(DPS) Dr Pepper Snapple Group on a Tight Rope

We have maintained a Neutral recommendation on Dr Pepper Snapple Group Inc. (DPS) following appraisal of the second quarter 2012 results.

Dr Pepper Snapple’s second quarter 2012 adjusted earnings of 85 cents per share increased 9.0% year over year driven by revenue growth and lower-than-expected tax rate. The company’s quarterly earnings also surpassed the Zacks Consensus Estimate of 82 cents per share.

During the quarter, Dr Pepper’s net sales grew 2% (up 4% excluding currency headwinds) year over year to $1.6 billion. Price mix benefited revenue by 4%, but volumes declined. Net sales were in line with the Zacks Consensus Estimate. Dr Pepper maintained its full year 2012 earnings and sales guidance.

Overall, we are encouraged by Dr Pepper’s strong position in the flavored carbonated soft drinks (CSD) market. Dr Pepper owns some of the most popular CSD and non carbonated beverages (NCB) brands. The company holds the #1 position in the flavored non cola CSD market in the US with a market share of 40% in 2011. Dr Pepper soft drink, the most popular CSD brand, holds the #2 position in the flavored CSD market in the US. The company’s portfolio of well-established flagship brands offers a strong competitive advantage and strengthens its position in the market. Further, the company makes regular marketing investments to build brand value. Over the last three years, the company has invested more than $100 million for marketing of popular brands.

In 2010, Dr Pepper launched its Rapid Continuous Improvement (RCI) program under which the company is working to free up critical resources, people, time and money so that these can be used to build brand value. Therefore, the company has been able to reduce inventory and storage costs and improve cash flows, which can in turn be returned to shareholders via dividends and share repurchases. Dr Pepper anticipates that the program will lead to productivity savings of at least $150 million through 2013.

Though the commodity cost pressures have subsided in recent times, the company’s weak volume growth and lack of exposure outside US keep us on the sidelines. Further, changing consumer preferences toward healthier drinks, as a result of heightened awareness, are affecting the company’s CSD volumes. Moreover, the company mainly operates its business in the U.S., Canada and Mexico, which are experiencing saturation. It thus lacks exposure in the fast growing emerging markets where demand is growing and health consciousness is comparatively less. This is a significant competitive disadvantage for Dr Pepper versus its peers like The Coca Cola Company (KO) and PepsiCo, Inc. (PEP), as they have significant exposure overseas.

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