Stockwatch: A proven winner with more to give

Has the 2017 rebound in mid-cap soft-drinks stock Britvic reached fair value, or is there further upside? It is also a study in the extent to trust brokers' targets or take a contrarian view.

Last January, at 585p, I drew attention to brokers turning negative, ironically after Britvic published respectable results for its year to October 2016, with after-tax profit up 10.3% to £114.5 million.

Several analysts reduced their targets from about 600p to 550p. The context was a two-year chart downtrend from 775p to 525p and the story involving controversy over sugary drinks (Britvic sells various PepsiCo brands in Europe), where the company hit back against a sugar tax, although doing so served mainly to draw attention to sugar as a negative theme.

As I pointed out, however, Britvic was already responding well to consumer demand for low/no sugar drinks, re-creating brands such a J20 Spritz, 7UP and Tango.

Teetotalism is rising among young people, hence demand also for novel soft drinks. Britvic's "transformational investment programme", initiated last year, also aims to deliver a minimum 15% improvement in operating profit from better efficiency.

While brokers fretted how sterling's devaluation post the EU referendum would raise input costs, Britvic is also expanding abroad, hence I suggested it could become an exemplary "Brexit play" on exports' vigour. Yet Goldman Sachs had thrown in the towel on its 850p "conviction buy", downgrading to "neutral".

Bullish "reverse head & shoulders"

All this has proven a classic chart reversal, the stock rising consistently this year to 723p - currently 703p given some profit-taking after the 24 May interims. I'm not a drinks industry analyst beyond what I see on supermarket shelves and perceive by way of social trends, but the brokers' end-2016 caution showed most capitulating to a stock trend and fretting on narrow issues rather than judging the wider picture.

Britvic's income statement for the 28 weeks to 16 April does indeed show cost increases, e.g. cost of sales as a percentage of revenue up from 46% to 48%, although selling and distribution costs were flat at 29.3% and administrative expenses reduced from 14.8% to 13.6%.

Like-for-like comparisons in such 2016/2017 periods should be a good representation of the sterling effect and Britvic has coped.

Admittedly, a net exceptionals charge of £7.2 million (including an £11.2 million charge for cost-cutting) meant a 4.9% fall in statutory after-tax profit to £38.6 million, although the full-year should benefit from £5 million overhead savings and normalised interim earnings per share (EPS) rose 9.2% to 18.9p.

While organic revenue growth of 3.7% hardly excites, total interim revenue rose 11.5% to £756 million and Britvic is acquiring in dynamic markets such as Brazil.

When you also consider, the prospective yield 4.5% in January was twice covered by earnings, the stock has justifiably risen 20% to more appropriately rate a quality yield from this major soft drinks group: at 703p it is more like 3.75%. But is profit-taking over 700p equally rational?

Mid-way in a three-year, £240 million investment programme

The chief executive speaks of a step-change in the capability of production facilities, e.g. at Leeds, Rugby and London, representing "a fantastic platform to grow the business". That's encouraging for efficiency, although I would emphasise continuing to develop healthier soft-drink choices as the chief means to revenue growth.

"We have continued to focus our innovation on low and no-sugar products with the launch of Club Zero Rock Shandy in Ireland" and he hints at "strong marketing plans for the important summer period".

The dominant public medical message is on cutting sugar to reduce obesity hence major health dilemmas such as diabetes, although there an "alternative" story how artificial sweeteners dampen the mental response to sweetness, hence encourage eating high-calorie food; also that artificial sweeteners can raise the risk of liver and heart damage.

The soft drinks industry rejects this, saying that sweeteners are tested and approved by independent regulators worldwide; and, as yet, the criticism comes from the US "Center for Science in the Public Interest", while the US Food and Drug Administration has them on its "generally recognised as safe" list.

I make this point because if health scares were to erupt over artificial sweeteners then it could compromise Britvic's re-positioning, although this looks low-risk. Realistically, the consumer climate is turning anti-sugar, yet still demands alternatives to plain water or alcohol or expensive sports drinks, so there is plenty of scope for a major soft drinks group to innovate.

Despite a risk that supermarkets will counter with quality replicas, e.g. to fruit squashes, and a consumer slowdown will see less brand loyalty, Britvic's Robinsons has already responded with new pack formats to the benefit of 12% brand revenue this year.

UK remains vital yet Brazil offers a growth angle

The UK is currently said by Nielsen market research to "show value growth ahead of volume", while personally I think this still benefits from low interest rates and longevity of the upturn from 2009.

It remains to be seen if any slowdown in discretionary consumer spending (in response to inflation) affects soft drinks, or marketing initiatives and social trends overcome this risk.

It's important given the UK represented 72% of profit in Britvic's 2016 financial year. Otherwise, France (14% of profit) remains subdued, while Ireland (9% of profit) is doing well from water and squash as consumers prioritise health.

Further expansion in Brazil has likely helped the stock's 2017 rebound, with the £54.5 million equivalent acquisition of Bela Ischia, a juice and concentrates business, announced on 3 January and partly a reason for my drawing attention on 5 January.

The local market has been challenging due to Brazil's economic volatility, but the soft drinks market has absorbed price increases.

After two acquisitions the aim is to expand organically across Sao Paulo state and into Rio de Janeiro. "I am very confident that we have built a strong platform for future growth," the chief executive says, hence Brazilian profit should rise from just 3% of group total for 2016.

Target 775p as investment yields further progress

This blend of investment in marketing as the soft drinks market alters, plus efficiency in production and distribution, therefore bodes well. Meanwhile, the consensus earnings estimate for the 2017 year is flat, which appears to mean in context of the 9.2% interim advance.

A qualification, potentially able to check demand for the stock in a consumer slowdown, is a 25.7% rise in net debt to £690 million comparing April 2016 to 2017, with long-term debt up 34.2% to £611 million.

The interim net interest charge clipped 16.1% of operating profit before exceptionals. So, you wouldn't want to see interest rates rise unexpectedly, especially if combined with soggy consumer spend.

All considered, the investment programme looks worth this extra debt and capable of improving EPS to at least 55p.

Applying a multiple in the mid-teens implies a medium-term price target of about 775p, i.e. "strong hold" or "buy on summer market jitters".