BREAKINGVIEWS-Big Booze can sweat off its multi-year hangover

By Edward Chancellor

LONDON, July 10 (Reuters Breakingviews) - Investors often confuse cyclical ups and downs with secular movements in the fortunes of companies. When revenue turns down, they panic. That is what’s happening in the global spirits industry, which currently faces multiple headwinds. There’s a simple rule of thumb to help avoid error: the longer something has existed, the longer it is likely to persist. Spirits companies have the longest brand histories out there. The chances are people will be splashing Johnnie Walker whiskey and sipping Hennessy cognac well into the twenty-third century.

During the pandemic the purveyors of hard liquor enjoyed an extraordinary boom. Cooped up during lockdown, households turned to drinking from home. When the restrictions were lifted, they flocked to bars. Caught short by this unexpected binge, spirits distributors loaded up on stock. Drinks companies hiked their prices and boosted capital expenditure. Davide Campari Milano’s CPRI.MI capex as a share of sales roughly tripled from the pre-Covid level. Profit soared. In October 2021, the Aperol maker’s then-CEO Robert Kunze-Concewitz predicted that what he called “revenge conviviality” would endure.

That was a bad call. The hangover following the pandemic binge has been particularly severe. Faced with a cost-of-living crisis, consumers spent less on premium drinks. Spirits distributors with bloated inventories slashed their orders. China’s real estate downturn, combined with Beijing’s ongoing crackdown on corruption, hit cognac sales. To make matters worse, China has imposed punitive import duties on European brandy. U.S. President Donald Trump has likewise threatened sky-high tariffs on European wine and spirits.

Cognac maker Rémy Cointreau’s RCOP.PA shares are down 74% from their 2021 peak. Shares in Diageo DGE.L and Pernod Ricard PERP.PA have dropped by more than 50%. Extreme negative sentiment about the future of the industry prevails. Gen Z consumers, we are told, are giving up on booze. Some think legalised marijuana might replace hard liquor. Growing use of weight-loss drugs are set to further depress alcohol sales. The World Health Organization wants to put health warnings on drinks bottles.

Investors can take comfort from what’s known as the “Lindy effect”: a simple rule which dictates that the longer anything non-perishable has been around, the longer it is likely to survive. The rule is named after Lindy’s, a New York delicatessen where, according to legend, regulars first observed that the future of a Broadway show could be predicted by how long it had been running for. Thus, a play that had been on for two weeks would have two weeks left to run, while one that had been around for two years would continue for the same period. The scientist Richard Gott in 1993 tested the effect and found the forecasts to be remarkably accurate.

In his book “Antifragile: Things That Gain from Disorder”, the writer Nassim Nicholas Taleb says the Lindy effect is ageing in reverse. “What survives,” he writes, “must be good at serving some (mostly hidden) purpose that time can see but our eyes and logical facilities can’t capture.” Technologies are subject to the rule, as are consumer brands. Johnson & Johnson and Coca-Cola have been around since 1886 and 1892, respectively. Luxury marques have lasted longer: Louis Vuitton started up in 1854 and Hermès in 1837. But nothing beats the durability of the top spirits brands: Rémy Martin (founded in 1724), Hennessy (1765), Johnnie Walker (1820), and Glenlivet (1825).

These businesses have endured trade wars, world wars, economic depressions, prohibition, and even revolutions. Bacardi, founded in 1862 in Santiago de Cuba, had its assets expropriated by Fidel Castro in 1960, after which the rum maker moved to Bermuda and continued to thrive. Until their recent travails, these companies were considered recession-proof. Spirits sales even increased during the global financial crisis.

The robustness of drinks companies is not just about brands. They have other competitive advantages, like geographical restrictions. Cognac can only be produced in the Charente region of France. Scotch whiskey must be distilled north of Hadrian’s Wall. Spirits that need ageing also require large inventories. If you want to get into the cognac business, don’t expect to generate any sales for the first eight years. The large spirits companies dominate distribution, reinforced in many parts of the world – including the United States – by regulations governing the sale and distribution of alcohol.

As a result, they enjoy tremendous economies of scale. It doesn’t cost much to open a new distillery, says Django Davidson, a portfolio manager at Hosking Partners, but it’s almost impossible to crack the distribution problem. Thus, successful startups in the industry are usually sold to one of the incumbents, as happened in 2017 when Diageo acquired the actor George Clooney’s tequila brand, Casamigos. In this respect, the structure of the drinks industry resembles the relationship between pharmaceutical giants and biotech companies, where startups bear the risks of developing new products.

Valuations for drinks companies are extremely depressed. Diageo’s enterprise value has shrunk from eight times revenue to around four times. Rémy Cointreau, which traded at almost nine times sales at the peak, fell below three times earlier this year. Campari trades at a similar multiple. Bernstein analyst Trevor Stirling points out spirits companies no longer command a premium to the European market. Rémy is priced at below the retail value of the cognac in its vaults. It’s very rare, says Davidson, to find a quality company selling at less than its replacement cost.

The situation of the drinks industry today is reminiscent, in some respects, to the problems faced by the world’s greatest brand, Coca-Cola, following the disastrous launch of its New Coke formula in the mid-1980s. After the stock slumped, Warren Buffett snatched up 7% of the company. The Sage of Omaha was impressed by Coca-Cola’s impregnable leadership of the soft drinks business and its prospects for overseas growth. Buffett paid 13 times forward earnings for shares that turned out to be one of his most successful acquisitions.

By coincidence, the $58 billion Diageo and $27 billion Pernod Ricard trade at around the same valuation today. The Lindy effect, a useful if not infallible guide, suggests that the spirits companies’ current travails, like Coca-Cola’s four decades ago, will turn out to be little more than a cyclical setback in their long history.

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