"Weather is for wimps." So said former Marks and Spencer boss Sir Stuart Rose back in November 2006, in a swipe at the propensity of his retail peers to blame the elements whenever trading didn't live up to expectations.
Despite Sir Stuart's bravado, weather certainly does have an important influence on consumer behaviour and this is particularly true of the soft drink segment of the beverage sector. Put simply, when the weather's wet or cool, people don't feel the need to buy quite as many soft drinks.
Shooting pains
The torrid early summer months have already been partly responsible for one profit warning from the sector this year. While headlines may have focused on Britvic's expensive product recall - the result of faulty caps recently introduced on its popular Fruit Shoot children's drinks which will cost it as much as £25m over the next two years - but the soft-drinks maker also said that because the wet weather meant trading conditions had failed to improve, profits this year were likely to be at the lower end of expectations. Analysts are now looking for pre-exceptional operating profits of around £130m, which is £5m lower than the previous year.
The latest mistakes at Britvic mean that the longstanding rating gap between it and its two closest peers in the UK, AG Barr and Nichols, has widened further still (see table). On the face of it, the discount looks justified. While Britvic's low valuation can be attributed to a string of profit warnings and writedowns in Ireland, for which it can hardly be blamed, Barr and Nichols deserve much of the credit for their own premium valuations.
| Name | Market cap | Price | Forecast PE ratio | Dividend yield | Performance year-to-date | Performance 3 years |
|---|---|---|---|---|---|---|
| AG Barr | £504m | 432p | 18 | 2.4% | +6.8% | +99% |
| Nichols | £262m | 709p | 18 | 2.4% | +34% | +201% |
| Britvic | £680m | 280p | 10 | 7.1% | -13% | -8.4% |
Brands with bottle
Unlike Britvic, which first warned on profits back in February 2011 after it was hit by unexpectedly high raw material cost increases, Nichols and Barr have proved adept at overcoming the challenges that have hit their larger rival; not just the weather but also escalating input costs and wider pressure on consumers' disposable income.
Both have been more able to pass on higher sugar and packaging costs while continuing to build market share. There are two key reasons for this. One has been investment in the so-called 'impulse' channel, such as newsagents, which is less price sensitive than the promotion-intensive supermarket business. AG Barr, for instance, makes nearly two-thirds of its sales in the impulse channel.
Second is the strength of their brands and development of their product variants. In Barr's case, its expansion into the exotic drink segment through the acquisitions of Rubicon and Ka has proved a particularly powerful growth engine. Nichols has followed suit with its licensing of Dragons Den star Levi Roots for a Caribbean drinks brand. "The exotic side of the market has done really well," says Mintel analyst Chris Wisson. "Just because they've got less cash to spend doesn't mean they default to what they've always drunk or the cheapest - people are perhaps migrating away from more traditional drinks and are exploring other drinks."
He adds that manufacturers that have been able to demonstrate that their product carries some additional benefit such as an energy or a vitamin boost have been more able to command a price premium. "They cost a little bit more, but are offering something extra that justifies the price," he says, pointing to the success of products such as Glaxo's Ribena Plus, which along with Vimto has been one of the few cordials able to resist the move to double concentrate versions. Nichols' investment in a new licence to produce Weight Watchers-branded drinks falls into this category, offering a variety of 'superfruit' based cordials for dieters, and analysts reckon it could add as much as £7m to sales in its first full year. Barr, meanwhile, recently extended its Rockstar licence for energy drinks, the country's fastest growing category.
Although Nichols does have a fairly sizeable dispensed-drinks business, both it and Barr are also far less exposed than Britvic to weakness in the difficult drinking-out market, where volumes have been falling as consumers opt to drink at home instead. "People are staying at home to save money - a lot of people have been put off by big uplifts in prices in the on-trade," says Mintel's Mr Wisson, noting that consumers are mindful of the hefty mark-up pubs put on soft drinks. As Shore Capital's Phil Carroll also explains, there's been a shift in buying behaviour within the on-trade itself, with customers downtrading from higher value products such as Britvic's J2O to cheaper and less profitable dispensed carbonates.
