Brown-Forman: Does Not Deserve This Premium
Summary
- Brown-Forman has strong brands and attractive end markets, with potential for growth in international markets.
- The company has impressive gross and operating margins, but its current valuation may be too high for new investors.
- Brown-Forman's low dividend yield and overvaluation may require investors to wait for market volatility to push the stock lower before adding to their portfolio.
Stephen Lovekin
Brown-Forman (NYSE:BF.B) has strong brands serving attractive end markets. The company’s torrid pace of sales growth over the past couple of years, driven by pandemic lockdowns and stimulus spending, may have ended. But the company can continue growing at a single-digit pace over the long term. Its international markets may offer much growth in the coming years. The company’s stock deserves to trade at a premium to the market, given the company’s brands, sales growth, and profit margins. But BF.B stock may not deserve its current stratospheric valuation. Investors may have to wait a while to buy Brown-Forman.
Good revenue growth & stellar margins
Brown-Forman has shown good revenue growth over the past couple of years. Although its torrid pace of growth may be ending, the company has strong brands in an attractive segment of the liquor market, and it should continue to register good sales and profitability growth. In Q3 2023, which ended in January, the company saw sales growth of 4%. Going forward, it is difficult for the company to register the double-digit growth it has done since July 2020 (Exhibit 2). But, a mid-single-digit growth rate is attainable, bolstering its profitability and margins.
The company has stellar gross and operating margins, which is one of the reasons why this stock trades at such a massive premium. The company recorded an average of 65% gross margins over the past decade (Exhibit 1). But inflation has reduced gross margins to below 60% over the past few quarters (Exhibit 2). The company’s brand allows it to charge a premium for its products, thus commanding impressive margins.
Exhibit 1:
Brown-Forman Annual Revenue, Gross, Operating Profits, and Margins (%) (Seeking Alpha, Author Compilation)
Exhibit 2:
Brown-Forman Quarterly Revenue, Gross, Operating Profits, and Margins (%) (Seeking Alpha, Author Compilation)
Dividends, share buybacks, and debt
The stock offers a low dividend yield of 1.3%, compared to the sector median of 2.5% and the U.S. 2-Year Treasury yield of 4.48%. Seeking Alpha gives the company’s dividend yield a “D-” rating (Exhibit 3). The company’s payout ratio is safe at 51%. The company has a stellar track record of consistently paying and growing its dividend for 17 years. The compare has grown its dividend at a 5-year CAGR of 5.3%, which compares favorably to the sector median of 5.5%.
Exhibit 3:
Brown-Forman Seeking Alpha Dividend Grades (Seeking Alpha)
I am impressed by the company’s share repurchase program. Typically, the effective share buyback (share buybacks - share issuance) paid during the repurchase program is much higher than the current share price, destroying shareholder wealth.
Exhibit 4:
Brown-Forman Annual Share Repurchases, Shares Issued, and Diluted Outstanding Shares (Seeking Alpha, Author Compilation)
The company has spent $2.5 billion on share repurchases since 2014 and has reduced its share count from 537.5 million to 480.5 million, a reduction of 57 million shares at an effective price of $43.89 (Exhibit 4). The stock currently trades at $63.67.
The company carried a total debt of $3 billion and a net debt, after cash, of $2.6 billion (Exhibit 5). The company generated $1.3 billion in EBITDA in 2022. That EBITDA puts the company’s debt-to-EBITDA ratio at 2.3x, a manageable debt level. The company generated $446 million in cash after paying for CapEx and dividends, the company’s total dividend payment in 2022 was $352 million. Its trailing twelve-month dividend payment was $369 million. The company generates enough cash from its operations to cover its dividends.
Exhibit 5:
Brown-Forman Debt (Seeking Alpha, Author Compilation)
Valuation
The stock is richly valued at a forward GAAP P/E of 36.2x compared to a sector median of 19.4x. The stock trades at a forward EV to EBITDA multiple of 24.7x. But the premium valuation for Brown-Forman may be justified given its margins and financial returns. The question remains what would be a reasonable valuation premium for the company? Brown-Forman has generated a great return on invested capital compared to Constellation Brands (Exhibit 6). The company’s five-year median return on invested capital is 19.4x compared to Constellation Brands’ little over 8% return. Based on the latest available balance sheet, my calculation puts the return on capital at 13.2% (Exhibit 7). The company has a great collection of exceptional brands which adds to the value.
Exhibit 6:
Brown-Forman Return on Invested Capital (Seeking Alpha)
Exhibit 7:
Brown-Forman ROIC based on Latest Report (Seeking Alpha, Author Calculations)
A discounted cash flow model estimates the per-share equity value at $45 (Exhibit 8). This model assumes a growth rate of 5%, a free cash flow margin of 17.7%, its long-run average, and a discount rate of 8%. The company has managed to grow its EBITDA at an average rate of 3.9% over the past decade, but this growth comes with a high variability of 8%. The stock’s free cash flow yield is low. Its 2022 free cash flow yield (Operating cash flow - CapEx) was 2.6%, while its trailing twelve-month yield is lower, at 1.59% (author calculations).
Exhibit 8:
Brown-Forman Discounted Cash Flow Model (Seeking Alpha, Author Calculations)
But the valuation metrics and the discounted cash flow model show that the stock has a massive valuation premium built into it. There is no room for any errors in operational execution or a slowdown in demand. As a long-term investor, I am averse to buying a stock at a massive valuation and then worrying about any negative news impacting it.
The stock has lost momentum over the past year, dropping 5.9%. Unfortunately, investors looking to purchase the stock at a lower valuation may have to wait longer. The stock may have a floor of around $60. The stock has repeatedly tested the $60 level and has bounced back. The RSI and MFI technical indicators have also gained moderately over the past few weeks, reaching the mid-fifties (Exhibit 9). Investors looking to buy the stock on a drop may be out of luck for the next few weeks unless there is some dire news on the economic front. The U.S. economy, where Brown-Forman generates 49% of its revenue, is solid. The U.S. added 339,000 jobs in May, far exceeding expectations and accelerating from 294,000 jobs in April. When the U.S. Congress passed legislation to increase the debt ceiling, another big uncertainty was removed from the market. The S&P VIX Index, which measures the market’s volatility, has dipped below 15, indicating a calm market. Investors may have to be cautious when buying stocks during these placid times. We may buy at the highs just before a recession and suffer losses that could take a while to recover.
Exhibit 9:
Brown-Forman RSI and MFI Technical Indicators (Seeking Alpha)
The massive valuation premium and a lack of weakness in the stock should keep new investors away from this company. The stock’s dividend yield is too low, driven by multiple expansion. The stock looks overvalued even when trading close to its 52-week lows. The market conditions are too calm, and investors looking to buy Brown-Forman may have to wait for volatility to return before considering adding this stock to their long-term portfolio.
This article was written by
Analyst’s Disclosure: I/we have a beneficial long position in the shares of VOO, VDC either through stock ownership, options, or other derivatives. 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.
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Comments (5)
I am grateful for your time!