May 20, 2008

Value Idea: Dr. Pepper

Spin-offs can be good hunting grounds for undervalued businesses that can outperform and earn excellent returns (a lot of academic studies back-up this claim). Spin-offs tend to be orphan companies initially misunderstood by Wall Street. Their managers relish the chance to prove themselves as independent operators.

In an earlier post I have talked about the potential Aircraft leasing division spin-off idea from AIG as potentially a good opportunity to make good returns. Here is another one that was recently spun-off from Cadbury Schweppes: Dr. Pepper Beverages (DPS). I have been following this one from last summer when plans for its sale or spin-off made public.

DPS was slated to be sold to Private Equity before the credit crunch occurred for about $16B as a result of the pressure applied by activist investor Peltz efforts, however you know how the story of private equity unfolded since 2007. Needless to say the sale never materialized. Peltz put DPS valuation at $8-10 Billion; a detailed analysis of his valuation letter can be found in my earlier post here. Currently DPS is trading with a market cap of $6 Billion. There is the potential to pickup a good business with numerous consumer brands at a good discount.

A nice read about the opportunity can be found here, mine is below.

Business Economics

DPS is an integrated maker, bottler and distributor of soft drink in north America. DPS owns a host of well known brands including Dr. Pepper, 7-up, Crush, Snapple and many others. DPS holds the no. 3 spot in market share behind Coca cola and Pepsi. There are some differences between DPS and Pepsi and Coke, mainly DPS is in the business of flavoured carbonated drinks rather than the traditional Pepsi and Coke drinks.

The most critical factor in this valuation, for that matter any business valuation, are the risks poised to DPS competitive position and operations in the beverage industry. One key risk is the competitive threats poised to DPS's market share from Coke and Pepsi. So lets review all types of competitive advantage that I have review in an earlier post, read it here.

However, I believe that in the same manner that Coke can fend Pepsi poaching its customer base and vice versa, DPS can hold its market share and lock-in cu'>stomer's buying habits. This is due to DPS's competitive advantage as it owns strong brands coupled with a predictable and loyal consumption habits. If you like Dr Pepper you will continue to buy it, there is no reason to switch brands. Some of DPS's brands are, in fact, increasing their market share. According to Beverage Digest, Dr. Pepper and Diet Dr Pepper posted US volume and market share increases in 2006 and 2007 compared to flat or declining traditional Cola volumes and market share. DPS's overall market share have also been increasing in 2006 and 2007.

To test DPS competitive advantage I will look at its market share stability and sustained profitability over time. DPS market share has been stable as far back as data from Beverage Digest allows me to examine in the same manner as Coke's and Pepsi's market shares. DPS market share hovers around the 15% mark, however in the recent 3 years it is on up trend, while coke and Pepsi are on downward trend. I can not interpret this as DPS taken market share from Coke and Pepsi but it can be interpreted as they are competing in different niches. The stability of DPS's market share leads me to believe to the existence of a competitive advantage.

DPS competes in the flavoured carbonated beverage and non carbonated beverages, a niche away from a direct competition with the more traditional Coke and Pepsi. Most of its major brands are No. 1 in their categories, including Dr Pepper, Sunkist, A&W Root Beer, Canada Dry and Mott's Apple Juice. The weak link: 7-Up, with eroding volume. However, market leaders Coca-Cola and Pepsi also have targeted flavoured and fruit-based drinks—and enjoy larger distribution networks and deeper pockets. DPS brands such as Nantucket Nectars and Hawaiian Punch already are feeling the squeeze, and the company may not hit its 3% to 5% annual sales growth targets.


Although its market share has been stable, it operating margins have not compared to its peers, as you can see from chart 2. DPS's cost of sales have jumped in 2007 reducing margins. The increase in the cost of sales is the result of aquisitions that DPS has completed in 2006. I expect that management will be able to restore margins once they fully integrate the aqusition. Another issue is the cost of sale for DPS contains manufacturing and distirbution, unlike Coke and Pepsi. This item in its cost of sales has increased due to increase in input costs like aluminum, plastics, and energy.

DPS enjoys economies of scale in key markets. As the country's No. 6 soda brand, with a 5.9% market share in 2007, it's particularly strong in Texas, Louisiana, Oklahoma, Missouri and Arkansas. It has distribution and bottling centres in these markets that will lead to lower cost of goods sold on per unit basis. DPS will realize lower costs as it is improving its distribution network to a regional hubs around these strong regional markets rather than central distribution.

I am comfortable with the integrity of DPS competitive advantage and competitive position and I see limited risk to its market share.

In my next post I will review other risks and DPS's valuation.

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