Thursday, February 25, 2010

Dr Pepper Wins Again & Again

Have I mentioned Dr Pepper Snapple Group (DPS) on this blog before? OK, once or twice. There wouldn't be a need for this crusade if anyone else seemed to be paying attention. Honestly, it seems like Crocs (CROX), a maker of plastic shoes, gets more press.

Despite relative obscurity, DPS is a serial winner. The stock was up 11% yesterday thanks to a combination of earnings and the Coca-Cola (KO)/Coca-Cola Enterprises (CCE) deal.

And yet, it's still cheap.

Dr Pepper hit the jackpot when Pepsi bought its largest bottlers (PBG and PAS). The deal triggered a change of control clause in DPS' bottling agreements with those companies. As a result, Dr Pepper renegotiated the deals and extracted $900 million from their new parent Pepsico (PEP). Dr Pepper was also able to reclaim some brands for their internal bottling operations.

On yesterday's earnings call, DPS management said they expect to close the deal by the end of February. So, like, tomorrow!

That's $900 million... cash... tomorrow.

Dr Pepper has approximately 256 million shares outstanding. At $32 a share, the current market value is just $8 billion. So the $900 million payment (did I mention that already?) is pretty significant in both absolute and relative terms.

What does DPS plan to do with the money? Debt repayments, share repurchases, and dividends. (Is that a song?)

On top of this windfall, Dr Pepper Snapple generated operating cash of $865 million in 2009. Of this, $312 million was spent on capital expenditures, approximately half of which were new investments (as opposed to maintenance capex). The remaining cash flow was spent on voluntary debt prepayments of $550 million.

How's that for straightforward capital allocation? (550 + 312 = 862) Not a coincidence.

At year-end 2009, Dr Pepper Snapple had $2.955 billion of debt outstanding. The company's target debt level is approximately $2.5 billion. So with the Pepsi payment, the company will immediately reach its debt target and have $400 - $500 million cash remaining. As in, like, tomorrow.

It is not surprising then that the company announced an increase in its share repurchase plan to $1 billion. Only 3 months ago, DPS announced its first ever buyback plan ($200 million) and its first dividend (15 cents a quarter). So in just 3 months since the first buyback announcement, the board became so confident in the company's cash generation that it increased the authorization by $800 million?!? Astounding.

Far from a publicity stunt, management announced that the repurchases will begin once the debt target has been met. Again, so like, tomorrow! Ok, Monday.

The excess Pepsi money ($400 - $500 million) will probably be allocated to share repurchases immediately. The same is probably true for all excess cash flow going forward. In short, cash previously dedicated to debt payments will now go towards share repurchases. This is not a bogus buyback (the norm) that simply offsets stock option dilution. Rather, it is a concerted effort to return cash to shareholders. Lot's of it.

Most companies in this situation would find some reason to throw it away on an expensive acquisition (here read Dell/Perot). But DPS (as I've been saying over and over again) is not "most companies".

When asked about possible acquisitions on the conference call, one company official (can't remember which one) put the issue to rest seemingly forever. Our growth is going to be "organic, not from M&A" (a pretty close paraphrase). He said that the company may buy some small distributors, but that any such transaction would be tiny. He may have even called it a "rounding error". Again, straightforward... and shareholder friendly!

So here is how DPS' free cash flow will probably being allocated into the near future.

$700 million in free cash flow (a conservative 2010 estimate)

$150 million in discretionary capex
$150 million in dividends
$400+ million in share repurchases

The $700 million free cash flow estimate could be low as interest expense will be dramatically lower going forward. The company has lowered its average interest rate to around 5%. And don't forget over $1 billion of debt repayments. That's as of, like, tomorrow.

The Pepsi money means that the current share repurchase plan could be completed in just 12 months. But it gets even better. That always seems to be the case with this company!

Dr Pepper Snapple Group's bottling agreement with CCE is "very similar" to the one that it had with the Pepsi bottlers. The Coca-Cola buyout of CCE's North American assets will presumably trigger the same change of control clause that is typical in such deals.

Does that mean another $900 million (or more) payment for DPS? I wouldn't be surprised.

My $40 price target is looking VERY low.

It's time someone (besides this lonely investor) started counting the cash at DPS.

Disclosure: Yes, the author STILL owns DPS shares.

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