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Why Dr. Pepper May Be the Best Short-Term Investment

March 25, 2014 | About:
Patricio Kehoe

Pato Kehoe

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Competing in the non-alcoholic beverage industry can be very tough, as giants The Coca-Cola Company (KO) and PepsiCo Inc. (PEP) control 40% and 30% of the soft drink market respectively. Thus, Dr. Pepper Snapple Group Inc. (DPS) is the third largest industry player, with 16% market share. Although the firm’s increased distribution has enabled it to gain share over the past four years in the domestic market, its lack of economies of scale make it very difficult to compete head-on with industry giants, especially in the international division. However, with short term profits looking solid, investment gurus like Joel Greenblatt (Trades, Portfolio) and Jim Simons (Trades, Portfolio) have been buying this company’s shares, hoping to benefit from its increasing EPS and dividend yield.

Strong Brand Portfolio, but Weak International Exposure

There are several factors that have contributed over the past years to Dr. Pepper’s success, but I believe its brand portfolio is the main catalyst for growth. Its carbonated brands include Dr.Pepper, 7UP, Crush, Canada Dry, and A&W, while noncarbonated beverages range from Snapple and Mott’s, to Hawaiian Punch. Furthermore, most of these brands are number one or number two in their category, and while overall domestic soda consumption has been declining these past ten years, Dr. Pepper has managed to outperform the sector through the introduction of its diet line products. However, while the company’s TEN (ten calorie brands) category has been successful at retrieving soda drinkers, Coca-Cola’s new Life brand and PepsiCo’s soon to launch stevia-sweetened soda will be tough competition in the long term.

Looking forward, Dr. Pepper is bound to deliver weaker top-line growth and EPS than its main rivals, as the firm generates 93% of sales from the Canadian and U.S. market, with the remaining 7% derived from Mexico and the Caribbean. This lack in significant emerging-market exposure not only concentrates the business’ risks, but will also make above-average, long term growth a difficult task. Nonetheless, despite the firm’s limited pricing power and inferior scale, a boost in distribution footprint, marketing spending, and cold drink equipment will likely increase the per capita consumption of Dr. Pepper beverages in the short term. Furthermore, the company’s 2.95% dividend yield and solid ROE of 27.4% should be attractive for investors seeking high short term profits.

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Valuation

Although Coca-Cola and PepsiCo’s geographic diversity, popular brands, and strong balance sheets put the beverage manufacturer at a competitive disadvantage, quarterly results have been solid so far. While Q4 of fiscal 2013 showed flat sales at $6 billion, due to price increases offsetting the overall decline in soft drink consumption, EPS grew at a 10% rate, closing the year at $3.20. While sales are expected to continue at a slow 1% pace for 2014, management’s EPS projection of $3.38 to $3.46 seems adequate. Furthermore, revenue can be expected to grow at a 3% rate over the next decade, due to price increases and larger penetration, while operating margins grow slightly to 18%.

Nonetheless, with returns on invested capital to average 16.5% of the next ten years and Dr. Pepper’s ability to recognize the growing consumer demand for healthier beverages, the stevia sweetened beverage line, and low-calorie TEN products should push solid profits in the short term. Also, with the stock currently trading at a price discount of 9% relative to the industry median of 19.0x, investors looking for quick and profitable results should definitely look at Dr. Pepper as an interesting opportunity.

Disclosure: Patricio Kehoe holds no position in any stocks mentioned.

About the author:

Pato Kehoe
A fundamental analyst at Lone Tree Analytics

Rating: 4.0/5 (1 vote)

Voters:

Comments

Enjoylife
Enjoylife premium member - 5 months ago

Hi Pato,

Thank you for contributing the article but I strongly disagree with your thesis that DPS would be a good short term investment right now at $55 per share. I did a quick back of the envolope valuation and came up with a $50 fair value. Meaning that if you demand a margin of saftey, this would become interesting around $35. Currently trading at $55 seems to be on the high side of fair but right about where it should be.

Regarding being the number 3 position in the industy. Buffette has pointed out the #1 and #2 positions in any market should command higher valuations. So saying that there is a 9% discount comared to PEP and KO is no sign of cheapness. DPS should trade at a lower multiple than the market leaders that have scale and cost advantages.

DPS seems to be poised to grow at a similar rate as the market and trades at a fair to slightly high price. It trades very near it's 52 week high and over 25% above it's 52 week low. It is not cheap against its historical pricing on P/B or P/E ratios.

Siting Jim Simmons and Joel G doesn't stregthen your case. Both run portfolos with companies numbering in the thousands so neither has a majr position and both own some percentage of almost every company in the S&P 500.

In summary I believe DPS is a fine company that could be a good investment quality issue at a good price. However I see no indication that there is any discount in the pricing from its fair intrinsice value or any sign of a margin of Saftey. Also there is no reason to believe they will have above average growth at a fair price.

So I disagree that it is a good choice for a value investing portfolio at current levels.

Thank you.

Best ragards,

Enjoylife

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