Updated: Jan 31
Welcome to The Quality Compound weekly round-up. In weekly round-ups, I provide commentary on the market from the past week, alongside digging into some of my favourite quality businesses and their trading updates or reports.
Today, I'll be looking at two high-quality beverage companies, Diageo and FeverTree, both of which updated last week. I will also provide a brief look at payments companies Mastercard, Visa and FICO.
The Continued Trend of Premiumisation, and The Tale of Tequila: Diageo
On 27 January 2022, Diageo released its interim results. Diageo delivered strong organic net sales growth across all regions, and in its off-trade channel (supermarkets, stores etc.), demand has remained resilient despite the re-opening of on-trade venues. Diageo’s performance was driven by the ongoing premiumisation trend, with consumers opting for higher quality brands.
As Diageo pushes forward, one key area to watch out for is the Group's ability to capture market share in the US tequila market. Tequila is now set to overtake American Whiskey as the second largest category in US spirits, according to research from Ash Park. Diageo has prioritised capital allocation to the Tequila category in recent years with the 2017 acquisition of Casamigos (c.$1 billion), Mezcal Union in 2021 and the reinvestment in Don Julio, Diageo’s largest Tequila brand. Explosive growth of the category suggests these investments are paying off.
Regional Performance and Inflation
In the interim report Diageo saw strong performance across both developed and emerging markets. North America grew 13%, driven by on-trade recovery, resilient consumer demand in off-trade and market share gains. Europe grew 27%, reflecting the recovery of on-trade, particularly in Great Britain, Southern Europe and Ireland. Latin America and Caribbean grew 45% with strong double-digit growth across all markets.
Performance Across Key Categories
Diageo saw significant growth across Tequila, which grew 56%, Scotch, which grew 27%, and its Beer business, which grew by 22%.
In the period, Tequila represented 9% of Diageo’s net sales. The 56% growth in the half reflects the strong performance of Casamigos and Don Julio in the US, where both brands gained significant share of the US spirits market and the tequila category.
Scotch drove around one-third of Diageo’s net sales growth, with a 3-year volume CAGR of 4% demonstrating the resilience of the category. Johnnie Walker grew 37%, supported by a strong performance by Johnnie Walker Black Label and fast growth in the more premium variants.
The Beer category, which includes Guinness and Hop House grew 22%. Guinness was up 27% due to strong growth in Ireland, Great Britain and Africa as on-trade continued to recover.
Strong performance in Gin (across both Gordon’s and Tanqueray) was driven by growth across Europe, Africa, and Latin America and Caribbean, with both brands growing double digits. Tanqueray benefited from increased marketing investment. In the first half, the Tanqueray brand grew by 28%, with Tanqueray No. TEN (a gin aimed to be used in cocktails rather than in a traditional gin and tonic) up 33% and growing category share across several key markets.
Chinese White Spirits (Baijiu) maintained its strong growth momentum, with sales up 26%, underpinned by up-weighted investment in this key strategic growth market.
As stated previously, Tequila represented 9% of Diageo’s net sales, with the 56% growth in the half reflecting the strong performance of Casamigos and Don Julio in the US, where both brands gained significant share of the US spirits market and the tequila category.
Diageo has worked hard to acquire brands in the Tequila category across the last few years. With the high profile acquisition of Casamigos, co-founded by George Clooney, for c.$1 billion.
At the time of the acquisition announcement, Diageo's shares fell 2% and analysts poured cold water on the deal. According to analysts at Credit Suisse and Citigroup, the price that Diageo had agreed to buy the tequila company for was approximately 10 to 20 times sales, versus an average purchase price in the category of only about four to six times sales.
Casamigos has been a stand out winner for Diageo. The brand sold 120,000 cases in 2016, and as of 2021, the brand had sold over a million cases.
The above chart shows just how great an acquisition Casamigos really was for Diageo in 2017. Compared to the other best-selling Tequila brands, Diageo’s Casamigos has been able to rapidly expand, trumping the growth rates of some of the best brands in the category such as Patron and Hornitos.
To me, this is evidence that Diageo is an astute capital allocator that is building its portfolio towards the biggest trends. Prior success in Vodka, with celebrity endorsements in brands such as Ciroc (by P.Diddy/Sean Combs) catapulted Diageo into the premium Vodka space, a manoeuvre Diageo has certainly replicated here in Tequila.
Tequila is set to overtake American Whiskey as the second largest category in US spirits, according to research from Ash Park. Tequila currently holds 14% market share, with American Whiskey at 15%. At its current rate of progress, it could become very close to the largest category Vodka in the next 10 years.
