Fizzing Out: Slowing LaCroix Growth Demonstrates National Beverage's Story Has Changed

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About: National Beverage Corp. (FIZZ), Includes: KO
by: Detroit Bear
Summary

I am changing my view on LaCroix after the brand suffered a decline in Q3 case volume.

The competitive intensity of the sparkling water industry coupled with negative PR for LaCroix appears to have destroyed brand value.

Shares continue to look inexpensive, but the range of potential outcomes is greater, as is the chance that LaCroix's growth expectations must be reset.

I remain long, but I am significantly lowering my fair value.

Shares of National Beverage (FIZZ) continued their downward drift while garnering significant media attention as the company posted weak Q3 results. For the first time in many quarters, volume growth in National Beverage’s most important product, LaCroix, likely turned negative, ending the company’s strong run of revenue and earnings growth. Although the media will focus on CEO Nick Caporella’s strange press release, long-time FIZZ followers know that Caporella’s bizarre press releases and behavior is a known-risk. He has written many outlandish press releases over the years, but they are not a concern, in my view. The issue is whether LaCroix is broken from negative media perception or if the competitive intensity of the industry is simply greater than I previously estimated. I believe it is a combination of both; therefore, I am significantly lowering my fair value of FIZZ to $70-100 based on much lower revenue growth expectations and a relatively wide range of outcomes. Let’s take a look at Q3 results, LaCroix, and recent capital allocation decisions.

Q3 – Slumping LaCroix Growth Disappoints

Revenue growth for Q3 was highly disappointing, with sales dropping 2.9% y/y to $220.8 million. We had seen evidence that LaCroix was slowing earlier in the year, so I certainly did not have high expectations for the quarter. However, I thought low single digits might be achievable based on distribution growth, but I was clearly wrong. More concerning, volume of the Power+ Brands, which is mostly LaCroix, declined 5.8% y/y.

With volume down, gross margin declined 360 basis points y/y to 36.5% of sales. A few factors also contributed here, including FIZZ’s recent capex spending increases leading to higher depreciation charges, lower manufacturing utilization, and higher aluminum costs driven by tariffs on imported aluminum from China. This is a troubling sign, and I am not optimistic about margin improvement until volume inflects.

Additionally, SG&A spending grew about 9% y/y to $49.5 million, equal to about 22.4% of sales, an increase of 240 basis points y/y. A great aspect of the FIZZ story has been margin expansion and the ability for FIZZ to grow sales while minimizing advertising spending increases. FIZZ reversed course on this philosophy a bit in Q3, likely trying to increase spending to drive sales conversion when LaCroix growth stalled.

Overall, operating income declined 32% y/y to $31 million, with operating margin declining 600 basis points y/y to 14% of sales. Without question, this result was incredibly disappointing, and there is not a lot of reason to hope that margins improve as long as sales growth stalls.

LaCroix – The Growth Story Might be Broken

For the last few quarters, I admittedly was not particularly troubled by LaCroix’s slowing growth because the growth rate remained solidly in the double digits. Competitive entrants made headlines, but the evidence supported that LaCroix could clearly maintain growth even as the space became more crowded. However, when an attack on the company made headlines and the “all natural” nature of LaCroix was challenged, I think consumers started taking competitive options more seriously.

Peer Nielsen, flavored sparkling water growth has remained robust. The category was up 17.4% y/y in January, with several competitors like Coke (KO), Nestle (OTCPK:NSRGY), and Talking Rain up solidly in the double digits. Private label sales grew 11.2% y/y , and only LaCroix showed a decline, down 1.4% y/y.

The category remains on-fire, and I think it continues to hold fantastic long-term growth prospects. However, the LaCroix brand appears to be less valuable than I assumed, and the growth of competing products from companies with huge distribution like Coke and Pepsi (PEP) is impossible to ignore.

Overall, I think the LaCroix growth story has been reset. I am not entirely sure what it will take to return the brand to growth, but it could mean partnering with a large strategic with a portfolio gap like Keurig Dr. Pepper (KDP) to drive channel distribution in a more cost-efficient and larger scale. Or, it could mean selling the company outright. This is an area where I do not believe Caporella necessarily cares about maximizing shareholder value, so I do not have tremendous confidence that he would sacrifice control of his company in order to do what’s best for minority shareholders.

Capital Allocation – Dividend Not an Issue

FIZZ’s decision to issue large special dividends always undergoes undue scrutiny as a means of Caporella “enriching himself.” Obviously, he controls around 75% of the company, so any capital allocation decision he makes will enrich him. Based on results over the past few years, there is little evidence that FIZZ underspent on capex. Buybacks would have been impossible to execute with such a small float available. Dividends were the logical mechanism of returning cash to shareholders.

One can argue that the irregularity of the dividend adds uncertainty, but I have personally thought that the US view on dividend policy is highly inflexible and can lead to poor management decisions. While some cash cows can afford to pay a predictable quarterly dividend, I think it would be better handled like buybacks at most companies. Irregularity would not be an issue. In fact, since I purchased National Beverage in 2016, 9% of my return can be attributed to special dividends while 20% of the return is market appreciation. In short, the special dividend policy drove 1/3 of my overall return. I am fine with this capital allocation decision.

A reset is needed

With irregular/non-existent coverage and likely little engagement from management, I am not interested or drawn to sell-side expectations for FIZZ. However, I think investors should reset their expectations – I certainly have.

LaCroix should no longer be viewed as a double-digit growth driver, though it may return to that status eventually. Monster (MNST) over the years has suffered some periods of contraction or slowing growth, followed by solid long-term performance. FIZZ’s management team lacks the same track record, but I believe there is a solid chance that the company can recover its growth status.

Nevertheless, the competitive intensity of the flavored sparkling beverage space is undeniable, and the competitors that FIZZ encounters have room to cut price and leverage their existing relationships with distribution partners to achieve superior shelf placement and economics.

As a result, I am lowering my fair value range to $70-100, reflecting a wide range of possible outcomes, including low single digit growth from LaCroix as well as a potential buyout from a larger rival. I do not have confidence in Caporella to exhaust all avenues for shareholder value, but operationally, LaCroix has done fantastic job of growing volume over the past four years, and I see a scenario where this is a short-term headwind in a long-term growth story.

Disclosure: I am/we are long FIZZ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.