Episode Transcript
The Finance Ghost: Welcome to episode 278 of Magic Markets from a cold and rainy Cape Town, which is also where our guests happen to be today. This is the second time that the team from Aylett & Co will be joining us on Magic Markets.
You can go back to episode 262 for our chat with Dagon Sachs. It was a really, really cool conversation where he gave us an overview of Aylett's investment ethos, as well as just some great pointers on capital allocation, how he thinks about free cash flow, and how the team on that side thinks about it, actually. We even chatted about the hotel industry, so go back and give it a listen. It was a great conversation.
So, no pressure on our guests today - Justin Ritchie and Ryann Dean from the Aylett team. Big shoes to fill here, gentlemen.
We're going to do it by talking about the alcohol industry, which has been a particularly tricky sector to really dig into. Moe, if it's okay with you, I'll just jump straight into welcoming our guests then, since I welcome you every other week.
Justin, Ryann, thank you for joining us. Maybe just give us a quick overview of a conference that you guys recently attended, which sounds pretty interesting.
Justin Ritchie: Thanks for having us. We're excited to chat to you today.
Ryann Dean: Yeah, thank you very much for having us.
Justin Ritchie: You asked about the conference. I was in Paris last week. It's a big annual consumer goods industry conference that I've been to now a couple of times; it was probably my fifth time I've been there. I started going pre-COVID.
So it's been a fascinating place to watch the events of the industry unfold. Obviously, consumer goods are more than just beer and spirits, but the whole alcohol space has been fascinating, and there's lots to talk about.
Mohammed Nalla: I'm really quite interested. And again, welcome to our guests from Aylett. I always love to pick the minds of the team here.
Alcohol is not really my forte. Obviously, it's a sector I haven't looked at in the past in a lot of detail, but it's definitely an interesting sector.
At a macro level, what I'd really like to jump into is, there's this big debate around whether alcohol stocks and the trends we're seeing there are actually structural or are they cyclical? Are they actually defensive, or are they not defensive?
There are a lot of underlying factors here, including changing consumer behaviours. And especially if we see the changes amongst Gen Z, if the headlines are to be believed. There's also the GLP-1 trend and what does that mean for the alcohol sector?
So maybe we can start there. Maybe you can take us through some of the key headwinds that you're seeing in the sector, and then also any tailwinds, to the extent that they are there and they're obvious enough in order to build an investment thesis around?
Justin Ritchie: There are a lot of good questions in there and a lot of things that we've been thinking about. It would be helpful if I started with a bit of a history lesson and set the scene.
The spirits companies, or alcohol companies in general, pre-COVID were mid- to high-single-digit revenue growth businesses. Quite consistent, nice businesses, and valued as such. And then COVID happened, and, as you know, a lot of things changed.
One of them was that we saw this explosive revenue and volume growth in alcohol for a number of years.
What was Diageo growing at in COVID?
Ryann Dean: So if we use Diageo as a proxy for global spirits, because it's the biggest one in the sector. Coming out of that initial COVID dip, I recall revenue growth rates of high teens in the one year, followed by high twenties in the following year.
To compare that to businesses that used to grow at a mid-single-digit rate, you can see that the revenue growth really accelerated.
Justin Ritchie: Also remember that because of operational gearing, and the ability to price through that, your earnings number was growing faster than that. So it was fascinating to watch as the market got excited about these companies and started to price in this higher revenue growth, higher margin, for a long period of time.
I remember coming out of ’21 and ’22, there was a lot of debate in the industry about whether this growth was structural or cyclical, and people started to think about it as a structural change and value them as such.
Ryann Dean: Well, I would almost say, based on my history of looking at the companies at the time, is that there was very little debate about whether it was structural or cyclical. There were constant articles about new cocktail culture, that people had gotten used to making their own drinks at home.
They were going to continue to do that. They were only going to drink very premium stuff, which is what they'd grown accustomed to. It was almost a consensus in the industry that this was a new base from where these companies could just continue to grow.
The Finance Ghost: Gin bars were everywhere. That's the thing I remember. Gin bars were sprouting like mushrooms. Fascinating.