Diageo stated that its supply chain has proven to be a ‘competitive advantage’, allowing the Group to navigate the volatility in the current environment. The Group's scale has allowed it to mitigate the majority of its supply chain disruptions. It has also been able to navigate port congestion due to its relationships and agreements with global shipping lines, as well as having advantaged access to local ports. However, supply constraints did impact Diageo’s whiskey brands, particularly the growth of Crown Royal (Diageo’s blended Canadian whisky brand) and also leading to a decline in Bulleit bourbon whiskey sales in North America.
In response to increased inflation across Diageo’s supply chain, and supported by strong marketing investment, the Group increased prices through the half.
In the US, Diageo increased prices by an average of just over 4.5% across Casamigos and Don Julio. There was strong volume growth for both brands, despite supply constraints on certain aged variants, with both brands having continued to grow share.
Diageo also increased prices across emerging markets, including Nigeria and Turkey, where the Group is exposed to significant foreign exchange devaluation and high inflation. In Nigeria, Diageo delivered average price growth of 30% across all key categories. At the same time, it delivered 13% volume growth in the half and grew share.
Return of Capital Programme
Diageo is continuing to execute its Return of Capital programme through share buybacks and is accelerating the completion of its current programme, which it expects to complete during fiscal 23. By December 2021, Diageo had completed £1.9 billion of its programme of up to £4.5 billion.
This was an impressive report for Diageo, and a further sign that Diageo’s broad portfolio of premium spirits, marketing prowess and unrivalled distribution channels makes the investment case for Diageo compelling.
The ability to purchase a powerful brand such as Casamigos in 2017 and grow sales nearly ten times by leveraging Diageo’s distribution network is proof that Diageo can continue to execute buy-and-build acquisitions in future growth categories. There are early indications Diageo is looking to do this with its fairly new Chinese White Spirits category too.
Diageo trades on a forward P/E of 24x and a FCF Yield of 3.5%.
During the week, FeverTree released a trading update, which provided details on its full-year performance for fiscal 2021 ahead of its full year report in March. FeverTree, similarly to Diageo, is a business aiming to benefit from the premiumisation tailwind seen across the drinks category.
Focusing on revenue growth, FeverTree had an exceptional year in 2021 with revenue growth of 23%, as its key growth markets of the US and Europe continued to build momentum as the tonic maker established its presence overseas.
The UK, typically described as FeverTree’s mature market and a market that the business has ‘fully penetrated’, grew a very satisfactory 15%, which is much faster than most staples categories in mature markets. I personally believe this is evidence of FeverTree’s successful pivot from its tonic water brand to its premium mixer brands, with flavours such as Pink Soda, Lime Soda, Yuzu Soda and Cola allowing FeverTree to continue growing even in a well-established market.
FeverTree's US Story Remains Intact
During the year, FeverTree hit some key milestones in the US, which is the focus area for the investment case in coming years. Below are some highlights from its report on its US brand-building journey.
A highlight of the year, and a clear indication of the brand's continued international success, is that we became the number one Ginger Beer brand at retail in the US, as well as finishing the year as the number one Tonic brand at retail in the US, overtaking Schweppes for the first time in the four weeks to 1st January 2022.
Becoming the number one US brand in Tonic is no mean feat, but FeverTree’s journey in the US has a significant amount of white space to grow into. The best way to explain FeverTree’s US opportunity can be shown by the below charts taken from FeverTree’s 2021 investor presentation.
Here, you can see premiumisation trends and FeverTree’s impact on the UK market where the premium mixer’s share of overall mixers is 43%. Contrast this with the US in 2021, only 10% of mixers consumed were listed as premium.
This means that for a market such as the US, which is an inherently consumer focused market and the largest consumer of premium brands in all categories (clothing, accessories, automobiles, beverages), premium share of mixers is significantly under-penetrated. Furthermore, we only have to scroll back up to Diageo’s results to see that the growth within the spirits industry is coming from the premium tiered brands. In Diageo’s interim report, 70% of Diageo’s growth came from the premium segment.
Whilst FeverTree pioneered the premium mixer category with the saying ‘¾’s of the Gin and Tonic is mixer’, I actually like the story of how Jordan Silbert created Q Mixers, FeverTree’s biggest competitor in the US.
14 years ago, I was living in a beautiful ground floor apartment in Brooklyn and it was a gorgeous summer night. We had some friends over for drinks and started pouring gin and tonic after gin and tonic. And a couple of drinks in, I realized my teeth were a little sticky. I picked up the bottle of Schweppes and I looked at the ingredients. 25 grams of high fructose corn syrup, natural and artificial flavors, sodium benzoate.
