Keurig Dr Pepper Inc. (KDP) Earnings Call Transcript & Summary

Hi. Good morning, everyone. I'm Dara Mohsenian, Morgan Stanley's beverage, household products and food analyst. And on behalf of Bryan Spillane, Bank of America's food, beverage, tobacco and cannabis analyst, we would like to welcome Keurig Dr Pepper's management team for joining us for a discussion as part of a series of in-depth video discussions we are having with C-suite management teams and additional executives across the Staples Group. It's a joint effort between Morgan Stanley and Bank of America. Before we begin, we have a quick disclaimer. This call is from Morgan Stanley and Bank of America's institutional client base. This call is not for members of the press. If you're a member of the press, please disconnect. And some of the statements Keurig Dr Pepper will make may be considered forward-looking and are based on assumptions as of today, and Keurig Dr Pepper undertakes no obligation to update them. Please refer to KDP's Form 10-K for a discussion of the risk factors that may affect results and Morgan Stanley and Bank of America's websites for important research disclosures.

Hey. Thanks, Dara. I'm Bryan Spillane, and we're happy this morning to introduce Keurig Dr Pepper's CEO, Bob Gamgort; and CFO, Ozan Dokmecioglu. The format of the call will be Q&A from Dara and myself. But if you have any questions during any point during the call, please e-mail either of us. It's bryan.spillane@bofa.com or dara.mohsenian@morganstanley.com. This call is going to run for 60 minutes. And Dara, I'm going to turn it over to you to start us off with Q&A.

Great. Thanks, Bryan, and thanks for joining us, guys. We appreciate the time. So perhaps we can start with maybe some of the near-term COVID-related dynamics on your business, starting with the coffee business. Can you help us understand or quantify the benefits you've realized since COVID began on the coffee side, both in terms of increased household penetration for your brewers as well as the benefit you've seen in attachment rates? And, more importantly, I guess, as we look going forward, as you think about how sustainable these gains are beyond 2020, I would assume it's reasonable to think household penetration has picked up in brewers in this environment, but is that more stealing future opportunity in your mind? Or is that something that's upside? And on the attachment rate side, how much risk is there that things just sort of fall off as the economy reopens from here?

