The alcoholic beverage sector has beat expectations during the pandemic because premium pricing and strong off-premise demand has offset weak on-premise sales, particularly in North America. Still, not all rated issuers have been able to shrug off the impact of bar and restaurant closures, particularly in regions where on-premise consumption represents a larger share of aggregate demand. With new waves of infection leading to more lockdowns in some countries, some ratings may remain strained for longer than expected despite much of the sector's resilience, its ongoing healthy cash flow generation, and a likely limited appetite for larger mergers and acquisitions (M&A).

Here, we highlight the pandemic's disparate impact on and recent trends in the sector. We also highlight those companies that are best positioned to benefit from market dynamics, and what ongoing lockdowns mean for those issuers that still have negative rating outlooks.

Industry Trends

The alcoholic beverage sector continues to benefit from premiumization.  The trend toward premium pricing, particularly in Spirits, hasn't let up despite the pandemic. Pricing continues to drive growth for global spirit companies enabled by innovation and product extensions of their core iconic brands as well as fiscal stimulus in certain economies such as the U.S. (see chart 1). Within the U.S. spirit category, we estimate the price/mix value contribution increases 7% year over year during the second half of this year. For example, from July through December, Diageo PLC's super premium segment significantly outperformed all others posting 14% year-on-year organic revenue growth. Brown-Forman Corp. too posted good organic growth by successfully launching several line extensions to its core Jack Daniel brand, while others also launched several premium offerings (often craft) in the fastest growing Spirits categories, which include Gin, Bourbon, Tequila, and to lesser degree cognac in select emerging markets like China. We expect premiumization to keep benefiting the spirits sector because many of these categories remain underpenetrated outside their respective home markets, positioning those brands to accelerate market share gains once an economic rebound takes hold. Premiumization is also playing an increasing role in the beer category. In the latest current trading update (first quarter of 2021), Anheuser-Busch InBev S.A./N.V. posted an annualized revenue growth from its premium portfolio of about 28%. Its premium offerings now represents more than 30% of its portoflio, up from a 24% contribution back in 2017.

Chart 1

Off-Premise Sales Rebound

We expect still weak off-premise sales to rebound in the second half of this year, with the sector restoring sales to prepandemic levels by next year.  A rebound in the on-premise channel remains elusive in many economies as second, third, and fourth waves of the pandemic continue to cause economic shutdowns. The related repercussions have been particularly acute in regions more exposed to on-premise consumptions such as Southern Europe and South America, where on-premise consumption constitutes a significant share of demand (ranging from 30% to 50% of consumption depending on the countries) than in countries such as the U.S. (about 20% of total share). Still, with vaccinations accelerating globally, and pent-up demand for travel and entertainment building, we expect a significant rebound in on-premise consumption by the second half of this year, and believe most issuers in the sector will be able to restore sales to prepandemic levels by 2022 with a rebound in on-premise volume and improved pricing as economic growth likely picks up.

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Hard Seltzer Opportunities

Hard seltzer is an important growth category for under-pressure brewers to tap into, but largely confined to the U.S. market.   Beer category sales continue to lose share to spirits reflecting demographic changes, with the older population opting for premium spirits and wine offerings while the younger demographic is more calorie-conscious and consume in lower quantities while also seeking alternative consumption occasions. Given this backdrop, beer has steadily lost 1 to 2 percentage share points to wine and spirit for each of the past five years (based on Euromonitor data), a trend that is projected to perpetuate for the next two to five years. While premium beer imports remain an important offset to share losses for brewers in mature markets like the U.S., hard seltzer is the fastest-growing category outside wine and spirits the brewers want to capitalize on, growing at mid- to high-single digits. Although we believe the hard seltzer growth is a secular trend that will last, underpinned by a flavor profile that resonates better with younger and female demographics, we believe it will likely remain a growth trend primarily for the U.S. and Australian markets (and to some degree in few other European markets) and not necessarily for other regions. Moreover, it continues to make less than 5% of total beer sales in the U.S. and an even smaller share of total alcoholic beverage sales. In short, participating in the hard seltzer growth is a competitive priority for the brewers we rate, but it's unlikely to significantly improve their growth outlook given its modest share of overall portfolio volumes.

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Tariff Issues

The tariff landscape has improved, which reduces event risk associated with international trade.  In October 2020, the U.S. imposed a 25% tariff on selected alcoholic beverage categories, including wines (from France, Spain, Germany, and U.K.), single smalt scotch whiskey, and Irish whiskey; to which the EU responded by imposing 25% tariffs on U.S. drinks such as rum, brandy and vodka. In March of this year, the U.S. and EU announced an agreement to suspend the tariffs (including certain retaliatory tariffs related to the aviation industry) for four months. Although a final agreement to the trade dispute about these tariffs isn't yet resolved, the suspension lowers the risk of an escalation in trade tensions for global sprits companies such as Bacardi Ltd., Diageo, and Pernod Ricard, and should further restore confidence in a global industry rebound.

