Tuesday, August 24, 2010

Dr Pepper Debate

A reader of Lonely Value was kind enough to pass along a recent Morningstar update regarding Dr Pepper Snapple Group.  The research note is critical of the company's valuation and recent capital allocation decisions.    
As we [Morningstar] had anticipated, Dr Pepper Snapple (DPS) will repurchase a further $1 billion of shares over the next three years. Although we think there are better uses of the cash, we are maintaining our fair value estimate [$33]. The proposed repurchases are in addition to the $450 million remaining on a previously announced $1 billion buyback program. Dr Pepper has around $1 billion in after-tax proceeds to spend from renegotiated distribution deals with PepsiCo (PEP) and Coca-Cola (KO) after both firms acquired their primary North American bottlers. However, Dr Pepper shares are currently trading above our fair value estimate, and we would prefer the firm to use the cash to acquire emerging brands in noncarbonated categories or to reduce leverage. The company's product portfolio is heavily skewed toward sparkling drinks, which are in decline in the United States, and we think tuck-in acquisitions of growing noncarbonated brands would help Dr Pepper to achieve stable long-term growth. In addition, Dr Pepper's ratio of debt to earnings before interest, taxes, depreciation, and amortization was around 2.4 times at the end of 2009, materially higher than most of its competitors, so it would have been more prudent to pay down debt than to repurchase shares that we think are overvalued, in our opinion.
At $36.50 a share ($9 billion market value), Dr Pepper is valued between 12 and 14 times free cash flow.  The exact multiple depends on the assumptions of maintenance vs new investment capital expenditures, but it's not exactly nosebleed territory.

At Morningstar's $33 fair value estimate, the valuation would be even lower.  Ridiculously so.  The analyst's suggestions for capital allocation make even less sense.

At the current price, repurchasing shares offers a much higher rate of return than paying off debt.  In addition, the author seems to ignore the fact that Dr Pepper Snapple has repaid nearly $1 billion of debt since its 2008 spin-off from Cadbury.  After reaching their pre-announced debt target (approximately $2.5 billion) ahead of schedule, the company shifted its focus to dividends and buybacks.  Dr Pepper's aggregate debt load is far from onerous.  This is especially true given how cheap the company is able to borrow in the current environment.

Acquisitions?  The track record of acquisitions is the beverage industry isn't stellar.  And many within the the company recall the lessons of its Snapple brand (which was one of those emerging non-carbonated beverage brands).  The competition to buy so-called "emerging brands" drives the price of such deals to the point where no gains are left for the new owner.  The return from buybacks is far more certain, especially relative to the unknown and elusive returns from any prospective acquisition.

Morningstar should not be surprised.  When asked about possible acquisitions during the 2009 Q4 conference call, Dr Pepper management responded as follows: 
Our growth is going to be organic growth. We may target some very small distributors indeed as we have done this past year, but they are rounding differences. Our strategy is to build the business organically not through M&A. Our share – our cash returns structure is going to be a combination of dividends and share repurchases. Obviously with our dividends, we're going to announce them quarter-by-quarter. We'll review the approach and the payout level on a regular basis.
The fact that Dr Pepper eschews acquisitions is a major reason to like this company.  They prefer to do the harder and more necessary work of building and nurturing their existing portfolio of brands.  Deals are glamorous and make news.  Give me a CEO who prefers to avoid this in favor of more boring decisions.

In a mature market, Dr Pepper is showing a great deal of success in expanding the reach of their existing brands with new offerings (i.e. Cherry Dr Pepper) and new distribution deals (i.e. the rollout of Diet Dr Pepper into McDonald's).  Prudent use of capital will augment this organic growth without the need for value-destroying acquisitions.

It goes without saying that DPS shares, which traded as low as $11.80 in 2009, isn't the bargain it once was.  That said, Dr Pepper's strategy continues to pay dividends, even if it flies in the face of the approved Wall Street formula.

Disclosure:  Long DPS

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