Pernod Ricard: Luxury Liquor - [Business Breakdowns, EP.141]

0:03This is Business Breakdowns. Business Breakdowns is a series of conversations with investors and operators diving deep into a single business. For each business, we explore its history, its business model, its competitive advantages, and what makes it tick. We believe every business has lessons and secrets that investors and operators can learn from. and we are here to bring them to you. To find more episodes of Breakdowns, check out joincolossus .com. All opinions expressed by hosts and podcast guests are solely their own opinions. Hosts, podcast guests, their employers or affiliates may maintain positions in the securities discussed in this podcast.

0:45This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. I am Zach Fuss, and today we are breaking down Pernod Ricard, a business whose history dates back to 1797. Today, the business is the second largest global producer of wine and spirits with a portfolio of 17 of the top 100 spirits brands, including Absolute Vodka, Beef Eater Gin, Jameson Irish Whiskey, and Malibu Rum. The portfolio produces north of 12 billion euro in sales and generates an impressive 60 % gross margin and high 20 % operating margin. To break down Pernod Ricard, I'm joined by Swetha Ramachandran, a fund manager at Artemis Investment Management.

1:31During this conversation, we explore the interplay between luxury goods and spirits, the post -COVID normalization and consumption trends, including the broader trajectory of the spirits industry, the importance of China and India to the future growth of the business, and the company's acquisition strategy. We hope you enjoy this breakdown of Pernod Ricard. So Suetha, thank you for joining us to break down Pernod, or as you aptly inform me, Pernod Ricard, a spirits business that interlops with a luxury brand, a CPG business. I think maybe just to set the table, let's talk broadly about the industry that they operate in and how you think about the business from that perspective.

2:11And then we'll go into the specifics of their business. Absolutely. And I think this is really interesting when you look at the spirits industry overall, all is that actually less than half of the global volume in spirits is made up of by what we know to be Western style spirits. About 75 % of it volume wise is made up of by local categories. And the biggest of these is a Baiju, which dominates the Chinese market. It's a fermented rice liquor, makes up 98 % of spirits consumption in China. And that on its own makes up about 31 % of global spirits volume. So when we're looking at Western style spirits, which is important because that is primarily the area that Pernod Ricard operates in.

2:49That market in terms of the contribution to the global industry is only 23 % volume wise, but much more significant value wise, nearly 40 % of total value, because it tends to be higher priced and more premium. And that's exactly the market Pernod Ricard is operating in. And then I think maybe it's just helpful to talk about the most relevant brands. People probably are familiar with the brands themselves, but not who owns them. What are the ones that you think are most relevant here? In terms of Pernod's brands, they own about 240 of them. But chief among them, I think if we step back a little bit, how they acquired them.

3:23This is a company that was really formed by the merger of Pernod and Ricard, both of which were Annecy -based Stisse or Liqueurs in France. One of them founded in 1805, which was Pernod. And then the young upstart Ricard brand, which launched in 1932. And the merger of these two rivals in 1975 is what has brought about this combination called Pernod Ricard, often shortened to Pernod, as you said, even though it's really the Ricard family that's been calling the shots ever since that merger. The founder, Paul Ricard, his son, Patrick, who ran the company from 1978 onwards, his mantra was very much, he had an ambition, which was conquer Europe and then the world.

4:01And we saw a hint of what this might mean for their future strategy when they first acquired Irish distillers in 1988, which actually gave it its very successful Jameson Irish whiskey brand. Today, Jameson really defines the category of Irish whiskey and has about a 67 % value share of that category worldwide. But the real game changer, I think, for the industry as well as Pernod was when the Seagram carve -up happened in the year 2000. This was a highly fought over set of assets, the Seagram beverage assets. So Brown, Foreman and Bacardi had a rival offer. Diageo and Pernod had one going. And it wasn't until the very last minute that Diageo and Pernod sealed the deal to acquire Seagram's beverage assets, which were then carved up between the two.

4:46And this was really quite transformational, not just for the spirits industry, but for Pernod specifically going forward, because it gave them what are some of its crown jewels today. It gave it Chivas Regal, Martel Cognac, the Glenlivet. All of that came by way of the acquisition of the Seagram assets, which was an $8 billion deal. So it was quite sizable at the time. And what it also gave the company were these amazing routes to market. So for example, in emerging markets prior to that, Pernod had very little presence there. And this deal really helped open them up into these markets, which are so critical to its current as well as future growth.

