Thursday, August 20, 2009

I'm a Pepper. Are You?

What follows is a bullish appraisal of Dr Pepper Snapple Group (DPS). Before we get started, here are a couple of disclosures.

First, I love spin-offs and have several in my portfolio. These situations have been very profitable in the past thanks to an information void and an excess of natural sellers. Research is often rewarded because so few investors want to do the work. And many investor sell because they don't want to hold "a few lousy shares" of XYZ company. In short, spin-offs are ripe targets for value investors.

Secondly, I am biased because of an addiction to Dr Pepper. If there was ever a "buy what you know" company for me, this is it. Nonetheless, this is not a Victor Kiam situation. Of the Remington electric shaver, Mr. Kiam famously said: "I liked it so much, I bought the company!" But, despite being born south of the Mason Dixon line, this is not an affinity holding for me. It's a bonus.

So there you have it. If the argument below isn't convincing, you can comfortably ignore me with these ready-made excuses for my horribly biased analysis.

This article is the result of my reexamination of Dr Pepper following a 60% year-to-date increase, which has has resulted in the exit of many well-known investors. Goldman Sachs even removed the company from its Conviction Buy List. Well, I remain convinced that Dr Pepper Snapple remains misunderstood and undervalued.

A brief history - Dr Pepper Snapple Group Inc. used to be a subsidiary of Cadbury plc, called Cadbury Schweppes Americas Beverages. Catchy, eh? The firm manufactures, markets, and distributes over 50 brands including Dr Pepper, Snapple, 7UP, Mott’s, A&W, Sunkist Soda, Canada Dry, Hawaiian Punch, Schweppes, PeƱafiel, Squirt, Clamato, Mr & Mrs T Mixers, Rose’s, and Yoo-hoo. They even own RC Cola! Geographic reach is limited to the United States, Canada, Mexico and the Caribbean. The company's road from subsidiary to spin-off was a long one.

Here are the high points for context.

In September 2007, the Financial Times said that the board rejected a £6.4 billion to £6.9 billion ($13B to 14B) private-equity bid for its beverages unit. The private-equity offer was the second made by a consortium consisting of Blackstone Group LP, Kohlberg Kravis Roberts & Co. and Lion Capital LLP. The FT said that Cadbury reportedly was not satisfied with the terms of the offer. The FT reported that Cadbury announced its intention to sell or spin off the unit in March, but in July was forced to delay the sale, citing "extreme volatility" in debt markets.

On May 2, 2008, a Reuters story encapsulated the rest of the story:
Last October, Cadbury moved to demerge Dr Pepper after activist investor Nelson Peltz pressured the group to decide to split in March 2007. A sale to private equity was abandoned in the summer of 2007 due to turmoil in the credit markets making a de-merger a more attractive proposition.

Interestingly, Peltz's Triac Corp. - now Wendy's/Arby's Group, Inc (WEN) - was involved in the eventual creation of DPS. Triarc acquired Snapple from Quaker Oats in 1997. Cable Car Beverage Corporation, maker of Stewart's Root Beer and other brands, was also purchased by Triarc that year. These brands were sold to Cadbury in 2000 for a tidy profit. Some 7 years later, none other than Mr. Peltz was the one agitating for a spin-off!

On May 5, 2008, he got his wish. Dr. Pepper Snapple Group was born. For the first time in its history, DPS' corporate boundaries were (and are) well defined. Historical financial information is not available - one possible reason for why its exceptional performance is not more obvious. The stock price is little changed from the time of the spin-off despite some dramatic volatility. Furthermore, these price gyrations do not reflect the resilience of the underlying business.

Here are the Dr Pepper Snapple Group (DPS) numbers:

Stock price = $26.50 (up again today)
Shares Outstanding = 255.1 million
Market Value = $6.76 billion
Total Debt = $3.24 billion

Like most parent companies, Cadbury loaded DPS with debt prior to the spin-off. As farewell gifts go, it could have been better. How about a gold watch next time?!?

Anyway, to see the free cash flow generation of Dr Pepper Snapple, I suggest that investors look at debt repayments. The company has indicated that its primary use of cash is paying off debt. In the first 6 months of 2009, principal debt payments came to $280 million. This is a clean number - pure free cash flow - as no asset or liability account changed dramatically.

