Half Moon Capital's Eric DeLamarter and Brandon Carnovale thesis on Keurig Dr Pepper $KDP (podcast #185)

The team from Half Moon Capital, Eric DeLamarter and Brandon Carnovale, come back on the pod to discuss their thesis on Keurig Dr Pepper Inc. (NASDAQ: KDP). For more on their KDP thesis, see their initial thesis from July and their post-earnings August update. You can also see their first appearance (on OXM) here.

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Transcript begins below

Andrew Walker: Hello and welcome to Yet Another Value Podcast. I'm your host Andrew Walker. If you like this podcast, it would mean a lot if you could rate, subscribe, review wherever you're watching or listening to it. With me today, I'm happy to have on for the second time from the team at Half Moon, Brandon and Eric. Guys, how's it going?

Brandon: Good morning. How're you doing?

Andrew: Doing great. I'm laughing because for those on the video you can see Brandon just opened up the Dr. Pepper. I'll join him. I've got my diet Dr. Pepper cream soda, but before we start talking Dr. Pepper, just quick disclaimer, nothing on this podcast is ever financial advice. Please consult advisor. We're not providing financial advice, all of that type of stuff. Eric, Brandon, I was telling you guys before, I'm so excited to have you guys on because we're going to talk about Keurig, Dr. Pepper, the tickers[?] KDP.

You guys have a really interesting thesis. You've done really great work there, but I'm also personally excited because Dr. Pepper's been my favorite drink for 20 years. I was telling you guys, I used to have Dr. Pepper pajamas. I treat myself to a diet Dr. Pepper, strawberries and cream, so I'm hitting the new stuff every night with dinner and I'm really excited because we're taping at 10:30 and I could treat myself to a diet Dr. Pepper at 10:30, so what's better? But Eric, y'all have done great work. I think you want to start by framing it. What's the thesis behind KDP right now?

Eric: Yeah, quickly just kind of conceptualize what the business is, so it's about 60% of business is the CSD, the beverage segment that's anchored by Dr. Pepper. They also have 7 Up, Schweppes and Canada Dry, which have pretty dominant share in those subcategories. Across that segment, CSD segment, it's about 25% US share. They've been growing share up nationally and raising prices, but we're only really now starting to see an inflection in terms of catching up with those margin headwinds, and the kind of overall growth trajectory has been low teens, and those tailwinds I think are just beginning to manifest on that side of the business.

The other side is the carrot business, that's the home brew kits and pods. That's about 30% of sales, about 34-ish percent of earnings. This has been the real area of kind of focus for the market, maybe fixation by the sell side to a certain degree buy side, and that's been a result of soft home brew appliance sales in Q-1 on what were really tough comps and also the bed bath destocking liquidation. That's kind of now behind them. Historically I think people looked at this as like that's a big driver of the business. Reality is the actual appliance is negligible, if any margin to them.

The K-Cups themselves are where they make all the money, and their strategy there on the K-Cups has been gain market share of the home brew segment, and don't raise prices. However, recently they raised the price, the first we've seen in 5 years, other than 1 maybe in 2022, which I don't think has been noticed by the market. Meanwhile, there's been inflection across that the K-Cups and the home brew appliances themselves, in Q-2, but also in the tracking data that we have so far in July, so heading towards the nice back half.

In addition, some of the cost inputs, input costs have been moderating, which are further tailwinds to that side of the business. There's been a little bit of technical overhang selling pressure from Mondelez legacy shareholder, and as well JAB. Mondelez is now fully out as of July, early July. JAB has sold down what they had said they desired to ending in June and they have stated no intent to continue selling for the time being. Meanwhile, the stock trades at historically wide margin the Pepsi code.

We believe for some of those factors we mentioned that the fixation on the coffee side and a lack of appreciation for the underlying drivers in business, the upside to it, which we think will manifest itself over the next several quarters. We think it's worth $50, about 50% upside given its trajectory. Kind of the turn and sentiment, it is kind of beginning to take hold following a solid Q-2 and what looks like a solid back half.

Andrew: Brandon, did you want to add anything to... I think Eric did a nice job with the overview, but did you want to add anything to that?

Brandon: No, I think Eric touched on the overview and maybe like the setup there. I think they're at a really interesting inflection point here, so looking forward to diving into it.

Andrew: Cool. I guess let's just start with the fundamental driver, so I think y'all did a nice job, but you've got the Dr. Pepper, the US beverage side, that's about 50, I think it's a little bit more than 50, I guess it depends how corporate goes, but a little bit more than 50% of the earnings are there. You've got the international side, which is about 10% of the earnings, and then you've got the Keurig, the US coffee side, which it's actually a little bit under 40%.

I think those roughly are right, so Keurig, you've got this great razor razor blade model and I think as you said, they haven't taken pricing, but every time I flip through a sell side report or anything, I think there's a lot of debates over, hey, how much of Keurig has been like affected by work from home versus going to the office. There's all these debates on different cost code trends, so what do you think the market's kind of missing on the coffee side?

Brandon: Sure. I can hop in in there if you want and you can follow up, but yeah, so it was really interesting into the print, we like to track the K-Cup prices on a weekly basis, and we noticed they had actually raised prices on K-Cups, and that's really interesting in this scenario because historically they've been in the position to only lower prices, they want to get mass appeal, so it is kind of been just in the last couple weeks, a big shift in strategy where they're no longer prioritizing necessarily just volumes as much as they are market share, so we think that's really starting to change the narrative.

