolio, and some brands like 7UP that's declining in terms of volume. So just wanted to understand how do you protect that shelf space? And then when you think about like maybe Monster launching Mutant in the CSD space and what that implication could be in terms of – particularly in the c-stores, as you think about protecting your own shelf space there.

Larry D. Young - President, Chief Executive Officer & Director

Yeah, well, one, we're not losing any shelf space. And I think what really helps us there, Judy, is when you look at we're number one ginger ale, number one root beer – I mean, if we're not number one, number two, we don't even have it on the shelves out there. So, I mean, we do a very good job on our accounts with category management for the account, but our brands carry the weight they're for. So we're fine there.

I think on the – you brought up a Monster – not just Monster, but a lot of these brands always come in and they try to get in different places, and they've not very – been very successful at it. I mean, there's been ones that wanted to get into the coffee, they want to get into the dairy, they want to get into the juice aisle, that want to get in the CSD aisle. But most of your retailers, and most of the customers want them in a block. They keep them in the same area. And so we'll have to watch it, but we're not that concerned with it. We think we'll see if it happens, although it'd probably be more along the lines of private label, which is continuing to decline, maybe losing some space.

Judy E. Hong - Goldman Sachs & Co.

Got it. Okay. Thank you.

Operator

Our next question comes from the line of Amit Sharma of BMO Capital Markets.

Amit Sharma - BMO Capital Markets (United States)

Hi. Good morning, everyone.

Larry D. Young - President, Chief Executive Officer & Director

Good morning.

Amit Sharma - BMO Capital Markets (United States)

Larry, just wanted to talk about the North American CSD pricing. We've seen at least the canned channel start to lose some steam there, and the pricing was – are you seeing anything different? And especially talking about some of the markets that Coke is refranchising similarly, are you seeing any pricing activity there, or change in how pricing has been in those markets?

Larry D. Young - President, Chief Executive Officer & Director

We're seeing pricing is flat. I think, before we might have seen a little shift in mix and some different things with packages, but pricing's flat. And so that's not a bad thing. I think there's still a tremendous amount of discipline out there, and we don't see any reason that would change.

Amit Sharma - BMO Capital Markets (United States)

And no change in – recently, your franchise markets?

Larry D. Young - President, Chief Executive Officer & Director

No.

Amit Sharma - BMO Capital Markets (United States)

Okay. Good. And then a question on the margin trajectory of the Packaged Beverages business. I mean, you talked about single-serve. You talked about even the premiumization of some categories. Is this current trajectory a margin improvement, and understanding that allied brands probably weigh down on that a little bit, is this the right trajectory? Or we – should we expect get a little bit stronger as we go along on this path?

Martin M. Ellen - Chief Financial Officer

Actually, let me handle that. It's Marty. Good morning. We're really – first, we're really pleased with the trajectory of Packaged Beverages. Operating margins up again this year, I think about 100 basis points year-over-year. And you're right. On an overall segment basis, the allied brands actually weigh it down a little, but they're still very profitable, way down the overall average margin.

I will also tell you this quarter – remind you that we said in our prepared remarks and on the press release, don't forget Packaged Beverages took a $4 million non-recurring hit. Quite frankly, we took our field people out of their company cars, we made a one-time payment to do that, and we expensed that in the quarter. And also, I'll be honest with you. We – some of the operating costs are up more than we would expect on a long-term basis, but we're making some investments in our front line. Lots of activities going on. It's no secret everybody is sort of worried about their front-line people. And we're taking care of our front-line people, and we're spending a little more money to do that. All of you know me. The runway for RCI improvement, as far as I'm concerned is unlimited. We find more opportunity every single day in this business. And therefore, we're pretty confident that actually Packaged Beverage margins can still appreciate at some level.

Amit Sharma - BMO Capital Markets (United States)

And the last question, and a follow-up to Judy's question on shelf space in CSD. So understanding that you're not losing any shelf space. But are you seeing the overall CSD category shelf space maybe being given to some of the other categories?

Larry D. Young - President, Chief Executive Officer & Director

We've not seen anything significant, no.

Amit Sharma - BMO Capital Markets (United States)

Got it. Thank you very much.

Operator

Our next question comes from the line of Vivien Azer of Cowen.

Vivien Azer - Cowen & Co. LLC

Hi. Good morning.

Larry D. Young - President, Chief Executive Officer & Director

Good morning.

Vivien Azer - Cowen & Co. LLC

I wanted to follow-up, please, on the commentary around 7UP and the evaluation that you're doing. And you called out pricing as one lever that you would be inspecting. I'm curious if you could expand on that a little bit, just given how narrow price gaps are in the category more broadly. Thank you.

