You don’t have to spend much time in Africa to realize that Coke has the upper-hand in the continent’s cola war. The bright red signs with the cursive lettering seem to be everywhere.
7UP bottles PepsiCola, Mountain Dew, Mirinda, and AquaFina in addition to its namesake brand. It operates nine bottling facilities and some 200 distribution centers across the country.
Founded (and still controlled) by the Lebanese El-Khalil family in 1959, the company’s profits surged 125.3% during its 2014 fiscal year. Sales increased 21.5% thanks in part to an innovative marketing strategy that included a giveaway of one minute of mobile airtime on every bottle cap. Efficiency gains helped widen the operating margin from 8.6% to 11.7%.
This outstanding performance made investors very thirsty for 7UP shares. The company’s stock price has risen 107% so far this year.
So, is the valuation too frothy here? Or is it time to gulp down some shares?
Let’s take a quick look.
7UP Valuation: Refreshing or Sickly Sweet?
7UP currently trades at a price-to-earnings ratio of 13.3 and offers a 1.7% dividend yield.
Is that a fair price?
To get a sense of a stock’s potential and downside risk, I often look at how well the underlying company has grown its book value (or shareholders equity) over time.
Over the past two years, 7-Up Bottling Company grew its book value at an annual rate of 24.5%. That’s fantastic. It means the net asset value of the company increased by well over half in just 24 months. It’s no wonder investors took note!
As long-term investors, however, the question for us is what sort of growth rate we can expect from the company over the next five years. A 24.5% rate would be excellent, but such rapid growth is exceedingly difficult to sustain for very long.
So, let’s dig deeper into our financial statement archive and calculate how quickly 7UP’s book value grew since March 2004 — over ten years ago. When we do so, we find that shareholders equity grew at an annualized rate of 16.8% without any injections of new capital.
That sounds like a rate we can reasonably expect the company to match over the next five years.
If it should do so, 7UP’s present book value of N30.43 per share will grow to roughly N66.15 per share by October 2019.
N30.43 x (1 + 16.8%)^5 = N66.15
Many companies trade at a substantial premium to their book values in order to account for their growth potential.
As you can see, with a current share price of N147.73, 7UP is no exception. It’s price-to-book ratio is 4.85.
N147.73 / N30.43 = 4.85
But investors haven’t always been so optimistic about the stock’s prospects. In fact, just two years ago, 7UP’s price-to-book ratio was only 1.98.
A Pessimistic Scenario
So let’s put together a pessimistic set of assumptions.
What kind of return would we get five years from now if:
- 7UP’s growth slowed to 16.8%,
- management decided not to raise the dividend from its current N2.50 per share,
- and a market mood swing reduced the price-to-book ratio to 1.98?
To find out, we multiply our estimated future book value (N66.15) by 1.98, and add five years worth of dividends.
N66.15 x 1.98 + (N2.50 x 5) = N143.48
Now, compare this result to the current share price of N147.73.
Not much difference, is there? So, even if growth slows and the market falls out of love with the stock, we can be fairly confident that the stock will be at least as valuable five years from now as it is today. The biggest downside risk is missing out on a better opportunity. Not bad.
An Optimistic Scenario
And what if the market is more bullish five years hence?
Suppose 7UP’s price-to-book ratio is 6.0 – the same multiple currently sported by shares of PepsiCo (PEP) on the New York Stock Exchange. We end up with a total future value of N409.40
N66.15 x 6.0 + (N2.50 x 5) = N409.40
That’s an annualized return of 22.6%. Most investors would be delighted with a tall glass of that sort of performance.
So, in my view, based on the recent performance of the business, its growth prospects, and market valuation, 7UP Bottling Company offers significant upside potential with limited downside risk.
What Do You Think?
Where do you think shares of 7-Up Bottling Company will trade five years from now? Is the stock a bargain? Let’s hear your thoughts in the comments!