HSD organic profit growth in sight and balance sheet muscle. Upgrade to Overweight
We expect Pernod Ricard to deliver HSD organic EBIT growth in FY19E/20E driven by strong growth in China. This marks a material change in trajectory from minimal organic profit growth since FY13. Strong operating leverage from China will enable the company to invest behind key brands (Absolut in the US, Chivas) and simultaneously expand margins. PR’s balance sheet is now rapidly de-gearing to a level that will provide near €7bn of firepower on our estimates which could finance a DD accretive takeover of Jose Cuervo (OW rated by JPM analyst Andrea Teixeira). We expect PR to increase its
organic EBIT guidance at its H118 results on 8th Feb. Any share price weakness on FX (likely -4% downgrade to FY19E consensus estimates) would be an opportunity to buy. Our DCF derived Dec-18 PT increases to €145 (€112). PR now trades on CY19E PE of 19.6x versus the European Beverages sector on 19.8x. We upgrade PR to OW from UW.
* China trends for high end spirits are improving materially with Kweichow Moutai and Remy Cointreau increasing price on strong underlying demand. Martell in China accounts for 10% of PR’s EBIT which we expect can fund investment behind Absolut in the US (6% of EBIT) and Chivas globally (9%). Strong growth in Martell can result in HSD organic EBIT growth for PR as it did in FY11 and FY12. This drives our 8% organic EBIT growth in FY19E vs consensus at 6%.
* Balance sheet muscle. We expect PR's net debt to EBITDA to be at 2.4x by June 2018. An acquisition of Jose Cuervo (discussed in 2013; PR and Bacardi took full control of tequila brands Avion and Patron this month) would be HSD to LDD earnings accretive to PR, augment top line growth, would be margin accretive and leave ND/EBITDA at a manageable c.4x on our estimates. Importantly, it would give PR scale exposure to the fast growing tequila category with potential to expand premium tequila brands in international markets through PR’s strong distribution network.
* Our FY18E/19E EPS estimates change by -1%/+0.4% with adverse FX movements offset by stronger organic growth. Our DCF derived Dec-18 PT increases to €145 (prev €112) on higher MT estimates, lower WACC (lower cost of debt) and roll forward our explicit forecasts by one year.