JAB Holding Company has been aggressively snapping up coffee and food businesses over the past few years, adding to its portfolio popular brands like Krispy Kreme, Peet's, Keurig Green Mountain, and Panera. But its latest deal -- a merger between Dr Pepper Snapple (NYSE:DPS) and Keurig -- presents an odd combination.
In this episode of Industry Focus: Consumer Goods, Vincent Shen and Daniel Kline look at the deal from top to bottom. Tune in to find out what synergies the companies will reportedly unlock through this deal, what Dr Pepper Snapple shareholders have to look forward to if and when the deal goes through, some of the biggest risks for the combined entity, and more.
A full transcript follows the video.
This video was recorded on Jan. 30, 2018.
Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Tuesday, January 30th, and I'm your host Vincent Shen.
Yesterday, a European investment firm announced another major deal, the latest in a multi-year shopping spree that has included coffee brands, restaurant chains, and now, a leading beverage company. That firm is JAB Holding Company, a conglomerate that will soon earn a regular guest spot on Industry Focus, given how many companies it's been scooping up from the consumer and retail sector. Its latest purchase will bring Dr Pepper Snapple, known for its namesake drinks, into the JAB family with almost $19 billion being paid out to Dr Pepper Snapple shareholders.
Joining me today in the Fool HQ studio to discuss the deal is Fool.com contributor, Daniel Kline. Hey, Dan! Great to have you here in flesh!
Daniel Kline: Thanks for having me! I will point out, though, in the winter, we could do this at my house. [laughs]
Shen: [laughs] Yes, I would not mind going down to Florida. We should definitely get a mobile studio for that. So JAB is at it again, but instead of diving directly into the deal specifics like we usually do here, I want to set aside a few minutes to provide some context for the merger. We'll hit Dr Pepper Snapple first. They're a bit more straightforward as a publicly traded company. I'm going to run through a little bit of background.
Kline: You should also explain that they're merging with Keurig, which is a JAB brand.
Shen: Yes, absolutely. We'll get to all these different players here. It's good to have this context before we dive into some of the whys and hows. The ticker for Dr Pepper Snapple is DPS. I'm going to refer to them as DPS going forward, just to keep it a little smoother.
The company had a market cap of about $17 billion prior to the deal announcement. They generated $6.6 billion of revenue in the trailing 12-month period by selling beverage concentrates and packaged beverages to retailers, bottlers, and distributors. The company has a portfolio that includes over 50 brands. A lot of them are household names that we know: Dr Pepper, obviously, Snapple, Canada Dry, 7-Up, Sunkist, Hawaiian Punch. When we were talking before the show, you seemed to say these are more second-tier brands.
Kline: Yeah, they don't have Coke or Pepsi, but they say they have all the top flavored brands -- they have the top root beer, they have the top fruit punch, they have the top orange soda. They literally say in their press release that they have the top grapefruit soda. If you could have named that before today, I would have been surprised.
Shen: [laughs] Dr Pepper Snapple, DPS, is also a business that has come together as a result of various acquisitions, mergers, and spin-offs over many years. Overall, top line growth for this company over the past several years has been in the low single digits. Not the strongest, given some of the changes that we've seen with consumer preferences and perception of sugary beverages. But the company generates 90% of its revenue in the U.S., with the remainder coming from Canada and Mexico, and it's managed to expand profitability pretty well, grow earnings at a higher rate, and they're starting to invest and turn their focus toward healthier products. They made a deal recently in 2016, they acquired Bai Brands for $1.7 billion. Bai is pretty firmly rooted in the healthy beverage trend.
Kline: And they're expanding Bai pretty aggressively into carbonated waters and healthy waters. They also have sort of an interesting business model where they distribute a number of up-and-coming brands, generally in the non-carbonated, healthier space, which sort of gives them a window into, "This is doing well, maybe we could acquire it down the line."
