You Don't Know Jack: Brown-Forman's Shares Are Currently Overvalued

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By Thomas Mullarkey, CFA

Based in Kentucky, Brown-Forman (BF.A, BF.B) is a 142-year-old, family-owned premium spirits manufacturer with a portfolio of more than 25 brands. But Jack Daniel's, which accounts for almost 50% of Brown-Forman's volumes, is the linchpin behind the company's wide economic moat. Jack Daniel's provides both intangible (strong brand) and tangible (aging process and distribution system) barriers to entry that provide Brown-Forman's sustainable competitive advantage.

Strong Brands + Aged Spirits = Competitive Advantage
We have increased our moat rating for Brown-Forman to wide from narrow, largely due to the competitive advantages enjoyed by its iconic Jack Daniel's brand of Tennessee whiskey. Federal regulations mandate that bourbon and Tennessee whiskey be aged for at least two years in new charred oak barrels. Consequently, roughly half of the company's inventories are barreled whiskeys waiting to mature. While this duration is notably less than premium scotches, it nonetheless provides the company with opportunity to smooth out commodity inflation with steadily increasing prices, thereby keeping gross margins steady.

The company's key raw materials (including corn, rye, barley, agave, sugar, glass for packaging, and wood for barrels) are typically well supplied and we do not anticipate any meaningful supply disruptions. In fact, the firm believes that cooperage (the making of wooden barrels) is a core competency that is best kept in-house and Brown-Forman will be increasing its barrel-making capabilities via its new facility located in Decatur, Ala. This facility should be operational in 2014, thereby helping further spur long-term volume growth in 2017 and beyond.

The Jack Daniel's family of brands, including ready-to-drink (RTD) products, accounts for almost half (49%) of the company's sales volumes. Global depletions for Jack Daniel's have steadily grown from 6.5 million cases in 2002 to 11.7 million cases in fiscal 2012. The firm has benefited from several secular tailwinds helping to propel volumes, including (1) growing spirits demand in the United States and (2) emerging-market growth.

United States Getting Into the Spirits
Since spirits manufacturers ended their voluntary ban on advertising in 1996, per capita consumption of their products has been increasing. Following prohibition, spirits manufacturers self-imposed an advertising ban on both the radio (1936) and television (1948). Much to the chagrin of brewers, spirits manufacturers once again began advertising in 1996. Since that time, spirits steadily have been gaining share in the U.S. In 1996, spirits represented 29% of the average American's annual alcohol intake (roughly 0.63 gallons per person a year); now they amount to one third of the average American's annual indulgence of alcohol (about 0.75 gallons per person a year).

And demand for Jack Daniel's is steadily rising. In 2002, 13.1 million cases of bourbon and Tennessee whiskey were consumed in the U.S., representing 8.6% of the U.S. spirits market. By 2011, U.S. consumers enjoyed 16.0 million cases of bourbon and Tennessee whiskey, or about 8% of the overall spirits market. During that time, overall unit volume for the bourbon and Tennessee whiskey category in the U.S. grew by 2.2%. However, vodka grew even faster, from 26% of the U.S. spirits category in 2002 to 32% in 2011.

Recognizing the growing demand for vodka, Brown-Forman expanded its portfolio with the acquisition of Finlandia. While Brown-Forman has marketed and sold Finlandia in the U.S. since 1996, it first purchased a 45% interest in the vodka firm in 2000, increased its stake by an additional 35% in 2002, and bought the rest of the company in 2004. Finlandia volumes have grown from 1.2 million cases in fiscal 2002 to 3.3 million cases in fiscal 2012, a 10% compound annual growth rate. Given that Finlandia's largest market is Poland, we believe that Brown-Forman's other products benefited from this acquisition as the portfolio's distribution system in vodka-heavy Eastern Europe was utilized to increase the presence of Jack Daniel's products there.

