Who doesn’t know the saying that quality has its price? While I would not necessarily view Jack Daniel’s Whiskey’s as high quality, the parent company Brown-Forman’s stock for long has been seen and valued by the market as such. Shares seemingly knew only one way: slowly, but reliably up. Despite small growth rates and unlike its bottles on the shelves, this high-margin business’ equity was never really on sale – until recently. Is this finally a once in a decade buying opportunity?

Summary and key takeaways from today’s Weekly
– Brown-Forman is operating in the defensive consumer sector and it has been known as a boring, but solid compounder.
– However, its and its competitors’ stocks have crashed – something unprecedented.
– There are good reasons for this. In essence, I do not see enough value in the stock of BF. Downside risks are still high.

Many investors love those almost maintenance-free under-the-radar stocks where one just buys and holds, watching them compounding reliably over time.

Due to strong brands and recurring purchases by the customer base, paired with little economic sensitivity (sales don’t fall much even in recessions) and price-elasticity (people reacting negatively to price increases), these businesses qualify as quality investments.

For years and until recently, this applied to alcoholic beverages producers, too.

Who doesn’t know sayings like “during a crisis, people drink even more alcohol”. The typical heads-I-win and tails-I-don’t-lose-much scenario, isn’t it?

These companies are certainly not spectacular, as their growth rates were only somewhere in the mid- to high single-digits over the last decade. The motive was not high growth, but little risk and decent upside.

These businesses are high margin, not very capital intensive due to not needing to constantly reinvent the wheel (thus generating high returns on capital) and shareholder friendly regarding distributions via dividends and also share buybacks.

Brown-Forman (ISIN: US1156372096, Ticker: BF.B), the parent company of Jack Daniel’s, is such a company.

Over the last months, however, and especially after having published its Q3 and final fiscal year results in March, respectively earlier this month (FY ended per 30 April 2024), the stock has come down almost by a third. This is a rather strong downswing for such a defensive consumer business.

If this weren’t enough of a headache, the price has been falling already even since the all-time high in late-2020 / early-2021. Since then, the stock of Brown-Forman roughly halved over several waves of small ups, but bigger downs.

A bit surprising and quite contrary to what many expected.

Brown-Forman and its competitors in recent history have been known to be expensive stocks when assessed by their rich earnings and cash flow multiples, but unspectacular growth rates.

Is this rare 50% mark-down of the stock now a buying opportunity?

We’re going to find out.

With my risks-first approach (paired with high upside), I am able to find stocks with great returns.

Currently, the tech mania has the upper hand. My picks, however, have way more potential, more attractive valuations (i.e. less downside risks) and one or the other upcoming catalyst ready to drive those positions higher again.

As my ideas have had an edge most of the time, it’s only a question of patience. My ideas are no momentum stocks and most often way smaller, under-the-radar ideas. So they tend to lag for some time, only to explode after strong earnings and / or upcoming catalysts.

Join me and my members on our journey to beat the markets!

^{both as per 26 June 2024 market close – since August 2022}

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Time to take a sip?

Whether a connoisseur or not, almost everybody knows the Jack Daniel’s brand.

The parent company, Brown-Forman, respectively its name, is not so well-known outside the world of stock markets. Its name originates little surprisingly from the two founders George Garvin Brown and his accountant and friend George Forman. The company was formally founded in 1870 first as a distributor of spirits, thus having a long history and heritage of more than 150 years.

The business was the first one to sell whiskeys in sealed glass bottles to make it more of a higher quality product.

(btw., it’s “whiskey” in the US and Ireland, but “whisky” in Scotland and Canada)

Later through buying one of its suppliers, it expanded its value chain to become a distiller itself. In fact and what many do not know, the brand of Jack Daniel’s was acquired only later in 1956.

If you really want to shine next time among sophisticated enjoyers of a dram of whisk(e)y, then keep in mind that Brown-Forman grew through the Old Forester brand.

Jacky only came later inorganically through the acquisition.

The prohibition period from post-WWI to 1933 was one of the most challenging times for the business.

According to the history on its website (see here), Brown-Forman is the only American distiller that existed prior to, during and after the prohibition, including until today.

As only one of a handful of some fortunate companies, Brown-Forman was allowed to produce whiskey for medicinal purposes during the prohibition, which likely saved them from bankruptcy.

Today, Brown-Forman is the fifth-largest spirits company in the world with commercial actives in more than 170 countries. It grew through several and frequent acquisitions (of which some were sold again).

This consolidation is common practice in the industry.

Besides Jack Daniel’s, the company also owns a few Scotch brands like Benriach, GlenDronach or Glenglassaugh, but also other whiskey’s from Ireland and the US.

Besides, Brown-Forman owns Tequila (Casa Herradura), Gin (Gin Mare), Liqueur, Vodka (Finlandia), ready-to-drink mixed beverages (Jacky Cola and the likes) and wine operations.

