Rémy Cointreau: 26% Down Since Start of 2022 on U.S. Cyclical Fears

Company Update (RCO FP) (Buy)

Highlights

• RCO’s premium+ portfolio has strong structural growth

• Organic sales growth was 43.6% in FY19-23, with 10.1% in FY23

• But U.S. demand is normalizing and expected to fall in FY24

• FY24 outlook implies a flat EPS and we believe P/E is ~30x

• We see a 10% IRR over time, driven by EPS growth. Buy

Introduction

We revisit Rémy Cointreau (RCO) after shares have fallen back 26% since the start of 2022, including a decline of 14% in the two days since it released its FY23 (ending March 31) sales update on April 28:

RCO Share Price (Last 5 Years)

Source: Google Finance (12-May-23).

Investors now fear a cyclical downturn in RCO’s business, particularly with demand in the U.S. normalizing downwards from pandemic highs. Sales grew organically by more than 10% in both Q4 and full-year FY23, but U.S. Cognac depletions fell by a “very strong double-digit” in value during Q4. FY24 guidance is for “stable organic sales” and a stable EBIT margin, but with a “strong sales decline” in H1 including “a very strong fall in the U.S.”. It is difficult to predict what a “normal” level of demand is; total sales have grown by 43.6% organically in 4 years during FY19-23. FY23 earnings will likely be more than 50% higher than in FY19, implying a P/E of around 30x. We believe RCO shares can generate a 10%+IRR if earnings do remain stable in FY24 as guidance implies. Buy.

FY23 results are scheduled to be released on June 1.

Rémy Cointreau Recap

Rémy Cointreau is a French Spirits company with a market capitalization of €8.0bn ($9.5bn).

RCO reports in two divisions, Cognac, which generates 90% of its divisional EBIT, and Liqueurs & Spirits, which includes a variety of alcoholic beverages such as brandy, gin, whisky, rum and champagne. Americas is its biggest region (contributing 52% of sales in FY22), followed by APAC (30%) and EMEA (18%):

RCO Sales by Division & Region (FY22)

NB. Partner Brands include sales from all 3 regions. Source: RCO annual report (FY22).

RCO brands primarily serve the high end of the market, including premium, ultra premium, luxury and upper luxury.

The company is controlled by the Heriard Dubreuil and Cointreau families, which together own 53% of the shares.

Since 2020, CEO Eric Vallat (who returned from Richemont in December 2019, having headed RCO’s Cognac division during 2014-18) has been implementing a new strategy, which includes increasing RCO’s value per case, optimising its portfolio, and improving both its Gross Margin and EBIT Margin materially over the following 10 years:

RCO Margins (FY20-22 vs. FY30 Targets)

Source: RCO results presentation (FY22).

The targets imply raising RCO’s Current EBIT margin by more half, from 21% to 33%. The continuing Current EBIT margin expansion alone implies an EBIT growth of about 3% annually in FY22-30. RCO’s organic sales growth averaged about 6% during FY12-23. These imply an EBIT CAGR of nearly 10% over time.

Spirits companies have an earnings algorithm of small volume growth, above-GDP price/mix growth and EBIT margin expansion (from operational leverage). Diageo and Pernod Ricard target high-single-digit EBIT CAGR over time, and we believe RCO’s more premium portfolio should be capable of delivering a long-term EPS CAGR of 10%+ once we include the benefits of financial leverage and periodic buybacks.

Our Rating History

We have followed the Spirits sector for more than 5 years. We first published our research on Rémy Cointreau with a Buy rating in December 2019 and reiterated it in June 2020 in the early months of the COVID-19 pandemic.

RCO shares have returned 41.1% (including dividends) since our initiation. However, we have largely let our coverage lapsed after 2020, instead focusing on Diageo and Pernod Ricard. This was a mistake. While we have made good profits on the latter two, they have returned only 12% and 17% respectively (in local currencies) since our initiations.

