Why I'm Still Bullish On Brown-Forman

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About: Brown-Forman Corporation (BF.A), BF.B
by: Ian Bezek
Summary

I recommended Brown-Forman stock as my first pick of 2019; it's up 30-35% since then as part of the trade into dividend and defensive stocks.

The stock isn't a strong buy anymore, but for long-term investors, it's still a great holding.

If you own the B class of Brown-Forman stock, this is a great time to consider swapping into the A class of shares.

The A shares, despite having more economic value than the B shares, are trading at a 4% discount due to liquidity issues.

On January 2nd, I published my first article of the year, calling Brown-Forman (BF.A) (BF.B) a "solid defensive pick" that was well-priced and could shelter investors from the market turbulence we were facing at that time. It's had a nice result. BF has done more than play defense - in fact, it's up 30% or 35% year-to-date (more on that discrepancy in a moment).

With those gains, Brown-Forman stock has now topped last May's peak to hit new all-time highs. That probably shouldn't come as a surprise. With interest rates slumping, dividend stocks are back in favor. Many Dividend Aristocrats are now at or near new highs as investors have moved back toward growth and income names.

Brown-Forman, for its part, has some tariff issues, but nothing that's a serious obstacle to the company's long-term business strategy. Hence the stock going up even more:

This has brought out the usual Brown-Forman skeptics, who point to the company as being overvalued. While I'll stand by my claim that B-F stock was most reasonably priced in January, it's back to being at a fairly ambitious valuation again today.

Which gets back to the question, why buy a stock like Brown-Forman in the first place? Are we buying for rapid short-term gains, or are we purchasing with the intention of getting an impeccable quality growth and income asset with unique pluses (family ownership, good balance sheet, fantastic brand, and extremely high profit margins) in a recession-proof industry.

I commented on a recent article that addressed Brown-Forman's valuation, saying:

If you plan to sell the stock within the next two year, BF could reasonably end up somewhere between $50 and $75 by the end of 2021. [The then stock price of $58] is hardly compelling. If you plan to hold for at least a decade, it's hard to envision BF stock not being worth at least $100 even assuming below average EPS growth for the firm and a normal PE ratio compared to its historical median.

BF stock almost always looks expensive in the short-run. It almost always looks underpriced with hindsight if your holding period is considerable. Up to you. I own a lot.

B-F has been growing earnings around 7%/year since before the financial crisis. As such, it should double earnings again over the next decade, putting us at close to $4 of EPS in 2029. A 25x P/E ratio on that gets us a $100 stock. We're at about 32x forward P/E now and B-F stock historically trades around 30x so 25x is fairly conservative. If the P/E ratio stays up at 30x, then we have a $120 stock in a decade.

Assuming a 2% average dividend yield on cost over the stretch (this factors in dividend growth plus the occasional special dividend that BF tends to pay) you get annual returns of 7.6% if the stock is at $100 a decade from now, and 8.9% annually if the stock ends the next decade at $120 (based on a starting price of $58 per share).

Now let's imagine you bought BF stock in January at $47 when I last recommended it. Run the same calculations out to 2029, and you get annual returns of 9.5% (if it ends at $100) or 11.3% (if it ends at $120).

To summarize, here's what you can expect to get from your purchase from the following starting points:

  • BF stock at $47 - 9.5-11.3% annual returns for the next decade
  • BF stock at $58 - 7.6-8.9% annual returns for the next decade

Now, obviously, we'd rather buy at a sale price than full price. An expected return of 10%/year beats 8%/year. But both of these will absolutely smash bonds and fixed income, and if the stock market is overvalued crowd end up being right, you'll be far happier owning BF stock even from this starting price then you would be owning an index fund from S&P 3,000. Given the current investing environment, particularly in fixed income, getting a low-risk high-probability 8%/year from Brown-Forman is right near the top of list for places I want to park investment capital for the long haul.

Part of the value I add at Seeking Alpha is to remind folks when great companies are available at reasonable prices like Brown-Forman on January 2nd this year.

You aren't going to hit many home runs with short-term trading in a stock like BF, but you can add a lot of alpha to your long-term returns buying quality when it goes on sale. An ideal long-term stock holding is one that rallies at least as quickly as the overall stock market - as B-F has done this year, but which drops far less during bear markets.

When Is It Worth Buying?

Chart

Data by YCharts

This chart is off for 2016-17 thanks to unusually high earnings which resulted from a one-time profit from selling brands.

Historically, B-F has traded above 25x earnings for most of the past decade, and has settled into a consistent range between about 27x and 35x earnings. At the moment, we're approaching the top end of that range - so there's no reason to feel the need to rush out and buy more BF stock tomorrow. We should get another chance to buy at or under 30x trailing earnings - BF stock dips back under that level fairly regularly.

However, the people saying they are going to wait for a big correction to buy will likely not get to buy BF stock anytime soon. This stock isn't going back to 18x earnings, let alone 15x barring a catastrophe. And with earnings steadily going up 5-10%/year, the fair value for BF stock moves up pretty quickly.

To give an example, my average cost basis is a touch under $40 (largely established in 2016-17) and that's already only 21x forward earnings. There's a good chance BF stock will never trade back to my cost basis again, despite the position being only a couple years old. And people still said the stock was "too expensive" when I was buying it then. Don't underestimate how quickly the intrinsic value of companies rise when their earnings steadily climb and are resistant to economic downturns.

