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Can Nichols bounce back?

Nichols has a great asset in Vimto, but Covid-19 has derailed its growth strategy for its out-of-home business. Can it get back on track when normal times return?
Can Nichols bounce back?

In more normal times, Nichols (NICL) is a very profitable business backed by the strength of its Vimto soft drink brand. Covid-19 has wreaked havoc on the company’s out-of-home growth push and begs the question as to whether it can recover its previous levels of profitability.

Even without an economic lockdown, many investors would question the long-term growth prospects of a soft drinks business. While it is true that they are not going to deliver the kind of stellar growth currently being delivered by technology and internet-related businesses there are grounds for thinking that these businesses still have something to offer investors in terms of dependable profits.

Soft drinks are a big market and consumers drink a lot of them. According to Nielsen, the UK market was worth £8.7bn of annual sales in 2019. While sales volumes declined by 2.4 per cent compared with 2018, sales values increased by 0.8 per cent, which built on the 7.8 per cent value growth in the prior year.

A growth market often provides a very helpful following wind to companies that operate within it. In many cases – at least for a while – a rising tide can lift all boats that are exposed to it. However, it is also possible for companies to grow and prosper in a mature market where overall growth appears to be sluggish.

When it comes to soft drinks, strong brands backed by effective product development and innovation can do very well. As with many consumer products there is a trend towards premiumisation, which has been exploited so well by companies such as Fevertree Drinks (FEVR). So while sales volumes may not be as high, the value of those sales can be much higher than existing products and create a growth opportunity.

Low-sugar drinks have been forced on manufacturers by government legislation, and adapting to this without destroying the customer taste experience has been a challenge for some brands, but is part of an increasing trend towards low-sugar drinks. No or reduced sugar drinks have been a big hit with consumers.

It is also possible to grow and pick up market share by adding distribution assets and expanding a geographic footprint within a market. Different packaging and sizes can also pick up new customers.

Let’s see how Nichols has been getting on with these issues.

 

The business

Nichols’ business is dominated by the Vimto soft drink brand, which was first sold in 1908. The drink is based on 23 fruit flavours and herbs and spices and is somewhat unique in the soft drinks world in that it is sold in both still and carbonated form. In recent years, the company has added additional flavours through the Vimto Remix sub-brand.

Its other brands are: Feel Good Drinks, which are based on natural flavourings and with no added sugar; StarSlush; Slurp frozen milkshake drinks; Froozie frozen drinks; and Frappe Chiqquo smooth iced drinks came with the acquisition of Noisy Drinks in 2016. 

Nichols also has the UK licence to produce and sell Sunkist and Levi Roots drinks.

The company has outsourced the production of its drinks to third-parties, which gives it a very asset-light business model. The distribution of them is shared between its own fleet of trucks and third-party delivery companies. Recipe and marketing functions are kept in-house.

The brands are sold through a variety of channels. The biggest part of the business is sales to supermarkets, wholesalers and independent retailers.

Over the past few years Nichols has made a big push in the out-of-home market. Vimto UK Out of Home specialises in packaging and selling drink concentrates in what is called a “bag in a box” to pubs, bars, clubs, cafes, restaurants, cinemas, festivals, events companies and fast-food outlets such as Mcdonald's. It also invests in assets such as  drinks dispensers and frozen drinks machines and rents them out free of charge to customers as long as they buy their drinks from it.

As well as its own brands, this business has the licence to package and sell other brands, including Coca-Cola, Pepsi, Irn-Bru, Dr Pepper, Oasis, Schweppes and ICEE fizzy slush drinks.

This business has been built up both organically and by the acquisition of regional drinks distributors in recent times.

The company has long had an international presence and sells Vimto concentrate to the Middle East, where the drink is very popular during Ramadan. It also has local partners who have been granted a licence to make Vimto. 

Nichols has also been building up its presence in Africa over many years and also has a very small but growing sales base in the US and Europe.

The final piece of the business concerns the brand licensing of Vimto. The rights to use the flavour have been sold to the makers of sweets such as lollies and jelly babies, doughnuts and lip balms.

The UK business is by far the biggest source of revenues and profits.

Great profitability, but can profits recover and then start growing again?

A cursory glance at some key financial ratios shows that Nichols has created a very profitable business. In more normal circumstances, the business has many of the hallmarks of an outstanding business with high profit margins, high free-cash-flow margins and high returns on invested and operating capital. All its growth and acquisitions as well as dividend payments have been funded from cash generation without the need for borrowing or fresh equity, which is very commendable.

Prior to Covid-19, the company had been reasonably successful in growing revenues, but growing profits had proved more difficult.

