2023-04-26 08:03:12 ET
Summary
- You don't need to be overthinking the process of finding shelter during the upcoming recession.
- My screening process has led me to one of the highest quality consumer staple names that operates in a very attractive segment of the industry.
- The company is also fairly priced and offers a relatively safe dividend which would further soften any potential market downturn.
Based on the 10-year & 3-month treasury yield curve, the chances of a recession in the coming months are extremely high. The curve has not been so strongly inverted for more than 50 years which makes the pending economic slowdown one of the most-telegraphed ever.
As we see in the graph above, however, once the yield curve bottoms, it usually takes up to 12-months before the economy is officially in a recession. Although this time-period could vary, there's still time to find businesses that perform well relative to the market during such periods and at the same time hold great long-term potential.
Don't Overthink It
The last time we had a proper recession was in the 2008-09 period, when the yield curve bottomed at the end of 2006 and the start of 2007. From that time to the end of 2008, the yield curve has almost peaked and we were already halfway through the recession.
During this period, the best performing sectors were - consumer staples, energy, health care and utilities - as measured by the Consumer Staples Select Sector SPDR® Fund ETF ( XLP ), Energy Select Sector SPDR® Fund ETF ( XLE ), Health Care Select Sector SPDR® Fund ETF ( XLV ) and Utilities Select Sector SPDR® Fund ETF ( XLU ) respectively.
prepared by the author, using data from Seeking Alpha
Although consumer staples and utilities are the first sectors that come to mind during a recession, energy and health care are less popular choices that hold significant potential within the current environment.
The problem with utilities in the current macroeconomic environment is their higher sensitivity to changes in interest rates and more bond-like behaviour.
Therefore, for obvious reasons, we will have the best chances of succeeding at finding the best recession-proof stock by looking at consumer staples.
My Screening Process
Now that we have identified our sector, we need to proceed with the screening process.
Here Seeking Alpha's stock screener does an excellent job. We can do our screening process by an endless list of metrics and criteria. As a starting point, I would use all consumer staples out there and sort them by market cap.
Since we are looking for a company that would be best-prepared to cope with an economic slowdown and all the risks that come with it, I will be using two main metrics:
- Gross Margin - it is one of the most important profitability metrics due to its stability over time and it is also a very good proxy for the company's pricing power.
- Dividend Payout Ratio - having a relatively safe and attractive dividend would be of paramount importance to improve returns, if the market remains under pressure for a prolonged period of time.
Having said that, we don't want to pursue the highest yielding stocks just to be faced with the risk of a dividend cut in the midst of a recession.
Before we proceed, I should also mention that out of the Top 50 consumer staple businesses by market cap from our initial screener, only two companies do not pay any dividend - Dollar Tree, Inc. ( DLTR ) and Monster Beverage Corporation ( MNST ). Therefore, these two companies will be excluded from our sample.
Fomento Económico Mexicano, S.A.B. de C.V. ( FMX ) on the other hand has a very high payout ratio of roughly 250%, which is way too high when compared to all other companies and hence will be excluded.
Now that we have cleared all the details, on the graph below I have plotted all the companies from the initial screening by their gross margins on the x-axis and dividend payout ratios on the y-axis. We will isolate and mark in green only those companies that have both high gross profitability and low dividend payouts.
prepared by the author, using data from Seeking Alpha
In the table below, you could also see all the short-listed companies by their major product segment within consumer staples. This is where I would like to narrow down the list by focusing on the segments that in my view are the best-protected during a major economic slowdown - soft drinks, brewers and spirits.
Arguably, Tobacco is also a very attractive area that I could add, but given the recent trends within the segment to rely heavily on battery-powered electronic devices for their high margin sales I am not very comfortable holding a Tobacco company at this point in time.
Beauty and Cosmetics stocks on the other hand are more heavily exposed to changes in consumer discretionary spending, which will be at risk during a recession.
Lastly, the Personal & Home Care businesses are well-equipped to weather a recession, but in my view are more exposed to private labels and the risk of consumers trading down on price.
Now that we have our small group of companies within soft drinks, beer and spirits segments, I will use a matrix similar to the one above, but this time on the x-axis I will use operating margins and on the y-axis Price-to-Sales multiples.
The reason being that in addition to gross margins I am interested in companies that also have low share of fixed costs to revenues (i.e. high operating margins) and also trade at relatively low sales multiples when considering their current profitability (i.e. plotted below the trend line in the graph below). Thus I have narrowed down our sample size to only 3 companies - Diageo ( DEO ), Constellation Brands ( STZ ) and Pernod Ricard ( PRNDY ).
prepared by the author, using data from Seeking Alpha
Anheuser-Busch InBev SA/NV ( BUD ) could also be considered, however, given the company's recent problems with asset impairments, management changes, high debt levels and dividend cuts, the company appears far too riskier at this point in time even as it trades at relatively low levels.
Based on Seeking Alpha's Quant Factor Grades, Pernod Ricard ( PRNDY ) emerges as a clear winner from the three short-listed companies. It has very high grades on recent EPS revisions, momentum, profitability and growth. When it comes to valuation grades, each of the companies below deserve their premium valuation (low valuation score) due to their high quality business models, however, PRNDY scores slightly better than Constellation Brands ( STZ ) and at par with Diageo ( DEO ).
What Makes Pernod Ricard So Attractive
As one of the largest spirits company worldwide, Pernod Ricard has a major benefit of a global distribution network, diversification of sales by region and last but not least - a strong brand portfolio that is recognized across all continents.
