May 31, 2008

Value Idea: Dr. Pepper- Part 3

Business Valuation

DPS, the No. 3 domestic soda maker behind Coca-Cola (KO) and PepsiCo (PEP), the shares at around 25, looks undervalued. On comparative PE ratio, DPS trades at 12.7 estimated 2008 profits of $2 a share. Compare that to 18 times 2008 earnings for both KO and Pepsi. DPS's P/E is one of the lowest among major food and beverage companies. The stock seems cheap, considering the strength of the Dr Pepper brand and the company's goal of generating "high single-digit" annual growth in earnings per share. DPS is trading even at lower multiples than bottling and distribution companies. Since DPS is an integrated operation, unlike Coke and Pepsi, it should command some premium to bottling only operations. DPS's PE is 12.7 compared to 14.3 and 13.9 for Coca-Cola and Pepsi bottling respectively.

PriceEnterprise value2007 EBITEV/EBIT3-year growthReturn on tangible capitalOperating margin2008 P/E Est.
Dr Pepper$25$10,162$1,00210.123%54.4%17.4%




Coca-Cola Enter$21
Pepsi Bottling$33

*Part of Table courtesy of futureBlind Blog, Yahoo Finance, Company Filings

Why is Dr Pepper trading less than its peers? May be because it gets about 90% of its revenue from the U.S. market and 80% from soda, consumption of which fell 2% in 2007 as health-conscious Americans turned to bottled water, iced tea, juices and energy drinks. Nonetheless, Americans still drink an average of 16 ounces of pop daily.

Another issue is U.K. investors in Cadbury who don't want to hold Dr Pepper probably have been selling. This temporary pressure may have created a buying opportunity. Under pressure from activist investor Nelson Peltz, Cadbury jettisoned Dr Pepper to focus on its attractive global candy and gum business. Cadbury's U.S.-listed shares (CBY) trade at 51, more than 20 times estimated 2008 profits.

DPS should trade at a multiple less than Coke, the closest comparison point, Pepsi has frito and does not make for good comparative point. We can assume DPS should trade at 20% discount to Coke due to its premium market share and international distribution profile. On the other hand, DPS should trade more that the bottlers as it derives the majority of its revenues from the concentrate business, like Coke. Coke trades at 18 EV/ ENT. Value, which will present the best case scenario and a valuation ceiling, and the average bottler trades at 12.7 multiple, bottom floor valuation. So a reasonable multiple for DPS is 14.5, the 20% discount to Coke. That makes DPS valued at an Ent. Value of $14 Billion, or 40% discount from its current valuation, or $35 per share.

I do not put a lot of emphasis on comparative valuation as there can be host of factors that can affect it and one of those is the lack of international presence of DPS. However it provided for an identifying measure for undervalued businesses to warrant a deeper look at it.

To properly value DPS, I will need to figure what is the cost of a new competitor will incur to compete against DPS by replicating its economics and operations. I will use a two part approach: determine the earning power of the company plus the economic assets it holds. Any new competitor has to pay that amount to occupy the same competitive position as DPS.

The reproductive assets of DPS does not vary significantly from its book value. A big chunk of the assets value, like any other branded consumer company, is its non tangible assets. Brands and trademarks are economic assets for any business and DPS owns a host of them. I do not feel any need to adjust the book value of these assets as any adjustment would be immaterial.

The company Earning Power is higher than its reproductive assets values. This implies that DPS does have a franchise value and management are able to garnish higher ROIC on capital employed. The figure for Earning Power Value is $34, assuming an average EBIT margin of 22% and capital cost of 10%. The valuation assumes no growth in revenue or market share any growth should be looked at as your margin of safety.

A third valuation yardstick I employ is the Free Cash Flow approach. The discounted free cash flow valuation gives me a share price of $26. The case assumes low revenue growth rates of 5%, high cost of sales at 44% (higher than DPS's historical average of 37%) and high level of recurring restructuring admin charges, which DPS's financial currently reflects. If these parameters were to change to reflect efficient operations due to DPS's recent restructuring initiatives, integration of acquisitions and lower input cost, DPS valuation would be $40 per share, again the top line assumes the same growth rate.


The business case for DPS includes many positives:

  • Brands with stable market share implies strong competitive advantage and pricing power
  • A spinoff company, which on average spinoffs historically outperform due to better capital allocation programs and fostering entrepreneurial culture.
  • restructuring of distribution and operations will lead to better cost management and higher margins.
  • new marketing and advertising programs to boost market share.

While its negatives of higher raw material costs and competition is not something new and already reflected in operations.

At DPS's current price, the market is pricing the worst case scenario which have limited downside coupled with heavy selling due to non economic reasons. The upside, with few operational adjustments, I assume no revenue growth initiatives, is worth the risk. The risk/ reward case for DPS is compelling enough to warrant investing in this business. I plan to accumulate up to 5-8% of my portfolio value in DPS over the next few months.