5:20That was the first of many deals. But after that, it followed up with a deal of Allied Domecq, a UK -based spirits manufacturer, which it had itself usurped Allied to be number two in the global spirits industry after the Seagram assets were acquired. And then it ended up swallowing Allied in whole together with Fortune Brands. That gave it brands such as Malibu, Rum, Beef Eater Gin, some of the champagne brands that we know at Pernod, such as Mum and Pervier Jouet. That came as a result of this acquisition as well. And then I think the final mega deal with this company was in 2008, where in somewhat crazy timing, when you think about it, just in June 2008, before it all kicked off, they completed the acquisition of Vinenskrit, the Swedish state -owned manufacturer of Absolute Vodka.

6:04So all of that has really put the company where it is today, which is as the number two global spirits player with leading category dominance in categories such as Irish whiskey. It's the global number two in Scotch. It is the tied number two in cognac. And these are very interesting categories because they're quite specifically constrained in terms of supply, as well as the ability to manufacture it, which creates quite high barriers to entry. That's really helpful background. I think the other question naturally then becomes, I have a general sense that the industry is somewhat consolidated given the presence of Pernod and Diageo.

6:39Where does Pernod sit in that global ranking and consolidation? And how do you think about just their footprint in these different categories and different countries and the scale and scope of the business? I think the hard yards in terms of consolidation for the industry are really past most of these companies. So Diageo has firmly entrenched its position as the global number one. Pernod is not far behind. It has about two thirds of the sales of Diageo, but just over half of its profit base. And the reason for that lies in a different market mix. So Diageo, very overweight, the highly profitable US spirits pool, Pernod, number two in that market and investing much more heavily behind emerging markets where it's an investment phase.

7:22And so the margins tend to be a little bit lagging in those markets where it's currently ramping up its presence. But overall, a very credible number two in the overall industry. It's interesting, though, that on the face of it, the spirits industry can seem more fragmented than the brewing industry, where, for example, the top five brewers have about two thirds of a share of the market, while the top five spirits companies only have about one third of the share of the market. And that's really because there are a lot of mom and pop independent spirits brands that still have not been consolidated.

7:52And many of these larger companies are trying to do that via bolt on deals. But when you've acquired the scale that Diageo or Perno have, you really need something meaningful in order to move the dial, which is why it remains a fragmented industry overall. But unlike beer, it also encompasses a lot of different subcategories. And I think that's where when you look under the hood, some of these subcategories can actually be quite concentrated, which is attractive because it's that level of concentration at the subcategory level, whether it's scotch or cognac or Irish whiskey, that actually gives those specific categories superior pricing power to those that aren't as concentrated.

8:28And then I think just to zoom out, what is it that makes spirits such a solid business? I look at the gross margins that these guys work with and their ability to sell at a premium seems quite defensible. If you look at the longevity of these brands, it's quite durable. What is it that makes that possible? Put it as a combination of staying power and pricing power. So staying power, because many of these brands have longevity, have provenance, have history, there is something that requires them, for example, to be produced in a particular area. You can't call cognac cognac unless the grapes that make up the cognac are acquired from a very specific part of Western France in Chahont.

9:07You can't by law call whiskey scotch unless it's been bottled and aged in oak casks in Scotland. So all of that creates these strong barriers to entry, which actually create quite a cachet around many of these brands, help them with pricing power over time. And then I think they also speak to a facet of consumer behavior that's evolving, which is this whole trend towards drinking less, but drinking better. So this premiumization, which we've seen in other aspects of life, has actually been very prominent in the spirits industry for the better part of two decades now. So even as volumes have actually been flat to slightly down globally for spirits, sales revenues have actually gone up because of a combination of pricing, as well as more importantly, mix, which is basically people drinking less, but trading up to more expensive variants, which again is quite positive for the margins of these companies.

