The overall direction to the stock market can have such a large impact on the direction of specific stocks, and it's quite fun to think through. Strong companies that typically command a premium valuation can really soar in an extended bull market. A great example of this is Brown-Forman Corporation (BF.A) (BF.B). The spirits conglomerate most famous for its popular Jack Daniels Whiskey brand has easily outperformed the S&P 500 since the recession.
However, this can create a sort of "trap" for investors, as sometimes the stock's appreciation outpaces the fundamentals of the business. Not only has Brown-Forman gotten ahead of itself from a valuation standpoint, but the company's fundamentals (although still solid) have notably weakened over an extended period of time. With a PE ratio at more than 30X this year's earnings estimates, Brown-Forman trades at a premium that is extremely difficult to justify (peer Diageo (DEO) trades at 24X by comparison).
We will circle back on Brown-Forman's current valuation and what it means, but we want to shine a light on the company's fundamentals first. We see some concerning downtrends that have formed over time.
We aren't overly concerned with the company's recent drop in operating margins. The major impactor here are tariffs between the US and other parts of the world such as China and the EU. The retaliatory tariffs these governing bodies have placed on US whiskey in response to Donald Trump's tariffs have squeezed pricing and profits for Brown-Forman. Assuming that an eventual deal is worked out between parties, these headwinds should subside.
We are diverting most of our attention to the company's declining FCF conversion rate and rate of return on invested capital. The company's current 15.5% conversion rate of turning $0.15 of every dollar into cash is robust, but is a steep drop from what was 20% a decade ago. The same trend has formed with Brown-Forman's CROCI. A driver behind this has been a rise in capital expenditures, which have steadily increased in recent years.
Brown-Forman has also increased its debt load in recent years. While the company has traditionally maintained a low leverage ratio (stayed under 1.5X EBITDA even during the recession), that has changed over the past four years. The current leverage ratio of 2.3X EBITDA is just below our "warning sign" threshold that a company is taking on too much debt. Meanwhile cash on hand has drifted lower, and debt now outnumbers cash by a ratio of almost 10:1.
Perhaps the most disappointing part of this is that the debt has been used to put cash in the pockets of shareholders. Shareholders receiving cash is normally a good thing, but I find it to be one of the worst ways to manage capital when it comes in the form of a special dividend that was funded with debt. It's instant gratification that steals from the future resources of the company that could have been used to invest in organic growth. Especially considering how reliant Brown-Forman is on its flagship brand (Jack Daniels contributes the majority of revenues to the company)
This brings us back to the valuation aspect of Brown-Forman. The strong positive momentum of the market has carried shares drastically higher over the years. So much so, that the share price has outpaced the earnings growth of the actual business. The earnings multiple has steadily risen to approximately 30.5X, which is a hefty 24% premium to the stock's 10-year median PE ratio.
We get a similar conclusion when we look at Brown-Forman's yield on FCF, which values a stock from a cash flow basis. The current yield of 2.04% is near decade-lows indicating that from a cash flow basis, the stock is nearly the most expensive it has been in a decade. If the company was growing enough to offset the increase in share price, these metrics wouldn't be so one-sided.
This isn't to say we are bearish on Brown-Forman the company, but a combination of outsized valuation and weakened fundamentals makes for poor investment returns. What would be an appropriate target price? You could argue that declining fundamentals warrant a reduced earnings multiple from decade norms. Brown-Forman's growth profile appears more potent than the much larger Diageo - a stock that we assigned a target multiple to of 19X. If we award a growth-based premium to the stock over its larger competitor, 22X this year's earnings would result in a target of $38 per share. Even a multiple of 25X would bring shares to $42 - still less than 52-week lows. However, this would be the absolute highest multiple that we would hear an argument in favor of.
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Disclosure: I am/we are long DEO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.