Introduction

We review our investment case on Pernod Ricard (OTCPK:PDRDF) (referred here as “PR”) after the company’s sales update for Q3 2020 (PR’s Q1 FY21) was released on October 22.

Since our initial Buy rating in August 2019, shares first rose by approx. 8% to approx. €175 a month later, but fell significantly after the COVID-19 outbreak, and have now lost 7.3% overall (in euros, after dividends).

Buy Case Recap

Our original Buy case was centered around the global structural growth in premium spirits and operational improvements at PR:

  • PR benefits from the structural growth in the global spirits industry, including premiumization and rising Emerging Markets (“EM”) consumption.
  • Management targeted a 4-7% p.a. organic net sales growth and a 50-60 bps operating margin uplift in FY19-21, implying 5-9% p.a. in EPS growth.
  • To achieve this, in its four key markets, PR had ambition to grow at mid-single-digits in the U.S., at low-double-digits in China, at double-digits in India, and at a “good” rate in Travel Retail
  • The involvement of activist investor Elliott, with a €1bn stake since late 2018, would help facilitate improvement at a family-controlled company that we believed had historically been under-managed

With COVID-19, we reiterated our Buy rating in June and again in September, as we believe the outbreak’s effects on PR earnings are not permanent, and that growth will resume eventually. Specifically, in our September update, we expected PR’s Net Income to be 26.7% lower than in FY19 (which implied a further 15.8% decline from FY20), to remain 7.5% lower in FY22, but to recover to be 3.6% higher in FY23. This reflects our view that the COVID-19-related weakness may linger until the end of CY 2022, especially in EM.

Q1 FY21 results, for the months July to September of 2020, showed that the recovery may occur more quickly than we expected, as we will explain below.

Q1 FY21 Sales Update

PR’s sales stabilized significantly in Q1 FY21 (i.e. Q3 2020), with the year-on-year decline decelerating to 5.6%, from 36.2% the quarter before:

PR Organic Net Sales Growth Y/Y (Since FY19)

NB. FY ends 30 Jun. Source: PR company filings.

Every region improved in the quarter, though growth only turned positive in the Americas; APAC / Rest of World, which includes China as well as India and used to lead PR’s growth before COVID-19, again showed the largest decline:

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PR Organic Net Sales Growth Y/Y by Region (Since FY19)

NB. FY ends 30 Jun. Source: PR company filings.

Regional variations in sales trajectories reflect the different mixes of “on premise” and “off premise” trades before COVID-19, as well as different stages of the outbreak, with some markets fully or partially re-opening.

The “off” trade has been resilient in most markets, as people continue to consume beverages while staying at home. This helped the Americas particularly, as 80% of industry volumes in the U.S. were historically “off premise”; it also helped Europe, though the industry “off” mix there was historically lower at about 50%, and varied widely between countries. Sales growth in Q1 FY21 was as much as +22% in the U.K., with a strong “off” trade, but as low as -26% in Spain, which had more exposure to restaurants and bars.

Partial re-openings took place during Q1 FY21 in many states in the U.S. and helped sales. Re-openings also helped China and Korea, but India, Southeast Asia and South Africa remained significantly disrupted by COVID-19, which was the reason behind the large sales decline in APAC / Rest of World.

In its four key markets, PR had positive organic net sales growth in the U.S. and China, a decline of 13% in India and one of 64% in Travel Retail:

Travel Retail saw only “very limited sell-out trend improvement vs. Q4 FY20”, as international air travel remained very low. Travel Retail volumes were actually approx. 80% lower year-on-year, but sales were boosted by a positive mix shift, especially to the brands Martell (cognac) and Royal Salute (scotch). Martell sales were helped by shipments to Hainan, where the Chinese government has tripled duty free allowances to encourage domestic tourism.

FY21 Outlook

Management did not provide an explicit FY21 outlook but shared some comments. Q2 FY21 is “expected to still be strongly impacted by COVID-19, but Sales (is expected) to return to growth in H2”.