Shen: And it's definitely interesting, on the concentrate side, for example, if you look through their financial filing, they mention that their biggest customers for that segment are Coca-Cola and Pepsi. So there's a lot of licensing and these different deals happening for Dr Pepper Snapple, and that'll possibly be some of the justification for this deal. We'll look into that for how they might work out the synergies with Keurig.
Let's jump now to the background for Keurig and JAB. Keurig Green Mountain was folded into JAB's empire in 2016 for $14 billion. Dan, tell us a little bit about the JAB story. We've talked about them before on the show, and the many strings of deals they've done, so let's hear it.
Kline: JAB is a family controlled German company that, honestly, we know very little about. What they've been doing for the past few years is, they've been acquiring a lot of companies in the coffee space. Little ones like Douwe Egberts, Tassimo, Senseo, all these little behind the scenes brands. And then they hopped out and bought Panera, they bought Keurig, they own Einstein Bros Bagels. When you look at it, they own maybe 30 something coffee brands, Peet's Coffee, all of these disjointed coffee products, and they haven't done much with them.
By that I mean, they own Krispy Kreme and they own Panera, yet there's no Krispy Kreme donuts at Panera. They own Peet's, they own Caribou Coffee, there's no branded coffee product at Krispy Kreme or Panera. So they have very much, so far, been an acquirer that's putting a portfolio together, and they really haven't given you much sense of what they're going to do with it. Maybe this deal is the first little hint of that.
Shen: Yeah. I'll note, in a period of five years, the company spent tens of billions of dollars and closed deal after deal taking over some of those big names that you mentioned, Panera, they took over Au Bon Pain late last year. That's really just the tip of the iceberg. But at the time of the initial acquisition for Keurig, who's now going to be the merger partner with Dr Pepper Snapple, Keurig was underperforming. They had declining revenue and profitability. The Keurig Kold, competitor to the SodaStream, for example --
Kline: [laughs] Was a disaster.
Shen: -- was an absolute disaster, and the company was having trouble competing with the lower-priced, third-party pod providers.
Kline: It was also facing a backlash over environmental issues. At the time, yes, you had Kold, yes, you had some of these disparate brewers that made cappuccinos that nobody bought. But when you're a one-product company and there's a backlash to that one product, that's not a good thing. The vast majority of their revenue came from K-Cups, and people were saying, "K-Cups pollute. K-Cups are a problem." Going private removed a lot of that scrutiny. Even though they pledged to go 100% recyclable, I think by 2020 --
Shen: Yes, in the U.S.
Kline: -- that took away all that pressure. And they didn't have to report anymore, that was good for them. But you also didn't hear where sales were, and that made people forget that, yes, K-Cups are kind of wasteful.
Shen: Sure. JAB actually paid an 80%, approximately, buyout premium for Keurig. I think that will factor into our discussion later on. But let's look at the deal itself, some of the deal specifics. Keurig and DPS will combine to form Keurig Dr Pepper. And that will remain a publicly traded company.
So if you're a DPS shareholder, you'll get a special cash dividend of $103.75 per share. And once the two companies come together, the ownership structure will have DPS investors claiming about 13% ownership of the combined entity. Mondelez, which held a pretty significant chunk of Keurig as well, will control a similar stake, about 13% to 14%. And the remainder will go to JAB and its other partners. Then, Keurig Dr Pepper will have almost $11 billion of annual revenue, and let's just say a pretty eclectic portfolio of different brands and things going on here.
Kline: I think the way to describe it is, these are complementary products. It's not obvious. You don't look at Dr Pepper and say, "Oh, a Dr Pepper K-Cup, that would be perfect." That doesn't work. And before Keurig Kold failed, you might see some obvious move like, "They could do cold drinks." They're clearly not going to do that any time soon. So really, the "synergy" in the deal comes in how they're able to get these products to market. And if you're already going to the store with your K-Cups, you might as well tack on some Dr Pepper, some 7-Up, some Clamato, whatever else it is, and make your supply lines better. Instead of having to have one truck make 10 stops, maybe that one truck makes one stop now, or two stops.
