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

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.


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.

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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.