When the Risk/ Reward Proposition Changes

Price is what makes an investment attractive or not. Price changes the risk reward proposition of any business even good ones. As such there is few issues that have to exist my portfolio: Dr. Pepper and some credit instruments.

I am going to sell some of the preferred issues that I bought during 2008 and early 2009. The risk reward proposition has changed significantly. I have discussed how investors are becoming yield pigs and I want to exist before the party is over. The low yield environment is forcing some instruments to trade higher artificially. Some of the credit issues like junk bonds, bank loans and preferred shares made sense in late 2008 and early 2009 but now it is

Here is an example of an issue I bought in November 2008, Brookfield Asset Management (BAM) issue BAM-O. I have bought additional issues from Brookfield as well like a yield floater, detailed here. The O issue gave me an IRR of 36% when I bought it, now it is yielding 2.5% to 6%, depending on the redemption or conversion of the issue. This issue trades at fair value now, if you consider the IRR to be the equivalent of YTM, then a BBB issuer like BAM is trading around the 6% mark. if I hold to maturity the upside is an expected rate of return of 4%, the downside is significantly more than that. I would never buy this issue now given its price so it is time to exist.

I am existing also most of my bonds positions however I am keeping a couple of floater preferred shares because they should do well in rising interest rate environment, given that there is no market surprise.

I sold Dr. Pepper (DPS ) as well for the same reason: risk reward profile changed. DPS is a spin off investment that was loathed by the market: too much debt, weak earnings and declining US carbonated volume sales. However, the reduced expectation and the strong brand portfolio made it a good investment. Now it is a good business but not a good investment. DPS has managed to drive efficiencies to its distribution and supply chain network, promote brands and gain market share, reduce debt and increase cash flows and dividends. The turnaround in operations made it a good business and share price followed. The risk reward profile changed. DPS is not fully valued at this point I reckon $40 is the mark but from where I sold it at $ 36 the upside potential is not significant to justify risk losing if they had a bad quarter.

Pepsi Bottling to Distribute Dr Pepper's Crush Sodas - WSJ.com

Pepsi Bottling to Distribute Dr Pepper's Crush Sodas - WSJ.com

Dr pepper is making nice moves in their distribution and marketing. Also they have improved their supply chain structure by adding regional distribution and optimizing their warehouse facilities. All good moves to improve the bottom line.

In addition, some high level value investors have moved into the stock among them Ackman, Einhorn and Pitz. I guess those only serve as a confirmation of the value in Dr pepper.

I have been adding to Dr Pepper in the past little while averaging down on my position and still think it is a very attractive company to own.

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.

	Price	Enterprise value	2007 EBIT	EV/EBIT	3-year growth	Return on tangible capital	Operating margin	2008 P/E Est.
Dr Pepper	$25	$10,162	$1,002	10.1	23%	54.4%	17.4%	12.7
Coca-Cola	$56	$135,725	$7,252	18.7	11%	37.1%	25.1%	18.3
Pepsi	$67	$108,721	$7,170	15.2	10%	41.7%	18.2%	18.1
Wrigleys	$80	$22,561	$963	23.4	14%	49.5%	17.9%	23.47
Kraft	$31	$67,686	$4,331	15.6	5%	28.8%	11.6%	18.16
Coca-Cola Enter	$21	$20,150	$1,470	13.7	7%	3.69%	7.31%	14.3
Pepsi Bottling	$33	$12,040	$1,071	11.2	7%	5.99%	8.07%	13.9

*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.

Conclusion

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.

Value Idea: Dr Pepper- Part 2

Part 2 can viewed here. In this post i will review some of the risks associated with DPS.

Declining US Soft Drink Volumes

Soda volume in the US is declining due to health conscious consumers. However, the domestic soda's woes largely are a cola problem affecting Pepsi and Coke more than DPS. The flavored segment in which DPS competes is still healthy. Hispanics, one of the fastest-growing segments of the U.S. population, tend to favor flavored sodas. Moreover the fruit-based drinks account for about one-fifth of DPS's revenues and posted growth of 5% last year.

The company brands are performing well in the flavoured segments. The company's leading brand, Dr Pepper, is one of the industry's best, with volume increasing an average of about 2% annually in recent years. Although Snapple, which has been tossed from one corporate parent to another, but has never quite lived up to its lofty expectation, DPS has managed to revive the brand -- the No. 3 iced tea behind Pepsi's Lipton and privately held Arizona. Snapple's sales volume rose about 7% last year, and could maintain that pace. Snapple is popular in the New York area and California. DPS is building a new Southern California plant to serve the West Coast, ending the need to truck in Snapple from the Northeast.

However, some of its brands past history is less than stellar. Dr Pepper's attempt to enter the sports-drink market with a Gatorade-like drink, Accelerade, flopped, costing it about $55 million last year. Dr. Pepper, for instance, was a pioneer in cherry-flavored cola, but now faces stiff competition from Cherry Coke, while Coca-Cola's Sprite long ago vanquished 7Up despite the latter's head start in the lemon-lime category.

Leveraged Balance Sheet

The company has a substantial but manageable load according to most safety ratios. Their debt level compared to their free cash flows is very manageable. The company now have a higher debt to equity ratio which is not a bad thing for me as it leverages the opportunity.

International growth limitations

The company does not have international distribution or sales profile. Actually there are severe limitations to achieve any results on this front. DPS has sold many of its well known brands to Coke for international markets. The company mainly operates in Canada, US and Mexico.

Quality of the financials

• no benefit plan obligations liability and the assumptions of the plan are reasonable with LTM expected return of 5.5%.
• Cash flow from operations growth matches earnings growth and close in absolute figures.
• inventory growth matches sales growth trends there are no apparent channel stuffing.
• Accounting policies do no seem aggressive

Management

This one will be difficult to assess for a new standalone company. However, the stability of its market-share over the years as noted earlier and improvements in the performance of some of the lagers brands like Snapple, reflect positively on management capability.

The compensation plans have not been set yet. I get a suspicion that management is waiting for a decline in its stock price so options and stock awards will be set a lower price. That is a possibility and not a negative one for me. Although outright ownership of common stocks is negligible, to the tune of .01%, I will be looking for insiders compensation once revealed to ensure they are properly aligned with shareholders interest.

In part 3 I will review my valuation and rationale for purchasing DPS.

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.

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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.

A new purchase

I have bought an entry position in Dr. Pepper Snapple Group (DPS). A recent spin-off from Cadbury.

In my analysis the company appears to be undervalued compared to its peers. The company has host of good consumer brands and good position to expand into Mexico and capitalize on the Hispanic population increase in the US.

Although the company has a high degree of leverage, as the parent loaded it up with debt to buy the bottling business, I think it is manageable as the company free cash flow is excellent.

Next post will be part 1 of my evaluation of the company. Part 2 will follow with share valuation.

Since now I own DPS I have to switch from Coke to Dr. Pepper or Canada Dry.