Keurig Dr Pepper (NYSE:DPS) has said it will save $600 million when it fully integrates. So far, it has reached a third of that and it may be challenged due to its structure. The company has, however, been very aggressive in paying down its debt -- about $16 billion on its balance sheet. That led to a $178 million interest charge in the most recent quarter -- approximately one-third of its operating profit for the period.
In this segment from Industry Focus: Consumer Goods, host Vincent Shen and Fool.com contributor Daniel Kline discuss some of the challenges facing the beverage specialist.
A full transcript follows the video.
This video was recorded on Dec. 11, 2018.
Vincent 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?
Dan 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 6X. That's a super high mark for any company. Management has said that they want to bring that down to about 3X 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. Asit 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 22X, as well. A little higher than Pepsi at 19X. 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.