Good morning, ladies and gentlemen, and thank you for standing by. Welcome to Keurig Dr Pepper's Earnings Call for the Second Quarter of 2019. This conference is being recorded. [Operator Instructions]. I would now like to introduce your host for today's conference, Keurig Dr Pepper Vice President of Investor Relations, Mr. Tyson Seely. Mr. Seely, please go ahead.

Thank you, and hello, everyone. Thanks for joining us. Earlier this morning, we issued our press release for the second quarter of 2019. If you need a copy, you can get one on our website at keurigdrpepper.com in the Investors section. Consistent with previous quarters, today we will be discussing our results -- our performance on an adjusted basis excluding items affecting comparability and with regard to the year ago period. Our financial performance also takes into account pro forma adjustments due to the merger. The company believes that adjusted and adjusted pro forma basis provide 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 and adjusted pro forma basis provide meaningful comparisons and an appropriate basis for a discussion of our performance. Details of the excluded items are included in the reconciliation tables included in our press release and our 10-Q, which will be filed later today. Due to the inability to predict the amount and timing of certain impacts outside of the company's control, we do not reconcile our guidance. Here with me to discuss our second quarter 2019 results and our outlook for the balance of the year are KDP Chairman and CEO, Bob Gamgort; our CFO, Ozan Dokmecioglu; and our Chief Corporate Affairs Officer Maria Sceppaguercio. 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 key 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 the risks and uncertainties is contained in the company's filings with the SEC. With that, I'll hand it over to Bob.

Thanks, Tyson, and thanks to everyone for dialing in. The second quarter was another good one for KDP. All four of our segments again registered underlying net sales growth with Coffee Systems leading the performance this quarter. We also grew dollar consumption and held or grew market share in a number of our key categories. A recent slate of innovation is performing well in the market, and we remain confident on our plans in this area for the balance of the year, which I'll talk about shortly. Operating income advanced nearly 10% despite of more than 3 percentage point headwind related to the comparison against a gain recorded in Q2 last year in connection with the Big Red acquisition and a onetime reimbursement from a resin supplier. The significant operating income growth combined with lower interest expense versus the year ago period drove a 15% increase in adjusted diluted EPS for the quarter, which is right in line with our long-term targets. Free cash flow generation of $575 million for the quarter was also robust, which enabled us to repay debt of more than $300 million in the quarter and nearly $720 million in the first half of the year. The quarter marks a significant milestone for us as it closes our first 12 months as a combined company. Before we jump into the details of the latest quarter, we believe it's helpful to recap what KDP has delivered in its first year as a public company. From a financial results perspective, at the time of the acquisition announcement, we targeted a 3-year average adjusted diluted EPS growth rate of 15% to 17%, fueled by top line growth of 2% to 3% combined with expansion in margin resulting from $600 million in acquisition synergies and ongoing productivity programs. We delivered…

Thanks, Bob. And good morning, everyone. I will start with a review of the financials for the second quarter, which was another strong one for KDP. I will then transition to our outlook for the balance of the year, continuing on an adjusted basis. Net sales for the second quarter decreased 0.4% to $2.81 billion compared to $2.82 billion in the prior year. This performance reflected strong underlying net sales growth of 2.6% driven by higher volume/mix of 2.1% and favorable net price realization of 0.5%. The shift of Easter into the second quarter of 2019 also added 0.2% of growth. More than offsetting this underlying growth and the calendar shift was the expected unfavorable impact of 3% from changes in our Allied Brands portfolio as well as unfavorable foreign currency translation of 0.2% in the quarter. On a constant currency basis, net sales declined 0.2%. Operating income in the quarter increased approximately 10% to $702 million compared to $640 million in the prior year. Excluding the more than 3 percentage point headwind from the year ago benefits that Bob mentioned earlier, operating income advanced more than 13% in quarter 2 2019. The growth in operating income reflected strong productivity and synergies in both cost of goods sold and SG&A. These growth drivers were partially offset by inflation, led by packaging and logistics. Operating margin advanced 230 basis points in the quarter to an even 25%. In terms of our segment performance for the second quarter, on an adjusted basis, net sales for Coffee Systems increased 4.3% to $990 million in the quarter. This strong performance reflected higher volume/mix of 8.3% that was partially offset by lower net price realization of 3.5%. Unfavorable foreign currency translation of 0.5% also impacted the quarter. On a constant currency basis, Coffee Systems net…

[Operator Instructions]. Your first question comes from Bryan Spillane of Bank of America.