Distribution the solution
But is the market being too hard on Britvic? Beyond its short-term manufacturing issues, Britvic has a well-established portfolio of brands that also includes favourites such as Robinson's cordial and J2O juices, as well as Fruit Shoot.
Analysts are generally optimistic that the Fruit Shoot recall will not have any long-term impact on its UK appeal, and more importantly the recall does not affect products in its international markets, Australia and the US, where distribution agreements have been agreed with Pepsi Bottling to take the drink across the southern states. At present, sales in the country are small, but analysts at Nomura reckon that there could be as much as 200p of upside per share if Fruit Shoot becomes as successful there as it has been in Britain. This year, Britvic expects growth of 20 per cent in its international business.
Nichols, meanwhile, already enjoys a significant international footprint - Vimto is widely drunk in Islamic countries as a restorative, especially during the Ramadan festival when it outsells even the world's most famous soft-drink, Coca Cola, but new distribution deals should help it push the brand further.
And although Barr is happy to stay at home, improved distribution is also proving key to its continued success. Historically, sales of its Scottish tipple, Irn Bru, have been biased towards Scotland and the north of England, while sales of exotic drinks brand Rubicon have been more concentrated in the south, and especially London, and the group is eking out growth by rebalancing their regional footprints. This will be further improved by the construction of a second production facility in Milton Keynes, which will double canning capacity at a cost of £41m and generate huge savings on transportation costs.
Commodity crunch
Of course, there is the risk that rather than Britvic catching up with sector valuations, rivals fall back towards it. Indeed, after pushing up prices by around 4 per cent last year, manufacturers may find that headroom for further increases should costs creep back up again is now more limited, given the wider pressure on consumer spending. While Barr and Nichols have recovered much of the extra raw materials costs, they have had to share some of the pain, which has seen a small contraction in gross margins.
AG Barr has, however, so far stuck to its view that cost inflation will remain in high single digits this year, but analysts remain mindful of continuing tight supplies in the European sugar market. "Sugar is one of the pressure areas, if not the pressure area," says Mr Carroll at Shore Capital, pointing out that manufacturers are focusing a disproportionate effort on marketing sugar-free varieties. AG Barr, for example, has heavily promoted its new Irn Bru Sugar Free variety, while Britvic is said to be investigating the wider use of the sweetener Stevia in its drinks.
And then there's the unreliable weather. "No one is immune it has to be said," says Mr Carroll. Nielsen figures from an unusually wet April showed that the UK soft drinks market was down by a massive 11 per cent - and, while Nichols and Barr have shrugged off the challenges so far, they'll also be hoping for a ray of sunshine, soon.
| FAVOURITES: |
|---|
| We first suggested buying Nichols in late 2009, and since then the shares have tripled. At the time we felt the market hadn't recognised its international strength, or the quality of its management, and the business has kept its above-average growth rates up with new products and distribution deals. The family-run group recently picked up a Queen's Award for International Trade, and a strong balance sheet means it's well placed to invest in further licences to expand its domestic portfolio. |
| OUTSIDERS: |
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| It's hard to see Britvic making much immediate headway - poor trading reports aren't likely to give the shares much of a lift and several own-goals mean sentiment is against it. However, Britvic has significant scope to drive its brands into new markets, although a change of management could be what the group needs to convince investors that it can take advantage of this opportunity. The £450m debt pile is a worry too. |
IC VIEW
This is an unusual sub-sector that, putting aside the specific problems of Britvic, has proved remarkably resilient to the ups and downs of recent years - data from the British Soft Drinks Association shows that the market has increased in both volume and value in each of the past three years. That's partly because soft drinks fall into the 'affordable treat' category, which means manufacturers have been able to put prices up without too much impact on volume. We're mindful that the recent soggy weather may put the brakes on growth this year, but if that means any share price weakness at Barr or Nichols we'd see that as a buying opportunity. As for Britvic, its long-term opportunities look sound, but we'd like to see a resolution of its internal issues before buying its shares.
