2023-11-01 19:34:45 ET
Summary
- Spirits is an attractive industry offering MSD growth, a premiumization trend and limited competition.
- Pernod Ricard's operational underperformance is attributed to lower exposure to the US and tequila, and higher exposure to the travel retail distribution channel.
- We believe Pernod Ricard's growth profile is not impaired and is not materially different than peers.
- Current valuations offer no significant margin of safety.
Company overview
Pernod Ricard ( PRNDY ) is the second largest spirits company in the world (behind Diageo (DEO)). Founded in 1975, the company owns and markets a portfolio of 240 spirits and wine brands, including 17 of the top 100 spirits brands such as Absolut Vodka, Chivas Regal, Ricard, Ballantine’s, Jameson, and Havana Club. The company markets its products in more than 160 countries, of which 75 with its own sales force.
The Ricard family owns 14% of the company and slightly more than 20% of voting rights (due to the French regulation that gives double voting rights to shareholders who have held nominative shares for at least two years). Alexandre Ricard, grandson of the company founder, is at the helm of the company. Revenue is split as follows: 43% Asia & Rest of the world (India and China account each for slightly more than 10%), 29% Americas and 28% Europe. Mature and emerging markets account for 53% and 47% of sales, respectively.
An attractive industry
The global spirits industry has been growing mid-single digit (in value) over the last decade, outgrowing other alcohol categories such as beers and wines that were growing low-single digit.
Spirits consumption (meaning volume) has been stable/slightly declining over the last decade as alcohol consumption per person has been falling in most geographies (excluding the US market). Indeed, younger generations are more health-conscious and prefer quality over quantity. This trend has somehow been offset by an increasing number of people coming of age to consume spirits, a rising middle class in emerging markets and a change in consumer preference (in favor of spirits). Indeed, spirits gained market share over beers and wine as spirits manufacturers have been successful to surf on the cocktail waves and associate spirits with quality products in the mind of consumers.
However, lower consumption has been more than offset by the premiumization of the category. Within spirits, premiumization or trading up is a long-established trend supported by consumers’ decisions to drink less but better and the broad price ladder of the spirits offering. In that context, the premium spirits segments outgrew value and standard segments over the past decade. Even though the definition of premium spirits change between players and markets, Pernod Ricard considers that the premium category starts with a bottle price above $23 in the US.
In addition, pricing competition is limited given that private labels account for a very small percentage of total sales. From our understanding, brand equity plays an important role in consumption decisions, which limits the attractiveness of private labels. Besides, on-trade consumption (bars, restaurants…), which accounts for roughly one quarter of total spirits volume and roughly half of the market in value, relies heavily on the distribution network of spirits companies and end-customers are even more prone to pick branded spirits while having special occasions and spending time with friends and relatives.
Existing spirits manufacturers should be able to capitalize on the industry growth as they are protected by some barriers to entry. First, some alcohols require to be distilled in specific locations (a scotch whisky can only be produced in Scotland, while cognac and champagne can only be distilled in very specific regions in France…). Then, many alcohols must be aged (unlike Vodka and gin). Cognac must be aged by at least 2 years while Scotch and Irish whiskies need at least 3 years and can even be aged for a much longer period. This time lag force potential competitors to incur production and storage costs for many years while preventing them to generate revenue, making it difficult to raise capital and survive several years without revenue generation. Besides, it takes decades at best to build brands equity and distribution network. The ageing process is an important element in developing brand equity, which make building a brand even more difficult for newcomers (due to a lack of aged spirits in their inventory).
Why picking Pernod Ricard within the industry?
Pernod Ricard’s organic growth has lagged peers over the last few years. We believe that its lower exposure to the US and tequila and higher exposure to the travel retail distribution channel are the reasons behind its operational underperformance.
Indeed, the US market was more dynamic and resilient than other regions (see chart above). Tequila was one the fastest growing category over the last few years because of a supply-chain disruption. The demand for Tequila soared while the production of agave, a key input, was relatively stable. Agave needs around 8 years to grow before being harvested. As a result, tequila producers have allocated existing resources to the premium segment and pushed for higher prices. Finally, the retail travel business suffered the most during the pandemic and has not yet fully recovered as airport passenger numbers is at c. 90% of pre-Covid levels.
We believe that the structural growth profile of Pernod Ricard is not inferior to peers. The company targets 4%/7% organic revenue growth over the medium term, which is in line with Diageo's target of 5%/7%. In addition, the company guides for +50/+60 bps operating leverage (assuming revenue growth is within the 4%/7% range), suggesting that operating income can grow ~ 6%/9%. Then, Pernod Ricard has a highest exposure to EM than peers and a dominant position in China and India (each market account for slightly more than 10% of revenue), which provides huge growth opportunities given Western spirits are significantly underpenetrated in emerging markets ( more volume growth than other region ex-covid) . For instance, Baiju, a Chinese white spirit, accounts for 96% of all alcohol consumed in China. Its product portfolio is also well diversified, enabling to benefit of most short-term trends in alcohol consumption (even if sometimes it is under-indexed to some trendy categories such as Tequila nowadays).
In terms of profitability, Pernod Ricard is at least in-line with peers (gross and EBIT margin) or even superior (FCF margin). While its ROIC is below peers due to the goodwill related to previous acquisitions, its return on incremental capital (that is not impacted by past acquisitions) is much better than peers.
Finally, Pernod Ricard is trading with the lowest valuation multiples among spirits companies despite no material difference in the growth profile and a better return on incremental capital (the higher ROIC suggests the company needs to spend less money for growing at a similar rate than peers).
Even though brewers share many similar attributes to spirits companies, they are trading at cheaper valuations. However, in addition to face declining alcohol consumption, the category is losing market share, faces an increasing competition from local brewers and has a narrower price ladder (more difficult to benefit from the premiumization trend). Besides, the gross margin is lower than spirits, making it more difficult to pass cost inflation through customers. For all these reasons, we are not interested in brewers.
From a historical perspective, Pernod Ricard's P/E appears trading in line with its 17.5x historical average while the EV/EBITDA is 7% below its historical average and the FCF yield is 20% above its historical average. The stock is trading at a 50% premium to the EuroStoxx 600 while it used to trade at ~ 25% premium. As a result, we do not consider the current valuation as attractive enough to initiate a position and prefer to wait for an eventual better entry point.
For further details see:
Pernod Ricard: Have A Drink And Wait For A Better Entry Point