Pernod Ricard: Near 52-Week Low After FY23 Results

Company Update (RI FP) (Buy)

Highlights

• FY23 organic growth was 10% in sales in 11% in EBIT

• Quarterly growth rates are volatile due to prior-year events

• U.S. and China to see declines in Q1 but growth in FY24

• Shares have a 20x P/E and a 2.6% Dividend Yield

• At €181.65, we see a 63% total return (19.3% p.a.). Buy

Introduction

Pernod Ricard ("PR") reported FY23 results on Thursday (August 31). PR shares finished the day down 6.4%, and those of peers Diageo and Rémy Cointreau also fell (by 2.6% and 3.9% respectively). After recovering 0.3% on Friday, PR shares are now down around 2% for the past year and only 6% above their 52-week low:

PR Share Price (Last 1 Year)

Source: Google Finance (01-Sep-23).

We have been following PR and other Spirits stocks for the past few years, and first published our research on PR online in August 2019. Our current Buy rating dated back to an upgrade in March 2022, and at present PR shares are roughly flat since then (after dividends).

Pernod Ricard shares are at 20x FY23 earnings. Headline results were strong, with organic growth of 10.0% in Net Sales and 11.0% in Profit from Recurring Operations (“PRO”, equivalent to EBIT). As with other Spirits stocks, we believe the current weakness in PR shares is due to investor fears of a deceleration in sector growth, made worse by volatile quarterly growth rates that followed unusual inventory moves last year. In PR’s case, management is expecting sales to decline in both the U.S. and China in Q1 FY24, but to show positive growth for the full year.

We believe the sector’s structural growth drivers remain powerful and PR was not materially over-earning in FY23. Medium-term guidance specifying a 4-7% Net Sales growth and implying a 6-9% PRO growth was reiterated. The dividend was raised 14% (to give a 2.6% yield) and a new €0.5-0.8bn buyback program was announced. Less positively, FY24 will see headwinds from higher CapEx and other investments, higher debt costs and currency. With shares at €181.75, our updated forecasts show a total return of 63% (19.3% annualized) by June 2026. Buy.

Compared to Diageo, PR has less exposure to the U.S. market, but higher exposure to China and Emerging Markets. Diageo remains our top pick in the sector.

Pernod Ricard Buy Case Recap

Pernod Ricard is a global Spirits company with headquarters in France but sales and profits from all world regions:

PR Net Sales & Profit by Region (FY23)

NB. "Europe" excludes Turkey, which is in "APAC / Rest of World". Source: PR results release (FY23).

PR's most important markets are the U.S. (18% of FY19 sales), China (10%), India (12%) and Travel Retail (7%). Updated figures have not been released but, as of H1 FY22, China was described as a larger part of PR than India.

PR is also diversified in terms of brands and categories, with Scotch being the largest (22% of FY23 sales), followed by Cognac & Brandies (16%), Irish Whiskey (12%), Indian Whiskies (9%), Vodka (8%) and Gin (5%).

The investment case for PR is similar to that for Diageo (outlined in our first Substack article on Diageo in July), being based on a number of structural drivers including demand growth, premiumization, pricing power, the ability of large players like PR and Diageo to gain market share, as well as natural operational leverage and margin expansion.

PR’s FY23-25 targets, announced at its investor day in June 2022, include:

• Average annual Net Sales growth of 4-7%, “aiming for the upper end of the range”

• Average annual operating margin expansion of 50-60 bps

With a PRO margin of 28.3% in FY22, these imply a FY23-25 PRO CAGR of 6-9% approximately, which is also what Diageo targets for its organic EBIT growth in the medium term.

PR’s organic growth was similar to its current targets in FY18-19, and exceeded them significantly in FY21-23 (partly rebounding from a COVID-hit FY20), but was less consistent before FY18. Part of the poor performance in FY13-17 was due to exogeneous events in China and India, as well as a correction in the U.S. vodka market:

PR Organic Net Sales & PRO Growth (FY10-23)

Source: PR company filings.

PR was also under-managed in the past, attracting the involvement of activist investor Elliott Management in 2018, after which management launched the “Transform & Accelerate” program to improve performance.

FY23 results released on Thursday showed that PR has exceeded its medium-term targets for another year.

Pernod Ricard FY23 Results Headlines

PR’s FY23 headline results were strong, with organic growth of 10.0% in Net Sales and 11.0% in PRO:

PR Group P&L (FY23 vs. Prior Year)

Source: PR results release (H1 FY23).

Including currency, Net Sales grew 13.4% while PRO grew 10.7%, with PRO Margin contracting 67 bps. This was entirely due to a currency headwind (worth 99 bps), with PRO Margin expanding 32 bps organically thanks largely to operational leverage on Structure Costs (which grew just 8% organically). Gross Margin improved slightly, while Advertising & Promotions (“A&P”) Margin was slightly worse but remained around the targeted 16%.