Sure. So first of all, good morning, Dara and Bryan. Thank you for hosting us, and good morning to everyone who's joining us today. Happy to talk to you through the coffee business, which we're receiving a lot of questions on, what is the COVID impact on coffee. And I can understand where they're coming from, and I'd be happy to provide some context to it. I always am consistent in saying that any short-term conversation needs to be put in the context of the longer-term trends and strategy because this is a really solid and predictable business. And the more we break it down in the short-term, I think it's actually less valuable. But COVID is unique, so let me talk more about that. You can go all the way back to when we talked about the combination of the 2 companies in our Investor Day in March of 2018, and that's 2.5 years old, but I -- we still reference that deck and refer investors back to our website to look at that deck because everything that we talked about the coffee business at that time is still relevant today. And so let me just refresh what are the key things, and then I'll talk to you about COVID. Key things are household penetration is the single biggest driver of our coffee system growth. It's the key metric to focus on for the long-term health of this business. We last updated that, because we only do it once a year, in Q4 -- on our Q4 call. So it's about 9 months old, but the number was 30 million American households. And if you look at that 30 million American household penetration number and you compare it to 2015, which is when KGM was taken private, that's an increase of over 40%. It's about a 9% compound annual growth range. And there are very few if any CPG companies that can talk about that level of real growth. But we also talked back in 2018 about our belief that we could grow beyond 50% household penetration. And that's very much intact, and we have a lot of confidence in that. So one of the other questions we get is, well, how much runway do you have in front of you? Well, if you look at our growth rates and you look at that 50% number, you have at least 10 years of strong growth in front of us before we have a conversation about what next. So that's why we don't spend a lot of time talking about that because, again, there are very few companies that have line of sight to that kind of growth. So with all of the long-term factors in place, COVID is unique. But what I will tell you right upfront before I get into the details is with all the pluses and minuses of COVID that I'll take you through, that long-term outlook and the way that we run our business is very much intact because we don't see this as a pandemic-driven business. It was doing really well before. It's delivering really well during the crisis. And whatever the new normal is, we have enough flexibility to manage it to success. But there are 4 factors that we ought to talk about in the context of COVID and how it fits into the long-term strategy. And you mentioned one of them, first, and that's the attachment rate. Attachment rate, just to make sure everyone knows, is the number of cups per brewer that's installed. And we usually don't talk about attachment rate because it's been absolutely steady for years. That's the good news of it. When a new household comes in, the attachment rate stays intact. But it's been also -- it's not a number that we saw as a big growth driver. Well, not surprisingly, the attachment jumped fairly significantly in the early days of the pandemic. What have we seen since then is you see a direct correlation with consumer mobility. So as consumers have become more mobile, and I know you talk about that all the time, that attachment rate has come down from its peak, call it, the March-April timeframe, but it still remains elevated. And honestly, where it goes from here is completely dependent upon the trajectory of the virus and how people think about their work situation going forward. Our base assumption is that the attachment levels will settle, but they'll settle at a slightly elevated rate in this new normal given a combination of things about work from home and how people now view value and the fact that this is a much greater value than going out. The good news is, we talked about it before, we've got this connected panel of brewers, smart brewers that give us point of consumption data. So attachment rate is something that we can literally manage -- not manage, measure hour to hour, if we wish. So it's something that we have a good grip on. Second metric is another one we never talk about, but worth referring to here, and that's the brewer upgrade cycle. So that's existing Keurig households upgrading their machine. Well, during COVID, we've seen an uptick in consumer upgrades. And it makes sense because, one, people are staying at home and they value their brewer much more. The other element is, for years, the company gave consumers no reason to upgrade. Now with our innovation pipeline and all the new brewers in terms of quality and the benefits, we've given people a reason to upgrade. So you have to think about the Keurig business very much like it's an annuity, and it's very similar to a subscription business. So every household that recommits is a really bullish indicator for the long term. But again, it doesn't provide an immediate increase in pod sales, but we're really happy to see people upgrading their machines at a higher rate. So then I get to the third metric, which is the one that I keep saying is the most important, which is household penetration. So no question, household penetration has accelerated during the crisis. But I want everyone to view this as an incremental boost to the long-term trends, not a transformational increase of short-term nature. And the reason why it's -- I put it in that category, it's pretty easy to understand if you analyze consumer behavior. Most consumers wait for their current brewer to break before they get a new one. So when the pandemic hit, clearly, at-home coffee consumption went up, but the majority of that was satisfied by the brewer already in the home. But what we see is as consumers replace their brewers, Keurig is getting a disproportionate share of those replacements. So like in the -- if you look at NPD data, which is available to everybody, if you look at the latest period, Keurig machines are growing at 17%, drip coffee makers are growing at 5%. And so there's clearly an attraction to at-home coffee, and we're getting a disproportionate share of that. But you have to remember, we have this incredibly strong and large household base that's already installed. So even that level of change is a modest increase to a household penetration in any given year. And that's why we keep saying it's interesting, but look at the long-term trajectory. That 9% compound growth over 4 years with continued strength is what you should be focused on and not overly focus on the short-term. And the last piece I would talk about is one that again that we rarely talk about is our away-from-home business. And that's primarily office coffee. And you don't have a lot of external visibility to that, and it has been just a really solid profitable performer within the portfolio that's moved along with the Keurig system's growth levels. And therefore, we haven't talked a lot about it. But let's be clear, there's a big gain in at-home coffee consumption. There's a big hit in office coffee. Office traffic has been one of the hardest hit of all mobility measurements in the pandemic. And if you look at it, it's persistently negative. So even as mobility has started to increase, and we're seeing restaurants recovering somewhat, and you see mobility at retail increasing, people have not come back to offices. So we've got these strong at-home trends, but there's been a significant offset to that, which is our away-from-home business. And if you think about how this all converges, in Q3 is when we're going to see the peak impact of the office on our coffee systems results. And then when you get beyond that, what are we seeing? We're seeing -- already in the latest IRi data, you're seeing changing seasons in the start of school, you're seeing an uptick in at-home coffee consumption again. And you're seeing some offices returning workers and talk about returning them at a faster rate. So it's the balance of the strong at-home offset by a negative away-from-home hits us to the most to the negative in Q3, and then it starts rebounding again. And then remember, we think going forward, as offices reopen, we actually have the ability to increase our share in that space because single-serve coffee has become a much more attractive format in this new normal, and we have the default single-serve system. So that's really what I want to talk about in terms of COVID. Those -- all of the things I just discussed all factored in the guidance that we've given for the balance of the year. The timing gets a little uneven, as I point out in Q3, and Q2 was a different situation. But what I would suggest whenever you look at any Keurig quarterly data, look at our conversations on these earnings calls over the past 8 quarters. We've been just as quick when we've had spectacular results to say, look at the long-term. As we've said when there's been results that have been below expectations look at the long-term, I would say the exact same thing here. And the takeaway is not that this is a COVID business or a pandemic-benefiting business. This is a really unique long-term growth play that has incredible line of sight to the future that has passed the COVID test. And that we believe that, yes, there's some incremental benefit to it, but what's much more important is the long-term trajectory.

