HL SELECT GLOBAL GROWTH SHARES
New Holding - Pernod Ricard
Fund changes
HL SELECT GLOBAL GROWTH SHARES
Fund changes
Gareth Campbell - Fund Manager
25 February 2020
Pernod Ricard is the second largest spirits manufacturer in the world. Its top 10 products account for 70% of sales and include brands such as Martel, Absolut, Jameson and Chivas.
Just over 40% of sales are to Asia and emerging markets with the remainder split roughly equally between the US and Europe.
The business was built by the Ricard family through acquisitions of established brands, while organic sales growth is driven by a mix of premiumisation in developed economies and growing consumer spending in emerging markets.
Consumers in developed markets are drinking less but are spending more on what they drink, this is called premiumisation and has been supporting growth in the alcohol industry for the last decade.
Aged spirits such as Whisky or Cognac are natural beneficiaries of premiumisation as the same brand can have multiple different price points depending on rarity and age. This means that as consumer wealth increases they can easily trade-up to a higher priced product of a brand the consumer already knows and trusts.
Spirits have one of the highest gross margins of all consumer goods. High margins enable the business to invest in advertising and promotion to grow sales and increase their brand value.
Consumption of spirits in China and other emerging markets has been driven by rapid growth of the middle class, official statistics estimate there are 400 million middle class consumers in China.
Currently less than 4% of spirits consumed in China are international brands. Baijiu, a local grain based spirit, is the largest alcohol category in China. We believe the influence of western TV and film along with international travel will help international spirits increase their market share in China. This should help support above GDP growth for the foreseeable future.
Pernod Ricard’s key brands have on average existed for over 170 years, this gives the brand value and shows that they can grow across multiple generations.
Over 60% of spirits have restrictions on the origin of their ingredients, manufacturing or ageing. For example Tequila and Cognac must come from defined regions in Mexico and France respectively. This makes it a lot harder for local competitors to start their own brands as they need to have infrastructure in the country of origin.
Any spirit which is aged can take more than 20 years before they are sold, this investment in inventory increases the costs of starting a spirits business.
Alcoholic beverages have strict laws around marketing with limits on when an advert can be shown, its location and content. These laws have the unintended consequence of supporting established brands in the market as new brands can’t advertise their product easily, limiting new competition.
A share price can change every day, but the true underlying value of the business is a lot more stable. When analysing a business at HL Select we try to identify its intrinsic value and then buy it when the share price gives us an opportunity for good risk-adjusted returns.
The market has been concerned about the impact of the coronavirus since news broke about it at the beginning of the year. It is an awful disease and our sympathies are with anyone who has been impacted by it.
We think the effects will reverberate around the Chinese economy for months. With working days cut and a highly infectious disease prevalent it’s likely the number of social occasions and consumption of alcohol will fall, which will undoubtedly have an impact on Pernod Ricard.
However its impact on the next 20 years of Pernod Ricard’s free cash flow, the factor which actually drives the intrinsic value will be small and that is why despite the current uncertainty we think Pernod Ricard looks like an interesting investment opportunity today.
Although please remember past performance is not a guide to the future and all investments will rise and fall in value so you could get back less than you invest.
We believe that the global spirits industry is the most attractive area within consumer staples. It offers strong margins and cash flows, supported by high barriers to entry and is well placed to capture value from the rising affluence of consumers in Asia and beyond.
Diageo is the largest global spirits manufacturer and is another holding in the fund. It is a great business, with industry leading margins and excellent return on capital.
We believe adding Pernod Ricard over increasing our position in Diageo is the right decision because it has better growth opportunities in Asia, a higher percentage of sales from aged spirits and higher likelihood of margin expansion.
Pernod Ricard margins are below Diageo, this doesn’t make sense in some regions where both businesses have similar scale. Pernod Ricard are committed to closing this gap which should help them grow operating profit and free cash flow over the next few years.
Our 3% position in Pernod Ricard was funded by cash, raised by reducing the size of holdings likely to be impacted by a slowdown in Chinese sales or international travel – CAE, LVMH, Booking and Shiseido.
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