Bob, maybe just a couple of follow-up questions related to the coffee business. One, if I caught it right, it sounds like the category is growing pods at 6% and you're growing at 5%. So if you can kind of talk about that gap. And then second, I guess, given the category growth at 6%, how we should think about that in terms of household penetration for brewers?

Yes. We talk a lot about quarter-to-quarter, month-to-month. I think this business is actually very stable and very predictable and I say stable, stable at the growth rate we've all talked about, which is mid-single digit. So if I just step back for a second and talk to you about the last 12 months and I'll address your specific question. If you look at over the past 12 months, we said at the end of the year when we give our once-a-year omnibus research that household penetration was growing at 7%. If you take a look at the pod category growth based on IRI over the past year, it was growing at 6.2%. And if you look at our shipments over that same time, it's 7.7%. So all of this triangulates around a growth of 6% to 7%. And in any given quarter, we're going to be above, we're going to be behind, but it's pretty remarkable how much the household penetration in the category and our shipments all track to the same number, which has been 7% over the past 12 months. The one piece that's interesting, and we're exploring ways to help you guys get more visibility of this, is that we are seeing IRI is now consistently underreporting, both our consumption as well as the category consumption. And that's because in this category, probably more than any other food and beverage category, unmeasured channels driven by e-com, for example, are accelerating and taking a bigger chunk the total pie. So we're thinking about how we can get you guys exposure to that, but we know that IRI is understating our consumption as well as the category. So I step back and say, we said household penetration growing at 7%, our pod shipments have been 7.7% over the past 12 months, that's all within the right range that you should think about. And therefore, to go right back to your question, a plus 6% versus plus 5% is within the margin of error that it almost doesn't matter.

Your next question comes from Lauren Lieberman of Barclays.

I was hoping you could just talk a little bit about new partnerships owned or partnerships, in particular in the energy space. So there's new agreements for Runa and for A Shoc and you're the minority investor in A Shoc. So talk a little bit about kind of portfolio strategy with those brands? How they fit in and kind of early, we think as Runa has been under your purview in the market for most of the quarter, so anything there would be helpful.

Yes. I think it's very early days for both. So there's not a lot to comment on there. I would think by the next quarter, we'll have more to talk about. But the strategy here behind energy is one that, I think, speaks to our desire to fill in whitespace in our portfolio and energy is an attractive category, both in terms of size, growth and profitability, and we certainly should close some of that gap. As well as it speaks to the way that we go about addressing those gaps. And I think the A Shoc example is a really interesting one because we're partnering with Lance Collins who developed Core and Fuze and NOS and a bunch of other products as well that have been very successful. And we went into this one side-by-side with him based on the concept with a prenegotiated formula to buy it out at certain milestones. So it's very early days. It's only in, I think, four markets, L.A., Texas, Illinois right now and we'll see how that goes and give you an update next time around, but we're bullish on the opportunity there, and I think more importantly, it gives you an indication of where we want to go with partnerships.

Your next question comes from Judy Hong of Goldman Sachs.

So I had a question about your sales guidance. So when I kind of look at the first half or second quarter, it looks like sales actually came in a bit short of, I think, what most people expected even with the timing benefit on the coffee sales. So I know you're keeping the 2% for the full year, which does imply a pretty big acceleration in the back half. So my questions are, one, was second question in line with your expectations from a sales perspective? And then can you just walk us through how we get to sort of this 2% for the full year, which I think implies the Allied Brands kind of impact actually turning to be a tailwind in the second half of the year? So that seems also like a big step-up as well. So if you can kind of address those issues as it relates to your sales guidance.

