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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