Acquisition Of Davis Beverage Group Would Strengthen Dr. Pepper’s Direct Store Delivery System

DPS: Dr Pepper Snapple logo
DPS
Dr Pepper Snapple

The third largest manufacturer of carbonated soft drinks (CSDs) in the U.S., Dr Pepper Snapple (NYSE:DPS) has seen its stock rise by nearly 20% in the last six months, more than the 8.4% and 12.6% increases for chief rivals Coca-Cola and PepsiCo respectively. Nearly 70% of the Texas based beverage maker’s valuation comes from the North America CSD division, according to our estimates. Despite growing consumer concerns over the high sugar and calorie content of soft drinks, which has stalled growth in this segment for nine consecutive years, Dr. Pepper has managed to secure steady growth by increasing its market share and improving its operating performance. The domestic CSD market is mature, with Coca-Cola, PepsiCo and Dr. Pepper accounting for almost 90% of the industry-wide volumes. According to our estimates, Dr. Pepper’s market share has risen in each of the last four years, reaching 17.5% last year. Now the beverage maker plans to further leverage in-house distribution to expand margins, by acquiring Davis Beverage Group and Davis Bottling Company, which bottles and distributes Dr. Pepper’s beverage brands. [1]

With this acquisition, Dr. Pepper will strengthen its direct store delivery (DSD) system, capturing downstream margin opportunity and also exercising more control over retail shelf space. We have a price estimate of $56.81 for Dr Pepper Snapple, which is around 9% lower than the current market price.

See Our Complete Analysis For Dr Pepper Snapple

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Davis distributes a wide range of Dr. Pepper’s carbonated and non-carbonated brands, including brands such as Vita Coco, Bai5, Neuro and FIJI, which have distribution deals with the latter. The acquisition might complete by the fourth quarter this year, and would contribute most of Davis’ DSD territory in Pennsylvania and a portion of its New Jersey territory to Dr. Pepper. In addition, Dr. Pepper would also acquire Davis’ production and distribution units, vending equipment, delivery vehicles and other assets, almost doubling its DSD business in Pennsylvania, which constitutes over 4% of the U.S. population.

Direct Store Delivery Could Improve Dr. Pepper’s C-Store Presence

Direct store delivery might boost Dr. Pepper’s beverage business due to increased control over retail shelf. Concentrates for both Coca-Cola and PepsiCo are largely bottled by the companies themselves. This means that the beverage giants control bottling operations and consequently direct store delivery systems, ensuring top-shelf positioning of their beverages in convenience stores. In contrast, around 63% volumes of the drink Dr. Pepper are distributed by bottlers affiliated with Coca-Cola and PepsiCo. Both these companies constituted nearly half of Dr. Pepper’s beverage concentrate sales in 2013. [2] This means that unlike Coca-Cola and PepsiCo, Dr. Pepper doesn’t posses as much control over shipments to ensure optimum store placement, somewhat hampering its reach and availability.

Retail shelf space is significant for Dr. Pepper, which generated over 12% of its sales last year from Wal-Mart, the world’s largest retail chain. CSDs are already losing shelf space to new high-margin attractive entrants such as energy drinks. Moreover, retailers have been looking to reduce shelf space for the ailing Dr. Pepper’s low calorie TEN lineup. Dr. Pepper’s DSD system could provide shelf inventory management and reduce costs of reordering and merchandising for the retailer, aiming to improve sales and margins for the retailer as well. This could protect the company’s shelf space in retail stores.

The company’s flagship brand Dr. Pepper Cherry (20-ounce serving) was the third highest grosser in measured U.S. convenience store (C-store) channels in the twelve months ended January, generating sales of $340 million, up nearly 10% year-over-year. [3] In fact, Dr. Pepper Cherry beat PepsiCo’s namesake CSD brand Pepsi by almost 40% in terms of unit sales. This reflects consumer inclination towards Dr. Pepper’s brands, and with more control over shelf positioning in C-stores, the company could further boost its reach and possibly improve sales. As most of the beverage purchases are impulse buys, proximity to the end consumer is crucial. In the first month of the third quarter, while both Coca-Cola and PepsiCo improved their C-store volumes by 0.8%, Dr. Pepper witnessed a 1.8% decline in unit sales. [4] Direct store delivery could improve shelf positioning for Dr. Pepper in Wal-Mart and other retail stores, possibly attracting higher sales.

Dr. Pepper Could Expand Its Operating Margins

Direct store delivery allows the beverage manufacturer to bypass third-party and retailers’ distribution centers. By bringing distribution in-house in parts of Pennsylvania and New Jersey, Dr. Pepper could leverage its integrated model to capture downstream margin opportunities. While Dr. Pepper only expects only flat to 1% top line growth this year, the company could increase cash flow by expanding its operating margins. The company improved its operating margins by almost 400 basis points to 20% through June. In contrast, Coca-Cola and PepsiCo expanded their margins by roughly 20 and 50 basis points to 23.9% and 15.9% respectively during this period. If Dr. Pepper continues to leverage its integrated model and gains from improved operational efficiencies, causing long term margins for the North America CSD division to rise to 26%, up from our current estimate of 23.4%, there would be a 10% upside to our valuation for Dr. Pepper, bringing our price estimate in line with the current market price.

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Notes:
  1. Dr. Pepper press release []
  2. Dr. Pepper 10-K“ []
  3. Carbonated soft drinks: 2014, cspnet.com []
  4. CSDs turn around sales declines, cspnet.com []