9:59It's also a relatively staple category in the sense that it's not something where your level of discretionary income necessarily influences your level of consumption, although we are seeing that theory tested in the short term because of the supercharged demand that we saw during the COVID period. that's throwing up some dislocations at the moment. But taking a longer view of the spirits industry, it tends to be an industry that moves through quite long cycles, remains quite resilient. We saw that during the financial crisis, for example, where volumes didn't actually go down very much. What happened was a temporary pause to the trading up phenomenon, which then reasserted itself as the GFC wound down.

10:37So that's, I think, one of the reasons that the barriers to entry, the wide moats that some of these brands have, the benefit that scale offers some of the leading companies. So this is really an industry because it's largely fixed cost base, where scale has the benefit of being able to drive outsized margin expansion. So that is really, again, something that we see coming through. Capital intensity, while historically has been high, is much lower than for, say, the brewing industry because of the whole value over volume strategy that many of these companies deploy. So for a whole host of these reasons, and I didn't mention the most important, which is exposure to emerging market consumers who are themselves trading up and where the market remains severely underpenetrated.

11:19We briefly discussed China earlier, where 98 % of all spirits consumption is made up by non -Western style spirits. And international spirits are a mere 1 .6 % of that total market. So even though for Pernod, China is an important market driving about 15 % of sales, it barely registers on the scale of the total market, which gives us an idea of how much growth runway there is in that market as it continues to grow as young people discover Western style spirits. Similarly, in India, with a demographic dividend, 20 million people expected to be joining the legal drinking age population every year.

11:54That's, again, a sizable, addressable market that these brands have not yet met that offers opportunity in the long term. We haven't really discussed the basics of the business and spoke about how from a regulatory perspective, and perhaps that's the wrong word choice, you can only produce some of these spirits in certain regions and there are certain barriers to entry. What is the basic business model here? You produce a spirit, you slap a brand on it, you distribute it. It's not that easy. How do you think about it? So if we look at what Pernod actually does, how does this company make money?

12:24It essentially is a simple model on the face of it in that it manufactures spirits and wines, operates in more than 101 production facilities, distributes 240 brands across 160 different markets. And this is through a combination of organic growth as well as M &A, it's risen to become the second largest spirits player in the world. It has an approach that it calls grain to glass, which helps uniquely highlight its vertically integrated approach as a brand owner, as a manufacturer, as well as a distributor of its products. Except, of course, in certain markets like the US where they're prevented from distributing because of prohibition and the associated amendment to the constitution.

13:03But essentially, spirits manufacturing basically involves transforming agricultural raw materials, which are mainly grain -based into spirits using fermentation, distillation, as well as aging. And then I think the important part here is the marketing of that product is building up brand equity through advertising, marketing, as well as importantly through distribution. So here we have consumers who consume these products in the on -trade, which is the restaurant and bar channel, as well as the off -trade, which is at home. And that was clearly the aspect of consumption that really boomed during lockdown when we were all sitting at home having Zoom cocktails.

13:38Today, the off -trade actually drives most spirits consumption around the world. The on -trade has become a little bit smaller, but the on -trade is very important because that's where brands get built. So when you go to a bar and you ask for a Jameson on the rocks or a particular brand that you're into, that typically tends to happen in the on -trade to help entrench that image in your mind so that then when you're at a liquor store or at a supermarket, you know to look for that brand by name. So that's really the essence of how the company makes money. When Alex Ricard, the current CEO, took over in 2015, he basically said that the company needed quote unquote, less complexity, more simplicity, more focus.

14:16Following this, what they did was simplify their organization, which used to have 22 management entities, somewhat unwieldy, into just 10. So this is now a combination of regional management companies, as well as brand owning companies. And the brand companies are important because they're responsible for developing the overall global brand strategy for their respective brands, as well as assets that can be deployed at a local level by the market companies, which are the regional companies. So this is the structure that enables the business to happen. It's interesting that compared to other spirits companies, it's a somewhat decentralized structure relative to its peers, where local management specifically is actually empowered to be agile, to be able to react to local conditions rather than by diktat from the center.

15:00So that's something that distinguishes it from other business models in the industry. And then when it comes to revenue growth and the focus on how it builds its book of business, the revenue growth really is a combination of volume growth, price increases, as well as consumers trading up, which is essentially mixed to higher priced variants. But that algorithm has actually evolved quite materially in the last 20 years, away from being volume focused towards being value focused, which is to focus more on these higher priced premium tiers, where price increases are more readily taken, because demand typically is less elastic.

