Keurig Dr Pepper: Growth is expected to accelerate in the coming quarters

Summary

I’m convinced of the Keurig Dr Pepper (NASDAQ:KDP). My summary thesis is that I think growth will improve from here because there are several drivers of growth. In particular, increasing partnership benefits and product innovation in the US beverage segment and the value strategy in the coffee segment.

Company overview

KDP produces non-alcoholic beverages (NABs) for the global market, with 88% of revenue coming from the US and the rest from international markets. KDP has some key brands under it and the most popular ones are Dr Pepper, 7 Up, Schweppes, Sunkist and many more which you can find here. Notably, KDP also has a US coffee segment that sells single brewers and specialty coffees in the US and Canada. This segment accounts for ~27% of FY23 sales. KDP’s key competitive advantage comes from well-known brands that has in the portfolio. While the drink can be replicated by peers (if they can reverse engineer it), the power lies in the brand that consumers recognize, and that is hard to replicate (think of the Coca-Cola brand).

Growth should see improvements going forward

There are several growth drivers that should help KDP improve its growth from low single digits to mid to high single digits in the coming quarters. First of all,

First, KDP will experience a comparable base of lighter growth in 2H24, where organic sales growth (OSG) was 8.9% in 1Q23 and 6.1% in 2Q23 versus 4.1% in 3Q23 and 1.1% in 4Q23. Assuming the same two-year stack growth from 1H24 (~11%), this means 1-year 2H24 growth will be ~8%, a massive acceleration from 1H24’s ~3% growth. Second, I expect the US soft drinks segment to experience accelerated growth given the strong lineup of product innovations that have seen positive demand growth since launch. Additionally, this segment should start reaping more benefits from new strategic partnerships as they are expected to intensify in 2H24. To give an idea of ​​the opportunity in these partnerships, a good example is KDP’s C4 partnership, which continued to experience strong growth (C4 retail sales up 30% y/y in 2Q24) despite the decline in demand seen in category of energy drinks (according to the comments of the Monster Beverage management). Importantly, C4 only has about 3% market share in the energy drink category, suggesting significant growth ahead. I also highlight the potential to improve the existing portfolio, which KDP has been actively pursuing. Some examples include the CORE Hydration partnership and Mott’s back-to-school programming.

Mentioned in the 2Q24 earnings call: Our innovation increased significantly in the second quarter, and as expected, these new products are enjoying good market traction. In US soft drinks, Dr Pepper Creamy Coconut is now our most successful limited-time offer.

Our new products are resonating in the market, as evidenced by improved rating trends for brands such as Dr Pepper and Canada Dry. Mentioned in 2Q24 earnings call

Mentioned in MNST 2Q24 earnings call: The energy drink category in the United States and certain other countries saw lower growth rates in the second quarter.

Finally, the segment dragging down KDP’s growth – US coffee – finally has a visible catalyst that led me to believe that growth could recover. Just to recap, US pod volume growth in 2Q24 posted its third consecutive quarter of improvement (from -8.1% in 3Q23 to -2.7% in 4Q23 to -1.1% in 1Q24 and 0, 2% in 2Q24). This suggests that recent innovation and marketing strategies are working to capture demand from value brewers. I would expect management to push this strategy to generate a higher volume recovery. Even if volume growth and negative price growth are net of each other, leading to 0% growth, this is still good enough in the short term, given that it is no longer a drag on overall growth (i.e. , does not drag down the positive growth prospects in the beverage segment).

Positive outlook for profitability as well

Accelerating growth should translate directly into margin expansion. So far, KDP has demonstrated strong execution in improving margins. Specifically, it reported five consecutive quarters of gross margin and three consecutive quarters of Y/Y EBIT margin expansion. Given that this has been achieved with slower sales growthimplies that KDP has succeeded in driving cost optimization. This is particularly impressive given that KDP is investing heavily in pricing and marketing in the US coffee segment.

Looking ahead, I see the potential for KDP to further expand its margins. First, improved volume growth should result in operating leverage. Second, lower inflation and a generally softer consumer spending environment should lead to commodity price deflation. Finally, I expect more productivity gains as management remains focused on improving supply chain optimization, digital capabilities and shared services.

ASSESSMENT

I think KDP is worth 13% more than the current share price. My price target is based on net income of ~$3.2B and a forward PE multiple of 20x.

Earnings bridge: Growth should accelerate from 1H24 ~3% to mid-single digits in FY24, resulting in FY24 mixed growth of 4%. From here, growth should continue to improve as the economy gradually improves, KDP reaps the full benefits of growing its partnerships, and there is a recovery in sales in the coffee segment. As mentioned above, margins should improve and I expect KDP to recover margins to their previous peak of 18% over the next couple of years.

Valuation Rationale: Historically, KDP has traded on a very tight valuation curve of 18 to 21x forward PE. Since my outlook for KDP is for a return to high single-digit growth and a previous peak margin, I think the stock should trade at least back to 20x forward earnings.

Investment risk

Consumers becoming more health conscious is an inherent risk for KDP. If this health-conscious trend becomes a bigger thing, it could hurt KDP’s long-term sales growth as consumers cut back on “sugary drinks.” Another risk would include an economic slowdown. I would classify KDP products as discretionary, and in bad times, consumers reduce discretionary spending. As such, higher rates for longer interest rates will put more pressure on consumers, which could affect KDP sales.

New product launches may not meet consumer preferences. This would be a major headwind as KDP may need to implement a promotional strategy to clear inventory, which will affect gross margins.

Conclusion

My positive view on KDP is due to the potential acceleration of future growth. There are several reasons why I believe, including a favorable comparable basis in 2H24, intensifying strategic partnerships, product innovation and continued margin expansion efforts. As my thesis plays out, KDP should see its valuation multiple revalued back to 20x forward earnings – in line with the historical average.