Keurig Dr Pepper Inc.

Good morning, ladies and gentlemen, and thank you for standing by. Welcome to Keurig Dr. Pepper's earnings call for the fourth quarter and full year of 2018. This conference is being recorded and there will be a question and answer session at the end of the call. I would now like to introduce your host for today's conference, Keurig Dr. Pepper, Chief Corporate Affairs Officer, Ms. Maria Scappa-Garcia. Please go ahead.

Thank you, and hello, everyone. Thanks for joining us. Earlier this morning, we issued our press release for the fourth quarter and full year of 2018. If you need a copy, you can get one on our website at KeurigDrPepper.com in the investor section. As you will recall from last quarter, the discussion of our Q3 performance was largely on an adjusted pro forma basis due to the merger, and our discussion here today will be consistent with that. The company believes that the adjusted pro forma basis provides investors with additional insight into our business and operating performance trends. While these pro forma adjustments and the exclusion of items affecting comparability are not in accordance with GAAP, we believe that the adjusted pro forma basis provides a meaningful comparison and an appropriate basis for discussion of our performance. Details of the excluded items are included in the reconciliation table included in our press release, and are discussed in detail in our 10-K, which will be filed later today. So, with quite an exciting 2018 now in the record books, our attention turns to driving another year of strong performance for KDP in 2019. Here with me today to discuss our results for 2018 and our outlook for 2019 are KDP Chairman and CEO, Bob Gamgord, and our CFO, Ozan Dagmasioglu. Also with us today is our recently hired Vice President of IR, Tyson Seeley, whom some of you already know. Tyson will lead the IR team here at KDP reporting to me. For those of you who don't already know Tyson, I'm certain you will enjoy working with him. And finally, our discussion this morning may include forward-looking statements which are subject to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These statements are subject to a number of risks and uncertainties that could cause actual results to differ materially, and the company undertakes no obligation to update these statements based upon subsequent events. A detailed discussion of these risks and uncertainties is contained in the company's filings with the SEC. And with that, I'll hand it over to Bob.