Martin M. Ellen - Chief Financial Officer

Vivien, it's Marty. Part of my comment was it's everything: it's pricing, it's packaging, it's channel. There's not – there's nothing specific per se that we're going to call in terms of pricing in a market, in a package. But we're looking at overall how the brand performs, the elasticity, the historic data on elasticities, and what we think of our current elasticities.

As we think about all the time balancing price share with regard to, for example, protecting our space – but big-time profitability, okay? So there's nothing there. There's no – let me allay any fears, there's no strategy here to sort of lower price on 7UP as a way to grow the brand. That's the last thing we're going to do.

Larry D. Young - President, Chief Executive Officer & Director

Yeah. That's not sustainable, and you just rent volume when you do it with price.

Vivien Azer - Cowen & Co. LLC

Okay. That seems reasonable enough. Thank you for that. My next question has to do with diet. It's certainly encouraging that you guys are outperforming the industry, but given how many years we are into this outsized decline in diet, I was wondering whether you have any updated thoughts on that, just given that we're continuing to see the volume base shrink. Is there a mix in terms of where that volume bleed is coming from? Do we continue to lose consumers? Is it – I'm sure it's a balance between losing consumers and reductions in per-capita consumption. But has that balance shifted at all over the last few years as the declines persist? Thank you.

Larry D. Young - President, Chief Executive Officer & Director

Yeah, and I don't – you know, like I said, we're outperforming the category, but I don't think we're losing consumers. I mean, if you look at all the – our broad portfolio, and especially with our allied brands, we have some people that are going over to some of our allied brands. Some of our better-for-you, some of the diet brands in there. I think we will continue our Lil' Sweet campaign, because we're seeing it get momentum. So I think we will find the bottom of where it's at with Dr Pepper. I think if you look at – if you break the diet category down, there's categories losing much more of the volume. So I think we're going to get it. But I still think some of our consumers, as we continue our insights, we're not losing them. They're switchers. They're going to other brands, and we're keeping them in our portfolio.

Vivien Azer - Cowen & Co. LLC

That's helpful. But within diet for those consumers that are just kind of leaving, are you also seeing reductions in per-capita consumption? Or is this really more of a migration to other pieces of your portfolio?

Larry D. Young - President, Chief Executive Officer & Director

We've not really seen it. The households are still holding up, household penetration. The per-caps are still there, I think. You've just got some with concerns about the sweeteners that are going to something else.

Vivien Azer - Cowen & Co. LLC

Okay. Thank you so much.

Larry D. Young - President, Chief Executive Officer & Director

And your diet drinkers are some of the most loyal consumers you'll ever see on their diet brands.

Vivien Azer - Cowen & Co. LLC

Understood. Thank you again.

Operator

Our next question comes from the line of Bill Schmitz of Deutsche Bank.

Bill Schmitz - Deutsche Bank Securities, Inc.

Hey, guys. Good morning.

Larry D. Young - President, Chief Executive Officer & Director

Good morning, Bill.

Bill Schmitz - Deutsche Bank Securities, Inc.

Did you have any impact from that fountain shift you talked about last quarter? I thought there was like a full forward of fountain, and it wasn't mentioned in the call and the press release. I may have just missed it.

Martin M. Ellen - Chief Financial Officer

Actually, last quarter, I'd remind everybody we actually had an acceleration of an order that helped our fountain business. We thought that would turn around second quarter and it did. The fountain business stayed healthy all throughout the quarter, then the specific Freestyle orders remained healthy as well.

Bill Schmitz - Deutsche Bank Securities, Inc.

Okay. All right. Good. And then, you said that advertising and marketing is going to be 7.5% of sales for the year. Can you just tell us where you are year-to-date?

Larry D. Young - President, Chief Executive Officer & Director

It's probably around 7%.

Martin M. Ellen - Chief Financial Officer

We're probably right around 7%.

Bill Schmitz - Deutsche Bank Securities, Inc.

Okay. All right. And then you said there's going to be a big uptick in the third quarter relative to the other quarters. Is that right?

Martin M. Ellen - Chief Financial Officer

Right.

Bill Schmitz - Deutsche Bank Securities, Inc.

Okay. And then lastly, is there any way to sort of like disaggregate your growth between like same-store sales and distribution gains? Because I know like when I was out there you talked a lot about having this RCI track on distribution voids. Is that getting decent traction? And are there any big opportunities that could actually move the needle?

