Description

DPS was last written up in February 2009 as a compelling spinoff idea (long).  DPS is the third largest non-alcoholic beverage player in the U.S. after KO and PEP, with the majority of its revenue and profits coming from the domestic CSD (carbonated soft drinks) category, which is in decline.  While DPS’ financials have not changed all that much, the stock is up over 5x, and it is now a compelling short.  

• DPS has benefited from the market rewarding U.S. focused “safe havens”

• DPS’s portfolio remains heavily weighted to the declining soda category

• The CSD category (~80% of DPS volume) continues to shrink in the U.S. with ongoing consumer health and wellness concerns.

• U.S. CSD category volumes declined 1-2% in 2015 (following 1% and 3% declines in 2014 and 2013, respectively), the eleventh straight year of decline.

• While DPS benefited from its lack of international exposure last year as the U.S. dollar strengthened, the fact that DPS does not own the Dr Pepper brand licenses in most international markets should place them at a strategic disadvantage - in the absence of major FX movement - as it limits their ability to offset declining domestic volumes.

• Management incentives continue to steer capital allocators and decision makers to make sub-optimal choices

• Unlike their peers, DPS management’s compensation is partly based on the company’s FCF yield, defined as (CFFO-Capex)/ Market Cap.  In 2015, the company increased the weighting of the PSU program (the piece that is partly driven by FCF yield) from 40% to 50% of total LTI Compensation.

• This performance metric helps explain why management is focusing on increasing reported FCF rather than maximizing shareholder value.

DPS LTI Design Evolution

Think about this… management is motivated to make its stock “cheaper”!  They can do this by shrinking the market cap and/or by increasing CFFO - CapEx.  They are doing both, and both in ways which destroy value.  They are overpaying for their own shares in the public market to reduce the float, and they are underinvesting in their business to flatter reported FCF.  

• Management is making the wrong choices in light of secular headwinds

• DPS has reduced capex by over ~40% since 2008/2009; it is now only 2.8% of sales, or roughly ~80% of D&A, and well below peers (3.4%-5.8% of sales).

• Despite KO and PEP outspending DPS on marketing/promotions by over 8x, DPS management has been reducing marketing spend as % of sales.

• DPS is only spending $18-$19mm on R&D each year (~0.30% of sales) while Pepsi is spending over $750mm (over 1% of sales).  Also, unlike DPS, KO and PEP frequently achieve growth and innovation through business acquisitions.

• Free cash flow merits adjustment on several fronts in order to present a more sustainable basis

• As a result of the spinoff from Cadbury, DPS has enjoyed a somewhat “depressed” cash tax rate.

• Real cash expenses are understated by the company’s aggressive use of share-based compensation (~$45-$50mm annually), as management has been spending $400-$500+ million per year buying back over-valued shares.

• The company’s recent cash return has been in the 5-6% range, annually (dividend yield plus share repurchases). On reported numbers, this looks very full as cash spent on dividends and share repurchases frequently exceeds reported FCF.

• Our adjusted FCF estimate shows a ~3.6% FCF yield, calling into question the sustainability of DPS’s cash return program at current prices.

• Valuation

• This is ultimately a cash return business and, given the secular headwinds and true sustainable FCF being lower than reported, DPS should trade at a much higher yield.  

• Our price target of $45-$55 (potential downside of ~40%+ from current share price) is based on a more reasonable adjusted FCF yield range (6% to 7% vs. current yield of ~3.6%).  

Catalyst

Nothing specific, other than gravity.  At some point cracks will show.  The business shouldn't grow much, and the multiple really shouldn't expand, so waiting for cracks to show will hopefully not be that painful.