- Brown-Forman's valuation remains high, reinforcing my hold rating.
- Recent results showed challenges related to distributor inventory comparisons, but core performance remains strong.
- Any further misses in consensus estimates could result in a significant decrease in the stock price (just like what happened after the 1Q24 results).
My recommendation for Brown-Forman (NYSE:BF.B) is a hold rating as the valuation continues to stay above its historical trading range. Moreover, the share price reaction of the stock after the 1Q24 results is a good indication of what might happen to the stock price if the business misses expectations again. Note that I previously assigned a hold rating to BF.B. due to my belief that valuation remained at a rich premium against peers with similar growth profiles. If the valuation were to compress, it would put pressure on the stock.
Recent results & updates
In my view, BFB's 1Q24 results didn't look as dire as they initially seemed. The challenging year-over-year comparison related to distributor inventory rebuilding created a significant obstacle, reducing the growth in total net sales by 600 basis points. Consequently, revenues fell short of the consensus expectations. To be fair, the fundamental performance remains robust. For the tenth consecutive quarter, the core net sales showed growth either in the single digits or the double digits. Despite the unfavorable annual fluctuations in distributor inventory, the management emphasized that these shifts were not due to destocking but rather the natural outcome of completing the rebuilding process and unusual ordering patterns. It's worth noting that this isn't a destocking issue, which means that when viewed over a more extended period, it doesn't significantly affect the growth trajectory. Looking at the medium term, there are clear factors driving growth. For instance, emerging markets have consistently shown upward momentum, with a notable 32% organic growth rate, and the management has expressed optimism about this region. This optimism is primarily due to the success of brands like New Mix in the rapidly expanding RTD market in Mexico and the popularity of whiskey in countries such as the United Arab Emirates, Turkey, and Brazil. Additionally, With the faster-growing M&A Gin Mare & Diplomatico added to BFB's revenue base in 2FH24, the business should also experience growth accretion. However, in the short term, lapping of distributor inventory rebuild is expected to continue to be a headwind in F2Q24, albeit to a lesser extent than in F1Q24.
Even though revenue fell short of projections, it was heartening to see gross margin rise by 90 basis points to 62.7% due to lower COGS brought about by pricing actions, a better product mix, diminishing supply chain disruption, and reduced tariff-related costs. However, this margin expansion was overshadowed by the higher marketing spend, resulting in a 4% decline in operating profit and an EPS miss at the bottom line. This earnings miss shouldn't worry investors too much, in my opinion, because the extra marketing dollars being spent are going toward expanding the company's brand. It was an effort to support Jack Daniel's Tennessee Whiskey and its new Jack & Coke RTD product. These growth impediments are, in my opinion, investments that must be made to drive growth and, as such, should not be seen as a dip in the company's financial performance. As the corresponding revenue kicks in from these investments, combined with the ease of increased marketing spend (already expensed in this quarter), margin should improve.
Future growth for the company, if any, should be in the mid single digits, as guided by management for FY24. With consistent growth in the high single digits over the past 10 quarters, BFB should have no trouble reaching this expansion goal. However, the restocking of distributor inventories at the same time should have a minimal negative effect on growth.
Valuation and risk
Based on my long-term DCF model (I did this in my previous post), I got a target price of $47.71. I believe the growth assumptions I assumed previously are still intact, even after this update. As such, I won't be repeating the model.
While the business has continued to show great underlying growth, I believe expectations continue to be high for the stock. If we look at the stock's historical trading range, it was between 25 and 30x forward PE during pre-2019. Post-covid, it is now in the range of 30x to 35x forward PE. Missing consensus estimates will likely drive valuation back to its previous trading range, and the 1Q24 result is a good example of what would happen to the stock price if it missed estimates again. Suppose the valuation trades down to peers' range of low-20x forward PE; the stock can be easily down 30% (from 31.6x forward PE today to 22x forward PE).
I reiterate my downside risks for BFB, which is that a deteriorating consumer environment that prompts consumers to downgrade their purchases, a sharper slowdown in the spirits category, and rising input costs.
I maintain a hold rating for BF.B due to its high valuation. While the recent results revealed challenges related to distributor inventory comparisons, the core performance remains strong, with consistent growth in net sales. However, the stock's valuation remains elevated, and any further misses could lead to a reversion to historical trading ranges, potentially resulting in a significant decrease in the stock price.
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