Time to Invest in the Dr. Pepper Spin

| About: Dr Pepper (DPS)
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Dr. Pepper Snapple Group (A.K.A. "Dr. Pepper") (NYSE:DPS) stands out from other spin-offs due to its well-known brand names, discounted valuation to comparables and added selling pressure due to its listing on a US  exchange from a parent with a UK shareholder base. Dr Pepper officially became an independent company after the demerger from its parent company, Cadbury Schweppes (CBY) (who is also trading under a new ticker symbol), was completed on May 7th, 2008.

Dr. Pepper is in the great business of selling sugar water. They, of course, have very well-known brand names, which include: Dr Pepper, Snapple, 7UP, Mott’s, A&W, Canada Dry, Hawaiian Punch, Schweppes, IBC, Sunkist, Nantucket Nectars and Yoo-hoo. The branded beverage business has been a great business for decades. Recently, there have been some concerns about the growth rates of carbonated beverages.

However, Dr. Pepper looks cheap. According to unaudited supplemental financial information released on June 27th (prepared on a “carve out” basis from Cadbury Schweppes historical financial data), Dr. Pepper is currently selling at a P/E multiple just under 13x.

Dr. Pepper is also attractive because it has had additional selling pressure due to being listed in the US when its parent company, Cadbury, is traded on the London Exchange. After being spun-off, Dr. Pepper began trading on the NYSE, causing many UK institutions to sell the stock right away, creating a steep decline in the stock price.

Dr. Pepper began regular-way trade back in May around $25. The stock has fallen during first three months of trading to the $21 level. During this same time period, Pepsico has been flat and Coke has only had half the decline of Dr. Pepper.

Industry Analysis

The beverage industry is a highly competitive industry with Dr. Pepper competing against multinational corporations with significant financial resources and brand name awareness, including Coca-Cola and PepsiCo. In addition, smaller regional corporations have the ability to glean some of the market due to their ability to exploit niche markets and quicker turnaround in product innovation. Therefore, in order to compete, Dr. Pepper must utilize advertising and marketing effectively while also using pricing measures to gain a competitive advantage. 

Currently the beverage industry is being hit by escalating commodity costs and a slowing U.S. economy, which has created 2008 as an especially challenging year for the beverage industry as a whole. Year to date, the soft drink index has had a 14.83 percent decline while the DJ U.S. Total Market Index has only declined 13.38 percent. 

Specific to Dr. Pepper, volume in bottler case sales (NYSE:BCS), which is determined by sales of finished beverages, in equivalent 288oz cases, sold by Dr. Pepper and bottling partners to retailers and independent distributors, declined by 3 percent this quarter versus 2007 first quarter. Carbonated soft drinks (CSDs) declined 2 percent and non-carbonated beverages (NCBs) declined 8 percent.

The 2 percent decline in CSDs can be summarized by: (1) Dr. Pepper volume declining 2 percent due primarily to “mid-single-digit” declines in fountain/foodservice and (2) “Core 4” (7UP, Sunkist, A&W, and Canada Dry) volume declining 5 percent due primarily to decreases in promotional activities for 7UP this quarter as compared to 2007 first quarter.

The 8 percent decline in NCBs can be summarized by: (1) “Double-digit” volume declines in Hawaiian Punch due primarily to price increases taken in April of 2007 and (2) the loss of a distribution agreement between Glacéau products, reducing NCB growth by 4 percentage points in the quarter. These declines completely offset volume growth increases of 3 percent and 6 percent, respectively, for Snapple and Mott’s. 

North America BCS declined 4 percent while Mexico and the Caribbean BCS grew 3 percent due primarily to “single-digit” growth in the product Squirt. 

Overall, sales volume decreased this quarter by 4 percent from the 2007 first quarter results. This is due, in combination, to BCS declines and a change in the timing of concentrate price increases from April in 2007 to February in 2008. 

Net sales, however, still increased by 3 percent, as sales volume decreases were offset by increased pricing. Though, the question is raised whether this growth can be sustained by raising prices again in order to further offset rising commodity prices and potential reoccurring volume decreases. Specifically, Dr Pepper has issued 2008 full-year guidance indicating they expect rising commodity costs to increase their COGS by approximately 6 percent. The ability to recover these increased costs through higher pricing may become more and more limited by the competitiveness of the beverage marketplace.  As a result, certain hedging strategies were used in the past to offset these risks and must continually be used effectively in the future so that these increased costs to not effect Dr. Pepper more so than their competitors.

Business Overview

Business Lines

Dr. Pepper is an integrated brand owner, bottler, and distributor of non-alcoholic beverages in the United States, Canada, and Mexico. Dr. Pepper’s non-alcoholic beverages include a diverse assortment of flavored (non-cola) carbonated soft drinks (“CSD”) and non-carbonated beverages (“NCB”), which include ready-to-mix teas, juices, juice drinks, and mixers. 

As a brand owner, bottler, and distributor, Dr. Pepper operates and reports through four business segments: (1) Beverage Concentrate, (2) Finished Goods, (3) Bottling Group, and (4) Mexico and the Caribbean. 

