Fevertree sales continue to fizz but need a broader base

Over the last few years its drinks – particularly its variety of premium tonics – have become deeply entrenched among Britain’s increasing number of gin and tonic drinkers.

Its success is not only down to the taste and provenance of its products but is also a triumph of marketing and branding. If you walk into supermarkets you can quickly see that Fevertree totally dominates the shelf space allocated to tonic water. Many bars I have visited over the last year no longer stock Schweppes, only Fevertree. Not so long ago Schweppes was the go-to tonic of choice – in a very short space of time Fevertree has taken its place.

The company has also proved itself to be a smart operator. It has no drinks manufacturing factories or bottling plants – these have been outsourced to third parties – and so hasn’t needed to tie up a lot of money in assets. When combined with the premium prices it can command for its drinks, the result has been one of the most outstandingly profitable businesses listed on the London Stock Exchange. Last year its profit margin was 33 per cent and its profits as a percentage of the money it had invested a whopping 48 per cent. Throw in rapid levels of sales growth and it’s not surprising that its share price has gone through the roof over the last few years.

2018 has been another very good year for the business as evidenced by this week’s trading update. Shareholders will have been delighted to have been told that profits “will be comfortably ahead of the board’s expectations”. We can only assume that these expectations are similar to those of City analysts who were expecting Fevertree to make pre-tax profits of £70.8m and earnings per share (EPS) of 49.8p.

Source: Company reports/my calculations

Sales growth for the year was 39 per cent, which is an excellent result following growth of 66 per cent in 2017. The UK market continues to lead the way with impressive growth of 52 per cent.

Based on the information the company has given in its trading statement, it is possible to look at the trend rates of growth in the second half of 2018 compared with the first half of the year. These are shown in the table above.

UK sales growth has slowed – it had to – but is still pretty good, whereas growth in Europe and the US has accelerated, which is encouraging, because arguably they need to.

If you were to constructively look for areas of potential weakness in Fevertree it is that its sales growth looks as though it is coming from too narrow a base – namely the UK and from tonic. For the company to meet the high expectations that continue to be reflected in the value of its shares, it needs to start growing significantly in the US, Europe and across different mixer drinks categories such as ginger ale and cola. The company still has a lot to prove here.

The US market is key to achieving this goal as it is the biggest spirits market in the world. Here, as with other major markets, the shift to premium spirits is a strong and growing trend. The company has signed an exclusive distribution agreement with Southern Glazer’s Wines & Spirits in an attempt to get more of its mixers into US bars.

It’s worth noting that Fevertree currently has sales of just £35m in the US compared with £55m in Europe and £134m in the UK. The potential to build a very big and profitable business clearly exists on paper, but the challenge is a tough one. Will American drinkers of premium bourbon mix it with Fevertree cola or stick with the iconic Coca-Cola and Pepsi brands? If they switch then the upside potential in Fevertree’s profits – and possibly its share price –  is immense.

In some ways, Fevertree has had some luck on its side in the UK. It is difficult not to see the response of Schweppes – still the market leader in terms of volumes sold – as anything other than slow and complacent. Its 1783 premium tonic is actually a very nice drink – possibly better than Fevertree’s – but it is virtually invisible in the shops and bars. Will Coca-Cola and Pepsi be as complacent in the US?

Fevertree’s share price has unsurprisingly reacted well to its trading update. The shares peaked at over £40 in September last year, but fell back in the general market decline which saw highly valued shares suffer more than most. Despite the pullback, the shares are still richly valued.

Let’s say that analysts upgrade 2018 and 2019 profit forecasts by 15 per cent. That would give EPS of 56.6p for 2018 and 65.9p for 2019. At 2,980p at the time of writing, that would put the shares on a trailing PE ratio of 52.6 times, falling to 45.2 times in 2019.

I always try to get a feeling of how much of a company’s share price is explained by its current profits and how much is reliant on future profits growth. Ideally, you don’t want to pay too much for future growth – if you are a long-term rather than a momentum investor – and if more than half of the share price is dependent on it, I generally tread carefully.

Taking my revised estimate of Fevertree’s 2018 operating profits of £81.2m, taxing them at 19 per cent, dividing that by my required return of 8 per cent and adding an estimate of cash balances gives an earnings power value – the value of a share if its current profits stayed unchanged forever – of 780p per share. This explains just over a quarter of the current share price with three-quarters of it explained on future profits growth.

This leaves me with a view of the business and its shares that I have held for a while. Fevertree is an outstanding business but its share price requires it to keep on over delivering for many years to come. It has been very good at doing this, but it now faces a tougher challenge.