Once described by a senior US regulator as little more than a casino the Alternative Investment Market (AIM for short) wouldn’t ordinarily be your starting point when searching for high quality UK-listed companies. Interested in an all or nothing punt on a firm prospecting for gold in sub-Saharan Africa? If so then AIM is your place. Looking for a boring company that has a consistent habit of making cash? Well, probably better to stick to the main market.
Despite the high failure rate of AIM-listed stocks you do get the odd success story every now and again. Domino’s Pizza Group – owner of the Domino’s master franchise across the British Isles – is one that springs to mind, as is the more recent example of Fevertree Drinks.
Premium Spirits, Premium Profits
Founded in the early-2000s by Charles Rolls and Tim Warrillow Fevertree’s aim was to cash in on the growing demand for premium spirits (gin in particular) by launching premium mixers to go alongside them. It has achieved this by making a big deal over sourcing high quality natural ingredients from exotic locations (e.g. the quinine used in Fevertree’s tonic water is sourced from a remote part of the Congo).
Leaving aside the specifics of Fevertree’s products what is undeniable is that they have proved incredibly popular. Growing demand means that upscale bars, restaurants, hotels and so on are all eager to stock Fevertree mixers to complement their premium spirits. Add in a significant first mover advantage (previously the mixer segment was dominated by Schweppes with no premium segment that I can think of) plus the fact that Fevertree outsources its bottling operations and you’re left with a capital light enterprise capable of generating incredibly high quality profits.
Last year Fevertree pulled in £27.5 milion in after-tax net profit compared to just £45 million in tangible capital sitting on its balance sheet. Its net profit margin was in the 25% range. Needless to say these are the hallmarks of an exceptionally profitable business.
Aside from the fact that it is rapidly becoming one of the best buinsesses on AIM the other aspect of Fevertree’s short life as a publicly traded company has been its incredible shareholder returns. Had you invested during the initial public offering (IPO) back in 2014 you’d have been looking at a share price of around £1.34. As it stands today the stock stock is selling for just under £17 per share.
By anyone’s measure a ten-bagger (or a twelve-and-a-half bagger to be precise) in the space of less than three years is an astonishing performance. So far this has been driven by two things. The first is the obvious huge growth in sales and net profit. Back in 2011 Fevertree was pulling in annual sales of just under £12 million of which approximately £2.3 million ended up on the bottom line as net income. Last year the comparable figures were £102 million in sales and £27.5 million in after-tax profit respectively.
The second is the fact that so far the stock has managed to maintain its sky high valuation. Back when the shares first listed on AIM they were being valued at approximately 11.5x forward 2015 earnings. Right now Fevertree stock is trading at something like 60x estimated 2017 earnings.
Going forward the big question is whether the company’s growth can sustain the current valuation. As you can see, in Fevertree’s early days as a listed company this was demonstrably the case: if, for example, the shares were currently trading at 20x annual forward earnings, rather than 60x, then shareholders would still have enjoyed compound annual returns of well over 60% per year to date. Not quite as spectacular as a ten-bagger, but still very impressive. Clearly the £1.34 IPO price was a steal for anyone who managed to get it.
Okay so that sums up the past situation, but what about going forward? Can Fevertree’s growth continue to make up for the extremely lofty valuation? On the face of it you might be tempted to say yes. Take the figures for fiscal year 2016 for instance: revenue was up almost 75%; diluted earnings per share more than doubled to 23.70 pence from 11.48 pence in 2015; net cash on the balance sheet more than doubled and the full year dividend grew by 100% as well. Moreover the company seems to be firing on all cylinders right across the globe: sales were up 118% in the home UK market; 24% in Continental Europe; 36% in the USA and 88% in the rest of the world (figures are in constant currency after adjusting for foreign exchange fluctuations).
The Growth Trap
If we could be guaranteed a few more years of that kind of growth then there’d be no issue – even with a current forward P/E ratio of 60. That said it’s pretty tough to forecast how well Fevertree will do in terms of growth going forward. Along with the 2016 figures management offered only a brief update on trading in 2017:
We have had an encouraging start to 2017 and remain confident that we are increasingly well positioned to deliver further growth across the business.
It’s difficult to take anything away from that in terms of solid numbers. What about City analysts? Well, if their estimates are correct then Fevertree is set to grow its earnings by around 15% on average over 2017 and 2018. For a beverage company that’s actually very good, but it’s nowhere near enough to justify the current valuation.
The danger is that anyone looking at investing in Fevertree today might fall into the dreaded growth trap. You can see that for yourself by playing with the numbers. Let’s take that average 15% annual earnings per share growth figure and apply it not just for 2017 and 2018 but over the entirety of the next decade. Under that assumption, and based on the current number of shares in issue, Fevertree would be posting annual earnings per share of approximately 96 pence by 2026. It also means that annual returns would also work out to around 15% a year assuming the current P/E ratio stays constant (though I’ve excluded any contribution from dividends). Of course it’s highly unlikely that the stock would still be trading at such a lofty valuation ten years from now once growth has moderated a bit so let’s go with a P/E ratio of around 20x annual earnings instead. Under this scenario annual returns would drop from 10% to just 1.5%.
Now you may think 15% average annual growth is selling the company’s prospects a bit short so let’s bump it up to 20% and see what difference it makes. In this case Fevertree’s annual earnings per share would grow to around £1.45 by 2026. Stick a 20x earnings valuation on that and you come away with a share price of just under £29.35 – equivalent to annual returns of 5.7%. Factor in cash dividends and you could reasonably assume that would increase by a percentage point or so.
It might not seem much compared to the last three years but coming away with approximately 7% annual returns over the next decade would represent a better outcome than it sounds. The issue is relying on 20% earnings growth to get it. Herein lies the problem for anyone contemplating purchasing Fevertree shares at this point: the growth rate required to generate even modest shareholder returns could well be bordering the unrealistic. Granted, a range of different outcomes could occur from here on out (Fevertree could get bought out by a Coca-Cola type and render this whole exercise meaningless) and it has the makings of a great company, but nonetheless Fevertree stock is probably not such a great buy right now.