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DUBAI, UAE - NOVEMBER 27: Burj Al Arab hotel on Nov 27, 2011 in Dubai. Burj Al Arab is a luxury 5 stars hotel built on an artificial island in front of Jumeirah beach.

Dubai Refreshments

Summary

At 12.5x earnings, Dubai Refreshments (DRC) is the cheapest bottler we have encountered across both developed and emerging markets, where bottlers currently trade at 26x and 23x, respectively

DRC holds a near monopoly of the UAE soft drink market with over 70% market share

Over the last 5 years (2008-2013), DRC has  increased sales and EPS by 42% and 770%, respectively, increased EBITDA margins to 14.4% from 5.9%, freed up working capital and reduced net debt to zero

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Tremendous hidden value – despite already trading at 50% discount to global peers, the market is also neglecting two massive upcoming value drivers:

-DRC is set to complete (YE2014) the construction of a new bottling facility which will triple its production capacity and make it the largest bottler in the Middle East

-The Dubai bottler is in value-accretive merger discussions with Abu Dhabi Refreshments, the UAE’s second largest player

Recent history and current operations

Dubai Refreshments is a dominant and rapidly growing $500 million market cap PepsiCo bottler listed on the Dubai Financial Market stock exchange and has its main production facility in Dubai, UAE.  The company was established in 1959 and in 1962 was appointed as the sole franchisee and distributor for PepsiCo in the UAE (excluding the emirate of Abu Dhabi).  Today DRC is the largest bottler and distributor of PepsiCo products in the country.  Its product line includes Pepsi, Diet Pepsi, Pepsi MAX, Miranda, Mountain Dew, Evervess, 7UP and Aquafina.

In 2008, regional industry veteran Tarek El Sakka joined DRC as its CEO and spearheaded a major turnaround of the company’s operations, which most significantly included the following initiatives:

-Initiated a new pricing/mix strategy whereby prices were raised in 2011 by 50%

-Began a greater focus on exports to the greater Middle East and Africa

-Freed up cash by ensuring a faster of collection receivables

-Sold off the entire trucking distribution fleet, which was too time and capital intensive, and switched to a leasing model

-Reduced net debt to zero

As a result of these strategic initiatives and the UAE’s rapid demographic growth and tourism inflows, DRC has experienced a surge in growth and profitability over the last five years, with sales and EPS increasing by 42% and 770%, respectively and EBITDA margins increasing to 14.4% from 5.9%.

Regional tailwinds

The Gulf Cooperation Council (GCC) has one of the world’s highest rates of per capita soft drink consumption.  With enviable GDP per capita ratios (averaging $41,000) and a population growing at 2.5% per year (4x faster than the G7 economies), the GCC’s soft drink sales growth is expected to exceed 6% per annum over the 2014-2019 period (according to Business Monitor International).

DRC’s future domestic sales growth is buoyed by the UAE’s population growth which is expected to surpass 3% per annum over the next 5 years.  Additionally, Dubai welcomed 11 million tourists in 2013, up 10% from 2012 and relative to a population of only 2.1 million. In real terms, the UAE is expected to experience non-oil GDP growth of +5% in 2014, then rise to 6-8% through 2020 on the back of Dubai’s Expo 2020 win.

Currently undervalued relative to peers

Despite its recent operating performance and continued market dominance, DRC trades at only 12.5x and 11.5x trailing and forward earnings compared to developed and emerging market bottlers, which trade at 27x and 23x forward earnings, respectively.  This makes DRC one of the cheapest publicly listed bottlers we’ve ever encountered.  The company also produces higher returns on capital than its peer group with 3-year average ROE of 26%, ROA of 18% and ROIC of 20%.  Additionally, DRC offers a higher FCF Yield (8%) and dividend yield (3.4%) than its peers, and it enjoys a positive net cash position.  DRC owns 14.2% of Oman Refreshments (AFS), which has a virtual monopoly of the soft drink market in Oman with over 90% market share and pays shareholders a 4.1% dividend.

In addition to being deeply undervalued on a stand-alone basis, we believe that the market is overlooking two critical near-term catalysts.

Dubai Refreshments

Catalyst one: new production plant to result in 3x capacity increase for domestic and export sales

DRC’s legacy bottling and distribution facility is over 4 decades old and currently running at full capacity, given robust domestic and regional demand. As part of its growth strategy, in April 2012 DRC undertook a capacity expansion plan to boost both domestic and export sales, through which it budgeted approximately AED658 million (c. $180 million) on a new state-of-the-art, Greenfield bottling factory and warehouse facility in Dubai Investments Park.  Upon completion in Q4 2014, the new plant will make DRC the largest bottler in the Middle East & North Africa (MENA).  We expect progress updates and an official launch in late 2014 to grab investors’ attention.

The plant will span over 140,000sqm (vs. 18,000sqm for the existing plant running at capacity) and triple DRC’s soft drink capacity to 70 million cases annually, while improving upon its operating efficiency by physically joining the storage and logistics facilities.

Dubai Refreshments

The facility will eventually have the potential to increase DRC’s product range, which currently only includes a small percentage of PepsiCo’s drinks category and has zero exposure to the snacks & foods portfolio (Pepsi’s portfolio worldwide is 60% food / 40% drinks).  Future focus products include local production and distribution of drinks including: Gatorade, Lipton Teas, Tropicana, AMP Energy, Naked Juice, and snacks including: Quaker Oats products, Cheetos, Doritos, Lays, Ruffles, Tostitos, Fritos, Sunchips, and Rice-A-Roni.

