It’s a funny characteristic of behavioural finance that we are conditioned to confirm our biases depending on whatever the prevailing situation is at the time. A strong bull market and we all get the itch to suspend what we know about value and future returns in order to buy. Conversely when the markets are going south a lot of folks can’t stand the losses and get the urge to just sell in case their investments fall even further.
Dr Pepper (NYSE: DPS) stock is a great example. Whenever I think about it I get reminded by the little jingle that defined the commercials played in cinemas and on television. Basically there would be some embarrassing scenario in which the drink would play a prominent role, followed by the “Dr Pepper, what’s the worst that could happen?” line sung right before the close. A great bit of marketing that kind of makes me want a bottle right now, but ironically it has also applied to the stock over the past few years.
In its most recent spell as a publicly listed corporation it IPO’d at a pretty awful point with the benefit of hindsight. I already covered the situation but coming onto the market in May, 2008 will probably prove to be one of those unique investing moments. We knew back then that, once you take into account the fact it had spells as a private company and under various different guises, Dr Pepper had delivered returns of 18% a year between 1953 and 2003. Needless to say there are only a tiny number of stocks that can boast that record – in terms of returns it basically puts it into the same league as Philip Morris/Altria, albeit more broken. Yet the market didn’t want to know as the stock went on to lose more than 50% of its value over the following ten months.
To further illustrate the earlier point on biases just look at the article distribution on Seeking Alpha. In 2009 there was just one solitary article written on Dr Pepper stock. In 2010 there were seven, and over the course of this year there have already been twenty-three. Now that its high quality profits and tremendous shareholder returns have been re-established in a listed company format again investors are more than happy to bid up the stock.
The only conclusion you can really draw from the crazy cheap valuation is that investors just totally ignored the history of Dr Pepper because it happened to spend periods of time as a private company. Coca-Cola and PepsiCo for example only went down to 13.5x and 12.1x earnings respectively at the same time. At the nadir in March, 2009 someone out there – probably clued up on the history of the company going back to the days when it was Dr Pepper/7Up and then part of Cadbury Schweppes – was buying $2.17 in forward earnings per-share for $11.90.
They understood that in the long-run it’s likely that popular brands with huge consumer loyalty like Dr Pepper will allow the company to remain capital light and throw off excess cash to shareholders, especially in a low-growth mature market like the United States. Most of all they realised that at those prices it was almost impossible not to make a bunch of cash over a medium-term horizon. Growth doesn’t even come into it that much when you’re looking at such depressed valuations. It was like picking up a diamond in a yard sale for a few bucks. To quote the jingle – what was the worst that could’ve happened?
Dr Pepper Stock In A Dividend Portfolio
If you look at the earnings-per-share and dividend history from 2008 you can immediately see the wisdom of buying stock during the 2008-2009 turmoil period. A $25,000 investment made at the bottom in 2009 would now be worth approximately $200,000 and would be pumping out $4,385 in dividend cash this year alone. That’s equivalent to compounded annual returns of almost 33%. Those are potentially life changing results even over a eight year period. I mean an investment would’ve pretty much returned 100% of starting capital by way of dividends alone from the March, 2009 bottom.
Now that the once-in-a-generation type valuations have long since disappeared what’s the outlook from here on out? As it stands today the stock is going for around 19.5x forward earnings. As you’d expect from a company tied almost exclusively to the domestic US market volume growth isn’t particularly going to set the world on fire. It’s a mature market in which per-capita consumption of carbonated soft drinks is already high and it accounts for around nine bucks out of every ten of the company’s sales.
Now on the face of it there are a few ways for the company to navigate around a low organic growth environment. One of them is through juicing productivity gains and focusing on higher margin activities. Another is to shower shareholders with cash. Ordinarily you’d say they can just go down the route of international expansion (which is what Coca-Cola and PepsiCo have been doing over the years) but it’s slightly more complex in this case as the company don’t own the licensing on a bunch of their brands outside of North America and the Caribbean.
In the absence of that you’ve seen margin expansion and an absolute bucket load of cash returned to shareholders. Since 2010 operating margins have risen from 16.5% to the 22.5% they have been for the first three quarters of 2016. In addition the company have returned about $5.5bn in cash back to shareholders by way of dividends and stock buybacks over the same time frame. When you’re dealing with a mature cash-cow that is the number one flavored carbonated soft drink seller in the United States, converts something like 10% of sales into free cash flow and generates near 50% returns on tangible capital there’s not all that much else to do with retained earnings.
You kind of get the impression that some folks would overlook the stock for a dividend portfolio simply because they only have seven years of dividend history in their most recent incarnation. At 19.5x earnings, a 2.6% dividend yield and about a 3% rate of share buybacks at the current stock price I think Dr Pepper is on the good side of fair value. And when you have a company that’s basically set up to return cash to shareholders that’s a great place to be in a long-term dividend portfolio.
To get a feel for what I mean let’s break down the returns since IPO in 2008. In total investors have seen 17% compounded annual returns to date assuming the cash dividends just piled up. Earnings-per-share growth has contributed 11% of that figure, with the remainder coming from cash dividends and the expanding value multiple applied to the stock. During that time the total number of common shares outstanding has fallen from around 250m to 185m – equivalent to a 3.5% per-year contribution to earnings-per-share. Okay, so at this valuation you can’t rely on multiple expansion to juice returns, but there is enough left over in terms of cash dividends, buybacks and organic growth to make them still look good going forward.