15:37And also where trading up or premiumization can drive further gains. And the reason this is quite essential to this industry is the costs are actually predominantly fixed, which is why that incremental percentage point of revenue growth that you can get from pricing or from mix can be three times as accretive to margin as an incremental percentage point of volume growth, which is why everybody has been pretty much pursuing some variant of this premiumization strategy. But at the same time, the consumer has given them permission to do that. It's not that they're forcing premiumization down the throats of consumers.

16:11There is an underlying willingness among consumers to trade up, which these companies have readily played into given the benefits it has had to their own business models. So the algorithm that we should expect from a company like Pernod Ricard on their own targets is mid -single -digit organic growth, more led by price and mix than volume, and an additional 50 to 60 basis points of margin expansion a year, which is again, a function of leverage driven by scale. So that buy less, buy better has really influenced every aspect of its business model from the top line down to margin expansion. And then I think there's also market strategy, which is that when you're operating in over 160 countries, it can sometimes get easy to lose sight of what's really important.

16:54But really, there are four markets that it has labeled must win markets. And these are markets which collectively account for over 50 % of its revenues, and importantly, over two thirds of its profit pool. And these markets are the US, China, India, and global travel retail. So these are really the four markets in which the company is acutely focused on in terms of driving growth going forward, because that's really where the vast majority of incremental revenue growth as well as profit growth is going to come from in the future. One thing we really like to see in the business model is gross margins, because to us, When we look at brands, gross margins tend to be quite a pure indicator of pricing power.

17:34We also don't like to see gross margins very wildly because that can indicate, for example, if we see a very aggressive expansion of gross margin in a short period of time, it can sometimes indicate that maybe the company is squeezing its suppliers too hard, or maybe it is sacrificing product quality, neither of which is optimal in the long term. And here, I think Pernod has a very interesting business model, which is that over time, for the last decade plus, it has shown pretty stable to flat gross margins. There are certainly some ups and downs on a yearly basis because of factors like commodity cost inflation, freight, for example, glass, all of these things that make a difference.

18:12But broadly, gross margins have remained around 60%, which we like to see because we don't think then the business is working its suppliers or undercutting on product quality. And similarly, another thing we like to see in branded businesses particularly is the level of advertising spend, because that can sometimes be the first line item to get sacrificed when times are getting tough and the company might feel pressure to make quarterly earnings. Here, again, we're quite comforted that over time, there's been a change in accounting standard that optically suggests that a percentage has reduced.

18:44But broadly speaking, adjusting for that, advertising as a percentage of sales has remained flat at about 16%, which again, we like to see because that's a sign of a company that's taking its brand seriously, investing with a long -term future. Despite these two being flat, gross margins being flat, advertising as a percentage of sales being flat, the company has managed to increase its operating margin by about 800 basis points in the last 15 years. So that's quite substantial from 20 % in the year 2005 to 28 % in the year just ended June 2023. The reason that is important is because that really, in a nutshell, encapsulates the appeal of the Spirit's conglomerate business model, which is that a wide portfolio is helpful because if you plug in an additional brand onto your existing distribution infrastructure that was built for one less brand, there's really very little marginal cost and very high marginal profit.

19:41So that's why these companies keep acquiring. They want to keep bolting on brands, especially those that are resonating with consumers, because that helps them drive not just incremental revenue growth, but incremental profit, which is disproportionate relative to the revenue that it adds. And then if I compare this to other beverage businesses, we did a conversation on Coca -Cola, which is really more of a brand manager in that it outsources most of its production to their bottlers. How does it work for spirits? Do they typically have vertical integration? Are they outsourcing and partnering on the production side?

20:14Because they still obviously have very impressive gross margins, as you highlighted. Just curious if they have that level of capital intensity in the production side. Absolutely. So the big difference here is that Pernod does make its product. Other than the investments that it's made into brands where it's a minority investor, all of its brands are bottled, made, manufactured in -house. And some of them have to be. So Scotch and Cognac, because of the restrictions on provenance, they have to set up facilities in those particular regions where they can manufacture them. And again, here, this is a really important point because it calls into highlight the importance of working capital.

