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Fevertree and Diageo: through a glass darkly

Distillers may well cope better with rising input costs due to an increased focus on 'premiumisation'
Fevertree and Diageo: through a glass darkly

We’ve seen recently how Fevertree Drinks’ (FVTR) asset-light business model provided little insulation against fast-rising input costs. In its latest pre-close update, the premium mixer producer downgraded its half-year profit expectations, guiding for a gross margin of around 37 per cent. That represents a 510 basis point (bps) contraction from the 2021 year-end.

The expected cash margin showed an even steeper decline and is now forecast at around 14 per cent. Prior to the onset of the pandemic the rate stood at above 30 per cent. That’s some comedown and the full-year outlook is even more dire, with “a forecast gross margin in a range of 33 to 35 per cent”.

Fevertree’s woes stem from a combination of labour shortages in the US and availability and cost issues linked to industrial glass. Indeed, bottle suppliers are experiencing severe problems sourcing glassware as the production is energy-intensive and prices have been rising steadily in tandem with those for wholesale gas. And it’s worth remembering that the wider drinks industry is also struggling with cost increases linked to grain and logistics.

It’s difficult to assess whether the group's margin squeeze is connected in any way to its outsourced business model, hitherto seen as a strength of the business. But it could certainly have implications for industry peers.

It’s perhaps telling that shares in Britvic (BVIC) were also marked down following Fevertree’s update. Admittedly, the proportion of Britvic’s product range that utilises glass is much smaller than that of Fevertree. But prices for alternative packaging materials remain elevated even though commodity traders have started to price in an expected increase in aluminium production from Chinese smelters.

The Coca-Cola Company (US:KO) recently revealed that it is taking measures to mitigate the impact of cost increases by expanding the distribution of cheaper returnable or refillable glass bottles in emerging markets in Latin America and Africa. It is also trialling the use of returnable bottles in some US states in the southwest of the country, a possible precursor to a broader roll-out in its markets.

Distillers and brewers are also feeling the heat. As per research published in the British Food Journal, a company such as Diageo (DGE) should find support in the face of inflationary impacts because it has been shown that alcoholic beverages with a large market share (a characteristic of many of Diageo’s brands) tend to have a more inelastic demand than alcoholic beverages with a small market share.

Yet the group’s shares have lost 11.3 per cent of their value since the start of the year, double the rate of decline for the FTSE 100 index. Based on historical precedent, analysts at Deutsche Bank believe that cyclical headwinds could drag on Diageo's organic growth rate as they maintain that the spirits category “is more macro sensitive than most other staples categories”, meaning that growth is at greater risk. The analysts cite the group’s performance in the wake of the global financial crisis when its “organic growth rate slowed 740bps from +5 per cent to -3 per cent and, although there was a swift recovery, it took until 2021 for growth to return to the levels achieved in 2007”.

That somewhat downbeat, though doubtless erudite, assessment is somewhat at odds with the general broker coverage. Diageo is trading at a 13 per cent discount to the FactSet consensus target of 23 brokers, while the latest analysis published by Jefferies states that although the drinks group is faced with increased external volatility it is well placed to deliver on its medium-term targets of 5-7 per cent organic net sales growth and 6-9 per cent organic operating profit growth for fiscal 2023 to fiscal 2025.

 

 

The technical signals, meanwhile, are far from definitive. Diageo’s 50-day moving price average crossed below its 200-day average on 18 May. This is normally a bearish signal and prices did pull back in its wake, although both averages are now in equilibrium.

We shouldn’t forget that Diageo also sells a lot of beer and we have seen greater efforts to pass input increases through to drinkers. The situation with spirits is different in that they have a wider range of pricing, so distillers can benefit more from premium-priced offerings. As for rising glass prices, it would be safe to work on the basis that they account for a much smaller proportion of the production costs of Diageo’s product range than that of Fevertree.

Results are due out on 28 July and analysts will doubtless paying as much attention to the cash margin as they will volume growth.