Net Finance Costs rose by 35.3%, after the average cost of debt rose from 2.3% in FY22 to 2.8% in FY23. This represented a 2.5% headwind to Net Profit growth, but was offset by tax and other items. The average cost of debt is expected to rise again in FY24 to 3.0-3.5%, which we estimate represents a headwind to Net Profit of up to 2%.

Recurring Group Share of Net Profit rose 10.2%, and Recurring EPS rose 11.4%, after the average share count fell by 1.1% following share buybacks.

Compared to pre-COVID FY19, PR’s Net Sales have grown by 32.2%, its PRO has grown by 29.7%, while its Recurring Group Share of Net Profit has grown by 41.5% and its Recurring EPS has grown by 46.2%. EPS growth has exceeded PRO growth largely due to Net Finance Costs have rising less than PRO, the result of low interest rates in recent years (the average cost of debt was 3.9% in FY19).

Quarterly Volatility Stroke Investor Fears

We believe the current weakness in PR shares is due to investor fears of a deceleration in sector growth. FY23 growth rates actually exceeded medium-term targets, so the focus appears to be on more recent data.

However, we believe quarterly year-on-year growth rates are simply not representative enough of long-term trends, and FY23 figures in particular have been distorted by unusual inventory moves last year, the result of supply chain shortages, post-COVID demand rebounds as well as distributor/retailer buying ahead of announced price increases.

For example, while PR’s H2 FY23 (January-June 2022) organic Net Sales growth was +8%, this in fact consisted of a -2.2% decline in January-March and an +18.9% growth in April-June:

PR Organic Net Sales Growth By Quarter (Since CY20)

Source: PR company filings.

The difference between the two quarters was due to different prior-year comparables: January-March had a prior-year quarter that was 21.8% higher than pre-COVID CY19, while April-June had one that was only 13.8% higher.

Similarly, Q1 FY24 is expected to be “soft” (with year-on-year declines in both the U.S. and China), but this should be seen in the context that its prior-year quarter (July-September 2022) had sales that were 26.1% higher than in pre-COVID CY19, more elevated than other quarters. Management has attributed this to distributors/retailers stocking up ahead of an October 1 price increase and the seasonally important October-December period, as well as supply chain shortages in January-June 2022 that pushed shipments into July-September.

U.S. and China to Show Q1 Declines

For the U.S. and China, PR is expecting sales to decline in Q1 FY24, but to show positive growth for the full year.

In the U.S, PR sees a decline in Q1 FY24 due to a tough prior-year comparable (as explained above). Management also believes U.S. growth is currently below long-term trend after a few years of strong growth, and can take up to 1.5 years to recover. As CEO Alexandre Ricard explained on the call:

“We are not at the 4% to 5% underlying growth, medium-term level, as we are normalizing. We believe right now the market, from a consumer demand standpoint, is probably anywhere between 1% and 2%. And then the rate at which and the timing to get to the 4% to 5% I would say your guess is as good as mine. But it's not going to happen in years from now on. It's a question of, is it 6 months, 12 months, or 18 months max?”

This is more pessimistic than comments by Diageo CEO Debra Crew on August 1, where she stated that they are “seeing it return to kind of mid-single digits”. This may again be due to volatility in year-on-year growth rates.

In China, Ricard has observed a significant slowdown in consumer demand due to macro conditions:

“We do expect a soft Q1 in China due to challenging macroeconomic conditions and also a high compare basis, which is clearly really expected to ease from Q2 … The channel which is probably suffering most related to the economic environment is the on-trade … Nightclubs are clearly suffering big time. The on-trade overall is, is being challenged due to the environment.”

In both the U.S. and China, PR expects to see growth improve after Q1 to produce a positive growth for FY24.

Long-Term View on Structural Growth

We believe the sector’s structural growth drivers remain powerful. We have reached this conclusion based on qualitative reasons and Spirits companies’ long-term track records. PR’s growth rates for any single year (let alone those for individual quarters) do not represent sufficient evidence to change our view.

We also believe PR was not materially over-earning in FY23, because its overall FY19-23 Net Sales CAGR was only 6%, well within its targeted 4-7% range and in line with its longer-term historical trend:

PR Organic Net Sales Evolution (FY14-23)

Source: PR results presentation (FY23).

As with Diageo, PR’s growth has been broad-based geographically, with overall FY19-23 organic Net Sales CAGR being in a narrow range of 5-7.5% across its three regions despite different annual trajectories, with Americas and APAC Rest of World rebounding before Europe:

PR Organic Net Sales Growth By Region & Market (FY20-23)

NB. U.S. CAGR based on disclosed 3-year CAGR of 8% as of FY22. Source: PR company filings.

