Dr Pepper Snapple's Lofty Valuation Leaves a Sour Taste

 Dr Pepper Snapple Group (DPS) has enjoyed market share gains and margin expansion over the past several years, but we think the company's already best-in-class profitability and secularly slower top-line growth opportunities leave it overvalued versus peers  Coca-Cola (KO) and  PepsiCo (PEP).

The U.S. soft drink industry makes up nearly all of Dr Pepper's earnings, and while we're not as pessimistic on the geography's future growth as some, given continued price rationality and gains in juices, water, and other noncarbonated beverages, we expect further declines in carbonated drinks will limit the country's growth rate to the low single digits. Moreover, we see limited upside in Dr Pepper's margins, given already solid comparisons to industry leaders Coca-Cola and PepsiCo.

Although we believe Dr Pepper's distribution network and brand intangible assets have carved a narrow economic moat, we think the market is currently pricing in an optimistic earnings growth scenario. Dr Pepper's moat is constrained to narrow, given its reliance on others for distribution, lack of scale globally (compared with Coca-Cola, which maintains lower costs on a worldwide basis), and limited ability to build brands outside North America. Both Coke and Pepsi should enjoy stronger top-line gains, with wide moats that protect their returns on invested capital.

Internal improvements at Dr Pepper have driven strong earnings growth, solid free cash flow, and ultimately impressive returns on invested capital. While ongoing programs and initiatives are likely to drive further gains, we don't expect these improvements to come at the same rate going forward, given the firm's already impressive work and best-in-class performance versus Coca-Cola and PepsiCo.

Dr Pepper's Minimal Noncarbonated Exposure Limits Volume Growth Potential
We expect volume in the U.S. nonalcoholic ready-to-drink beverage market to grow at a 1.3% CAGR over the next five years, driven by a 1.0% annual decline in carbonated soft drinks and a 3.9% increase in noncarbonated drinks and bottled water.

In this industry, we expect the highest volume gains for Pepsi's North American beverage segment and the lowest for Dr Pepper Snapple, owing to stark differences among each firm's exposure to carbonated soft drinks versus still beverages. Although each company has varying exposures to ready-to-drink versus bulk chilled products (such as larger-format Tropicana juice for PepsiCo or Minute Maid for Coca-Cola), Beverage Digest notes that the bulk of industry value stems from ready-to-drink products, including juice, sports drinks, and iced tea. As such, we assume each company's noncarb portfolio will grow more in line with the RTD industry. We forecast Dr Pepper's North American volume growing at about 0.2% annually versus about 1% for Pepsi and 0.8% for Coca-Cola.

Dr Pepper also has a wider range of outcomes, in our opinion, given the potential for market share gains and increases in its allied brand distribution. Over the past 10 years, the company has seen CSD share climb to more than 17% from less than 15%, according to Beverage Digest, largely at the expense of PepsiCo, which has seen share slip to about 27% from nearly 32%; Coca-Cola's share has been roughly even at 42%-43%.

Pricing Rationality and Package Mix Support Positive but Minimal Revenue Growth
Over the past several years, soft drink manufacturers have held firm on positive price and mix contributions, following past periods of intense competition that dented revenue growth due to muted positive volume responses to these pricing actions. Going forward, we expect rational pricing to persist, and along with a further runway for new, smaller packaging, we forecast a roughly 2%-3% annual contribution from price and mix.

There are two main reasons for our optimism here. First, management teams at all three manufacturers have been adamant, despite frequent questioning, that undercutting one another on pricing is counterproductive to revenue goals, as past experiences have shown that price reductions don't drive a commensurate volume response. Because of the oligopolistic structure of the beverage industry—Coke, Pepsi, and Dr Pepper control more than 85% of CSD volume and 70% of total nonalcoholic ready-to-drink beverage volume—we believe these companies' strategies will ultimately drive the industry's direction (and entering the market without partnering with one of these firms offers sizable barriers to entry).

Second, a continued move toward smaller package sizes has helped to drive up price per ounce over the past few years, and there remains a long runway for further increases in this product mix. In the U.S., soda has been predominantly sold in only a few major package sizes: 12-ounce cans, 20-ounce plastic bottles (typically for immediate consumption), and 2-liter plastic bottles. However, recognizing consumers' bent toward healthier fare and the better pricing and profitability of different package sizes, soft drink manufacturers in the U.S. have worked to increase sales in smaller-size products in recent years. As such, sales of alternative package options such as 7.5-ounce cans, 16-ounce bottles, and 1-liter bottles have climbed as a percentage of total sales volume; per our conversations with the major manufacturers, along with Beverage Digest's own figures, we estimate roughly 10%-15% of U.S. volume is now sold in one of these smaller packages, up from just a single-digit percentage in 2013.

