Constantinis
Unexpectedly stronger headwinds from foreign exchange and input costs aren’t exactly unusual today, but they are combining to make life more challenging for Brown-Forman (NYSE:BF.A)(NYSE:BF.B). On top of that, the underlying volumes in spirits aren’t really that exceptional and the stock remains richly-valued by most approaches.
These shares are down around 10% since my last update, underperforming consumer staples (the Consumer Staples Select Sector SPDR Fund (XLP)) overall and names I preferred back in the day like Diageo (DEO) (that article is here) and Pernod Ricard (OTCPK:PRNDY) (that article is here). Still, while the long-term returns haven’t been bad at all (a double-digit annualized total return over the last 10 and 15 years), the valuation today is no clear bargain to me, and I don’t really find this a compelling idea even after the sharp post-earnings reaction.
Forex Winds Blow More Fiercely, Undermining Brown-Forman’s Reported Results
Brown-Forman’s fiscal second quarter results were no disaster, but there were definitely some shortfalls in the results and guidance that worried the Street.
Revenue rose 16% in organic terms, good for a small (around 1%) beat versus the sell-side expectations. Shipments grew 13% and price/mix was up 3%, the latter beating the Nielsen category average of 2%. Excluding changes in distributor inventories, net underlying growth was around 11%, suggesting high single-digit underlying volume growth.
Gross margin declined 340bp to 56%, missing by over 400bp. Forex drove the miss, but the company is nevertheless experiencing elevated input, supply chain, and fulfillment costs as are most other companies. Operating income declined 2% as reported, missing by about 12% (or around $0.06/share), while organic operating income rose about 8%. As reported, operating margin declined 380bp to 28.6%.
Guidance was very much a mixed bag. Management raised its full-year target from mid-single-digit organic revenue growth to high single-digit growth, but that means relatively flat underlying performance in the second half. While management did guide to organic operating income growth in the high single-digits, the Street was nevertheless disappointed with the weaker gross margin guide.
Normalizing Inventories And Some Growing Risk Of Trade-Downs In Calendar 2023
Brown-Forman has been benefiting from inventory replenishment, and the company has been shipping overseas ahead of consumption to offset ongoing logistics/shipping risks. I do expect, though, that this inventory replenishment cycle is close to the end, as most indicators of distributor inventories suggest healthy levels now.
The end of this replenishment cycle does create some challenges for volume growth, but volume growth is actually not a new challenge here. Volume growth in Brown-Forman’s core spirits portfolio has actually been rather modest relative to pre-pandemic levels, with volume growth in the neighborhood of 2% versus overall whiskey volume growth of around 3.6% as per Nielsen data. Most of Brown-Forman’s growth over that period has been driven instead by its wine and ready-to-drink products, and while I’m sensitive to the “growth is growth” argument, there’s more margin leverage in the core spirits portfolio.
Looking at the next year or so, I do see some challenging trends ahead. Consumption trends in spirits are difficult to predict, but whiskey has been underperforming over the last three years (by about 100bp), with tequila still far and away the fastest-growing category outside of ready-to-drink.
On top of that, with the economy slowing, I do see a risk of consumers trading down to lower-priced options among their preferred categories. Demand has been relatively healthy for Brown-Forman in its premium categories, and the company launched multiple super-premium products earlier this year, but I am concerned that weaker consumer discretionary spending could stall out some of the company’s mix leverage in the short term.
The Outlook
I don’t see anything fundamentally broken or worrisome about Brown-Forman’s business. Shifting consumer tastes are an ever-present risk, but there’s good brand value here in the Jack Daniels portfolio, as well as Herradura tequila, and I do think the start of Generation Z reaching legal drinking age can help underlying volume growth trends. International growth is harder to predict – China hasn’t really developed much of a taste for American whiskies, but with the country accounting for more than 20% of global spirits consumption volume, it’s nevertheless still an important potential market.
I’m looking for long-term revenue growth of around 4% (against a long-term trailing average of around 4.5%). I do think Brown-Forman will have the option over time to make strategic acquisitions, but I’m not factoring that into my modeling assumptions. I do see margin leverage opportunities, particularly if the company can drive better volumes in its super-premium categories and scale up in areas like ready-to-drink, and I believe low-to-mid-20%’s FCF margins are achievable (against a long-term trailing average in the high teens). If this is achievable, 5% to 6% FCF growth is reasonable (against a trailing average closer to 7%).
Brown-Forman isn’t anything close to undervalued (let alone “cheap”) on a discounted cash flow approach; if my long-term cash flow growth assumptions are reasonably accurate, it would take a discount rate in the 4% to 5% range to get a fair value in the high-$70’s. Looking at EV/EBITDA, there’s a fairly good historical relationship in the spirits sector between ROIC and EBITDA multiples, and a low-20%’s ROIC supports a forward multiple of 27x (not far off the five-year average forward multiple of a little over 25x). At 27x my 12-month EBITDA estimate, fair value would be around $72.
The Bottom Line
As has usually been the case with Brown-Forman, my biggest issue with the stock is the valuation. I can appreciate some of the flight-to-safety arguments for a stock like this, but I believe the valuation more than reflects those positives. I do see opportunities for Brown-Forman to outperform expectations over the next few years (increased acceptance of premium/super-premium products, share gains, international growth, et al), but at this valuation I think that outperformance is more of a “must have” and I just don’t see a good argument for the shares at this price.
Be the first to comment