In this week's episode of Industry Focus: Consumer Goods, host Vincent Shen and Motley Fool contributor Dan Kline look at how the company's fared in the last few months on the market. Was crossing the soda and coffee streams the right move? What segments are growing the most? What competitive threats does KDP have to front up against? And can it really possibly stand off to Coke and Pepsi? On the other hand, how could this distant No. 3 position in the market actually be an advantage for KDP? What risks and trends should investors watch in the next few quarters? Find out more below.
A full transcript follows the video.
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This video was recorded on Dec. 11, 2018.
Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. I'm your host, Vincent Shen. Joining me today via Skype from Orlando, Florida, is Motley Fool contributor Dan Kline. Dan, great to have you back! How are you?
Dan Kline: Hey, Vince! How are you holding up?
Shen: I'm holding up OK. Long day so far. I'm glad you could come on and record one last show with me.
Kline: It's always a pleasure!
Shen: Listeners, my time with the Industry Focus team will end with next week's show. I think I finally got my tears under enough control to dig into Keurig Dr. Pepper, ticker KDP. Keurig Green Mountain and Dr. Pepper Snapple announced in early 2018 that they'd be joining forces. Another huge deal for JAB Holdings, which is pulling all the strings with its control of Keurig, which it acquired in 2016, not to mention the many other businesses that it has purchased over the years, like Peet's Coffee, Caribou Coffee, and bigger chains like Krispy Kreme, Panera Bread, and Au Bon Pain. In fact, since the Keurig Dr. Pepper deal announcement, the company's already scooped up Big Red, a smaller soft drink brand, and Core Nutrition, a premium water company. That was over a $500 million deal.
I remember at the time of this deal announcement, Dan, we were a little puzzled by the decision for these two companies to come together. You're bringing a non-coffee beverage company into the fold. But Keurig Dr. Pepper is now the third largest beverage company in North America. There is some strength, I think, in the safety of having that sort of scale. Bring us up to speed, Dan. If you had to get to some of the core strengths, what's jumped out to you about this combined entity so far? What is it?
Kline: I think it's become pretty clear in the beverage space that moving away from soda is very important. But beyond that, you want to diversify. We did a show a few months back about Coke-Costa, which is a coffee company deal, which was a $5 billion transaction. It's becoming, if you're building all these channels, whether it's retail distribution, stores, restaurants, the more things you could pump into that, the better. So, while Keurig, which is largely a home-based, brand doesn't seem to fit, it is sold in stores, there is a commercial platform for it, so it becomes this, we don't know where American tastes are going to go. It might swing back to soda. Canada Dry had a really good quarter. It might swing away from water, because people might realize they're paying a lot of money for water, which they have in their house for free. [laughs] So, this is a company that covers a lot more bases.
And, while it's still only No. 3, and a relatively distant No. 3, it does give it a little more marketing oomph when it comes to shelf space or the ability to talk to some of these partners. You're not going to start seeing major restaurant chains switching over to the Keurig Dr. Pepper soda and coffee platform, but at least you will see some retail shelf space in convenience stores. It gives the company a lot more power to negotiate there.
Shen: Sure. To remind listeners and give you an idea of the scale of this brand portfolio that the company has at its fingertips, of course, there's Keurig, the coffee side of the business. In the name, Dr. Pepper. But also, the company has names like Canada Dry, Snapple, Bai Brands, an acquisition they made shortly before they announced this merger. Entering the healthier beverage space, a lot of these companies are trying to do that.
In total, between owned and partnered names, the company has over 125 brands at its disposal. It makes for a pretty, I think, formidable enterprise. Keurig Dr. Pepper actually reported its first quarter of results as a combined entity. Dan, what do you think? Are we seeing some of the promised synergies or other deal benefits materialize?
Kline: It's very early. But the good news is, we've seen a lot of these mergers. It's very hard to pull off a merger without having some sort of disruption. We tend to see it worse when it's a technology merger. Frontier Communications, if you remember, a couple of years ago, was a disaster. But here, they've maintained their supply lines, and they're on track to save $600 million over about three years. That'll be an annual savings, and it'll come in at about $200 million each year before they get to the total $600 million. It really is a so far, so good integration.