Just in the last, you want to look at like 2 years, the commodity cost of coffee has doubled. They haven't really passed that on.
Now we're starting to get easing input cost inflation and pricing going up, and as you mentioned some of the mobility people are working from home, drinking lots of coffee, now they're going to the office, they're going to Starbucks. They believe that headwinds going to be over by post Labor Day, so Q-3, we're going to be fully normalized, easier comparisons, and that's why we think this like 2H inflection point is really interesting just because the coffee business has, you kind of cycled up big then it cycled back down and now we're starting to get more to a normalized run rate.

I think the way we like to frame it is if you look at 2019 today, everything's grown brewers, K-Cups mid single digits, so I think people may be panic when they see one quarter of soft brewer sales, but realistically it's on the right trajectory and taking market share in fact.

Andrew: I think on the Q-2 call, the CEO said something along the line, he was like, "Look, we have 80% of the pod market and if you believe that the trends are from people brewing whole pots of coffee to people brewing kind of by the cup, by the pod, then we have 80% of that market, and ultimately like we are going to be a growth market and we're going to be a growth because we're going to benefit from that growth." Do you guys think that's the right way to look at it? Or are those trends kind of stopping or reversing?

Eric: Yeah. From a value and proposition, I mean, coffee prices have been increasing, so people have brew at home, a whole pot, a pot cup. That's been, while cakes have been kind of flat in pricing, those prices have been going up, and then not to mention Starbucks prices have been increasing substantially, and also people are brewing and using K-Cups care platform in their office as well, so I think that is a offset. Maybe they have their first cup of coffee at home with their K-Cup, maybe have another one on the way, and it's something obviously people have every day. It's a ritual and have maybe multiple times a day, so I think that's adoption base is increasing and that is driving it.

Andrew: Just on coffee, and this will come into play when we talk multiple stuff, but I think I've seen things that Gen Z tends to drink less coffee than millennials, and obviously there's a little bit of an age thing and I think millennials might drink a little less coffee than the people before them. There is some age to it. You're more likely to drink coffee at 30 than 20 and 40 than 30, but is there trends like, look, we've got energy drinks now tea, all sorts of other things. Not that it's a dead market, but are there going to be maybe medium term headwinds as this kind of demographics play out?

Eric: Yeah, Brandon, you know that. Yeah, go ahead.

Brandon: Yeah, so I mean it's kind of interesting, we looked at some of the industry data from the Coffee Association in the United States, which is really fun, so they kind of view themselves as the original energy drink coffee, so that's kind of like their viewpoint, and I think they did some analysis and I believe they found, I think it's 86% of US adults drink coffee, and that actually in their survey data actually ranked higher than tap water.

Andrew: No way. Really?

Brandon: Yeah, so it's 60% of Americans had a cup of coffee in the past day, more than any other beverage, more than soda, tap water was 47%. Yeah they say coffee's here to stay.

Andrew: That holds up over age because you just said Americans, that holds up over like younger people. Okay. Okay, cool. Yeah, and then just turning over, and I just want to do it because look, these are great businesses and I want to just give some people some ideas of trends because they're good businesses, but especially on the US beverage side, I do agree they're taking trends. This will come to valuation, but let's talk about US beverage, they've released Dr. Pepper Zero. They've released some Dr. Pepper's Strawberry and Cream Zero, which I'm holding up for people who are watching the YouTube.

They've done a partnership with C4. Basically, I guess what they're saying is the US beverage business is doing really well. Do you guys want to talk about what's kind of driving some of the trends there?

Eric: Yeah, sure. I can start, Brandon hop in if you like. Dr. Pepper's kind of in some way, it's a kind of a unique brand. It's not a cola, so it's not directly competing with Coke and Pepsi. It's actually alongside Coke in many instances that the fountain, they have partnerships with them on the distribution side, so that's there. The adoption growth of Dr. Pepper, kind of its nascency was coming out of Texas and the South region. It's only really now fully expanding in some of the other regions, yes, broadly available, but consumption is only accelerating in some of these other parts of the country.

From a kind of overall beverage consumption standpoint, yeah, they have the diet offerings now, which they have in kind of all the different flavors, that's been tracking very well and some of their ancillary brands that've expanded into on the energy side as you referenced. That's been going really well. They've JVs that they form to have a distribution agreement, marketing agreements with these folks, that's been going really well, and to one other point is the fact that they've been raising prices and seeing this negligible decline in consumption demonstrating the elasticity of demand there. People are continuing to consume despite higher prices at the store.

Andrew: Brandon, did you want to add anything there?

Brandon: Sure, yeah, so I think Eric touched on it, it's really a regional soda that's starting to take and make its way across America, and I think the cool part from being the Dr. Pepper as you mentioned, it's a non cola, it's actually the flavored category, so 90% of the distribution is actually what they call it through the blue and red systems, which is Coca-Cola and Pepsi, so from their perspective that's great distribution and both Pepsi and Coca-Cola really want to carry it because that gives them a market share edge, Dr. Pepper being the number 3 player.

Our big call on Dr. Pepper in the carbonate soft drink portfolios here is right now they have I think a little over 24 maybe getting closer to 25% market share. We think Dr. Pepper's on the path to be the number 2 carbonated soft drink portfolio in the United States, essentially dethroning Pepsi, and we look at what's driving that as he mentioned, their elasticity of demand have just been so phenomenal since we look at it since 2019, so we kind of have that normalized base rate. Their volume growth is up 10% since 2019. Pepsis is down 2.6%, so the trends actually for Pepsi in the last... we want to call it like year to date, are actually worsening, and Dr. Peppers are holding up if not improving, so there really been a big net market share gain, and actually the biggest net market share gain in the last 2 quarters is what they announced on their earnings call.