Justin Ritchie: We had this big pull forward because of COVID. You were going out before and you were ordering maybe a single G&T or two G&Ts. Now you're stuck at home, you're ordering your bottle of gin, maybe a bottle of whiskey. If you've got a stimulus check in the developed world hitting your bank account, maybe you're ordering two bottles of gin.
So we had this big (in hindsight) - this big demand pull forward. Then we all got unlocked, started to go out again, and we saw the big volume declines, especially in spirits, especially in the developed world.
That brings us neatly back to your question: what is causing these volume declines? Is it structural or is it cyclical?
We think a lot about the data. Alcohol is an interesting space because we all come at it with our own priors. A lot of anecdotal data, your own experience with the substance, maybe your socioeconomic context. There's religious stuff. All wrapped up in the way that we think. So we spend quite a lot of time trying to separate anecdote from fact.
And when we think about the possible structural changes that we've seen in the market, certainly the things that are getting the headlines, there are two. And the one that we find least convincing is probably GLP-1s.
So GLP-1 is this weight-loss drug. I think in South Africa, the most popular one is Mounjaro, which you would have seen overseas. People talk about Ozempic and Wegovy. I think we've all got a friend or family member who's on them and trying them. And the anecdotal evidence there is that people consume less. But when we looked at the survey data…
Ryann Dean: There was a Cornell University survey done. Just to be clear, you’ve always got to take survey data with a pinch of salt, whether it confirms or disconfirms your view. With alcohol surveys in particular, you've got to take them with a pinch of salt because, again, back to the point: alcohol is more than just a product that people buy.
There's a lot of other stuff around it. People tend not to report their alcohol consumption truthfully in surveys, is the most charitable way I can say it.
The easiest example for us here in South Africa is: think about your annual Discovery Health survey that you do online. How honest is everyone really about their alcohol consumption and the amount of fruit and vegetables that they eat in a given day?
Justin Ritchie: I've seen Ryann's Discovery profile. He's not honest.
The Finance Ghost: This is a very anecdotal example coming through right here. Lived experience. [Laughs].
Ryann Dean: [Laughs]. Surveys where people self-report, there are going to be issues with that.
So the Cornell University study - why that was very useful is that it analysed credit card spend pre- and post-people using these drugs. So, basically, how much their spending patterns changed in the store, which is actual transactional data. There are no ifs, whens, or buts about that. That's the actual data they used.
And what we found interesting is people spent less overall, and they spent less on things like sugary snacks, sweets, that kind of stuff. But then for alcohol, the net decrease was pretty small.
Justin Ritchie: 1.4%, within the margin of error. So statistically, it actually doesn't tell you anything. It seems like when people are on GLP-1s, they eat less and drink less, maybe, but they drink better. So that would explain why spend is unchanged.
In terms of GLP-1’s structural change, no doubt that there is an effect. We think it looks quite small, and certainly when we do the numbers, the number of people on GLP-1s is not big enough, not statistically significant enough to account for the volume drop.
Ryann Dean: And I think a key point to add as well is that GLP-1s are still largely a developed-market impact, and primarily really a US market impact right now. It's less widespread in the rest of the world.
Justin Ritchie: Looks like a small impact. So then the next candidate would be, Moe as you mentioned there, generational drinking pattern change.
This is a really interesting topic because I think there have been a lot of headlines. It's a popular topic at the moment. Also, it was a year ago or so. When you look at the data, we agree with that. It's actually very clear in the data that the current generation will drink less than their parents.
But what's interesting is that this is not new. This is something that's been happening for decades. What is interesting is that the slow drift is not nearly enough to explain the volume declines.
Ryann Dean: I went and looked at French per capita alcohol consumption as a developed market that, as most of us know, is quite fond of wine, historically has been very fond of wine. Their alcohol consumption peaked per capita around 1960 at 26 litres. We're down to under 10 now. That's pure alcohol across wine, spirits, and beer.
Pretty much every single developed market you look at has seen lower per capita consumption for decades now.
Justin Ritchie: And all through that period, what's interesting is these companies have been able to build big, profitable businesses with growing revenue. So, selling less alcohol, but selling more premium alcohol generally. I mean, it's a little bit different in emerging markets for beer.