I think the company has to figure out what it's going to be. It's ended some relationships, it's added Evian Water, which is a known brand which gives it a premium water play in the market. This company, which will be about an $11 billion company, becomes a very attractive partner play. It doesn't have everything. If you're going to partner with Coke, Coke might have three brands. If you're going to partner with Pepsi, Pepsi might have the same thing, they might have two, three, four brands competing in your space. Keurig Dr. Pepper has a little bit simpler of a portfolio. There are some holes in it. There's really some room to bring in some other things and to grow what they do.
Shen: Yeah. To give listeners an idea of some of the headline numbers and performance from this combined report revenue -- oh, I should add, all these figures I'm about to use are pro forma, adjusted essentially so it's an apples-to-apples comparison for this quarter where it's a combined entity to the prior year as if it were a combined entity at that time.
Revenue up 2.9% to $2.9 billion over those pro forma prior-year figures. Again, in terms of annual revenue, as Dan mentioned, it's amounting to be about a $11 billion business. Net income up 19% year over year to $301 million. The way the company reports for its business, it breaks it down into four segments. In descending order by revenue, we have Packaged Beverages, Coffee Systems, Beverage Concentrates, and then Latin America Beverages. Package Beverages is the core business where the company's producing and distributing its own drinks, some third-party brands. Coffee Systems is that legacy Keurig Green Mountain business. Beverage Concentrates is when they're selling these concentrates to bottlers and fountain customers. And then, the last one, obviously, their beverage business focus in Latin America.
The two biggest segments are Packaged Beverages and the Coffee Systems. Together, they make up over 80% of the company's top line and, I think, drive a lot of the story for the company. Any updates specific to those two segments, Dan, that you want to highlight?
Kline: One thing I thought was really interesting -- you and I used to cover Keurig when it was a publicly traded company. We'd look at the K-cup sales as an indicator of where the company was going. There was a lot of thought that Keurig had plateaued, and that because of some of the environmental backlash, there was going to be a slowdown. And we see here that K-cup sales are actually up 3% year over year in the quarter. Brewer sales, which stunned me, were up 8%. And that's on the strength of the company launching two new, more functional, they make lattes, cappuccinos, without having to use a different pod. The company has struggled with that, go from the basic cup of coffee to go to the full latte/cappuccino. If you remember, the Vue struggled. Now, they have a system where you don't have to buy anything special, you just have to add milk, and it will make you those products. And consumers are really liking it.
They also had success with a revised version of their Mini. I'm looking over my Keurig Mini just off-camera here. The new one is much sleeker, it takes up a lot less shelf space. Consumers have bought, which, I have to be honest, surprises me, because I've never particularly cared for the cup of coffee a Keurig makes.
Shen: I will say, that 8% growth, especially for the volume in brewers, that's a nice longer-term signal, where they're growing that installed base of devices. And ultimately, that's what they want. Once that device is in your home, there exists the potential for them to create that more sustainable recurring revenue with the pods.
Something with the pods that they've changed is the way they view pricing. I think in the beginning, they realized that what they called a barrier to entry for consumers to their whole Keurig system is the price of the pods being expensive, them having to deal with lower-price competitors, getting some public backlash from trying to lock out people using these third-party pods. But now, they're approaching it from the view that they have to lower their prices, make it more competitive, and this recurring revenue will speak for itself.
Kline: I think it's a case where they've proven that this is how Americans make coffee, for the most part. It's a convenience over quality model. You're certainly going to get the people like me, who are going to sit there and do pour-over cups, or French presses, or who knows what $400 brewer you might have. But for the average office, the average person, this is the standard. The other thing that staying part of this JAB Holdings family is, is you're starting to see a couple of more partnerships within that family. The ability to roll in all those different coffee brands --Douwe Egberts and Caribou and I can't even list all of them, Peet's is one. You have this in your home, and now, JAB, Dr. Pepper, they can make all of these new deals to keep it interesting. Tim Hortons is one they just partnered with, and that's the biggest coffee brand in Canada. So, being able to have that as your flagship for that market should continue to push sales.