Thanks, Maria, and thanks to everyone for dialing in. We are very pleased with the strong results delivered in Q4 and for the full year of 2018. And we're especially proud of the progress we have made in creating our new beverage company. We expect to create sustained shareholder and stakeholder value over the long term. We have largely completed our integration, bringing together 25,000 employees under a unified culture and harmonized processes. And we have established a singular focus to capture growth across the majority of beverage occasions in North America. Most importantly, our in-market business momentum never lost a beat while we were in progress of integration, a real testament to the quality of our team members and the strength of our integration program. We drove growth across the majority of our portfolio in 2018, are on track to deliver our synergy goals, and are in position to deliver the overall value creation targets we communicated at the time of the merger, even in an environment that has become much more challenging over the past year. Let's talk specifics for 2018 before we speak to our expectations for the coming year. I'll begin with in-market results based on IRI. Retail market performance was strong across most of the business. Our CSD portfolio registered market share growth in both units and dollars, with strong dollar performances from both Dr. Pepper and Canada Dry, and to a lesser extent, A&W, Squirt, and Schweppes. Outside of CSDs, we gained share in multiple cold beverage segments, such as enhanced flavored still water, premium unflavored still water, ready-to-drink coffee, apple juice, vegetable juice, and mixers. Our coffee portfolio also delivered strong results in 2018, driven by unit growth approximating 10% for pods manufactured by KDP, outpacing category growth of approximately 8%, In dollar terms, KDP manufactured pods grew over 4% in a category that advanced approximately 3%. As a result, the dollar market share of pods manufactured by KDP advanced to 82%. Turning now to total company financials on an adjusted pro forma basis. Net sales were up 2.3% for the year, with strong revenue growth registered for all segments except coffee systems which was up in volume but essentially flat in dollars due to our previously discussed strategic pod pricing investment. Operating income advanced approximately 7% to $2.6 billion, with double-digit growth in the second half of the year, more than offsetting flat performance in the first half. For the year, the profit contribution from growth in net sales and continued strong productivity was partially offset by increased inflation in input costs and logistics. Further, the operating gains from changes in the Allied Brands portfolio in 2018 were less than those realized in 2017. Adjusted diluted EPS advanced 22% to $1.04 for the year, squarely in line with our targets, reflecting the growth in operating income and lower interest expense as well as the benefit of non-operating income recorded in 2018 related to a cash distribution from Body Armor and a gain from the acquisition of Core, also benefiting the comparison with a lower effective tax rate in 2018 due to U.S. tax reform. Turning to our segments on an adjusted pro forma basis, I'll start with beverage concentrates, which posted strong results for the year, Net sales, which represents our sales of concentrates to bottlers and syrups to fountain customers, advanced approximately 4%, driven by growth in both net realized pricing and volume mix. The increase in net sales was driven by very strong growth of Dr. Pepper and A&W, as well as increased sales for Squirt, Schweppes, Big Red, and Canada Dry. Operating income for beverage concentrates advanced 5% for the year. reflecting the strong net sales performance and slightly lower marketing spend. Turning to packaged beverages, packaged beverages delivered 4% growth in net sales for the year, reflecting volume mix growth of 5.4% for continuing brands, partially offset by the anticipated unfavorable impact of 1.2%, resulting from changes in the allied brands portfolio during the year. Pricing for the year was essentially even with a year ago, driven by the pricing actions implemented in late Q3 that offset lower net price realization earlier in the year. Driving the net sales momentum was double-digit revenue growth of Canada Dry, reflecting successful innovation. Dr. Pepper also registered growth for the year, driven by the particular strength of our college football marketing campaign, Fansville, which featured an engaging storyline that played out over the course of the season. Core and Buy also posted very strong growth, partially offset by Fiji, Vitacoco, and Hawaiian Punch. Contract manufacturing also contributed to the revenue growth for the year. Operating income and packaged beverages declined approximately 10% for the year, primarily due to inflation that was not covered until we took pricing late in the third quarter. as well as the impact of gains recorded from allied brands being lower in 2018 than 2017. Partially offsetting these factors were the benefits of net sales growth and productivity. Illustrating the importance of our late-year pricing actions, operating income for packaged beverages accelerated in the fourth quarter, growing more than 8%, which Ozan will cover shortly. As we head into spring, we see the benefits from the launch of diet Canada Dry ginger ale lemonade and the introduction of Canada Dry ginger ale and orangeade, both of which will be supported by marketing investment. In addition, we have continued innovation plan for Dr. Pepper and Snapple, among other brands. Turning now to Latin America beverages. Latin America beverages had a strong year, with net sales advancing 4% and operating income up 28%. The net sales performance reflected higher net pricing of 5.5% and favorable volume mix of approximately 1%, partially offset by unfavorable foreign currency translation of 2%. Pena Fial led the growth in net sales, along with Clamato, Squirt, and Mott. Operating income for Latin American beverages grew 28% to $82 million for the year. primarily reflecting the growth in net sales as well as the favorable impact of comparison to a year ago write-off of prepaid resin inventory and, to a lesser extent, productivity. Now turning to the coffee system segment. Coffee systems had a solid year with volume mix up 3.2%, driven by strong K-cup pod volume growth, offset by lower net realized pricing of 3.7%. reflecting the previously discussed strategic pod pricing investment, which continues to moderate. K-cup pod volume grew 7.4% for the year, driven by increased household penetration of the Keurig brewing system, which expanded by 7% and is now approaching 22% on a rolling 52-week basis ending December. Somewhat counterintuitively, brewer volume declined 1.5% despite the growth in household penetration. This is the result of increased brewer quality, which has led to consumers holding onto their brewers longer and has also resulted in fewer returns. Brewer sales were also impacted by the discontinuation of select legacy brewer models, partially offset by the success of our recently introduced K-Cafe and redesigned K-Mini. Since 2016, our entire brewer lineup has been refreshed or replaced with new models. The launch of K-Cafe, which was supported by the second year of our Brew the Love campaign featuring James Corden, has been well-received in the market. K-Cafe enables consumers to make lattes and cappuccinos at home using any K-Cup pot. The consumer reviews of the new brewer have been exceptionally strong. In addition, our updated K-mini brewer platform, which features a modern sleek design and improved coffee quality and temperature, is another example of our robust innovation pipe program designed to drive new household penetration in the Keurig system. Operating income for coffee systems was up a strong 9% for the year, primarily reflecting volume growth and strong productivity, partially offset by strategic pod pricing investment. inflation, and higher marketing. As you know, partnerships are a key element of our coffee system strategy, and in 2018, we added Tim Hortons, the iconic coffee brand in Canada, which was previously unlicensed, and Panera, the well-regarded bakery cafe brand in the U.S. We've also signed an agreement with Met Cafe in Canada, previously an unlicensed brand, which we will begin distributing in 2020. We also added and expanded multiple private label partnerships in 2018. And finally, the strong pace of brewer innovation will continue in 2019. While too early to share the specifics today, on our next call we will have the opportunity to discuss our 2019 innovation plan, which will begin shipping in Q2. We will also be increasing our investment behind Keurig brand marketing this year. Before I turn it over to Ozan to provide more detail on the latest quarter and 2018 full year, I'll speak to our 2019 targets. For the full year, we're targeting adjusted pro forma diluted EPS growth in the range of 15 to 17%, representing $1.20 to $1.22 per share. This growth rate is the same as the long-term target we communicated at the merger announcement over a year ago, despite an increasingly challenging operating environment marked by higher inflation and CSD industry volumes that are somewhat pressured by the elasticity impact of pricing. To navigate these pressures, we are strengthening our productivity efforts and investing in innovation, marketing, and retail execution to continue to drive market share gain. With that, I'll hand it off to Ozan.

