Short Beam:

Thesis:

Priced to perfection

End of spinoff momentum

Ackman short squeeze

Cashflow mismatched with earnings growth

Spirits trends

Complacent shareholders are ignoring recent supply constraints and valuation.

Distilled spirits have had a great decade, at the expense of beer.  Over the same period, whiskey has been one of the best in the group and Beam holds the top bourbon brands.    Beam management is promising to keep the drive alive.  The market has fully accepted that the trend will continue infinitely.   My thesis is that this trend will fade in the coming years and the stock price will fall back to mid-$40 per share range.

The trend may already be slowing.  Nielsen surveyed distilled spirits sales over previous 12 months.  Growth in volume and price are in line with inflation.  Nielsen reports overall spirits volume growth of 2.6% and price increases of 2.4% over previous year.  According to the same report, BEAM’s growth in volume is less than the industry, at 2.2%, but made up for it in stronger pricing, +4.4%.  

In February, they announced that they’d be watering down their fastest growing “power brand,” Maker’s Mark.   They said that it wouldn’t change the taste and it was required in order to meet product demand (it takes 6+ years to age and apparently they under-produced 6 years ago – something that has happened 20 of the last 35 years, but this year they talk about watering it down?).   Customers complained so Maker’s Mark backed down on their plan to water down the whiskey.   

The market price didn’t even blink.  When Coke changed the recipe I seem to remember quite a bit of hoopla.  If there is a shortage, why not just raise up the price?  They’re going after the high-end drinker anyway?  It is possible that they can’t raise prices and they can’t increase production.  This is either a legitimate constraint on their fastest growing power brand, or a desperate marketing ploy to move some volume in the near term.

There is chatter about how this move might’ve been a marketing ploy:  http://www.greenmatterthoughts.com/social-business/buying-makers-mark

Or it could be a pricing power issue that is trapping Maker’s Mark, as this article from the Washington Post implies, http://www.washingtonpost.com/blogs/wonkblog/wp/2013/02/17/bourbonomics-101-what-the-makers-mark-dilution-debacle-says-about-corporate-strategy/

They don’t want users to substitute and build a different brand in their recipe.

Based on the low rating (3.5!), VIC-raters must’ve thought Beam was expensive a year ago when Scrooge wrote it up as a long - and the price is even higher now!  Since that write-up, the revenue has increased by only 7% (that’s after $700 million in acquisitions!), shares outstanding increased by 3%, debt increased by 30%, dividend increased by 8%... and share price increased by 24%.   The strongest point of Scrooge’s write-up was pointing out the dynamics of the spinoff from Fortune Brands, which I believe have now sufficiently played out given that they’ve been independent for over 18 months.     

Management is targeting high single digit longterm growth.   If I use a 10% growth rate, and project that growth rate for eternity, that gets you a $32.80 intrinsic value, half the market price, or a 91% premium.  Ok, so now you are laughing at me for whipping out the dividend discount model and discounting an infinite series of cashflows.  Well, applying the same dividend discount method to the DOW30 (using 4% growth) gets you an intrinsic value that is only 20% premium to the current price.  It is easier to argue that the Dow’s dividend will grow perpetually at 4% than Beam’s dividend growing at 10% (perpetually, say it again!).   Why is even ten percent growth too high?  It’s been the heydays for Bourbon this last few years and Beam’s only eked out 7-9% increases in dividend.   Maybe the model is inappropriate but it clearly points to an expensive stock compared to the rest of the market.   I thought sin stocks were supposed to trade at a discount to the stock market?    Couldn’t a pure-play liquor stock fall out of fashion and trade at a discount to the market?

Added bonus: Indirect Short Squeeze – Bill Ackman owns 1/8 of Beam and he may have to sell in a hurry if Carl Icahn calls his broker and demands to hold paper shares of his Herbalife Stock.  Ackman also owns a slug of J.C. Penny, and may go down with the ship on that, too.  So in a perfect storm, if Ackman’s partners want out, I believe Beam will be front and center on his chopping block.   Then again, if Ackman somehow reads this write-up his ego will get involved and he will surely double his position, hold a giant press conference, tout it on CNBC and hold the stock forever…  Doh!

RISKS:

It is a prestigious pure-play liquor brand.  Ackman, Merrill Lynch and Scrooge say it is an acquisition target.  Management is NOT incentivized to sell the company as they would receive only $45 million in a change-of-control, whereas if they just sit on the company they receive $20 million per year in salaries, bonus, perqs, CNBC interviews, liquor-tasting events, drunk girls, etc.  I’d take the $20 million a year and all the intangible perqs of running a prestigious liquor company.   

The downside is limited.  Merrill Lynch reports that the spirits industry has been consolidating with more than 40 deals in the last 14 years.  They have ranged in price between 5x and 23x EBITDA.  Beam is trading at 18x EBITDA.  If BEAM is taken out at that high end of reported historical deals then that would be $80/share, or a loss of 29% on this trade  (Meanwhile, If BEAM falls back to intrinsic value then you will book at 48% gain).   It was reported in December that Diageo delayed making a formal takeover offer because it was only willing to pay $65 a share – which seems like a more reasonable downside to me.  

Read Scrooge’s writeup from October 2011 for more reasons to be cautious (or bullish) but I believe this deserves to be part of your short book.

Priced to perfection

End of spinoff momentum

Ackman short squeeze