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Morningstar | Keurig Dr Pepper's Margin Trajectory Remains Strong in 1Q; Shares Overvalued

The highlight of wide-moat Keurig Dr Pepper's first-quarter results was its substantial margin expansion despite lukewarm top-line performance, with adjusted operating margin expanding 260 points to 24.8% (tracking in line with our full-year estimate of slightly above 25%), as the firm continues to extract merger-related synergies. Profitability improvement was most pronounced in the Beverage Concentrates segment (12% of sales, but roughly one third of segment operating profit given the asset-light, higher-margin nature of concentrate models), where adjusted operating margin increased 400 basis points to 66.1%, which we surmise was supported by a 7.1% increase in pricing. We anticipate lifting our $23 fair value estimate by about a dollar to incorporate a stronger near-term margin outlook, but our longer-term outlook (which calls for 2% to 3% sales growth and high-20s average operating margin over the next five years) remains intact. Even with this revision, we'd suggest investors wait for a more attractive risk/reward opportunity.

Excluding several one-time factors that weighed on sales, including a 2.5% headwind from changes to the firm's Allied Brands portfolio, underlying sales grew 2.5% (including a 1.1% increase in pricing), which is comparable to our full-year outlook. We were pleased to see recovering performance in the Coffee Systems segment (39% of sales), where pro forma sales grew 1.7% (versus a 0.4% decline in fiscal 2018) as growth in volume/mix accelerated to 5%, including a 7% increase in K-Cup pod volume. This helped offset a 2.5% decline in pricing, as Keurig Dr Pepper continues its efforts to increase household penetration of its brewers (which stood around 22% in 2018) by making pod prices more affordable.

Moreover, the firm's productivity efforts helped adjusted operating margin in the Coffee Systems segment expand 180 basis points to 34.6%. From our vantage point, this trajectory of margin expansion (adjusted pro forma operating margin stood at just 29.4% in fiscal 2017) bolsters our confidence that the firm will be able to balance bottom-line strength with its pod pricing initiatives.