Brown-Forman: Valuation Is Relatively High

Summary

• 3Q23 results were positive and exceeded expectations with a 5% y/y increase in organic net sales growth due to strong demand for premium brands, higher pricing, and normalized distributor inventories.
• However, gross and operating margins were pressured due to input cost inflation, supply chain constraints, and FX.
• When compared to fast-growing competitors like MNST, Brown-Forman's valuation looks relatively high.

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Investment thesis

Brown-Forman (NYSE:BF.B) is a company that produces and markets a diverse range of alcoholic beverages, which are sold under popular brand names. The company's collection of alcoholic drinks comprises well-recognized labels such as Jack Daniel's, el Jimador, Finlandia, and Woodford Reserve, while its wine products include Sonoma-Cutrer and Korbel champagnes. Jack Daniel's is the most prominent brand that the company produces.

Overall, I believe BF.B is a solid business with the potential for long-term sustained growth - in that I find BF.B's long-term algorithm of mid-single digit top-line and high-single digit operating income growth to be credible. The strong growth potential of its super-premium brands, the company's exposure to high-growth categories like American whiskey and tequila, and the possibility of continued international expansion for the Jack Daniel's brand are all likely to contribute to the company's growth over the long term. However, I find the current valuation (31x forward PE) to be excessive, as I anticipate slower growth in the US spirits market after two years of very strong growth thanks to the . On top of that, when compared to fast-growing competitors like Monster Beverage (MNST), BF.B's valuation looks relative high (MNST is trading at 32x forward PE but expected to grow net income by 55% over next 2 years, whereas BF.B is trading at 31x forward PE but expected to grow net income by ~30%). As such, Despite the bright growth prospects, I would wait for the price to drop before investing in BF.B.

3Q23 results

In general, the results for BF.B in 3Q23 were positive and exceeded expectations. The company reported a 5% year-over-year increase in organic net sales growth, which I believe is due to a combination of several factors. Firstly, the company's premium brands experienced strong demand, which helped to drive sales growth. Secondly, the company implemented higher pricing, which also contributed to increased sales revenue. Finally, distributor inventories returned to more normal levels, which helped to further boost sales growth. While I do think BF.B is making progress toward its premiumization goals, I also believe that several key headwinds, such as input cost inflation, supply chain constraints, and FX, are continuing to pressure margins. Evidently, gross margin fell 225bps during the quarter to 57.7%, and operating margin dropped 470bps to 28% as a result. These factors contributed to the adjusted EPS of $0.44. In conclusion, 3Q23 results suggests that, despite some relief, cost pressures will continue to be difficult.

Growth momentum

As previously mentioned, BF.B experienced a surprising increase in organic growth in the recent period. This growth was more robust than expected, with a lesser negative impact from distributor inventory shifts. Given the strong year-to-date performance, with organic growth at 12.0%, management has revised its forecast for organic top-line growth for the full year. Although the industry growth trends, especially in the U.S., are showing signs of normalization, management is still confident that BF.B can achieve mid-single digit percentage organic top-line growth over the next decade. The consistent low-single-digit percentage organic pricing growth strategy and long-term secular trends toward spirits are the key supporting elements to management confidence, and I believe are plausible. Another good news is that, even though consumers in developed international markets face more economic pressure than those in the United States, management claims to see no evidence of significant trade-down. Clearly, this bodes well for the future of the business.

Management has observed that, from the point of view of distributor inventories, things are beginning to settle down in the United States, with stockpiles becoming more normalized and shipments becoming more evenly distributed across the portfolio. However, it's vital to remember that BF.B will soon be lapsing a substantial tailwind from F4Q22, when net changes in distributor inventories contributed significantly to top-line growth. Therefore, I would advise investors to exercise caution when modeling 4Q23 results.

Margin headwind

While gross margins were in line with expectations, I was hopeful that the incremental costs of ensuring product availability were behind us and that the depreciation of the dollar would lead to an increase in gross margin and a more optimistic outlook for FY23. However, the cost headwinds persisted, as inflation remained high and supply chain easing was sluggish. That said, management has reaffirmed its previous forecast that gross margins for FY23 will be in line with the 58.8% reported for the 1H23. This would suggest that margins for 4Q23 will be around 60.0%. However, I believe that there may be potential for higher margins than what management has projected. This is due to the normalization of distributor inventory levels which should relieve some of the logistical pressure on the company. Additionally, areas where BF.B had experienced significant inflation are starting to ease. As for modeling, management also provided some useful data. One-third of the cost inflation seen so far this year was attributed to company-specific costs, according to their estimates, which, in my opinion, suggests pressure will ease in 4Q23.

Conclusion

Despite the positive 3Q23 results, which showed a year-over-year increase in organic net sales growth, headwinds such as input cost inflation, supply chain constraints, and FX are continuing to pressure margins. Nonetheless, management has reaffirmed its outlook for FY23 gross margins, which I believe has potential for upside due to the normalization of distributor inventory levels and the easing of inflation in certain areas. Overall, while BF.B has strong growth potential, it may be wise to wait for valuation to come down before investing as it seems relatively expensive relative to MNST.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. 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.