European Beverages
What's that coming over the hill ... the risk of a further
slowdown in revenue growth for European spirits
stocks
Beverages
Mike J GibbsAC
(44-20) 7325-1205
mike.j.gibbs@jpmorgan.com
Vanessa Lai Min
(44-20) 7325-4240
vanessa.laimin@jpmorgan.com
J.P. Morgan Securities Ltd.
For Specialist Sales advice, please
contact:
Andrew J Holder
(44-20) 7779 2210
andrew.j.holder@jpmorgan.com
Natasha Cobden
(44-20) 7325 3092
natasha.z.cobden@jpmorgan.com
See page 107 for analyst certification and important disclosures, including non-US analyst disclosures.
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YTD price performance vs MSCI Europe
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60
70
80
90
100
110
31/12/2007 29/02/2008 30/04/2008 30/06/2008 31/08/2008 31/10/2008
Bev erages MSCI Europe
Source: Datastream, MSCI
• We see evidence of volume deceleration and trading down across both
mature and, potentially, emerging markets (EM) in spirits. We expect spirits
companies to ease back marketing spend as in past recessions. However, too
deep a cut may damage brand equity into any upswing.
• EM still delivering 20%-plus organic revenue growth for spirits
companies. Demand for Scotch and cognac in Latin America and Asia has
proved cyclical in the past. With GDP growth set to halve in EM, we expect
slower consumer demand in 2009. A “deflationary” environment may affect
pricing power. With little visibility on inventory levels in EM, there may be
de-stocking in the event of demand shocks. The importance of EM to profit
growth means past share price behaviour for spirits in recessions is less
relevant, in our view.
• We see mainstream beer consumption in the US as more resilient in
recession than premium spirits consumption. A more consolidated US
beer industry is likely to be more rational on pricing than spirits. Any
increase in federal or state taxes would put further pressure on volume
growth. External data continues to show accelerating trading down in our
view though we still expect industry revenue growth in 2009.
• In W. Europe volumes have decelerated in on and off trade channels.
Pricing has accelerated to pass on input cost and excise tax increases but this
will not be sustainable into 2009 in our view. We see clear evidence from
external data of down-trading in key category market combinations in W.
Europe. Historically, the duty free channel tends to react quickly to external
demand shocks. 2009 air passenger forecasts numbers are being revised
down and retailer confidence in the channel is falling.
• European spirits stocks trade at significant multiple premiums to
brewers. We don’t think this discounts the potential impact on revenue
growth from weakening demand, notably in EM. Multiple compression
could become more acute if spirits “late cycle” earnings are downgraded at
the same time as investors turn to more cyclical sectors. We remain UW on
Diageo, Remy Cointreau and Campari and N on Pernod Ricard.

Table of Contents
Limited visibility on revenue growth for spirits.....................3
Executive Summary .................................................................5
What history teaches us ........................................................13
Where do the spirits companies make their money?..........14
History … it’s just one thing after another ...........................16
Reported numbers for the European spirits companies
show no real slowdown … yet...............................................21
Detailed analysis by geography............................................25
What might happen in emerging markets? ..........................26
Case study: Diageo in LatAm................................................40
Spirits slowdown in the US continues..................................44
Western Europe is not immune from trading down ............69
Duty Free may also see a sharp slowdown..........................77
Marketing can be cut … in the short term ............................83
Valuation: Spirits trading at a significant premium to beer90
Company Profiles...................................................................93
Diageo .....................................................................................94
Pernod Ricard.........................................................................97
Remy Cointreau....................................................................100
Campari.................................................................................103
Risks to our ratings and price targets ................................106

