Description

     Recommendation: Long Keurig Dr. Pepper (“KDP”) with an upside price target of $38/share (+37% upside) vs. downside target of $22/share (-18% down). The market is currently discounting the intrinsic value of KDP relative to beverage and Food/Personal Care peers given 1) no pure play comps for Keurig Green Mountain (“KGM”) 2) higher pro-forma deal leverage the number and 3) recent comments from Barclay’s conference walking down the high-end of the guide (buyside/sell-side wasn’t there anyways). Despite these short-term issues, KDP is led by a proven CEO (Bob Gamgort) and backed by a world-class organization in JAB Holdings.  

My investment thesis is predicated on the following 8 catalysts: 

• FCF Materially Higher than EPS - The street is missing the large difference between FCF and EPS currently. Two factors are driving 60 cent delta in 2020 including: 1) Capex cycle vs. D&A 2) Working capital improvement at DPS (same playbook as KGM).

• Fully Synergized FCF Path to $2.12/share in 2021 values KDP at 13.8x FCF vs. Beverage Peers at 25x FCF (40% discount): The combination of DPS and KGM came with $600mm of announced synergies in over the course of 3 years from the closing date of July 2018. KDP is the only real material pro-forma M&A story in staples, where synergies help subsidize the risk of core fundamental growth. 

• KGM is a New Public Business with no Real Comps – Time Needed: KGM was privately owned for the last two years after being taken private via JAB (largest coffee owner in the world). KGM was effectively taken public through the combination with DPS last year. KGM is the #7th largest retail food/beverage company in the U.S. 

• World-Class Management Team and Private Equity Backing – JAB and MDLZ own 81% of KDP. JAB is second only to 3G in terms of reputation within the private equity backed retail consumer space. JAB is the leader in coffee and found the most respected available CEO in consumer staples to run KDP (Bob Gamgort). Gamgort did an excellent job driving shareholder returns at Pinnacle Foods before leaving for KDP and handing over the reins to Mark Clause (who late sold the business to CAG). 

• Flattening of Pod Pricing after Strategic Reset to Drive Household Penetration: Over the last 4 years, KGM has deliberately reset pod pricing lower to drive household penetration given the market-share grab for share of throat for coffee. KDP is getting close to the floor for lower pricing and in a few years after getting to a higher market share (27mm homes today with penetration TAM of 65mm additional homes), could use their scale to drive pricing back up.   

• Debt Paydown to Investment Grade Upgrade – By 2021, KDP expects to be at close to 3x leverage (from 4.5x FY end 2019) with the goal of becoming an investment grade credit. At this point, the leverage driven discount should close fully. 

• Technical Share Offerings Close Valuation Gap – With JAB owning 67% of the shares and the free float only at 20% by end of 2019 (JAB planning a secondary), the ability liquidity will continue to improve driving indexes and more investors to the company. 

• Next Acquisition Teed up for 2020 – JAB wants more M&A and given the balance sheet will be inside 4x in 2020, it is realistic that KDP looks to make another beverage acquisition (expected close in 2021) with its $10-12bn of balance sheet capacity, assuming (2-3x B/S capacity). 

Business Overview

KDP consists of two segments: 1) Dr. Pepper and 2) Keurig Green Mountain. 

• DPS (50% of 20’ Synergized EBITDA ~ $1.8bn) – Dr. Pepper is the #3 player in the beverage market behind, KO and PEP. Within beverages, DPS is the #1 player in flavored CSD, #2 premium water, and #2 fruit juices. 

• KGM (50% of 20’ Synergized EBITDA ~ $1.8bn) – Keurig Green Mountain is the #1 player in Single Serve Brewing with over 80% of pods sale share. Coffee category is growing 5% p.a. while KDP’s pods are growing 5-7% (taking market share).

Valuation & Risk/Reward

Risk/Reward – KDP ’s R/R is 2.3x using a probability weighted average of 5 scenarios ($37/share) vs. a stressed 3 part weighted average downside case ($22/share). 

