Fevertree Drinks: Headwinds Make Outlook Uncertain (OTCPK:FQVTY)

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After being among the top wealth creators on the London stock markets, 2022 has seen a rapid reversal of fortunes for drinks maker Fevertree (OTCPK:FQVTF)(OTCPK:FQVTY). The company’s shares are down 70% so far this year as I type, significantly underperforming the broader iShares MSCI UK Small-Cap ETF (EWUS) In the process.

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At one point, Fevertree’s progress seemed unassailable. The company overturned Schweppes’ decades-long dominance of its UK home market – pretty much inventing the “premium blender” category in the process – while also expanding into continental Europe, the US and overseas. other international markets. This has increased annual revenue tenfold since the company went public in 2014.

Earnings growth was also blistering, helped by an asset-light model that drove capital returns in the 40% range. That, in turn, fueled a sky-high valuation for Fevertree shares, which at their peak in 2018 traded at more than 70 times annual earnings.

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The situation seems quite different today. Just as soaring earnings and expanding multiple valuations make a great combination in good times, collapsing earnings and multiple deflation make a toxic duo when the going gets tough. This has been the case here recently as the company struggles with the side effects of the war in Ukraine and the subsequent decline in the stock’s earnings multiple.

While this has led to a terrible recent performance on the share price front, the equally steep drop in earnings means Fevertree stock still doesn’t look particularly cheap. The near-term headwinds the company faces aren’t easing either, meaning investors can probably afford to sit on the sidelines until the outlook improves. Hold.

Growing sales; Declining profits

On the face of it, Fevertree is regaining its stride after the COVID containment measures hit the global restaurant industry (approximately 45% of Fevertree’s pre-COVID revenue). Total sales in the first half of 2022 were £160.9 million, up 14% year-on-year and around 40% more than the equivalent period immediately before the pandemic. Sales in the UK domestic market (a third of the company’s total) still look a little soft – standing at £53.5m compared to over £60m in H1 2019 pre-COVID – but the US (~25% of sales), Europe (~30%) and the Rest of World segment (~10%) saw more robust growth, collectively roughly doubling sales from levels pre-COVID.

Unfortunately, earnings have moved in the opposite direction, with the company’s gross margin falling to 37.4% in the first half of 2022 from 51.9% pre-pandemic. One of the immediate issues is in the United States, where Fevertree’s bottling partner is struggling to ramp up its East Coast plant due to common post-COVID issues like labor shortages. In addition, its established West Coast facility has also experienced its share of generic post-COVID issues (e.g. port congestion affecting glass availability). The result is that US production levels have stagnated, meaning the company has been shipping product from the UK in order to meet growing US demand. Since this happened in a period of very high transportation costs, profits were hit hard. Fevertree has also seen more generic input cost inflation eat into its margins.

Source: Evolution of gross margin Fevertree 1H 2022

Source: Fevertree H1 2022 results presentation

Pricing power is also in question here. The company only saw a 110 basis point increase in gross margin from pricing and is forecasting 150 basis points for the full year, which seems pretty low to me given the broader rate of inflation and the company’s status as a major player.

Storm clouds don’t rise yet

Admittedly, some of this seems transitory – as management was keen to point out – and eventually US production will match demand, helping to reduce high logistics costs. In the short term, however, this appears to be a persistent problem, with transatlantic freight costs remaining high despite transpacific costs falling due to global recession fears.

That doesn’t mean margins will rebound completely, though. For one thing, the US now accounts for a bigger slice of the company’s revenue pie, and while Fevertree doesn’t break down profitability by region, its US operations are much less profitable than in the UK. UK, where growth will also be harder to come by as the company reaches market saturation.

Moreover, the national macroeconomic environment is becoming increasingly bleak. Retail energy costs have soared despite a recently introduced price cap, eating away at household budgets, while businesses face an even more uncertain outlook given their weaker levels of government protection. The razor-thin margins in the hospitality sector look very vulnerable, which could mean bad news for the domestic restaurant industry. Mortgage costs and rents are also rising alongside general inflation (food, indexed internet bills, etc.), putting further pressure on UK consumers. Supermarkets have previously warned that customers are shrinking, while discretionary spending is the easiest to cut in a downturn. All in all, it is not difficult to envisage a difficult period for the company.

Stocks could still be expensive

So far I’ve painted a pretty gloomy picture, at least in the short term, although I must point out that despite its issues, Fevertree is still a very good deal. Taking analyst estimates for 2022 and 2023 earnings (£25m and £30m respectively) at face value still implies a double-digit return on invested capital here. That’s about in line with the average business – maybe a bit more – and not bad considering we may be on the verge of a bad recession. The balance sheet is also healthy, with net cash still around the £100m mark.

Source: Fevertree H1 2022 Balance Sheet and Cash Flow

Source: Fevertree H1 2022 results presentation

The main problem is that expectations have been very high here in the past – fueled by strong growth and high quality earnings – and still can be. At around £8.40 in London, these shares are currently trading for around 40 times estimated 2022 earnings and 33 times 2023 earnings – figures that could rise further if earnings disappoint on the downside. Despite the sharp drop in the share price, potential investors can still afford to wait.

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