 

Nichols: Key numbers and financial ratios

£m

2015

2016

2017

2018

2019

LTM

Revenues

109.3

117.3

132.8

142

147

134.6

Gross profit

53

59.1

60.6

64.9

70

62.3

Operating profit

27.8

30.3

30.5

31.6

32.4

25.9

Net profit

22.2

24.4

25

25.5

26.8

21.4

Free cash flow

16.6

17.9

14

19.6

22.5

24

Invested capital

77

93.5

103.8

116.7

130.4

131.7

Operating capital

57.9

70.4

73.2

82.2

94.8

95.6

Cash balance

35.4

39.8

36

38.9

40.9

46.8

       

Gross margin

48.5%

50.4%

45.6%

45.7%

47.6%

46.3%

Op margin

25.4%

25.8%

23.0%

22.3%

22.0%

19.2%

FCf margin

15.2%

15.3%

10.5%

13.8%

15.3%

17.8%

FCF conv

74.8%

73.4%

56.0%

76.9%

84.0%

112.1%

ROCE

36.1%

32.4%

29.4%

27.1%

24.8%

19.7%

ROOCE

48.0%

43.0%

41.7%

38.4%

34.2%

27.1%

Source: Annual reports/Investors' Chronicle

Profit margins have fallen away from the 2016 peak. The fall in the value of the pound led to a significant increase in input costs in 2017 which pushed down gross profit margins by 480 basis points. This has dragged down operating margins and returns on capital.

Nichols: Profit margin analysis

% of sales

2015

2016

2017

2018

2019

Gross profit

48.5%

50.4%

45.6%

45.7%

47.6%

Distribution costs

5.0%

5.3%

4.5%

5.1%

5.0%

Admin costs

18.0%

19.2%

18.2%

18.3%

20.5%

Op profit

25.5%

25.8%

23.0%

22.3%

22.1%

Source: Annual reports/Investors' Chronicle

Nichols is selling to big supermarkets which have a lot of buying power which makes it difficult to pass on cost increases. Middle East sales have also been highly profitable until this year and the volatility seen in them in recent years – particularly due to the troubles in Yemen – can have an impact on gross margins in any particular year.

The other important driver of gross margins is the mix in sales between stills and carbonates. Stills have much higher gross margins. Most of the time the mix between the two is pretty even but since Covid-19, stills’ sales have been much more resilient and this has given some protection to Nichols’ gross margins in these difficult times.

Nichols: Stills and carbonates revenues and gross profit margins
 

Stills

Carbonates

Year

Revenues

Gross profit

Gross margin

Revenues

Gross profit

Gross margin

2014

56.0

30.9

55.1%

53.2

19.4

36.5%

2015

54.4

32.0

58.7%

54.8

21.0

38.3%

2016

59.5

34.7

58.3%

57.8

24.4

42.2%

2017

64.1

35.2

54.8%

68.7

25.5

37.1%

2018

64.7

35.4

54.7%

77.4

29.5

38.1%

2019

71.7

42.7

59.6%

75.3

27.2

36.2%

LTM

70.1

39.9

56.9%

64.5

22.3

34.6%

Source: Annual reports/Investors' Chronicle

Distribution costs are incurred almost entirely in the UK and are essentially a function of sales and stock levels. These have been well controlled in recent years.

Administrative costs have eaten into profit margins. Acquisitions have brought higher overheads and wage costs as has the push into Out of Home where the big increase in investment in dispensing assets has led to a significant increase in depreciation.

Growth strategy: Vimto, Out of Home and International

Vimto

Vimto has been a great success story for Nichols during the past few years. It dominates the UK business and accounted for 77 per cent of its revenues in 2019.

Between 2015 and 2019, Vimto’s brand value increased from £69m to £90m and has taken market share. The launch of its Remix stills drinks has been a great success with its target teenage audience and has accounted for the majority of the sales uplift. As a result, Vimto has been one of the few UK squash brands to see meaningful growth in recent years.

The growth has also been achieved without significant promotional activity, which has seen sales values increase faster than sales volumes. The real strength of the brand has been shown in 2020 where its brand value increased by 5.8 per cent in the nine months to September against a market that was showing very little growth.

This is all well and good, but it remains to be seen how far this performance can continue and contribute to higher revenues and profits in the future. Unfortunately, the good results achieved by Vimto have been offset a little by the very disappointing performance of Feel Good Drinks. This brand has failed to resonate with consumers and the value of some of the goodwill on its acquisition in 2015 has been written off to reflect this. The brand is in the process of being relaunched, but is unlikely to change the fortunes of the business in a positive way.

 

Out of Home

This had been a great success story until Covid-19 struck.

