Why National Beverage Might Not Be Dead In The (Sparkling) Water Yet

About: National Beverage Corp. (FIZZ)
by: Gavin Fourie

A recent lawsuit, amongst numerous other allegations, claims that National Beverage uses artificial ingredients in their drinks.

This has resulted in shares trading down over the past couple of weeks, despite the claims being proven false almost immediately. As of today, shares are down ~39% YTD.

The company's points of differentiation remain intact and they will remain a top 3 competitor. The market has pushed shares into oversold territory.

The artificial ingredients lawsuit and why it's not important

Sales of LaCroix have taken a knock recently. On October 1st 2018, the law firm of Beaumont Costales filed a class action lawsuit against National Beverage Corp (FIZZ). In this lawsuit, the firm claims that National Beverage "intentionally misled consumers" by using synthetic ingredients while claiming that their products contained only natural ingredients.

Among these ingredients was limonene, which can cause kidney toxicity and tumors. Another ingredient, linalool, is used in cockroach insecticide according to Beaumont Costales.

From the start, National Beverage Corp has denied the claims that any of their ingredients were synthetic. In an official statement, the company said:

All essences contained in LaCroix are certified by our suppliers to be 100% natural. The lawsuit provides no support for its false statements about LaCroix's ingredients

Lawsuit or not though, this isn't important. What's happening here is temporary setback. In the future we will see National Beverage return to modest levels of growth. We believe this because the US sparkling water market is on fire and, as of 2017, is the fastest growing segment in the bottled water category. The largest driver of this growth has been spillover demand from traditional CSD consumers looking for healthier alternatives.

Dismissing the claims of artificial ingredients

First of all, it's important to note that these claims have been proven to be baseless almost immediately and I do not believe that anything will come from the lawsuit. To prove this, we can go through the claims and debunk them one-by-one.

Let's start with limonene. A 2013 paper on limonene safety concluded that "notable toxic effects" have not been reported in humans, and that it appears to exert no serious risk.

Next up is linalool. While this is known for its use in insecticides, its not toxic to humans. It may, however, cause skin and eye irritation as well as allergic skin reactions.

Finally, the artificial ingredients claim. As early as October 18th, National Beverage released an official statement with evidence to the contrary. In this statement, the company cites the results of testing performed by a certified independent laboratory on vendor-supplied ingredients confirming that they were derived from natural sources and not artificially created in a lab.

The golden goose problem

While the artificial ingredients lawsuit in particular might not be much of a risk in my eyes, the company does have another, much more serious problem.

Aging populations and increasing healthcare costs have resulted in consumers becoming more health conscious. National Beverage is desperately trying to distance themselves from the fact that a large part of their revenues is still generated from their 'legacy' soda business. It remains an essential part of the business overall, though, even if the Power+ division offers higher margins. That's why management is continually trying to find ways of reducing their sugar and caloric contents without significantly altering the flavour profile of the respective drinks.

Therefore, it is evident that the company wants to distance themselves from any unhealthy image. This perception was strengthened even more with the most recent lawsuit that claims Nick Caporella, President of National Beverage Corp, planned to falsely state in April that LaCroix cans were free of BPA, months before the true production date.

LaCroix is, and always will be, the company's 'golden goose'. None of their other brands are as well-positioned in their respective markets. None of the other brands have such a significant first mover advantage. None of the other brands operate in segments with quite the same level of customer loyalty.

National Beverage have come to rely on LaCroix as their sole source of revenue growth. It's their only brand with a top 3 position in a growing segment. They don't even have to spend much pushing the product to the market, which is evident by their noticeably tiny advertising budget. Over the past 3 years, National Beverage' advertising spend averaged ~$44m or 5% of revenues. Monster Beverage (NASDAQ:MNST) averaged ~$316m in the same period or ~9% of revenues. While the average amongst the top 5 competitors was ~7% of revenues.