Generational drinking pattern changes certainly are causing a decline in volumes, but it looks to be small.
And then there was another very interesting survey that we came across, an IWSR survey. And with a caveat that this is an alcohol industry-run survey, but we've been through the methodology, and it looks pretty sound.
And what was really interesting: they asked people in 15 different countries about their alcohol consumption patterns over the last six months, and how many people drank alcohol.
And we've seen a very big shift in the last two years. I think overall there's been about a 10-percentage-point increase over the last two years in people reporting participating in alcohol in the last six months.
Ryann Dean: From about two-thirds to about mid-70s.
Justin Ritchie: So we're seeing the younger cohorts start to come back into the category. This is maybe anecdotal, but it makes a lot of sense. And when you speak to the management teams of the alcohol companies, they will tell you that their data shows that there's a whole generation of young people late to leave home or stuck at home because of COVID.
When you're stuck at home, I don't know about you, but I certainly wasn't having lots of mates over and drinking a lot of beer. I did that more when I had my own place. So that would explain some of the change.
In terms of the structural candidates, we think that those two obviously are having some effect, but cannot explain the volume declines we've seen, the sharp declines we've seen over the last three years.
So that brings us to cyclical. If it is cyclical, that's a very interesting thing because cycles pass, and they give us opportunities in markets and in stocks. And when we look at the cyclical candidates, I think there are really two. The first is inventory.
So as we mentioned, there's a very long inventory cycle on spirits. That whiskey you've got sitting on your counter at home that you ordered during COVID is still good. But, I don't know about you, but I don't have any beer that I ordered four years ago. It has a limited shelf life.
Ryann Dean: I certainly don't.
Justin Ritchie: So there's this long inventory cycle. These things last a long time. There was this pull forward in demand.
And we also think (and this was something that came across time and time again last week) is that there's an affordability problem in the alcohol category. People can't afford to spend what they used to.
If you remember, the developed world had very low inflation for a good decade or so going into COVID. And then out of COVID, we've seen much higher inflation rates. It’s sometimes hard for South Africans to understand because we've lived with inflation for many years.
But if you go and look at menu prices in the UK or in Europe, often menu prices wouldn't change for years on end. And then we've seen three or four years where they've had to change quite regularly, and that shock has been felt by consumer wallets.
So it looks like people are going back out. Restaurant traffic in many parts of the world is positive. But as the Campari CEO said to me last week, people are buying two drinks, not three; and that has a big effect on their business.
When we look at all the possible candidates, we think it's more cyclical than structural, which provides a pretty interesting jumping-off point when you're analysing potential companies to invest in. Because the market is valuing them like this decline is terminal, and not like it's cyclical.
The Finance Ghost: Tons of fantastic insights in there. I'm certainly doing my best to help the CEO of Campari with that income statement. I can tell you my half-Italian blood is firmly coming through here.
But I think, as you say, lots of debate around structural versus cyclical. The “this time it's a different” argument that always comes up. You know, what's going to really happen, what's going to stick, what's not.
I think that point right at the end there around two drinks, not three, is probably the most believable and compelling. If I just look around me, it feels a little bit like it is less volume, maybe more quality, to your point.
And that, of course, is one of the really interesting things about the alcohol industry. One drink can cost anything from a student special right up to an eye-watering number on a very special spirit - that's still one drink, yet the actual rand or dollar or euro value is completely different. Just something very interesting in this market, obviously.
And regional trends are another thing that's really interesting. Emerging versus developed markets, as you said, tend to have quite different patterns. I saw in AB InBev's recent numbers that beer volumes were firmly on the up in LatAm, for example.
The Corona brand was the big winner of the pandemic. I think the biggest lesson from the alcohol space in the last few years is: next time there's a pandemic, quickly go and name a product after it because you'll make a lot of money. That worked very well for Corona beer.
Perhaps you can just walk us through some of these regional trends, why you see this deviation, and then how it informs your investment thesis when you're considering the sector and what to potentially own versus not own.
Ryann Dean: Sure, happy to take that. Just a quick point on your helping out the Campari brand is that they have released an Aperol pre-mix in a can. It's not in South Africa yet, but it's probably going to land here at some point, and I think a lot of people might enjoy that now. It'll take all the effort out of mixing the Aperol.
