Interactive Investor

Stockwatch: Tax trouble may create buying opportunity here

2nd February 2018 11:05

Edmond Jackson from interactive investor

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Is the reality of a "sugar tax" from 6 April now weighing on shares in mid-cap soft drinks groups, despite their scope to benefit from a longer-term generational switch from alcohol?

After a rock-solid upwards chart from 524p at end-2016, up to 820p at end-2017, Britvic has dropped 9% from 790p to 720p after a mushy Q1 update.

Alongside mixed revenue figures, it added a defensive PR prop: "The introduction of a soft drinks industry levy in the UK and Ireland brings a level of uncertainty, but we are well placed to navigate this given the strength and breadth of our brand portfolio, and exciting marketing and innovation plans."

Britvic derives some 62% of revenue from the UK and 9% from Ireland. Soon after, A.G. Barr quite similarly noted:

"The soft drinks industry faces significant changes in regulation, customer dynamics and consumer preferences, bringing both challenges and opportunities."

Yet its shares added about 15p to 660p, nearly regaining their 670p all-time high, asserting total revenue up 7.5% for its year to end-January 2018, which ought to be similar like-for-like given a recent lack of acquisitions. Otherwise, these stocks have quite similar charts, drifting over 2015 to 2016 then rising strongly in 2017.

Is Britvic's like-for-like revenue really so weak?

The stock's fall is in reaction to Q1 like-for-like revenue growth of 0.7%, below one analyst looking for just 1%. Britvic's explanation includes strong comparatives, with acquisitions rescuing headline revenue to show 3.3% growth.

Yet, its narrative is mixed: UK fizzy drinks enjoyed 4.9% growth, helped by Pepsi MAX, but still drinks fell 6.6%. Q2 sees the launch of Robinsons' Fruit Creations and Cordial ranges, but the administration of Palmer and Harvey means exceptional costs.

Abroad, France (19% of FY 2017 revenue) was down 5% in a subdued market and against a strong comparator; Ireland jumped 16.5%, but was acquisition-related and like-for-like performance was undisclosed; in the US, an 8.1% drop was also blamed on a strong comparative of a 19.8% rise after a new product launch; and Brazil was down 6.5% like-for-like if boosted 22.6% by the January 2017 acquisition of Bela Ischia. The market is, therefore, seeing through acquisitions to weak organics: is this just a confluence of setbacks or lack of marketing edge?

Meanwhile, Barr asserts 7.5% total revenue growth for its financial year to 27 January 2018, without citing like-for-like figures, but has anyway not made acquisitions. "We have continued to out-perform the total UK soft drinks market and increased our share," it says.

Its RNS shows busy share buybacks which ought to support consensus for a 39% recovery in earnings per share (EPS) this last year; although its four-year record to 2017 showed scant revenue growth towards £260 million, while Britvic grew its top line 15% over £1540 million, admittedly helped by acquisitions.

Thus, qualitatively Barr's update comes across as stronger and fully capitalising on fiscal change: "We have extended our innovation and reformulation programme such that we now expect that up to 99% of our portfolio will contain less than 5g of total sugars before implementation of the sugar tax."

This compares with Britvic saying two months ago at prelims, by April 2018 72% of its total portfolio and 94% its owned brands would be outside the UK levy, and in Ireland 69% and 79% respectively.

Britvic - financial summary           Consensus estimates
year ended 1 Oct 2013 2014 2015 2016 2017 2018 2019
               
Turnover (£ million) 1322 1344 1300 1431 1541    
IFRS3 pre-tax profit (£m) 82.6 120 138 152 139    
Normalised pre-tax profit (£m) 120 136 148 152 138 177 180
Operating margin (%) 11.1 11.9 13.2 12.1 10.2    
IFRS3 earnings/share (p) 25.3 36.2 41.2 43.5 42.2    
Normalised earnings/share (p) 39.1 42.7 45.3 43.6 41.8 53.1 57.0
Earnings per share growth (%) 59.5 9.3 6.1 -3.7 -4.2 27.0 7.4
Price/earnings multiple (x)         17.2 13.6 12.7
Annual average historic PE (x) 18.0 17.4 16.4 15.8 19.2    
Cash flow/share (p) 47.4 49.8 58.4 42.9 67.7    
Capex/share (p) 14.4 23.3 22.9 44.0 49.0    
Dividend per share (p) 17.8 6.1 21.5 23.3 24.7 27.0 28.5
Yield (%)         3.4 3.8 4
Covered by earnings (x) 2.3 2.3 2.2 1.9 1.7 2.0 2.0
Net tangible assets per share (p) -113 -87.8 -35.7 -52.1 -43.9    
               
Source: Company REFS              

Modest dividends put emphasis on narratives

Both stocks have until recently offered yields in the order of 3% versus price/earnings (PE) multiples in the mid-teens and goodwill/intangibles reigning back net tangible assets. Barr now enjoys a forward PE of about 20 times versus 14 for Britvic, most likely due to its firmer narrative; Britvic's markdown showing it balanced quite precariously between perception as a growth or income stock; 720p exacting a better yield of about 4% if forecasts are met.

