There can be no doubting that Fevertree Drinks (FEVR) is a very good business. Its premium mixer drinks have gone down a treat with consumers who have been adding more of them to their gins and cocktails over the past few years.
Fevertree has ridden the gin boom extremely well. It has convinced a growing number of consumers to pay very high prices for its products and has leveraged this on its very profitable business model.
Fevertree is essentially an ingredients and marketing company. The heavy lifting of making and distributing its drinks has been outsourced to third parties. This means that its business is very asset-light and that it has minimal capital investment requirements. It does, however, have to invest in working capital by building up stocks of finished goods to meet future demand while offering its customers credit to drive sales.
The high selling prices of its products make for high profit margins. Combine this with its asset-light balance sheet and you have a recipe for an outstanding business with high returns on investment and lots of free cash. Turbo-charge this mix with rapid growth and it’s not difficult to understand why investors fell in love with the shares.
But during the past year this love affair has turned sour. The shares peaked at nearly £40 last September and have fallen by 37 per cent during the past 12 months. What’s potentially more alarming is that the shares have fallen by more than 20 per cent in the past month alone.
Sentiment towards the shares is weak and has raised the question of whether the company could issue a profits warning over the next few weeks. The company has made no comment on trading since its interim results and is probably waiting to see how the key Christmas trading period goes.
I’ve held this thought for some time now for a number of reasons. For me, Fevertree has been too reliant on the UK and on tonic for its growth in recent years. Gin sales have continued to boom, as Diageo’s annual results showed in July, but it’s not unreasonable to assume they cannot continue at recent rates.
The other reason to be cautious is that there appears to be rising competition in Fevertree’s core UK market. The company has hammered Schweppes in recent years, but the easy wins seem to have been made here.
You do have to question what the barriers are to new competition in this market. Given that Fevertree has outsourced production and distribution to third parties – and is avoiding the large costs of building manufacturing and bottling plants – to concentrate on ingredients and marketing, is it unreasonable to think that someone else could do the same? High profits naturally attract competition and if large upfront investment costs can be avoided then that’s a barrier that does not have to be crossed.
Building a brand does take time and money and this has been where Fevertree has delivered a first-class performance. Yet, take a look around the soft drinks aisles of supermarkets and you can see that competition is increasing.
Fentimans has been in business since 1905, but its UK sales increased by 31.8 per cent to £24.8m in 2018, according to its annual accounts. Schweppes has responded with its own range of premium mixers, while Waitrose is stocking the Double Dutch brand of mixers which have very favourable reviews.
Even the supermarkets themselves have got in on the act. Own-label products are a key source of additional profit margins, with Tesco increasingly pushing its Finest range of premium products. Its premium flavoured tonic water sells for less than a third of the price of Fevertree and, based on my own experience, don’t taste too bad at all.
The other factor in the UK this year has been the weather. The hot summer of 2018 was not repeated this year and the company has alluded to the fact that this has had an effect on UK sales growth.
Fevertree sales and growth rates
(£m) | UK | Europe | US | Rest of world | Total |
TTM | 136.9 | 58.8 | 40.4 | 14.5 | 250.6 |
H1 | 60.7 | 29.0 | 19.8 | 7.8 | 117.3 |
2018 | 134.2 | 55.5 | 35.7 | 12.0 | 237.5 |
H2 | 76.2 | 29.8 | 20.6 | 6.7 | 133.3 |
H1 | 58.0 | 25.7 | 15.1 | 5.3 | 104.2 |
2017 | 87.8 | 44.7 | 29.5 | 8.1 | 170.2 |
H2 | 54.2 | 22.7 | 16.3 | 4.9 | 98.3 |
H1 | 33.6 | 22.0 | 13.2 | 3.2 | 71.9 |
2016 | 44.7 | 31.1 | 21.3 | 5.2 | 102.2 |
Growth rates | UK | Europe | US | ROW | Total |
Annual run rate | 2.0% | 5.9% | 13.2% | 20.8% | 5.5% |
H1 | 4.7% | 12.8% | 31.1% | 47.2% | 12.6% |
2018 | 52.8% | 24.2% | 21.0% | 48.1% | 39.5% |
H2 | 40.6% | 31.3% | 26.4% | 36.7% | 35.6% |
H1 | 72.6% | 16.8% | 14.4% | 65.6% | 44.9% |
2017 | 96.4% | 43.7% | 38.5% | 55.8% | 66.5% |
Sources: Company reports, Investors Chronicle
This is already happening, as seen at the half-year results in July. UK sales growth slowed to 4.7 per cent, while on an annualised basis the run rate of growth was down to 2 per cent with sales just £2.7m higher.
