Description

Summary

I recommend the purchase of shares of Remy Cointreau.  This is a company that produces and distributes alcoholic beverages, with the main brand being Remy Martin cognac accounting for roughly 65% of revenues.  I believe that over the next twelve to twenty four months, analysts will have to significantly revise their earnings expectations up and that in turn should result in the shares moving up materially.

Please excuse the sparseness of the write-up, since I wanted to get it done before the company announces its Q4 and fiscal 2017 sales on April 19th. 

Variant perception

Analysts are not taking into account massive price increases that are necessary to bring supply and demand in the cognac market into balance.

Investment thesis

This investment thesis is predicated on the belief that there are very significant price hikes that are coming to the cognac market given the need to address supply/demand in balance in favor of the producers, and analysts are not taking these price hikes into account.  If that does not happen, then the investment thesis is flawed and this will not be a great investment.

On its latest conference call, LVMH stated that it was worried that it was going to run out of stocks by year end, and quite a few stores have high end cognac - XO sold out.  Remy itself stopped selling VS, its lowest priced cognac to conserve stocks a while ago.  As we all know, the cure for shortages is higher prices.  I do not know the elasticity of demand for cognac with respect to price, however it is my guess that price increases on the order of twenty percent over the next couple of years are required.  If I am correct, then the company should earn roughly E 5.15 per share in fiscal 2019 (starts 04/01/2018 and ends 03/31/2019) which is more than 50% above the current analysts estimates.   

Long term demand growth should continue to be robust.  Several of the current markets for cognac are somewhat depressed - China is way below its consumption peak, so is Nigeria, and Russia is still below its previous peak due to economic difficulties.  Moreover, in the United States, the growing population of blacks and hispanics favors cognac demand, since these demographics favor cognac versus other spirits.  According to a number of analysts, both cognac and tequila are the best positioned out of all alcohol categories and are expected to grow volumes in low to mid single digits for decades to come.  If these analysts are even somewhat correct, then producers will probably be able to boost prices by 1-2% per annum in real terms and grow volumes at say 1% per annum in the long run.

Financials:

I estimate that the company earned 223MM euro in operating income in fiscal 2017 (03/31/2017), and had net income of E 135MM and EPS = E 2.78.  This implies a 20% operating income margin, exceptionally low for an alcohol beverage producer.   A couple of  years ago, the company had stated that it was planning to get to an 18-20% operating income margin by Fiscal 2020 assuming the exchange rate of 1 Euro = 1.30 USD. 

[For a frame of reference, Diageo has 30% operating income margins and is in the midst of a major cost cutting program, that should boost its margins above 32%.  I happen to believe that Diageo will hit operating margins closer to 35-40% thanks to currency tailwinds. Despite that program, Diageo is considered by many to have tremendous fat.  Remy's gross margin is 500 basis points higher than Diageo, and yet its operating margin is currently 1000 basis points lower.  Pernod has a 26.2% operating income margin and is in the midst of a cost-cutting program to boost it to 30%.  Remy's gross margin is 320 basis points higher than Pernod's and yet its operating margin is 620 basis points lower.  LVMH in its spirits business has 33% operating income margins or 1300 basis points higher than Remy.   While Campari does have EBIT margins of 20.7%, its gross margins are 800 basis points below Remy's.] 

Assuming Remy would have hit its target in the absence of euro's weakness, the currency tailwind alone should carry the company to a 24% operating income margin, or EBIT of 20% higher and EPS closer to E 3.34 per share.    Without taking into account margin benefits of major price hikes in cognac, I believe that there is tremendous room for margin expansion given the tremendous gap between the company's margins and the competition, which itself is fat and happy.

I estimate that Remy finished the fiscal year with E 400MM of debt.  Roughly 50% of that debt is convertible at a strike price of I believe 110 euros per share.  If the entire bond was converted, there would be roughly 4% dilution. 

Valuation

The company is selling at 33x my earnings forecast for fiscal 2017 (ended 03/31/2017) and 18.4x my estimate for fiscal 2019 (ends 03/31/2019.)  So a legitimate question is: let's assume that I am right, why isn't 18.4x EPS and say 20x free cash flow not the right multiple for this business?   Well, when TIPS yield less than 1%, and class A real estate in NY/Boston/San Fran/London trades at sub 4% cap rates or more than 25x cash flow, shouldn't this business with real, post inflation growth in revenues of say 2-3% per annum, and possible margin expansion on top of that trade at more than 25x cash flow?  I know that DCF is garbage in, garbage out, but with a real discount rate of say 5% and real growth rate of 2%, and assuming no margin expansion beyond say fiscal 2020, this would be trading at 33x free cash flow or roughly 70% higher at around E 154 per share.

Conclusion:

Again, I apologize for the brevity of the write-up but I wanted to get this out before the April 19th announcement.  I am happy to answer any questions in the Q&A.

Catalyst

Significant increases in analysts' earnings forecasts driven by material price increases in the cognac market.