Dr. Pepper Snapple: How Fast Can Dividends Grow?

| About: Dr Pepper (DPS)

By Mark Bern, CPA CFA

A reader asked in a comment to my article on Coke (NYSE:KO) versus PepsiCo (NYSE:PEP), “any thoughts on Dr. Pepper Snapple (NYSE:DPS)? Nice dividend, and some room to grow perhaps ... problem is balance sheet. Any thoughts if this has more growth opportunity?”

As I got into the research, since I don’t follow Dr. Pepper Snapple, I decided that it would make a good subject for an article. The first thing I noticed about DPS is that the balance sheet isn’t really that bad. KO’s balance sheet is better, with a debt to equity ratio of 31% compared to DPS’s ratio of 48%. That is a little high, but manageable. PepsiCo also has a debt to equity ratio of 48%. Besides the obvious, PEP is about 10 times the size of DPS. So what else makes PEP better able to handle the debt load? PEP’s cash flow is approximately 12.4 times that of DPS. PEP is in a more dominant position in the industry with greater geographic diversity. The likely growth rates for DPS are slightly lower and its cost of capital is higher, a function of size, industry position, brand values and credit ratings. So while DPS isn’t in bad shape, it just doesn’t have the advantages of the industry leaders.

The second part of the question asks whether I thought DPS had better growth prospects. Unless DPS finds its way into more of the developing and emerging markets I would have to say, no. I expect DPS’s EPS to grow in the range of about 8% over the next few years. While that compares well too much of the S&P 500, it falls about two percentage points below what I expect from the industry leaders.

Other analysts expect DPS to grow its dividends faster, but here again I don’t see the potential for a whole lot of room for expansion relative to the competition. The current dividend yield for DPS is 3.5% which is excellent in the current economic climate and the dividend is well supported and sustainable, in my opinion. I believe that there is some room for expansion of the payout ratio, but DPS would have to weigh that against investment in potential growth areas.

It comes down to where management believes the best value can be created for shareholders. If management chooses dividends, it sends the message that growth prospects are limited. I would rather see management sustain the current payout ratio of about 38% to 40% and focus more on long-term market growth. Of course, management has to find the right balance, but my thoughts are that if the payout ratio expands (maybe to 50%) too quickly it may be doing so at the expense of future growth.

In the end, I don’t view DPS as a risky stock. On the contrary, the company appears well positioned to maintain a modest growth in both earnings and yield that would serve most investors well. My personal preference is to stick with the dominant leaders in an industry when there is so little difference. In this case, I don’t think the smaller size will create a growth advantage, but rather it may be a hindrance in terms of gaining entrance to the faster growth emerging and developing countries. That is where size, brand recognition and the ability to make large investments matter.

Sorry, but my opinion on DPS is that it is a good company, but not great. Better options are available for both income and growth, and those options come with a little more safety and a little less potential volatility.

If readers are interested in a more detailed analysis of PepsiCo, please consider my recent article at this link here.

Disclosure: I am long PEP.

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