For me and many other commentators out there, the US remains the key source of opportunity and risk. The actual volume of sales from the US remains small, but growth rates are not that stellar given the low base, especially as national distribution agreements are in place.
The company is hoping that new business won in the first half of the year will feed through to higher rates of growth in the second half. One important issue to keep in mind is the value of the pound against the dollar. Products are shipped into the US from the UK and the recent modest rise in sterling would have made them more expensive on US markets.
If the current political mess in the UK gets sorted out over the next few months then there are grounds for thinking that sterling could appreciate quite significantly against the dollar. If it did, then Fevertree would be up against a significant headwind while trying to grow its US business.
The key question is: How much of these risks has been priced into the shares? My view is that not enough has.
Fevertree has gone from being a momentum share where valuation concerns were ignored to one where valuation matters a lot.
A company experiencing strong trading conditions often sees regular and significant upgrades to its profit forecasts. This sees people pile into the shares in the expectation that the good news will keep on coming. While this is going on, the share price and the valuation relative to earnings (the PE ratio) can rise to stratospheric levels. This was the case for Fevertree between 2015 and September 2018.
Year to Dec | 2014 | 2015 | 2016 | 2017 | 2018 | 2019F |
Diluted EPS (p) | 1.54 | 11.48 | 23.7 | 39.15 | 53.19 | 56.9 |
Change | 645% | 106% | 65% | 36% | 7% | |
Year end share price (p) | 173.5 | 599 | 1139 | 2277 | 2199 | 1758 |
Change | 245% | 90% | 100% | -3% | -20% | |
PE ratio | 112.7 | 52.2 | 48.1 | 58.2 | 41.3 | 30.9 |
Earnings yield | 0.9% | 1.9% | 2.1% | 1.7% | 2.4% | 3.2% |
Earning yield on 170p IPO price | 0.9% | 6.8% | 13.9% | 23.0% | 31.3% | 33.5% |
Sources: Company reports, Investors Chronicle
The problem facing Fevertree’s share price for most of 2019 has been the lack of forecast upgrades. With the momentum from that source taken away, the shares are now rightly being appraised on its business fundamentals and the possible returns that may accrue to investors from future profits.
One of my favourite ways of looking at a potential investment is to try to get a feel for the yield on cost. Yield can be measured in many ways, but the most popular choices are based on earnings per share (EPS), dividend per share (DPS) and free cash flow per share as a percentage of the share price paid.
If yields have the potential to grow sustainably over a number of years then an investor can experience a very significant yield on their initial cost of investment. An investor buying Fevertree at its flotation price of 170p five years ago would have been getting an initial earnings yield of less than 1 per cent. This is expected to rise to 33.5 per cent of profit if forecasts are met in 2019.
These earnings yields are not actually represented by cash in the investor’s pocket as would be the case if Fevertree was privately owned, but are represented by a higher share price as the stock market puts a value on the profits.
The key risk for investors is when they pay too high a price – too low a yield – and future profits don’t grow enough to give them an acceptable return. With growth slowing and considerable uncertainty about what the future will bring for UK and US markets, this is the big risk that faces anyone buying Fevertree shares right now.
