Beverage Solid, but Weak Demand and High Costs Pressure Coffee at Keurig Dr Pepper

We are maintaining our $34 fair value estimate on narrow-moat Keurig Dr Pepper KDP after digesting its fourth-quarter results ($3.8 billion in sales and $0.50 in EPS) and 2023 outlook (constant-currency sales and adjusted EPS growth at 5% and 6%-7%, respectively) that match our estimates. The shares are fairly valued. We continue to view the beverage portfolio (65% of 2022 sales) as in good shape thanks to strong brands (the source of its moat) and category diversification beyond soda. However, the firm’s update confirmed our suspicion that its coffee business will require more investment in customer acquisition and retention to shore up its growth prospects, thus limiting margin upside.

Our constructive view on Keurig Dr Pepper’s beverage portfolio is reinforced by a positive (0.6%) volume expansion in 2022, alongside a 13% price increase (similar to price hikes at wide-moat peers Coke and PepsiCo), as demand held up well thanks to brand resonance, product innovation (especially in non-sparkling categories like flavored water, seltzer, and sports drinks), and convenience channel expansion. We stand by our 10-year forecast for 5% beverage sales growth and operating margins in the high 20s.

On the other hand, we see soft volume (down 1%) and an operating margin squeeze (down 150 basis points to 26.4%) in the coffee segment in 2022 as evidence supporting our tapered enthusiasm in its long-term prospects given intense competition. This view is already reflected in our 10-year forecast for 5% coffee sales growth annually (same as historical trends) and a modest 100-basis-point operating margin expansion to 27.4%. We suspect the pod price increases of 7% in 2022 (amid double-digit cost inflation) versus falling prices in past years drove cracks in its value proposition, especially against ground coffee (80% cheaper per cup) and amid consumer belt-tightening. However, we expect the firm to remedy the situation by reining in prices and investing more in customer acquisition.