Shen: Something that you mentioned, I think it's part of their Packaged Beverages business, this increase in the number of partnerships and some success they're seeing with some of the brands that are key parts of their portfolio, you could call it a more organic innovation with Canada Dry, for example, seeing some real success in terms of the volumes and the growth for that brand.
With the partnerships, how do you think this plays out longer-term, in terms of how Keurig will ultimately be able to gain on its bigger two competitors?
Kline: Here's the thing. It is a challenging space. I mentioned to you before we started taping that almost the second the Peet's distribution deal was announced, I started seeing Peet's products in my grocery stores, in convenience stores in my area. So, the good news is, because you cannot as a grocery store chain say, "I'm not going to carry K-cups," or, "I'm only going to carry third-party K-cups." You simply have to have a pretty good selection, like a quarter of an aisle, devoted to just a wall of K-cups. That gives Keurig Dr. Pepper leverage into saying "Hey, we're already here. Can we have some shelf space for this?"
The challenge is that the companies they're going against, Coke and Pepsi, are absolute masters in the shelf space game. They will put money into it. They will put resources, people into making sure that they continue to have the best space. That's a financial challenge for Keurig Dr. Pepper, to make sure these Peet's beverages don't get the back shelf compared to whatever Coke is distributing, the Costa brand, and various other products.
Shen: Yeah, especially with the leader here, Coca-Cola, starting to really make its move into coffee with that big deal that you've mentioned.
Something else I wanted to talk about, in terms of these different reporting segments, how they break down for the business, is with their profitability and contribution to the bottom line. Interestingly, Coffee Systems and Beverage Concentrates actually lead the way when it comes to profitability. Concentrates have a 61% operating margin, Coffee Systems 32%. Packaged Beverages might bring in the most revenue. For this quarter, I think was about $1.3 billion out of the $2.9 billion. But the operating margin there, just 5%. That's something to keep in mind. I think this is just the nature, with the high margin behind producing and selling these concentrates, and the same thing on the coffee side, the high margins they can enjoy with these single-serve coffee products from Keurig and how that contributes to the profits.
Kline: Yeah, and selling concentrates isn't a sexy business. It's nothing we ever talked about with Coke or Pepsi. But it's very much like being a fully franchised restaurant model. There's very little risk involved. If the soda market declines by 10%, yes, they'll sell 10% less concentrate, but they're not going to have huge amounts of inventory tied up, they're not going to have the systemic problems that their bottlers might have if they lose 10% of their volume. It's very much a pure profit market and a sensible place. That's why you've seen Coke and Pepsi sell bottlers back, and no longer own control of some of that stuff.
Shen: Yep. Let's get a little bit into the more bearish view of the company, in terms of what might hang up this integration, the combined entity. For example, you mentioned earlier that management said they're on track to recognize $200 million of synergies annually over the next three years for a total of $600 million. I feel like that's the kind of promise that we see often with these big deals. Sometimes they materialize, sometimes they don't. Is there anything that worries you, in terms of the company achieving those targets?
Kline: The only thing that worries me is, it sounds like a low number. Some of the companies we've talked about have projected billions in synergy savings. But these aren't inventory, manufacturing-rich companies. You don't need two accountants, you can get rid of one secretary here and an office space there. But those do seem like pretty high numbers, given the overall size of the company and its operations, we were talking about concentrates a second ago. I don't know what the headcount is in that division, but my guess is there's not a lot of room to cut, even as you bring things together.
That said, the company has been very aggressive about paying down its debt. It paid off $550 million in debt in this quarter. That's going to bring down savings in another way, because their interest costs were a couple of hundred million dollars through nine months. I think $221 if I'm somewhere in the ballpark there. So, you might not see the full $600 million, but I do think you will see a steady step down of expenses.
