Brown-Forman May Struggle To Keep This Premium

By Stephen D. Simpson, CFA | December 07, 2012 AAA

When times get tough, investors will hit the bottle. Although sales of beer and spirits aren't quite as invulnerable to economic conditions as some investors like to believe, they are a lower-beta product category. All of that said, and allowing for the good success seen lately in promoting new internally-developed products and boosting margins, it's hard to see how Brown-Forman (NYSE:BF.B) keeps its elevated premium for the long haul.

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In-Line Results and Better Margins in Fiscal Second Quarter
While there were a few deviations here and there on the details, Brown-Forman basically delivered the quarter that investors expected of it.

Reported revenue was flat, though down slightly net of excise taxes. Underlying sales were up about 6%, with half of that coming from price/mix. While Jack Daniels continues to show some strength (up 9% year to date) and Southern Comfort is reviving (up 2%), elevated inventory levels could be a threat as the year moves along.

Brown-Forman did reasonably well on the operating lines. Gross margin improved more than three points (more than sell-side analysts expected). Operating income rose more than 6%, and while operating margin did expand by more than two points, the company did give back some of that gross margin outperformance with higher-than-expected SG&A spending.

Headwinds Could Blow Harder in the Coming Quarters
All in all, I think the underlying trends at Brown-Forman are in decent shape. Like Diageo (NYSE:DEO), Beam (NYSE:BEAM) and Pernod (OTC:PDRDY), Brown-Forman is seeing a reasonable tolerance for price hikes and those hikes are sticking. That said, it looks like customers/distributors bought ahead of these hikes and there could be some risk of de-stocking compressing growth in the coming quarters.

Brown-Forman is also going to start rolling into the anniversaries of sizable new product launches (Jack Daniels Honey) and the Hopland-based wine business. That should put some pressure on the growth and margin comps.

Scale Still a Challenge
Brown-Forman is the strongest player in United States whiskeys and has more than just a toehold in markets like vodka and tequila. Moreover, the company's solid margins and returns on capital speak well to the quality of the business.

That said, I do wonder if the company is going to find it harder to improve those numbers significantly. Brown-Forman can't match the global distribution capabilities of Diageo, and distribution is an underappreciated facet of the spirits business. What's more, the family ownership of the company likely means that a sale or merger of equals is a non-starter. There are smaller deals that the company can do to add brands and distribution, but I have to wonder if this will cap the company's long-term free cash flow margin potential.

It's also worth noting that Brown-Forman is not so large that fads can't influence the business. Bourbon seems to be reviving as a category, but if consumer tastes shift again (say, to gin) it may be harder for Brown-Forman to adjust.

The Bottom Line
I have virtually no qualms with the quality of this business, and I think management's decision to pay a special dividend of $4 per share before year-end is a reasonable and logical distribution of capital. Where I have my issues is in the valuation on this company.

Brown-Forman simply cannot grow fast enough anymore to justify a mid-teens EV/EBITDA. Likewise, on a free cash flow basis, even if Brown-Forman ultimately outdoes Diageo on margins and free cash flow generation (and pushes into record territory in the mid-20%s), revenue growth has to more than double from the trailing ten years just to reach today's stock price. That seems like a set-up for disappointment, and I would not be a buyer of Brown-Forman today.

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

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