Brown-Forman Another Example Of Overpaying For Safety

By Stephen D. Simpson, CFA | June 03, 2012 AAA

As has been the case with other names in the spirits business like Diageo (NYSE:DEO) and Beam (NYSE:BEAM), investors seem comfortable overpaying to own the stock of Brown-Forman (NYSE:BF.B). Certainly there is a growth angle to this story, as the company looks to extend its world-leading share in bourbon to new markets like China. That said, even high single-digit free cash flow growth isn't enough to push the fair value estimate to an attractive level.

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A Reasonable Close to the Year
Brown-Forman reported respectable results for the fiscal fourth quarter. Although reported net sales was up just 1%, that was better than expected. What's more, the underlying sales growth was more on the order of 10%, and the company continues to see a good recovery in its core Jack Daniel's business, as well as growth from new brand extensions like Jack Daniels Tennessee Honey.

Margins and profits were OK, but not quite as strong as sales. Gross margin (excluding excise taxes) improved more than half a point, and underlying operating income did grow 13%. Nevertheless, the company did post a slight miss for the quarter and guidance for the next year wasn't exactly blistering.

SEE: How To Use Price-To-Sale Ratios To Value Stock

Still Largely a Single-Story Stock
While Brown-Forman is seeing better performance from its Finlandia vodka business, the reality is that Jack Daniels is still nearly 50% of the company's volume. On one hand, the fact that Brown-Forman and Beam pretty much dominate the bourbon market does reduce the risk from being so heavily dependent on one category. Still, it's worth noting that Brown-Forman management is just sitting on an old tried-and-true formula. The company has been getting more active of late in developing new flavored and premium products, and the market acceptance (at least in North America) has been pretty solid. That said, it still lacks the ability of a company like Diageo to market a wide range of brands into emerging markets and respond to whatever the consumers' tastes happen to be.

SEE: The Risks Of Investing In Emerging Markets

Just How Dependable Is This Market?
I suspect that a lot of the investor enthusiasm for names like Diageo, Beam and Brown-Forman stems from the seemingly low-risk business models. After all, people who drink tend to drink in good times and bad, and the business of spirits can look like good high-margin options when the economy gets shaky.

That's fair, but only to a point. Spirits are heavily taxed and it is worth asking if governments will resist the temptation to ratchet up excise taxes on spirits. Should that happen, consumers may be forced to consume less, switch to cheaper brands, or switch away from spirits entirely. Historically, beer companies like Anheuser-Busch InBev (NYSE:BUD) and Molson Coors (NYSE:TAP) have done a good job of fighting back on tax increases on beer and the higher per-bottle value of spirits tends to make them a more appealing target.

SEE: What Countries Get For Their High Taxes

The Bottom Line
Brown-Forman would fit in nicely with Diageo, Pernod or Bacardi, but the nature of the company's ownership is such that I wouldn't expect a sale of the company. More likely is that management will look for further deals along the lines of Chambord and Casa Herradura to augment their product offerings and better leverage their distribution channel.

While I like the Brown-Forman business and can make my peace with the company's dual-class share structure, I don't like the price. Even with double-digit returns on capital and the world's leading U.S. whiskey brand, I don't like to pay a mid-teens EV/EBITDA multiple for a business with this sort of growth profile. A discounted cash flow model likewise suggests that Brown-Forman offers little fundamental value at these levels.

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At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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