Brewers Are Challenged

Brewers face a slower recovery than Spirits manufacturers.  The degree of on-premise exposure has been the most relevant driver of performance during the pandemic. Beer volumes are more exposed to on-premise volume pressure than spirits, which benefit more from premium pricing to offset lost on-premise and travel retail volumes; whereas, beer consumption occurs at higher rates on-premise than spirits such that fewer visits to the pub have a higher impact on lost sales volumes. Therefore, a portfolio that's more reliant on the on-premise channel (e.g., national beer brands) is likely to face ongoing near-term volume pressure. To that end, it's no surprise that our rating outlooks on global brewers such as Molson Coors Beverage Co., Anheuser-Busch InBev S.A./N.V. (ABI), and Heineken N.V. remain negative, albeit the latter two should benefit more from a post pandemic emerging market economic rebound because their portfolios' are positioned to leverage growth in those regions.

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Delayed Recovery In Some Developing Economies

Emerging markets still represent upside, albeit with higher volatility.  The degree of on-premise exposure varies by region. Generally, emerging markets have a higher exposure to the on-trade channel than mature economies. This, coupled with a less stable regulatory environment, is adding earnings volatility to some rated issuers. Government regulation is creating a less stable framework to plan for long-term investments within the industry. For example, the Indian government imposed a temporary ban on alcoholic product sales (lifted in May 2020 after 40 days) with the aim of imposing a more stringent COVID-19-related lockdown. The decision created substantial disruption in the end market and within the supply chain. Similar measures have been implemented in other emerging economies, such as in some regions in Mexico and South Africa. Moreover, illicit trade and the risk of consumer trading down to more value-based options are additional constraints on volumes and margins.

By contrast the U.S. market exposure to on-premise is close to 20%, so companies primarily selling in the U.S. are comparatively better off. This would include Constellation Brands Inc. whose flagship Modelo and Corona brands in the U.S. (where Constellation has exclusive right to sell) are still gaining market share given favorable demographic trends for those premium imports brands in the U.S., particularly in the off-premise channel.

Despite near-term headwinds, we believe positive long-term trends for emerging markets are still in place.  This assumption is mainly supported by a growing middle class and ongoing trade-up from regional products to global-branded leaders. Moreover, spirits penetration is still relatively low compared to more developed markets, providing greater potential for future growth. Still, we don't expect emerging markets to return to prepandemic levels until well into next year and possibly not until 2023.

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Trends in Asia and Latin America

Both Diageo PLC and Pernod Ricard S.A. have about 40% of their sales coming from emerging markets, with India being one key contributor for both companies. In India, Diageo manufactures and sells Indian whiskey, rum, brandy, and other spirits through a controlling stake in United Spirits Ltd., while in Greater China, Diageo has a controlling investment in Sichuan Shuijingfang Co. (not rated), which manufactures and sells baijiu (Chinese white spirit). India and China combined represent about 10%-15% of Diageo's sales, in our view. Pernod Ricard has higher exposure to these two markets with India accounting for about 11% of total sales in 2020 and China at around 9%, mainly thanks to its broad whiskey portfolio in India and its cognac brand in China.

So far, the Chinese market is showing strong momentum across all channels. Positive developments in volume, price, and mix, supported by sound performance during the Chinese New Year, bodes well for growth prospects. Industry trends in China include a higher penetration of international spirits (in particular, brandy, whiskey, and vodka) in a country still dominated by the local spirit category (baijiu), and the ongoing acceleration in premiumization with a potential for higher prices.

In India, there's been a more gradual sequential improvement since the second half of last year. However, due to the accelerating rate of spread of COVD-19, we lowered our industry projections for the country. We now expect it will take longer to return to pre-pandemic levels compared with other emerging markets. The Indian market is generally dilutive in terms of overall profitability for the global alcoholic players and we don't exclude future consolidation as a way to drive profitable growth.

Recent performance trends in Latin America are better than expected. Despite the pandemic, sales in key countries in the region (namely Brazil and Mexico) have been resilient primarily driven by good demographics, per capita consumption increases, and ongoing premiumization. Within the beer segment, both ABI and Heineken reported good developments in Brazil (a key beer market) with a better than expected start to 2021. According to ABI, its beer segment volumes were higher than pre-pandemic levels with volume increasing close to 16% year on year. Also, the spirits category showed sequential improvements after a steep decline in the first half of 2020 (at the beginning of the pandemic). For example, Diageo posted an organic revenue decline of 40% in the Latin America and Caribbean regions in the first half of 2020, while in the second half organic sales were broadly neutral on annualized basis. Still, the rollout of vaccination is much slower compared with mature markets. This continues to be a key risk for the industry that could lead to further government lockdowns. Moreover, on a reported basis companies' earnings will be hurt by negative currency mix.

