Description

DR. Pepper Snapple Group (DPS) is undervalued recent Spin-off trading at a substantial discount to its NAV.

Company Overview

Dr Pepper Snapple Group, Inc. engages in owning, bottling, and distributing non-alcoholic beverages in the United States, Canada, and Mexico. The company operates its business in four segments: Beverage Concentrates, Finished Goods, Bottling Group, and Mexico and the Caribbean.

Division I -Beverage Concentrates

The Beverage Concentrates segment is a brand ownership business. In this segment, the company manufactures beverage concentrates and syrups in the United States and Canada. Its brands in this segment include Dr Pepper, 7UP, Sunkist, A&W, Canada Dry, Schweppes, RC, Diet Rite, Vernors, Squirt, Sundrop, Welch's and Country Time, and the concentrate forms of Hawaiian Punch and Snapple.
The company's Beverage Concentrates brands are sold by its bottlers, including its own Bottling Group, through all major retail channels including supermarkets, fountains, mass merchandisers, club stores, vending machines, convenience stores, gas stations, small groceries, drug chains and dollar stores. Unlike the majority of its other CSD brands, approximately three-fourths of Dr Pepper volumes are distributed through the Coca-Cola affiliated and PepsiCo affiliated bottler systems.

Division II --Finished Goods

The Finished Goods segment is a brand ownership and a bottling business, and a distribution business. In this segment, the company primarily manufactures and distributes finished beverages and other products in the United States and Canada. Its brands in this segment include Snapple, Mott's, Hawaiian Punch, Clamato, Nantucket Nectars, Yoo-Hoo, Orangina, Mistic, Mr and Mrs T, Rose's, Margaritaville, Stewart's, Crush and IBC. The company manufactures Mott's apple sauce as a finished product. The company's Finished Goods products are distributed to retailers and their warehouses by its own distribution network or third-party distributors. It sells its Finished Goods brands through major retail channels, including supermarkets, fountains, mass merchandisers, club stores, vending machines, convenience stores, gas stations, small groceries, drug chains and dollar stores.

Division III - Bottling Group

The Bottling Group segment is a bottling and distribution business. In this segment, the company manufactures and distributes finished beverages, including its brands, third-party owned brands and certain private label beverages in the United States. The Bottling Group's primary business is manufacturing, bottling, selling and distributing finished beverages using both beverage concentrates purchased from brand owners (including its Beverage Concentrates segment) and finished beverages purchased from brand owners and bottlers (primarily its Finished Goods segment). Its own brands in this segment include Snapple, Mistic, Stewart's, Nantucket Nectars and Yoo-Hoo. It also distributes third-party brands such as Big Red soda. The company's Bottling Group's product portfolio is sold within the United States through approximately 200,000 retailer accounts across major retail channels.

Division IV - Mexico and the Caribbean

The Mexico and the Caribbean segment is a brand ownership and a bottling and distribution business. This segment participates mainly in the carbonated mineral water, flavored CSD, bottled water and vegetable juice categories, with particular focus on carbonated mineral water and grapefruit flavored CSDs. Its primary brands include Peñafiel, Squirt, Clamato and Aguafiel. In Mexico, the company manufactures and distributes its products through its bottling operations and third-party bottlers and distributors. In the Caribbean, the company distributes its products through third-party bottlers and distributors. In Mexico, the company also participates in a joint venture to manufacture Aguafiel brand water with Acqua Minerale San Benedetto. The company sells its finished beverages through various major Mexican retail channels, including the 'mom and pop' stores, supermarkets, hypermarkets, and on premise channels.

The following table summarizes business segments on a rolling 12 month basis.

Investment Positives and Opportunities:

• "Mis-priced" Spin-off in a defensive industry - the company is valued in line with Bottlers even though ¾ of EBIT comes from concentrates.
• The company operates a unique model of an integrated concentrate and bottling company (which has its pros and cons). On the positive side, the company is not entirely reliant on Pepsi's or Coke's Bottling groups for bottling services and avoids a situation that it is squeezed out in times of increased competition (as it happened in the 1980s). Furthermore the company can leverage its distribution and bottling system to run incremental brands.
• DPS has the number 3 market share in soft drinks with well-established brands albeit in a mature market (N. America). Smaller market share à easier to grow
• Strong positioning in non-carb drinks - teas (Snapple), juices (Mott) and energy drinks (3-party marketing)
• Strong positioning in flavored soda, which unlike colas are characterized by flattish growth vs declines of 2-3% annually for the colas. DPS has a c.37% market share in flavored sodas.
•   o The company has managed to implement price increases last year amidst flattish volume growth (given the state of the economy, this will be more difficult to do in the current environment)
• Growth opportunities: The previous owner of the business massively under-spent on the DPS brands. The new management is committed to significantly increase growth CapEx to 5% of sales in the next couple of years, which is much higher than competitors. The investment will go into:
•   o New products & packaging
•   o Increased display and advertising
•   o Cold drink vending machines (much better gross margins than retail) - currently very limited such vending machines carrying DPS products are in the market
•   o Integration of recently acquired bottling operations (significant inefficiencies in the existing systems that new management wants to rectify)
•   o New plant in CA, where a large portion of customers reside which will reduce plant to market costs
• Significant operating leverage:
•   o Every incremental 10mm cases lead to $0.01-$0.02 of incremental EPS.
•   o Further opportunities to reduce SG&A.
• Strong Free Cashflow - generated c. $320mm of FCF in LTM, cashflow is expected to rise substantially as debt is being repaid and company normalizes CapEx post its near-term expansionary phase.
• Incentivized and focused management - good capital allocators, focused on debt reduction and potential share buybacks
• Activist investor involvement (Pershing Square, Nelson Pelz, Greenlight)

Investment Negatives / Risk Factors:

• Some structural disadvantages
•   o Limited international exposure (Mexico / Caribbean)
•   o It is the number 3 player after very strong number 1 and 2 (Pepsi and Coke)
•   o Potentially disadvantageous distribution arrangements with Pepsi and Coke bottling operations (40% of volume)
• Hybrid model (bottling and concentrate) is more capital intensive - needs to invest in CapEx to improve distribution
• Low ROIC, more inline with bottlers than with concentrate companies
• Although less prevalent currently, cost inflation could lead to declining margins
• Consumer slowdown / weaker demand for beverages leading to increased promotional activity and margin pressure
• Leveraged balance sheet (3x)
• Risk of losing some profitable third-party distribution agreement (Monster)
• Execution risk - no significant current signs of turnaround

Valuation
The consensus estimate for DPS' EBITDA is $1.1 bn, slightly lower than what the company achieved during 2008.  The implied valuation multiple 2009E EV/EBITDA is 6.9x which is more inline with the bottlers (6.3x) rather than the concentrate companies (9.5x).  Clearly investors are not paying for optionality on DPS' long-term potential to increase its market penetration through new products and enhanced distribution/vending channels, turnaround its less profitable brands, integrate its recent acquisitions and streamline the cost base. Given the domestic distribution and smaller market share, and adjusting for the fact that about 10% of the EBITDA comes from bottling, an EV/EBITDA for DPS of 8x-8.5x seems more appropriate.  Using net debt of $3.4bn and 253mm shares, one gets to target valuation of $21-$24 / share, i.e. 25%-45% higher than the current price.

 Catalysts:

Broader investor and analyst coverage as post-spinoff technical selling subsides

Activist pressure

Hitting operational turnaround targets

Catalyst

See above