However, Brown-Forman is basically Jack Daniel’s which is the oldest registered US distillery. They write in their annual report that Jack Daniel’s is key and everything else is built around it.

The company is clearly highly depend on this brand and its products.

The stock of Brown-Forman went public in 1933 and it is still controlled by the descendants of the Brown family who own more than 50% of the voting stock (since 1959 there are two stock classes A and B).

There are c. 80% more class B stocks floating (64% of total share count) with no voting power. The class A issue has full voting rights and secures the family’s control over the company which they do not intend to change anytime soon. Self-explanatory, class B is much more liquid with about 50x more shares changing hands.

Just for completeness, as of writing trading volume was 54k class A and 2.5 mn. class B stocks. The current stock prices are both about 43 USD each, so roughly 2 mn. USD for class A and 100 mn. USD for class B.

Most of the time, both stock classes trade at almost identical prices and go in the same direction (with a few exceptions). In the following, I am always referring to the more liquid class B stock.

And here’s the long-term chart, showing us already that it looks more like a glass only half-full as the stock roughly halved from 80 USD in late-2020 / early-2021 to now only 43 USD – an unprecedented waterfall as of late.

Or in other words, the stock is back to 2015-levels.

Without the dividend, this would be akin to a lost decade.

It should not be underestimated, though, as the company is paying big special dividends here and there if the business did well.

Over the last ten years and including the spacial payouts, more than 6 USD per stock have been distributed to loyal shareholders.

That’s about 15% to where the stock came from a decade ago.

We can also see that the dividend has been raised for decades every year.

So, what has happened that such a dramatic decline occured? The answer is: Business activity has slowed down remarkably.

That’s even a too optimistic description, as operations went from over-exaggeration to the upside during the lockdown and high-inflation years (with people buying more and hoarding due to staying at home and fearing price hikes) into effective shrinkage as can be seen by reported and organic growth rates for the whole company.

This is a negative development, culminating now in growth way below historical averages (not just regarding their shown five-year period).

The question now is, has this been a correction of the prior excess or is the business really going south?

Brown-Forman generates almost half of its sales in the US, the rest is international.

Unfortunately, they don’t break down sales by individual brands. What we can see from the annual report, though, is that 69% of sales come from the whiskey product group.

My guess is that they generate maybe even 50% of their sales with Jack Daniel’s products as it’s a mass market brand with the other whiskeys being rather nichy – but that’s just a guess.

What we can also see is that neither any geography, nor any product category showed any growth whatsoever year-over-year.

And next, we can see that during the last year, Brown-Forman hiked prices by 8%.

However, volumes dropped by 9%, so effectively this was only an attempt to stabilize sales, which didn’t work out.

Or in other words, consumers dialed back on buying after prices went up.

To be frank, this was not a Brown-Forman-only problem, but an industry-wide challenging year as competitors Pernod-Ricard (ISIN: FR0000120693, Ticker: RI) or Diageo (ISIN: GB0002374006, Ticker: DGE) also suffered from weak business and strongly dropping stock prices.

Very unusual movements, especially of such magnitude.

^{source: TIKR}

Now, looking at inventories and cash flows of Brown-Forman, we can see that stocks are way too high, thus drying up cash generation which was a big negative surprise.

Below, we see sales heading sideways.

Next, the balance sheet with inventories and total assets.

We can see that sales slightly went down, while inventories increased by almost 15% year over year. Besides, inventories make up 30% of total assets and 60% of sales which seem to be quite high figures, tying up lots of capital.

Next, the cash flow statement shows us that despite higher net income, cash flows dried up. This was due to the aforementioned higher inventories, but also due to a capital gain generated through a sale of some business parts. So better don’t look just at the bottom-line number!

Over the last two years, inventories have risen strongly.

(negative inventories’ numbers in the cash flow statement mean that they have been subtracted from cash flow as cash has been spent to built inventories, but the company could not generate cash through sales).

Below we can see that free cash flow was weak and on 10-year lows for the last two fiscal years, even.

Besides a weakened business environment, Brown-Forman has also spent more on investments. Does it make sense to increase capacities / invest in growth when the business isn’t running well? In the next fiscal year, investments are expected to be somewhat lower, but still higher than in the past.

What I’ve found more surprising and a bit freighting is the long-term trend of sales and inventories – not only in the last two years.

Over the last ten years, sales only grew by 24%, while inventories almost trippled.

Looking at inventory days outstanding below, we can see a strong bull chart with a big jump recently (not good for the business and cash generation).

The cash conversion chart looks the same.

If this weren’t enough, a look at margins explains why the stock has been heading south. Important for me are gross margins, operating earrings margins as well as free cash flow margins.

All three have been trending south over the last decade.

Gross margins fell from almost 70% to temporarily even under 60%, indicating that the company was not able to pass on higher material costs to the customer.

Operating margins fell from 33–34% to 27% and free cash flow as written above was very weak with only 4% and 8% over the last two years (before it was up to 17%).