Right. That's helpful. That's very comprehensive. And just 2 quick follow-ups on that. One, the brewer uptick you've seen, how much of that is new customers versus sort of upgrading existing customers? Is your sense that, that's more incremental longer-term? Or is it just sort of taking customers that might otherwise have come in over the next year or 2? And then second, can you help put in perspective a bit more the size of the office and hospitality business in coffee relative to at-home relative market shares, et cetera, however you want to frame that?

Yes. You would when -- one of the metrics that we discount in our earnings calls are brewer sales. There's been a lot of attempts to correlate brewer sales with household penetration growth. And we say, over time, there's a correlation, not -- that there's not -- it's not a direct one-to-one. And definitely, on a quarterly basis, it's almost meaningless. Because embedded in those numbers is a combination of people replacing our existing brewers with new households coming in. So you've seen in the Q2 results, and if you look at the NPD data that I just referenced, you're seeing a big increase in the number of brewers that we sold. It's a mix between new households coming in as well as existing households upgrading their machine. They're both good because, as I said, this is a subscription business. You want people to re-up, and they're doing that. And then when people come in, it's very sticky. When our success rate in a new household coming into the system, our success rate of them staying for the long haul is very, very high. So the numbers that you're seeing in our brewer sales are a mixture of the 2, and we don't break them out specifically. But the most important takeaway is every new household that we bring in now is an annuity for the long-term, and they're not going to drop out post-pandemic. This is a behavior that sticks for the long-term. Your point about the away-from-home -- your question about away-from-home coffee, we've not broken that out either. But what we have said, I can talk a little bit about that, is about half of our coffee business is in untracked channels. That includes away-from-home, which has taken a big hit; specialty retail; department stores; et cetera. You can imagine those have taken a hit. The Canadian business is in there, and Canada's behavior looks a lot like the U.S. Everything I just said before applies to Canada. But also in there is e-com. And I think it's important to just take a moment to say e-com has been a very big driver of growth, and it's been able to offset some of that hit that we talked about in specialty retail, and to a degree, away-from-home. We said on our Q2 call that e-com represented 10% of KDP sales. You can imagine that's a much more meaningful number in coffee systems. And I think that, that is another really strong future indicator that as our business becomes more developed in e-commerce, that's stronger towards the long-term trends, where consumers are going, where they're shopping for the future.

Hey, Bob, just one follow-up to Dara's question, more longer term. If Keurig was building household penetration early on wedding registries, so getting on the wedding registry was one way that it was -- an effective way of sort of getting in the household -- early household formation. And another was people -- consumers were actually replacing -- using the Keurig machine as a replacement for drinking coffee away-for-home. So put a mug in the machine before you got in the car and left in the morning. So are those 2 behaviors still relevant today? Are they still driving sort of adoption into the system today?

Very much so. Gifting is an important driver, and what we've talked about in the past is a requested gift is better than an unrequested gift. So when somebody puts it on a wedding registry, that's the definition of a requested gift. But it has always been a driver. And your second driver, which is using this in a replacement for away-from-home coffee, becomes even more relevant if we were to enter into a recession because now you've got a much bigger installed base. The quality of the machines and the coffee that it produces is significantly greater. And remember, we've got K-Café and K-Latte that produce cappuccinos and lattes. So there's a lot -- it's a much better-installed base than it once was. And that conversion for cost reasons is available, not to mention our pod price is way down it was before. Just as -- one more point on gifting. We had a very strong Mother's Day. We talked about that on our Q2 call. And when you -- when we get feedback from retailers, as we gear up now for the Christmas and the end-of-year holiday season, we're seeing some real interest and strength from retailers as well. In an environment like this, there's a shift to more pragmatic gifts. And with all of the innovation that we have coming out there, we're giving people a reason to really push Keurig for gifting. And so we're very optimistic about that being a continued driver of household penetration.

Maybe, Ozan, just to shift a little bit. On the last earnings call, it was pretty clear that you had a bias in the second half of the year to reinvest any upside that there might be -- back behind the business. And so I just wanted to better understand that, especially after 2Q was a little bit better, and maybe the theoretical benefits of COVID on the top-line. And even after the away-from-home weakness, it sounds like top-line benefits that emerge could be offset by reinvestment. So I guess, is that the case? Or is it more net that there probably is not much top-line benefit by year-end, putting all your puts and takes together?

