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Morningstar | Keurig Dr Pepper Posts Solid Margin Improvement in 3Q; Shares Aren't a Bargain

Wide-moat Keurig Dr Pepper experienced solid performance in the third quarter (during which the merger of Keurig Green Mountain and Dr Pepper Snapple was completed), with net sales up nearly 3% (80 basis points above our full-year outlook) and gross margin expanding 80 basis points to 55.5% (matching our full-year outlook), both on an adjusted pro forma basis. Sales were driven by strengthened volume/mix (up 3.6%), with a 0.2% headwind from lower pricing, reflecting the firm's ongoing efforts to increase the affordability of its coffee pods. From a category perspective, the packaged beverage segment (45% of sales) led growth, with pro forma sales up nearly 5% (driven by volume growth) thanks to strength in the Canada Dry, Bodyarmor, Core, and Bai brands. We were also pleased to hear the firm took pricing actions within this business to help combat input cost inflation, which has been weighing on firms across the industry (as evidence, pro forma segment operating margin fell roughly 3% to 12%). We aren't expecting a material change to our $21.50 fair value estimate as we incorporate these results and plan to maintain our longer-term outlook, which calls for around 3% sales growth and mid-50s gross margin.

Adjusted pro forma operating margin expanded 240 basis points to more than 24%, thanks to improvements in productivity and the phasing of marketing investments. We expect more substantial margin expansion longer term as the firm extracts synergies from the merger (targeting $600 million by fiscal 2021, including improvements in warehousing, procurement, and overhead costs), allowing adjusted operating margin to average north of 26% over our forecast. However, we contend the firm will reinvest around 40% of these synergies in its business, to bring new products to market and ensure their visibility in front of consumers.