This is the second of two parts. Click for part 1
In the first part of this article, I presented an overview of 10 companies operating in the liquor & spirits industry. Having a better feel for what these companies do and sell, as well as their individual situation, let’s now look at how they are priced by the stock market.
Price and profitability analysis
In the following graph, I have plotted the companies’ position relative to each other in terms of return on equity (ROE) and current P/E ratio (stock price at January 21,2011). For a better long-term understanding, I took the four-year average return on equity (2006-2009) as well as the price to average earnings ratio, with the earnings being averaged over the years 2006-2009.
(Click charts to enlarge)
The closer a company is to the horizontal axis, the cheaper it is priced by the market (low P/E ratio). The farther the company is placed to the right, the higher its average return on equity. The most expensive stock in the group is Grand Marnier. This is mainly due to its net loss in 2008 and low earnings in 2009. Rémy Cointreau (OTCPK:REMYF) comes second, having posted a net loss in 2006. Pernod (OTCPK:PDRDF), Campari, Brown-Forman (NYSE:BF.B)and Diageo (NYSE:DEO) are all roughly priced at the same level, between 19 times (Diageo) and 25 times (Brown-Forman) average earnings.
The cheapest stock in the lot is Zwack Unicum, trading at only about ten times its four year average earnings. Diageo, Brown-Forman and Zwack rank highest in terms of return on equity. Diageo has the highest return on equity, but also has a much more leveraged balance sheet.
Berentzen and Constellation did not have positive earnings over the last four years, and are thus on the lower left side of the graph.
One can also analyze at what yield the market is currently pricing the shares. This is the yield you would receive as a private owner of the company if all earnings were distributed to you. Effectively, it is the reverse of the P/E ratio. I have chosen a different method to present this value, which also incorporates the return on equity and the price to book metrics.
The equity yield is then given by a straight line in the P/B vs ROE graph, which is plotted below.
The line represents a yield of 5% (corresponding to a P/E of 20), which is arguably a minimum that a stock investment should achieve on an ongoing basis to justify the higher risk of equity.
Stock below the line are priced at higher yields and are thus cheaper, while stocks above the line are priced at lower yields, and are thus more expensive. The book value used for the graph is the latest book value from the fiscal year 2009, while the ROE is the four-year average. Grand Marnier, Rémy Cointreau and Brown-Forman are the most expensive stocks, and Brown-Forman has the added risk of trading at a high multiple of book value, while Marnier and Cointreau are trading at around double their shareholder’s equity. The stocks priced for a yield above 5% are Pernod Ricard, Campari, Zwack and Diageo. Once again, the cheapest stock is Zwack (around 10% yield), followed by Diageo and Pernod. Diageo trades at around 7.5 times book value and achieves its high ROE on a comparatively low equity base. Zwack and Pernod meanwhile trade at around double their book value. Berentzen and Constellation posted losses over the past four years and are thus on the left side of the vertical axis. Berentzen trades around book value, which could still makes it attractive regarding the restructuring story.
Next to the market pricing of the companies’ equity. Let’s have a look at the financial risks of the companies. To get a better idea of these risks, I have plotted the four year average net margin agains the companies’ current equity ratio. A higher equity ratio means less balance sheet risk, a higher capacity to sustain losses or to make important investments or make acquisitions. Higher net margins imply a higher profitability and thus a lower risk of posting losses should margins contract. The higher the company is placed to the upper right side of the graph, the lower its financial risk (low gearing and high margins). The stocks with the lowest risk in this regard are Zwack Unicum and Brown-Forman, which both have strong balance sheets and elevated margins. Diageo also has high margins, but has the lowest equity ratio of the profitable companies, and thus the highest leverage.
Campari and Pernod have roughly the same margins, with Campari having a higher equity ratio. Marnier has the second-highest equity ratio (is it surprising that the century-enduring family controlled companies are on top when it comes to financial safety?), but has the lowest margins (influenced by the last two years of below-average profitability). Berentzen and Constellation have equity ratios which can be considered safe, but have to improve their profitability.
The enfant terrible of the lot it Belvédère, whose equity has been wiped out and thus has the vultures’ attention.
Right now, you probably already have a good idea of where these companies stand. Let’s finally review the competitive position of the stocks. To this effect, I have plotted the net margin achieved by the business over the years 2006-2009 against the revenue growth during this period (OTCPK:CAGR). This segregates the companies into four categories.
Companies with positive margins, but declining revenues: Zwack and Marnier fall into this category. These companies are inherently profitable, but have seen declining revenues over the past years, and thus face declining earnings if the trend is not broken. In the case of Zwack, the sharp decline in revenue is due to the well-known recent financial troubles of Hungary. A restocking by vendors and improvement in the Hungarian economy should quickly bring it back the the second category, to the upper right: companies with growing earnings and positive margin. These include Cointreau, Campari, Pernod, Brown-Forman and Diageo. Diageo and Brown-Forman had the highest revenue growth and margins in the years 2006-2009. Pay attention to the fact that interest costs for more leveraged companies can have a strong influence on margins.
Companies to the lower right are companies with growing sales, but negative margins. This is often a result of overly aggressive expansion where pricing is not under control. The only company in that category is Belvédère. Belvédère had the highest revenue growth over the past four years, but did not turn these into a profit.
The last category (lower left) comprises companies that faced both declining revenues and negative net margins. Constellation brands (14% annual earnings decline 2006-2009) and Berentzen (1% decline). Both companies have issues regarding revenues and profitability and should thus be viewed as turnaround candidates.
This concludes my review of the listed liquor & spirits industry. I hope readers now have a clearer look on what the strengths and weaknesses of the individual companies are, and their relative valuations and market positions. Maybe you have even discovered a new potential investment or a reason to sell your holding. The data presented did not take into account the fiscal year 2010, about which most companies will soon report - it will be interesting to see which trends have turned or have been confirmed. Please be reminded that the complete picture requires a detailed individual analysis of each company’s annual report and current situation and you are encouraged to conduct your own due diligence. And a final warning: as exciting as these companies’ products might be, consume them in moderation – and don’t drink and trade.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: I am long Zwack Unicum. I have indirect ownership of Pernod Ricard through stock of Compagnie Nationale à Portefeuille (NYSE:CNP) which controls a significant stake in the company.