Investment Thesis
Keurig Dr Pepper (NASDAQ:KDP) is a beverage company based in the United States and operates internationally. Some of its iconic brands are Dr. Pepper, 7UP, Snapple, Schweppes, etc. Taking a closer look at the company, we believe that IT will suffer from some mean reversion in the near term as the relative valuation and the fundamentals of the company diverge. Overall Keurig Dr Pepper has a good portfolio of products and is deleveraging; however, valuation is too high. We believe there are better opportunities out in the market.
Back in 2018, Keurig Green Mountain and Dr Pepper Snapple Group merged to form the current KDP. Given the short history of the merger, we will have a closer look at the fundamentals of the company since the merger.
Source: Annual Report
The graph above demonstrates the impact of the merger as it was consummated in July 2018. Since the merger, the revenue, operating profit and net profit increased by 4%, 4% and 6% respectively. The Q1 2021 results filed indicate that the Q1 2021 revenue was $2.9bn, operating income $0.6bn and net income $0.3bn. These results are impacted by some seasonality. Management's explanation of seasonality is that the sales are expected to be higher during the second half of the year due to holiday shopping season. In addition, cold drinks sell better in the summer and hot drinks during the winter. So even though Q1 2021 results might be depressed due to the seasonality effect, we see the growth rate between Q1 2021 and Q1 2020 is around 11%.
Source: Own analysis
Similarly outstanding shares and diluted EPS paint the same picture as the top and bottom line for the company. Following the merger, diluted EPS increased by $0.35. Between 2020 and 2019, diluted EPS increased by 6% whilst shares outstanding by 0.3%. The company has a well-diversified portfolio, and we expect the modest growth to continue into the medium term future.
Source: Annual Report
As the revenue breakdown suggests, the biggest revenue source comes from packaged beverages. The company also benefits from 10% revenue being direct to consumer. Due to the diversification of the products, we do not expect the company to have significant changes in its revenue sources or revenue growth. However, a closer look at the revenue highlights some risk. The 2020 annual report highlights that KDP has some concertation with its customers. Walmart (WMT) features as one of the largest customers in coffee systems, packaged beverages and Latin American beverages and represents 15% of the total sales. We would like to see the concentration of the revenue to become more diversified in the future as there is always the risk that WMT stops its business relationship with KDP.
Source: Annual Report
Since the merger management has been focused on deleveraging and they are on target to meet their goal. Since the 2018 leverage levels, the company managed to reduce the leverage from 5.4x to 3.6x as at the end of the FY 2020. The management's target is to be below 3.0x on leverage by the end of 2021. Similarly, the interest expense cover improved year on year and is around 4x which indicates that the company has no issues paying down its interest. Over the next 5 years (2021 to 2025 inclusive) the company has to repay around $6.5bn in principal payments. We would like to see the company continue to pay down debt and improve its financial position.
Source: Annual Report
Between 2020 and 2019 CFO decreased by 0.7% and total dividend paid increased by 0.2%. CFO/Dividend cover is around 2.9x which is reasonable; however, over the long term, we would like to see the cover expand slightly. The Q1 2021 results show CFO of $0.6bn an increase since Q1 2020 of 32%. More years are needed to establish the size of the seasonality of the business as a whole which should provide better indication on how the company is performing when adjusting for seasonality. Given that Q1 2020 was impacted by the pandemic, the figure is distorted. In addition, the company recently announced a 25% increase in their dividend. This means that the new dividend will be $0.1875 per quarter or $0.74 per year. This is expected to reduce the CFO multiple to 2.3x assuming CFO remains the same. As we have highlighted above, the 1-year quarter growth for Q1 has been 32%. If the same growth persists in the following quarters, then the multiple is expected to improve. We are comfortable with a multiple above 2x as dividends are covered; however, a multiple expansion would mean that dividends can continue to grow in the future sustainably.
Overall, the company is focused on deleveraging following the merger which should help it build a stronger balance sheet and expand profitability margins slightly. Between 2020 and 2019 the top and bottom lines grew at a modest rate as we have indicated above. However, 2020 was a disruptive year which makes the comparison hard. The company also faces some revenue concentration risk as WMT's exposure is above 15% of net sales. In addition, CFO decreased marginally in 2020 compared to 2019 which is a not favourable for the company. We need to see CFO growing before we are more comfortable with the company's future. Q1 2021 results show some increase quarter on quarter; however, due to the seasonality of the business, estimating how the full year results is pure speculation. As we are going to highlight below, the company is trading at rich valuations. Post-merger performance and Q1 2021 did not highlight a development or characteristic that justifies the multiples. Often, the market likes to put a premium on well-known brands. For us fundamentals need to support the multiples as companies are susceptible to mean reversion.
Relative valuation
As we have highlighted above, KDP is moving towards the right direction; however, we cannot ignore the valuation risk.