Shen: Yeah. I'm glad you brought up the debt, that was actually the other big red flag for me. Keurig Dr. Pepper has about $16 billion of debt on its balance sheet. Something to consider is that interest expense during the third quarter was $178 million. That's good for about a third of total operating income in that period. You mentioned $550 million of debt being paid off since the merger closed. They're still at $16 billion, which is a pretty big figure. A common metric for considering a debt load is debt to EBITDA -- that's earnings before interest, taxes, depreciation, and amortization. That figure is at 6 times. That's a super high mark for any company. Management has said that they want to bring that down to about 3 times over the next two to three years. But I think that's a pretty tough thing to achieve, given that the company generated about $1.7 billion of free cash flow in the trailing-12-month period. So, there's going to be a lot of strong execution necessary for them to get to the point that they're targeting.
Kline: It is an aggressive target. Also, because you're backed by JAB, there's some cushion there. This was a way for JAB to sort of backdoor take care of Keurig and make it public again without having to do an IPO. This frees up some ability for them to have capital back in the coffers, but if there's a bad quarter, it's not like there isn't money to be had or money that can be pumped into this. But, I agree with you, it's a very aggressive paydown plan.
Shen: Wrapping up, some final thoughts. [Fool.com contributor] Asit [Sharma] and I talked a couple of weeks ago about the idea of certain names in the consumer and retail sector as defensive plays in weaker markets, the consumer staples idea. I'm curious, do you think a Keurig Dr. Pepper can play that role? People still want their coffee, people still have their soft drinks and other products that this company offers, even in tougher markets or a tougher economy.
Kline: Here's the thing. I love the Keurig part of the business. It's held up long enough. Nobody else is going to come in with a coffee pod system that replaces it. This is the Mr. Coffee for single cup. That's not going away. It's not going to change in 20 years. That part of the business isn't vulnerable to what Coke does, to what Pepsi does, to what Starbucks does. I mean, we saw, the Verismo, which is the Starbucks take on this -- and I'm also looking over at my Verismo -- it barely dented the market. It is a tiny, tiny shareholder. I want to say, last time we knew this number, Keurig had something like 80% of the U.S. market. Not as much globally. Room to expand, absolutely, there.
The part of the business I don't like as much is the soda water, the part that directly competes with Coke and Pepsi. Yeah, Canada Dry is a nice, niche winner. That's probably the top soda brand. Dr. Pepper is the top for whatever flavor soda you'd call that.
Shen: The non-cola category.
Kline: Non-cola brown sodas. [laughs] But, the reality is, most of the top-tier brands are owned by Coke and Pepsi. Coke and Pepsi absolutely have the ability to freeze Keurig Dr. Pepper out of certain markets or make them a very minor player. We've talked about earlier in the show, you don't want to be on Coke's radar. And this takes a company that was sort of a nuisance and maybe makes them a real threat. That could be dangerous.
Shen: Last point that I'll make is, given some of those growth numbers that we mentioned, 3% on the top line, double digits for the company in terms of their net income, their earnings growth, the current valuation I'm seeing for Keurig Dr. Pepper on a forward earnings basis is about 22X. That's in line with the S&P 500, but also in line with Coca-Cola, right around 22 times, as well. A little higher than Pepsi at 19 times. Given some of those growth figures, I'm definitely in a wait-and-see position in terms of this integration. I'd love to see another few quarters of reports for this combined entity. Where do you stand, Dan?
Kline: I feel the same way. I like the coffee business, but for me, the fact that I don't like the coffee actually weighs in pretty heavily. I always wonder when that's going to catch up. We've talked about this with the pizza brands. When are consumers going to go like "Hey, this pizza I can get really quickly isn't very good, and there's a pizza place around the corner that is pretty good?" I do worry about that.
I want to see if they can be resilient in the soda brands. If there really is room in the market for three players, and maybe there is, can they revitalize Snapple, which was once an important brand? It was once part of the name of the company, and now it's very much an afterthought. I'm going to follow it, but I wouldn't be buying it right now.
Shen: Thanks, Dan! It has been a pleasure! I will miss hosting you here on the show!
Kline: Vince, I'm trying not to cry! This has been one of the better experiences of my professional life! I wish you luck in the next chapter, and I'm looking forward to hearing all about it.
Shen: Thanks, Dan! Thank you, Fools, for tuning in! People on the program may 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. Fool on!