I think when people look at the Dr Pepper portfolio, I mean it'll be a ginger-ale, they have 75% market share, Orange soda. They're number one with Crush and Sunkist. These are just higher growth categories that are taking share from Colas. Pepsi's kind of stumbled with being the number 2 player of Coca-Cola, and the Mountain Dew actually has not been doing very well in track channels. It actually represents the majority of their market share losses, which historically has been one of their stronger ones

Andrew: That's because all my friends aren't teenagers anymore, so the Mountain Dew trends had to subside. Brendan, I want to ask you a question on that, so I knew Coke and Pepsi like did distribution for Dr. Pepper, but I didn't realize that they would look at it as a competitive advantage. Like I always kind of thought of it as a a risk factor, and again, you guys have done way more work than me. I've only followed it loosely, but I always thought of it kind of a risk factor where if Dr. Pepper grew too much, like it has to get sold, Coke could look at it and say, "Hey, why are we even given the shelf space? Let's just take that shelf space."

I understand what you're saying, but like a lot of the beverage game is just having the distribution, having those logistics. Why wouldn't Coke at some point look at it and say, "Hey, if we just cut the Dr. Pepper out." Or I guess we're in 2020, I don't know if they could release their own Dr. Pepper style brand. They have done stuff like that in the past but why wouldn't they eventually just say, "Hey, let's just cut this out and try and take that for one of our other drinks, or give up some lost sales and stop kind of funding a competitor."

Brandon: It's so funny because we re recently read the book Fizz, which is the history of soda, so when we look back in the eighties, it's exactly what Coca-Cola did. It came out with Mr. Pibb.

Andrew: I remember Mr. Pibb

Brandon: Everyone knows Mr. Pibb.

Andrew: Not a big fan.

Brandon: They came out with Cherry Coca-Cola, that's like their competitor to Dr. Pepper, and they just haven't really taken off and gained market share. I mean, Dr. Pepper's still the number 3 soda right now in the United States depend how you kind of look at it, so yeah, in terms of shelf space, so I guess we had the opportunity recently to speak with the manager for Dr. Pepper distribution at Pepsi's Buffalo Rock facility, which is like their largest independent bottle or distributor, and they do the Southeast, which is big soda drinkers, so when we're talking to him, he goes, yeah, he goes, whoever can get Dr. Pepper essentially they have the edge in that market, they have majority market share.

It increases your scale, increases your SG&A leverage. You can hit more stores with more volume, so it's just like a huge, advantage to whoever has the Dr. Pepper in that territory because Pepsi, Coca-Cola, generally speaking are like they're pretty close.

Andrew: That territory you talked to, they've got the Dr. Pepper distribution right. Now, how often do the Dr Pepper distribution regional agreements come up, do you know?

Brandon:Every year and it's fixed pricing.

Andrew: Then every year, can they just kind of like flip it and be like, Coke and Pepsi distributors, whoever wants us, whoever wants that extra market share, come and get it.

Brandon: Whoever wants... what do you mean?

Andrew: Like your Pepsi guy, you talk to December 31st, his agreement with Dr. Pepper comes up in October. Can Dr. Pepper say, "Hey, we're doing a bake off. You versus the Coke distributor, whoever's giving us the best economic terms is going to win." Every year could they kind of look forward to bouncing each other off?

Brandon: They actually are, so I guess okay, I understood the question. Yeah, so those are perpetual agreements, so when Dr. Pepper wants to... what they call is refranchising, they actually have to buy out that distributor, and I believe they can buy someone out at any time.

Andrew: I'm familiar with the bottling. Okay, so they've got their distribution locked in. Got it. Okay. That makes total sense. No, that's super helpful. I didn't even think we'd go in that. Okay, so at this point, and listeners probably came in thinking, okay, they're talking about Keurig, it's got a great brand, 80% of the pod shop, they're talking about Dr. Pepper, this is a branded drink. They probably know it's a pretty good business. Historically, if you had bought Coke a hundred years ago, you're listening to this podcast from the beach, so I guess my question here is this is a 50 billion ish company.

It is widely covered, it's very large, it trades at 20X plus next year's free cash flow, so my question to the 2 of you is, I don't disagree' this is a really good business, but I know you guys, you guys are looking to generate Alpha, I think my listeners are probably listening not for investing advice, but thinking about generating Alpha, how can you generate Alpha at kind of twenty to twenty five times on a good business, but ultimately a pretty low growth business, that type of stuff.

Brandon: Sure, so yeah, so on valuation, we're kind of looking at it as like a little under a little closer to maybe 16 times price to earnings. Yeah, and to your point, it's a widely followed company. The people who follow it just don't like it. I think they kind of get bearish and focused on all the wrong parts, so I think for us we kind of viewed this as op... we're very opportunistic when we're kind of getting involved. It was everyone's pricing in the death of coffee.

We're like, no, coffee's actually a really growing net market share gaining business, and I think that was an extremely contrarian call. Kind of like walked the plank on that one, so we kind of got... I don't say lucky, but we kind of were very fortunate that coffee kind of outlook held up there, so that's kind of helped stock recently, and to your point about performing Alpha, I mean, I think we could have to run the numbers on it, but I believe over the last few years it has I think generated Alpha versus SNP 500 at least since they merged in 2018.

Valuation, and it's so interesting, we did this sum of parts analysis to kind of understand how, because this was a merger in 2018, so we said, what's coffee worth? What's US beverage worth? Everyone kind of loves beverage, doesn't like coffee, so let's do this back in this implied valuation, and we sent it to a couple sell side analysts, and I think within like a month, I think 4 of them had published this analysis, so it's just a way where I think we were kind of like adding new information to the market, or at least getting people to look at things in a different way, and we shared that with IR and they were like, "Oh, this is super interesting."