Sure. I think it's a couple of things. I think first of all, just with the conversation with guidance from an overall perspective, back in January of '18, we talked about a long-term outlook where we said 2% to 3% over a three year period, 15% to 17% EPS over a three year period. So we've just stuck to that. And as you know, we have to navigate a lot of different changes in the marketplace, but we feel confident that we'll stick to that framework, and we'll stick to it over the long term unless there's some big change to take it a different direction, which we don't foresee. So having said that, I think the hardest part for you guys on the outside to model has been the impact of this Allied Brands. And all I would say is it impacts us through Q1 through Q3, and then in Q4 of this year, it goes away. And there really, you're getting an even comparison, and I will be very happy to not talk about underlying net sales at that point and just talk about reported net sales at that point in time. And so I think that's part of it as well. So it's a combination of the two. The other part is, we also said that we would be ramping up the growth over time because the Keurig business we were still into the strategic pricing implementation and so that 2% to 3% again is a long-term target and that's why we take a look at the year the way that we described it.

But on the Allied Brands impact am I right in thinking so year-to-date, I think the impact was a negative $160 million or so and you're guiding to $110 million negative for the full year. So if third quarter is a negative, it sounds like the fourth quarter you all of a sudden have a pretty meaningful acceleration...

Well, remember, when you get to the fourth quarter, the comparison against very substantial businesses of FIJI and BODYARMOR are now out of your base and you have the benefit of a growing evian piece and FORTO in the business for this year. And so yes, you would expect fourth quarter to look materially different than we've seen in the first three quarters of the year, and I think that's been the hardest part to model for us.

Your next question comes from Amit Sharma of BMO Capital.

Ozan, just a very quick clarification. Can you quantify the margin impact of the pre-ship in the Coffee Systems business in the quarter?

Amit, we are not going to get into the specifics of that, but part of the quarter two growth is reversing in Q3 due to timing of the retail stocking approvals and the timing of the pod shipments to our partners as they requested. But as Bob explained I believe in a great detail, it's -- one would expect to see 6% to 7% of pod growth on a continuous basis. Some quarters may be a little bit plus or minus, but that's what averages on an annual basis as well. So on the basis of that, there will be some correction that we're expecting in Q3, but on an annual basis, our guidance still holds, which is a mid-single-digit growth.

Got it. And then Bob, I just want to make sure that I heard this right. So as you're talking about strategic price implementation, are you suggesting that we'll start to lap the impact of that later this year or certainly in 2020? And if that happens like, does that mean the price mix becomes less of a headwind in 2020 and beyond that?

No. I'll go back to what we said in January of '18 because it's playing out exactly as we discussed. We said that volume would be mid-single digits. The strategic pricing investment would continue for a period of time, but would moderate over the horizon that we put out there for our targets. And again, that's exactly what's happening, 7% household penetration over the past 12 months, 7.7% shipment growth. I think what's interesting is when you take a look at our Coffee Systems revenue, in 2018, it was negative 0.4%. On the latest 12 months, it's positive 1.5%. If I just look at year-to-date 2019, it's positive 3%. So we're not saying anything different than what we said all the way back in 2018. All I would suggest is now 12 months into the official close of the merger, essentially 18 months since we communicated the first outlook, it's playing out exactly as scripted. There's no change in our thought process around the Coffee Systems business.

Okay. That's maybe I didn't see it properly. I think that's what I'm saying that as you go into 2020, that price headwind starts to moderate even more, especially as you lap...

It's already been moderating. It will continue to moderate over the three year horizon, but we never gave a timing of saying pricing investment would stop on a certain date. We said it would moderate over time, and you're seeing the slope of it right now. If you go back all the way to January of '18, you could put the slope out between then and now and see that improvement and that's exactly what we expect to continue. And again, I just want to make one other point on this. We have visibility internally as to what the pricing is going to be because these are based on long-term contracts for the great majority of our agreements. And so I know it's a challenge for you to model, but it's not a challenge for us to manage because we see it and we also know that we have the appropriate productivity and cost projects in place to offset that pricing. And the evidence that you're seeing is that we've been able to handle this pricing investment at the same time we're expanding margin and accelerating volume growth. So it's not a big mystery to us. In fact, it is not a mystery at all. We have it mapped out. It's just a challenge for us to get out and communicate details to the outside world here. But just know that internally we have good visibility of it.

Your next question comes from Kevin Grundy of Jefferies.

Bob, can you speak to the pressure on the Bai business. This was of course a sizable acquisition from the Allied portfolio a few years ago. So disappointing performing well below expectations at this point. Can you talk about some of the factors driving the weakness, competitive dynamics, lack of investment, lack of innovation, maybe just drill down a bit more on your plans to turn that brand around?