20:51Some of these categories, such as premium brown spirits, cognac, scotch, Irish whiskeys, they have pretty lengthy aging requirements. You need to be able to age something for a minimum of three years in order to call it scotch. Similarly, cognac, depending on what you're going for, if it's VS, VSOP, or XO, you have to age for two, four, or 10 years. So all of that actually means that that business is traditionally more working capital intensive than it is fixed capital intensive. And in fact, for the last seven years, net working capital has averaged roughly just less than 5 billion euros in absolute terms, which is about 55 % of sales.

21:28So that has led to an annual outflow of cash of about 200 million euros, which is roughly about 2 % of sales. So again, this is meaningful because you need to have a wide portfolio in order to be able to absorb this level of working capital outflow in the sense that you need brands that are also immediately cash generative, that do that heavy lifting of cash generation, while you can then go invest with a long -term view into aging these spirits, which will be where, of course, the magic and the pricing power comes through the aging process. But nevertheless, in the short term, that does require working capital, which again, I think is interesting at this juncture in time, because the opportunity cost of that capital is much higher than it was in the past.

22:11And I think that's also one of the reasons where we had seen maybe some startups in some of these categories that were flush with capital in a zero cost of capital environment, who are now maybe not finding it so easy to carry on that strategy when the carrying cost of inventory is much higher than it has been in the past. So here, I think the conglomerates and the larger companies with wider portfolios have a significant edge in being able to invest behind these categories of aging spirits, which also longer term are the most value creative categories. So if you consider the narrative around spirits businesses, I think that people started to discuss the association with luxury brands, but also being cognizant of the fact that they are CPG businesses.

22:53How do you think about the structural versus cyclical versus secular nature of these businesses? That's a particularly pertinent question at the moment, because it seems like not a week goes by that we hear about a spirits company that is having some problem somewhere in the world. The temptation then is to conflate all of these problems. It's similar. I liken it to the Anna Karen and a quote, which is that every spirits company is unhappy in its own way, in the way that Remy is particularly suffering from destalking in U .S. cognac. Diageo has an issue with Latin American inventory. They're not necessarily all the same issues.

23:25But what we are seeing as a common thread lying through them all is this feature of COVID demand having distorted our view of what normalized growth should be. Because we saw very strong growth coming out of the pandemic fueled by what the Campari CEO has labeled revenge conviviality, this idea that we've all being deprived of social contact, have all wanted to go out, party, drink, etc. That has hugely benefited the spirits industry. Stimulus checks, particularly in the most profitable spirits market, the US have not hurt either. And all of that now that we're lapping the absence of all of that has basically led to a bit of a lull in growth, which again, has people wondering whether this is structural or cyclical.

24:07So in our understanding of what we have seen to be past cycles in the spirits industry, it seems to us that that structural runway for growth remains pretty intact. 2022 was the first year where spirits overtook beer in terms of share of throat among the US consumer. To be fair, it's really wine that's seeding that's the biggest share donor to spirits more than beer. It's quite remarkable because it speaks to greater propensity among younger legal drinking age consumers who are entering drinking population for the first time are more likely today to enter that category through spirits than they are through beer or through wine.

24:44So that trend remains unchanged. Similarly, we have demographics in emerging markets such as India and China, which are quite visible for the next decade and plus, where again, the underpenetration of Western style spirits in those markets creates a strong and long runway for growth. So I think unpacking the cyclical from the structural at this time can seem a bit complicated. And there is a tendency sometimes to say, well, premiumization went on for 220 years. Clearly, it's come to an end when actually I think it's a bit more nuanced than that is that we're probably similar to during the time of the GFC, taking a bit of a pause from premiumization.

25:21But over the long term, all the trends that we know about younger consumers, generation moderation, which is how they're referred to, trends towards drinking less but better. All of that, I think, suggests that the longer term runway for spirits remains quite intact. And then how do you compare and contrast that to different global areas? You made reference to India and to China and the importance to the business. Presumably, the runway is significant there. How important are those jurisdictions to their future growth prospects? For Pernod, particularly important. And this is why I think the company is also a