Thanks, Bob, and good morning, everyone. Let me start with the results of the fourth quarter, which was another very good one for KDP. I will then transition to our outlook for 2019, continuing on an adjusted pro forma basis. Net sales for the fourth quarter increased 0.5% to $2.81 billion, compared to $2.80 billion in the prior year, which reflected underlying net sales growth of 2.3%, significantly offset by the unfavorable impact of 1.8% from changes in our allied brands portfolio, which we expected. The underlying 2.3% growth was driven by higher volume mix of 2.7%, partially offset by unfavorable foreign currency transition of 0.4%. Net realized pricing in the quarter was flat. Operating income in the quarter increased nearly 13% to $720 million, compared to $638 million in the prior year. This performance primarily reflected strong productivity, lower general and administrative expenses, reduced marketing spending, and the benefit of the net sales growth. Partially offsetting these drivers was inflation in input costs and logistics. On a margin basis, operating income advanced 280 basis points in the quarter to 25.6%. Before turning to a quick review of the segments, it's worth noting the acceleration in performance in the second half of 2018 versus the first half prior to the merger close. Specifically, operating income advanced 13.5 percent versus a year ago in the second half, compared to a slight decline in the first six months of 2018. This step up in performance largely reflected very strong productivity and the benefit of pricing actions in packaged beverages taken in the third quarter. In terms of segment performance for the fourth quarter, On an adjusted pro forma basis, net sales for beverage concentrates increased 4.8% to $352 million, driven by higher net price realization of 2.6% and increased volume mix of 2.4%. Partially offsetting these positive factors was unfavorable currency translation of 0.2%. This growth was fueled by sales of Dr. Pepper, along with increases in 7-Up, Big Red, Schweppes, and Sunkist. The shipment volume growth for beverage concentrates was driven by Canada Dry, Dr. Pepper, Big Red, and Sunkist. In terms of bottler case sales, beverage concentrates registered growth of nearly 1% in the quarter. Operating income for beverage concentrates increased more than 14% to $242 million, reflecting the benefits of the net sales growth and lower marketing partially offset by inflation. As a percentage of net sales, operating margin advanced 570 basis points versus year ago to 68.8%. Net sales for our packaged beverages segment were essentially even, with year-ago at $1.18 billion, including the unfavorable impact of 4.2% from the changes in our allied brands portfolio, which we expected. Excluding this impact, underlying net sales grew 4.3%, reflecting favorable volume mix-off growth 2.7% and net price realization of 1.7%. Unfavorable foreign currency transition of 0.1% served as a slight offset to the growth. Driving the strong underlying net sales growth were Canada Dry, Core, Dr. Pepper, Big Red, and Mods, as well as contract manufacturing. Operating income for packaged beverages increased 8% to $206 million, largely reflecting the underlying net sales growth including pricing actions taken late in the third quarter, as well as favorable product mix, productivity savings, and lower marketing spending. These factors were partially offset by inflation and the unfavorable comparison against the $21 million gain on buy in the fourth quarter of 2017. Net sales for Latin America beverages increased 1.7% to $120 million, compared to $118 million in the prior year. This performance was driven by higher net price realization of 5.8% and favorable volume mix of 0.1%, partially offset by unfavorable currency transition of 4.2%. Operating income for Latin America beverages advanced 20% to $18 million, reflecting the benefits of the net sales growth and productivity savings, partially offset by inflation. Finally, net sales of our coffee system segment declined 0.5% to $1.16 billion in the quarter. This performance reflected higher volume mix of 2.9%, more than offset by lower net price realization of 3%, and unfavorable foreign currency transition of 0.4%. The 2.9% volume mix growth for coffee systems was driven by an 8.6% increase in K-cup pot volume, partially offset by an 8.6% decline for brewers during the quarter, the latter being primarily driven by shipment timing between the third quarter and the fourth quarter. For perspective, brewer sales in the second half were modestly below a year ago. As you know, Q4 is a big brewer selling period for retailers, and their purchase of inventory can shift between the third and fourth quarter. Partially offsetting these factors were recent innovation launches that have been very well received in the marketplace. Operating income for coffee systems advanced approximately 9% to $328 million, primarily reflecting strong productivity, partially offset by higher marketing expense and inflation. Turning to interest. Interest expense in the fourth quarter totaled $139 million, reflecting a $21 million benefit from unwinding several interest rate swap contracts, our ongoing deleveraging, and the benefit of commercial paper in our debt structure in 2018. You may have also noticed that earlier this month, we announced the refinancing of our term loan in an oversubscribed indication that reduced the pricing on our outstanding term loan balance of $2 billion by approximately 30 basis points. The support that we continue to receive from our banking partners speaks to the confidence our lenders place in KDP. Net income for the quarter increased 28% to $423 million, driven by strong operating income growth and the lower interest expense we reported in the quarter. Taking all of these factors together, our adjusted pro forma diluted EPS in the quarter increased 25% to $0.30 per diluted share, compared to $0.24 per diluted share in the prior year. In terms of leverage, we paid down approximately $940 million of bank debt since merger close, reducing our bank debt to adjusted EBITDA ratio, which we refer to as our management leverage ratio by half a turn to 5.5%. four times. This aggressive pace of deleveraging is consistent with our expectations, and we are confident that we will achieve our leverage target in the timeframe previously committed. This rapid debt pay down in the six-month period following the merger close was supported by strong free cash flow delivery. In 2019, we expect free cash flow to approximate $2.3 to $2.5 billion. which will be a significant enabler to our ongoing deleveraging. We remain firmly committed to achieving our targeted leverage below three times in two to three years from merger closing. And finally, in terms of our outlook for 2019, as Bob already mentioned, for the full year, we expect adjusted pro forma diluted EPS growth in the range of 15 to 17%. representing $1.2 to $1.22 per share, in line with our long-term merger algorithm. Net sales are expected to grow approximately 2%, which is also in line with our long-term merger target of 2% to 3%. Despite the short-term transitory impact we discussed with you last quarter from the changes in our allied brands portfolio, We continue to expect merger synergies of $200 million in 2019, consistent with our long-term merger target. There are few items related to changes in the Allied Brands portfolio in 2018 that we do not expect to repeat in 2019. These items totaled $58 million in gains in 2018. Specifically, other operating income, in 2019 is expected to be a few million dollars of expense, as it will exclude the $22 million gain on Big Red recorded in 2018. Below operating income, other non-operating income and expense is expected to be an expense of $30 million in 2019, as it will exclude the combined $36 million of gains recorded on Core and body armor in 2018. Interest expense is expected to be in the range of $570 million to $590 million. This reflects our expectation of significant cash flow generation and continued deleveraging during 2019, as well as the benefit from additional unwinding of interest rate swap contracts, which is a strategy we use to manage interest rate risk. Our effective tax rate for 2019 is estimated in the range of 25 to 25.5% for the year. We expect our diluted weighted average shares outstanding to approach 1.42 billion in 2019, including the 16.7 million of shares issued in November 2018 for the acquisition of CORE. While we are not providing EPS guidance by quarter, we expect EPS growth versus 2018 to be tempered in quarter two and quarter three due to comping the significant gains on allied brands in 2018 that we discussed today. With this perspective, you should also keep in mind the following when doing your modeling. We expect our second-half synergies to be greater than our first-half synergies as our programs build throughout the year. Based on our input cost coverage, we expect inflation to be the highest in the first quarter and then moderate over the balance of the year. Finally, the shift in ISTER into the second quarter this year from the first quarter in 2018. will likely pressure quarter one net sales and operating income in 2019 by approximately $20 million and $10 million, respectively. With that, before taking your questions, I will turn it back to Maria, who has some good news to share regarding IRI data.