UK soft drinks EPS forecasts and earnings yield on share price
Company | Share Price (p) | TTM EPS | fc EPS | 2-yr fc EPS | 3-yr fc EPS |
Fevertree Drinks | 1758 | 54.8 | 56.9 | 64.4 | 72.7 |
Yield on cost | 3.1% | 3.2% | 3.7% | 4.1% | |
Barr (AG) | 552 | 29.1 | 26.1 | 28.2 | 28.3 |
Yield on cost | 5.3% | 4.7% | 5.1% | 5.1% | |
Britvic | 954.5 | 56.9 | 57.9 | 61.5 | 64.9 |
Yield on cost | 6.0% | 6.1% | 6.4% | 6.8% | |
Nichols | 1600 | 69.2 | 72.1 | 75.9 | 79.4 |
Yield on cost | 4.3% | 4.5% | 4.7% | 5.0% |
Sources: SharePad, Investors Chronicle
Based on trailing 12-month (TTM) EPS, Fevertree shares offer a meagre earnings yield of 3.1 per cent at a share price of 1,758p. If forecasts are met for its next three years then this yield only increases to 4.1 per cent. Yet, forecasts assume that EPS will grow by 27.7 per cent between 2019 and 2021. They might do, but unless growth picks up – particularly in the US – there’s a risk that they won’t and the forecast earnings yield will be lower than currently expected.
Fevertree shares therefore still look very expensive and have considerable scope to disappoint. This is why the share price may still have further to fall.
How much does BT need Champions League football?
There’s no two ways about it, BT (BT.A) is in a mess. There is little revenue growth across its business, while the pressure on its cash flows only looks set to increase.
It is aiming to cut £1.5bn from its costs over the next few years by getting rid of 13,000 jobs, which will cost it just under £900m. The hope is that it can keep making enough money to at least cover its 15.4p dividend per share.
Judging by its share price of 197p and a dividend yield of 7.8 per cent the market seems to be implying that at best BT’s dividend is unlikely to grow and that there is a real possibility of a hefty dividend cut.
For years BT milked its Openreach infrastructure business – the telephone and broadband connections to homes and businesses – for cash. It invested less than its depreciation charge (a proxy for the amount needed to maintain its asset base – as it essentially tried to deliver fibre broadband on the cheap. Instead of laying fibre-optic cables to people’s homes (known as fibre to the premises, or FTTP) it only went as far as the green cabinets seen on the streets (fibre to the cabinet, or FTTC) and then squeezed as much speed and bandwidth out of its old copper network.
That strategy is now exhausted and BT knows it. It is now planning to have 4m FTTP connections by 2021, with the hope of a lot more than that if it can get the government and Ofcom to allow it to make a decent amount of money from doing so.
This is when things get difficult for BT. The government wants to get people off copper networks by 2025 and has committed to spend £5bn to help achieve this. BT hopes that it will be the company that benefits from this money, but competitors such as City Fibre will want to get a share of it as well. BT could lose its near-monopoly grip on the last mile of the UK network and the profits that come with it.
This week, the bidding for the UK broadcasting rights to the UEFA Champions League and Europa League will begin for the period 2021-24. BT has held these rights since 2015 and spent a whopping £1.2bn last time around to win them. Along with its Premier League rights, these have formed the backbone of its BT Sport channels, which have been used as a tool to woo and retain profitable broadband customers.
There had been some hope that BT might be able to win the next set of rights for less money. However, there are strong rumours that Sky is preparing to bid for them as well.
If BT was to lose these rights then it would save a lot of money, but would it mean the loss of broadband and mobile customers? If Sky was the winner then it is likely to use the rights to offer more TV, mobile and broadband bundles. However, it might not be a total disaster for BT.
Sports rights have proved to be a very expensive way of keeping hold of broadband customers. Walking away from sports and letting its rights run down – or selling them to other parties – might prove to be a blessing in disguise if it can get an acceptable fibre investment deal.
BT’s current broadband and mobile packages are arguably no worse and probably better than the competition and are competitively priced. Getting out of sports and focusing on its core business and making it better may be a better strategy. It’s difficult to think that BT Sport makes anywhere near a reasonable return on investment on a standalone basis while even as part of BT Consumer its value is very questionable.
Its relationship with Sky has become less frosty in recent years and this means that it could still offer a TV service – and therefore bundled services – by wholesaling Sky’s channels as Virgin Media does.
The Global Services IT business also needs to go as it offers little value and is increasingly at odds with the company’s core strategy.
BT may also need to think the unthinkable and cut its dividend, which is costing it £1.5bn a year. Halving it would still offer a yield of 3.9 per cent, while the £750m saved could be reinvested in fibre or be used to pay down its £5bn pension fund deficit further. Both may be a better way of increasing the value of the business to shareholders than being a slave to unsustainable dividend policy.