Yes. Thanks, Bryan, and good morning, everyone. First of all, let me start with the fact that, as Bob was saying, the COVID-19 environment was not a windfall for us at all. In fact, it was a product of effective mix management and a ruthless prioritization. Let me expand what do I mean with those points. For example, when you take a channel look, we have experienced and is still the case significant swings within our channels from the sales channels perspective. It is true that at-home consumption of our beverages has increased while the office and hospitality coffee consumption has declined significantly as has fountain foodservice, convenience and gas on the cold beverage side of our equation. When we take, for example, look of the products and the packaging formats of our business, we have also seen significant swings in what consumers are buying in terms of the rapid shift like shifting toward larger multipack sizes away from more profitable, either impulse or convenience-driven items. Well, we have had to drive our growth areas harder to offset the pressure from declining segments. And when our share gains across our CORE portfolio is a great example to this. We have also had to manage the cost side of our portfolio to offset the negative mix impacts and continue to deliver on our financial commitments by doing several things. We should not forget that we are more than into 2 years of our integration process that actually enabled us to have a great visibility as well as the management of all the cost drivers across the network across our company. A couple of them to share as an example is significantly lower travel and entertainment expenses. Also, some reduced marketing spending given that the return on investments were not there in some of the investments that we were planning to do before. And at times, it was not even appropriate to continue or carry on with the investments that we thought. Therefore, it was not a justified environment perhaps and as part of the oil sector that had some reductions. Plus, again, as I said, we had great visibility in all other controllable cost drivers. We are managing this business for the long-term, no question on that. Therefore, we never like to reduce marketing spend. But this is an extraordinary year in which everyone has needed to do so. Having said that, we continue to deliver our merger algorithm on the financial results that the commitments that we put out there. And let's make sure that all those financial returns have been well above our peer set. Therefore, we believe it makes sense to reinvest any financial upside beyond those already aggressive returns back into brand growth and innovation to ensure continued momentum in 2020 and beyond.

Okay. That's very clear. So -- and just to be clear, it's really investing. A lot of it sounds like it will go behind innovation, right? Just teeing up the innovation pipeline for next year, is that a big priority in back half of the year?

With -- innovation investments have always been priority, and that has never changed. And we are increasing our innovation investments in all parts of our business whenever we see the opportunity. And that applies, as you say, both this year as well as next year as well as by considering the longer-term of our top-line as well as bottom-line growth.

Yes. And Bryan, we've had -- just to add to that, we've had very strong innovation on the cold side as well as the hot side in 2020 that has served us really well. We'd like to invest incrementally behind those if we have the opportunity because we see opportunity now to continue to build household penetration on the cold side as well as the hot side of our franchise.

Right. Okay. And then maybe -- I know it's early to talk a little bit about '21, but at a high level, I guess, Ozan, if you could talk a little bit about maybe how you're seeing the external environment shaping up, maybe some of the considerations like on comparisons, maybe some of the company-specific levers that you have to deliver on your '21 targets. I know there's going to be some concern about whether it's a tough comparison year or not in 2020. Again, we talked a lot about puts and takes. But just -- maybe just at a high level, just kind of how you're thinking about the environment for next year as you see it today and how that sort of squares with delivering on your targets for next year?

Sure. And please let me start by saying that Keurig Dr Pepper, we are only one of the few companies that have provided visibility into the 2020 financial results delivery for the full year and not just for the next quarter. And that visibility included a double-digit EPS growth as well as a significant debt reduction. We continue to express our confidence in our 3-year merger algorithm, which takes us through the end of 2021. And 2021, we likely expect to continue to be another volatile and challenging year. But if this crisis has proven anything, it is that we can drive our business to succeed in nearly any working environment. That speaks to the long-term confidence we have in this business and how we have been running and have the control, both the top and the bottom-line drivers. We will share our 2021 outlook at the appropriate time, no question on that. Let me provide a few thoughts. We are on track to achieve our leverage ratio of 3x or below by next year, which will provide significant optionality to create value for our shareholders. For example, cash generation is and will continue to be exceptionally strong. As you would remember, when we announced our 2019 full-year results, our cash flow conversion ratio was in excess of 140%. And in quarter 2, this year, 2020, the same ratio was approximately 112%, and we expect it to continue to be strong going forward. We are currently investing in several large projects as well that will provide productivity and support of our growth in future. Just to name a few, the state-of-the-art K-Cup pod production facility that we are building as we speak in Spartanburg, South Carolina; for Beverage Concentrates, our newest Allentown facility; and for the Beverage Concentrates, the new facility we are building in Ireland. So we will still have considerable white space in our portfolio that we can address through many means, likes of M&A, partnerships, innovation and so forth. I believe we have proven our ability to execute in each of these areas with strong brands that we have brought into the KDP portfolio and that we will continue as such, Bryan.