Thanks, Ozan. I know that tracking KDP manufactured pod performance is challenging for you using the existing syndicated reporting. I'm pleased to share that in addition to their regular reporting, IRI has developed a KDP manufactured sales trends report for single serve coffee that encompasses all of the K-cup pods manufactured by KDP, whether owned, licensed, partner, or private label. This new report will be available directly from IRI beginning in March. I hope you find it useful. With that, I'll turn it back to the operator for questions.

At this time, I would like to inform everyone, if you would like to ask a question, please press star, then the number 1 on your telephone keypad. If your question has been answered and you wish to remove yourself from the queue, press the pound key. Once again, to ask a question, please press star 1. Our first question comes from the line of Lauren Lieberman of Barclays. Great. Thanks.

Good morning. I know you guys went through some of the data points on brewer sales and the dynamics of the replacement cycle, but I think there might be a bit of confusion this morning around results from the coffee segment. So if you could just talk again a little bit about how you are thinking about the role of brewers, brewer sales, brewer profitability, how that may have changed. in the long-term plan, and also, you know, anything around pods as you see it as being indicative of kind of consumer uptake, adoption rates, things like that. Because I think, you know, what I'm getting from people this morning is just questions around that coffee segment and, you know, does this mean that my longstanding concerns about legacy KGM business are coming to fruition? So I just love your perspective on that. Thanks.

Yeah, thanks, Lauren. Happy to answer that. I mean, from our perspective, the metrics across the board on the coffee system are all flashing green. I think our understanding is that sometimes this is a complicated business that requires some thought from our perspective to tell you why we feel that way. And it's consistent with what we talked about in the March of a year ago, Investor Day, as well as the follow-up analyst meeting that we had. So let me start at a higher level about the metrics that really matter on this business from a management perspective, and then I want to drill specifically into household penetration, brewer sales, and a little bit on what we see on pods. So the way that we run this business is the four metrics that matter are household penetration of the system, pod volume growth, KDP manufactured pod share, and coffee system profitability. Every single one of those metrics is going in the right direction in a very significant way. Household penetration up 7% in the past year to about 22% of households. There are now 28 million households in the United States that are using a Keurig brewer on a regular basis. And we still believe there's another 67 million households left for us to target. But a 7% growth in household penetration up to 28 million households is significant. Pod volume growth, up significantly. If you take a look at the K-Cup pod category in IRI, plus 10% for the year. Incredibly robust. KDP manufactured share, up a point to 82%, as we talked about. And we gave you the list of partners that we've added over the past year, some of them very significant. Several of them were unlicensed parties, and we haven't lost anyone in the past year. So that speaks to the forward-looking confidence that we have in that. And then finally, coffee profitability. I'll get to brewer sales because I know people are concerned about brewer sales, which there's zero correlation in the short term between household penetration and brewer sales, and we're going to give you the example of that right now. But also things like mix and pricing. But you also have to look at coffee systems, even with the investment in pricing, grew margin in the fourth quarter by 240 basis points. And for the year, 290 basis points, which tells you that we also have incredible line of sight to productivity that we use to protect that pricing investment that we made. So those are the metrics that matter. Some of those are easier for you to get than others, but we're disclosing household penetration on an annual basis as we did today. And as Maria said, There's now a report available through IRI that will allow you to measure KDP, manufacturer, pod share. So those are all pointing in the right direction so that you can see the business the way that we do. Let me just talk about brewer sales for a minute. At a very high level, we've talked in the past kind of theoretically that you could have a situation where brewer sales were up significantly but had little impact on household penetration because they were all replacements. Similarly, we talked about a theoretical scenario where brewers could be down significantly, yet household penetration was up because the replacement cycle was different and they were all going to new households. We're more towards that in 2018 in the last quarter, which were brewer sales were down, but household penetration was way up. The reason underlying that is actually really good news. A higher percentage of the brewers sold went to new households versus replacement households. Why is that? Because the quality of the brewers is up significantly. You can see that by going online on Amazon or Walmart or anywhere else and look at the star ratings of the brewers and how much higher they were than those in the past. We also see it because we see significantly lower returns and significantly lower warranty claims. Those are really good for the P&L in addition to speaking towards a better mix of new users versus replacement users. And the other part is we know as one of the metrics that we track internally is that consumers are happier with their brewers. They don't break. And as a result, they're holding on to their brewers for longer. So we're in sort of this virtuous situation. It's the opposite, I think, of being concerned. We're actually very bullish. Because of the quality of our brewers, we're driving household penetration. And ironically, it means that we're going to have some lower brewer sales in situations like we did in the fourth quarter. because fewer people are buying them to replace a broken brewer. That means happier consumers in the end. So net-net, we see these as all flashing green from that standpoint. Then the last thing I'll say on this point, and apologies for the very long answer, but I think it's a really important question. In the past, when the company lost a significant amount of money on brewers, everybody wanted to model brewer sales because the more you sold, the bigger the negative impact on profitability was. Similarly, if we made a lot of money on brewers, you'd want to know that because there'd be a direct correlation between sales going up and down and profitability. We're about break-even, as we've talked about. So to be honest with you, brewer revenue going up or down has zero impact on the profitability on our P&L. And the only thing that you guys would care about it for is a proxy for household penetration. And as I just went through in great detail, it's actually a poor proxy for household penetration. So short, short answers. Brewer revenue is really a meaningless metric in terms of our P&L as well as in indicating the health of the system.