Yes, sure thing. Bai is now north of $400 million in sales and on a 52-week basis, it's growing about 6% with a weak quarter. We lost some distribution along the way. We've since regained that, but you're seeing it go through the system. And so as I said, we expect it to improve in the coming quarters. [Indiscernible] a lot of likes to it, there are elements of Bai, for example Bai Super Teas are growing at an incredibly good rate. The core business is reasonably healthy. Bai Bubbles hasn't been as strong. So if you really drill into it, the core Bai business is quite strong and some of the newer additions to the Bai portfolio are adding even further growth. But this was -- we analyze these things very extensively and this was all driven by some distribution changes, not velocity changes in the business. And so we're still bullish on the brand going forward. And as I said a number of times before, when you get to a certain scale, like crossing $400 million, approaching 500 million in sales, you're not going to see 20%, 30% growth rates. It's just the natural evolution of all of these brands where when it was acquired, it was in the steep part of the growth curve, continues to do very well. Now it's going to be more in a moderate growth curve going forward. But none of us are happy with a negative even for a quarter, so that's quickly being addressed.

Your next question comes from Steve Powers of Deutsche Bank.

I guess one follow-up question to Brian's initial one. The 6% that you cited for the category consumption this quarter is, just to be clear, is that an all-channel number because it looks like the measured channels, at least as I see it, the Nielsen data, it looks like it was tracking 5% plus alone. So I would expect may be closer to 7% if the untracked was as strong as we talked about before just for final clarity, that would be great. And then my real question was just more on the negative pod mix that we saw this quarter. Directionally, not really a surprise, but I just wonder if you're able to quantify the magnitude because it's bigger this quarter with the timing element. But -- and then stepping back, I guess really what I'm asking about is how should we -- how do you recommend we think about pod mix going forward to the extent that we should expect that to remain in a bit of a structural headwind on revenue growth even as pricing maybe gets a little bit better?

Okay. Let me start with the last one and I'll come back to the category piece. The best way for you to guys to take a look at this is go back to how I started this. Look at it over a 12-month basis and know that what we said about the coffee category over a 12-month basis has come 100% true in terms of what our projections have been. There's variation quarter to quarter. And so the key is when you see variation by quarter, a good assumption is that it goes back to the average again over time. And so I can explain the mix very easily in the second quarter. The shipments above consumption was all driven by certain partners requesting more volume early, that could be in advance of a promotion, it could be because they're doing some internal changes to their own warehousing or supply chain and they want to make some movements, build some inventory. This is for us normal course of business quarter-to-quarter or month-to-month and it all flattens out over time. Because this situation was accelerated shipments from our traditional branded partners, you will recall, in that situation, we receive a tolling fee on those products versus a complete product fee. For example, if we supply a private label partner, we source the coffee, we do everything and we charge them a full product price. In the case of branded partners where we receive the coffee from them, we're just charging a tolling fee. So by its very nature, it's going to show up as a negative mix if you sell more of that volume versus all other volume. It's just mechanical and has no impact on the business at all from a profitability standpoint, nor does it impact the business over…

No, that's perfect.

Your next question comes from Laurent Grandet of Guggenheim Securities.

This is Clay Crumbliss on for Laurent. Bob for you, just on the Dr Pepper franchise. It continues to perform really well and it's not just driving the top line, I think it's contributing quite a bit to the margin expansion that you're getting. Can you just talk about how you see that playing out over the course of the year? And then longer term kind of the same, just what do you see are the strengths of that brand and what's going to help it continue to do what it's doing?

Yes. We haven't been in the CPG industry for a very long time. You see certain brands that's real gems, and this is one of them. It's got very unique positioning, unique product offering. It is one of the brands that the heavy consumers of it absolutely love and it continues to expand household penetration. It used to be at onetime a very regional brand, it's now a national brand. And so if you take a look at the brand development, there's still opportunity to increase household penetration in the regions of the country where it was less established. This is a good story of getting everything right in terms of marketing, strength, limited-edition innovation and great execution. And I would remind you that part of the reason why the profitability shows up as even stronger on this brand is because the way it flows throw our P&L, is a -- more than half of that business is distributed through Coke and Pepsi system, in which we sell concentrate to them and the concentrate shows up on the P&L as a much higher margin mix, and therefore, when you grow the Dr Pepper brand, a big chunk of that goes to that very profitable Coke and Pepsi system that shows up as a real profit generator on the P&L. So we have, no, -- everything that we take a look at on the Dr Pepper brand has continued strong performance on there, there's still a lot of upside on that brand.

