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.

Guide To Oil And Gas Plays: We've got your comprehensive guide to oil and gas shales in North America.

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.

Related Articles
  1. Stock Analysis

    3 Resilient Oil Stocks for a Down Market

    Stuck on oil? Take a look at these six stocks—three that present risk vs. three that offer some resiliency.
  2. Economics

    Keep an Eye on These Emerging Economies

    Emerging markets have been hammered lately, but these three countries (and their large and young populations) are worth monitoring.
  3. Stock Analysis

    Is Pepsi (PEP) Still a Safe Bet?

    PepsiCo has long been known as one of the most resilient stocks throughout the broader market. Is this still the case today?
  4. Investing

    The ABCs of Bond ETF Distributions

    How do bond exchange traded fund (ETF) distributions work? It’s a question I get a lot. First, let’s explain what we mean by distributions.
  5. Stock Analysis

    3 Stocks that Are Top Bets for Retirement

    These three stocks are resilient, fundamentally sound and also pay generous dividends.
  6. Investing News

    Are Stocks Cheap Now? Nope. And Here's Why

    Are stocks cheap right now? Be wary of those who are telling you what you want to hear. Here's why.
  7. Investing News

    4 Value Stocks Worth Your Immediate Attention

    Here are four stocks that offer good value and will likely outperform the majority of stocks throughout the broader market over the next several years.
  8. Investing News

    These 3 High-Quality Stocks Are Dividend Royalty

    Here are three resilient, dividend-paying companies that may mitigate some worry in an uncertain investing environment.
  9. Stock Analysis

    An Auto Stock Alternative to Ford and GM

    If you're not sure where Ford and General Motors are going, you might want to look at this auto investment option instead.
  10. Mutual Funds & ETFs

    The 4 Best Buy-and-Hold ETFs

    Explore detailed analyses of the top buy-and-hold exchange traded funds, and learn about their characteristics, statistics and suitability.
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  5. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  6. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>

You May Also Like

Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!