We believe the continued positive contributions from price and mix will also help to stave off the impact from cost inflation, helping to boost profitability.

Dr Pepper Has Boosted Profitability but Already Enjoys Best-in-Class Performance
While Dr Pepper is likely to see lower top-line growth in the U.S. than Coca-Cola and PepsiCo, we note that the firm's productivity initiatives (internally known as rapid continuous improvement, or RCI) have driven cost savings, improved processes, and ultimately better operating margins in North America and free cash flow than peers over the past several years. In particular, although Dr Pepper's organic revenue (excluding structural headwinds) has grown at only a 2% rate since 2013 versus just over 5% for Coca-Cola (Coke has only recently broken out its core North American business from its bottling arm, leaving us only three years of comparable figures), the former firm's operating income has climbed at a 7.9% annual rate, outpacing Coke's 2.8% yearly rise.

But we don't think Dr Pepper can continue to drive earnings growth ahead of Coca-Cola, given its lower long-run top-line growth opportunity (that is, more exposure to the declining CSD category) and already top-of-class margin profile in its core North American business.

Beyond operating profitability, Dr Pepper's RCI program, along with minimal capital reinvestment needs, has also strongly boosted the firm's free cash flow and ROIC. We expect solid performance to continue, but we also don't expect material improvement. Over the past three years, free cash flow at the consolidated entity has averaged about 109% of adjusted net income, compared with 108% at PepsiCo and just 89% for Coca-Cola, while returns on invested capital have averaged about 15% for Dr Pepper (including goodwill) versus 14% at PepsiCo and about 13.5% for Coca-Cola. Over the next five years, our forecasts incorporate Dr Pepper generating above-average free cash flow conversion (averaging roughly 114% of net income, shown in Exhibit 15) and improving ROIC (to about 18%), but similar to operating profitability, we don't see room for outsize gains versus peers given already strong performance.

Dr Pepper Snapple's Shares Still Look Overvalued
We expect Dr Pepper Snapple's top-line growth rate to be dominated by trends in the U.S. carbonated soft drink market for the foreseeable future, a market that offers only low-single-digit revenue growth opportunities, in our opinion—substantially lower than the 5% annual gains Coca-Cola management targets for the global nonalcoholic ready-to-drink industry's retail sales. On top of this secularly lower top-line growth rate, we believe Dr Pepper's cash flow growth is equally likely to be constrained versus its larger peers, given already impressive profitability and working capital improvements over the past several years. In all, we forecast Dr Pepper's free cash flow growing at roughly a 3% annual rate over the medium to long term, versus 6% for Coca-Cola and about 4% for PepsiCo.

In addition, we discount Dr Pepper's cash flow at a higher rate than Coke's or Pepsi's, using a 9% cost of equity versus 7.5% at the latter two firms. We believe this increased relative cost of equity is justified, given Dr Pepper's much higher geographic and product concentration than its more diversified global peers, as the future direction of U.S. carbonated soft drinks will have a particularly outsize impact on the firm versus Coke and PepsiCo. While a discount rate akin to peers would lead to a valuation more in line with the current market price, we believe this suggests substantial downside risk rather than an appropriate base case.

We also arrive at a valuation near the current market price in a more bullish expectation for Dr Pepper's growth (largely owing to market-share gains) and margins. With a 9% cost of equity, our fair value estimate rises to about $89 per share if we assume long-term revenue growth of 5%—led by a more optimistic U.S. beverage environment and market share gains for Dr Pepper's CSD products—and operating margins rising to nearly 24% (versus roughly 23% in our base case) given the increased scale and positive mix shift that additional carbonated beverage volume would bring. Again, however, we see this as a rosy scenario built upon continuing recent trends rather than incorporating the assumptions laid out in our $70 fair value estimate. 

As a result, in a potential market pullback, we anticipate a higher likelihood for suitable margins of safety on Coca-Cola's and PepsiCo's shares, given their more appropriate current valuation, wide economic moats, low fair value uncertainty ratings, and higher long-run growth prospects. We admire Dr Pepper's internal improvements and narrow economic moat, but overall, the firm's capital-allocation decisions are largely limited to returning free cash flow to shareholders through share repurchases (lately at increasingly loftier valuations), given its limited international opportunities and already efficient North American operations.