I think they maybe like even shared it with a couple of people, and I'd say, where we also we've kind of taken a maybe somewhat differentiated view, is there's this post-merger, there's a lot of intangible assets. For whatever reason, people don't... they don't add back other amortization expense, which is about a 10 cents benefit, so if you want to look at maybe like cash earnings here, there's just like a big discrepancy between CapEx and DNA, so you kind of like neutralize for that. They were getting very aggressive on their supply chain financing, so they're actually winding that down and that's going to be a big headwind to free cash flow over the next twelve months.

Historically, their free cash flow conversion has been over a 100% where they're comparison, the comparables is actually like 80 to 90%, so it's a PE discount, but with higher free cash-flow conversion, and we like to focus on upside to earnings versus where we see upside to valuation multiples, presumably that will trace that, so when look at what this business can do, gross margins are... Go ahead.

Andrew: Can I just dig into one thing. You said we sent around to a lot of sell side people, some of the parts analysis, and within a month you saw 4 of them published a similar, some of the parts analysis. What was in some of the parts analysis that they were kind republishing because to me like beverage, international coffee, corporate, slap a multiple on all those. I think that's pretty basic. Was there anything else you guys were kind of looking at, or thinking about that the sell side hadn't done?

Brandon: Yeah, so I would point to just the Wells Fargo, Morgan Stanley, JP Morgan. I'm forgetting any of them, but...

Andrew: Any other big banks you want to list there?

Brandon: Those are the guys who published it within a month, and everyone had the same sentence, which is coffees trading at a mid-single-digit, like either PE or EBIT multiple and only, I mean, I think the only point that we made that we did differently was saying, "Hey, $32, everyone agrees with the valuation on cold beverage. It's outperforming by such a large degree, there's no really discount required. Let's back into what the current market price is implying for the coffee business." I think once we kind of framed it that way and we said, "Let's look at Hamilton Brands."

They make Keurig single serve coffee and small appliances, the valuations are actually somewhat similar, so we said, "This is how the business is being valued and viewed. People are discounting estimates so much." I think it kind of resonated with some people and like, wow, that actually is an interesting way to look at things, and it would kind of like caught on fire pretty quick.

Andrew: Eric, Brandon just went through a ton. Did you want to add anything to that?

Eric: Yeah, I think, how do you get paid here? What generates your Alpha? I think the key catalysts are the inflection in the margins. If you look back to 2019 margins were five hundred basis points higher, so as the coffee moderates, there's a 6 month lag, they have contract coffee and various other input costs that's just only starting to get absorbed, and I think that's accelerating. That's going to be a back half story here, and in a 2024 story, I think this kind of fixation on the decline of coffee mentioned as it relates to the brewer systems, that trajectory has changed.

The narrative just seems to be changing, kind of the bias towards that and the marketplace seems to be changing, and I think that's kind of how you frame it. Then back to your question about like consumption trends, hot coffee being kind of the key.
They recently were announced or released a cold brew system, single serve basis. We have tested that have one looks to be quite good, and that's adoption that's been strong, so I think that's one way they can attack that side of the market to help stem some of those younger folks that like cold brew.

We drink cold brew, so that's I think one thing I've done in addition to some of these kind of... I don't want to call them free options, but they're recent JVs and other smaller brands to partner with that are growing really nicely.

Andrew: I was reading the Q-1 earnings and they partner with LA Colombe and when they said that I was like, "Oh, between Dr. Pepper and LA Colombe, they've got my drink and they've got my wife's drink." They've got this household locked up pretty good, and C4 is another one where they've done, I think they just have a distribution agreement with them. I don't think they own that brand. You guys can correct me if I'm wrong, but I see those every gym I go to, I feel like I see somebody drinking. They've got like a Starburst branded C4 and then the Legacy C4. I feel like I've seen those. It's where Celsius was 2 years ago is kind of how often I see those. If that makes sense.

Brandon: I mean great scenario. Yeah. Yeah.

Eric: They're on 40%. C4 they had an agreement whereby they get an attractive valuation not taking over the company.The company's able to retain their marketing brand, and product development and can partner with a larger company with scale the system distribution and market penetration, and they've done that. That's kind of their blueprint. They've used it 3 or 4 times and that's exactly what they're doing with C4.

Andrew: It reminds me of what Coke did with Monster in 2003 or whatever. Like that's what they did, and that's the thing. You say an independent company, you focus on your brand growing your business, and obviously distribution takes a huge fixed cost on a huge system. We can do that, and you kind of get the best of both worlds though. Eventually Monster grew so big that that did become kind of an issue. Let me ask a different question, so on the Q-2 call, the company's comes out and says, hey, we've bought back 7, I think it's 7 million shares in Q-2, and they say kind of the same thing you guys are saying.

We see value in our stock and when we see value, we're going to lean into the stock with repurchases to capture some of that value but the counter to that is, Monndelez and JAB are both sophisticated corporate/strategic buyers in some way, shape or form, and both of them have been reducing their exposure. Have been selling over the past year, and I think the executive chairman's also sold a pretty substantial amount of stock over the past year, so it's kind of interesting when you hear the company saying, we see value, and then you see these key control strategic shareholders, or high level executives who might be saying, "Actually, I kind of want to ring the register."

Brandon: Yeah, so I mean that's a really interesting point, and that's been the, it's so funny, since they went public, that's been the huge overhang on the stock because every couple months we get these secondary press releases, people kind of hit the panic button and the stock kind of like sells off, so we're thankfully that that's now out of the way, no longer an issue but, Mondelez ended up selling their coffee business to Keurig pre Dr. Pepper merger, so once these things merge, they're like, "We're not in the business of owning other publicly traded companies. We own 13% of the company. We're going to work it down to 0 over the next few years."