As yet, such a status change towards income may be early stage if Britvic's narrative persists as soggy; buyers are quite assuming Q1 weakness is exceptional.

Barr's yield just over 2% involves forecast earnings cover of 2.0 versus 2.2 for Britvic; however, Britvic also had £588 million net debt versus Barr with £8 million net cash, thus Barr's dividend security is arguably stronger in the event of interest rates rising and/or a recession.

Brokers analysts: "behind the curve" on Britvic?

One of the reasons I drew attention initially at 585p in January 2017 was the contract between analysts increasingly negative despite Britvic's annual results showing post-tax profit up 10%.

The City's sense was fair value in a 550p to 600p range after a two-year downtrend from 775p, as fears for a sugar tax mounted. Yet it proved more reliable to follow a reverse head-and-shoulders chart pattern I drew attention to; the stock rallying persistently through 2017 achieving 40% capital growth. Or was brokers' caution - mainly over the sugar tax - just premature?

A value play with 23% upside

A point I made a year ago was Britvic already responding to public demand for low/no sugar drinks, e.g. revamping Robinsons fruit squashes, this happening amid a three-year £240 million investment programme towards a minimum 15% improvement in operating profit.

After the May interims I updated in June to suggest "strong hold" with a 775p target, which the stock has soared through, but has now dropped back in light of Q1.

A proven winner with more to give

Thus, latest action again contrasts, this time with a net positive brokers' consensus suggesting fair value targets up to 870p (UBS) and 950p (Deutsche Bank), Shore Capital alone advising "sell".

Net debt is also a potential issue

Last June, I noted Britvic's rise in net debt exposed it to rising UK interest rates, especially if coinciding with a softer consumer economy. Might supermarkets also widen their offerings of own-brand, low/no sugar drinks?

At the time, Britvic's investment programme looked to justify its extra debt; but currently I would mind how an interest rate rise is now being mooted as early as May, followed by one already expected later this year.

Such issues have complicated the buy/hold case for Britvic, its Q1 update reinforcing a sense to lock in gains after last year's 40% run. Yet, barely two months ago, the stock continued to rise (if volatile) after prelims showed pre-tax profit 2.5% easier due to £24.7 million investment costs, albeit free cash flow up four-fold to £54.5 million, on like-for-like revenue up 2.5% or 7.7% including acquisitions.

Acquisitions were said to exceed planned synergies. The outlook statement was coloured by the impending sugar tax creating uncertainty "but we believe we are well placed to navigate it."

Material sugar tax from 6 April

The liabilities are: 8p per litre for sugar content of 5g or higher per 100ml, and 24p for sugar at 8g or more, quarterly returns to be made to HMRC. This applies both to ready-drinks and concentrates unless milk substitutes, infant or alcohol replacement drinks.

Frankly, it's a guess how this will pan out versus soft drinks groups adjusting towards low/no sugar marketing. The chief risk is whether Britvic ends up formally warning, in a situation where profit expectations for the 2018 year re-rated last year (see table), although on 20 times earnings and a circa 2% yield, Barr similarly has no room to disappoint.

Holding either stock, therefore, significantly depends on your risk appetite. With fresh money Britvic currently looks more an "avoid" than does Barr; yet both can prosper longer-term with low/no sugar offerings.

Britvic is potentially more exposed to warn than Barr, though both trade in fair value ranges if they can avoid warning, which offers comfort to holders. An overall stance is, therefore, buy on weakness, with interest warranted from fresh money if warnings do arise.

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Disclosure

We use a combination of fundamental and technical analysis in forming our view as to the valuation and prospects of an investment. Where relevant we have set out those particular matters we think are important in the above article, but further detail can be found here.

Please note that our article on this investment should not be considered to be a regular publication.

Details of all recommendations issued by ii during the previous 12-month period can be found here.

ii adheres to a strict code of conduct.  Contributors may hold shares or have other interests in companies included in these portfolios, which could create a conflict of interests. Contributors intending to write about any financial instruments in which they have an interest are required to disclose such interest to ii and in the article itself. ii will at all times consider whether such interest impairs the objectivity of the recommendation.

In addition, individuals involved in the production of investment articles are subject to a personal account dealing restriction, which prevents them from placing a transaction in the specified instrument(s) for a period before and for five working days after such publication. This is to avoid personal interests conflicting with the interests of the recipients of those investment articles.

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