Spending Cuts, Fewer Shareholder Distributions Helped Stabilize Credit Measures

Aggressive cost-cutting, capex reduction, and fewer shareholder returns are preserving cash flows and other credit measures.  Pandemic-related cost-cutting has met and even exceeded our expectations, while capital expenditures (capex) have been prudently pared back closer to maintenance levels. This has enabled companies to steady their EBITDA and cash flows and keep credit measures from materially weakening. Most companies have significantly reduced operating costs by anywhere from 5% to 20% year over year since the pandemic's onset. A significant portion of companies' operating expense are variable, consisting of marketing and promotional expenses while discretionary administrative expenses like travel and executive bonuses have also been cut. Capex for the sector too has been reduced with most companies cutting spending below deprecation levels. This has kept the sector with strong free cash flow conversion. In fact, most companies we rate have been converting close to 50% of EBITDA into free operating cash flows.

We expect companies to increase advertising and promotional expenses as the on-premise channel reopens more broadly.  However, the discretionary nature of these expenses will likely enable them to do so at a measured pace. Most will seek to ensure that a rebound in sales volumes offsets incremental spending. So, despite a likely increase in marketing and promotional spending, lost EBITDA will likely steadily return to prepandemic levels over the next two years.

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Shareholder returns have been pared back as well, and will likely remain so, particularly for those companies facing more topline pressure.   The majority of rated peers cut shareholder returns in 2020, and several by more than 30% year over year. As an example, for 2020 ABI has decided not to pay an interim dividend and to reduce the annual dividend payment to €0.50 per share (from €1.30 for the previous year).These prudent actions have enabled companies to largely offset the negative impact of lower EBITDA on their debt leverage. In fact, few companies have had leverage ratios spike more than a half-turn above our downgrade triggers because of their aggressive responses. Such tactics will likely enable leverage to return to targeted levels to the extent demand rebounds as expected over the next 12 to 18 months. With this outlook, some companies may consider increasing shareholder returns again. Following better-than-expected performance in the first half of fiscal year 2021, Diageo announced in its most recent earnings report that it's recommencing its share buyback program of up to £4.5 billion (by 30 June 2024) suspended in 2020 because of the pandemic.

Adjusting To Evolving Business Dynamics

The sector continues to adapt to secular change, including pivoting to more online delivery, increasing digital marketing, and prudently managing social risks around responsible alcoholic beverage consumption.   More at-home consumption of alcoholic beverages has led to higher digital sales, albeit still modest compared to overall distribution, making up less than 5% of off-premise sales by our estimates (see chart 9). Although the social nature of drinking means there will always be a large on-premise share of consumption that will keep the online mix of sales lower than the broader branded consumer product sector (which we believe may approach 15%-20% consumption share in the coming years), it nonetheless will continue grow as a channel. China is the country with the largest alcoholic beverage e-commerce footprint, given that it has a much larger online delivery presence across all consumer products. In the U.S., online alcoholic beverage companies like Drizly (not rated) are aggressively expanding their footprint nationally and e-commerce sales are already 10% of off-premise sales according Euromonitor. Because of the three-tier distribution system in the U.S., where producers, distributors, and retailers must operate separately, doing business online doesn't present a different margin structure, and only presents a competitive threat to retailers. In other mature markets like Western Europe, e-commerce sales vary by country. France and the U.K., for example, have a much larger e-commerce presence (closer to 10%) compared with Germany and Italy where share remains below 5%. As a result, we don't expect e-commerce expansion to be uniform across these regions and, therefore, will have less of an impact on the industry.

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Companies have had to change their marketing strategies to become more digital during the pandemic.   Traditionally, the sector uses the on-premise channel to test innovation and introduce new products. With the on-premise option still closed in many important regions, the sector has turned to more targeted advertising on social media, which also can be more cost effective. In addition, it's easier to target more specific demographic groups. Social media is increasingly becoming an important medium for companies to promote responsible alcoholic beverage consumption, which is an important social risk for the sector, given the health risks associated with excessive alcoholic consumption and the hazards of driving while under the influence.

The Sector Outlook Remains Modestly Negative

Avoiding downgrades will hinge on stabilizing performance more than on financial policy or pursuing aggressive M&A.  Although the sector has performed better than expected during the pandemic, a third of the sector still has a negative outlook. Sales and margin pressure caused by the pandemic underpin most negative outlooks—more so than financial policy. Companies have demonstrated a commitment to sustain good free cash flow and stable credit measures through actions like cost-cutting and reducing shareholder returns. Moreover, companies integrated a flurry of larger mergers several years back. Today, large and transformative M&A aren't as likely, given the degree of consolidation in the sector and the importance of managing portfolio mix and product innovation for better growth.

Hard seltzers remain a hot trend. Brewers that are facing market-share losses could consider acquiring market share in hard seltzer but, so far, they appear more committed to leveraging existing brands to penetrate that category rather than look for acquisitions, which would likely come at a steep premium and pressure ratings. Despite remaining committed to keeping ratings stable through prudent financial policy decisions, rating pressure may persist for those issuers whose outlooks remain negative to the extent the pandemic further delays an operating rebound that would otherwise enable them to strengthen their balance sheets more quickly. Therefore, avoiding downgrades will continue to hinge on how well companies manage cash flows through prudent cost and investment management. In that regard, companies with negative outlooks have largely met our cash flow expectations, but an on-premise rebound has yet to materialize across many of their key markets.

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