That's great. Thank you so much.

Sure.

Your next question comes from the line of Judy Hong of Goldman Sachs. Thank you. Good morning, everyone.

Good morning, Judy.

So I guess the other sort of question or concern that I'm hearing from investors is 2019 guidance. And I know it's in line with your long-term target in terms of the EPS guidance. But if I sort of take the implied EBIT growth in 2019, it looks like it's around 10% versus the 11% to 12% EBITDA growth that you had given previously. So First, I just wanted to confirm that this is, in fact, sort of what you're guiding to for 2019 just from an EBIT growth perspective. And if so, is this reflective of some of the challenges that you called out, particularly on, I guess, the CSD side? And does it imply that you're going to be putting more investment to deal with some of the operating environment getting tougher?

Hi, Judy. This is Ozan. Our guidance, as we have communicated just now, is on the EPS, which is in line with our long-term merger targets that we put out there, 15% to 17%, and on that sales, 2% to 3%. And as you pointed out, we did also provide significant amount of details with regards to the makeup of the P&L, hoping it will make your jobs easier to model it out. And you are right. We put the 11% to 12% operating income guidance back then as well. But as you said, it's a long-term algorithm. And it wouldn't be right to make specific comments on a year basis. What matters is how we are managing the overall results delivery over the long term, as the name implies. Sometimes there will be pluses or minuses here and there, but what matters is that we are 100% committed to deliver two things, which is the bottom line of the company as well as the cash deleveraging to reduce our bank debt and overall to get to a lower multiple. On your second part questions, as Bob explained, we always look to the business from a holistic basis, cold and hot. We make the investments whenever it is necessary. And when we look to the approval side of the equation, we have been investing in our campaigns in order to improved the household penetration numbers and came in as a 7% growth, which was a very robust number. And whenever it is needed, as we have been doing, we will make all the trade-offs and the necessary investments in our cold side of the portfolio as well, which included a couple of brands of acquisition that we did in the second half of 2018.

Yeah, look, just to add to that, I think our role as managers and also, as we've said a number of times, we have a significant amount of our personal investment in the company as well. So we're all aligned on creating wealth, is to make sure that we do it over the long term. So I think what you really want us to do as leaders is navigate really difficult environments, make sure that we're delivering the commitments that we have, which we are. We're right in line with the targets that we gave a year ago, despite the environment that everyone else has talked about. But also doing it in a high-quality way. So we're getting to these numbers that we talked about while still investing more in the marketing and innovation side of our business. And what's the evidence of that? The evidence of that is that we grew share across the great majority of our portfolio in 2018. And actually, if you take away the IRI in the first quarter in 2019, we grew share in every single segment of our business. So to be able to grow our business, invest in innovation and marketing, deliver the EPS targets while absorbing inflation that is significantly higher than it was at the time of the merger a year ago, I think is, I'll say, I think it's pretty good management and good navigation of the complexity, and that's what you want out of us.

Yeah, no, I guess just to follow up on that, I just wanted to be clear just in terms of the forward commentary, because, Bob, you alluded to sort of the price elasticity pressure on CSD. Obviously, you know, Pepsi's investing pretty significantly in their beverage business this year, so if that's, you know, obviously is kind of driving maybe some of the the caution as we think about 2019 from an operating standpoint, why you're sort of managing to get into that long-term target?

Yeah, let me give some stats on that, right? So as one of the offsets, but not the only offset to this significant inflation that the industry has faced, we've all taken pricing. And I think the good news is it's a very rational industry. When you take a look at the final quarter of 2018, for example, The category pricing was up 5.6%. Volume was down 4%. So that's the elasticity impact of the price that you see in the category. For KDP, in the fourth quarter, our pricing was up 5.9%. These are all in IRI, by the way. What's interesting is our volume was down 2.2%. So the elasticity impact of our pricing actions is lower, is more muted, than you'd see for the industry in total. And that speaks to the quality of the brand marketing in the innovation pipeline, which means consumers are effectively willing to pay more for some of our brands as a result of all the innovation in the market behind it. So that's why we say we have to be really balanced as management to make sure that we're offsetting inflation with pricing and productivity, but we're also, on the other side of the equation, investing in our brands to continue to drive growth. And we're talking forward-looking, but all you have to do is look at the last quarter for evidence of it working.

Got it. That's helpful. Thank you.

Okay. Thanks, Judy.

Your next question comes from the line of Sean King of UBS.

Hi. Thanks for the question. Can you expand on any benefits from green coffee coming down? Is that yet to come, or is that sort of being absorbed in the pricing investments in KCOPS now?

Sure. Sure. Obviously, we do have certain coverage positions, actually not only in coffee but across our commodities that impacts both categories. And on the basis of that, we have a great visibility in terms of our cost structure in line with the price structure at the same time. That is true that coffee beans have been in a declining mode 18 to 24 months, and we take all the opportunities on the basis of the positions that we do have. And all the pluses or minuses have been configured and included in our 2019 guidance.

Yeah, and the other thing, just to build on that, Sean, is compared to a traditional coffee company, the percentage that coffee represents in the total cost of goods sold in a Keurig system is significantly lower than you would see for somebody who's producing traditional roasting ground. Because there's a lot of value added that comes in the single-serve format in the delivery of that. It has a benefit or a negative if it were to go the other direction. We're well covered, so it never is a short-term impact for us. We like to be able to plan going forward, so we have good visibility for the year. But any movement, as you think about coffee in the future, any movement up or down is less of a direct impact on our P&L than it is for sort of a lower value-added coffee scenario than K-Cups. Got it. Thank you.

