- We review recent datapoints on spirits companies, to assess the impact of COVID-19 so far, ahead of trading updates starting next week.
- Latest Pernod Ricard and Rémy Cointreau guidance imply declines of 50% or more in operating profits in CY20H1, and Diageo will likely be similar.
- Diageo and Pernod each has an approx. 2.5% Dividend Yield, but keeping this may depend on management attitude on leverage and investment.
- Relative to unimpacted CY19 financials, Diageo and Pernod are both on approx. 20x P/E and 4% Free Cash Flow Yield; Rémy is on 35x and 2%.
- We still believe in our long-term thesis on premiumisation and rising affluence driving spirits growth, but expect more near-term volatility.
- "Diageo: A Longer Historical Perspective"
- "Pernod Ricard: Long-Term Emerging Market Compounder"
- "Rémy Cointreau: Buy After 20% Correction In 3 Months"
While the three companies have distinct characteristics, their investment cases are based on the same common themes of premiumisation, rising affluence and strong incumbent advantages in the spirits sector.
Unfortunately, these stocks have done poorly so far. Since our initial Buy ratings, Diageo has lost 16.8%, Pernod Ricard (referred here as "PR") has lost 12.6% and Rémy Cointreau ("RCO") has lost 7.3% (inclusive of dividends and in local currencies), with the bulk of the losses appearing after COVID-19. By contrast, Brown-Forman (BF.B) investors ("BF") (no rating) have seen shares rise 29%:
Spirits Companies’ Share Prices (Last 12 Months)
NB. Share price performances in local currencies. Source: Yahoo Finance (29-May-20).
In this article we review the latest datapoints on each company, to assess the impact of COVID-19 so far, ahead of trading updates starting next week.
Overview: 90% of RCO's EBIT comes from its House of Rémy Martin cognac business. This has APAC as its most important region, with 44% of FY19 sales, followed by Americas (42%) and EMEA (14%). The smaller Liqueurs & Spirits business more is weighted towards EMEA but is still sizeable in Americas:
RCO Net Sales & EBIT Breakdown (FY19A)
NB. Figures are pre IFRS 16, 15 and 9. Source: RCO results presentation (FY19H2).
Within APAC, a significant portion of sales come from Hong Kong and Travel Retail there, so much so that disruption in Hong Kong during FY20H1 (April to September 2019) was enough to drag APAC growth down to 2.9%, from 29.0% the year before.
Pre-COVID Growth: RCO has no explicit growth rate targets, but management aims to take “exceptional” ($50+ per bottle) spirits to 60-65% of net sales in the medium term and to expand operating margins. Historically, RCO has achieved double-digit organic EBIT growth in most years, except FY14, which was hit by the anti-corruption drive in China, and FY16, which was affected by technical factors (including an U.S. contract exit):
RCO EBIT Growth by Component (FY12-20A)
NB. FY ends on 31 Mar; FY15 organic growth rates exclude loss of Edrington US distribution contract. Source: RCO company filings.
Latest Datapoint: RCO released its FY20 sales figures on 29 April, which showed Group Brands sales falling 22.3% organically year-on-year in FY20Q4 (January to March). Greater China sales was “down strong double digits” in Q4 due to COVID-19, with a small €5m impact from Chinese New Year timing. U.S. Group Brands sales was down 12.3% in Q4, from lower retailer inventories, the postponing of price hikes and lower orders. Note that RCO's U.S. cognac volume was much worse than the market, which was roughly flat:
U.S. Cognac/Brandy Volume Depletion Trends
Source: RCO results presentation (FY20Q4).
RCO's Travel Retail has showed “significant deterioration” since August, from “Hong Kong events, commercial disputes in the Americas & COVID-19”.
Latest Guidance: RCO's FY20 guidance is now for EBIT to fall 25% organically (20% reported), on Group Brands sales falling 6.3% and total sales falling 11.2%. With EBIT down 4.7% in H1, this implies FY20H2 (October to March) will see an organic EBIT decline of nearly 50%.
Management also expects FY21Q1 (April to June) to show a 50-55% organic sales decline, and only “anticipates a very gradual sales recovery in fiscal Q2”.