Martin M. Ellen - Chief Financial Officer

So though we've made great – we talked even last year, we've closed voids through RCI lean tracks on Snapple, on Canada Dry. I mentioned the specific activity around Dr Pepper. We look at velocity, points of distribution and velocity all the time internally, but there's no way I could share with you for modeling purposes how you can model growth, for example, between new points of distribution and velocity from existing points of distribution.

Bill Schmitz - Deutsche Bank Securities, Inc.

Okay. No, that's fine. I just thought I'd take a stab at it. Thanks very much.

Operator

Our next question comes from the line of Caroline Levy of CLSA.

Caroline Levy - CLSA Americas LLC

Good morning. Thank you. A couple of questions from me, your debt-to-EBITDA coverage is very good. And so I just have to ask if you guys would consider either stepping up your repurchases or if you see a brand out there that might be attractive to own versus use as an allied brand. How do you think about that?

Martin M. Ellen - Chief Financial Officer

Caroline, good morning. It's Marty. Our debt level, roughly $2.9 billion is where we have targeted to be, not that we wouldn't raise it for something that necessitated us to do that. It would not be for share repurchases. We're buying our shares out of our free cash flow, which has been, as I said in my remarks, pretty healthy, and a pretty healthy increase over prior year.

And I don't know. That's pretty much it. I mean, we've stayed at this level for a little bit. We did raise a little more money. Again, the last year, I referenced that, we took advantage of the yield curve at the time, and did an incremental $250 million at 30 year, about 4.5%. And in essence that's going into share repurchase this year. If you look at our $650 million to $700 million, it's roughly $250 million higher than our $400 million to $450 million average per year amount. That's simply reflecting that incremental $250 million borrowing. But there's no other plans to significantly change our capital structure.

Caroline Levy - CLSA Americas LLC

Great. And what makes you decide that you would actually acquire a brand outright versus taking the allied strategy?

Martin M. Ellen - Chief Financial Officer

Well, Caroline – it's never say never. But our history has been to be very prudent about how we use our capital. And when you say buying brands, that's a sort of a generic question. I mean, brands come to us all the time early stage. They're not selling. And actually, at early stage, if they were, they would want such a – in our view, a large sum of money as to make it just a non-starter for us. We're just not going to get involved in those sorts of risky investments. We just don't feel we need to do it.

To come back to a TSR algorithm for this company that really only requires us to grow the top line 2%, maybe 3% to get close to a double-digit expected return with our free cash flow yield. And we're not really trying to step out of that model.

Caroline Levy - CLSA Americas LLC

Got it. That makes a lot of sense. Just wanted to ask you on RCI and forgive me if you've already talked about this. But when you look at advertising and promotion, are you seeing opportunities through the shift to digital to really reduce spending and get the same impact?

Martin M. Ellen - Chief Financial Officer

Yes. I mean, in our marketing return on investment work, of course, digital shows some of the highest returns. And if your question goes to the dollar cost effectiveness of digital, for example, than traditional TV, yes, you can. But digital, too, is getting pricey as well because everybody is trying to take advantage of it. But there are a lot of things we're doing in marketing that come specifically from our marketing return on investment work, which is yielding improved effectiveness on that same level of marketing spend, at that 7.5% of sales.

One of the reasons we don't feel we need to do more is because we're getting good results moving our TV spots from 30 seconds to 15 seconds depending upon the campaign, all sorts of shifts around between, I'll call, prime channels and cable channels, programmatic through digital display.. There's lots of things that we're doing that we're learning and learning from our ROI, reducing in certain markets, traditional out-of-home, billboards, local radio. There are places where they're effective, but we've discovered lots of places where they're not. And we've spent a lot of time working with our marketing folks to analyze this data and shift our monies where we get best return. And it's very consistent with RCI. That's an area we want to find the ways and we want to redeploy it. And slowly but surely, we think we're getting there.

Caroline Levy - CLSA Americas LLC

Thank you. That's great. My last question is for Larry, if I could, just given your perspective on the industry. Do you think that for carbonated soft drinks some of the weakness in the total category has more to do with colas than anything else? Do you think it's very specific to cola, because Dr Pepper does seem to be outperforming?

Larry D. Young - President, Chief Executive Officer & Director

Yes, I think Dr Pepper and the flavors both are outperforming. If you look at the change in our demographics also, they're switching much more to people who are wanting the flavored CSDs, the full sugar. So the colas they've had decline for quite some time, and I think it's more in the cola than what we're seeing in the flavors. The flavors continue to be strong, and that's why we look at them positive and say that we think that we can keep CSDs basically flat to maybe up a little bit.

Caroline Levy - CLSA Americas LLC

Got it. Thank you so much.

Operator

Our next question comes from the line of Bonnie Herzog of Wells Fargo.