If you want to own a stock like this, know you'll have to pay a fair price for it, and be prepared to make a move when it does correct 15 or 20%, as it did this past winter.

Tariffs: The Latest Scare

Look at Brown-Forman's Q4 2019 conference call transcript, and the word tariffs was mentioned 37 times. In fact, management even referred to this as the year of the tariffs:

So rather than remember fiscal '19 as the year of tariffs, we'll change the headline to be 2019 remembered as the year we continue to invest in momentum across the portfolio and we delivered balanced growth across many geographies and brands.

Brown-Forman estimates that the tariffs are having a $125 million annual impact on the business - given that it has sales of $3.3 billion annually, that's a fairly consequential number - more than 3% of the overall business. From that, we see a sign of Brown-Forman's strength; more than 60% of European whisky imports are of Brown-Forman products - that's some beautiful market share.

Regardless, both revenue and earnings growth will be down this year due to the tariffs. Sales are growing around 5% annually, while EPS gains are closer to 2% or so. Without the tariffs, earnings would have been up more than 5%.

In other words, this is a tempest in a teapot. B-F makes slightly less money this year, and then they'll get a bigger than usual earnings growth year in 2020 or whenever the tariffs situation resolves to normal. If you are playing the quarterly earnings report game, the tariffs are a major concern. If you are a long-term investor, these tariffs are irrelevant to the stock's value.

As the company notes, the four hottest spirits trends right now are whisky, gin, tequila, and ready-to-drink canned spirits (think B-F's canned jack and coke or tequila and lime soda style beverages). Of these, Brown-Forman is a big player in three of the four - remember that it bought El Jimador tequila at a fair price more than a decade ago and has grown that brand tremendously as well in addition to the mainstay Jack Daniels:

Source: Corporate website

BF Stock's A And B Shares: A Chance To Add To Your Dividend Yield

One final note on Brown-Forman. As you probably know, the company has two classes of stock, the A and B shares. These are generally listed as BF-A, BF-B or BF.A and BF.B depending on the brokerage/website. It's simple to understand the difference between these shares – the A shares have voting rights, the B shares do not. That's it. Everything else including dividend payments is the same.

Inherently, having something is better than not having something, right? As such, in a perfectly rational efficient market, the A shares would always be worth as much as the B shares, if not obtaining a premium for the voting right. But this isn't a perfectly rational world.

Chart

Data by YCharts

In 2015, for example, the A shares (orange line) dramatically outperformed the B shares as there were rumors that there would be takeover offers for Brown-Forman that year. As you can see, this premium for the voting class A shares gradually dissipated throughout 2016 as M&A chatter died down.

As it is, the B shares often trade for more than the A shares for the following reasons: liquidity, and index inclusion. There are far more free-floating B shares than A shares in existence, and as such, the B shares attract way more trading volume. As a result, short-term traders that don't plan to own Brown-Forman for long transact in the B shares. This higher trading volume leads to lower spreads and easier executions. If you are a short-term player, you may want to use Brown-Forman's B shares, despite paying more than the A shares.

Additionally, index funds, by their mandates, generally have to own the more liquid/widely available class of a stock. Practically, it'd create a ton of slippage for ETFs if they were buying and selling the relatively illiquid A shares every day.

These factors often make the B shares trade for more than the A shares, even though both pay the same dividend, have the same ownership rights, and the A shares give you the ability to vote. Normally, the market assigns little value to the voting rights, as the family owns the majority of the stock. If your vote is unlikely to make a difference, how much is it worth?

That said, Brown-Forman is periodically hit with takeover chatter, despite the family ownership situation. This has caused the A shares to spike to as much as a 10-15% premium to the B shares, such as in 2015 as I showed with the chart above. I have no idea when, but this is bound to happen again at some point.

As a result of this dynamic, whenever the A shares are trading below the B shares, it makes sense to sell the B shares and buy the A shares (if you are in a tax-sheltered account). Right now, the B shares are trading at a significant premium to the A shares. At this writing the A shares trade for $61.65 and the B shares sell for $64.06. Thus, you could sell 100 B shares, buy 100 shares A shares and give yourself a $241 cash dividend without reducing your ownership stake or dividend income from BF stock in the slightest. Alternatively, you could use the extra cash to buy four extra shares of the A stock per 100 shares of the B stock that you own, giving yourself a home-made 4% dividend hike. The possibilities go on.

Here's the two share classes in chart form this year:

Chart
Data by YCharts

A shares are the orange line, B shares are the blue line. As you can see, they were at parity earlier this year, but the B shares have pulled ahead lately despite the A shares inherently being worth more to a long-term investor thanks to the extra voting rights.

If you own the B shares, you can swap out to the A shares and immediately increase your ownership stake by four percent. Additionally, the next time takeover chatter hits, the A shares may run up to a sizable premium again, allowing us to swap into the B shares and add to our ownership stake again at no out of pocket cost.

Disclosure: I am/we are long BF.B, BF.A. 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.

Additional disclosure: I own much more of the A class than B class shares of Brown-Forman stock.