Your next question comes from Bonnie Herzog of Wells Fargo.

I actually wanted to circle back on your operating margin growth, which was really impressive this quarter. So hoping you guys could maybe break out the contribution from synergies just a bit more in depth. And then looking forward, should we expect a meaningful ramp in the contribution from these cost synergies as you get maybe even deeper into the integration process?

Yes. First of all, as we reiterated many times and we are on that trajectory, in terms of delivery $200 million of merger synergies in 2019, 2020 and 2021, in total $600 million. So we are confirming that trajectory as well as for this year. And as we also said, besides the deal synergies, you also have -- has the defined base productivities. And as we spoke probably 10, 15 minutes ago, we expect both deal synergies and the base productivities to continue to ramp up as we go throughout 2019, which means the second half, we expect to deliver overall productivities a little higher and better number compared to the first half. So when we look to the margin expansion, you're right, it's a very good number. But please bear in mind, when you go back and look to January 2018, the guidance that we put that did foresee a healthy margin expansion, and we are happy to share with all of you that we are exactly delivering what we said we would. And we do expect further margin expansion to happen, again in line with our guidance, no surprise, in the upcoming, let's say, two more years after 2019. And the balance is quite healthy between the legacy KGM and legacy DPS businesses, which reflects is a good combined company margin growth. And we are exactly on our trajectory in terms of what we said we would do.

Your next question comes from Robert Ottenstein of Evercore.

It's Brendan Metrano for Robert. Bob, just want to circle back on Packaged Beverages just for a couple of points. First, can you give us some insight into how the new Allied Brands like evian and FORTO are progressing that gives you confidence that those will ramp up and sort of replace the brands that you've lost? And then secondly, any impact from weather in April and May that you'd kind of call out as unordinary this quarter?

Last one, I'll go first. No meaningful impact from weather. On the Allied Brands, it will take time. I mean you take a look at it, and we're starting from a much smaller base than the two businesses that came out of the system. That's really clear if you take a look at the -- how big they were versus where we're starting. But they're all moving in the right direction. And over time, the growth trajectory that they're on plus additional brands that we're at will more than offset that. But the way that we forecast it is we've been conservative in not assuming that they are a replacement, for example, starting in 2020, that it's going to take some time to build on that. The one thing I would add though is, if you take a look at brands that we'd added into our portfolio from an own standpoint, that no longer show up in Allied Brands, Core being a great example. Core is quite a remarkable story, now $250 million in sales and it's growing north of 40%. Now, like Bai, my previous conversation on Bai, there will be a point, which it hits critical scale and is not going to be growing at that trajectory, but to have been able to add a business that was once in Allied into our portfolio that that's meaningful in size with that kind of growth rate is another way that we're able to manage the portfolio growth in that 2% to 3% long-term range that we talked about previously.

And then one real quick follow-up, just in terms of -- in that Allied portfolio and just within Packaged Beverages, how are you and are you, I guess, thinking about CBD at all?

Well, the basics of CBD are it has to be legal first, proven to be safe and proven to be effective. And all three of those are either unknown or a question mark at this point in time. My theory on this one is that if it is proven to be safe, legal and effective and the government gives a big green light and all the other issues that are surrounding a pop-up in effect becomes caffeine and it becomes something that this can be added to a lot of different beverages, and if it gets to that point, we'll participate in it, but we're not going to be on the bleeding edge of something that is frowned upon by the government and unsure from a consumer safety standpoint.

Your next question comes from Bill Chappell of SunTrust.

Bob, as we go into the holiday season, I know it's still only August, but what's the plan, the thought for brewers in terms of -- you rolled out several last year, the goal was to kind of increase household presentation, didn't know if you really need that many more or if it's better -- if your money is better used on kind of supporting pods or supporting brands or -- how you look at it as we go into kind of the next year?