The revenue growth has come from both organic growth and acquisitions. The acquisition of Noisy Drinks in 2016  brought additional distribution footprint and frozen products to the business, which has been complemented by the acquisitions of DJ Drinks in 2017 and Adrian Mecklenburg in 2019. The latter beefed up distribution in the south-east of England and brought a licence to sell liquid coffee – an attractive growth market – with Douwe Egberts in central London and Kent.

Strong organic growth has been driven by heavy investment in drinks dispensing and frozen drinks equipment in recent years. Customers can use these for free while buying their drinks from Nichols, which is an incentive to become and remain a customer. The contract with Coca-Cola was renewed in 2019, keeping Nichols exposed to the growth in sugar-free cola, which has served it well in recent times.

While this business has been a source of growth, it has been hammered by Covid-19 which has seen the vast majority of its customers close during lockdowns. Revenues have fallen off a cliff and were down by 45.2 per cent in the third quarter of 2020.

The bounce-back potential of this business is strong when Covid-19 is finally under control and pubs, bars and cinemas open their doors again, but there must be a risk that Nichols will be serving a smaller customer base when it happens.

The pandemic has seen the company undertake a review of its capacity and a number of jobs are likely to be lost. This can be read two ways. It could mean that the business will be more profitable when normal conditions return as the same volume is serviced from a smaller asset and cost base, or it could be a sign that the management thinks that there will be fewer customers to serve as some pubs and bars fail to survive the pandemic.

This aside, I still think this is a business that can grow when kinder trading conditions returns. The company’s strong financial position gives it the firepower to make more bolt-on acquisitions and to continue to invest in dispensing and frozen drinks machines to win customers.

 

International – Middle East profits blunted and African growth

There has been no meaningful growth from the Middle East business for years, but the £11m-£13m of revenues it generates in most years used to come with very high profit margins attached. Ramadan sales are the key driver, but the introduction of a sugar tax in Middle East states has blown a hole in the profit stream, which led to a profit warning in December 2019.

Nichols has been steadily expanding its geographic footprint in Africa, which has taken sales from £8.3m in 2014 to £13.7m in the 12 months to June 2020. This is also a nice bit of incremental business, but is unlikely to change the company’s fortunes in a meaningful way.

US and European sales are tiny in comparison and are not yet game changers as far as investors are concerned in my view.

 

Does the recent share price recovery have further to go?

Nichols’ shares have bounced strongly in recent months as hopes of a vaccine roll-out in the UK and a return to normality have seen its share price jump from under £10 at the end of October to £13.40 at the time of writing. This compares with a 52-week low of 910p on 18 March last year and a high of 1,410p a year ago.

Whether it can get back to the days when shares changed hands for more than £18 is another matter.

A lot depends on how quickly profits can recover. The introduction of a new national lockdown this week which is likely to see hospitality businesses closed until March at the earliest is not helpful at all. That said, it is not unreasonable to eventually expect a strong recovery in profits in my view.

Nichols: Consensus forecasts January 2021

Year (£m)

2020

2021

2022

Turnover

121.8

137.9

145.2

Ebitda

20.6

29.8

33.9

Ebit

16.1

25

29.1

Pre-tax profit

14.2

24.3

29.5

Post-tax profit

13.1

20

24.1

EPS (p)

36.1

55.7

64.5

Dividend (p)

34.9

37.2

38.9

Capex

3

4.1

4.1

Free cash flow

13.7

21.6

23.9

Net borrowing

-45.3

-53.5

-61.9

Source: SharePad

The company said in early December that it expected pre-tax profits for 2020 as a whole (its year-end is December) to be between £11m and £13m. City analysts are currently expecting a big recovery to £24.3m in 2021.

Nichols will release a trading update next week (Tuesday 12 January) and my current thinking is that these forecasts are at risk of being cut – perhaps quite significantly – given the current lockdown. That said, 2022 profit forecasts may still be doable if a return to something approaching normal is achieved by late spring or early summer 2021.

If that is a reasonable assumption, then at 1,340p, the shares would be trading on a 2022 forward price/earnings ratio (PE) of 20.8 times. A leaner and fitter business could see a recovery of 2019 pre-tax profits of £32.4m and earnings per share (EPS) of 72.8p shortly afterwards, which would put the business on a multiple of 18.4 times.

This kind of valuation is not unreasonable in a low interest rate world for a business that can chug along and offer dependable and modestly growing profits in most circumstances. That said, I think Nichols will have to demonstrate that it still offers some growth potential when normal business conditions return. Vimto has proved itself to be a very dependable asset, but the uncertainty regarding the Out of Home business could be a drag on the share price for some time.

Nichols is a business that I have a lot of time for and one that is well suited to those with a conservative investment approach. Now may not be the right time to buy the shares, but they are worth a place on a watchlist and could become attractive again if they sell off significantly in the next few weeks.