Larry D. Young - President, Chief Executive Officer & Director

Hi, Bonnie.

Operator

Bonnie, can you make sure you're not on mute? Okay. Our next question we'll go to Kevin Grundy of Jefferies.

Kevin Grundy - Jefferies LLC

Thanks. Good morning, guys.

Larry D. Young - President, Chief Executive Officer & Director

Good morning, Kevin.

Kevin Grundy - Jefferies LLC

Larry, a question for you back to the diet category. So Pepsi recently announced that they are returning to the original formula. What, if any, impact do you expect to see on your portfolio?

Larry D. Young - President, Chief Executive Officer & Director

None. I think they're going to have a little bit of all of them out there and we don't make changes on ours. And we don't jeopardize anything on the taste or our consumers and customers that rely on us. I mean, they're very loyal. So I don't think it'll have any impact.

Kevin Grundy - Jefferies LLC

Okay. Thanks. And then, Marty, one for you, return of capital. So we're seeing dividend payout ratios edge up here in the consumer staple space, which is unsurprising given where interest rates are globally. Can you touch a little bit on that? Any update? Understanding that it's a board decision, any change in philosophy there potentially with respect to your dividend payout ratio?

Martin M. Ellen - Chief Financial Officer

So, Kevin, it is a board decision. It is a decision taken up typically in our February meeting every year. I've said it and I'll say it again, if we and I believe our board gets before them, but I believe if we had to lean in one direction or other, be it to increase the dividend over and above putting more money to share repurchases, that would be our tendency. I wouldn't look for a dramatic change, but we'll take that up in February.

Kevin Grundy - Jefferies LLC

Okay. That's helpful. And then one quick housekeeping question, just because fountain foodservice seems to becoming more topical and a bigger contributor to top line growth. Is that still about 10% of volume mix for the company? Is that roughly accurate, Marty?

Martin M. Ellen - Chief Financial Officer

That's correct.

Kevin Grundy - Jefferies LLC

Okay. Very good. Thank you, guys.

Operator

Your final question this morning comes from Brett Cooper of Consumer Edge Research.

Brett Cooper - Consumer Edge Research LLC

Good morning, guys. Just a quick question on brand fragmentation specifically, I think it's more common outside of CSDs. But your thoughts on that going forward. And then wanted to understand your capacity to take on new brands, how that evolves over time given some of the efforts that you're making in the DSB business with RCI.

Martin M. Ellen - Chief Financial Officer

Brett, I'm not sure I understand. Your question referred to non-CSDs and what, does it go to our ability to deal with an increased number of brands in our system?

Brett Cooper - Consumer Edge Research LLC

What's your capacity to take on allied brands? Is there a bottleneck in doing that? And then, yes, also the idea of as SKUs proliferate, what does that do to your cost base?

Martin M. Ellen - Chief Financial Officer

Yes, it's a great question, because actually RCI is a real important element to make sure that the complexity that comes from handling these brands actually doesn't result in higher cost. And early on, particularly when these brands are small, order size is small. Pack sizes, case sizes, delivery sizes of these brands are smaller. Through RCI we learn how to do this still at a very effective cost. That's been one of our efforts in our warehouses with RCI. Because we've always had to handle a lot of brands. We've always had a pretty broad portfolio of brands. So this is something we've had to get good at. And the allied brands just get us even more focused on it. And we have plenty of capacity.

Brett Cooper - Consumer Edge Research LLC

Okay. And historically where we've seen DSD operations struggle with small brands and all these companies are coming with small (52:44) brands. So what is it that you guys do differently than maybe some of your other competitors in terms of being able to nurture these brands as they go into market at a relatively small scale I guess versus what we are used to seeing?

Larry D. Young - President, Chief Executive Officer & Director

I think probably the biggest difference that you see with our packaged beverage and our DSD system is that unlike our competitors, whether it's soft drinks or beer, we don't have one brand that is 50%-plus of the sales. Our guys have all their careers have managed a lot of brands, and they're able to manage them well, had them on display, had points of interruption, get the shelf space, and sell more than just delivering a bulk delivery out there. So I think it just really works well whenever we get the new brands in, the allied brands, that they see that these guys can go out and sell. They're some of the best sales guys we've got around. They get the job done.

Brett Cooper - Consumer Edge Research LLC

Perfect. Thanks.

Larry D. Young - President, Chief Executive Officer & Director

Well, I want to thank everybody for joining our call today and for your continued interest and investment in Dr Pepper Snapple Group. Thank you.

Operator

Thank you for joining the Dr Pepper Snapple Group's second quarter 2016 earnings conference call. Please disconnect your lines at this time and have a wonderful day.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!