Although the overall market volume for bourbon and Tennessee whiskey in the U.S. has grown just 2% in the last nine years, the premium and super-premium blends have grown measurably faster. Value brands, such as Black Velvet [Constellation Brands (NYSE:STZ)] and Early Times [Brown-Forman], have been losing volume. While high-end premium whiskeys and bourbons, such as Jack Daniel's and Makers Mark [Beam (NYSE:BEAM)], have grown volumes at almost 4% per year. And super-premium products, including Crown Royal [Diageo (NYSE:DEO)] and Woodford Reserve [Brown-Forman], have grown volumes at a 13% CAGR since 2002.

This trend toward premiumization helps spirits companies expand margins and further price-segment the market. While a fifth of Brown-Forman's Jack Daniel's Old No. 7 Tennessee Whiskey can be purchased in Chicago for $22, its Gentleman Jack and Jack Daniel's Single Barrel whiskeys are more expensive, costing a respective $30 and $48. Additionally, we believe that brand extensions such as Jack Daniel's Tennessee Honey ($22 per bottle) help the company court additional drinkers into the whiskey category.

Also, international demand for U.S. spirits has yet to be quenched. Since 2002, the value of U.S. spirits exports has grown by more than 10% per year--and American whiskeys amount to nearly 70% of all exports. While emerging markets likely will be a long-term growth area for Western spirits manufacturers, developed markets consume the bulk of U.S. spirits exports, with just 10 countries consuming roughly 75%. These countries include Canada (15%), the United Kingdom (11%), Australia (10%), Germany (9%), France (9%), Japan (7%), the Netherlands (4%), Spain (4%), Mexico (4%), and Italy (2%). Although the company's announced cooperage expansion should enable the firm to further expand its volumes, investors will have to be patient as the incremental whiskey volumes age for several years.

Southern Discomfort and Canadian Miss
Although Jack Daniel's and Finlandia consistently have grown volumes, Southern Comfort and Canadian Mist have stumbled for Brown-Forman. Sales of Southern Comfort ($17 per bottle) were 2.1 million cases in fiscal 2012, roughly the same as in 2002 and 17% lower than the 2.5 million cases sold in 2007. The brand has been hurt by increased competition from flavored vodkas, spiced rums, and even flavored whiskeys. Likewise, Canadian Mist whiskey ($13 per bottle) has seen volumes decline from 2.4 million cases in fiscal 2002 to just 1.7 million cases in fiscal 2012. Canadian Mist competes in the more price-sensitive value segment of the market. Value-brand consumers tend to be less brand loyal than premium brand. Unlike premium brands, which are consumed both on- and off-premise, value brands tend to be consumed at home.

Given that Southern Comfort is still a premium priced brand, we believe that Brown-Forman should continue investing in it. The flavored spirit still has growth opportunities abroad and RTD opportunities at home. Additionally, the company's "SoCo & Cola" campaign could help with on-premise consumption, encouraging more consumers to drink the spirit in a premixed cocktail.

A Disciplined Allocator of Cash
Brown-Forman's returns on invested capital have been in excess of its cost of capital for decades. Several of the company's brands, including Jack Daniel's, are more than 100 years old. Over that time, they have built a strong brand following and vast distribution network. We believe that aged spirits with strong brands result in formidable barriers to entry that enable Brown-Forman to enjoy meaningful pricing power, such that its profitability should continue over the long-term. As such, the firm has been increasing its focus on the spirits category for several years by divesting most of its non-spirits portfolio, including the Hopland, Calif.-based wine business (2011), Bolla and Fontana Candida wines (2009), and its consumer durables business (2007). Offsetting these divestitures, the firm purchased Casa Herradura tequila brands (el Jimador) in 2007 and we expect the company to opportunistically look for similar small bolt-on acquisitions. Brown-Forman also has invested in brand extensions such as new flavors in its vodka and RTD portfolios as well as new whiskey extensions such as Tennessee Honey.

There's a Better Entry Point for Brown-Forman
With Brown-Forman's share price approaching $100 versus our $79 fair value estimate, we believe the stock is currently overvalued. Brown-Forman currently trades around $94, or 24 times our estimate for its 2013 fiscal earnings. This is well above the 16-20 times multiple that typically has persisted for the last five years. And while we continue to believe that Brown-Forman has plenty of runway to steadily grow earnings during the next decade, we believe the company has little room for error at current valuations and would wait for a pullback in the name before considering an investment.

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