Dr. Pepper Snapple (DPS) – Merger Arbitrage – 8% Upside

Current Price – $119

Merger Consideration - $103.75 + KDP Stub

Upside – 8%

Expiration Date – Jul 2018

Merger Presentations

This idea was shared by Tony.

 

Keurig Green Mountain has offered to acquire Dr. Pepper Snapple (DPS) for a combination of $103.75 and one share of the pro forma entity Keurig Dr. Pepper (KDP). Keurig is currently owned by JAB Holdings the Luxembourg based family office. The transaction is expected to close in July 2018. The stub is currently valued by the market at $15.72/share and peer comparison suggests valuation of at least $25/share, resulting in total merger consideration of c. $129/share or 8% upside.

The transaction is being mispriced relative to other merger transactions for a couple reasons. 1) There is a large cash component of consideration, without being entirely cash and 2) there is no public entity to short for a clean hedge. Due to the relatively long timeline since announcement in January, the risk arb community has been uncomfortable with this deal given the time value of money exposure. That said, there is an opportunity for investors who are willing to provide liquidity for the transaction that has passed all regulatory hurdles, has an effective definitive proxy, and is set to be approved at a June 29th meeting. At this point, the only risk to the deal being derailed is that the shareholders do not approve the deal at the shareholder meeting. The financing has also been syndicated from the original bank commitments as $13.1bn of IG notes.

On a fundamental basis, JAB is assembling a group of coffee/breakfast related assets, including Stumptown, Panera (PNRA), Krispy Kreme (KKD), Peet’s (PEET), and of course Keurig Green Mountain (GMCR), the last of which was purchased for TEV of $14B. The thesis is essentially to vertically integrate the DPS business and execute on synergies related to distribution and bottling. On the distribution side the value comes from the high number of nodes (convenience stores, gas stations, grocery, etc.). On the bottling side, the PF Company is focused on expanding into bottled coffee, similar to Starbucks bottled beverages, but will benefit from a larger distribution network, and brand recognition. Expected synergies are $600m, although analysts across the street suggest this is a lowball estimate by management.

Mechanically, when the transaction closes investors will receive $103.75 in cash and one share of the stub KDP. The stub at current prices is $15.72 and will pay a declared dividend of $0.60 (implied 3.8% yield).

DPS is a compelling fundamental story with interesting technical factors that make it an interesting investment. The primary concern is likely Keurig performance, however K-cup unit sales have turned in 2017 and the shift into bottle coffee is a smart transition. As the transaction comes closer, the KDP stub will begin to trade when issued (KDP-WI), which will allow arbs to short a public stub and naturally drive up the price of DPS as the risk arb community enters the trade.

 

Peers

The Street generally views DPS as a combination of PEP/KO and MNST/FIZZ and I believe that is an accurate assessment. With KO and PEP you have cash machines with low long-term growth, and with DPS you have a core suite of brands with an adjacent portfolio (Allied Brands) that is rapidly growing a la MNST/FIZZ. To offset, the pro forma KDP will now include a hardware business in Keurig that has had struggles in the past. Prior to the acquisition by JAB, GMCR was trading at all-time low levels of close to 16x P/E but as can be seen from the investor presentation this was at a 3-yr bottom for the business. The average over that period had been closer to 20/25x.

 

Valuation

P/E – The current implied KDP price of ~$16/share equates to 12.4x P/E on 2019 EPS of $1.27, including synergies. The EPS estimate ranges across the street from $1.14 up to $1.35, however the Company has not provided an official 2019E number, and has noted that 2018E does not include synergies. The comps KO, PEP, MNST, FIZZ, STZ, etc. are trading at an average of 25x P/E. Even assuming you give KDP a 20% discount to peers due to Keurig, or 20x earnings, the stub is worth $25. This makes the total compensation for the transaction $130, resulting in the 8.3% return.

EBITDA - A similar analysis using EBITDA multiples of 16x (mean peers) for DPS on 2019E EBITDA of $1.75B and 12x for Keurig ($1.3B) + Synergies of $1.9B gets you to a KDP stub price of $27. This is inclusive of net debt of 3.5x, although the Company has reiterated they will be reaching less than 3x leverage by transaction close. They have raised about $13B of debt as a part of the transaction and there will be 1.4B shares outstanding.