Cyclicality in the Spirits Industry

The Spirits industry is cyclical, as consumer demand can fluctuate significantly between different macro environments.

During FY12-23, organic sales growth in RCO’s group brands has bounced between +27.7% in FY22 (rebounding from COVID lockdowns) and -14.8% (inventory cuts in China after weak consumption, following an anti-corruption campaign):

RCO Group Brands Organic Sales Growth (FY12-23)

NB. FY ends 31-Mar. Source: RCO company filings.

The effect of COVID-19 on RCO was effectively spread across two years: group sales fell organically by 11.3% in Q3 and by 25.4% in Q4 of FY20, then by 18.1% in H1 of FY21, before rebounding by 27.0% in H2 of FY21.

RCO’s EBIT is correspondingly volatile, in part because management tends to maintain investments through downturns. EBIT fell by 39% year-on-year (in euros) in FY14 and by 19% in FY20, though rebounding eventually in both cases:

RCO Current EBIT (FY12-22)

NB. FY ends 31-Mar. Source: RCO company filings.

RCO has benefited from higher market demand in the later part of the pandemic, as many travel & entertainment options remained restricted and at-home consumption of alcohol increased significantly.

Investors now fear a cyclical downturn in RCO’s business, particularly with demand in the U.S. normalizing downwards.

U.S Deceleration in Q4 FY23

RCO sales grew organically by just over 10% year-on-year in both Q4 and full-year FY23; including currency, sales grew by 7.4% year-on-year in Q4 and 17.9% for the full year:

RCO Sales Growth by Division (Full-Year & Q4 FY23)

Source: RCO sales update release (Q4 FY22).

However, for the Cognac division, organic sales growth was just 2.9% in Q4, and U.S. depletions fell by a “very strong double-digit” in value and by more than 30% in volume:

RCO U.S. Cognac Volume Trends (Q4 FY23)

Source: RCO sales update presentation (FY23).

Measured in value, U.S. Cognac depletions in Q4 FY23 were still 10% higher than the pre-COVID Q4 FY19, thanks to the growth in price/mix over the past few years.

U.S. market demand appears to be normalizing materially downwards from pandemic highs. RCO stated that:

“(Cognac) activity was affected as the normalization of consumption gathered pace.”

A slowdown in the U.S. demand has also been observed by Pernod Ricard. In their Q3 FY23 (January-March) sales update, group sales fell 2.2% organically year-on-year; with sales in the U.S. going from +5% in H1 to -1% for Q1-3.

FY24 Outlook Implies Flat Sales

RCO’s FY24 guidance is for “stable organic sales” on a group level, but with “strong sales decline” in H1 followed by a V-shaped recovery, and with a decline in the U.S. offset by growth in other regions:

RCO FY24 Sales Outlook by Region

Source: RCO sales update presentation (Q4 FY23).

Management’s reasons to expect a “new normal” in U.S. sales higher than pre-COVID FY20 include improvements in its brands, investment capacity and organization, as well as a lasting shift in consumer habits. However, the prediction is necessarily speculative, and can be derailed by a U.S. economic downturn.

More positively, RCO’s FY23 outlook also implies a stable EBIT margin, based on a “resilient” Gross Margin, “stabilization” of Advertising & Promotion expense margin and “tight control” of overhead costs.

Permanent Sales Growth in FY19-23

It is difficult to predict what a “normal” level of demand will be for RCO.

RCO’s total sales have grown by 43.6% organically in 4 years during FY19-23, implying a 12.8% CAGR. Organic sales growth includes a 14.3% contribution from volume (4.6% CAGR) and a 29.3% contribution from price/mix (8.9% CAGR).

We expect RCO’s premium+ means that its sales will be more resilient than the overall market, and that a large part of the price/mix component of its growth since FY19 will prove permanent. Q4 FY23 U.S. Cognac depletion figures above imply a 20%+ price/mix growth from pre-COVID levels (the difference between volume at -12.2% and value at +10%).

