Soft drinks – may be the next tobacco, but could be good news for share price performance?
As The Coca Cola Company reported its full-year results last week, I spent a bit of time considering the outlook for the large operators in the global soft drinks industry. Let us be honest – this is an industry which has had its head in the sand and, until recently, ignored the potential health issues around sugar. That has now changed, with Coke launching in 2015 a huge overhaul of its advertising towards the “One brand strategy”, which shines a spotlight on the no/low sugar variants for the Coke brand: diet, zero and Life products. But is this too little, too late? The health lobby has focused strongly on the negative implications of high sugar consumption, and this has led to regulatory change, such as the sugar taxes implemented in markets like Mexico and France in recent years, with a UK tax planned for next year. And there continue to be other new restrictions which impact negatively on sales, such as the location of vending machines in several markets and bans on unlimited refills (just announced in France). All of these events create strong headwinds for Coke and for Pepsi.
So are the major soft drinks companies facing a future that has echoes of that other heavily regulated industry, tobacco?
The major tobacco companies do not tend to offer any volume growth; any growth in emerging markets is at least netted out by declines in mature markets. However, pricing remains strong, leading to some revenue growth. Combined with some operating leverage and the benefits of strong FCF, this can then offer a solid high single digit EPS growth model for the long-term. With limited requirement for new investment, the high FCF usually offers scope for large dividends and possible share buybacks. With the heavier regulation in soft drinks starting to have an impact, Coke no longer appears to be producing volume growth (overall for FY16 volumes were flat, with Q4 -1%); on the other hand, price/mix looks quite healthy (3% for the FY and a whopping 6% in Q4). I would expect increasing regulation to continue to put pressure on volumes, especially in the key segment of carbonates. However, as taxes on soft drinks become more common, this should allow higher pricing to the producer as the retail shelf prices will rise more slowly, which has long been part of the tobacco model. And a no-growth environment tends to focus management on running a tighter ship on costs.
Sure, market valuations tend to be a bit lower for the tobacco FCF model than for a topline growth model – the shares of BAT trade on 17x this year’s PER compared with Diageo on 20x. But when you look at the last five years, the share price performance of large tobacco companies BAT and Imperial Brands are up +60% which is as least as good as, if not a bit better than, other consumer companies like Diageo and Unilever, and well ahead of Coke where the share price has declined over 5 years. As big tobacco investors have found out in recent years, the tobacco model does not mean that the share price will go up in smoke.
My stock of the year – PureCircle, trying to “find the sweet spot”
In my new firm Bell Pottinger we have an annual competition for the best stock pick and I have just been asked for my recommendation for 2017 (based on the UK market). Now, as an ex-analyst, I do feel rather exposed; there is an expectation that I will more than outperform the average. Of course, if life was that simple, I would be a very wealthy man by now and would have retired with my fortune to a desert island. I always felt that, as an analyst, I was justifying my existence if I got my recommendations right at least 50.1% of the time. So what stock should I choose? The safety first option would be to plump for a large cap consumer stock, preferably, with a good dividend payment, that is unlikely to be that volatile and would certainly keep me out of the “bottom quartile of shame”; Diageo would tick the box, as would other large consumer names like Unilever. This cautious approach to investing would mirror the behaviour of many in the fund management community today, where supposedly active asset managers become highly risk adverse and end up running passive positions. As a result, there is a strong trend of individual investors moving away from more expensive active funds to cheaper passive funds. A recent article in the FT indicated that by 2021 it was expected that half of the US equity market would be in passive funds. If you think about it, this is yet another negative factor for the sellside analyst, as who needs expert stock advice when you just index your investment against a market? (see my postscript below)
I think I need to take some risk here and aim for top quartile performance in the competition. I do not need to limit my choice to beverages, but of course that is still my field of expertise. I thought about Fever-Tree – certainly that would have won me the competition in either of the last 2 years as the share price has gone up 10 fold from the IPO price of 134p (now over 1300p) – and the niche position in premium mixers still looks well protected, despite a few signs of increased competition in some markets (eg Britvic’s recent launch of the London Essence Co). But I am a bit nervous that, as the investment houses have to say these days, “past performance is not indicative of future results”.
So I have opted for more of a recovery play. PureCircle is not a beverages company but its product, stevia, the natural sweetener, is used by most soft drinks companies, as well as many food companies. In theory, this should be a super-growth company, given the pressure to reduce the reliance on sugar (as I discuss above), but the share price is down from its highs of over 600p in 2015 to under 300p today, mainly due to some issues with US customs. These have now been resolved and, although it will take a few quarters for business to rebuild, I expect a return towards historic high growth levels. I hope that this will leave me in the “sweet spot” for this year’s competition.
Reporting season to-date – certainly not dispiriting!
The results reporting season is well and truly underway in the consumer and beverages space. If I had to give an interim overview, it is fairly simple: spirits are high, but food is stodgy. We have had better-than-expected topline growth from the 3 spirits companies which have reported, with Diageo organic revenues up over +4%, Remy +9% and Pernod +4%. On the other hand, several food companies have disappointed, eg Unilever, Mondelez. Kellogg. As ever, it is never easy to generalise; at Diageo there appears to have been better momentum across most regions, which particularly reflects better Scotch sales after a couple of weak years; at Remy and Pernod a turnround in China has been the key moving part, with some benefit from the earlier Chinese New Year.
If I had to pick an underlying theme, however, it is that the spirits industry is much less of a volume game than other consumer sectors, with a greater focus on price and mix. Unilever, which managed only 2% revenue growth in its Q4 to December, particularly blamed emerging markets like Brazil and India where volumes had come under pressure. Spirits has generally been seen as “affordable luxury”, with a consistent focus on trading the consumer up to higher value products. Pernod, for example, does not report a total volume growth figure, as it does not see this as meaningful, preferring to focus on its revenue numbers. It is also true that recent historic growth in spirits has been depressed by lower shipments due to destocking in the supply chain. Now this appears to be at an end, the spirits price and mix model appears to be delivering.
And there are some signs of M&A picking up in the spirits area. Just before Xmas, Beam Suntory bought out the superpremium Sipsmith gin brand (for a multiple near 10x revenue, I understand) and last week Campari bought out the Bulldog gin brand where it already had a distribution agreement (headline multiple was cheaper at 5x revenue, but those sleuths at Just Drinks have found out that the earn-out clause could take this upto 9x). With such high acquisition prices, we would interpret both these deals as a vote of confidence in the growth prospects of the brands purchased.
Of course, this does not rule out that there could be some other factors at play here as well – could the Brexit and Trump world we live in be driving us to drink? In which case, it looks like we had better get used to good reporting from the spirits industry.
“Death of the analyst” – postscript
Last month I highlighted the potentially negative impact from new financial regulation (MIFID ll) on the role of sellside analysts. Since then the FT has run several articles on the subject, with one last week suggesting that a good 30% of analysts could disappear. As an ex-analyst, I must say that it is more comfortable writing, and reading, about this from the outside looking in rather than the other way round. And remember – you read it here first!