Limited visibility on revenue growth for spirits
European spirits stocks trade at significant multiple premiums to brewers. We
don’t think this discounts the potential impact on revenue growth from weakening
demand, notably in EM. Multiple compression could become more acute if spirits
“late cycle” earnings are downgraded at the same time as investors turn to more
cyclical sectors. We remain UW on Diageo, Remy Cointreau and Campari and N on
Pernod Ricard.
Our 12 month DCF derived price targets show -11% and -16% downside
respectively for Diageo and Remy Cointreau, no upside for Campari and just 1%
upside for Pernod Ricard from current share prices. This contrasts with the
significant upside we see for our favoured stocks within the European beverages
sector, Britvic (21%), Carlsberg (130%) and C&C Group (114%).
We think there is compelling evidence of volume deceleration and trading down
across both mature and, potentially, emerging markets in spirits. We have
therefore adjusted our volume and price/mix assumptions notably for Diageo and
Pernod Ricard to reflect a more cautious view into calendar 2009. Our estimates for
Camapri and Remy Cointreau already assume a slowing of top line growth.
We expect spirits companies to ease back marketing spend and focus on cost
cutting to offset the impact on margins. Easing back on marketing takes a little
time to feed through into margins however.
We have also adjusted our estimates for recent currency moves notably the
translation effect of weaker UK£ relative to US$ for Diageo. Further US$ strength
is generally a positive for the spirits companies although transaction hedging, debt
make-up and in market pricing, notably in emerging markets, may offset or delay
some of the translation benefits.
We still expect 3-5% organic sales growth for the European spirits stocks over
the next three years or so and in no case do we assume any volume decline. We
also assume gentle EBIT margin expansion with the exception of Remy Cointreau
where margins should contract sharply in FY09E on the investment in the new
distribution structure but should bounce back in FY10E and beyond.
In the context of North America and Western Europe our forecasts should
prove robust though even here we may be being too generous on top line behaviour
in a recession. In the emerging markets we have far less visibility. In the sections
below we examine recent trends in spirits across the various regions and see what
history teaches us in respect of consumer demand for spirits in a slowdown. However
the key point is that, frankly, we do not really know how this will play out for the
simple reason that the profit pool in the US and in EM is now a much bigger part
of the total profit base of the European spirits companies than in the past, a
function of significant M&A developments in the last decade or so and of very
significant organic growth in these markets.

Although we believe that spirits companies will be able to manage the cost lines and
notably marketing to offset the impact of any top line slowdown, we think we may
see some volatility and dislocation in the next few quarters especially in Q1 and Q2
of calendar 2009 as a slowdown in consumer demand may be aggravated by
“de-stocking” further up the value chain by retailers and wholesalers. We also
think volumes may come under further pressure from the impact of tightening credit
terms and availability through the value chain.
As for how the shares behave in recession and subsequent recovery we would
also caution against reading too much into past behaviour. Diageo did not exist
until 1997 and its precursor had a very different mix of business in the early 1980s
and 1990s. Pernod Ricard was a relatively small and very European skewed company
until the acquisition of its share of Seagram in 2000, which brought it an emerging
market platform and premium Scotch and cognac brands. Campari only came to the
stock market in 2001 and Remy Cointreau shares collapsed in 2001 thanks to its
stressed balance sheet.

Executive Summary
History … it’s just one thing after another
• We forecast slower but still robust volume growth in emerging markets for all the
European spirits players and positive price/mix. This reflects our overall JPM
economists view of a slowdown in GDP growth in 2009E and inflation subsiding.
In particular, given the importance of price and mix improvements to driving up
gross margin in spirits, we would be concerned around what a “deflationary”
environment might mean for profit growth in these markets.
• There is plenty of evidence for demand for premium international spirits
plummeting in times of emerging market slowdowns. Demand for Scotch and
cognac in Japan fell off a cliff post 1990 and has never recovered. Cognac
exports to emerging markets collapsed through 1998. Scotch demand in South
Korea, Thailand and Venezuela has shown alarming volatility in the past.

Reported numbers for the European spirits companies
show no real slowdown … yet
• The last set of results through calendar Q308 for the European spirits companies
all delivered positive top line, and for Remy Cointreau and Campari, bottom line
surprises.
• Outlook statements were either confident though with caveats that the uncertainty
around consumer demand was increasing and visibility decreasing. However,
only Campari explicitly warned and that was for the specific credit crunch on the
wholesale tier in Italy.
• The performance of some the smaller companies, notably in champagne, and for
the US players has proved less robust.

What might happen in emerging markets?
• Emerging markets are delivering the bulk of the profit growth for the European
spirits companies with the exception of Campari.
• We estimate the companies were still delivering organic sales growth of around
20% or more in the last quarter for emerging markets generally with profit
growth probably running at or above this level. We would expect currency and
financial markets dislocation to have impacted some of these markets in Q408.
• We believe demand for premium spirits in many emerging markets is more
“cyclical” than beer. With GDP growth set to halve or worse in some of these
markets we would expect some impact on consumer demand into 2009.
• Scotch and cognac are the key profit contributors by category in emerging
markets. Many Scotch markets in LatAm and in Asia have proved very cyclical
in past slowdown as has cognac demand. Cognac exports to major emerging
markets have already shown a very sharp deceleration through 2008.
• With very long value chains in some of these markets and with little visibility
around inventory levels through the chain we are concerned that there may be
significant de-stocking into 2009 in the event of demand shocks.

