4 reasons to fill up on Dr Pepper Snapple

May 11, 2011, 1:00 PM UTC

Cash flow connoisseur Bob Olstein of Olstein All Cap Value sees the beverage company as an undervalued gem.

By Scott Medintz, contributor

FORTUNE — Bob Olstein likes companies with strong brands that generate lots of free cash flow. He’s used that approach in his Olstein All Cap Value Fund (OFAFX) to return 10.2% a year since 1995, vs. 7.5% for the S&P 500. In 2009 it led him to beverage maker Dr Pepper Snapple Group (No. 404 in this year’s Fortune 500), which Olstein began buying at $26. He now owns 300,000 shares — and believes the stock can go higher than its recent price of $38. Here’s why:

1. Its deep roster of powerful brands is hard to beat

Olstein reels them off almost giddily: Dr Pepper and Snapple, of course, plus 7 Up, A&W, Sunkist, Canada Dry, Hawaiian Punch, Schweppes, Yoo-hoo, and more. “I haven’t seen many companies with a lineup like that,” he says. Olstein points to recent marketing coups as example of Dr Pepper’s brand power: In 2009, PepsiCo (PEP) agreed to pay $900 million to Dr Pepper Snapple to distribute brands in certain U.S. markets; in 2010, Coca-Cola (KO) paid the company $715 million in a similar deal.

2. And those brands have lots of untapped potential

Dr Pepper Snapple (DPS)  was spun off by Cadbury Schweppes in 2008. (Cadbury was then purchased by Kraft Foods (KFT) in 2010.) Olstein thinks that Cadbury didn’t build the value of the beverage brands that it acquired over the years and which now belong to Dr Pepper Snapple. “To Cadbury, this was just peripheral,” says Olstein. “These brands were generating free cash flow, and Cadbury was using it to benefit the rest of the company. Now that cash flow is being used to grow the beverage brands.”

3. There’s plenty of room to grow, here and abroad

Some analysts gripe that the company has little presence in developing economies. “I see that as a major opportunity,” Olstein argues. Dr Pepper can take its brands global by leveraging existing relationships. “If Coke doesn’t distribute them, they’ll get Pepsi to do it, or vice versa.” As the distant No. 3 in the U.S. beverage market, it can grow fast by making small gains on its rivals. Says Olstein: “When you have only 3% market share, it’s not like you have to knock Coke off the shelf to gain more.”

4. The market is blinded by short-term issues

Olstein believes investors are too concerned about commodity costs hurting the beverage maker’s margins. “This company has pricing power,” he says. He sees earnings growing more than 5% annually and predicts that Dr Pepper Snapple will generate $3.50 per share in free cash flow in three years, up from $2.60 now. The stock currently trades at 13 times this year’s projected earnings; Olstein believes that ratio can rise to 16 or higher. With a higher valuation, he believes shares will trade above $50.