The Surprisingly Good Dr Pepper

Dr Pepper (DPS) began regular trading on the New York Stock Exchange last week, with the company's enterprise value (debt plus equity) now around $10 billion, a big discount to the now-vanished LBO price.

Fans of Dr Pepper, the No. 3 domestic soda maker behind Coca-Cola (KO) and PepsiCo (PEP), argue that the shares, at around 25, look undervalued. Dr Pepper trades for less than 13 times estimated 2008 profits of $2 a share. That's a discount to Coke and Pepsi, which fetch 18 times projected 2008 profits, as well as to the two main U.S. soda bottlers, Coca-Cola Enterprises (CCE) and Pepsi Bottling (PBG), which trade at 14 times estimated 2008 profits.

So far, Dr Pepper's stock has disappointed Cadbury — which projected that it would trade in the 30s — and Dr Pepper CEO Larry Young, a 30-year soda-industry veteran. "The market is looking at us like a bottler and not a brand owner. We have much more attractive margins than a bottler," Young tells Barron's. "We've been a well-kept secret. Our job is to get investors to understand our story, deliver good results and let the market deal with the stock price."

Dr Pepper probably doesn't deserve to command the price/earnings ratios of Coca-Cola and PepsiCo, but it should trade at a premium to the bottlers. It gets more than half its profits from its high-margin concentrate business. This involves selling to bottlers the syrup for Dr Pepper and other key soda brands, including Seven-Up, Canada Dry and Sunkist. Concentrate suppliers, including Coca-Cola and PepsiCo, get higher price/earnings ratios than bottlers, which operate in a low-margin, capital-intensive business. Dr Pepper also sells Snapple iced tea and Mott's apple juice.

Dr Pepper's P/E is one of the lowest among major food and beverage companies. The stock seems cheap, considering the strength of the Dr Pepper brand and the company's goal of generating "high single-digit" annual growth in earnings per share.

A couple of Wall Street analysts, while cautious about Dr Pepper's outlook, agree that the stock looks undervalued. The most bullish analyst, Andrew Wood of Sanford Bernstein, values Dr Pepper around $35 a share, while Mike Branca, Lehman Brothers' beverage analyst, puts the stock at 28 to 32 a share. Morgan Stanley's Bill Pecoriello started covering the stock last week with an Equal rating, but has a 30 price target. Judy Hong of Goldman Sachs valued the stock at 32, and also rated it Neutral. If Dr Pepper hits 31, that would be a nearly 25% gain from the current level.

Why is Dr Pepper trading so cheaply? For one thing, it gets about 90% of its revenue from the mature U.S. market and 80% from soda, consumption of which fell 2% in 2007 as health-conscious Americans turned to bottled water, iced tea, juices and energy drinks. Nonetheless, Americans still drink an average of 16 ounces of pop daily.

U.K. investors in Cadbury who don't want to hold Dr Pepper probably have been selling. This temporary pressure may have created a buying opportunity. Under pressure from activist investor Nelson Peltz, Cadbury jettisoned Dr Pepper to focus on its attractive global candy and gum business. Cadbury's (CBY) U.S.-listed shares trade at 51, more than 20 times estimated 2008 profits.