Spirits industry slowdown in the US continues
• The US is still the most important market for the European spirits players at an
average 30% of total profit based on J.P. Morgan estimates for forecast Year 1.
• The market has already seen a gentle slowdown in volume price and mix through
2H07 and 2008. This has been reflected in the organic sales growth of the
European players. We would expect more pressure, particularly on price and mix
into 2009. Further on trade declines will likely impact brand equity.

• Price and mix growth is 1.5x more important than volume to spirits industry
profitability on our analysis. Given the importance in recent years of growth in
premium brands, notably in vodka, to driving up the overall industry profit pool
we see real downside risk to margins from accelerated trading down. Diageo is
best insulated against this risk in our view.
• The AC Nielsen data continues to show slowing volumes and pricing for the key
premium players and brands and some acceleration in volume growth for the
"value" players and brands.
• We see mainstream beer consumption in the US as more resilient in a recession
than mainstream spirits consumption. A more consolidated beer industry in the
US is likely to be rational on pricing than spirits in our view.
• The last Federal Excise Tax increase was in 1991. Any further increase in federal
or state taxes could put further pressure on industry volume growth.
• We see a near term risk from limited de-stocking post Q408 if consumer demand
falls away and if the retail and wholesaler tiers cannot or will not finance existing
inventory levels.

Western Europe is not immune from trading down
• Western Europe still accounts for around 30% of Diageo, Pernod Ricard and
Remy Cointreau’s profit and near 60% of Campari’s based on J.P. Morgan
estimates for forecast Year 1.
• Reported volumes have decelerated across the region with GB and Spain now
firmly in decline. Volume decline in the off trade is getting worse and volumes
are now falling in many of the key off trade categories.
• Pricing has accelerated in both on and off trade. We think this reflects the passing
on of input cost and excise tax pressures. We do not think this level above
inflation pricing is sustainable into 2009 however.
• We see very clear evidence from the AC Nielsen data of down-trading in the key
category market combinations in Western Europe. This will have deleterious
margin consequences for the spirits players in our view.

Duty Free may also see a sharp slowdown
• We estimate the global duty free channel is around 4% of Diageo and Pernod
Ricard’s profit and 10% of Remy Cointreau based on J.P. Morganestimates for
forecast Year 1. The channel is relatively high margin given favourable mix.
• The channel has been showing near double digit revenue growth in US$ terms
with very robust pricing.
• Historically, this channel reacts quickly to external demand shocks. Air passenger
numbers are being aggressively revised downwards into 2009 and retailer
confidence in the channel has collapsed.
• Scotch and cognac are the key categories in the channel with most to lose in the
event of the slowdown in demand that we expect.

Marketing can be cut … in the short term
• We would expect the spirits companies to ease back a little on marketing spend in
the event of further top line slowdown. This is what has happened in past
recessions.
• If total industry marketing investment eases then the major players can retain
their share of voice in the short term. However, too deep a cut potentially
damages brand equity into any upswing. Diageo has the most opportunity to pull
back on marketing to protect margins in our view.
• It takes a little time to adjust marketing investment which may create a more
margin pressure into calendar H12009.

Valuation: Spirits at too high a premium to beer
The European spirits companies now trade at significant multiple premiums to their
brewing peers. We estimate that the spirits companies trade on an unweighted
calendar 2009E PE multiple of 11.1x. This compares to an average of 8.6x for the
brewers where we currently have a rating.
We do not think this fully discounts the potential impact on top line growth for spirits
companies that would come from weakening consumer, retail and wholesale demand
notably in emerging markets.

Whilst the margin impact of slowdown especially in emerging markets may be
ameliorated through cutting back on marketing we think there is some risk across the
spirits companies to relative ratings. This could become more acute in the event that
these “late cycle” earnings are being downgraded at the same time as investors can
finally see the light at the end of the tunnel in terms of overall equity valuations in
Europe.