Keurig Dr Pepper: There Is Potential In This Newly Formed Company

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About: Keurig Dr Pepper Inc (KDP), Includes: KO, MDLZ, NSRGY, PEP, SBUX
by: Dividend Power
Summary

Keurig Dr Pepper is now the third largest non-alcoholic beverage company in the U.S.

The company has competitive advantages in distribution network and well-known brands in soft drinks, fruit juices and drinks, water, and coffee.

The company has initiated an annual dividend of $0.60, but the future dividend growth policy is not yet known.

The combined company had $16.6B in total debt, but it is rapidly de-levering.

Keurig Dr Pepper will likely face increasing competition in the single-serve coffee market category.

Overview

I have focused on stocks with decent income and a growing dividend over time with the potential for capital appreciation. In this article, I discuss Keurig Dr Pepper Inc. (KDP), a company that was formed through the merger of Dr Pepper Snapple Group, Inc. (DPS) and privately held Keurig Green Mountain. The company pays an initial annualized dividend of $0.60, has decent debt metrics, and strong brands. But the stock has increased roughly 30% since its debut in early-July 2018, leading to a PE ratio above the broader market averages. Despite having several competitive advantages and merging a leading player in cold beverages and single-serve coffee, investors should probably wait for a better entry point and thus I am not a buyer at this time.

Keurig Dr. Pepper Merger

Source: underconsideration.com

Keurig Dr Pepper Is Now The Third Largest Non-Alcoholic Beverage Company

Keurig Dr Pepper is a result of an approximately $20B merger between Dr Pepper Snapple and privately held Keurig Green Mountain completed in mid-2018. The new company started trading on July 10, 2018. DPS shareholders received $103.75 per share in cash for each share owned, and DPS shareholders retained 13% of the company while JAB Holding Company and its partners now own 87%. Mondelēz International (MDLZ) reportedly has about a 13%-14% stake. KDP is now the third largest non-alcoholic beverage company in terms of revenue and one of the top 10 food and beverage companies in the U.S. as seen in the chart below. Although much larger than before, the company still trails its two largest competitors, PepsiCo (PEP) and Coca-Cola (KO) in terms of net sales.

U.S. Consumer Staples Companies Source: Keurig Dr Pepper 2018 Investor Day Presentation

The rationale for the merger was for revenue and cost synergies and furthermore providing a larger platform and distribution network for the company to grow brands organically and through additional acquisitions. The company now reports four business segments that are Beverage Concentrates, Packaged Beverages, Latin America Beverages, and Coffee Systems, which is largely the old Keurig Green Mountain business. The combined company’s business focus is carbonated soft drinks, ready-to-drink teas and coffees, and K-cup pod coffee, but it also has growing brands in fruit juices and drinks and bottled water. Some of the company’s owned brands are well-known, including Dr Pepper, 7-Up, Ginger Ale, Schweppes, A&W, Snapple, Nantucket Nectars, Mott’s, Hawaiian Punch, and Green Mountain Coffee. In addition, the company licenses and partners with many other growing brands, including Fiji Water, Vita Coca, and SunnyD.

Some of Keurig Dr Pepper’s Owned, Licensed, and Partner Brands After The Merger

Keurig Dr. Pepper Brands Source: Keurig Dr Pepper 2018 Investor Day Presentation

Keurig Dr Pepper Reported Decent Performance In Its First Quarter As Merged Company

The company has reported only one quarter of earnings since the merger. In Q3 2018, KDP reported net sales of $2.7B, operating income of $344M, and diluted EPS of $0.11. The former Dr Pepper Snapple businesses showed growth, but the coffee business is experiencing pricing weakness due to long-term trends for pods. Beverage Concentrates increased both volume and pricing but Packaged Beverages exhibited volume increases and lower pricing while Latin America Beverage had volume decreases but high pricing. Coffee Systems exhibited only 0.4% increase in net sales since volumes grew 2.5%, but prices were lower at 1.7% and foreign currency had a negative impact of 0.4%.

Keurig Dr Pepper’s Debt Is Large But The Company Is Delevering

After the merger closed and at the start of trading, Keurig Dr Pepper’s debt was $16.6B in short-term and long-term debt. The company has indicated that debt repayment is a priority for the next two to three years and I expect that debt will decrease rapidly. Keurig Dr Pepper is targeting a debt-to-EBITDA ratio of 3.0X or less from a current value of roughly 4.3X. In this regard, Keurig Dr Pepper has had a successful start since it has already paid $550M in debt since the merger. The company maintains only a small amount of cash, but at the same time, the company has sufficient interest coverage and is able to meet its obligations. In addition, the debt-to-equity (D/E) ratio is < 1 and the total liabilities-to-equity are reasonable. Overall, I view Keurig Dr Pepper’s debt profile as conservative.

Keurig Dr Pepper’s Balance Sheet Data and Debt Metrics

Keurig Dr. Pepper Balance Sheet and Debt Metrics

Source: Dividend Power Research and Calculations Based on Data from Annual Reports, Quarterly 10-Q and Presentations, and Morningstar.com

Distribution Network and Brand Strength Are Competitive Advantages

Keurig Dr Pepper’s competitive advantages derive from its distribution network and the strength of its brands. The company now has one of the three largest distribution networks for non-alcoholic beverages. Hence, the merger of DPS and Keurig has created a company with sufficient scale to compete with the two largest non-alcoholic beverage companies, PepsiCo and Coca-Cola. Notably, both predecessor companies had developed licensing partners and collaborations with smaller entrepreneurial brands leveraging their individual distribution networks to grow and expand sales. I view this as a positive in context of brand growth through scaling smaller brands and performing acquisitions with less risk.