The Finance Ghost: I'll certainly give it a test. The effort's kind of half the point, but yeah, let's see [laughs].
Justin Ritchie: Campari is not a sponsor of this podcast.
The Finance Ghost: But they can be if they want to be. No, just kidding [laughs].
Ryann Dean: So on the regional dynamics, the easiest way to really think about it is to group the beer into the two big beer companies, which is AB InBev and Heineken. They are the bulk of the market. In both of those businesses, upwards of 60–70% of their volume comes out of the emerging markets.
The key point on those markets is actually the volume growth, or the long-term volume growth, is not really in question. Incrementally, in emerging markets, you are benefiting from a young population that is aging into the legal drinking age, depending on which country they're in, plus the growth of a middle-class household. Basically, people getting richer. And those trends for a lot of their main markets are still firmly a tailwind.
So incrementally, you're going from drinking one beer a week to two beers a week.
Justin Ritchie: When a lot of us were students, we were most focused on the quantity of beer we could get, right? How much beer we could afford with all the money in our pocket on the student account. As adults with decent jobs, we focus more on the quality of what we drink. That's a trend that's going to play out across a lot of these emerging markets for decades to come still.
Whereas if we switch to the spirits companies in general, they are more developed-market focused. And that really is just because they tend to command a more premium product profile.
For a lot of markets, a bottle of spirits is completely unaffordable for someone. So people start drinking on beer and maybe on ciders, and then over time, as they get richer, they move into spirits.
With spirits, you sit with this more premium-heavy portfolio, which is more developed-market focused. More exposed to, say, any of these potential structural factors. And with beer, you've still got the long-term volume tailwinds that should continue.
In any given year, there's going to be ups and downs. Markets that go backwards, markets that go up. Emerging markets come with volatility; so do developed markets. But your long-term trend is in favour there.
On AB InBev's recent results, they mentioned they had record volumes in Colombia, South Africa, Peru, and Mexico in this last quarter. So those are still healthy, growing markets.
Justin Ritchie: Big markets too, big markets.
Ryann Dean: And I think just a key point as well: the alcohol industry, the focus for them for a very long time has not been on making people drink more (more volume). The focus has been on making people drink better. They would rather sell you a more premium beer or a more premium offering of their spirits than just simply sell you more volume.
Justin Ritchie: Get you to go from a brown bottle to a green bottle.
Ryann Dean: That's a key thing to understand about these alcohol companies, is that their drive is to get you to drink better, actually. So in many cases, if you're drinking two of those drinks, to use an earlier example, and not three, but you're drinking two more expensive beers versus three cheaper beers, that's a better financial outcome for them anyway.
Mohammed Nalla: I think you've almost pre-empted where I want to go with this, because you've mentioned the premiumisation, the drinking better. There's been a lot of talk around this declining consumption for a variety of reasons. And what I'd like to get into is: what are the steps that the alcohol companies can take to mitigate the impact?
For example, we've also seen a proliferation of those alcohol-free beers. I see a lot of those 0% Heineken adverts when I'm watching Formula One. So in this overall construct, you've touched on premiumisation, but what are some of the other steps that these companies can take to try to mitigate those changes?
Justin Ritchie: Something that was much discussed last week: every one of those management teams admitted that in the heyday of post-COVID, they have over-premiumised many of their markets and some of their brands.
Price has been pushed to a point where the bulk of the consumer can't afford to buy the product. So you've got these big gaps that have opened up as prices have grown and affordability has struggled.
So there's a lot of work to do. And they kind of approach that in two different ways. Some will launch new products. Rémy Martin, for example, has hinted that they're going to launch a new product in the US (a new brand of cognac) probably sometime next year. And that will be a lower-end product to try and address that big hole.
Someone like Diageo, which has a portfolio of brands, has talked about a repositioning (a polite way of saying price cuts) to try and make the portfolio more accessible for the people who want to access it.
On the spirits side, that's what they're going to do. And we've also seen (and this cuts across categories) a big push into canned cocktails. So you will have seen, if you go and walk around a bottle store even here, quite a wide variety of cocktails. If you go and look overseas, it's also a big trend.
