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One FTSE 250 stock I’d buy today, and one I’d sell

Image: AG Barr. Fair Use.

FTSE 250 soft drinks group A.G. Barr (LSE: BAG) is best known as the maker of Scottish favourite Irn Bru. Sales of the fizzy drink rose by 3.2% last year, helping to lift Barr’s pre-tax profit by 4.4% to £43.1m. Shareholders were rewarded with an 8% hike to the dividend, which rose to 14.4p per share.

Barr reported a strong performance across its portfolio of brands and said that 90% of its drinks will contain less than 5g of sugar per 100ml by this autumn. This should enable the firm to avoid the sugar tax on soft drinks that’s due to take effect from April 2018.

When the sugar tax was first announced, Barr’s share price fell. But the firm’s latest figures suggest to me that its profits probably won’t be affected by this new legislation.

Is Barr a buy?

Indeed, I believe this is a quality business that’s likely to be a profitable and low-risk investment.

Barr’s adjusted operating margin rose by 0.5% to 16.8% last year, highlighting the profitability of its portfolio of brands. The group generates consistently high returns — its return on capital employed has averaged 20% over the last five years, well above the market average.

Recent investment has left the company with modern production facilities with capacity to support future growth. Spending is carefully managed and costs fell by £3m last year. This helped Barr to clear its net debt of £11.7m and end the period with net cash of £9.7m.

Barr’s share price has edged higher following Tuesday’s results. The stock now trades on a P/E of 18 and offers a yield of 2.6%. This may not seem cheap, but I believe it’s worth paying up front for this company’s strong cash flow and stable long-term growth.

I’d ditch this stock

Barr’s popular brands and efficient manufacturing facilities enable the group to generate above-average profit margins. Neither of these advantages applies to online appliance retailer AO World (LSE: AO).

It has increased its sales by an average of 30% each year since 2011. That sounds impressive, but the group has reported a loss in most of these years and is expected to do so again this year.

The problem with this business is that AO’s products are totally commoditised. The same products are available elsewhere, with the same delivery times and warranties. There’s no reason to buy from AO unless it’s cheapest.

This may be good for customers, but it’s not good for shareholders. Broker forecasts suggest that AO will generate an after-tax profit of just £550,000 on revenue of £843m in 2017/18.

AO shares have already fallen by 23% this year, following the firm’s warning in January that it was “cautious about the final quarter [of the year]”. I believe investors need to question this stock’s valuation and ask whether the business can grow fast enough to reach a profitable scale.

AO’s annual sales are still less than 10% of those of its more profitable rival, Dixons Carphone. But Dixons’ market cap is 0.35 times its annual sales. For AO, that figure is 0.9.

AO’s current valuation makes no sense to me. I believe the shares are worth — at best — about a third of their current value.

Could this growth stock beat Barr?

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Roland Head has no position in any shares mentioned. The Motley Fool UK has recommended AG Barr. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.