Description

Sharp market downdrafts provide a chance to buy great companies at attractive prices.  This particularly makes sense for taxable investors who are interested in compounding machines as the foundation of their portfolios.  Though not super cheap, I think Pernod Ricard is an excellent current opportunity, trading at under 13X forward earnings and with a prospective free cash yield of almost 8%.I further believe that free cash should grow at high single digits for many years to come, which should yield a very attractive total return even absent rerating.

Company Background:

Pernod is the second largest spirits company in the world after Diageo.  Family controlled (the Ricard family has a 15% economic interest and a 20% voting interest). the company made three large acquisitions since 2000.  That year, Pernod teamed up with Diageo to buy Seagram Spirits and Wine.  For $3.15 billion, the key brands purchased included Chivas Regal, Royal Salute, Martell, Glenlivet and Royal Stag, which is the leading local whiskey in India (where high import duties make imported brands extremely expensive).  This was a home run deal:  Today Martell (cognac) alone might command a higher price.  

In 2005, Pernod bought Allied Domecq and then turned around to sell some of its brands to Fortune Brands and then Dunkin Donuts to a consortium of private equity firms.  Hence, for around $5 billion, it took control of Ballantine, Kahlua, Malibu, Beefeater, Mumm and Perrier-Jouet.  If not the tremendous coup of the Seagram deal, this too was a smart acquisition.  

In 2008, Pernod paid a very steep price (21X EBITDA) for Vin & Sprit, a company owned by the Swedish government.  Here the prime asset was Absolut, the fourth largest international spirit overall and leading premium vodka.  At the time of the purchase management committed to realize 150MM Euro in synergies and has confirmed that they have done so.  On that basis, the price was a somewhat more reasonable 14X EBITDA.  This year Absolut sales should approximate 11MM cases (40% in the US) and is the most important Pernod brand.  Worldwide volume growth is running in high single digits.  Management has raised the price aggressively (example: 50% in China) to establish it clearly as a premium brand, consistent with its US positioning and to create more resources for advertising and promotion (A&P).  Absolut’s gross margins top 75% and returns are very high as there are no aging requirements for vodka.

Premiumization:

Strong emerging market exposure (37% of sales) and a proven ability, both within those markets as well as developed markets, to grow higher-priced, higher-margin products faster than the corporate average, are the keys to the investment case for Pernod Ricard.   Management is keenly focused on the “Top 14” brands, which comprise around 60% of revenues. As a group, these brands consistently show superior growth to the corporate totals and, importantly, very positive price/mix trends on top of healthy unit growth.  For example, in the nine months through March, the Top 14 were up 7% in volume and 11% in value, versus 7% organic growth for Pernod Ricard as a whole.  The corporate A&P spend is 17-18% of sales, but approaches 25% for the Top 14--a key factor in perpetuating the strong growth of the key brands.  

Pernod is very well positioned in Asia, most notably China and India.  The Asia/ROW segment (80% of which is Asia) is now the largest geographic unit in the country:  This year (6/30) should wind up about 35% of sales and 38% of profits.  Profits have been growing in the high teens in recent years and even went up slightly in Fiscal 09.  In China alone, where Pernod has a 40% share of international drinks firms, sales have climbed 22%/year over the last 4 years while profits have compounded at 41%. The dominant products here are Martell, Chivas, and Ballantine’s.   Martell has a 40% share by volume in China--slightly smaller than Hennessy in units but higher in value given a rich sales mix skewed to the XO category ($150+).  Driven by Chivas Regal, the company’s market share in scotch in China, a market that has been growing in mid-high single digits, exceeds 50%.  Throughout Asia, management believes that Pernod enjoys a 55% share in the prestige ($84+) segment of the drinks market.  India is also important, though the mix of business is much more skewed to local whiskeys. 

Balance Sheet:

As noted above, Pernod significantly levered up to acquire Absolut.  A combination of modest divestitures (Wild Turkey and Tia Maria, for example), a convertible offering in early 2008, and strong free cash generation have reduced gearing to manageable levels.  Debt currently stands at 4.5X EBITDA and should decline to management’s target of 4X EBITDA by next June, which should qualify for an investment-grade rating. Management has consistently reiterated that they have no interest in acquisitions until that debt target is met, so I would be very surprised to see the company emerge as a buyer for the Fortune Brands business in the short term.  

Conclusion:

Distilled spirits are among the great franchise businesses.  Customers tend to be very loyal to brands and well-managed brands have enjoyed pricing power over the long term.  Unit growth has at least matched population growth in most mature economies and has been very rapid in most emerging markets.  Returns on tangible capital are very high.  While there is an important inventory investment in certain categories (notably scotch and cognac for Pernod Ricard), there is a demonstrable payoff in the price points for more mature products.  

The ultimate keys to success are the portfolio of brands themselves and effective brand management and market development.  Pernod has a highly attractive array of brands (a desire to publish quickly led me to omit the Jameson story, as just one example, but I am happy to go through it if anyone is interested) and demonstrable skill in marketing its wares.  

Finally, while Pernod is usually, and understandably, compared to Diageo and other drinks companies, I think there is also merit in looking at it next to LVMH.  Many of the attributes in the two businesses are similar; both benefit from iconic brands and growing affluence in emerging markets yet the valuation gap is very wide in favor of Pernod.  

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