KDP - Keurig Dr Pepper: Waiting For More Visibility In Q2/Q3 2023

2023-05-10 08:11:17 ET

Summary

• The US Coffee division's performance was weak due to lower volume, with Brewer shipments down 29% in 1Q23.
• I see risk to FY23 guidance due to uncertainty and the need for a strong 2H23 performance to offset the weak 1Q23.
• The current macro environment has forced many consumers to rethink their discretionary spending, but the long-term story is still intact.

Investment thesis

Keurig Dr Pepper ( KDP ) produces and sells soft drinks. After KDP announced its 1Q23 results, the stock plummeted from the mid- to low-$30s. I attribute this primarily to the disappointing performance of the U.S. Coffee segment and the resulting reduction in the 2Q23 forecast. With brewer shipments down 29%, it's clear that demand is weak, and it's possible to infer that consumers are feeling the pinch and postponing big-ticket discretionary purchases because of it. Consequently, management now anticipates that the same brewer volume pressures will weigh on its U.S. Coffee segment in 2Q23, resulting in low to mid-single digit % growth in 2Q23 EPS.

What is interesting is management maintaining its FY23 guidance, which implies that 2H23 needs to see meaningful acceleration, which also means additional risk for investors to undertake. This is especially when the U.S. Coffee business is the highest margin business that represents 37% of the business operating profits. I believe this results have forced many investors to reset their expectations on the business growth and also long-term exit margin. Overall, I would avoid investing in the stock until I see a recovery in the coffee segment, and also clearer demand trajectory given the uncertain demand environment today.

1Q23 results

KDP revenue experienced organic growth of 8.9% during the reporting period, primarily attributed to a net price realization of 9.9%. However, the volume and mix were below expectations. The newly created U.S. Refreshment Beverages and International segments contributed significantly to this growth momentum. In contrast, the U.S. Coffee business's top-line performance was weak due to lower-than-anticipated volume. Gross margins remained unchanged at 52.7%, while operating margins decreased by 290 basis points to 20.8%. Additionally, adj EPS stood at $0.34.

Coffee segment

The US Coffee division was largely responsible for the overall poor 1Q23 results and subsequent share price drop. Brewer shipments dropped by 29% in 1Q23, which was a major factor in the 500 basis point drag on segment revenue. However, I should point out that the first quarter is traditionally a slow one for Brewers, accounting for only about a fifth of annual shipments. The slow growth in Pods' volume (down 1.5%, entering negative territory) may also be to blame for the dismal performance. I am less worried about Pods volume as I believe the comp in 1Q22 might still be high given the surge in 1Q21. KDP should be in its final phase of normalization for this, and we should begin to see performance revert to historical levels in 2H23. As such, I believe the weak guide for 2Q23 is purely a function of the weak Brewer performance and not the pods. This might have impacted investors' expectations on KDP long-term growth and margin, but I believe the long-term story is still pretty much intact.

My belief is that the current macro environment has forced many consumers to rethink their discretionary spending, as such it is not surprising for KDP to get hit by this dynamic. In addition, while there will still likely be volatility in brewer shipments ahead, I believe longer-term challenges in specialty retail shouldn't impact brewer performance as KDP will continue to diversify its channels mix such as Ecommerce. All in all, I have very low expectations for the near-term performance, but still positive on the long-term trajectory.

Margin

Gross margins were stronger than expected, offsetting the impact of higher spending on SG&A expenses. However, I don't think the increase in gross margin is entirely structural, and instead attributes it to a problem with the product's mix. There was a tailwind to margins from the sharp decline of low margin brewers, but I anticipate that this mix will normalize and come back online, putting pressure on margins once again. This normalization applies to the price vs cost inflation as well, which is headwind now but should turn to a tailwind in the normalization phase. I expect to see gross margin staying flattish for the near-term with possible improvement due to increase pricing (exceeding cost inflation).

Guidance

In FY23, management is still anticipating 5% fx-neutral net sales growth. The underlying assumptions are that inflation moderates to the mid-single digit % range, supported by past and upcoming price increases. This increase in pricing would result improvement in gross margin in 2023, when commodity price increases are expected to level off. All of these factors combined would lead to 6-7% growth in adj EPS in fx-neutral terms. However, I believe there is risk to the FY23 guidance given limited visibility and overall macro uncertainty, particularly if 2H23 needs to performance much better to offset the weak 1Q23. Furthermore, assuming the US Coffee segment does not recover or perform as expected, the FY23 guidance would need to be heavily supported by the US Refreshment Beverage segment, which has been performing very well since the pandemic (growth accelerated from the typical mid to high-single digits to mid-teens level).

I expect growth to normalize, and with the tough comps in FY22, it puts further risk to KDP hitting FY23 guidance. With regards to gross margin, I would also expect it to be offset by the planned investments into the business. As such, I am very wary about FY23 guided figures for now, and would prefer to see 2Q23 performance before making a more concrete judgement.

Conclusion

While the company's 1Q23 results showed organic revenue growth and strong gross margins, the weak performance of the U.S. Coffee segment, which represents the highest margin business, is a cause for concern. Furthermore, the uncertainty in the current macro environment and limited visibility of the future Coffee segment (highest margin and also represents largest % of profit mix) demand trajectory add to the risk for investors. While the long-term story for KDP US Coffee segment remains intact, in my opinion, it would be prudent to avoid investing in the stock until there is a clearer recovery in the coffee segment and demand trajectory.

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