3 Reasons Dr Pepper Snapple Group Will Narrow the Gap with Coca-Cola and PepsiCo in 2014

Dr Pepper Snapple Group (NYSE: DPS  ) often gets short shrift from observers of the beverage industry. It is a distant third in the cola wars, with Coca-Cola (NYSE: KO  ) and PepsiCo (NYSE: PEP  ) combining for a 70% share of the market compared to Dr Pepper Snapple's 17% share. However, the latter's recent initiatives may enable it to close the gap in 2014.

Dr Pepper Snapple is gaining on Coca-Cola and PepsiCo
Carbonated soft drinks, or CSDs, have been linked to obesity and other unhealthy conditions. At issue is the copious amount of sugar and artificial sweeteners found in the drinks. This has resulted in weak CSD sales volume in 2013 and an uncertain future for the industry in the United States.

Dr Pepper Snapple, however, is convinced that its line of low-calorie beverages -- namely, TEN -- is the answer to the company's woes. The TEN platform consists of 10-calorie versions of its most popular brands, including Dr Pepper, 7UP, and Sunkist. The drinks have the full flavor of the regular drinks and fewer calories.

Although TEN includes artificial sweeteners like high-fructose corn syrup and aspartame, it appeals to consumers that fled diet drinks because of their poor aftertaste. A little over half of TEN sales are made to consumers who used to drink diet soda but stopped. This suggests that the TEN platform is a noticeable improvement over traditional diet sodas and a possible avenue for market share growth.

PepsiCo, on the other hand, has struggled to retain its market share amid a challenging environment; its share of the CSD market fell from 31.1% in 2007 to 28.1% in 2012. Coca-Cola also lost market share over this period, falling from 42.8% to 42% according to Beverage Digest. Meanwhile, Dr Pepper Snapple's market share grew from 15% in 2007 to 16.8% in 2012, although the bulk of those gains came in 2009.

Source: Beverage Digest

If the TEN platform can draw drinkers of Diet Coke, Diet Pepsi, and Diet Mountain Dew, then Dr Pepper Snapple is in position to narrow the gap between the company and its larger rivals.

Dr Pepper Snapple institutes Rapid Continuous Improvement
There is only so much Dr Pepper Snapple can do about its revenue, but it has significant control over its cost structure. In February 2011, the company began implementing a program called Rapid Continuous Improvement, or RCI. The point of the program is to streamline Dr Pepper Snapple's operations and eliminate waste.

In addition to optimizing distribution logistics, RCI enhances inventory management by syncing production and distribution with customer traffic patterns. Customer traffic fluctuates in more-or-less predictable patterns throughout the month based on when people receive their paychecks and other factors. Traditionally, merchandisers had not accounted for these fluctuations, but now Dr Pepper Snapple is accounting for them. As a result of these efforts, the company has tuned production to a level where it can meet demand without carrying excessive inventory.

Source: Morningstar, SEC Filings, author's calculations

If RCI continues to increase efficiencies at Dr Pepper Snapple, the company will generate more free cash flow to support a more aggressive balance sheet.

Latin America and beyond present long-term growth opportunity
Coca-Cola and PepsiCo own global brands with worldwide distribution systems. Dr Pepper Snapple, on the other hand, has only dipped its toe into international waters. The company's Latin America segment represented just 7.6% of its overall sales through the first three quarters of 2013, but that was up from 6.9% in 2012.

The Latin America segment includes Mexico and parts of the Caribbean. It is fully integrated, meaning Dr Pepper Snapple manufactures, bottles, and distributes most of its products in the region. An integrated model can be advantageous once the distribution network reaches scale, but it is a capital-intensive endeavor that takes time to develop.

It cost $157 million to build the company's two wholly owned bottling facilities in Mexico -- that is more than one-third of the segment's total sales. After you add the distribution centers and fleet of delivery vehicles, it comes out to a lot of capital required to operate the system.

Despite the low returns on capital, Dr Pepper Snapple's determination to build its own bottling and distribution system will help wean the company off of third-party distribution systems, namely those of Coca-Cola and PepsiCo. The two soft drink giants account for half of Dr Pepper Snapple's net sales in the beverage concentrates segment, or about 10% of its total sales. The company also partners with local entrepreneurs that build the system outside of the company, reducing Dr Pepper Snapple's capital outlay.

Regardless of how Dr Pepper Snapple chooses to expand, its brands have global potential similar to those of Coca-Cola and PepsiCo, so it has a long runway for growth beyond its current markets.

Bottom line
Dr Pepper Snapple is doing well in a poor environment. It will always play third wheel to Coca-Cola and PepsiCo, but product innovation, cost reductions, and future growth put the company on a path to narrow the gap.

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