I know in the US it's been a big driver of ABI volumes. They call it “beyond beer.” So it's not only alcohol-free, it’s trying to give consumers a way to access the category at a lower price point, with a view to recruiting them back into participating, working, and interfacing with their brands.
Those are the key ways that we're seeing those alcohol companies address the issue.
Ryann Dean: No-alcohol spirits tend to be quite niche at the moment. It's growing, but far more niche. No-alcohol beer has pretty much been an outstanding success for most of the beer companies because it's a similar product, an almost identical product, tacked onto the same distribution in the same stores.
And the best part about it so far has been it is, in many ways, quite incremental. You can have a no-alcohol beer with lunch on a workday. It's just a malt-flavoured drink, right? If you don't feel like something sweet. So all the companies are finding that there's quite a level of incrementality to the no-alcohol beer.
So they're actually growing occasions, and they're not taking share from each other - they're actually taking share from, say, the soft drink companies, sparkling water, for example, or anything like that.
Justin Ritchie: And I think a key point is there's little to no tax on alcohol-free beer. So they can sell you a Heineken Double Zero at the same price as the full alcohol one, and the margins are much better.
Ryann Dean: Much, much better.
The Finance Ghost: Yeah, it's interesting. I think if the GLP-1 issue was the big issue, I'm not sure that these zero-alcohol options would be doing well, actually. I've personally just always seen it as all the calories, none of the fun. But that's me, because I do drink. I'd rather then just have the sparkling water and save it for another occasion.
But yeah, if it was purely a health focus, it feels like the zero-alcohol brands would be struggling because it's still not a healthy drink.
Mohammed Nalla: I'm their target market, right? That's who they're going for. I think the incrementality point that was raised is really vital because it's opening up new surfaces, new markets for these companies to target. So that's certainly very interesting.
The Finance Ghost: The Formula One ads are working on Moe here, which is quite exciting for the industry.
Justin Ritchie: And also, those Formula One ads are interesting, right? Because for a very long time, the alcohol brands have not been allowed to advertise in forums like that.
But advertising the alcohol-free version is perfectly fine. And you saw they sponsored the Olympics. So you're seeing the brands getting out there more and more. They can just address so many more occasions than an alcoholic drink can.
The Finance Ghost: Olympic sponsorship is always so fun because McDonald's also does it, right? It's like, our product is really, really unhealthy, but also look at this person running. This could be you; pretend they had a Big Mac.
We've got time for a couple of questions, and one of them I want to talk about is spirits, because obviously the spirits producers have been struggling. You've alluded to some of the issues there. I think maybe just an oversupply of inventory and people bought a lot of stuff that they're still drinking - sounds like a valid argument to me.
Are you basically saying the spirits side is probably more cyclical than the rest in the cyclical versus structural debate, and does that deliver opportunities? Are you buying up these stocks at the moment, or are you staying away from them for now?
Justin Ritchie: The defensive versus cyclical nature of these businesses is an interesting thing to think about. When you compare beer to spirits, there's no doubt that beer is more defensive. It's closer to a staple than the spirits, for example.
Again, when you survey people and you ask them: if money were tight, which one would you cut first? They overwhelmingly will say they're going to cut a spirits occasion, not a beer occasion. Beer is often seen as an affordable luxury.
So the textbooks will tell you that beer is less cyclical, it's more defensive.
But you've also got to think about where the current multiples are, what the valuations look like. And the spirits companies (if you look at something like Diageo) have come from 30 times earnings in 2021, 2022. We're now at low- to mid-teens times earnings. So the valuations have compressed significantly, they've halved.
And a compressed valuation often gives you a bit more protection on the downside, so it makes it more defensive, maybe than it would be at any other time.
Without getting into specific stocks, we think it's a very interesting place to be looking. And we do own a few of the spirits companies and the beer companies in the portfolio. We think that in 10 years' time these are going to be valued differently, and they're going to be bigger, better businesses than they are today.
