Premium Spirits Drive A Premium Valuation For Beam

By Stephen D. Simpson, CFA | May 31, 2012 AAA

With bad news seemingly rolling in every day about the economic conditions in one part of the world or another, I can understand the flight to quality/consistency that has pushed up some well-known names. But while I understand the appeal of a stock like Beam (NYSE:BEAM), I still don't want to overpay for an asset that is unlikely to bail me out with exceptional growth. So while Beam is certainly a global spirits company worth watching, it will have to pull back a fair bit before the valuation looks truly appealing.

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Growth Isn't Much of a Problem
Although the spirits business as a whole is not a torrid growth market, quality companies with operating leverage are finding plenty of growth potential.

Around a month ago, Beam reported that revenue rose nearly 12% (on an adjusted basis), with 9% volume growth and a favorable mix shift. North America led the way with nearly 13% growth, though Europe did grow faster on a constant currency basis. Curiously, the company's so-called "Power Brands" delivered 19% growth, while the "rising stars" grew 16%.

Done right, the spirits business can be quite lucrative, and Beam saw good leverage this past quarter. Gross margin improved more than two points, with adjusted net income improving about 17% and strong growth (better than 19%) in North America.

SEE: A Look At Corporate Profit Margins

Additional Opportunities Here and Abroad
With the old Fortune Brands now broken up, Beam management can really focus its attention on addressing multiple growth opportunities. In particular, I see three meaningful avenues for growth.

The first opportunity is in growing the bourbon category on an international basis. While whiskey is pretty popular around the globe, American bourbon has yet to capture the same enthusiasm as other subtypes like Scotch whiskey. So not only can Beam try to grow the relatively small global presence of brands like Jim Beam and Maker's Mark, but there should be relatively little direct competition. Only Brown Forman (NYSE:BF.B) has a major presence in bourbon, while companies like Diageo (NYSE:DEO), Bacardi and Pernod Ricard do not.

Beam also has the opportunity to increase its North American share in market segments where it does not have a historically strong position. Vodka, rum and gin are sizable categories in the U.S., but Beam's brands hold a relatively small share. The question is whether Beam can convince drinkers to give brands like Effen or Cruzan a try, or whether they need to consider additional acquisitions (including, perhaps, Constellation's (NYSE:STZ) Svedka brand) like the recent deal for Pinnacle Vodka.

Last and not least is the broader question of growth by acquisition. While Beam has single-digit market share and a fair bit of debt, it is the fourth-largest spirits company in the world. That means that there are numerous companies/brands out there with quality products and insufficient or inefficient distribution.

SEE: The Evolution Of Sinful Investing

The Bottom Line
Owning a liquor business, or at least a liquor business with major popular brands, is a veritable license to print money. With spirits market share on the rise over the last decade (at the expense of beer and wine) and even more potential in emerging markets, this is a good place to be for the long term.

All of that said, Beam's potential has to be evaluated next to what is already in the price. On the basis of backward-looking metrics like EV/EBITDA, the company already trades at near-parity with the much-larger Diageo. While I don't discount Beam's above-average growth potential, even steady low-teens compound free cash flow growth produces a fair value target below today's price. Accordingly, for the time being at least, there may be more value in Maker's Mark than the maker of Maker's Mark.

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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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