That's all that's been going on there. They had a member on the board of directors who stepped down earlier this year, so it was kind of just yeah, it was a non-strategic holding for them. They kind of worked it down. At JAB, they had distributed, I mean they bought Keurig, I want to say like 12 years ago. It was really early mid 2000, so they had just distributed their final bit of stock to some of their LPs. In their press release, in their form 4, they said, "That's our last distribution. We're long-term shareholders from here."

They still own 30% plus of the company, and have a few board seats. Oh, and then the executive chairman, so Bob Gemgo, we like him a lot. He did a great job as a CEO, they transitioned him to executive chairman and then the CEO replaced him. I had a very, very short tenure, I want to say a month or 2 tops, transitioned him back to CEO and since then he sold off some slack when he wasn't the CEO. He became CEO and thankfully those insider sales have stopped.

Andrew: It seems like he was kind of getting ready for retirement, and then had the, "Ooh, who did I replace myself with? I might need to come back in and make sure the ship stays on course." Eric, did you want to add anything there?

Eric: No, I think kind of those are the key points I would say. Yeah. As it relates to Mondelez yeah, their corporate needs didn't want all the public company stock and can use that cash with their own business, and in JAB it struck me as more of like a fun life, decision to distribute to the LPs as opposed to a fundamental call on the business itself, and if you look at where they've been selling, where they sold, pretty inopportune an disorganized, they weren't do communication with KDP.

If they were trying to maximize the price, they would've struck out to KDP and instead if you do share it, versus buy our stock here. Something like a tender but yeah, that's how that's played out.

Andrew: Just one more question on multiple here, so US beverage, it is taking share, it's growing nicely. A again, I keep holding up the Dr. Pepper Zero, but the Dr Pepper Zero sugar has done really well. They've introduced interesting brands like they're taking share there. Just the international business for Dr. Pepper is very small and this is a brand game. People drink Coke because their parents drink Coke and their grandparents drink Coke. If you're international and you're going to lo launch Dr. Pepper, you might know it, I might know it, a lot of the listeners might know it.

If International doesn't know it, you're launching a startup soft drink. Coke and Pepsi a lot of their value comes from their international play. They've got the international brands, a lot of their value comes there. That's where a lot of the growth still comes from. I guess can you give the beverage side of Keurig, Dr. Pepper, the same multiple that you kind of would give a Coke, or a Pepsi when they don't have that huge international exposure?

Brandon: I think how we look at it is we're saying, hey, let's discount those 2 maybe by 10 to 15% for our implied valuation of beverage, and for the US it's interesting that this really was a better being a Texas guy yourself, it really started and what they had...

Andrew: Louisiana, but I'll take it. [inaudible] Texas. Close enough, close enough.

Brandon: I was in the ballpark, so it really started as a regional business and now they're expanding it. A great example is in the Northeast, they just signed a new distribution agreement. In 2020 that doubled their amount of distribution in the northeast, the tri-state area where like that's twenty million people right there who were under penetrated distribution in the Northeast is still, only represents, I believe it's a like low, double digits percentage of Dr. Pepper drinkers, so it's like really underpenetrated in the Northeast, but it is a US-focused business. They focus on where they can win and they think they can win in the United States market.

It's outgrowing some of the other guys in the United States market like Coca-Cola and Pepsi, and it's really at this point too, an earnings growth story as much as is a revenue growth story, so Dr. Pepper has on the top line exhibited better pricing power, better elasticities, but where we're kind of looking at it is 2019 margins are still 3, four hundred basis points above where they are today, and they just inflected positively Q-2 of this year, I mean by 6 basis points, so we're kind of saying, "Hey, the work that we've done, we think carbonate soft drink prices are going to be flat to up going forward from here. Volumes will be hopefully pretty close to flat, if not declining slightly."

They've been growing lately, but you kind of look at that and now you have a low single-digit growth top line but we're going to keep scaling those input costs, and we think the earnings potential of this business is so drastic. I mean, sales are up over 30% since 2019, so we have a lot of SG&A leverage in there over a hundred basis points. We kind of put that all together to get to like maybe a 27% EBIT margin consolidated business, which is a few hundred basis points higher than the consensus estimate over the next few years.

US beverage alone for Dr. Pepper, 1 profitability advantage they have is a over-index to these, which is the twenty fluid ounce. These are single serve, they're the highest margin product for them, for the industry, and they over index those is about a third of the business. The majority of US beverage revenue is actually their concentrate sales. This is just selling the bag of the syrup. That's a 65% EBIT margin business, which is highly attractive. That's why US Beverage has 29% EBIT margins.

Andrew: The twenty ounce just on it. I obviously this is an data, not anything, but whenever I go down the Duane Reade down the street and get a diet Dr. Pepper, the Diet Dr. Pepper. No, it's in the fridge but, so they're providing you a service and I think a lot of the margins going to Duane Reade because they're charging that service but I'm pretty sure it's higher margin for Dr. Pepper as well. Dr. Pepper in the fridge is always like 299 and then the 2 liter bottle that's on the shelf is 299 as well, and I always pay for the cold one because I just want a cold one and I want that hit right then but I do think about that, that they probably it works there.

Do you guys want to talk about, you had a really interesting bottling piece of the thesis. Did y'all want to talk about that? Because I think on your recommendation, maybe one side sell side person has kind of mentioned it, but yeah, I'll pause there.
Do you want to start?

Eric: [inaudible] What?

Brandon: Here's a bottle cap for the Dr. Pepper bottling cap right here. I don't know if the viewers can see it, but it says, bottled by affiliate of American Bottling Company under the authority of Dr. Pepper Snapple, so this is their bottling subsidiary and it began in 1999 as a roll-up with the Carlisle group, so private equity guys got in the business, saw big growth market and soda combined it with Dr. Pepper, and since the early... well, I'm sorry, since the early 2000s, they've been rolling up all their other independent distributors and you're really creating a in-house bottling group.