RCO FY20 full results are scheduled for 4 June.
Overview: APAC / Rest of World the most important region, with 46% of its EBIT, and China and India each contributing roughly a third of APAC. Group net sales is 25/75 split between “on” premise (restaurants, bars, etc.) and “off” premise; 60% is from Emerging Markets and 20% from North America:
PR EBIT by Region (FY19A)
Source: PR company filings.
Pre-COVID Growth: PR EBIT growth has re-accelerated to more than 5% after a weak FY14-17 (which was affected by weak Emerging Markets, especially in China and India, and the reversal of the U.S. vodka boom). Management had targets to grow net sales by 4-7% organically on average each year, including low-double-digits in India and high-single-digits to low-double-digits in China, and to expand EBIT margin 50-60 by bps in FY19-21:
PR EBIT Growth by Component (FY10-19A)
NB. FY ends 30 Jun. Source: PR company filings
Latest Datapoint: PR released its sales update for FY20Q3 (January to March) on 23 April, with the quarter's sales falling 14.5% year-on-year organically, including Travel Retail sales falling 38%. PR suspended its buybacks but would still pay its interim dividend (€1.18) in July.
Latest Guidance. PR now expects FY20 to see a 20% organic decline in EBIT, which after the 4.3% growth in H1 implies a decline of more than 60% in H2 (H2 was only a third of the full-year in FY19). The new guidance assumes no “on” sales and a 80% decline in Travel Retail until the end of Jun, but management did observe a "slow recovery" in China from April:
PR COVID-19 Assumptions (FY20)
Source: PR results presentation (FY20Q3).
PR FY20 results are scheduled for 2 September.
Overview: North America is Diageo's most important region, with 45.2% of EBIT, followed by Europe & Turkey and APAC. We estimate the "on" trade is roughly 30% of total Diageo sales, based on U.S. spirits sales being split 20/80 between “on” and “off” channels, while Europe net sales is split 50/50:
Diageo EBIT by Region (FY19A)
NB. "Europe & Turkey" is approx. 90% Europe. Source: Diageo results release (FY19).
Pre-COVID Growth: Diageo guidance was for a “consistent” organic growth of 4-6% in net sales and 5-7% in EBIT annually in FY20-22. Historically, organic EBIT growth has been more than 5% in most years, except in FY10 (the Great Financial Crisis) and in FY14-16 (due to China and other reasons as stated for PR above):
Diageo EBIT Growth by Component (FY09-19A)
NB. FY ends 30 Jun. Source: Diageo company filings.
Latest Datapoint: Diageo last updated investors on 9 April, when it withdrew its FY20 (ending June) guidance, stated that COVID-19 has started to significantly impact business in the U.S., Europe, India and Africa; on the positive side, it did see a “very slow return of on-trade” in China:
Diageo COVID-19 Comments by Region
Source: Diageo press release (Apr-20).
Diageo has stopped buybacks, but still paid its interim dividend (27.41p) in April. FY20 results are scheduled to be released on 30 July.
Overview: BF has the highest Developed Market focus among spirits companies, with 47% of its FY19 sales in the U.S. and another 28% in non-U.S. Developed Markets; Emerging Markets contributed only 18% (with Mexico at 5%; limited exposure to China or India) and Travel Retail only 4%:
BF Net Sales by Region (FY19A)
Source: BF 10-K filing (FY19).
Pre-COVID Growth: BF has historically had a mid-single-digits sales CAGR on an underlying basis, though EBIT growth has been slowing as margin uplift gets smaller. Net sales and EBIT each grew 5% in FY19 despite new tariffs in China, the E.U., etc., from mid-CY18 onwards; for FY20, management had expected sales growth of 5-7% and EBIT growth of 2-4%:
BF Underlying Sales & EBIT Growth (FY12-19A)
NB. FY ends 30 Apr. Source: BF company filings.