A similar pattern can be seen in the U.S. China and India, with the three markets showing FY19-23 organic Net Sales CAGR of between 6% and 8%. Flat sales in the U.S. in FY23 followed a FY19-22 CAGR of around 8%.

With different macroeconomic conditions in these different regions and markets, we believe the broadly similar CAGRs show that PR’s growth has been propelled by global structural drivers (including both secular demand growth and premiumization) rather than temporary tailwinds in individual regions and markets.

FY24 and Medium-Term Outlook

PR has reiterated medium-term guidance specifying a 4-7% Net Sales growth and implying a 6-9% PRO growth.

For FY24, PR is expecting a “challenging environment” and only provided general comments, including:

• “Broad-based and diversified Net Sales growth for the full year, with soft start in Q1”

• A&P costs at around 16% of Net Sales

• Structure costs with “discipline investments”

• “Organic Operating Margin expansion”

• Negative currency impact

While sales growth in any individual year may be hard to predict, we believe much of A&P and some of Structure Costs are discretionary in nature, which means management should be able to meet cost and margin guidance even in the event of weak sales growth (provided any deceleration does not happen too quickly).

Pernod Ricard Valuation

With shares at €181.65, PR shares are at 19.9x FY23 earnings:

PR Earnings, Cashflows & Valuation (FY19-23)

Source: PR company filings.

Management’s Recurring Free Cash Flow “FCF” of €1.65bn implies a FCF Yield of 3.5%. The gap between this figure is our FCF figure is primarily €222m of non-recurring items attributed to “restructuring and M&A”. A large part of the restructuring costs is likely related to Project Tomorrow, an exercise in delayering the company and consolidating management entities, which PR stated will be completed by September.

PR expects to declare a dividend of €4.70 for FY23, 14% higher year-on-year and implying a 52% Payout Ratio (in line with the “around 50%” target). This represents a 2.6% Dividend Yield.

Share repurchases totalled €786m in FY23 (mostly a €750m buyback program), and PR has announced a new buyback program of €500-800m for FY24, equivalent to 1.1-1.7% of the current market capitalization.

Net Debt / EBITDA has risen from 2.4x to 2.7x during FY23, with Net Debt rising from €8.66bn to €10.27bn, with the  €1.08bn spend on acquisitions and most of the buybacks in effect funded by new debt. PR has no explicit Net Debt / EBITDA targets, but Diageo has one of 2.5-3.0x, against which PR’s current leverage is reasonable.

Short-Term Cashflow Headwinds

Higher CapEx and other investments were a headwind to PR cashflows in FY23, and will be again in FY24.

CapEx was €602m in FY23, 25% higher year-on-year, and guided to increase further to €0.8-1.0bn in FY24. CapEx is expected to be “elevated” for “the next two years” (FY24-25) as PR continues to invest in both production (including new distilleries in Scotland and Kentucky) and sustainability technologies (such as mechanical vapour compression).

Working capital was a cash outflow of €568m in FY23, worse than in prior years. Most (€508m) of this was due to investments in “strategic inventories”, as PR continues to build up aged stock for future years. FY24 is expected to see such investments at a level “similar to FY23”.

Illustrative Pernod Ricard Stock Forecasts

PR’s actual FY23 EPS was 8% higher than our most recent forecast in February (when we included the possibility of a U.S. recession in CY23). We update our forecasts to reflect this and factor in lower growth for FY24, but leave most of our other assumptions unchanged:

• FY24 Net Profit growth of 2% (was 7.5%)

• Net Profit to grow at 7.5% each year thereafter (unchanged)

• Share count to fall by 1.5% each year (unchanged)

• Dividends Payout Ratio of 50% (unchanged)

• FY26 year-end P/E of 25.0x (unchanged)

Our new FY26 EPS forecast is 2% higher than before (€11.01):

Illustrative PR Return Forecasts

Source: Librarian Capital estimates.

With shares at €181.65, we expect an exit price of €281 and a total return of 63% (19.3% annualized) by June 2026.

About half the forecasted return is attributable to the upward re-rating. If we amend our exit P/E to 20x, unchanged from the present, then our forecasted total return is 32% (10.6% annualized).

We reiterate our Buy rating on Pernod Ricard.

Ends

Stocks mentioned: RI FP, DEO 0.00%↑, RCO FP. We are long Diageo and RCO.

Disclaimer: This article consists of personal opinions, based on information believed to be correct at the time of writing, but not guaranteed. We undertake no responsibility in updating content in this article. Nothing published here should be taken as financial advice.