When they originally IPOd in 2008, they had a bottling group and it was these guys right here. Is that what they do though? They're marketing and more of like a marketing business and a formula business than they are a manufacturer of sodas.
so our whole thesis was these guys right now actually are trading more like a bottler than a high margin syrup and marketing business, valuations have somewhat converged, let's get rid of the... at least spin it out. Coca-Cola has a few publicly separated entities that have also done this.

Let's get rid of that and just show the very best part of the business, which is what we do best to get management to focus on that, so I think that's just how we're looking at it, and it they used to say in the 10K, we are more vertically integrated than our peers. They got rid of that language and they used to break up the bottling revenue, which is in the billions. They don't longer do that either, so we think there's essentially like a $5 billion hidden asset value in this business that just no one's really paying attention to. Management has not signaled any intention of spinning it out, so we don't expect people to start paying for it yet but, if an activist ever emerged, I think that'd be one of the angles that they would pursue.

Andrew: As we're talking I think Coke, not Coca-Cola, Coke, which I believe a lot of Robin Hooders confused with Coke a few years ago, but they'r a Coke distributor and bottler and they're up like 15% I'm guessing on an earnings bit or something, but they trade for a very healthy multiple for a bottling system. I guess my push-back there it's really interesting because again, I've never even heard of anyone talking about the hidden bottling value in Dr. Pepper, and you are right, like Coke they've spun out the... especially their international side, they've spun out their bottling assets, then sometimes they bring them back in.

They go back and forth but it's really interesting as a hidden value. My question would be, is it really like you tend to get hidden value where a company is just at the wrong multiple.
Like I think of a restaurant company. A restaurant company that owns all their land and the restaurant company trades for 5 times earnings and then one day they say, hey, we did a sale lease back and look our earnings are going to go down because now we're going to have to charge ourselves run expense, but we do the sale lease back at a 5% cap rate, which implies a 20 X earnings multiple, so your earnings go down, but you get like way more.

Like we're saying the US beverage business should be worth like 18 X and I think a bottling business should probably be worth a little bit less than that, so if you spend that out, like you're going to have to start paying out to the bottling business, is there really hidden value there, or would that just kind of be a financial engineering spin and maybe a little value because it's a big business and people can like put the proper multiple on each of them, but is there really a lot of hidden value there?

Brandon: Yeah, I mean I think they could sell it for $5 billion. Maybe Coke consolidate who's up big today. Maybe they're trading should higher premium. They're not going to have to dig in on that one but they actually are a Dr. Pepper distributor, a Dr. Pepper bottler, so seeing them go up 15% with a $6 billion market cap maybe makes us think that they hit an asset value on Dr. Pepper, has maybe just increased a little bit, at least maybe 14% like you mentioned, but yeah, I think they could sell it and then just what they would do would be selling to concentrate to that new entity.

It actually is its own corporate entity subsidiary called American Bottling Corporation on this bottle cap, so I think it's very doable.

Eric: Yeah, I mean it's not like a financial alchemy situation depending on the value, they realize for the sale it's a much higher margin business selling is syrups as opposed to the capital intensive nature of bottling in that and the like, so margin it would be accretive to on a margin basis, unlike say a sale lease back where you're still having to pay someone to use that property in that situation of the restaurant image.

Andrew: I guess, yeah, I'm just knocking because then you would, you have to pay the bottling fees but 5 billion it would be a lot and as you said, it would really clarify the margins and show people just how much cash flow this core business is generating. Is there anything else when obviously you guys talked to a lot of people on the thesis, your thesis are widely read as you said. I love that you sent the sell side, this some of the parts and within a month, 4 of them are doing it. Are there any other pieces of the thesis that you think either people are missing or that you guys have kind of engaged the most back and forth with people when you're discussing it?

Eric: There was the Bud Light issue. There was...

Andrew: Yeah, I thought y'all did fantastic work here. I didn't know if y'all wanted to talk about it or not, but you go ahead. Why don't you say it.

Eric: Yeah, there are a few days they're around surround, following the Bud Light PR debacle where we're like, are we missing something? Are they somehow affiliated associated with that? We found that it is like Lamato, essentially it's like a mixed drink that they partnered with Bud Light on, which was getting hit as a result of that kind of brand version, and then dug into the numbers and it only equated to like 0.02% of revenue, so de minimis inconsequential, and I think that that was one potential thing that everyone was looking to see what was the little bucket across the industries it related to those dynamics of Bud.

Andrew: This year has just been the year where it shows just how thick the left tails are in the market. Like who thought a bank could blow up because they own too many US long-term US treasuries, who thought investing in AT&T might turn out that they were killing all of their customers and communities with lead, and who would've thought like Bud Light could send an influencer what, $50, a hundred dollars worth of gifts and basically destroy or maybe not destroy, but put at risk a lot of their brand value.

It's just shown how thick the left tails are but yeah, I just said you guys did such great work on it because again, I hadn't seen anybody even mentioned it. Obviously you guys said, oh, this could be a risk went uncovered, it wasn't a big deal, but I hadn't even seen anybody mention or think about that. Right. Brandon, anything else that you guys, when you come to talk to bulls, bears or anything engage with think it gets people really up about this, kind of the different pieces of the stock?

Brandon: Yeah, I'd say one big inflection point that happened this year has kind of evolved too, was just earnings quality. I mean, that's usually where you get these debates, but some of the bulls are spares as they say. They're driving EPS by doing these sale-leasebacks and the sale of leasebacks have one-time gain and they actually include those above the line, so it's included in adjusted EBIT and people always kind of frown on that kind of discount the earnings.