Estimating FY23 Earnings

RCO’s FY23 earnings will likely be more than 20% higher than FY22 and more than 50% higher than in FY19.

FY22 Current EBIT was 27% higher than in FY19, and we know that for FY23:

• Organic sales growth was reported at 10.1%

• Current EBIT guidance for a “strong organic growth” and an “organic improvement” in margin was confirmed

• Currency was a benefit of “around €40m” for Current EBIT (implying an 11% benefit on FY22’s €334m)

Assuming a 50 bps improvement in Current EBIT margin (from 25.5% to 26.0%), these imply a FY23 Current EBIT of €415m, 24% higher year-on-year and 57% higher than in FY19 (€264.1m). This compares with H1 FY23 Current EBIT of €319m, which was 50.0% higher year-on-year and implied a 380 bps margin increase (33.0% to 36.8%).

Recurring tax rate was expected to be around 30% in FY23, similar to FY22’s 29.3%.

The share count was reduced by 1.93% in January following the cancellation of 1.0m shares after a buyback. The new share count was 50.8m, slightly higher than the FY22 average of 50.4m.

RCO Valuation: Likely ~30x P/E

With shares at €156.90, relative to FY22, RCO has a P/E of 37.5x and a Free Cash Flow (“FCF”) Yield of 1.1%.

RCO Earnings, Cashflows & Valuation (FY19-22)

NB. “WCR” = Working Capital Required; “EdV” = Eau de Vie. FY19 includes €46.3m move in trade payables, "mainly the result of a change in payment terms with eaux-de-vie suppliers". Source: RCO company filings.

The large gap between Net Income and FCF is largely due to working capital, as RCO continues to increase its inventory. Inventory rose from €1.49bn in FY21 to €1.62bn in FY22, the 86% of this being in “Ageing Wines and Eaux-de-Vie”. This enables sales in future years and is typical of Spirits companies.

Assuming RCO’s EPS also grows by around 20%, in line with its Current EBIT (as described above), RCO shares have a P/E of around 30x relative to FY23 earnings.

The Dividend Yield is 1.2%, based on RCO’s regular dividend of €1.85 in FY22; there was also a €1 special dividend. RCO has a history of increasing its dividends, though it was cut during the difficult years of FY14 and FY20:

RCO Dividend History (FY04-22)

Source: RCO results presentation (FY22).

RCO had €348m of Net Debt as of September 2022, or 0.9x its FY22 EBITDA. The debt included €72m of convertible bonds. A buyback program was executed from September 2022, with 1m shares acquired.

Conclusion: Likely 10%+ IRR

RCO shares are attractive if earnings do remain stable in FY24 as guidance implies.

We believe RCO’s can deliver a long-term EPS CAGR of 10%+, with its premium+ portfolio driving a small volume CAGR and a strong price/mix CAGR over time, EBIT margin expanding due to operational leverage, and EPS growing faster than EBIT thanks to financial leverage and periodic buybacks.

We believe RCO’s P/E is around 30x relative to FY23 earnings and that this is a reasonable multiple. It is still lower than, for example, the 37.6x for L’Oréal in the Beauty sector, while Estéé Lauder shares are on 27.5x FY22 EPS despite EPS having been guided to more than halve in FY23 (ending June 30, 2023). RCO’s Dividend Yield of 1.2% is roughly equal to the current U.S. 10-Year TIPS yield of 1.24%, and has far superior growth potential.

Shareholder returns will come from a combination of the dividend (worth 1.2% annually at present) and EPS growth (likely at around 10% over time, though much less in FY24). We do not expect any contribution (or detraction) from a change in the P/E multiple, though it had obviously been much higher in the recent past.

We believe RCO shares can generate a long-term annualized return of 10%+ and reiterate our Buy rating.

Ends

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

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.