In addition to serving Dubai’s rapidly growing local and tourist population, we anticipate accelerated growth in export sales as well. Management has traditionally focused on targeting exports to underdeveloped regional markets that do not already have indigenous bottlers or which still require additional supply.  Since 2008, DRC expanded its export sales from 7% of total to an average of 26% and now exports to 40 different countries.  Major export markets from 2011-2013 were South Sudan, Afghanistan, Somalia and Angola.

At the time of writing, 90% of the budgeted capex has been spent on the new AED658 million plant.  This implies that new shareholders will be able to enjoy this massive, value accretive boost in production without paying for the vast majority of the 3-year build out.  Also, given the company’s low debt levels and minimal future capex requirements, we expect that the imminent completion of DRC’s capacity expansion will allow for a dramatic increase in its dividend payout (up to a yield of 12%). It is important to note that DRC has consistently raised its dividend since 2010, and management has emphasized to us the high priority they place on the dividend payment to their shareholders, which include key UAE families.  60% of DRC’s shares are owned by the public.

Catalyst two: value-accretive merger talks with DRC’s sole competitor in Abu Dhabi

In December 2013, DRC and Abu Dhabi Refreshments (ADRC), the sole Pepsi bottler in the emirate of Abu Dhabi, disclosed their intention to explore a merger and capture significant synergies from larger scale, lower overall overhead, and greater bargaining power with vendors including PepsiCo MENA and raw materials suppliers.  We also believe that the enhanced trading liquidity subsequent to a merger would benefit shareholders.

In a 2014 interview with Arabia Business, the head of PepsiCo’s MENA operations, Omar Farid, backed a merger between the two franchisees, stating: “This is great, consolidating and putting the two businesses together, that that’s something we support and we encourage 100 percent…These are two independent bottlers, both of them have been doing business for the last 50 years – very strong market share, very strong volumes – and putting them together is going to be creating lots of synergies…and we play our role as the owners of the brands in making sure that they get together as close as possible – blessing that partnership.”

Why has DRC flown under the radar of investors?

Management does not place a priority on investor relations, as most of their shareholders are UAE royals and their executives prefer to focus on managing the business.  It is therefore typically very difficult to get a meeting with management. However, through our local relationships we were able to secure very productive meetings with DRC’s management this year and establish a long-term dialogue with their team.

Two additional factors should be considered, which we believe contribute to DRC’s deep discount to fair value.  First, shares of DRC are currently only available to UAE and GCC nationals and local investment companies.  However, foreign investors are able to purchase the shares through P-Notes or total return swaps (TRS) through a local broker such as EFG-Hermes, HSBC, Standard Chartered, Emirates NBD, NBAD, MENACorp, and Mubasher Trade.

Second, DRC trades an average daily value of approximately $300,000. While only a small percentage of its market cap of $500 million, DRC’s illiquidity is typical of trading volumes for other frontier market consumer stocks.

Ultimately, we foresee restricted UAE public companies eventually opening up to foreign investors and are encouraged by the following developments:

-MSCI upgrade: In June 2014, MSCI upgraded UAE to emerging market status for including in its index at a 0.60% weight at the time of the announcement.$70 billion of global capital is benchmarked to the MSCI EM Index, implying passive capital inflows of around $450 million to the UAE.While this capital will be earmarked for MSCI’s selected UAE stocks, inclusion in the MSCI will have the impact of also putting the country’s other non-index equities onto the watch list of international investors.

-In March 2014, the UAE’s securities regulator (SCA) ruled that it is mandatory for each UAE-listed company to have an investor relations department, including personnel and website disclosures.This development reveals the UAE’s continuing willingness to open up its market to foreign investors, which could eventually also mean raising foreign ownership limits on restricted securities

-In May 2014, Qatar’s ruler announced a directive to raise foreign ownership limits on all Qatari listed stocks to 49% from 25%, in preparation for incoming MSCI EM fund flows (June 2014). The UAE seems ready to follow the same trend, especially as it has already increased foreign ownership limits on several previously restricted stocks over the past year.

Bottom line: DRC is significantly undervalued

We value DRC at AED33/share over a 3-year holding period (70% total return).  Our DCF valuation implies a 17x average forward multiple (still 25% lower than EM peers).  However, to put DRC’s massive potential upside into the proper perspective, it is critical to note that our valuation excludes all of the upcoming benefits from the imminent tripling of production capacity and the potential merger with ADRC (we do not factor either development into our assumptions)

Without these two catalysts, on a stand-alone basis, our main assumptions are conservative and as follows:

-Total sales and EPS CAGR of 5.4% and 6.6% from 2014-2018, respectively, vs. 7.3% and 54.2% historically

-Local sales growth rate of 4% through 2018 (~UAE GDP), vs 5% since 2008

-Export sales growth rate of 8% through 2018, vs. 27% since 2008

-Flat EBITDA margin of 15% (average of 2011-2013)

-WACC of 11% and terminal growth of 3.5%

-Capex of AED180 million in 2014, and an average of AED23 million thereafter (equal to maintenance capex).

Dubai Refreshments

Even when excluding DRC’s hidden value drivers, at only 12.5x this year’s earnings, DRC is deeply undervalued on an absolute basis and relative to peers (which are far inferior on a fundamental and qualitative basis). If the merger with ADRC goes through, this name should appreciate to its intrinsic value fairly quickly. If not, then investors can still generate a very compelling total return through a major boost in capacity and the resulting jump in earnings and dividends.

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