Distribution

Dr. Pepper’s operations are more integrated than Coke and Pepsi’s because Dr Pepper owns a higher percentage of its bottling operations. This arguable because Coke has a large stake in Coca-Cola Enterprises and Pepsi has a stake in Pepsi Bottling Group. It is also debatable whether owning bottling operations is a good ROIC business. Certainly, owning bottling operations reduces the natural friction between the concentrate company and the bottler. However

Brands

Dr. Pepper’s brand portfolio has some of the most well-recognized beverage brands in North America, which include: (1) popular CSDs such as Dr. Pepper, 7UP, Sunkist, A&W, Canada Dry, Schweppes, and Squirt and (2) NCBs such as Snapple, Mott’s, Hawaiian Punch, Clamato, Mr & Mrs T, Margaritaville, and Rose’s. 

Management’s background

Larry D. Young—President, CEO and Director

Young was elected to the position in October 2007 and he remains subsequent to the company going public. Young worked his way up after servings as President and COO of the Bottling Group segment and Head of Supply Chain in 2006 after the acquisition of Dr. Pepper/Seven Up Bottling Group, where he had been President and CEO since May 2005. Before join the company, Young served as President and CEOO of Pepsi-Cola General Bottlers, Inc. and Executive VP of Corporate Affairs at PepsiAmericas, Inc.

Hidden values from the spin

Integration

Dr. Pepper’s boasts its business model as being a competitive advantage to other competitors. They claim their integrated business model strengthens the route-to-market, provides opportunities for net sales and profit growth through the alignment of the economic interests of their brand ownership, bottling, and distribution businesses, which enables them to be more flexible and responsive to the changing needs of large retail customers. This could be the case as soon as the benefits from the separation start to truly take effect. However, as mentioned before, operating margins are still on the lower end compared to its competitors. This could change as the separation will allow Dr. Pepper to further pursue new acquisitions through the use of shares of common stock as consideration. 

Acquisition of SeaBev

Dr. Pepper acquired the Jacksonville, Florida-based Southeast-Atlantic Beverage Corp. (“SeaBev”) on July 11, 2007 for $53 million. SeaBev is the second largest independent bottling and distribution company in the United States with 2 manufacturing facilities and 16 warehouses and distribution centers located from Miami to Atlanta. This will provide Dr. Pepper with gained distribution and geographic coverage in the Florida market. Due to this acquisition, SeaBev accounted for an increase of net sales growth by 2 percentage points and added an incremental $39 million to Dr. Pepper’s net sales for the three months ended March 31, 2008.

Restructuring

Prior to the spin, in October 2007, Dr. Pepper announced a restructuring of the organization that was intended to increase efficiency. Specifically, the company cut 470 employees in their corporate, sales, and supply chain functions. In addition, the restructuring will include the closure of two manufacturing facilities in Denver, CO (closed in December 2007) and Waterloo, NY (closed March 2008). The employee reductions were expected to be completed in June 2008.

As a result of the restructuring Dr. Pepper said they recognized a charge of approximately $32 million in 2007 and they expect to recognize a charge of approximately $21 million in 2008. They expect to generate annual cost savings of approximately $68 million due to the restructuring, of which most is expected to be realized in 2008 and the full benefits realized from 2009 onwards. 

Balance sheet

Debt Structure

Dr. Pepper settled all receivable and loan balances in relation to Cadbury Schweppes upon the completed separation from Cadbury Schweppes on May 7, 2008. The net balance was paid using new unsecured senior credit totaling $3.9 billion. The new capital structure has a blended interest rate of 6.3%, based on current LIBOR and including 50 basis points related to the amortization of certain fee and expenses associated with establishing new facilities. 

Dr. Pepper entered into arrangements on March 10, 2008 with a group of lenders to receive an aggregate of $4.4 billion in senior financing, which included a term loan A facility, a revolving credit facility, and a bridge loan facility. As of March 31, 2008, no amounts of these facilities were outstanding.

However, on April 11, 2008, the previous March 10, 2008 arrangements were amended and restated to consist of a $2.7 billion senior unsecured credit agreement that provides $2.2 billion term loan A facility and a $500 million revolving credit facility (collectively, the “senior unsecured credit facility) and a 364-day bridge credit agreement that provided a $1.7 billion bridge loan facility. The bridge loan was replaced by a $1.7 public debt issue at the end of April.

Capital Management Going Forward

Dr. Pepper plans to manage capital to the liquidity needs of the business with any excess cash to be used in order to pay down debt.

Valuation

Dr. Pepper has exhibited a much larger 3-year growth in earnings and its price has not followed this figure proportionally since the company going public, having a P/E ratio of only 12.85. If the company can increase operating margins to rival its competitors and keep growth in earnings relative to where they are, Dr. Pepper seems like a very good bet in the long-run.

Summary

Dr. Pepper is a well-branded, popular soft drink business that could very well exhibit the benefits of a spin-off after a huge sell-off from Cadbury stockholders. In addition, Dr. Pepper looks like a great value buy with its current valuations and growth prospects. Moreover, with the separation complete, management can now focus more on growing the business and using capital more efficiently. 

Disclosure: Author and firm have a position in DPS