Dr Pepper’s Hedging Activities Help Keep Costs From Bubbling Over

Cola companies such as Dr Pepper Snapple (NYSE:DPS), Coca-Cola Co (NYSE:KO) and PepsiCo (NYSE:PEP) switched from using sugar cane to high-fructose corn syrup in the U.S. around 30 years ago. There were two key reasons for this move. The first is that government subsidies on corn produce made it cheaper than sugar cane. The second reason is the high import tariff on sugar cane brought in from countries in Central and South America. Cola companies now use corn syrup as the primary sweetener in the U.S. in nearly all their non diet soda products. This means that corn purchases now make up for a significant bulk of these companies’ raw material expenses. This is particularly true for Dr Pepper Snapple, whose operations are almost entirely focused on the United States.

Dr Pepper has a network of around 21 bottling plants, with 18 of these in the United States. Over 90% of the company’s revenues come from the U.S. This lack of geographical diversity means that the company is particularly vulnerable to volatility in U.S. corn prices.

See our full analysis for Dr Pepper Snapple Group

Dr Pepper’s Margins Refuse To Dry Up

In 2012, a nationwide drought in the U.S. pushed corn prices to record highs during the summer with bushel prices settling near the $9 mark compared to the usual $5 mark. ^[1] One would expect that this would have a negative impact on Dr Pepper Snapple’s bottom line. But a look at the company’s latest quarter filing paints a different picture as the company’s gross margin for the 9-month period of January-September 2012 stood at 58%, the same as in January-September 2011. So what allowed the company to shield itself so effectively from rising commodity prices? The answer is that it benefited from its hedging activities.

Dr Pepper Snapple’s hedging activities have been quite aggressive in the recent past. The company hedged 100% of its corn requirements in 2011, while around 50% was hedged in the first quarter of 2012. While making a statement for the second quarter results of 2012, Dr Pepper Snapple’s CFO, Marty Ellen, mentioned that the company’s corn requirements were, again,  “pretty well hedged” for the year. Despite betting high in terms of volumes, however, Dr Pepper Snapple is also focused on keeping its strategy dynamic – the company’s management has explicitly stated that they try to limit their hedging within the 9 month period.

And this strategy seems to be paying off quite well for the company. The latest news surrounding the U.S. drought situation suggests that persisting dry conditions will probably keep corn at higher prices for at least the next few months. ^[2] Keeping in mind the company’s medium-term hedging strategy, Dr Pepper Snapple seems to be well prepared for the near future.

Volatility Works Both Ways

The long term outlook, especially considering the later months of 2013, looks a little more complex. The trouble is, no one can really predict the weather accurately. Favorable conditions in the next year could mean that corn prices spiral downwards rather rapidly. A normal yield in the next season could see prices drop to as low as $2 per bushel. ^[3]

The company’s dynamic hedging strategy ought to give the company enough leeway in this regard. But if Dr Pepper Snapple gives in to fears around the current drought situation and decides to take its high-volume hedging towards the long-term (say a 12-month period) in 2013, we might see the company lose out on a chance to improve on its profitability. However, keeping in mind this year’s bottom line performance and the company’s emphasis on medium-term hedging, there is no reason to investors should keep their faith with the management for 2013.

We estimate a $46 price for Dr Pepper Snapple, which is just above the market price.

1. “U.S. drought pushing corn prices toward record highs“, Los Angeles Times, August 2012 [↩]
2. “U.S. drought persists despite rain; wheat struggles“, Reuters, November 2012 [↩]
3. 2013 corn yields, prices uncertain (Surprise! It all depends on the weather), FarmandDairy.com, December 2012 [↩]