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Hadrian’s Wall was built in AD122 to help protect the Roman Empire from the ‘barbarians’ of Caledonia1 to the north. 1,902 years later, Scotland’s modern-day borders help to protect the profit margins of companies involved in an export worth more than £6bn a year: whisky2.
The rules around what is legally allowed to be called Scotch whisky are onerous. It has to be matured in oak casks for a minimum of three years. It can only be made from three ingredients – water, yeast and cereals. And most importantly of all, it has to be made in Scotland3.
It is a similar story for Cognac, a variety of brandy that can only be made from certain grape varieties grown in the Cognac region in France. It must be distilled twice, in copper pot stills, before being aged for at least two years in oak barrels4 – this increases to four years for VSOP Cognac and 10 years for XO Cognac5.
These rules may sound off-putting – to new entrants. But they ensure established producers won’t be undercut by competitors who scrimp on costs or shift production to regions where labour is cheap. This ‘barrier to entry’ gives these companies ‘pricing power’, allowing them to charge more for their product without having to worry that customers will switch to a cheaper alternative.
More importantly, it gives us the confidence that these companies can capture the full opportunity set ahead of them. And the opportunity set is enormous.
Emerging market spirits consumption
The growing middle class in emerging markets is set to be one of the main drivers of growth in the leading consumer brands sector over the long term. Yet unlike in most other categories, the premium spirits market in the developing world remains under-penetrated by western companies.
Making small inroads into this market could have a major impact on these companies’ bottom line. For example, at 15% of sales, China represents an important market for Pernod Ricard6. But although it has a dominant position in Cognac (at 38% of the market) and whisky (37%)7, the company’s brands only make up 2% of total spirit consumption8 in the country, with locally brewed baijiu accounting for 94%9.
It is a similar story in India, where 20 million people come of legal drinking-age every year10. What is most interesting about India is its love of whisky: it consumes more than 900 million cases a year, of which Scotch accounts for about 18 million11. So even though India is the biggest destination for Scotch whisky exports12, it barely registers as a proportion of that market: most people there drink local whisky which is molasses-based rather than grain-based, meaning it is typically cheaper13.
This is partly due to regulatory reasons. A tariff of 150%14 has been placed on imported spirits, preventing western brands from gaining a foothold.
There are hopes that this tariff will eventually be removed; should this happen, the question will not be how much extra demand will be created, but whether western companies will have the capacity to meet it.
Margin expansion
It is not just sales volumes that we expect to increase. While there has recently been a trend among the customers of leading brands to ‘buy less but buy better’, this has been prominent in the spirits industry for the best part of two decades.
This helps to explain why even though sales volumes have been flat, revenues have gone up, as customers have upgraded to more expensive variants.
With industry costs predominantly fixed, a percentage point of revenue growth derived from trading up or raising prices can be three times as accretive to profit margins as a percentage point of volume growth.
Founding families
The provenance and ageing process of Scotch whisky and Cognac play into this trend more than other spirits such as vodka and gin.
And often they are aided by the continuing role played by descendants of the founders – for example, the current chief executive of Pernod Ricard, Alexandre Ricard, is the grandson of Société Ricard founder Paul Ricard15.
The multi-generational mindset that founding families provide helps ensure a focus on longevity and maintaining the barriers to entry that have got them where they are today.
These barriers to entry may not last for as long as Hadrian’s Wall, but all the evidence so far suggests they are ageing just as well as the Scotch whisky and Cognac on which they are based.
1https://web.archive.org/web/20190221112558/https://hadrianswallcountry.co.uk/hadrians-wall/hadrian%E2%80%99s-wall-facts
2https://www.scotch-whisky.org.uk/newsroom/scotch-whisky-exports-2022/
3https://www.scotch-whisky.org.uk/insights/facts-figures/
4https://www.eater.com/drinks/2015/11/17/9747068/what-is-cognac
5https://www.cognac-expert.com/types-of-cognac/
6, 7 & 8JPM_First_principles___P_2022-05-31_4108017.pdf
9https://www.statista.com/statistics/1222374/china-breakdown-of-spirits-sales-by-type/
10https://www.theiwsr.com/how-do-you-tackle-the-indian-beverage-alcohol-market/
11https://www.lifestyleasia.com/ind/dining/drinks/india-is-the-largest-scotch-whisky-buyer-in-world/
12https://www.masterofmalt.com/blog/post/india-becomes-scotch-whiskys-largest-market.aspx
13https://www.linkedin.com/pulse/spirited-tides-how-india-leads-world-whisky-aakanksha-sadekar
14https://www.livemint.com/news/india/eu-liquor-cos-for-50-cut-in-tariff-11701883358796.html
15https://www.pernod-ricard.com/en/our-group/our-governance/alexandre-ricard
FOR PROFESSIONAL INVESTORS AND/OR QUALIFIED INVESTORS AND/OR FINANCIAL INTERMEDIARIES ONLY. NOT FOR USE WITH OR BY PRIVATE INVESTORS. CAPITAL AT RISK. All financial investments involve taking risk which means investors may not get back the amount initially invested. Please remember that past performance is not a guide to the future.