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DPS - A Sweet 2010

February 22, 2011 | About:
Henry W. Schacht

Henry W. Schacht

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Dr Pepper Snapple Group (DPS) capped off 2010 with an impressive conference call. And that goes for the analysts involved too. Both the buy and sell side were well represented and (as you might imagine) there was a good mixture of forest vs. tree questions. Then again, conference calls usually go well when news is good.

For the year, some brands did better than others, while some geographic regions were more favorable than others. Pricing, costs, volumes, etc. All these competing forces tend to cancel each other out at Dr Pepper Snapple in favor of a very favorable status quo.

In fact, the 2010 can be summed up pretty well in one paragraph from the DPS earnings release:

For the year, the company generated $2.5 billion of cash from operating activities including one-time proceeds of $900 million from PepsiCo and $715 million from Coca-Cola. Capital spending totaled $246 million. The company repaid $881 million of its debt obligations and returned $1.3 billion to shareholders in the form of stock repurchases ($1.1 billion) and dividends ($194 million).
Ex the bottling transactions, cash flow from operations would have been $922 million. After capital expenditures, explicit free cash flow foots to $676 million. More if you adjust capex for maintenance vs. new investments. No matter. The cash generating capabilities are on full display.

How Mr. Market ever assigned a $3 billion value to this company is a wonder. But that is well in the past. Dr Pepper shares closed at $36.41 for the week. With 224 million shares outstanding at year-end, the current market value stands at $8.15 billion. A screaming bargain no longer, but hardly expensive.

In previous posts on Dr Pepper, I've held to that range of $600 million to $700 million in free cash flow. It looks like the higher end of the range is being realized.

Most investors see low single digit revenue increases and fall asleep, not appreciating the operating leverage of a beverage business. Or the benefits of intelligent capital allocation.

Dr Pepper eschews headline-making acquisitions in favor of more obscure (and harder) activities like IT improvement, working capital management, line extensions, distribution rationalization, paying down/refinancing debt, etc. As a spin-off from Cadbury, one gets the impression there is plenty to do. And the results are evident in cash flow generation.

In past posts, I've received many questions about commodity cost inflation and pricing power. Please refer to the conference call transcript as this issue was beaten to death by those in attendance. In short, cost cutting and price increases should more than offset these increases. Two comments by management capped off the discussion... and conveniently confirmed this author's beliefs on the subject (and isn't that all that really matters?).

[Everyone is] under the same pressure we are. I mean, they've got the commodity costs coming in.
I've really not seen the pricing heat up any. We continue to see very disciplined and rational pricing.
Another area that elicits questions is Dr Pepper's relationship to/with the likes of Pepsi (PEP) and Coca-Cola (KO). One would have thought that the $1.6 billion in bottling agreements (re)signed last year would have put some of these fears to rest. Not so. Some investors seem to need more explicit reassurance. They got it this week.

When asked how the Dr. Pepper brand was growing so quickly and consistently, CEO Larry Young attributed it (in part) to the partnerships with KO and PEP saying:

“[W]e are just thrilled to death with the execution by our partners, our bottling partners out there. I mean, we're seeing very strong growth in the fourth quarter with Pepsi system up a little over 3%, Coke system up over 3%. So we're very, very happy with that.”
So much for a cut-throat pricing environment and nasty relations with one's neighbors.

A recent Bloomberg article quoted Warren Buffett as saying that pricing power is more important than good management. With Dr Pepper Snapple, investors get both. The full measure of this is evident on the capital allocation front. With its cash windfall last year, Larry Young and friends reduced shares outstanding by nearly 12%. Shares outstanding at year-end 2009 were 254 million. At year-end 2010, the figure was 224 million.

This is the kind of leverage shareholders can embrace.

The federal taxes (around $500 million) on the bottling payments come due in 2012 and DPS is already planning for this cash outflow with incremental increases in cash on hand. In essence, the bottling proceeds allowed the company to reach its debt targets early and to implement an accelerated buyback. Since the investor community was slow to realize the value creation, Larry Young's crew was able to purchase shares at advantageous prices.

Nonetheless, look for a further investor misunderstanding to surface regarding this large tax payment. A year from now, some may need to be reminded that this was a small price to pay in exchange for retiring so many shares in 2010.

While short-term issues like this tax payment may become a distraction, management has given clear guidance for what shareholders can expect. 2011 share repurchase are expected to be $400-$500 million. The dividend (currently $1 a share) will see another $200 million find its way into shareholder pockets. That looks like $600-$700 million in free cash flow to this analyst, but I've reached the limit of my math skills!

And this doesn't count capex spending, which is expected to be 4.5 to 5.0 percent of sales (or around $250 million). Some portion of that is new investment spending. Translation: a component of free cash flow.

With numbers like these, one wonders when private equity rumors will surface for Dr Pepper. Lesser companies have garnered far more attention. But perhaps DPS is too boring for the sexy PE crowd? A low to no growth beverage company, right?

Hardly.

Dr Pepper at current levels is a hold at worst. Any pullback will find me adding to an already substantial position.

Disclosure: Long DPS.

About the author:

Henry W. Schacht
Henry W. Schacht, CFA is the founder of Schacht Value Investors, an investment management firm serving individuals and institutions. He currently serves as President and Chief Investment Officer. He earned his MBA at the University Of Chicago Graduate School of Business and a BBA in finance from the University of Notre Dame. Mr. Schacht is a member of the Association for Investment Management & Research (AIMR), the Investment Analysts Society of Chicago (IASC), and the National Association of Corporate Directors (NACD).

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