Here's a gem from the June 30th 10Q filing (yes, some investors still read such arcane things):

During the six months ended June 30, 2009, the Company made optional principal repayments totaling $280 million, prepaying its principal obligations through September 2010. Since the Company’s separation from Cadbury, DPS has made combined scheduled and optional repayments toward the principal totaling $675 million.
In 14 months as a freestanding company, Dr Pepper Snapple has repaid $675 million in debt, averaging over $48 million a month. To be clear, these are payments over and above the company's interest expenses. Annualize these payments number and you get $578 million a year. If this is an approximation of free cash flow, then DPS is currently trading for just 11.68 times free cash flow. Go and compare that to KO or PEP.

It gets better. Depreciation expense for the 6 months ended June 30th was $79 million, which purchases of property, plant, and equipment for the same period was $138 million. A difference of $59 million, meaning that capex is running 75% higher than depreciation. This got me wondering. In response to my inquiry, (the DPS finance and investor relations staff are excellent) I have learned that (and I quote): "Capex today is around 50/50 maintenance vs growth". So maintenance capex is actually running at or below the level of depreciation. Half of the capex expense represents free cash flow that the company is consciously spending on new investments. That was $69 million in the last 6 months alone.

So how much free cash flow is DPS generating?

At the very least, Dr Pepper is generating $500 million a year in free cash flow (13.5 times). But I think that figure is too low. Add the $578 million from above and $138 million ($69 x 2) from new investment capex and you get $716 million. In this case, the fcf multiple falls to 9.4 times.

But is the $716 million estimate too high? No.

In 2008, Coca-Cola generated around 17.5 cents of fcf for every dollar of revenue (19.7 cents if I make the same assumptions about capex as with DPS). A similar calculation using 2008 numbers for DPS got me just 7 cents. But this was the spin-off year and DPS had more wholly-owned bottling assets.

Dr. Pepper should have revenue of $5.5 billion or more this year. $700 million would represent 12.7 cents of fcf per dollar of revenue. Not very aggressive to my mind. The current enterprise value is still far below the private equity valuation mentioned above. And with almost $50 million a month in debt repayments, that enterprise figure is falling by the day.

Two other items give me confidence that operations will meet or exceed my free cash flow expectations:

#1 Debt repayments are lowering interest expense quickly. $107 million in the last 6 months vs. $140 million in the corresponding 2008 period.

#2 Gross margins are expanding. The first 6 months of 2008, it equaled 55.7% and in Q2 of 2008 it fell to 55.1%. Compare that to the first 6 months of 2009, where gross margins equaled 58.9% and in Q2 of 2009, when it increased to 59.8%.

It's only 14 months of data, but the operational trend is clear. Whether Dr Pepper's fcf multiple is 12, 11, 9 or even lower, this company is dramatically undervalued. Just watch the debt fall and do the math yourself.

I contacted management yesterday about capital allocation going forward. Specifically I asked: What is your long-term debt target and when will you begin to focus on share repurchases and/or dividends?

Here is the response from management:

Since the spin-off we've said that getting to BBB (from BBB- with negative outlook) is goal one. With our higher than expected debt repays we feel we're getting closer to this objective with each passing day. We certainly would look to dividends and/or share repos and will update the market as our board approves such actions.
With cash flow fundamentals like Dr Pepper has, I am scratching my head at the "negative outlook" position of the rating agencies. Given their past performance, they lack any credibility with me. By contrast, Dr Pepper continues to deliver. Come to think of it... I'm thirsty!

Thanks for reading, The Lonely Value Investor


  1. They work fast...

    Standard & Poor's Ratings Services said Thursday it raised its outlook on Dr Pepper Snapple Group Inc. to positive from negative despite weak economic conditions. S&P affirmed its BBB- corporate credit rating on the company. "The outlook revision reflects DPS' good operating performance and debt reduction efforts that have led to improved credit measures, as well as the expectation that the company will be able to continue to improve its financial profile in the near-to intermediate term," said Jean Stout, an S&P credit analyst, in a statement. As of June 30, 2009, DPS had about $3.2 billion of debt outstanding.

  2. As you can see, i am way behind on my reading.

    I have no comment on DPS as my preference is for stocks which i can understand sitting here in my remote corner of emerging world. If a stock doesn't have emerging market (read China and India) exposure, i am personally not interested in it. Of course, this is not (repeat, not at all) to say it won't be a great stock ... and i might break my own rules as i have done with Berkshire.

    The reason i am posting such a long winded response is to request you to take a look at erstwhile parent company, Cadbury. That, i can see all over from my corner. I did some work on it which i will share in a separate email.


  3. Ravi,

    Let me know your email and I'll get in touch.

  4. Hi,
    I am at ravi dot aranke @ gmail