Shen: Yeah. The synergies that the management team has mentioned in their presentation for this deal, they mentioned $600 million of annual synergies that will be recognized around 2021. But there's also $750 million of one-off costs that will stem from this deal, as well. Ultimately, they mentioned things like integrating warehousing and transportation, saving on scale with suppliers, removing duplicate processes and positions. Nothing we haven't heard before in a deal like this in terms of duplicate processes.
Kline: And it's not all that impressive. You look at this, and a lot of times, a company gets to a bigger scale, and there's huge savings. This is just sort of some added efficiency because, like I said, the trucking routes are going to get easier, you won't need two accountants, one sales rep might be able to sell both to a grocery chain. But these are relatively small efficiencies, and on that basis alone, this deal doesn't make all that much sense.
Shen: So look at the numbers, we take that $600 million in annual synergies, they use that in a calculation -- they have pro forma estimates for adjusted net income for the combined entity that's at $1.8 billion, and earnings per share of $1.27. Those bottom line figures, again, include the synergies, which won't be recognized until 2021, so it's not exactly the most accurate pro forma estimate. But it'll also include the potential impact of new tax rates.
With all that in mind, if we take their pro forma $1.27 in earnings per share and apply the trailing price to earnings multiple that Dr Pepper Snapple was trading at prior to the deal announcement, that was around 21x, then Keurig Dr Pepper share will come in at around $27 per share. And the company will also pay $0.60 a year in dividends. That lets them start with about a 2.2% yield. Just to give you a little bit of idea in terms of the numbers behind the deal.
Moving on from some of the strict financials, I'd like to step back and look a little bit at the management team and operations for the new Keurig Dr Pepper as well. The two companies will continue to operate out of their current locations for the time being.
Kline: Which has been sort of a JAB calling card. It does seem like they often replace the CEO ...
Shen: And other leadership, yeah.
Kline: ... though, even when they do that, like with Panera, Ron Shaich stepped upstairs. The CEO of Dr Pepper is joining the board. They're very light-touch about how they do this, and I think that's strategic. They don't want to change, call it, upper middle management, or everything but the top layers, because they don't want to see employees leave. There's obviously going to be some cuts, that's how those synergy savings happen. But JAB has been very smart, and they take a hands-off approach. And in this case, I don't think you're going to see huge groups of leadership, the vice president level people, leaving. They're just going to work for a new company now.
Shen: So leading the combined entity, from Burlington, Mass., will be Keurig CEO Bob Gamgort and Keurig CFO Ozan Dokmecioglu. Larry Young, as you mentioned, who's the president and CEO of Dr Pepper Snapple, will join the board of directors. The deal is expected to close this summer.
That about does it for the core details behind players involved, the deal itself, the structure of the deal itself. Next up, we're going to look much more closely at what might be driving this merger, and then some of the important risks that I think investors will want to consider looking ahead.
Alright, Dan, we're peeling back some layers now on this deal. I'll first pose this question to you, and that is: Why? Why Dr Pepper Snapple? Do you feel like the hot and cold, soda and coffee combination makes sense?
Kline: If you ignore the fact that it's a public company where only 13% of it is actually going to be traded, you can say, alright, there's some distribution benefit here. Keurig is in every grocery store. Obviously, some of the top Dr Pepper Snapple brands are, but maybe Bai isn't carried. Then, when you look at convenience stores, there's obviously a very strong Dr Pepper Snapple area, where maybe there's some room for Keurig products. There's absolutely a ready-to-drink component here, where you look at some of the Keurig brands and really some more of the JAB brands like Peet's and Caribou, where you could go into a convenience store and compete with Dunkin' Donuts and Starbucks. So there's some small benefits, like in, hey, I know who to call at this company. But I don't see a real reason to do this.
