2023-07-24 23:34:43 ET
Summary
- It's hard to fault Pernod's track record through the years.
- But the current operating backdrop is challenging.
- Having already swung to a relative valuation premium, the near-term setup for Pernod isn't as compelling.
Having (rightly) been bullish on wine & spirits company Pernod Ricard SA ( PRNDY ) last year, I think it's time to cash in the chips heading into next month's fiscal Q4 results. While revenue and EBIT YoY growth numbers will benefit from the China reopening, the 'premiumization' appeal in Europe and the US is likely on the wane as consumers adapt to heightened inflationary pressures post-COVID. Another swing factor for FQ4 will be FX headwinds from Europe and the UK – as Pernod is a mostly unhedged exporter, the stronger EUR in FQ4 could well reverse much of the H1 currency benefits.
Perhaps the biggest downside risk, though, is an expectations reset for the FY24 and post-FY24 guide. Note that despite the challenges in its key markets post-FQ3 report, management hasn't yet adjusted its mid-term guidance for +4-7% organic revenue growth and +50-60bps margin expansion. Hence, a slower-than-expected start to FY24 could trigger big downward revisions to the rather optimistic consensus estimates currently. To be clear, I still like Pernod's best-in-class brand portfolio and have no qualms about underwriting a steady earnings growth algorithm long-term. But this needs to be weighed against valuations that have re-rated in recent months, with Pernod stock now priced at a slight earnings premium to key peer Diageo (DEO).
Leaning Too Hard on Asian Growth as the US Deteriorates
Pernod has outperformed its spirits peers over the last decade, to a large extent, because it over-indexes to emerging Asian growth areas like China and India (note >40% of Pernod's sales come from Asia). While the stock initially bounced on reopening hopes in China last year, recent retail sales data indicate some China-driven disappointments could be on the horizon. To be clear, the company will most likely post strong YoY numbers, given it is lapping a COVID-impacted base this year. And there are certainly factors that could swing the near-term guide in the right direction, including the pace of restocking activity, as well as the post-reopening recovery in the higher-margin travel retail business (i.e., in-airport and in-airline sales). But having already priced in a fair bit of optimism into consensus estimates, the risk/reward is skewed in the wrong direction.
While Pernod is diversified, there isn't much buffer against China's weakness, given the prospect of further underperformance in the US, its other key market. Volume weakness in the region has been the result of price rises the group has taken to offset input cost pressures; as Pernod will have to lap a lot of these price rises in FY24 as well, the growth outlook appears challenged. Readthroughs from key peer Diageo's Scotch presentation last month haven't been positive either for the US – per Diageo management, shipments are running ahead of depletion (i.e., cases sold to retailers by a distributor) across the industry. One potentially positive swing factor for Pernod US is the pace of accretion from majority stake acquisitions like peanut butter-flavored whiskey brand Skrewball and ultra-premium brand Codigo Tequila ; better-than-expected performances by these brands pose upside risk to the US organic sales growth algorithm over the next year.
Full Russia Exit Weighs on the Mid-Term Guidance
Having initially decided to restart Russian sales during the April quarter, Pernod has subsequently reversed its stance and instead committed to exiting Russia entirely . While Pernod had already shifted to running down its inventory through last year and only went through with restocking in April this year, Russia's high-single-digits % European sales contribution (low-single-digits % overall) means any impact will be material. FY24 will bear the initial hit, though my concern is the achievability of management's mid-term +4-7% organic revenue growth guidance without Russia.
On the margin side, losing Russia will likely be a bigger hit – premium Pernod brands like Absolut Vodka and Chivas Regal have traditionally underpinned the Pernod franchise there, and thus, exiting Russia inevitably adds a big hurdle to the +50-60bps mid-term margin expansion target. With limited buffer against a more subdued performance in the rest of Europe amid ongoing inflationary pressures, the size of future ex-Russia downward revisions could surprise the market negatively.
Contending with Near-Term Margin Pressures
Below the line, Pernod will need to navigate some meaningful near-term headwinds. Some of these are transitory – for instance, unfavorable FX swings during the quarter from a stronger EUR reversing the ~EUR140m FX benefit in the first half of the fiscal year. Given Pernod doesn't hedge out the currency volatility, management could extrapolate these less favorable rates into FY24 as well, posing downside to the guide. Beyond the currency swings, higher net interest expenses will also be a factor, albeit a smaller one, given Pernod's long duration bond portfolio.
On the opex side, I don't expect too many new developments. The usual inflationary pressures should persist, though hedging taken in 2022 could temporarily swing the P&L in the meantime. Perhaps the biggest issue is the already high bar - relative to Pernod's FY23 guidance for ~10% organic EBIT growth (vs. ~8% in H1 2023), the company will need to deliver >20% H2 EBIT growth just to meet expectations. And relative to an elevated FY23 base, organic EBIT margin expansion in FY24 isn't a given, particularly with limited room to take more pricing, as evidenced by its US performance.
Still Quality but Now at a Higher Than Usual Price
There remains a compelling case for Pernod's compounding ability over the long term, supported by its quality brand portfolio and optionality on the digital side. In the near term, on the other hand, the upside case is tricky, particularly with the stock already trading above its closest comparable, Diageo (reversing the prior valuation discount). Fundamentally, Pernod's Asian business is the key growth driver, though with China's reopening sizzling out in recent months, the 4-7% mid-term organic revenue growth path is vulnerable to a reset. Challenges in the US, Pernod's other key market, are also worth keeping an eye on as demand elasticity kicks in following the latest round of price hikes. Alongside the export-driven FX headwinds from a EUR rebound in recent months (Pernod maintains limited hedging), I would be cautious about going long into next month's FQ4/FY23 report.
Finally, the completion of Pernod's EUR750m buyback removes a key technical tailwind over the last year; with the stock already at a premium and bumping up against its net leverage targets, an upsized program seems unlikely in FY24. In the meantime, Diageo's quarterly results (due early next month) will provide useful insight into how Pernod's FQ4 will ultimately shake out.
For further details see:
Pernod Ricard: Still Quality But Now At A Higher Price (Rating Downgrade)