From a brand perspective, the company’s brands are well known in the U.S. Keurig Dr Pepper has a strong presence in carbonated soft drinks with No. 1 or No. 2 leadership positions in its market segments. In particular, Dr Pepper and Canada Dry have been growing net sales. Keurig Dr Pepper also has strong presence in ready-to-drink teas with Snapple, which is the market leader, and Nantucket Nectars. Its flavored enhanced water brand, Bai, is the No. 1 brand in the category and has experienced 106% CAGR growth from 2014 to 2017.

In coffee, Keurig Dr Pepper owns the market leader in K-cup pods with Green Mountain Coffee. The company has an advantage in that its brewing systems have achieved 20% household penetration and the estimated potential is 30%-50%, suggesting that there exists room for further volume growth. In this context, the company is expanding its brewer line up and achieved +9% growth in household penetration and +11% growth in brewer unit sales. Importantly, brewer growth drives growth in pod sales. Furthermore, the high degree of penetration likely leads to greater opportunities for licensing and partnering with other established and entrepreneurial brands.

Keurig Dr Pepper New Single Serve Brewer Models

Keurig Dr. Pepper New Coffee Brewers Source: Keurig Dr Pepper 2018 Investor Day Presentation

Increasing Competition Is A Risk

One concern is that although the Green Mountain brand is the market leader in K-cup pods, pricing has been decreasing on average for pods since 2014 due to more brands and increased competition after the expiration of the K-cup patent in 2012. Although this can be thought of as a positive in context of improving affordability and volumes, this trend has had the effect of lowering net sales.

K-Cup Pod Pricing Is Decreasing

K-Cup Pod Pricing Is Decreasing Source: Keurig Dr Pepper 2018 Investor Day Presentation

In fact, now private label brands and Starbucks (SBUX) are the No. 1 and No. 2 brand leaders in the category by market share. Furthermore, other brewer systems such as Nespresso from Nestle (OTCPK:NSRGY) have a greater presence outside of the U.S. and have been slowly increasing household penetration in the U.S.

Single-Serve Market Share By Brand in 2018

Single-Serve Coffee Market Share By Brand Source: statista.com

A second concern is that Coca-Cola has been aggressive in entering the coffee market. The company bought Costa Coffee for roughly $5.1B in 2018 with the intention of expanding in the ready-to-drink coffee market and the single-serve coffee market through vending machines. Notably, Coca-Cola has a larger distribution network and certainly sufficient financial resources for this effort. Furthermore, Coca-Cola recently acquired a minority stake in Body Armor, a former partner brand with Keurig Dr Pepper, essentially limiting the latter’s growth in the sports drink category.

Valuation

Keurig Dr Pepper currently pays a dividend of $0.30 per share in 2018, which will be $0.60 per share annualized. Since I conventionally focus on dividends and their growth, I applied the Gordon Growth Model using a desired return of 8% and assuming a stable dividend growth rate of 5%-6%, giving an estimated valuation range of $20-$30. At the closing stock price on February 1, 2019 of $27.21, this implies that the stock is currently priced between 136% and 91% of estimated value. At the mid-point or a 5.5% dividend growth rate, the stock is priced at 113% of estimated value. Note that the actual dividend growth rate is not known, leading to some uncertainty in the dividend growth model.

Valuation Based On Gordon Growth Model

Dividend Growth Rate

Desired Return

5.0%

5.5%

6.0%

8.0%

$20

$24

$30

% Estimated Value at Current Stock Price

136%

113%

91%

Source: Dividend Power Calculations, Gordon Growth Model

From the perspective of PE ratio and the mid-point of the expected pro forma EPS for 2018 of $1.09, the company’s current stock price is elevated. Since the combined company is a new entity and 10-year long-term averages do not exist, I use a PE ratio of 18.0 as a long-term industry average and I obtain a current valuation of $20. Applying a sensitivity analysis using PE ratios between 17.0 and 19.0, I obtain valuation between $19 and $21. These values are somewhat lower than those obtained from the dividend growth model, implying that they are conservative. At the closing stock price on February 1, 2019 of $27.21, this implies that the stock is currently priced between 147% and 131% of estimated value.

Estimated Current Valuation Based On PE Ratio

PE Ratio

17.0

18.0

19.0

Estimated Value

$19

$20

$21

% Estimated Value at Current Stock Price

147%

140%

131%

Source: Dividend Power Calculations

Applying a sensitivity analysis using PE ratios between 17.0 and 19.0 and a projected EPS growth rate of 10%, I obtain an estimated valuation range of $30-$33, suggesting that at the current price much of the projected gains are already accounted for. However, note that the there is a high degree of uncertainty in this valuation, as the company has not yet reported full-year 2018 results.

Final Thoughts

Keurig Dr Pepper is a result of a merger and the combined company has sufficient scale to compete at a national level in both cold and hot beverages. It is now a viable competitor to the two largest companies in the non-alcoholic beverage market. The company should extract cost synergies and generate sales synergies from the merger leading to higher top line and bottom line growth. Furthermore, Keurig Dr Pepper has a nationwide distribution network and strong, well-known brands in carbonated soft drinks, ready-to-drink teas and coffees, flavored water, and single-serve coffee. But despite the potential, at the current stock price, there are likely little gains over the next several years and the future dividend growth policy is unknown. Hence, I am not a buyer of this stock.

Disclosure: I am/we are long KO, PEP, SBUX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.