This negative development, especially over the last two years, led to a repricing of the stock, which is not a surprise. The question is only, whether this adjustment to the new reality was enough and whether the business will turn the corner again.

Brown-Forman has some net debt of ~2.7 bn. USD, which is quite a bit, but not freighting much.

Hence, for simplicity, I am showing the PE ratio here, as it is easy to grasp and put into perspective (though as my longer-time readers know, I do not like this metric).

Lots of hot air (PE over 40x at the highs) has left the stock – we are seeing now a valuation multiple on the lower side of the last decade, even below the 2020 crash low.

That’s good news, but only looking at this number in isolation.

At c. 20x earnings, there’s still some growth expected and priced into the stock. So, let’s look at the guidance for the new fiscal year.

Organic sales of 2–4% are expected. The same for operating income.

I must say that this is not enough growth for me to justify a 20x PE, though this is debatable.

Look, for a first impression, I did a DCF with the following assumptions:

• starting free cash flow of 600 mn. USD (about their historical achievement and akin to a 15% FCF margin)
• the business will grow 4% over the next ten years (which is already including some goodwill from my side)
• perpetual growth rate of 3% (after 10th year)
• The discount rate is 10% (my wanted yearly return)

You see below that this results in a fair equity value of only 19.35 USD – and by the way not including net debt (~2.7 bn. USD or 5.66 USD per share). As a reminder, the stock trades for 43 USD (or 48.66 USD on an enterprise value basis).

Even if you told me my assumptions are very pessimistic, okay, let’s be optimistic and see whether this would be realistic to achieve by changing only the 10-year growth rate to 7% assuming Brown-Forman will buy back some shares and it somehow even manages to grow higher than the historical average.

You might be surprised, but even under optimistic assumptions, the fair value only rises to 24.49 USD – still a significant gap towards 43 USD (respectively 48 USD for the EV).

The other thing is, we are dealing with sector-wide issues.

Consumers have reacted to the price increases (inflation target 2%, anyone?) with buying less, as volumes have been shrinking strongly. This limits the pricing power, because further hikes risk to shake off even more volumes.

The deciding factor will likely be whether inventories can be sold again. Are consumers through their purchases from 2021 and 2022? I do not know.

What I’ve been observing personally – with limited impact on the whole company – is that people do buy whisk(e)ys primarily when they’re on sale. Though Jack Daniel’s is marketed like a premium brand, it is a mass market brand. Shelves in my local supermarket are full when fully priced. When marked down, people buy en masse.

And this is also what Pernod Ricard has been saying and confirming, too, by speaking about “very aggressive price promotions” in their latest conference call. The current environment is one of promotional activity, high stocks and sales below expectations.

Being under pressure to sell inventories down is seldom a favorable situation to be in.

Rather a tough environment to operate.

Another thing I’d like to add is, I do not think Brown-Forman will achieve its guidance.

Why so? Above, I have shown the full-year results. Now, let’s have a look at the last quarter for an indication how the current business is doing. As the recent economic data has continued to be weak and not improved, the current company’s Q1 unlikely will show any major improvements, either.

Coming from –8% sales growth (!) for the last quarter going into 30 April, there needs to be lots of improvement which would need to be above historical growth rates.

I’m honest, that’s a mission impossible.

And net income tumbled when factoring in (subtracting again) the one-time gain on business divestures of 177 mn. USD. Net income without this special item went from 207 mn. USD to only 89 mn. USD – barely any sign of strength.

Even assuming they improve sales towards –5% now in the current quarter, in order to achieve +2–4% for the full year, the back half of the fiscal year needs to be really strong.

Will it?

Time will tell, but this looks tough to achieve. Above historical growth rates in a subdued economy is very ambitious.

It looks even worse when we look at my favorite EV / FCF metric.

Inclusive of net debt, the enterprise value is currently around 23 bn. USD. Free cash flow was only 400-something mn. USD over the last two years. Assuming (optimistically) they sell lots of inventory without overproducing and achieve a FCF of 700–800 mn. USD, this would be a valuation multiple of 28–32x.

The problem is, the highest free cash flow the company ever achieved (during the crazy 2022 run) was 798 mn. USD. Using a more achievable historical FCF margin of 15%, at current sales, FCF would come in at ~650 mn. USD.

In essence, much needs to work out while the valuation remains pretty high. This is not a favorable risk and reward for me. I’ll pass on this one.

The dividend yield is only c. 2%. However, over the last two years the full free cash flow was used for it, not leaving any room for buybacks.

All in all, not convincing with still too much downside from the valuation front.

Conclusion

Brown-Forman is operating in the defensive consumer sector and it has been known as a boring, but solid compounder.

However, its and its competitors’ stocks have crashed – something unprecedented.

There are good reasons for this. In essence, I do not see enough value in the stock of BF. Downside risks are still high.

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