The moon was shining down on the table. The light caught the gin, transforming it into a glowing orb of green goodness. Next to it, the plastic tonic water bottle with its label peeling off and its contents going flat looked particularly decrepit.
My guess is that many Americans are going to question the value of mixing premium Tanqueray, Ketel One or Patron with supermarket high fructose mixers. It is FeverTree’s role to introduce the US and other markets to a new premium category. I’d expect over time for the results to look similar to the market shares seen in the UK.
Short-Term Profit Outlook
In the short term, the market remains focused on FeverTree’s profitability through its margin profile, which has been squeezed in the last few trading years by rising logistics costs and higher costs of raw materials.
In the latest trading update the below statement caused some concern for investors:
However, it is now clear that cost headwinds in 2022 will be more significant than we anticipated, and whilst we are employing a range of mitigating actions, margins are expected to remain broadly flat in 2022, resulting in an EBITDA range of between £69 million and £72 million.
FeverTree has suffered a series of impacts to its gross margin since 2020 driven primarily by logistics pressures. However, in 2021 the company has made some efforts to mitigate this, as seen by the set up of a new bottling facility on the East Coast of the US.
East Coast bottling line; our second production site in the US. We will be gradually ramping up production during the first half of 2022, with local bottling in the US providing increasing mitigation against elevated logistics costs.
The Market's Reaction to the Results
Despite the good growth numbers, FeverTree's share price was down 8% on the day of reporting, as the market remains focused on near-term profitability. As a long term shareholder in the business and someone who believes the key to FeverTree unlocking shareholder value is through category expansion and brand building in the US, I am very happy with the latest result from the company, and I believe it is making further progress against its strategy.
This is exactly why we continue to encourage the company to keep pursuing its global potential, whilst some other investors seem to worry more about short term margin impacts from elevated freight costs or channel/country mix etc. This is a young, dynamic UK growth company, and we believe it is still very early in its innings. — Nick Train, 8th October 2021
As I have alluded to in the report, FeverTree’s update was very encouraging. The business now sits on a prospective forward P/E of 55, which may seem expensive — and I probably would want to wait for a slightly cheaper valuation before adding to my holding. However, I believe this business to have a significant long-term opportunity ahead of itself and a fairly high likelihood of being able to execute on its strategy (partnerships with premium brands and defence of its premium category showcase FeverTree’s resilience so far).
Other Market News This Week: Visa, FICO and PayPal
Elsewhere in markets this week, I was particularly drawn to the rebound in payments companies such as Visa, Mastercard and Fair Issac Corp (FICO). I have exposure to the sector through investments in Fiserv, MasterCard, PayPal and Experian, so this is a key area of interest for me for my portfolios.
Payment operators' stocks have been under pressure for many months for various reasons — such as regulatory risk (Visa), technological disruption (FICO) and declining spend growth due to supply chain challenges (PayPal). Regardless of the reason, the payments and credit reporting industry offers attractive prospects for investors, especially in an inflationary environment (GMV increases with inflation).
Interestingly, market sentiment during the week turned positive for the first time in a while on these operators, with Visa/MasterCard results sending the stocks up 10% and 9% respectively and good earnings from FICO sending the stock up 16%.
FICO — Eventually the Best Business Wins
Within this space I have been closely watching FICO, the monopolistic provider of credit reports to credit customers in the US. FICO is a quality business with strong relationships with its core customers and a vast amount of credit data on consumers allowing FICO to have a powerful position in its credit ratings market (through the FICO score).
In 2021, FICO started selling off, and was down 40% from all time highs as the technology bubble seen in US growth companies gave rise to the likes of Upstart. Upstart rose meteorically, as its AI solution was intended to strip away clients from FICO towards Upstart's new method of credit rating.
As you can see below, the FICO chart has almost reacted in an inverse relationship with Upstart, where investors have begun to realise that a quality business such as FICO can not only defend its position but generate real cash flows and profits.
Since the bubble popped at Upstart, investors have been flooding back to FICO, with the 16% stock price gain on Friday after its earnings report showcasing the fears of competitive intrusion from Upstart were overblown.
What Does This Mean?
To me this is more evidence that irrational markets often throw up opportunities in quality businesses that are likely more resilient than investors perceive at the time.
When Mark Menervini was touting Upstart on CNBC at all time highs (even though he didn’t know what the company did) and panic ensued with concern over its business, smart investors were buying FICO.
That’s all for now folks. Be sure to check out the website during the week for more articles and analysis.
Writer at The Quality Compound
At the time of writing, James owned shares in Diageo and FeverTree.
To see the first 20 portfolio holdings in both of James' portfolios, click here.
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