Pernod Ricard Investor Presentation
Thus, sales growth has been exceptionally strong over the past year with Asia and Rest of the World region significantly outperforming more developed markets in Europe and Americas.
Pernod Ricard Investor Presentation
Although the competitive advantages of a worldwide exposure are undeniable, Pernod Ricard and other such businesses have been at a disadvantage to their more localized peers as of late. The reason being that the strong U.S. dollar (and the Euro in our case) have been a major headwind for sales growth and profitability in most Emerging Markets.
As the probability of a recession increases, however, the dollar is likely to go down just as it did during 2007-08 period and as it has been doing since October of last year when the yield curve became inverted - thus signalling an upcoming recession.
FRED
This tailwind is likely to come in effect just as PRNDY is experiencing an unprecedented demand for its products and is making a stronger push towards premium alcoholic drinks in new geographies.
Pernod Ricard Investor Presentation
Therefore, just as growth is getting downgraded across more cyclical segments, Pernod Ricard is now experiencing a high-growth phase.
Seeking Alpha
By having a wide-mix of strong global brands across different alcohol categories, PRNDY growth is also well-balanced and less likely to suffer as a result of idiosyncratic events in a given category or market.
Pernod Ricard Investor Presentation
As I already mentioned, PRNDY business is also characterized with very strong pricing power, which results in the company being one of the most profitable enterprises within the sector.
Seeking Alpha
This is also important due to the fact that during an economic slowdown, asset turnover usually decreases which leaves leverage and profitability as key drivers of the overall return on equity. Increasing leverage is far less popular with investors during such times as liquidity dries up. This leaves highly profitable businesses, such as PRNDY, in the best-position to weather a storm.
As a result of all that, Pernod Ricard is already enjoying a period of high topline growth and record-high profitability.
FY22 was a record year in many respects . Our sales broke the symbolic milestone of €10 billion with our fastest growth rate in over 30 years , delivering a record €3 billion profit from recurring operations at a record operating margin of 28.3% .
Source: Pernod Ricard Annual Report
High Quality Is Not Necessarily Expensive
As we saw in the graph above, PRNDY is trading at a slight discount to its peers when we consider its Price-to-Sales multiple relative to its operating margin.
The same holds true on a time-series basis with Pernod Ricard's EBIT margins being the major driver of the company's Price-to-Book ratio over the years.
prepared by the author, using data from Seeking Alpha
Once again, PRDNY does not appear to be either over or undervalued at the moment, given its current operating profitability.
On a free cash flow basis, the company appears very expensive with FCF Yield standing at one of its lowest levels historically.
prepared by the author, using data from Seeking Alpha
But a closer look shows that this is largely due to the larger working capital outflow during the past 6-month period which is associated with the post-pandemic recovery.
Pernod Ricard Earnings Release
The overall impact of changes in working capital and other operating assets stands at roughly EUR 900m over the past 12-month period. This is a significant number relative to PRDNY's annual free cash flow (see below) and although the headwind is unlikely to go away, it will normalize over the coming year.
prepared by the author, using data from Seeking Alpha
Last but not least, PRNDY's very low beta coefficient is yet another positive sign that the company would not influenced by a downward market movement to a degree that some of its other peers would.
Some Risks That You Should Keep In Mind
There are a number of risks associated with investing in Pernod Ricard and although the vast majority of them relate to macroeconomic, trade, regulatory and geopolitical events there are some more specific ones that investors should follow closely.
The impact of an economic slowdown on more premium brands is among the key risks for Pernod Ricard's share price and profitability. So far, change in price/mix have been more than enough to offset the rising costs of raw materials.
Pernod Ricard Investor Presentation
Most of the raw materials utilized by PRNDY have gone up significantly in price over the past year and the fact that gross margin has remained steady is encouraging.
Pernod Ricard Annual Report
However, a recession that is more severe than the one currently expected, could have a more permanent impact on the upward premiumization trend.
Pernod Ricard Investor Presentation
Trade tensions and regulatory changes in response to geopolitical events should not be ignored either. One of the very important markets for PRNDY is China, which so far performs well and does not raise any red flags.
We feel quite confident about the immediate future in China with the very welcomed lifting of COVID restrictions. Obviously, these coverage restrictions did impact us in our Q2 for China. (...)
We’ve driven some very strong pricing across the whole portfolio in China.
Source: Pernod Ricard Q2 2023 Earnings Transcript
Nevertheless, investors should be mindful of supply chain risks and the possibility of domestic policies aimed at prioritizing local brands.
Pernod Ricard Investor Presentation
Conclusion
As the recession looms on the horizon, high quality consumer staple companies are among my personal favorites to weather the upcoming storm. On top of that, some of these businesses that also possess strong competitive advantages are among the best long-term investments for investors who are also mindful of the risks that they are taking.
For a number of reasons, I believe that Pernod Ricard is among the best-in-class businesses that would offer significant downside protection during an economic slowdown. I have also covered a number of similar opportunities for my subscribers and followers on Seeking Alpha.
Editor's Note: This article was submitted as part of Seeking Alpha’s Best Investment Idea For A Potential Recession competition, which runs through April 28. This competition is open to all users and contributors; click here to find out more and submit your article today!
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Pernod Ricard: Pricing Power, Safety And Dividends Make It The Best Shelter During A Recession