Bai Guatemala

BAI BUBBLES GAUTEMALA GUAVA, ONE OF BAI BRANDS, LLC'S TYPICAL BEVERAGE OFFERINGS. IMAGE: BAI BRANDS, LLC.

Dr Pepper Snapple's(NYSE:DPS) announcement this week of its pending acquisition of antioxidant-infused beverage maker Bai Brands, LLC for $1.7 billion in cash certainly represents the direction in which the carbonated soft drink industry is headed. But it also marks a particular achievement for Dr Pepper Snapple, which has often felt the sting of opportunity cost in its relationship with independent beverage companies for which it provides services.

The beverage giant obtains about 5% of its annual volume from bottling and/or distributing brands it doesn't own. Dr Pepper Snapple refers to these labels as "allied brands," and they encompass both well-known and more obscure names such as Bai, Fiji Water, SunnyD, and BodyArmor.

In the past, it's been debatable if running several non-proprietary brands through the company's system for just a few percentage points of volume is even worth the effort. Particularly open to questioning is the fact that, as allied brands grow with the help of Dr Pepper Snapple, they often leave for other distributors or get acquired by "DPS" competitors.

During the company's most recent earnings conference call in October, an analyst asked about protective contractual provisions Dr Pepper Snapple has in place when an allied brand decides to seek bottling and distribution elsewhere. This led to some musing on the part of CEO Larry Young about the brand relationships and the sudden loss of volume from a departing label:

When they're for sale, as Marty said earlier, we know it. And we're their partner. So we're always observing, but sometimes you lose them and then you have to go out and make it back. And I think we've been very successful at building back. We lost Rockstar. We lost Monster. We lost vitaminwater. We lost FUZE. And we continue to go. We keep building our allied brand portfolio.

The names mentioned above, once distributed by Dr Pepper Snapple, are some of the most vibrant and respected young beverage companies around today. Rockstar is now distributed by PepsiCo(NYSE:PEP). But perhaps more painfully, The Coca-Cola Co. (NYSE:KO) not only distributes Monster energy drinks, but boasts an equity stake in Monster Beverage Corporation (NASDAQ:MNST), and owns the vitaminwater and FUZE brands outright.

To put it another way: More than losing revenue and gross profit, there's a potentially significant opportunity cost in assisting small brands and then watching them flourish after your competitors snap them up. 

Coca-Cola has its own venture capital arm, Venturing and Emerging Brands, or VEB, which takes minority stakes in fledgling beverage companies, then ratchets up investment once they're proven to be scalable across the Coca-Cola system. With the acquisition of its allied customer Bai Brands, Dr Pepper Snapple has for the first time put meaningful dollars behind a company it similarly helped nurture.

The low-calorie, low-sugar, antioxidant-rich beverage profile that Bai's water drinks offer will certainly help the organization diversify outside of its carbonated soft drink revenue streams. But more importantly, the transaction proves the point of having an allied brands business in the first place. Just last quarter, the company cited both Bai and the popular Fiji Water as the main drivers of 16% year-over-year growth in its non-carbonated beverages water category.

Management has promised that the $1.7 billion cash consideration for Bai will be funded through unsecured notes and commercial paper, thereby avoiding long-term debt which might weigh on the company's investment grade credit rating. And Dr Pepper Snapple expects the purchase to be accretive to earnings by 2018.

But beyond the financial impact, this transaction is vital as it introduces a process the company should try to repeat many times. Help an allied brand hit critical mass, then purchase it to increase long-term value for shareholders, rather than watch that value get transferred to a competitor. For this reason alone, the Bai deal is, for both mangement and investors, a no-regrets acquisition.

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