Should You Sell Diageo plc And J D Wetherspoon plc And Top Up With Fevertree Drinks PLC?

Roland Head takes a look at the outlook for Diageo plc (LON:DGE), J D Wetherspoon plc (LON:JDW) and Fevertree Drinks PLC (LON:FEVR).

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Pub chain J D Wetherspoon (LSE: JDW) warned today that the impact of the national living wage will put pressure on profit margins this year.

The group said that pre-tax profits fell by 4% during the first half of the year, despite a 6% rise in total sales and a 2.9% increase in like-for-like sales. Wetherspoon’s operating margin for the first half of the year was 6.2%. That’s consistent with last year, but below the firm’s five-year average of 7.6%.

Wetherspoon shares currently trade on a forecast P/E of 15, falling to 14 in 2016/17. This doesn’t look unreasonable, but it’s worth noting that the firm’s earnings per share are expected to fall for a third consecutive year in 2016.

I’m also concerned about Wetherspoon’s borrowings, which have risen by 32% to £626m since July 2013. Interest costs are now £31m per year and the group’s debts are more than 10 times its annual profits. That’s a little too much for me.

Wetherspoon shares have risen by 70% over the last four years. However, I suspect that slower earnings growth and debt pressures could continue to push the shares lower over the next few years.

Diageo

As a Diageo (LSE: DGE) shareholder, I’m faced with a dilemma. I’d like to own more shares in this excellent business, but I don’t want to pay 20 times earnings for a company whose profits are expected to be lower this year than in 2013.

Of course, Diageo does have some extra qualities that make it worthy of a premium valuation. The firm’s portfolio of major spirits brands and its sin stock status mean that sales are unlikely to collapse, whatever happens to the market.

A five-year average operating margin of 28% and strong free cash flow are also major attractions, and provide good backing for the 3.2% dividend yield.

However, Diageo’s share price has been trending lower ever since it peaked at 2,113p in 2013. I suspect that if you’re willing to wait another year or two, as I am, Diageo shares may get even cheaper.

Fevertree Drinks

Upmarket mixer firm Fevertree Drinks (LSE: FEVR) has taken the market by storm. The stock has risen by 237% since the firm’s flotation in November 2014.

Sales are expected to have risen by 71% to £59.2m in 2015, while post-tax profit is expected to have increased from £1.3m in 2014 to £14m in 2015.

However, I think there’s a risk that the good news is already in the price. Here’s why.

Fevertree’s earnings per share are only expected to rise by 19% in 2016. This is a comparatively modest increase for a stock that trades on a 2016 forecast P/E of 37.

A second concern is that Fevertree’s price-to-earnings growth (PEG) ratio is very high, at 2.3. Growth stocks are generally said to be cheap when they have a PEG ratio of less than 1.0.

Finally, Fevertree already has a market cap of £638.4m. That represents a price/sales ratio of 11, based on the company’s forecast for 2015 sales. Such a high price/sales ratio is a classic warning sign of an overheated growth stock.

I suspect now could be a good time to take profits. But we’ll know more about the outlook for 2016 when Fevertree publishes its 2015 results on 14 March.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Roland Head owns shares of Diageo. The Motley Fool UK has recommended Diageo. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

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