Yes. Household penetration is a growth engine for this higher business. When household penetration grows, it benefits all parties who are involved in it, the partners who do business with us, the retailers who sell our machine and our pods as well as whom we supply their branded pods. And of course, it benefits our owned and licensed business. So if you can pick one metric to drive across the entire Coffee Systems business that would benefit everybody, including our specific P&L, it would clearly be household penetration growth. The way that we think about brewers is not how many brewers that we want to sell or how many do we need; we think about barriers to household penetration. And we talked before about the work that we've done to understand all of the people who should be in the Keurig system and why they're not in there right now. And if you step back and think over the past two years, we've increased the number of households who have a Keurig machine by 20%. So that's a meaningful accomplishment itself. Yet at 22%, we think that number should be, as we said before, more than double that. And then the question would be how long is it going to take and we don't know. We're moving along at a nice 7% rate. And the question is, could we accelerate that over time? The reason that K-Duo becomes important is because it fills the gap in the need states for brewers that we know a fairly sizable segment of the non-Keurig households need, which is treat with the idea of brewing one cup at a time and would probably do it during the week, but I want the ability to make a pot of coffee on weekends or when company comes over. And so therefore, you introduced -- we introduced the Duo specifically to address that group and that's very similar to what we've done in the past with the K-MINI, which targets a specific demographic and price point with the K-Café, which goes towards people who are interested in specialty coffees, cappuccinos and lattes. So our -- just to go back, our goal is of increased household penetration, brewers are the vehicle to do so and the way that we think about innovation in brewers is to address people who are not in the system who we want to have come into the system. And that's why it makes sense to invest a disproportion amount of marketing in driving household penetration.

Got it. And then on the pod manufacturing efficiency, should we look at this quarter where margins aren't moving quite as much as some of the low-hanging fruit is starting to -- has been picked? And maybe any update, I think there is a South Carolina plant that's soon to be up and running, and will that have meaningful benefits anytime soon?

What we know is -- again, I would suggest you take a look at our margin and our progress over time because it's not evenly distributed quarter by quarter. And I think one of the things that we've all learned in the past year is we never want to overreact to the positive or the negative on any quarterly numbers. I would recall the conversation we had about brewer sales, brewer unit sales back in the fourth quarter of 2018 that scared everybody off. And we said, don't worry about it. Similarly when we're up double digits, we also say it's not a meaningful metric. So I would suggest that there's really no incremental news on margin at all based on this quarter that it's part of the long-term trend. The point that I made a couple of times is we know that there's pricing investment. We talked about it; we've been incredibly transparent. We have great visibility of it going forward because we have long-term contracts with a great majority of our partners, but we also know that we have a reservoir of productivity and projects to offset that pricing. So we would not have negotiated the deals that we did if we didn't have the ability to address them through productivity. And one of those projects is the state-of-the-art manufacturing facility in South Carolina and that will be up sometime in the next year or so, but that's just part of that project in getting towards that goal. I don't know if you have anything to add to that, Ozan?

Exactly. I mean when you again go back and look to the guidance that we put out there, actually almost a little bit more than 18 months ago, we said on a Coffee stand-alone basis including '18 through 2021, we expect margins to improve 600 to 700 basis points. And as you know, we improved almost 300 basis points of our margins in Coffee Systems in 2018. And you see the improvement as we've announced in the first two quarters or year-to-date 2019 and we are doing pretty well, I must say. So you would expect to see further margin improvement, again in line with our guidance between now and end of 2021. And I think all these things, as Bob said, have been pointing out and still pointing out the great visibility we have, the relationship between the top line, which relates to the pricing, and the strategic moderating of that allowing a huge visibility and great road map in terms of improving our base productivities between the cost of goods sold as well as the overhead. And that's what we have been executing and that's what we will continue to execute. And as Bob said, we have too many projects, Spartanburg is very important, last guy on the block, but it's one of them and we'll just continue to execute.

This concludes the Q&A portion of today's call. I'd like to turn it back over to management for any closing remarks.

Thanks, everyone, for dialing in today and joining us. I know we went a little bit over. The IR team is around today for any additional follow-ups, and we look forward to talking to you. Thank you.

This concludes today's conference call. You may now disconnect.