This year there's expected to be what they call above their long-term growth Algo year, so they got for 9% growth this year, it has to be like 14% growth, so people are saying, "Ah, they're not going to be able to do that without like some material one-time gains." So on the Q-1 call we got 5 million, and then on the Q-2 call we got 0, and they said originally we were expecting to have 50 million one-time gains, now we're going to have close to 0, so I think it really kind of proved the model and supported some of the bulls who thought that their earnings power is actually better than they had been fearing.

Now we think people will be more comfortable kind of placing like a full PE multiple on these earnings and hopefully close that discount with some of their bigger peers.

Andrew: If I can just add, add one more and it relates to that. You mentioned the factoring earlier, but JAB who I think they've been unbelievable. If you look at their consumer holdings, I think we all probably just wish we had had the jab like buy Krispy Kreme when no one thinks Krispy Kreme is good. Buy Panera whenever... like they've been unbelievable but, I do think there's something to people see JAB this big consumer oriented thing that takes these brands and really spruce them up, and people might have like a little bit of echoes of 3G in their mind.

When you've got KDP both with a lot of adjusted EBITDA ad, adjusted add-backs in their earnings and that big factoring thing and you just look and you're like, "Hey guys, you're a tens of billion dollar company. Do you really need to be factoring your receivables from your bottlers? Do you really need all these adjusted?" Like I think the fact that those are going to be in the rear view mirror it, again, it really cleans up the quality of the earnings, but I also think it just moves a little bit of that irk factor away from it, if that makes sense.

Brandon: Yeah, I mean we would email in our and be like, "Why are you guys so aggressive on your supply chain financing?" I mean, the real answer is it's a performance metric for the management team, so like in the proxy it would say, we're going to push out our days payable to increase, to decrease our networking capital and that is 30% of our bonus this year. We're like, "No, that's not really aligned with the shareholders, but management's getting aligned to essentially work that." So we're glad that this year they actually... and then this quarter they announced, hey, we're no longer going to do that. It's a $600 million head free cash flow.

It's going to be maybe brutal on the way down, but next year we'll have a clean base and that'll all be normalized, so I think for the long-term health of the business, that was great.

Andrew: Yeah, a 100% agree. Yeah. They're not the only ones who are doing it. It's like AT&T at and t is doing it and AT&T deals with a lot of smaller suppliers and stuff, so I get maybe you're solving some credit things, but it's like AT&T your investment grade, so you really need to go factor your receivables [ inaudible] and your investment grade. Like I understand you guys have a dividend you want to pay and you're worried about headline leverage and stuff, but making it by factoring it's very strange. It's very strange.

Brandon: Yeah. I mean we told the company like, "You guys aren't bed bathing beyond, you're not having a cash crunch like, you guys are doing just fine. Let's keep things on track here." But if I could maybe just quick on earnings, expectations for this year, so, I think the big mass why people are continuing discount is the coffee inflection. We think that'll be good. The Q-3 versus Q-4 build, I think is what people are really focusing in on.

They somewhat lowered Q-3 EPS expectations at mid single digits, maybe even a little bit lower than that, so there's kind of like this like Q-4 build. When we look at what they did guide for Q-2 and delivered on Q-2, it was so far above, so we're kind of looking at Q-3 being similar. We think they're actually going to actually it'll be more evenly split between Q-3 and Q-4 as people are fearing, and then what's interesting is when we kind of look at the exit rates in the 2024, that would imply somewhat material step up to earnings and run rates and everything like that.

I think it's going to have like a really good flow through, so when we see that since December 1st, which was before they did this fireside chat and talk down that expectations, the stock's down 15% earnings estimates are down not even 2%. The driving force behind that is cold beverage offsetting some coffee weakness, so we think that now that earnings revisions are actually starting to become positive, that'll start to close that gap between what the stock's been doing with the fundamentals have been doing, and consensus at the low end of guidance were at the high end, so that's kind of where we're differentiated on expectations for earnings.

Andrew: Eric, did you want to add anything to that?

Eric: No, I think that that hit it. I mean, one other quick point about maybe points of push-back or tension in stock, probably about the categories as a whole is the fact people in probably our markets are saying, "Well, I don't drink sodas and I don't see sodas serve the kids." And yeah, that's fine. That's good. Well the reality is majority of the country still does. I mean, and there's a low sugar option or non-sugar option in the case of diet, and people that think about it, that they drink these multiple times a day, they didn't get it as like a treat, so to speak.

Like instead of a meat donut, I'll like Dr. Pepper, that's their afternoon snack, so, and that has invaded despite, health pressures, the well-known, vilification of sugar and stuff we agree with but yeah, they have the diet off diet's growing really nicely and that's probably a good thing for health.

Andrew: Eric, I'm laughing because I felt so seen when you like people drink them as their afternoon treat and as I said it, it is my afternoon treat. For a while there was the scary like as part of me, it might cause cancer from the who or whatever, and I think if you looked at the research, it's like, yeah, if you drink eighteen cups a day every day for your entire life, you might have some issues, which if I could, I would but I try to stay underneath that limit.

Eric: Yeah. That comes and goes. The uncertain concerns and such but...

Andrew: As you said, I understand there are healthy trends, but there's a 0 sugar option, people have been doing these for decades. It's a lifelong... I don't want to say habit, they can be addictive if you like really are drinking tons of them every day but it's a lifelong treat. I don't think like the demographics on changing that are just so long. I think in the long run there's the heat death of the universe and that's probably what we're talking about coming out of that.

Hey, if you guys don't mind just really quickly, the last time you guys came on, I thought you did a great pic for Oxford. The business is doing well, maybe not quite as well as people thought at the beginning of the year, because I think they did a little bit of a pull down in their Q-1 earnings. Just wanted to, if you guys have 2, 3 minutes, just see how you guys are thinking about Oxford because I think that's a super interesting one as well.

