The Gross margin recovery begins (PRGO)
Perrigo reported Q2 EPS of $.43 vs. consensus expectations of $.44. Adjusted for Fx, EPS was $.49. Sales grew 14.3% with a 6% headwind from Fx. Organic revenue grew 17.2%, with only 4% points coming from price. CSCA organic revenue grew 21.2%, with gross margins contracting 380bps YOY and operating margins contracting 280bps. The Nutrition business grew by 31%, driven by infant formula. Upper Respiratory revenues grew 44%, driven by an extended cough/cold season and a strong start to the allergy season. CSC International organic sales grew 10.6%. Gross margins expanded by 240bps due to the inclusion of HRA. Operating margins expanded 60 bps.
Gross margins contracted 190bps in Q2 due to inflationary pressure on COGS, higher freight costs, and lower planned productivity. Gross margins sequentially improved from a 540bps YOY contraction in Q1 and expanded 310bps sequentially. The HRA contribution was 220bps. Perrigo’s gross margins have been under significant pressure with price increases that have lagged well behind cost increases, as well as from non-repeating headwinds. Management expects another 100-200bps of gross margin expansion in the 2H vs. Q1. Operating margins contracted 160bps YOY. Sequentially margins improved 230bps.
Management lowered EPS guidance for the year by $.05 from $2.30-2.40 to $2.25-2.35 due to the weaker Euro. Management raised organic sales guidance for the second time to 9-10% from 8-9%. Earlier in the week, we moved Perrigo to a top three long position. We highlighted the Euro exposure when we moved Perrigo higher. The improvement in gross margins assuages what was perhaps the largest concern of the business being impaired. The recapture of gross margins from a recovery in a cough/cold season, productivity, and pricing is still ahead. Private label goods are gaining share against national brands with the inflationary headwinds facing consumers, as seen in the following chart. Most of the catalysts we have outlined for Perrigo are still ahead of it, while others are just beginning to contribute to the results. Perrigo is a top long idea.
Accelerating traffic in Quad 4 (GO)
Grocery Outlet reported Q2 EPS of $.29 vs. consensus expectations of $.24. Revenue growth of 15.7% was 4.4% above expectations, driven by SSS of 11.2% vs. consensus of 6.8%. Average ticket drove the comp while transactions were up and improving sequentially. Gross margins expanded 40bps to 31.1%, the highest since Q3 of 2020. The purchasing environment and strong inventory turnover were tailwinds to gross margins, while product and supply chain costs were headwinds. SG&A costs deleveraged 10 bps due to higher commission costs, incentive compensation, and new store costs, which offset sales leverage.
Management described the buying environment as favorable, which is how they generally describe it. Improving in-stock levels at food retailers should be more favorable to supply. At the same time, inflationary pressures for CPG should be more favorable for consumer demand. The sequential acceleration in traffic, which is a rarity in retail and restaurants, confirms the favorable competitive environment for Grocery Outlet.
Management raised EPS guidance from $.94-.99 to $.97-$1.00. Comps are now expected to be up 8-8.5% from 5.5-6.5% for the year and 10% in Q3. EBITDA guidance was raised from $213-220M to $218-223M. Gross margin, new store openings, and capex guidance were unchanged. Grocery Outlet is a long. It currently operates in only eight states, but it is proving its ability to open nationwide with new stores in the Mid-Atlantic states. Grocery Outlet’s open runway for store growth can lead to a large valuation when SSS is accelerating and the broader economic outlook is favorable.
Water Emergency (STZ)
A Bloomberg article quoted Mexican President Andres Manuel Lopez Obrador, also known by his initials AMLO, saying, “This is not to say we won’t produce any more beer, it’s to say that we won’t produce beer in the north – that’s over. If they want to keep producing beer, increasing production, then all the support for the south or southeast.”
There is a drought currently in Northern Mexico (map included below), and the water shortage was declared a national security issue. It would behoove the beer industry to announce some more efficient uses to be seen as a partner for the country. Several weeks ago, Heineken said it could give up 20% of the rights to water it holds in Monterrey. Soda manufacturers were also called upon by AMLO to cut production to increase water supplies. The state water utility said soda producers have given access to their wells and Heineken has drilled a deep well providing water for Monterrey. There may be some additional costs for new equipment or processes, but a shutdown of the factories would set a terrible precedent for manufacturers in the country.
It would be a mistake to dismiss provocative statements by AMLO. AMLO spoke out against the mostly completed brewery in Mexicali, and Constellation Brands had to abandon its project there to build in the southern part of the country where jobs are needed, and water is plentiful. The beer industry is one of the largest manufacturing activities in Mexico. When the USDA halted imports of avocados from Mexico, the Mexican government quickly responded to restore market access. Mexico exports $3B of avocados; in comparison, beer exports are $5B. Temporary throttling of water usage during a drought when people are being rationed with water probably makes sense. The national state of emergency does give the government more power to change water usage, but the same state of emergency has been instituted once or more a year since 2015.