Your next question comes from the line of Kevin Grundy of Jefferies.

Thanks. Good morning, everyone.

Good morning, Kevin.

Bob, I apologize if I missed this, but from a quantitative perspective, all the color on the Keurig side was very, very helpful. But specifically, part of the long-term guidance beginning in 2019 was that the Keurig side of the business was going to get back to 2% to 3% revenue growth. Are you still confident in that? Maybe you could touch a little bit on that and then touch upon, Bob, the composition of pricing and volume. I think the hope was that the price investment was going to kind of tail off after this year and stabilize. Are you comfortable with where pricing is? Should we still expect negative pricing as well? So maybe you could talk a little bit about the composition as well. Thank you for that.

It's a great question. Thank you. You're seeing it. Over the past couple of years, what you're seeing is we made that decision to invest in pricing in a significant way. We did it for two reasons, to get all of our partners, unlicensed players into the system and to extend the agreements with our partners, which has been successful. And also it was the single biggest barrier to consumer adoption of the system. So we were able to get two consumer and partner benefits by doing that, but obviously we needed to have protection on that by visibility into productivity, which Per my earlier comment, the margin expansion suggests that we have that well under control. The way we sit now, let me talk about pricing for a moment. If you look at the last three quarters of 2018, the average KDP manufactured pod retailed for 53 cents. So it's been relatively stable over that last time, over the last three quarters. It breaks out into tiers that are exactly what you'd expect. Premium at $0.68, mainstream at $0.49. That's actually a really important metric. So mainstream is just under $0.50. And private label that we manufacture is $0.33. And all of those are within those thresholds that we talked to you guys about from a consumer standpoint. Below $0.50, almost every American says it's no longer expensive. At $0.30, most say it's a bargain. So we're right into that structure that we thought about. And you're also seeing this pattern of volume doing really well, accelerating, and pricing change moderating. So we're going to continue to see some negative pricing. But as that moderates and as volume increases, to get to the very first part of your question is, yeah, we're comfortable with the way that we talked about the revenue growth of Cura going forward. And it's all falling into line really exactly on plan.

Okay. Thank you, guys. Good luck. All right. Thanks.

Thanks.

Once again, if you'd like to ask a question, please press star 1. Your next question comes from the line of Bill Chappell of SunTrust.

Hey, good morning. This is actually Grant on for Bill. Just a quick question on the Dr. Pepper side. As you guys have got a little bit more visibility into that business now, maybe looked at some more cost-cutting initiatives kind of beyond just the synergy realization, have you found more opportunity here going forward to maybe bring some more structure to that system? And kind of following on that, Ozan, is there a bigger opportunity on working capital from that business than maybe they've seen in the past? Thank you. Yeah, sure.

Let me do the first part, and then I'll ask Ozan to do the working capital part of that question. From our standpoint is we've got the base Keurig productivity programs and the ones that we're investing in significantly, like the new plant in Spartanburg and the whole reinvention of our pod supplies. We have the synergies that we've talked about at length, and the good news is we're very much on track for that. And then we always look at what are opportunities to drive productivity above and beyond that. And we see lots of opportunities in that space. And, again, what's evidence of that? Evidence of the fact that we've been able to find more productivity is the fact that we've been able to stay right on track with the guidance that we gave a year ago despite a significant uptick in inflation while at the same time upping the investment in our brand. That tells you that we've been able to find more efficiency within the system, that we've been able to deliver a really nice balanced forecast for 2019 that delivers the commitments while still investing in the long-term health of the business. So, Ozan, you want to talk about the working capital side of it? Sure.

And as we shared with you, everybody, we had a long-term guidance between 2019 and 2021 in terms of the working capital delivery from an incremental perspective and improvements. And once we had a greater visibility into the legacy DPS business, we are very happy to share that all the findings were either on the forecast that we anticipated or even better. That's why it increases our confidence in terms of delivering our deleveraging commitments that we put out there more than 12 months ago. We are quite pleased with the performance of the working capital. coming along, and you will see in 2019 and beyond when we report quarter in, quarter out, the improvement as well on our balance sheet.

Our next question comes from the line of Amit Sharma of BMO Capital Markets.

Hi, good morning, everyone. Good morning, Amit. Two questions, Bob and Ozan. Can you just provide us a little bit update on the new capacity for kick-ups? How far along are we? And once it is up and running, what does it do to your cost structure? And the second one, Bob, and that's something that we're hearing today as well, I mean, at least if you look at 2019 EPS growth, the bulk of that is coming from cost synergies from the merger and interest savings. And in the context of what happened to the packaged food space last week, the questions are like once those factors start to moderate, do we have enough visibility that the base business is able to continue to grow this level of EPS growth once you lapse on these benefits?

Well, let me start with the last part first. The last part is I think in this environment, the fact that we're able to deliver 15% to 17% EPS growth while investing in our business and the fact that we're growing across every single segment, growing share, gives us a ton of confidence in the sustainability and the health of this business. In terms of visibility, I mean, we've given visibility at the time of the merger announcement for three-plus years. And we're only, what, nine months into, a little less than nine months since we've closed on the business, six months from a financial reporting perspective. So we're in the really early days of that. We've got the visibility that we've communicated. And, again, the fact that we're here today saying, despite all these changes in the environment, we're right on track, says we have the flexibility to navigate to the right answer. And we'll worry about what happens after three years from now when we get closer to it, because we have no idea what the environment is. But the fact that we have that kind of visibility, I think, puts us in good position versus most of the world. With regard to the pod supply chain, all of the savings, all of the pricing, and everything else is all built into the long-term targets that we've given you. So to start pulling those all apart actually isn't really constructive. That's how we're able to do what we're able to do, as I said before. A lot of the concerns about brewer sales and pricing, my counter to that is volume up and accelerating, household penetration growing, very healthy, consumers returning brewers at a lower rate and holding on to them longer because they like them, and margins for coffee systems up almost 300 bps for the year. We get there by the combination of all the things we talk about. It's all contemplated. It's all built into it. Where are we on the One of the big projects within our pod supply chain reinvention, Spartanburg, buildings under construction, lines have been tested at the manufacturer. They're ready to be installed once the building is done. Things are moving along nicely on that, and it's all part of the long-term plan that we put out there before.

