A consumer stock poised to fizz again

This is the situation Cumbernauld-based AG Barr (BAG) finds itself in, after it confirmed last month that boss Roger White will depart in the next 12 months. White has led the business for two decades, making this a significant moment for the Scottish drinks company. Given his success – marked by the shares’ 11 per cent average annual total return during White’s tenure – it seems safe to assume that a successor will build upon the operating culture the incumbent has honed, rather than rip up the rule book. 

White’s exit, nonetheless, presents a good opportunity to take a fresh look at a company whose investment case (and share price) has failed to fully recover from a 2019 profit warning. Four years on, the group’s market capitalisation sits at a fraction of fellow UK soft drinks players Britvic (BVIC) and Fevertree (FEVR), both of which are dwarfed in turn by FTSE 100 bottler Coca-Cola HBC (CCH). But with attractive financial metrics and solid brand equity, AG Barr has good potential to grow profits after an anaemic period. 

More than Irn-Bru

The new boss, whoever they turn out to be, will be aware that investors expect improvements, and that pre-tax profits in the 12 months to January 2023 were still below the level first reached in 2018. The eyewatering profit warning that arrived in July 2019 – which laid bare the impacts of the UK sugar tax, changing consumer tastes and a campaign against teenagers’ use of high-caffeine drinks – has cast a long shadow over the group. So too has Covid-19, and subsequent cost pressures. 

The company is known, first and foremost, as the purveyor of the fizzy orange liquid called Irn-Bru. A successful hangover cure (according to some), this renowned nectar first hit the shelves in 1901 and battles it out with Coke for carbonated market supremacy in Scotland. Irn-Bru contributed 38 per cent of company sales in the latest year.  

The dependence on Irn-Bru has lessened, though, as AG Barr has expanded its product offering. The wider portfolio includes the Rubicon fruit-based soft-drinks range, leading UK cocktail brand Funkin, oat drinks and cereals business Moma, and energy and sports drinks purveyor Boost. New launches are planned for later in the current financial year.

Recent trading has been encouraging. Ahead of the publication of half-year results later this month, management said in August that it expects first-half revenue growth of a third and like-for-like growth of 10 per cent, meaning sales are also set to rise from £158mn in the same period last year to around £210mn this time. A forecast that full-year profits would come in ahead of market expectations led the City to upgrade consensus earnings estimates for each of the next three years.

The positive outlook is helped by the defensive nature of AG Barr's brands, which helped the company to grow sales during the financial crisis. Management’s disclosure that volumes grew in the first half of this year, despite price rises, suggests enduring customer loyalty and pricing power in the face of challenging trading conditions. This brand equity, combined with the attractions of the company's relatively 'value' offering amid a cost-of-living crisis, should be an enticing prospect for any investors uncertain of the outlook for the UK economy.

Other financial metrics appear robust. Take its return on total capital, which has averaged 18 per cent over the past five years, ahead of the 17 per cent at key rival Britvic (with which AG Barr almost merged in 2013), according to FactSet. Free cash flow may have fallen of late, but the consensus is for this to head north in the coming quarters and to hit £31mn in FY2025 – equivalent to a yield of 5.7 per cent.

Challenges remain, though. Like other drinks operators, AG Barr hasn’t been able to escape cost pressures. Cost of sales and operating expenses rose by a cumulative £47mn in the last financial year on the back of higher energy, packaging and sugar bills. Regulatory headwinds have also pushed up the cost base, with funds spent on the anticipated introduction of a deposit return scheme in Scotland. The scheme has now been delayed, which broker Peel Hunt thinks has “freed up operational capacity” for the company.

The impact of cost headwinds can be seen in the slowdown in margins, and the company warned in its latest update that "first-half margins remained under pressure". However, AG Barr's cash profit margin compares favourably with peers, and management is targeting a recovery in operating margins to between 14 and 15 per cent by 2026. To help in this push, the group is focusing on "supply chain optimisation, cost management and portfolio development". 

Acquisition potential 

AG Barr has stepped up its M&A activity and brokers think more acquisitions could be incoming. Given the company's strong track record of integrating business purchases, this augurs well. Sales for the Funkin brand, for instance, have soared since it was acquired in 2015, jumping from less than 5 per cent of total revenues to around 14 per cent today. 

Should the group seek to buy in growth brands in its ongoing efforts to build a broad and diverse portfolio of beverages, a net cash position should help. Analysts at Investec have also noted that AG Barr tends to take a counter-cyclical approach to strategic acquisitions.

If executed well, this should be a driver of future profit growth, adding to the momentum from recent acquisitions, that analysts believe will be a major driver of earnings in the coming years.

The latest round of dealmaking – last December’s purchase of Boost and the rest of the equity in Moma – look like good bits of business, giving it exposure to fast-growing segments of the drinks market.

Moma is enjoying “significant year-on-year growth” in this financial year, according to the company, with oat milk doing particularly well. Moma posted revenue growth of over 41 per cent last year, and AG Barr cites projections that the size of the UK oat milk market is halfway through a three-year tripling that will see sales hit £450mn by 2024.

The prospects for Boost look even better, albeit at the cost of a short-term drag on margins. The division contributed almost a quarter of the company's overall net revenue growth in the first half, notes investment bank Liberum, and revenues (and investors will hope, profits) look set to grow quickly. The business posted £2mn of pre-tax profits in 2021.

Portfolio expansion is supported by a conservative balance sheet. The net cash position, together with almost no liabilities other than payables, means a positive exposure to higher interest rates and a flexible working capital position that allowed the group to invest £17mn in the business in the latest year. 

A valuation discount

A 12-month consensus analyst target price of 608p for the shares highlights the potential for some significant gains for investors if the company's growth strategy and acquisitions can deliver the goods. 

AG Barr may need to overdeliver to remove the poor sentiment hangover of recent years. But the flipside of this is a valuation that looks cheap when viewed against the business’s prospects. The shares trade hands at 15 times forward earnings, a good discount to the five-year average of 20 and below Nichols' (NICL) rating of 17 times.

The opportunity here for investors, though, is made fully apparent by adjusting for differing capital structures. On an enterprise value (that is, market capitalisation, plus debt, less cash) of nine times Ebitda, AG Barr is cheaper than each of its UK market soft drink peers. Now looks a good time to buy in.