FCF Yield - One of the merits of the business is strong free cash flow generation. While numbers here are opaque relative to the above methodologies, the combined businesses will generate ~$2B of free cash flow. This number comes from 2018E $2.8B of pro forma Adj. EBITDA and a punitive estimate of $800m of capex (estimates are closer to $400m). On the current stub valuation that is a 9.1% FCF yield. Again comparing to peer group FCF yield of 4.0%, a 4.8% FCF yield on the new KDP (20% discount), would be a $30 stock. A consideration is that KDP will be more levered than the peers and may result in levered free cash flow differing significantly from the unlevered.

PF Combination - Another useful angle is to simply look at the combined businesses in terms of enterprise value. GMCR was taken private for $14B in 2015 and today has $1.3B of standalone EBITDA. DPS TEV PF for the acquisition is $23B. On the PF 1,400 shares, and including the $600m of synergies, the stub is worth $21.60. If you exclude synergies it is worth $17.36. These are assuming no growth at GMCR since the take-private, which to be fair, the business appears to have been flat.

 

Risks

This is a large cap merger that is widely known and followed by the market. Therefore current prices likely present market consensus of expected outcomes and valuation.

The transaction might still get rejected by shareholders. Unaffected price of DPS is $96/share or 20% downside.

Upside from this trade  depends not only on succesful closure of the merger but also on the market valuation of the to-be-listed KDP stock.

17 COMMENTS

  1. RJChicago

    Thanks for thorough and well written write-up. One question, did I understand correctly that stub will trade prior to the closing of the deal? Thank you!

    1. Tony G

      In a sense, yes. It will trade as KDP-WI, which means KDP when-and-if-issued. This is basically a conditional share that settles at T+n, n being the day the deal closes. If the deal doesn’t close all trades in KDP-WI will be nullified.

      I’ll post a comment when I see KDP-WI trading, it hasn’t been listed yet.

      1. dt

        I do not think this is correct. Stub will not start trading before the deal is completely closed. Only after the deal is finalized and it is absolutely certain that KDP will be formed and listed, KDP-WI might start trading.
        The moment KDP-WI starts trading any arbitrage will be eliminated completelly, just the valuation of KDP will remain under question mark.

        1. Tony G

          To be fair the stub does not have to trade, but it can theoretically trade at any point in time. KDP-WI is conditional on the deal closing, so if the deal does not close they will not list and any trades made up to that point are ripped up. This is more traditional with spin-offs, but this acquisition is unique in that there is a new ticker so it makes sense for a WI to trade.
          You are correct that if it all works and KDP lists, the arb will close when KDP starts trading and that is a part of the opportunity/reason to own DPS now.

  2. greg lia

    I have never heard of a situation where trades are “ripped up” and executed on a conditional basis. Would like to learn more. Can you send the link describing this?….thanks

  3. Michael Lax

    When is this merger expected to close, assuming shareholder approval on June 29th?

  4. riantyk

    On the $103.75 cash component, will there be dividend withholding tax applied for non-US resident?

  5. Rick Sanchez

    stupid question but how did you get to implied $15.72/stub?

  6. Tony G

    I connected with the NYSE and the stub will not be trading WI but instead with Due Bills. The length of time depends on when the transaction closes / when the record date is. Illustrative close per the proxy is July 9th, but could be earlier.

    At the time DPS was trading at $119.47, and less the $103.75 dividend you get to a stub of $15.72.

    Per the proxy, there will be dividend withholding on $29-$32 of the total dividend.

    It could theoretically close after market close that day, but the proxy shows an illustrative close date of July 9th. If you’re the Company you want this to close prior to Q2 for ease of reporting, but it is tight timing at this point…

    1. Rick Sanchez

      thanks Tony. also wanted to add that the stub will fall out of S&P 500 index:

      “When Dr Pepper Snapple (NYSE:DPS) merges with Keurig Green Mountain to become Keurig Dr Pepper (KDP), its Investable Weight Factor (measuring the percentage of free float available to the public) will fall below 50%, the minimum threshold required to be included in the S&P 500.”

      1. Tony G

        Good point to flag – It will officially be pulled out from the S&P 500 on 7/2 pre-market.

  7. Michael Lax

    I see the merger was approved, wonder when the KDP when issued stock will start trading.

  8. Rick Sanchez

    Closing should be on/around July 9, 2018, so you have to imagine not far off from that date.

  9. greg lia

    Thanks to Tony for posting this idea. Worked our very nicely for me. Stub, kdp, looking like a 20.25 to 20.44 premarket equating to a 124 dps price. I was also able to execute dps 125 calls as they reorg into a cash and stub deliverable today and I felt they were grossly overpriced.

  10. Rick Sanchez

    Thanks Tony! I just bought common DPS at ~$121 and it worked out for me too. Stub trading at $21 at time of my post here which was close to where I was expecting it start at (around $20)

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