A Bartender's Thoughts on Fever Tree
A Bartender’s Thoughts on Fever Tree
As I’ve developed my investing style, Buffett’s ‘circle of competence’ concept has become increasingly important to me as a tool for limiting downside. Personally, my circle of competence is limited and my list of areas I can potentially get an edge over the market is even smaller. The only areas I possibly add a bit of extra insight are subjects like sports, physics, young person stuff, nerdy stuff and bartending/ hospitality and my backlog of writing reflects that with commentary on companies such as Snapchat and Hasbro. On bartending, I recently discovered that premium mixer company Fever Tree ($FEVR.L) is a publicly listed company, only 4 months after being introduced to them within a work setting. Following Peter Lynch’s “invest in what you know” strategy, I decided to look into it and what I found was a company with a niche market, compelling premise and solid tailwinds.
The Business
Fever Tree’s slogan is “If ¾ of your drink is the mixer, mix with the best”. This encapsulates their strategy as a premium alcoholic mixer brand. Unlike other prominent soda companies like Coke and Pepsi, Fever Tree doesn’t market themselves as a standalone product, instead specifically markets themselves for use with spirits. Fever Tree is based out of England and already dominates the market there with 45% share within the mixer market. The next is Schweppes with 31% (who don’t compete as a premium mixer) followed by Fentimens, the next largest premium brand with a measly 2% market share. They did this by combining creative marketing with smart partnerships with premium spirit brands such as Bombay Sapphire and Grey Goose, along with a distribution plan focused on bars and bartenders, which is how I stumbled upon them.
The Premise
While at first glance tying themselves so heavily to the spirits industry may seem restrictive, it’s a niche that gives them a significant pricing advantage. Their premise is simple: if you are already spending a large sum of money on alcohol, you may as well spend a little extra on a mixer that will add to the experience. At the core of this is their product. While taste is subjective, as a tonic water hater I was blown away by how good their premium tonic tastes. They seem to have a legitimate edge on quality compared to generic mixer brands, while they have a huge edge on brand compared to other premium mixers. This is essential, as within premium products brand is everything, and with brand comes pricing power.
Alcohol Trend Tailwinds
This premise is coupled with global shifts that are steadily increasing their TAM. First is a shift from beer and wine towards spirits. However, the biggest shift is within the spirit category as premium spirits are continuing to take market share globally. This is essential as the more expensive the spirits, the more appealing their premise and the less price sensitive the consumer is.
Marketing Strategy
Fever Tree perfected their marketing strategy in the UK, and are now looking to roll it out globally. There are a few elements to this strategy. The first is general advertising spreading their ¾ message. This is combined with advertising partnerships with other premium spirit brands that allow them to target their audience more specifically and strengthen their association with premium spirits. On top of this they continue to run other strategies to increase exposure such as pop up bars, trade events and co-promotions. However, the core of their strategy comes from on-trade distribution (within bars such as my own). As a premium mixer brand, they offer a win-win-win for bars. As a bartender, I get to offer people a more interesting and unique drinking experience by suggesting Fever Tree products. As a bar owner, I want to sell premium mixers because they are very high margin, and you can charge extra to the customers unlike your generic mixers. Naturally, Fever Tree is the most prominent brand for this and therefore makes the most sense to stock. This culminates in Fever Tree getting essentially free promotion if they are able to penetrate into bars. I know this works because I’ve seen it first hand, and it’s a strategy they’ve already rolled out across the UK.
Margins
While I have painted a pretty story so far, a look at the company's margins over the past 3 years looks grim. From 2019 to currently their gross margin has dropped from 50% to 37% and it’s expected to get worse for the end of FY22. Naturally this has resulted in net profit margins falling from 22% to 9% in that time. This fall is put down to a combination of logistics costs, input costs and glass costs (which is an input cost but has different dynamics to other inputs). While cost increases have somewhat been offset by price increases, they’ve been hesitant to raise prices too quickly especially in growth markets. Logistics costs are the simplest to look at, as they should continue to normalise over the next few years and provide a significant tailwind over that period. Costs related to inputs and ingredients are a bit more difficult to forecast. I suspect ingredient costs will begin to come down or at least stabilise over the next year, while glass costs are continuing to get worse. Overall, I believe that by 2024 margins will have somewhat recovered, providing a significant tailwind for what are currently depressed earnings.
Financials
The first thing that stands out is Fever Tree’s consistent revenue growth. After a few years of explosive growth, the last 5 years have seen a low double digits revenue CAGR. The bottom line looks significantly more choppy as margins have declined significantly over the same period. While I’ve addressed the COGS impact on margins, net income margin decline actually started in FY2019 as the company ramped up international expansion in the US. The economies of scale seen in the UK should provide another tailwind if the bull case plays out internationally and revenue scales faster than operating expenses. One aspect of the company that’s comforting is its financial risk. Fever Tree has been FCF positive every year since listing and has £100m on the balance sheet with no debt, and continues to pay out dividends to shareholders while expanding.
Valuation
While I love the story, and think their business model and competitive position is fantastic I am cautious around the valuation. A PE of 33 doesn’t accurately reflect the valuation due to their depressed margins. My estimate of more normalised earnings to be around £46m, which backing out cash gives us a PE of 25. In my DCF for the company I have significant growth in 2024 as margins revert back to the mean, followed by low double digits income growth out 15 years as the company steadily takes market share globally while their TAM expands slowly. With a 12% IRR and adding back the cash this gives me a valuation of £1.3B. This is where I stumble with this idea. My valuation already includes significant margin reversion, plus steady revenue growth over the next decade. In the bull case, the stock is very cheap here, but looking at my base case it’s certainly not a bargain. I think I’d be more interested if the stock either dropped 30% or I saw significant indications of margin normalisation.
Risks
The key risk is that other markets aren’t as interested in premium mixer products as the UK, as the current thesis revolves around international expansion. It should be noted here that Fever Tree essentially created its own category and demand in the UK and will be hopeful it can do the same internationally. Another key risk is around margins. While freight costs will ease, I don’t have a particularly strong opinion on what will happen to glass and ingredient costs over the near term and if these headwinds continue and margins don’t normalise the valuation looks hefty. The last key risk to note is competitive risk. To be honest I’m much less worried about this risk than the others. In crafting out its own niche, Fever Tree established itself as the name brand, in a premium space where brand name is everything. It would be very difficult for a new brand to break into the space and follow in their footsteps. While an incumbent like Schweppes could try, I suspect that they would be at a disadvantage due to their brand reputation and their lack of focus.
Takeover Potential
I’m not a huge fan of investing in companies with a takeover as the main thesis, but there is a compelling case to be made for Fever Tree. There would be significant synergies were Fever Tree to be added to a larger company’s distribution network both for increasing sales growth (through combined distribution packages) and cutting costs (through the economies of scale it currently lacks in international markets). There’s a reason why the beverage (especially alcohol) industry is so consolidated, because there are significant benefits of scale to the larger companies. Additionally, this reduces margin risks as it would likely put them in a stronger negotiating position with suppliers. Furthermore, being taken over would likely bring significant benefits to the parent company’s offerings, and provide marketing synergies we’ve already seen with their advertising partnerships. I believe Fever Tree is likely worth significantly more to a larger player, and it would shock me if the company were to get cheaper and not see any takeover interest. Another possibility would be a Monster-Coke-esque partnership that would still see all these benefits, but while keeping the company public.