We expect their leverage to be broadly unchanged in FY22 despite share buybacks, increased dividends and bolt-on M&A spending.
Both companies have intensified their share-buyback plans following strong 1HFY22 results. On 10 February 2022, Pernod announced an increase in its share buyback spending in FY22 to EUR750 million from EUR500 million. Diageo, its closest peer, has brought forward its share-buyback plan by a year and increased its interim dividend by 5%.
The two companies reported record sales in 1HFY22, around 10% above the pre-pandemic levels of 1HFY20, despite the only partial recovery in sales through bars, restaurants and night clubs (the on-trade channel) and travel retail due to continued movement restrictions and social-distancing measures in many markets. Sales in the Americas were 19% and 12% above pre-pandemic levels for Diageo and Pernod respectively.
Diageo and Pernod reported consolidated organic sales growth of 20% and 17% respectively due to robust consumer demand across all regions as the off-trade channel remained resilient and the on-trade channel continued to recover. Growth was also supported by a continued consumption shift towards spirits and away from other alcoholic beverages (especially in the US) and towards more premium brands ("premiumisation").
The two companies also reported a strong improvement in their operating profit margins. However, we expect margin progression to moderate in 2HFY22 due to greater investments in advertising and promotion and higher costs related to logistics, commodities and energy. That said, we believe that the margins of spirits producers are less exposed to commodity price inflation, which is challenging other fast-moving consumer goods producers. This resilience is due to their cost base structure, portfolio premiumisation and operating leverage from sales volumes growth in recovering, more profitable channels. Both companies also increased their selling prices in many markets, partly reflected in 1HFY22 sales and helping to mitigate cost pressures.
Both Diageo and Pernod have shown faster profit recovery and leverage reduction to pre-pandemic levels than we had expected at the onset of the pandemic. They demonstrated a return in funds from operation (FFO) net leverage to 3.5x, the maximum threshold for their ratings, in FY21; something we did not expect to happen until FY22 for Pernod and FY23 for Diageo.
Expected EBITDA growth in FY22 will allow Pernod to execute its enlarged share-buyback plan without significantly increasing leverage, despite a rise in bolt-on M&A spending. Pernod spent EUR464 million on M&A in 1HFY22 (FY21: EUR53 million), mostly to acquire the UK spirits online and physical retailer The Whisky Exchange alongside a minority stake in the US premium wine and spirits producer Sovereign Brands. This is a part of Pernod’s portfolio rebalancing strategy as it grows its exposure to more premium high-growth brands and channels. Assuming limited bolt-on M&A in 2HFY22, Pernod’s FFO net leverage should stay at or slightly above 3.5x in FY22 (FY21: 3.5x).
Similarly, Diageo’s FFO net leverage should only slightly exceed 3.5x in FY22-FY23 as stronger EBITDA will balance a higher dividend payout and acceleration of the share-buyback programme by one year. Although 3.5x represents our negative rating sensitivity for both companies, we believe this level could be slightly and temporarily breached without endangering their ratings, if accompanied by strong operating performance and healthy free cash flow generation.