Hey, Bryan, one -- just one thing. You talked about a tough compare. We get some of those questions. Is this going to be a tough compare next year? This goes back to a couple of points we made a couple of times. So apologies for reiterating, but I think it's really important. This is -- this situation in 2020 is by no means a windfall for us. We've had a large number of negatives impact our business as well as the positive. So as Ozan said, this is really a mix management exercise that I think we've executed really well. So as the economy and the environment changes in '21, there are equal number of rebounds that we get. It's not a situation where we had a windfall, now we have to comp against that. We got a lot of negatives. I talked about away-from-home coffee that we get a rebound on as well. So it's a very different situation than a lot of other CPG companies that have been able to get a onetime benefit in '20. We're quite different than that.

Right. Yes, very clear.

And then Ozan, maybe we can talk about coffee pricing for a bit. Retail pricing has improved recently aided by mix. Obviously, that accrues to your partners, not necessarily KDP as much. But I was just hoping we could review the pricing environment in coffee longer-term post-COVID. And also with smart brewers now out there, recyclability coming in the U.S., it seems like you're sort of upgrading your system relative to other alternatives that are out there. So does that factor into pricing over time, how should we think about the relationship with your partners over time and how much of an impact that might have?

Sure. So let's take a step back, just to refresh our memories. As Bob also referenced, during our March 2018 Investor Day, we set the followings. And I think we'll shed quite a bit of light to your question as well, Dara. At that time, we said pricing was starting to moderate, and volume was improving, but not enough to offset the pricing from a negative perspective. Then we also said and projected that as pricing continued to moderate, volume would accelerate, driving revenue growth of 2% to 3%, and the margin would continue to expand. Well, we are more than 2 years, 2.5 years into that. And what we have seen? Let's take a look at it, exactly what we said. For example, in 2018, pricing was down almost 4%. Net sales were flat, and margin expanded approximately 300 basis points. Then when we take a look to what has happened, for example, in 2020, first half, pricing was down less than 3%, net sales were up 3%, and margin continued to expand another 120 basis points. So COVID-19 environment doesn't change that long-term outlook, but the pricing trends you mentioned do confirm our consumer elasticity insights, that overall pricing has reached a level where consumers believe pods are a good value. And the category has evolved into good, better and best pricing structure. With the stronger growth at the best level in 2020 that we are all seeing when you look, for example, to IRi's and reason all these kind of data, pricing for the coffee systems in our profit and loss statement primarily reflects the contracts and the partnerships that we have in place. Those investments, while predictable to us, are not always evenly paced. It's an important point to note that creates some fluctuations. Most importantly, all the investment in pricing, and very importantly, the productivity we were driving to enable the investment is transparent to us. So we run all these things around a very tight strategy and execution as we have communicated several times. Please note that Coffee System margins continue to expand, 140 basis, for example, in quarter 2 this year as we continue to make these investments.

Okay. And as we think about the long-term on the pricing front, obviously, one of the goals in the last few years was with the significant cost savings you've had. You could sort of reinvest that in pricing and drive household adoption. You mentioned that we're now getting to a more sustained pricing level in consumers' minds. As you think about long-term, is there less of a need to take pricing down over time? How should we think about that looking out from a multiyear standpoint?

I mean, I'll take this one, Dara. I mean, I think if you look forward on this, as we said, we've got long-term visibility to the pricing that shows up in our P&L because they're long-term agreements with our partners. What they choose to do with the pricing we give them is really up to them. Those partners are branded partners as well as store brands. And the environment right now is allowing for retail price stability and increases, but that's really up to them to do that. And just because, as we pointed out before, if somebody wants to invest in pricing because they want to gain share or because they have -- they want to drive foot traffic in their stores, that's really up to them to do that. So it's impossible for us to predict. The most important thing that our investors need to take away, though, is we have line of sight to the pricing that we're going to realize on our P&L, and we have that matched up with the productivity programs that you talked about. They don't always come in the same period, but we have line of sight to that one, and that's what gives us the confidence to do so. I think your other point, though, about in the future, can pricing go the other direction? I think that's an innovation idea. And that's -- we'll talk a little -- I'm sure we'll talk about brewer innovation, but there's broader innovation conversation that we could have that would give you an indication that we could do that.

Right. Okay. Why don't we switch to brewer innovation then? Obviously, you've come out with the smart brewer recently. You can control it from your phone, customize that to customers' needs in terms of temperature, brew preferences, et cetera. I guess, first, how significant an upgrade is this in your mind both from a retail customer and maybe from a partner perspective? What are the financial implications as you think about that longer-term and sort of the advantages that can emerge from having a smart brewer?