Is there another question?

No. Okay, go. Yeah, exactly.

Our next question comes from one of Laurent Grandet of Guggenheim Securities.

Hi, good morning. This is Clay Crumblesson for Laurent. Bob, if we could just go back to coffee real fast. So I think in the scanner data, we continue to see that you're losing share to private label, and you touched on the pricing, which is really helpful. But could you talk about the interaction of your branded portfolio with private label, and then how you sort of reconcile that performance with the fact that you're the third-party manufacturer for the majority of the private label offerings? And then related to that, just how are you looking at the composition of your current branded coffee portfolio, especially given sort of the recent press that a major brand could be on the block? And even more broadly than that, how are you thinking about potential opportunistic M&A across the portfolio, given the constrained balance sheet? And that doesn't have to just be coffee. It could be sparkling water, for example. So I know there's a lot there, but anything you could offer would be helpful. Thanks.

Yeah, I'll start. You may have to remind me on a couple of these points here. I'll be sure if I got them all down. Let me just clarify some things on share because there's a lot of confusion on that. First of all, we produce the majority of private label pods that are out there. As I said before, 82% of the dollar in pods going through the Keurig system are manufactured by us, and that's up a point. versus a year ago. We said that's one of the four metrics that we really track very carefully here. Within that 82%, there's a mixture of brands that we own, partner brands that you would recognize, as well as some private label brands. The differential in margin between each of those has been narrowed greatly. So we're fairly indifferent to mix within that. All we care about is do we manufacture the pods? And is household penetration growing, which means that pod volume is going to grow? So, again, why are we sitting here so bullish today? The number of households that take on the Keurig system the past year that use it regularly is up to 28 million, which is a 7% growth in household penetration up to 22%. Pod volumes and IRI are plus 10%. And our KDP manufacturer chair of pods is up to 82%. up a point. So those are all the things that really matter in this system, and that's why the profitability of our coffee systems is so robust in 2018. The mix within there is much less of a concern. And again, I think there's this confusion where people equate private label with unlicensed. We do the majority of private label, and the margin that we achieve on that is very respectable. The last thing I would say is our owned and licensed portfolio, so those brands that we are actually not only the manufacturer but also the brand owner, Green Mountain Donut Shop is an example. If you go back, they once had 100 share of the system. So as brands have been added to the system and as it has grown, by definition, our share of owned and licensed pods has declined. And we're at a point now where in the latest four weeks, At the end of the year, 2018, we had a 24 share, down about a point and a half versus a year ago. That's all projected in the numbers that we've talked about and we look at going forward, and we see that as all part of the natural sort of evolution of the system. As it continues to grow, the single biggest benefit for consumers is brand choice. We want every coffee brand to be in the system, and we want to be the manufacturers of those pots. That's the way we think about it strategically. And, again, that's why we're so bullish on the coffee system and its delivery. On the M&A side. M&A side, we don't talk about M&A on any side. I would tell you on the cold beverage side, there's still a significant amount of white space in our portfolio. We've filled in that white space through a combination of brands we've acquired, like Core, new partnerships that we've entered into, like Evian and Peets. and other things that we're contemplating in the future, including organic development of brands on our own or segments on our own. But the fact that we have available white space in the cold-sided portfolio is net, a real positive for the future of this business because it tells you we have many avenues for growth that haven't been pursued yet.

And you also mentioned that our balance sheet is tight due to our leverage or the multiple, and this can be a limiting factor. In fact, it's the opposite. As we have shown and proven the core acquisition, we always more than welcome to use our shares in order to buy right targets for us if they do exist as well. So there's no any constraint in terms of the balance sheet and we still 100% committed to our deleveraging commitment at the same time.

Okay, thanks for the comments.

Sure.

Our next question comes from the line of Peter Grom with J.P. Morgan.

Hey, good morning everyone. Thanks for taking the question.

Good morning.

So I just wanted to kind of follow up on your last comment and kind of get your thoughts on the Allied Brands portfolio. So maybe could you provide a little bit more color on how Evian is performing versus your expectations? And then any commentary you'd be willing to offer on the pipeline for new Allied Brands? And then aside from organic beverages, are there any particular categories you are looking to become more involved in? Thanks.