Shen: If I boil that down, you're saying distribution capabilities, more so on the Dr Pepper Snapple side. And Keurig is undoubtedly the leader in terms of that single serve coffee space with the machines and their pods. And in the presentation, they tout having a more established footprint in e-commerce and other less traditional retail partners.
Kline: Keurig is very good at e-commerce. But are you going to buy a Dr Pepper online?
Shen: That what it comes down to. I feel like this is an odd combination in that Dr Pepper Snapple is still dealing with declining popularity of their sodas. They've been late to the game in terms of adopting the more health-focused strategy with their Bai acquisition, for example, when their bigger competitors, Coke and Pepsi, have been on that and spending heavily in that space already for some time now.
Keurig has improved its financial and operational standing in the two years since it's gone private. Management actually shared some details about the progress that they've made since going private under JAB. Pod volume is up 3%, but revenue is down 3%. But in terms of their operations, they've certainly been streamlined. Profitability is up, their operating margin, I think they mentioned, is up 7 percentage points, so pretty significant. But these are not high-growth businesses, as far as I can tell. And I'm curious and struggling to see how they power each other for shareholders.
Kline: Also, it didn't open up any new markets. There's some Dr Pepper strength in Mexico, so maybe Keurig could expand a little bit into there. But, I could see if Keurig bought something that gave it access to Europe, where it has almost zero market share. Same thing with Dr Pepper Snapple, those brands have very little --
Shen: Yeah, they're both very U.S. and North America-focused businesses.
Kline: Yeah. So you look at this, and either the goal of this is just about creating a public company, which gives them more flexibility going forward, or there's another shoe that's eventually going to drop. If you look at what JAB has been doing, this is not a short-term strategy. They didn't accidentally find themselves owning 35 different coffee companies.
Shen: [laughs] Yes.
Kline: They clearly have a long-range vision, and their coffee brands are global. So there might be something else. Maybe Nestle's coffee business. Who knows what it might be. But, there's obviously, or very likely, something else to come. And being public gives them more flexibility when it comes to buying a bigger company.
Shen: And management mentioned that the penetration in the U.S. of the brewers is up 3 percentage points from 17% to 20% in the U.S., and they see the ultimate end target and potential for that penetration level to be much higher, as much as two or even three times higher.
Kline: You know I vehemently disagree with this.
Kline: Keurig is a mature product. There was a point, and I'm sure you remember it, where if a friend got a Keurig, you went to his house, like, it was awesome. Now, everyone has a Keurig. A lot of them are with the Crock-Pot under the counter. I know you and I both have Keurigs, but I have two of them, they're both in cabinets, I never use them, I go out for coffee.
Yes, there's market share to gain. They can go from 20% to 23%, maybe to 25%. Are they really going to go to 40% or 60%? It seems preposterous to me. And those numbers are based on the European market. But the difference is, there are different coffee traditions in different countries. And Keurig introduced the idea of a fussier but also convenient coffee at home here. We've seen Nespresso and Starbucks try to give you a better product, and it hasn't worked, so I just don't see that there's a huge group of Americans to be tapped that still don't know what Keurig is.
Shen: Going back to what you mentioned about the other shoe that you mentioned dropping, I think it's important to distinguish between JAB and Keurig and all of the other separate portfolio companies. They're still distinct entities. While you have this connection as all being part of this conglomerate, it might make some licensing deals easier, might make a collaboration a little bit easier. I think to me, having them work together to drive this growth that I'm sure the company wants to deliver, requires more of a one to one, hand in hand relationship under the same roof and management team. S, I'm curious what that might mean in terms of, for Keurig Dr Pepper and some of the other brands that JAB holds.
Kline: I think, what's been good for Keurig is, well, JAB obviously doesn't force its companies to do much. That if you're Keurig and you go to Peet's and say, "I want us to make a licensing deal," Peet's is not going to be able to say, "Oh, we don't think K-Cups are right for us." So there's that benefit. And there's an industry-established standard of what you pay. There's not a lot of negotiating when it comes to that type of deal. So I do think there's a sort of open cupboard for Keurig, which gives them some business protection.