Latest Datapoint: BF released its FY20Q3 (up to January 2020) results on 4 March, before most of the U.S. and Europe had entered lockdown. It cut FY20 guidance to a low-single-digit sales growth and a “flat to modest decline” in EBIT on an underlying basis. This implies a flat to slightly down EBIT decline in its Q4 (February-to-April), given underlying EBIT was down 1% for Q1-3.
BF FY20 results are scheduled for 9 June.
Higher “Off” Trade & Online Not Enough
While consumers have been buying more spirits in “off” channels, these are not sufficient to offset the loss of (higher-margin) “on” sales (likely 30% of total sales). U.S. in-store sales have been up 15-20% year-on-year from late March (including up 54% in one week), and online sales were 4 times their prior-year level from early April - so the guidance figures described above were issued by management after they had already seen such growth:
U.S. Alcohol Weekly Sales Growth vs. Prior Year (Mar-Apr)
Source: Nielsen (07-May-20).
While most U.S. states (see below) and many European countries have announced plans to gradually ease their lockdowns, near-term spirits sales will remain weak as restaurants, bars, etc., face new "distancing" restrictions.
U.S. Re-Opening Status by State (as of 30-May)
Source: New York Times (30-May-20).
The P/E and Free Cash Flow ("FCF") Yields of the 4 spirits companies, relative to unimpacted 2019 financials, are below:
Spirits Companies’ P/E & FCF Yield (Last 12 Months)
NB. PR & Diageo last-12-months as of Dec-19, RCO as of Sep-19 and BF as of Jan-20.
Source: Company filings.
BF and RCO are on a clear premium to Diageo and PR. We believe all are likely to see significant profit declines in the short term. However, given their long-term growth potential, we believe the valuation multiples will either be stable or (for Diageo and PR) expand over time.
The Dividend Yields of the 4 companies are shown below, with all except BF offer one in the 2.0-2.5% range, though BF's 1.1% Dividend Yield is arguably the most secure. Diageo and PR each has relatively high Net Debt / EBITDA (2.8x and 2.7x respectively, as of FY20H1), so a substantial short-term EBITDA decline may push their ratios too high (Diageo has a target range of 2.5-3.0x); on the other hand, management may decide to disregard any increases as temporary, and PR has paid dividends at higher Net Debt / EBITDA in the past (3.7x at 2014). BF is at 1.7x while RCO's is at 1.4x.
Spirit Companies’ Dividend Yields (Latest)
NB. RCO dividend of €2.65 includes €1 special dividend. Source: Company filings.
Whether dividends will be cut also depends on management attitude on investments. Spirit companies' margins can be altered significantly in the short term, as Advertising & Promotion ("A&P") spending is up to a mid-teens percentage of sales and can be varied with limited near-term consequences:
Spirit Companies’ EBIT & Cost Profile (Last 12 Months)
NB. PR & Diageo last-12-months as of Dec-19, RCO as of Sep-19 and BF as of Jan-20.
Source: Company filings.
COVID-19 will have a major impact on all spirits companies, with PR and RCO guidance implying 50% or higher EBIT declines CY20H1 (BF's FY20 is less affected because it ended on 31 March). Diageo will likely be similar.
Relative to unimpacted CY19 financials, Diageo and PR are both trading at approx. 20x P/E with ~4% FCF Yields, while Rémy is at 35x and 2%. There is a risk of a dividend cut for Diageo and PR, but this will depend on management attitudes on leverage ratios and investment levels.
COVID-19 clearly an exceptional event and we continue to be believe in our investment thesis on the spirits sector. We believe the "on" trade will recover and, if not, sales can eventually move to "off" channels.
We continue to believe in high single-digit EPS growth for Diageo and PR, and low-teens EPS CAGR for RCO. We believe valuation multiples will either be stable or (for Diageo and PR) expand over time. Including dividends, this mean annualised returns of 10% or higher over time.
We expect some near-term volatility in share prices, especially with upcoming results potentially giving early datapoints on markets that have re-opened. As long-term investors, we maintain our Buy ratings on each of Diageo, PR and RCO, with a preference for Diageo for its more balanced profile.
Note: A track record of my past recommendations can be found here.
This article was written by
Analyst’s Disclosure: I am/we are long DEO, PDRDY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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