It has been almost a year since I first covered Fevertree Drinks (LON: FEVR) on the site. By now I’m sure most readers will have heard of the company but for those who haven’t then its primary business is in the manufacture of premium mixers, specifically tonic water. Now, for years this was an extremely boring area of the market that was totally dominated by Schweppes; a company with deep, deep roots in the UK. I mean it had already been distributing drinks here for over a hundred years before it floated on the stock market back in the late 1800s. Britvic – another inconic British company with bags of history under its belt – also had a share of the mixers market well before Fevertree came along.
All-in-all the picture painted above doesn’t exactly show an industry that’s ripe for disruption. That said Fevertree continues to be something of a revelation. I don’t want to spend too much going over points covered in last summer’s piece so I’ll try to be brief here. The three great aspects of the Fevertree story so far are its growth, earnings quality and shareholder returns. The first and third points pretty much speak for themselves: the company has tripled annual profits over the last couple of years and has delivered total shareholders returns of over 120% per annum since floating back in 2014. Those are phenomenal numbers for a beverage company.
As for the second point regarding the company’s earnings quality there’s also a lot to like about Fevertree’s performance to date. The big one for me is the underlying cash flow. Due to the fact it outsources production and distribution of its drinks the company is consistently pumping out heaps of surplus cash (the ratio of capital expenditures to cash generated by operations is currently a minuscule 3%). Furthermore its premium prices attract very attractive net profit margins that are currently running in the 25% area. Last time I checked my local supermarket was selling 8-packs of 150ml Fevertree tonic water for around £4.00 – around 50% higher than the price of Schweppes.
The Growth Trap Deepens
I finished last summer’s article with this comment regarding the stock’s valuation:
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.
Since then it has delivered shareholder returns of around 70% (excluding dividends). That is as a good an indicator as any that short-term share price prediction making is a pointless endeavour.
However the growth trap issue I talked about hasn’t gone away. Last year Fevertree made a net profit of 39.2 pence per share. At the time of the article its share price was around £17, giving us a then P/E ratio of around 45x earnings. Right now Fevertree shares are changing hands for around £29.30 apiece (70% higher than last summer). Will profits for fiscal year 2018 be 70% higher than they were in 2017? Probably not. In other words the expanding valuation attached to the shares has continued to boost the returns of current shareholders.
The big question remains: What happens if, or rather when, that relationship goes into reverse? If by the end of fiscal year 2022 Fevertree stock has contracted to a P/E ratio of, let’s say, 20x earnings then how much would profits need to grow in order to justify today’s share price? Well, a P/E ratio of 20 implies annual profits of £1.50 per share at today’s share price. In order to achieve that Fevertree would need to grow earnings by an average of 30% per annum between now and then.
What if prospective investors, or indeed current shareholders, want to see double digit annual returns? After all most folks wouldn’t be happy to tread water and lose out to inflation after five years. Well, if my sums are correct then generating 10% per annum over the next five years implies a future share price of £47.50. Attach a P/E ratio of 20 to that and you get required earnings per share of just under £2.40. In terms of earnings growth that means Fevertree would need to post an average annual figure of nearly 45% out to the end of fiscal year 2022. I know I’ve ignored the contribution of the future dividend stream here, though even factoring it in still results in a fairly big ask once you run the numbers.
There’s undoubtedly a lot to like about Fevertree’s business (high quality consumer stocks aren’t ten a penny on the London Stock Exchange), and yes the shares could go even higher in the short term. In the long-run though it still has to satisfy extremely high growth expectations, and that’s something investors should try to bear in mind.