If Starbucks and Dunkin' Donuts don't want to sell K-Cups, they don't have to. But there's a lot of brands that can still keep Keurig interesting, which is definitely something that's hurt their competitors. If you own a Starbucks Verismo, all there is is the eight different Starbucks pods. Whereas, if you own a Keurig, between licensed and unlicensed, there's hundreds in every grocery store. Owning all those brands under the same corporate entity gives them that protection. But you're right. It's not like Dr Pepper can, without working with Peet's, make a deal for a Peet's ready-to-drink beverage to go into 7-Eleven.
Shen: Alright. Our last couple of points that I want to wrap up with. The fact that Keurig basically going public again through Dr Pepper Snapple will also allow JAB and its partners to harvest their two-year-old investment in Keurig a little bit more easily. On the flip side, I also think it will ultimately give the combined entity, Keurig Dr Pepper, more flexibility to pursue these potential future deals and other acquisitions. That's definitely not something we can rule out, given the way JAB operates with their shopping spree in the past several years.
Closing points. If you end up a Keurig Dr Pepper shareholder, Dan, what are you the most worried about? I've seen some people bring up the $17 billion of debt that there's supposed to be post-deal. Management says they'll be reducing that debt load in several years thanks to the company's strong cash flows. But that's definitely a risk nonetheless. But is there anything that's keeping you up at night?
Kline: Yeah. I worry -- and we've talked about this with other companies. We talked about it with Sprint and CBS and Viacom. I worry when a public company is mostly controlled by a private entity. There are only two independent board seats on a seven or eight person board for the new company. So you, as a shareholder -- and you have to remember this -- you are not going to be the primary interest of this company. Now, your interests may align with JAB's and their shareholders, and I expect that they will most of the time. But if there is something that provides short-term, better liquidity or a score or whatever it is for the company that owns most of it, and you have to sacrifice shareholders to do that, with only 13% of the company in shareholders' hands, that doesn't give me a lot of confidence.
Shen: Yeah. I think, you already have the integration risk and challenges that you would expect from bringing any companies like this together, especially pretty different ones here. But in this situation specifically, investors do have to remember what you mentioned, Dan, in terms of the differing incentives and other factors cooking beneath the surface between Keurig, JAB, its many, many portfolio companies, and the relationship between all of them. And again, remember, public ownership, 13% of the company. JAB and its partners, including Mondelez, 87% ownership.
Kline: And there's just one other thing that worries me. On one hand, it's great that JAB buys a company like Panera that's very well run and helps it focus, gives it some resources. But the fact that they have not gone to Panera and said, "Hey, by the way, we own Peet's and Caribou and you don't have a branded coffee service, can we integrate this into your brand?" It does concern me that, maybe there's some big strategy that's going to happen all at once, but the fact that they're not going in and saying, "You have to do these things," or exploring what the synergies between their various owned products are, it concerns me that there's a lot they could do with this new combined Keurig Dr Pepper that maybe they won't.
Shen: OK. So the deal, again, is expected to close this summer, barring any issues with regulatory approval. We don't foresee any of those, given that they're very different businesses, Keurig and Dr Pepper Snapple.
Kline: And also, the total revenue is about what Coca-Cola does in a quarter, so there really aren't any antitrust concerns here.
Shen: So Dan and I will be bringing you updates on this deal as they come. Dan, thanks a lot for coming into HQ today!
Kline: Thanks for having me!
Shen: Thanks for tuning in! Austin Morgan is the producer for Industry Focus. People on the program they own companies discussed on the show, and The Motley Fool may have formal recommendations for or against any stocks mentioned, so don't buy or sell anything based solely on what you hear during the program. Thanks again for listening. Fool on!