Yeah, so let me just do a quick refresher just for everybody on sort of, you know, the Allied Brand portfolio as we sit here today. has been transformed versus where we were sitting a year ago. And I think a year ago, there was a lot of concern what was going to happen. And I tell you again, fast forward to a year later, and you say, wow, we've got a really good stable of partner brands, and that provides a source of growth for us going forward. So the new brands we added were Evian Pizza and Forto. The brands we acquired were Core and Big Red. The brands that left were Fiji and Body Armor. And the brands that continued on with us were Vitacoco, Hyde Brew, and Neuro. So we like that lineup, and we've got a lot of opportunity in front of us to really now drive Evian, Peet's, and Forto, which are new brands. It's just getting started in this quarter. There were minimal sales of those businesses in the fourth quarter of last year. That's now ramping up in the first quarter and will accelerate throughout the year as we pick up distribution. And that's exactly what we track as a management team is are we getting the distribution, a build that we committed to to our partners? Are we getting the pricing and the merchandising performance? So all of that is nicely on track. Again, having said all that, you've got to remember that when you take out two brands like Fiji and BodyArm and you add these new ones, which are in the emerging stages, we took quite a hit in the fourth quarter and in the beginning part of this year on revenue. because those brands were gone and the new ones weren't in yet. And that's now more of a tailwind for us going forward, because as we build it, we're able to get the revenue and profit growth over those businesses that we had absorbed. But I repeat myself, as I said on a couple other things, despite that hit, we didn't miss a beat in terms of profit delivery or our commitment to our algorithm. I think we put ourselves in a really nice position to grow. So where are we future on allied brands? We've taken a very disciplined approach to this, something that we talked about before. There's a lot of interest in brand owners to work with us and through our system. As we've all talked about and we now realize firsthand, distribution, DSD distribution into small outlets and cold cases in particular is a scarce resource. And we're one of the partners that's a really good opportunity for them given that we have so much white space. but we've been really disciplined about the terms of how we will work with somebody. And it either has to be a situation where if we can't own the brand in the future, like Evian, then we need a really rock-solid, long-term equity-like agreement. And by the way, the other side wants that as well. But if it's a brand that we can own, we want to have an equity stake in that up front, and we want to have a path to ownership, which means, for the most part, we've pre-negotiated the terms of an exit in the future. What we won't do is just quickly jump into a distribution agreement, make the brand successful, and then have a negotiation with them about what the value of that brand is. That's not something that we're repeating. So short summary on that one is we're really bullish about the brands we have in our portfolio, and there's all upside and a lot of work to do to get that distribution. Lots of interest, but also it's matched with a lot of discipline on our part to make sure that we're entering into this in the right way. Great, thanks.

Our next question comes from the line of Robert Ottenstein of Evercore ISI.

Hey, good morning. This is Brendan Metrano for Robert. I had a quick question on marketing spend. Yes. So in the third quarter, you guys had called out that timing of marketing spend was a benefit to operating profit performance and indicated that it would be put towards investment against the holiday season. And then, so again, we're kind of calling out marketing as a benefit to the fourth quarter. And so I was wondering, are you spending the right level? What are the puts and takes on that?

Let me clarify that because you'll get a chance to go through the K or whatever. But the only comment we made on marketing spend was on the beverage concentrate business, not in the other sections of the business. And we're investing heavily in both the curing system as well as the cold system. And then the other thing you have to – and this is a little more nuanced, but it really is important to understand. When you put two companies together, one of the synergies that you create is more purchasing power on media. We've got a significant increase in scale and capabilities on our media side now. And what that means is that you're able to get the same reach and quality at a lower cost. So – In that situation, you could actually spend the same dollars and have a fairly significant increase in the effective reach of those dollars because you bought that media at a better price because of your consolidation. So there's a lot of that all working together, but what you need to take away from this is we're not using marketing as a source of profitability at all, as tempting as that would have been given the world of inflation right now, and in fact are doing the opposite and investing more behind our total business.

Great. Thanks.

Your next question comes from the line of Damian Witkowski of G-Research.

Good morning. Congratulations on a great 2018. Bob, your comments on the curing machines and household penetration make a lot of sense. But I'm just curious, do you actually have enough information to precisely know whether a new curing machine is a replacement machine versus a new household?

We do. It's a great question. So that's an ongoing data source that's proprietary to us that we have that's been consistent for years, so we're able to test that. backwards against the history to make sure that it's accurate and it's very good. In addition to that, we also have metrics on return rates, which we get from our customers, and also warranty claims. Those are really hard numbers, and we've seen a significant improvement in those numbers. To give you an example, if somebody puts a warranty claim in or they return, that actually boosts brewer sales. So if you send people back out there to re-buy a brewer that they turned in for a warranty, perversely, that increases the revenue of brewers. I would argue that's a terrible situation. So the fact that we're getting fewer warranty claims and fewer returns is a profit positive to us. It also means happier, more satisfied consumers, but it also has a negative impact on revenue. And quite frankly, we don't care about that because there's no profit or loss impact resulting in that. Sorry for the long answer, but we really have a ton of data. The other thing that we haven't talked about, but I just want to remind everybody, is we have a household panel that's statistically significant. It's about 12,000 to 15,000 connected brewers out there. And we provide that data to our partners. So if you're in the Keurig system, you get exclusive access to this. And it literally captures point-of-consumption data, meaning when somebody brews a cup in this panel, We know what they brewed, what brand, what size, what strength, and we feed that live to our partners, and you get a lot of data in terms of the quality of household penetration around that. So we feel really good about those numbers. We want to give them to you on an annual basis. You could get a proxy for this by looking at household penetration of pods through IRI. The caution on that is it's volatile for no good reason, but over time it's a good proxy, but that's why we're going to give you household penetration.

This is very helpful. And then, Matthew, did you comment at all about your pricing expectations for CSDs in 2019?

I can't forecast it. Like I said, it's a rational industry, and it's going to depend on inflation. But, you know, the numbers that you can see it on a weekly basis through the syndicated data, as I said before, in the 13 weeks ending December, the category was up between 5% and 6%, which is pretty robust pricing, you know, in a CPG environment. So it's all going to depend on what inflation looks like going forward. Thanks.

Thank you. That was our final question for today. I will now return the call to Maria, Scott, and Garcia for any additional or closing comments.

Thank you. Thank you all for listening in today. As always, we are around, so if you have any follow-up questions and you want to talk to us, just give us a call. Take care. Have a good day, everyone.

Thank you.

Thank you for participating in Keurig Dr. Pepper's earnings conference call. You may now disconnect.