Eric: Yeah. Quick, kind high level Brandon, feel free to hop in, but so the last quarter they, again beat numbers, but the guidance was softer. The cadence that they articulated was that March was a little bit softer than they expected and then they even noted that April and May were subsequently stronger, but they gave a kind of soft Q-2 guide tracking data we have, and indications are going to exceed those expectations.

I think it was more conservative messaging and being kind of low on their guidance forecast relative to what is probably the reality. Yeah, business still doing really well being Tommy and Lily also, and that has largely remained unchanged. There's some like capital allocation, questions have been going back and forth with them on, but margins start to inflect paying down debt. This is aren't necessarily promoting, so maintaining those nice attractive margins.

Yet still trades like 8 to 9 times earnings, and in a market where others are being forced to discount or aren't able to price pass along price, they're demonstrating the strength of their brand and lifestyle they call it, within their customer set.

Andrew: I got my father-in-law, Tommy Bahama shirt for Christmas. I don't know if y'all factor that into... this was last Christmas, but I just wanted to let y'all know. I think last time we recorded it was like they announced that Johnny Was acquisition either a day or 2 before or a day or 2 after. I can't remember exactly. I was kind of... this is me personally. I was kind of like, "Hey, it seems fine, but you've got this great time ham growth business. I don't know if you really need to like go buy another thing and have 3 brands under it."

I always get a little concerned when you have these companies trying to run like 3 different lifestyle growth brands under the same thing. I'd rather just see a focus on 1, let investors really focus on one. How are you guys feeling about the Johnny Was acquisition? Is it Johnny Was? Johnny Was? I'm not quite sure. How are you feeling about that acquisition?

Eric: Yeah, yeah, so yeah, we agree. We prefer that resources and focus be on the core brands. We're still pretty early on in Johnny Woods acquisition cycle. They acquired them like late November. They're just starting financials, we'll give them some time to deploy their playbook, kind of the marketing schemes and direct consumer kind of channels. They've shown that they can utilize really well within their core brands and help accelerate growth. There's a nice store opening trajectory of course within Johnny Was, but it's the quality of that brand is attractive as Tommy.

No, but it's also what, 10% of revenue, so it doesn't derail the story but I think time will tell, but so far it's been okay, we'd say.

Andrew: Yeah, it's more than just the distraction. Like I was almost hoping you got to the point where, hey, they were at the point where their balance sheet was, hey, we can just start buying back shares and you can get this like financial engineered levered playback story on Tommy Bahama growth. It spits off a ton of cash. We grow it, but we also buy back shares. Brandon, did you want to add anything to that?

Brandon: Sure, yeah, no, I mean, I think you guys nailed it. I think, a big thing for us was coming into the 2023 guidance was everyone was playing for this big negative. They've been over-earning overgrowing, 2023 is going to be a down year. In fact, they guided for high single-digit direct-to-consumer growth, which is 80% of the business. They said wholesale is going to grow maybe 0%, which is like five hundred basis points of net market share gains, so Tommy Bahama is just crushing it right now. Big beat on Q-1.

They're going to grow mid single digits this year, so when we look at some other players in the space, we're trading at like mid-teens PE multiples, and we look at Tommy Bahamas, growth in margins, return investing capital. They're rolling up Marlin bars. We haven't had a new unit growth story for Tommy Bahama like 10 years. We're instead of like ballpark it, they've been a net closer, so for this year Tommy Bahama, the outlook has just been so fanatic. I mean, so fantastic, and we kind of look at that business as being worth more than the current market cap for more current enterprise value.

We kind of look at some of the other brands, it's like sure, maybe those is maybe slowed from mid single digit to low single digit growth this year. I think where people really got tripped up was EBIT margins are coming down this year. We were kind of hoping for a flat that maybe slightly down, in fact, they're going to take it down maybe like seventy basis points and that's just SG&A catching up. They scaled SG&A and a just so nicely over the last few years. They felt like they had maybe under invested in the business, so he said, SG&A expect EBIT margins down slightly this year, but then to effect positively next year, consensus is still not modeling that.

They're still discounting it, so we think in terms of like what this business can do, it's going to be hopefully over $12 of earnings per share in 2024. We think they're on that trajectory. They've kind of proved that not just a one-time COVID winner, so let's just really beat it up and say it's worth ten times earnings. I mean, I think Deckers and some other you like Gap are worth double digit multiples, but...

Andrew: I mean, if you guys talk to multiple Crocs[?] paid for Hey dude, if you guys slap that on, I mean, I know apples to oranges, but woo.

Brandon: You're like starting at a $100, like maybe $120 per share is like your starting point, for like a fair value for this business, and we think that obviously worth much more than that, so it's just timeless to prove the story at this point.

Andrew: No, look, I didn't tell you guys I was going to ask, but I knew y'all be ready, so that's what I did because I just think it's a super interesting story. I think Tommy Bahama has a chance to be a real brand. It already is a real brand, but ha have real legs behind it, and if I remember correctly there were some sharp guys quoted in Baron's about a month ago about how Oxford Industries was undervalued, so I had to ask them while the sharp guys were on the podcast, because it's a really interesting one. Eric and Brandon were quoted in Baron's on Oxford, so just for people who don't know.

Anyway, guys, this has been great. I think we're close to the end of the hour, so I just want to say thanks again for coming on. Brandon, thanks for joining me in the Dr. Pepper party while we were here. Eric, I don't know what sort of shareholder you are.

Eric: I have a Keurig in there. I have a Keurig, I'll have to make up for this afternoon with snacks.

Andrew: I'll have a coffee this afternoon as well but guys, I really appreciate you coming on and, looking forward to the third one.

Eric: Excellent, Andrew, always a pleasure. Thanks for your time.

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