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Management was clear that investors “cannot assume” Q2 to show the same sequential improvement as Q1 for a number of reasons, including the return of COVID-19-related travel restrictions and continuing weakness in India. For FY21 as a whole, PR is expecting a number of headwinds, including “challenging economic conditions” and a “prolonged” travel retail downturn:

PR Management FY21 Comments

Source: PR results presentation (Q1 FY21)

It is also worth noting that “growth” in H2 FY21 may be less meaningful than it sounds, given the prior-year period (January to June 2020) suffered the blunt of the initial COVID-19 lockdowns, with PR sales declining 25.3% organically year-on-year.

Nonetheless, the Q1 FY21 organic sales decline of only 5.6% was encouraging. While we expect Q2 to be tougher due to the resurgence of COVID-19 in the winter, we now believe our previous assumption of a 15.8% decline in EBIT in FY21 from the already impacted FY20 to be too conservative.

Valuation

At €147.55, on pre-COVID-19 CY19 financials, PR shares are trading at a 23.4x P/E and a 3.8% Free Cash Flow (“FCF”) Yield; the valuation looks more expensive on impacted FY20 financials:

PR Earnings, Cash flows & Valuation (FY16-20)

Source: PR company filings.

At our initiation in August 2019, PR shares were trading at a 26.6x P/E and a 3.1% FCF Yield (on CY18 financials).

The Dividend Yield is 1.8%, based on the FY20 Dividend of €2.66, which was 15% lower year-on-year, having fallen with earnings in line with management’s target 50% payout ratio.

Buybacks are still suspended, with €0.5bn left in a €1bn program.

Net Debt / EBITDA was at 3.2x at FY20 year-end, is likely now higher, which is manageable but likely higher than what management prefers, so additional capital returns are not likely until EBITDA grows again to reduce the ratio.

Illustrative Return Forecasts

We revise our forecasts for PR upwards, now assuming a faster recovery but a similar endpoint at FY24 (with the new FY24 EPS 3.3% higher than before):

  • H1 FY21 Net income to be down 15 year on year (was 30%)
  • H2 FY21 Net Income to be 10% lower than H2 FY19 (was 12.5%)
  • FY22 Net Income to flat vs. FY19 (was 7.5% below)
  • Thereafter Net Income to grow at 7.0% each year, roughly the mid-point of the range implied by management targets before COVID-19
  • Share count to be flat in FY21, then falls by 2.0% each year.
  • Dividends to be based on the 50% payout ratio target
  • FY24 year-end P/E of 25.0x (unchanged), below the near-27x level last August, but higher than the 24x assume for Diageo.
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The exit P/E of 25.0x is appropriate for a “quality” stock like PR, and implies a Dividend Yield of 2.0%.

At €147.55, the exit price of €190.50 at FY24 year-end (June 2024) and dividends imply a total return of 38% (9.7% annualized) in just over 3 years:

Illustrative PR Return Forecasts

Source: Librarian Capital estimates.

Conclusion

PR’s sales stabilized significantly in Q3 2020, with year-on-year decline decelerating to 5.6%, from 36.2% the quarter before.

Sales growth in the Americas turned positive, helped by the high mix of resilient “off premise” trade and partial re-openings in the U.S. market.

China also showed positive sales growth, but sales were down double-digits year-on-year in India, and down 64% in Travel Retail.

We continue to believe earnings will recover fully after COVID-19, and now expect earning to return to pre-COVID-19 FY19 levels by FY22.

At €147.55, shares offer a total return of 38% (9.7% annualized, including an 1.8% Dividend Yield) in just over 3 years. Buy.

We reiterate our Buy rating on Pernod Ricard.

However, we prefer Diageo (DEO) for its higher exposure to the more resilient North America, its more diverse portfolio and its lower current valuation multiples. (Diageo shares are currently trading at a 19.6x P/E and a 4.1% FCF Yield with respect to pre-COVID-19 CY19 financials).

We also have a Buy rating on Rémy Cointreau (OTCPK:REMYF), though its share price has risen 30% since our last review in June.

Note: A track record of my past recommendations can be found here.

Disclosure: I am/we are long PDRDF, DEO. 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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