Wednesday, December 9, 2009

Dr Pepper Snapple Delivers

Dr Pepper Snapple Group (DPS) has been a top Lonely Value pick for some time. Since the 2008 spin-off from Cadbury (CBY), CEO Larry Young and his team have delivered again and again.

The August 20, 2009 Lonely Value article, I'm a Pepper. Are You?, outlined my basic investment thesis. Here's a quote from that article:
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.
On November 20th, Dr Pepper announced a $0.15 quarterly dividend and a $200 million stock repurchase. The dividend represents a 2.2% yield at the current price. Both moves are an attempt to wake up investors to the value of this company. But the response from investors: a collective yawn.

Undeterred, Dr Pepper announced a deal with Pepsico (PEP) on their outstanding bottling contracts yesterday. Lonely Value addressed this issue on August 22 in an article entitled DPS Bottling Bonanza?

As part of the announced deal, Dr. Pepper will receive $900 million in cash (now) and the return of distribution rights to certain brands. The company announced its intention to use the proceeds for further reduce debt. The result: another yawn.

Nonetheless, the fundamentals of DPS are such that investors won't ignore them forever.

As of September 30, Dr Pepper had $3 billion in debt. Optional debt repayments total $480 million year-to-date. As of November 4th, the company expected to pay off $550 million this year. The $900 million Pepsico payment will push this figure much higher.

The dividend/share repurchase announcement is a signal that DPS is nearing its target debt level (2x EBITDA). At that point, will investors finally reward the company for its ample cash flow? Let's hope so.

I use the optional debt repayments as a base case for free cash flow ($480 million in 9 months), but it is actually much higher. In the last 9 months, Dr Pepper has generated $500 million in stated free cash flow. The company informs me that capital expenditures are split 50-50 between maintenance and growth. That adds another $100+ million to actual free cash flow in the same period. This lends credibility to my August 20 assertion that Dr Pepper's annual free cash flow exceeds $700 million, a number that may prove to be conservative.

Today's stock price is $27.25 a share. With shares shares outstanding of 255 million, the company's market value is $6.95 billion. Total debt is $3 billion. By year-end, the company's debt could be as low as $2 billion thanks to the bottling proceeds and previously announced payments from free cash flow.

With a price to free cash flow multiple of 9 (or lower), DPS is a steal. Viewed another way, if one bottling agreement is worth $900 million, certainly Dr Pepper Snapple Group (as a whole) is worth more than $7 billion.

Perhaps its independence is short-lived? Pepsico is a logical buyer, an idea put forth in "Dr Pepper Buyout?". But standalone or not, Dr Pepper is a wonderful business at a compelling price.

Additional positive catalysts remain.

Dr Pepper, the company's signature drink, will soon be sold at all McDonald's (MCD) restaurants. Until recently it was selectively offered. The final roll-out involves 2,500 additional restaurants. In many cases it will be replacing Coca-Cola's (KO) Mr. Pibb brand, which was specifically designed to take on Dr. Pepper. How's that working out?

CEO Larry Young is an industry veteran whose clearly having the time of this life. (Read Dr Pepper CEO Interview). Young is thrilled to be running a newly independent beverage outfit and it shows. With numbers like these, who can blame him!?!

My short-term target price: $40 a share.

Disclosure: The author is Long DPS shares and is addicted to Dr Pepper.


  1. Hey,

    Just found this blog, and I have to say I'm extremely impressed, this is the best value blog I've come across in a very, very long time. Keep up the great work!

  2. TedK,

    Can't thank you enough for those kind words. If I ever fail to live up to those high expectations, please let me know that too! ;-)