Keurig Dr Pepper Holds Ground in Soda, but Coffee Competition Tempers Our Conviction Around Its Edge

Equity Analyst

Dan Su

We award a narrow Morningstar economic moat rating to Keurig Dr Pepper and expect the firm to generate excess returns aided by intangible assets and scale benefits in its soft drink portfolio and entrenched retail and brand partner relationships in its coffee systems business for the next 10 years at least. 

Within its sparkling beverage arm, we believe brand affinity built around distinct taste, recipe reformulation and innovation to meet evolving consumer preference, should enable the firm to maintain the top position in its specialty categories. This should afford continued pricing power despite secular headwinds driven by consumer health concerns and restrictive regulations. Additionally, its expansive and well-connected selling network should facilitate exposure to high-growth categories (including premium water, seltzer and energy drink) via distribution partnerships forged with emerging brands, which could later lead to acquisitions.

However, we’re less sanguine about the coffee system business. We believe its retail penetration and the pod availability of top coffee brands continues to underpin its competitive position, with its annual target for 2 million new households (roughly 5% increase off a 35 million installed base) achievable the next few years. But we see growing threats to the long-term durability and value of the Keurig ecosystem, given competitive pressure, most notably from a more aggressive Nespresso now poised to expand in North America as well as reusable pods gaining adoption given low cost and environmental benefits. We expect Keurig Dr Pepper will have to invest more in innovation, brand partnerships, and customer acquisition to fend off competitors, funding such initiatives partly with cost savings (roughly $600 million, or 5% of the total cost base) from distribution and procurement consolidation and a leaner organization. 

We don’t think this strategic roadmap stands to change after the abrupt departure of former-CEO Ozan Dokmecioglu in November, following code of conduct violations. And until a permanent replacement is named, we take comfort that experienced business operator and ex-CEO Robert Gamgort has retaken the top position.

Business Strategy & Outlook

We believe Keurig Dr Pepper has amassed a narrow economic moat, based on intangible assets and scale benefits in its ready-to-drink beverage portfolio, as well entrenched retail and brand partner relationships in its coffee systems business. While significant goodwill (40% of total assets versus 20% at both wide-moat Coca-Cola and Pepsi) following its 2018 merger has raised the bar for earning economic profits, we expect steady revenue growth and operational efficiency gains to help the firm deliver an average return on invested capital above our estimated 7% weighted average cost of capital for more than 10 years. That said, we don’t expect such excess returns can stretch over a 20-year horizon given secular headwinds in its U.S.-focused beverage arm and competitive pressure facing the coffee business.

We see an intangible assets moat source bolstering Keurig Dr Pepper’s competitive standing in both the packaged beverage and coffee categories. Its collection of well-known flavored carbonated soft drink, or CSD, brands (including Dr Pepper, Canada Dry, 7UP, and A&W) has enabled Keurig Dr Pepper to enjoy strong pricing power and close relationships with top retailers and food-service providers, therefore securing a solid number three position in the CSD category in the U.S. with a 21.7% volume share, trailing only wide-moat peers Coke (46.3%) and PepsiCo (25.6%) in 2021, per Beverage Digest. In particular, its CSD revenues (90% of beverage sales) are generated entirely from non-cola CSD subcategories (collectively accounting for half of total CSD volume) such as pepper, orange, ginger ale, and root beer (where the company dominates). This has allowed the firm to avert a head-on collision with the most iconic brands at Coke and Pepsi, with its differentiated beverage products driving brand affinity among consumers and boosting the firm’s appeal to retailers and food-service chains. The popularity of its Dr Pepper drink is exemplified by a 100% penetration at the foundations of the top 10 fast-food chains in the U.S. (per Beverage Digest), whereas CSD giant Coke only has a 70% penetration for its cola and lemon-lime CSDs. Similarly, shopper traffic and purchasing dollars driven by consumer demand for Keurig’s top non-cola CSD brands has given the firm leverage in negotiating with retailers to gain and expand shelf space. The beverage brand prowess of Keurig Dr Pepper, in turn, has enabled the company to raise beverage concentrate prices by 4.5% on average over the past four years (excluding the extraordinary price hikes in 2022) while keeping volumes flat, in contrast to overall CSD category volume contracting by 1% each year over the same period per Beverage Digest. Though the category-beating volume performance, driven mainly by the launches of low and no sugar/calorie versions of its popular non-cola CSDs, is unlikely to persist, in our view, we do expect pricing and volume trends to stay positive over the next 10 years, with prices up 2% annually on average (consistent with our forecasts for Coke and Pepsi) and organic volume growth at 1.0% (behind the 2%-3% rate modeled at its larger peers due to Keurig Dr Pepper’s narrower subcategory and geographical exposure).