KDP MNST KO Sector Median P/E 24.6 34.4 26.0 22.5 P/S 4.0 8.9 6.4 1.6 P/Cashflow 16.5 32.8 21.5 13.2 EV/ EBITDA 15.6 24.2 21.6 12.9 Return on equity (%) 6.4 31.0 37.5 12.2 Return on assets (%) 3.0 22.1 8.0 5.4 Return on total capital (%) 5.1 22.4 9.3 7.6
Source: Seeking Alpha
As we can see above all metrics highlight that the KDP is overvalued compared to the sector median. On an average, the price and EV multiples, excluding P/S, show that the company is 18% overvalued and with the P/S multiple, this rises to 50%. This overvaluation does not come with superior returns on equity, assets or total capital as they are all below sector median. In addition, looking at the PEG TTM and PEG FWD, the company is overvalued by 30% and undervalued by 23%.
The graph below, as well as the historical price to cashflow multiple, indicates that over the past year KDP outperformed KO but not MNST and its multiple has expanded significantly. Market seems to be over optimistic about the company with a 1 year performance of 22.7%. Going forward, in our eyes, this means more risk and less downside protection as fundamentals and price diverged. In addition, Q1 2021 filing does not provide the support required for these high valuations.
Comparing the company against two peers, MNST and KO, we can see two things. We wanted to compare MNST with KDP due to the similar size of the two companies. MNST has a market cap of $47.7bn and KDP $48.9bn. At a first glance and based on price and EV multiples KDP looks undervalued. KDP looks on average 42% undervalued compared to MNST. However, looking at the return metrics, MNST is returning on average 80% more than what KDP does which shows that higher multiples can be supported.
Comparing KDP to KO, the leader in market share in the beverage market in the U.S., KDP demonstrates a similar picture. At a first look the company and multiples indicate that KDP might be undervalued; however, the return metrics show that the higher multiples of KO can be supported by higher returns. We would like to see higher return metrics from KDP as we would like the company to demonstrate the ability to continuously provide sufficient returns which should greatly benefit shareholders due to the compounding effect.
Relative valuation demonstrates three key things for us. Firstly, over time the price has deviated from fundamentals and is now trading at rich valuations. Secondly, the company is overvalued based on the sector median. Finally, MNST and KO comparison shows that the company at first might seem undervalued due to price multiples; however, the return metrics highlight that MNST and KO are better compounding machines. The market often likes to put a premium to well-known brands and it seems that KDP trading at rich territories at the moment.
Mondelez International Secondary Offering and concertation risk
Early in June KDP announced a secondary offering on behalf of Mondelez International Holdings (MDLZ). The company will be selling a maximum of 4.2m shares or 2.3% of the outstanding common shares at a price of $35.65. MDLZ has reduced its stake further back in November 2020 at a price of $28.45. We do expect the market demand to be strong however, the move from MDLZ acts as a signal. The company seems to be cashing in its investments and these trades are opportunistic based on market conditions. In other words MDLZ sees current KDP prices as opportunistic and the company believes that there are better ways to utilise cash. Some may argue differently but MDLZ knows what is happening at KDP as the company has two seats on the company's board of directors. This is in line with what we believe. KDP is a good company; however, the company trades at rich valuations and we believe there are better places to invest our money in the market.
Lastly, as we mentioned above, KDP has about 15% of its revenue coming from Walmart. We would like this concentration to be lower; however, given that Walmart has around 9%-10% of all the U.S. retail sales and growing year on year, this can be difficult. The risk is in case Walmart drops the KDP business relationship or if they decide to aggressively compete with own branded products. The trends have been clear for some time and the profitability can make a case to compete with their own brands. Channels such as direct to consumer should be strengthened further and management should try to diversify its revenue sources further.
Summary
KDP has many well-known brands that will help the company continue to have a modest growth. Management's deleverage target is on track and shareholders will enjoy an increase of 25% in dividend payments. However, the company is trading at rich valuations and we expect mean reversion to negatively impact shareholders. Lastly, Mondelez signal of cashing in their investment aligns with what we believe, KDP is a good company but cash can be better utilised elsewhere in the market, hence we are bearish with KDP in the short term.
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Hi there! I am a passionate investor looking to build an all weather portfolio. My goal is to build a portfolio that is tilted towards providing a sustainable income for the long term. I am completely independent analysing numerous companies and providing my own opinions. My focus is to build a portfolio of reliable dividend paying companies. My idea of successful investing is to focus in identifying companies that will continue to pay dividends and increase them over time. I am more comfortable with value plays as I am a believer that prices revert to intrinsic values over time. About myself: I am a veterinary student with a passion for investing. I search companies from the ground up and focus greatly on fundamentals and future prospects. Full Disclosure: All content is published and provided as an information source for investors capable of making their own investment decisions. None of the information offered should be construed to be advice or a recommendation that any particular security, portfolio of securities, transaction, or investment strategy is suitable for any specific person. The information offered is impersonal and not tailored to the investment needs of any specific person.
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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