Based on all this, it's no surprise why management loves the brand so much. It's their literal golden goose. In business, unfortunately, this means that things either go exceptionally well or exceptionally bad for the company. Due to the lawsuits and National Beverage's large reliance on solely LaCroix, things are going exceptionally bad. This is a perfect example of why it is so dangerous to be over-invested in a single area.

Competitors are already taking advantage of this setback. Looking at PepsiCo (PEP) with their Bubly brand, which has already increased its market share over the past year at the expense of the top 3, apparent from the chart below. We don't believe that Bubly will secure a top 3 spot anytime soon, though, as this isn't PepsiCo's first crack at the sparkling water market. It goes to show how hard it is to go up against established brands such as LaCroix in the unique sparkling water market in the US. That being said, LaCroix is feeling the heat, Bubly's market share increased from 2.3% in 2018 to 6.5% in 2019. According to data from IRI and Bloomberg, LaCroix now stands at 15.1%, down from 18.4% one year ago.

13 weeks ended 4/18/18

market_share_2018 13 weeks ended 4/7/19

market_share_2019 Data from IRI, Bloomberg Intelligence. Charts by Author.

National Beverage is in a better position than the market thinks

Let's start by looking at the beverage market in general. Nielsen and Wells Fargo value the sparkling water market at $2.2B. Unit sales are up by 7.1% for the 52 weeks ending July 28, 2018. This growth isn't a recent phenomenon; across the past 4 years, sparkling water is up by 54%.

It's also not a slowing trend as data from as recent as March of this year state that sparkling water was up by as much as 11.4% in terms of volume over the four weeks ended. So, while CSDs might be in decline, sparkling water is showing strong growth. In fact, during 2018, non-sparkling water overtook CSDs in terms of per capita consumption in the US.

In addition, a recent poll by the IBWA showed that 94% of Americans believe that bottled water is a healthier option than soft drinks. This strengthens the case behind the argument that the growth in demand for water is driven by consumers leaving CSDs behind in search of healthier options. It's also great news for National beverage who are putting considerable amounts of effort into the pursuit of the healthy image. When talking about CSDs, the fact of the matter is that consumers will always associate them with sugar and, therefore, see them as unhealthy.

In Conclusion: Putting a realistic value on National Beverage Corp

It's true that the lawsuits and other allegations are putting a strain on revenues, but keep in mind that the sparkling water market is booming. I see the contraction in market share as a temporary headwind that will correct itself, but even so, we definitely won't see historical revenue growth rates returning any time soon. Instead, I believe that top line growth will continue at a more modest, and perhaps more sustainable, trajectory. The slowing growth is due to existing customers switching over to other brands due to the allegations, partially offset by the new crossover demand.

The attributes that contributed to the LaCroix brand's initial success remain largely intact. They are: Health, Flavour and Innovation. To new sparkling water consumers coming from the expansion in demand in the broader industry, these attributes are the only things they will base their choice of beverage on. This, combined with the fact that LaCroix is an established and well-positioned competitor in the market already gives them a significant advantage over newcomers like Bubly.

This leads us to the following: How much is FIZZ worth realistically?

Well, let's take a look. First we have to make a few assumptions, the first is concerning revenue. Since we aim to be as conservative as possible in our DCF model, we forecast revenue growth rates of ~5% for the next 5 years. This is way down from the historical rates in the high teens.

The second assumption is regarding the industry. As mentioned above, we see the beverage industry as a whole continuing its expansion, with sparkling water a key driver.

For our risk free rate we opted for the yield on the US10Y which was ~2.10% as of writing. For the market risk premium we used the implied equity risk premium calculated by Professor Damodaran for June of 2019, which was 5.38%. Finally we used the Reuters beta for FIZZ which was 0.57. All of these combined resulted in a cost of equity of 5.16%. Since the company has no outstanding debt, the cost of equity is also our WACC.

After modeling out the financials and plugging the above into our model, we got an estimated value per share for FIZZ of $53.38. That's ~10% upside for the shares from the current level of $48.45. It isn't much, but it will prove to new short sellers looking to make a quick profit that they're late to the party. National Beverage has been oversold and investors that like the fundamentals should start looking for an entry point around here.

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.