FCF Method – KDP trades at 13.8x 2020 FCF or a 7.2% FCF yield vs. north of 22x for beverage and Food/P&C peers. KDP expects synergies to be 2/3rds realized by 2020. 

2021 Fully Synergized FCF Valuation – KDP expected to continue to grow EBITDA double digits through 2021 (last year of synergies). On $2.12 FCF/share and 22x average multiple, we get $47/share of +74% upside. 

DCF Value – Using a 16.7x terminal FCF growth rate (discount to sector) applying excess FCF for paydown, we get a $33/share price target (or +18%). KDP is guiding to $2.4bn in FCF in 2019, which bakes in 1/3rd of announced synergies. 

Downside Case – We use a weighted average 3 prong approach on not fully synergized 2020 numbers (EV/EBITDA, P/E, FCF), where we use the lowest comps in the sector (GIS/K). For EV/EBITDA (normalizes capital structure), we apply a 1.25x turn discount to $22/share. For FCF/share basis, we use a 3x discount on the $1.71/share consensus FCF to get to $22/share downside price (vs. 25x for beverage peers). Part of the large discount is based on the fact that we have 2/3rds left of the synergies to achieve (assume low hanging fruit is snagged already), higher peer leverage and working capital factoring program lapping in 2021. 

Lastly, on a P/E basis, which doesn’t include the working capital improvements or the benefit of lower capex, KDP trades at 19x 2020. This is a discount to the 24x P/E for KO/PEP, but we use 15x P/E in-line with GIS/K to get to $21/share downside. Blending all three approaches, we get to $22/share downside price target (18% downside). 

Downside Risks

• EBITDA risk ~ $600mm of synergies don’t come through or need to be reinvested given innovation reinvestment spend at KO/PEP currently 

• FCF risk ~ Working capital factoring program will lapse in 2021 for DPS legacy and will be a headwind

• KGM ~ Pod volumes normalize from 6-8% outsized growth (due to e-comm) closer to industry growth of 5% for coffee

• KGM ~ Negative pricing expected to flatten to zero by 2020 gets pushed out 

• DPS ~ CSD taxes (Berkley, CA) and political concerns around obesity weigh on CSD consumption 

• DPS ~ Pricing from KO/PEP leads and if their price hikes stall, it could weigh on DPS

Exhibits

Exhibit 1. Nielsen Data 

KDP has been tracking +3% on the last 52 weeks, which is in-line with their 2-3% LT guide for revenue growth. Based on their financials, calls with management and commentary from Barclays “Back to School” conference, KDP is seeing: 

• 5-7% pod growth within their KGM coffee segment (above coffee category growth of 5%)

• LSD revenue growth in beverages

• Negative 160bps headwind in Allied Brands (losing Fiji and Body Armor in 2019) ~ delta between Reported and Underlying Net Sales

• Nielsen only tracks 50% of activity for KGM as it doesn’t include any e-commerce growth (AMZN) ~ IRI underreports KGM 

Exhibit 2. Consensus Valuation – Use a blended multiple for beverages (higher multiple) and Food/P&C (lower multiple) to value KDP

Exhibit 3. Comps Table 

Exhibit 4. $600mm Synergies Breakdown (3 years ~ 2019-2021) – KDP has completed the first year since the DPS acquisition and has achieved the $200mm worth of synergies, leaving $400mm to go.

Exhibit 5. KDP 2019 Guidance – At Barclays, KDP “cleaned up” their guidance to 1-2% from 2% after the 2Q to fully incorporate the Body Armor lost brands. When pressed on it, KDP said “nothing has changed post 2Q,” but that they were being too prescriptive when they gave a point estimate (2%) vs. a range (historical). 

Exhibit 6. KDP ROIC (Pro-forma for deal) = KDP generates mid-teens ROIC fully synergized in 2021 (a hurdle rate for high quality companies).

Catalyst

- Synergy Realization

- Comfort with KGM business

- Debt Paydown