Ryann Dean: To Justin's earlier point in the conversation on the inventory cycle, spirits tend to last for a long time in your cupboard. Beer goes stale quite quickly, right? So the cycles you see in beer tend to be shallower and over shorter periods, whereas with spirits, that half a bottle of Johnnie Walker on your shelf can last for years.
So it takes time for those cycles to work their way out. And I think we're seeing that reflected in the performance of the spirits versus the beer stocks in the market at the moment.
Justin Ritchie: And admittedly, this is a very deep, down cycle.
Ryann Dean: Yeah.
Mohammed Nalla: I was going to ask whether you view these stocks as defensive, or are they more cyclical - we've touched on that.
What I'm going to maybe wrap up with on my side is that quite often in this segment of the market that's maybe seen as the vice, how would you compare stocks in this sector versus big tobacco? Something like a British American Tobacco, which kind of went through similar themes. It was seen as defensive, it's the vice, then they saw declining volumes.
There's a decent analogue there. Maybe if we can just unpack your thinking on how you would compare this sector versus some of the other vice sectors that are out there?
Justin Ritchie: There are some similarities, but also some important differences. Tobacco (and we internally refer to it more as big nicotine because it's much more focused on nicotine now than just tobacco) - these businesses for a number of years were considered terminal-decline businesses, had very little terminal value ascribed to them.
It's taken them a number of years and a lot of money to show the market that they have a future with the next-generation products. Anybody that watches any TV or spends any time with Gen Z will know all about nicotine pouches and Zyn and Velo. These are very popular products. They're growing quickly, they're very profitable for the nicotine companies.
The companies were able to show that you need to put a terminal value on them. And if you go and look at the valuations of British American Tobacco or Philip Morris or Imperial, they have re-rated significantly.
The whole cyclical versus structural debate at the moment in alcohol certainly brings up those questions, and the terminal value debate is definitely raging.
The difference with alcohol, is it's more competitive. If you wanted to start a new cigarette brand, it's almost impossible. You can't advertise. It's very difficult to get listed anywhere. Most of the retailers are not interested in stocking something new.
Whereas with alcohol, there's a lot of marketing, big advertisers, and there are new things coming out all the time (new brands, new formats, et cetera). So there the comparison, I would say, falls down. With a longer-term horizon, probably more growth potential long term, these businesses probably attract a higher multiple.
Ryann Dean: I would also just add that in the consumer staples or consumer discretionary space, where you could classify these companies, the key thing that the alcohol companies benefit from is that they are a branded good.
So they don't fight the private-label competition like your generic household food provider or household goods provider will fight, right? The Pick n Pay no-name brand version. No one's drinking Pick n Pay no-name brand beer, to use that as an example.
What people choose to drink, the beer brand you choose, the spirits brand you choose, says something about you, whether at home or out at a restaurant.
And that's why it's generally been viewed as a more attractive category within the consumer goods space; you've got this brand and heritage. You don't have to fight private label at the bottom end of the pricing ladder in every single store that you're in.
The Finance Ghost: Gentlemen, thank you so much. This has been such an insightful chat. I think it shows exactly what we heard about the investment philosophy at Aylett from Dagon the first time that we engaged with him.
Just really digging in, getting to the crux of the data, asking the questions, not just going with the headlines and the sort of conventional wisdom. That's very much part of the work that you guys do on a day-to-day basis.
For those who have enjoyed listening to you and the way you guys think, go and check out aylett.co.za. You'll go and find all the information you need about the funds and all the different things going on there.
From our side, Justin, Ryann, thank you so much for your time. Really insightful. Some stuff that I need to also go and think about as I continue to write about the AB InBevs of this world and British American Tobacco. It is just a really interesting space, undoubtedly. Thank you for coming and sharing these insights with us.
Justin Ritchie: Our pleasure. Thanks for having us.
Ryann Dean: Thank you very much.
Mohammed Nalla: To our listeners, we hope you enjoyed that.
Hit us up on social media, let us know. It’s @MagicMarketsPod, @FinanceGhost and @MohammedNalla, all on X.
There's also a full transcript of the show, and we will have links to the Aylett website on there if you're interested in engaging with the team further.
We hope you've enjoyed this. Until next week, same time, same place. Thanks and cheers.
