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New: Phil Oakley’s weekly highlights

In the first edition of his new newsletter, Phil Oakley asks whether shares in soft drink manufacturer AG Barr still have fizz.
September 28, 2018

Each week, I’ll be going under the bonnet of companies that have been in the news or caught my eye. The aim is to pick through financial statements and relate underlying numbers to companies’ operating issues, hopefully learning something different, that perhaps hasn’t been mentioned elsewhere.

The first part of the newsletter will be made available on the Investors Chronicle website for free and this week I’ll be looking at soft drinks manufacturer AG Barr (BAG) and examining if there is room for further upside.

The full edition of the newsletter, a brand-new and exclusive service, is available to Investors Chronicle Alpha subscribers. As well as AG Barr, this week I examine whether shares in James Halstead (JHD) have room to move higher; ask whether McCarthy & Stone (MCS) deserves to be considered a good value strategic play on the UK’s ageing population; and ponder whether investors should have an appetite for Hotel Chocolat (HOTC) at the current share price.

Alpha subscribers can read the full report here 

AG Barr

Soft drinks maker AG Barr (LSE:BAG) has long been regarded as a very good business by long-term investors in quality companies. The steady and predictable profits and cash flows that come from the frequent purchases of its iconic IRN-BRU drink have shown a remarkable tendency to keep on growing over the years and have made Barr shares a reliable if not spectacular investment.

 

As well as IRN-BRU, Barr’s branded soft drinks portfolio includes Funkin fruit cocktail mixers, Rubicon juice drinks, Strathmore water and Tizer. It also makes and distributes the brands of other companies in the UK, including Rockstar energy drinks, Snapple, San Benedetto and Bundaberg ginger beer.

Barr displays many of the financial performance hallmarks sought after by quality investors. It has high profit margins (over 15 per cent last year) and a very decent return on capital employed (ROCE) of more than 18 per cent. It has also proved to be reasonably good at turning its profits into cash.

As with many quality companies, though, these characteristics are not worth much unless it can continue to grow and compound the value of its high returns on investment. The main concern with Barr is that it is too reliant on IRN-BRU for its profits and that it is something of a one trick pony and that sooner or later it will stop growing.

This week’s half-year results suggest that this is not something to worry about at the moment. Despite having to put up with changeable weather, the introduction of a sugar tax in the UK and a shortage of carbon dioxide, Barr is enjoying a reasonable 2018 so far, with revenues increasing by 5.5 per cent to £136.9m. Higher costs – such as investments in brands – resulted in lower profit margins, with operating profits only increasing by 2.2 per cent to £18.4m.

All Barr’s revenue growth came from fizzy drinks (carbonates), which account for just under 75 per cent of total sales, with revenues increasing by 8.9 per cent. Stills and water saw revenues decline by 7.9 per cent.

As far as fizzy drinks are concerned, the company is doing well and taking a bigger slice of a market that is growing. The company’s strategy is to focus on selling more drinks (volume) rather than increasing prices too much. This seems to be working, with Barr’s volume share of the UK soft drinks market growing by 15 per cent in the first six months of 2018, as the company is selling more IRN-BRU in England and Wales and adds more distribution points. Funkin has also seem some decent growth.

The company is putting more money behind marketing IRN-BRU, Funkin and Strathmore and seems happy to sacrifice a small amount of profit margin in order to sell more of these products.

Apart from the small reduction in profit margins, the other notable item of financial performance was the relatively weak operating cash flow, which fell from £20.1m a year ago to £15.9m in the first six months of 2018.

The reconciliation of profits into operating cash flow is my go-to check on whether a company’s profits are believable or not. Changes in working capital which often account for differences between the two can be very revealing about what is going on in a business.

As we can see from its cash flow statement there was an outflow of cash from increased stock building (£3.2m) to meet the increased demand for soft drinks during the hot summer we have just had and a jump in receivables relating to unpaid invoices at the end of July. Note that the increase in receivables is not much bigger than last year and probably reflects some degree of seasonality in ordering and payment terms. There was also a £1.6m difference between the cash paid into pension schemes and the expense booked in the income statement.

Overall, there was a £7.4m cash outflow from working capital as the company offset its increased stocks and receivables by increasing its payables (invoices received but not paid). This compared with an outflow £1.9m last year.

 

I don’t think there is anything to worry about here. Increased stocks can be a sign of weakening demand and be used to shift expenses, but this is not the case here. Big jumps in receivables can be a sign of overtrading (offering generous credit terms to boost sales), but I very much doubt AG Barr could be accused of this. I would expect the bulk of the working capital outflow to reverse in the second half of the year.

Barr says that it is on course to meet expectations for the whole of 2018, which implies operating profits of £46.3m according to the consensus of City analysts’ forecasts. This compares with £45.1m made last year and £45.5m over the past 12 months.

 

I like this company and the way it is managed, but it does concern me that there is not much profit growth at the moment nor is there any expectation of any. Yet the shares trade on a one-year forecast rolling PE of 21.4 times at a share price of 725p – slightly lower if you adjust for the expected net cash balance. 

That looks quite expensive to me. Even with good profit visibility and good management, without meaningful growth the current valuation is beginning to look a little bit stretched in my opinion. It would not surprise me if Barr eventually approached Britvic (LSE:BVIC) again about getting together as the two businesses combined would probably be more prosperous than staying on their own.

 

Click here to access the full Alpha report.