On the other hand, the intangible moat source in Keurig Dr Pepper’s coffee business is evidenced not by pricing power (trends have been negative since 2018), but by its entrenched relationships with major retailers and brand partners, as it boasts an installed base of 37 million households (per company disclosures). An early mover advantage and solid execution have earned Keurig Dr Pepper a number one position in single-serve coffee brewers in the U.S. and Canada with an estimated market share north of 75%. Meanwhile, a full assortment of Keurig compatible pods from most of the top-selling coffee brands including Starbucks, Peet’s, Dunkin’, and Folgers, made possible through Keurig’s flexible licensing and/or manufacturing partnership agreements with the brand owners, gives Keurig Dr Pepper an 80% pod volume share in North America. Deploying a razor/blade model aimed at driving household penetration of brewers and subsequently pod orders, Keurig Dr Pepper sits at the center of a virtuous cycle it has cultivated over the years among consumers, retailers, and coffee brands, positioning itself as an important partner for retailers looking to ride healthy growth trends (mid-single-digit rates forecast by Euromonitor, driven by convenience and better coffee taste/aroma relative to standard ground coffee, which strikes us as reasonable) in the $8 billion single-serve coffee pod market. This has created considerable hurdles for new single-serve brewer entrants, and we surmise this position should allow Keurig Dr Pepper to grow sales and profits for the next 10 years. We have modeled coffee system sales to grow at a mid-single-digit CAGR (mostly on volume increases) over our explicit forecast period with expanding operating margins on efficiency gains; as such, we think its investment returns can exceed its cost of capital in 2025 and years beyond.

In addition to intangible assets, cost advantages based on sourcing, manufacturing, and distribution scale adds the second pillar to our narrow moat rating on Keurig Dr Pepper. The $14 billion revenue base, though small relative to Coke’s $42 billion and Pepsi’s $85 billion, still gives Keurig Dr Pepper considerable negotiating leverage to lower sourcing costs for advertising services (advertising spend at $540 million, 3.8% of 2022 sales) and for raw materials including plastic, aluminum, coffee, and other agricultural ingredients. An integrated business model facilitating full supply chain control, coupled with a network of over 100 tech-enabled manufacturing plants and distribution centers offering dynamic store delivery scheduling and warehousing capabilities, has allowed Keurig Dr Pepper to accelerate commercialization at a faster clip and lower costs compared with similar-sized peers, expanding shelf space with over 250 major retailers in North America. In addition, the firm has been able to attract top coffee brands such as Folgers (owned by no-moat J.M. Smucker) and Starbucks, as well as beverage brands (Evian, Peet’s ready-to-drink tea, and Vita Coco, to name a few) onto its manufacturing and distribution platform, further adding to its reach. We believe the scale benefits can accrue to Keurig Dr Pepper’s bottom line in the beverage business given its pricing power and have helped drive the 400-basis-point expansion in beverage operating margins to 27.5% between 2018 and 2021. However, we expect such benefits in the coffee business to be passed on to brand partners, which are in a stronger position to negotiate for more favorable terms in their five-year renewable manufacturing contracts with Keurig Dr Pepper given the importance of the brands’ volume and the availability of competing manufacturers.

While we see evidence of brand intangibles and cost advantage moat sources for Keurig Dr Pepper, we are not convinced that it is poised to generate excess investment returns over a 20-year horizon, hence our narrow economic moat rating. From our vantage point, competition from Nespresso (the single-serve coffee unit of wide-moat Nestle), reusable pods, and disruptive new coffee brewing technology could potentially weaken Keurig’s ecosystem in the single-serve coffee market. When combined with our expectation that CSD volumes will stagnate over the longer term (as health-conscious consumers in North America shift away from sugary drinks), we lack confidence that Keurig Dr Pepper can out earn its cost of capital over a 20-year horizon.

Narrow

Economic Moat

Keurig Dr Pepper Inc

Keurig Dr Pepper, Inc. engages in the production and marketing of non-alcoholic beverages. It operates through the following segments: Coffee Systems, Packaged Beverages, Beverage Concentrates, and Latin America Beverages. The Coffee Systems segment includes the manufacture and distribution of finished goods relating to coffee, pods, and brewers. The Packaged Beverages segment offers finished beverages and other products, including owned brands and third-party brands. The Beverage Concentrates segment sells branded concentrates and syrup to third-party bottlers. The Latin America Beverages segment refers to sales in Mexico, the Caribbean, and other international markets from the production of concentrates, syrup, and finished beverages. The company was founded in 2018 and is headquartered in Burlington, MA.

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