Newly minted beverage giant Keurig Dr Pepper (KDP +0.00%) issued its first earnings report following the merger of Dr Pepper Snapple Group and Keurig Green Mountain in July 2018. The business combination created the third-largest beverage company in North America, with projected annual revenue of $11 billion. Let's dig into the third-quarter 2018 filing, released Nov. 7, to get a sense of how the combined operation has initially fared. Note that all comparative numbers in this article are drawn from the company's adjusted pro forma schedules. In other words, prior-year results of Dr Pepper Snapple Group and Keurig Green Mountain have been combined, with certain adjustments, to facilitate an apples-to-apples comparison with current earnings.
Keurig Dr Pepper: The raw numbers
| Metric | Q3 2018 | Q3 2017 | Growth (YOY) |
|---|---|---|---|
| Revenue | $2.86 billion | $2.78 billion | 2.9% |
| Net income | $301 million | $253 million | 19% |
| Diluted EPS | $0.21 | $0.18 | 16.7% |
Data source: Keurig Dr Pepper. EPS = earnings per share.
What happened with Keurig Dr Pepper this quarter?
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The company's revenue growth was propelled by a 3.6% improvement in volume and product mix, which was offset by slightly lower price realization of 0.2%, and 0.5% of negative foreign currency translation.
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The combined organization operates in four segments: beverage concentrates, packaged beverages, Latin America beverages, and coffee systems.
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In packaged beverages, Keurig Dr Pepper's largest business, year-over-year revenue increased 4.9% to $1.3 billion. The advance was due to higher owned and contracted manufacturing volume for the Canada Dry, BODYARMOR, Core, and Bai brands. Segment operating income dipped by 16% to $164 million, which the company attributed to input cost and logistics inflation not yet covered by pricing increases, as well as investments in new sales, delivery, and merchandising personnel.
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The concentrates business expanded revenue by 3.1% to $331 million, primarily on the strength of price increases in the Dr Pepper and A&W labels, partially offset by the Sunkist brand. Operating income of $204 million was flat against the prior-year period.
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The Latin America beverage business notched a modest 2.3% advance in revenue versus the third quarter of 2017, to $136 million. Higher pricing of nearly nine percentage points was offset by negative foreign currency translation of 5.8% and lower volume and mix of 0.6%. Operating income soared 145% due to a favorable comparison with the prior-year quarter, in which the division took a writedown of prepaid resin inventory.
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In Keurig Dr Pepper's second-largest segment, coffee systems, revenue grew 0.4% year over year to $1.05 billion, as higher volume and mix of 2.5% was almost completely negated by lower price realization, including a strategic pricing investment in Keurig coffee pods. Operating income jumped 22% as productivity improvements and the timing of marketing spending offset inflationary pressures.
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Total company adjusted operating income increased 14.3% to $697 million against the comparable quarter.
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During the last three months, the company entered into an agreement to purchase bottled water manufacturer Core Nutrition LLC for $525 million. Keurig Dr Pepper also acquired one of its customers during the period, regional soft drink brand Big Red.
Image source: Keurig Dr Pepper
Management's perspective
In the company's earnings press release, CEO Bob Gamgort praised Keurig Dr Pepper's healthy initial results and alluded to one of the organization's longer-term drags on earnings -- its heavy debt load:
We're off to a great start as a combined company. Our new organization is working well and delivered a strong quarter, with both top- and bottom-line growth and market share strength across our major categories. We also repaid approximately $550 million of debt since the merger close. We remain confident in our outlook for 2018 and the long-term value creation framework we shared at the time of the announcement of the merger.
Keurig Dr Pepper has roughly $16 billion of borrowings on its books, which obligates the company for significant debt service: Interest expense in the third quarter of $178 million equaled nearly one-third of the operating income the company generated during the period. Management intends to bring the organization's debt-to-EBITDA ratio, which I calculate at roughly six times (i.e. debt is six times annual EBITDA), down to a more manageable leverage ratio of three times within a time frame of two to three years.
Looking forward
In its third-quarter release, Keurig Dr Pepper maintained the initial full-year adjusted diluted earnings per share (EPS) target it shared with investors premerger of $1.02 to $1.07. In addition, management believes the organization will realize more than $600 million in merger synergies between 2019 and 2021, at a rate of roughly $200 million per year. Achieving these cost savings and reducing interest expense should provide significant near-term earnings leverage for the company if it can maintain its moderately improving top line going forward.
