Description

I believe Brown Forman (“BF”) is an asymmetric short opportunity. Investors have been crowding into the name based on a thematic thesis (the “bourbon boom”) that is unsound and in the process of unraveling. With valuation vs. the S&P near record-highs, the potential for meaningful margin contraction, and an uninspiring EPS growth algorithm, shorting BF yields the potential for a meaningful de-rating (38% in reasonable downside case) while not risking much if the thesis doesn’t play out (6-12% total return algorithm at a constant multiple).

The thesis in brief:

1. BF gets a rich valuation because it is the closest thing to a pure-play bet on the bourbon boom, although this logic is misguided
2. Competition is exploding, with a proliferation of new craft brands and massive capacity expansions announced and completed
3. Nature of aging requirements means that there is a huge bourbon glut building – supply will soon overwhelm demand
4. Tariffs target bourbon and both impose costs on BF and exacerbate the supply/demand issue
5. Recent results and disclosures suggest the above issues are already starting to impact the business, although it has not yet affected the market narrative
6. Plenty of other risks & red-flags exist

Business Description:

BF is the largest American-owned spirits company, tracing its roots back to 1870 with the production of Old Forester Bourbon. It’s been a public company since 1933 although is family-controlled, with the Brown family retaining both a majority economic stake in the company and nearly all of the voting control (the more liquid “B” shares carry no votes) – as a result, the takeout risk is effectively zero. It has grown to more than 40 brands, the most notable being Jack Daniels, Old Forester, Woodford Reserve, Finlandia, Herradura, el Jimador, and Glendronach. Whiskey brands dominate their portfolio (~80% of sales), with the Jack Daniels brand constituting the vast majority of that category.

BF sells globally, with ~50% of sales going to the U.S., ~30% going to developed markets (e.g. UK, Australia, Canada, Europe), and ~20% going to emerging markets (e.g. Mexico, Poland, Russia, Brazil). The international markets skew more towards non-bourbon products (Finlandia is big in Europe, Tequilas are big in Mexico) while the U.S. market is driven heavily by bourbon sales (mostly Jack Daniels). This whiskey-focused mix stands out when BF is compared to other large global spirits companies which tend to have more diversified portfolios.

Within the bourbon category, BF has a leading share @ 32%, larger than Beam Suntory @ 28% (Jim Beam, Maker’s Mark, Knob Creek), Heaven Hill @ 6% (Evan Williams, Elijah Craig), Sazerac @ 4% (Buffalo Trace) and all other brands @ 30% (Wild Turkey, Four Roses, Bulleit, etc.).

Industry Backdrop & Current Situation:

The most important thing to appreciate about the current industry dynamics is that the spirit industry, and particularly the bourbon category, is experiencing something of a renaissance. This should be no surprise to those of you who are spirit consumers – over the last ten years spirits have continued to take share (mostly from beer), and bourbon has gone from something your dad (or grandfather) drank, to an integral part of cocktail culture with continued premiumization driven by appreciation for the more complex flavor profile of “brown spirits” over e.g. vodka. This massive increase in interest has increased bourbon’s share of spirits from the ~9-10% level 10 years ago to 13-14% today, outgrowing the spirits industry by ~300-400bps per annum, and has resulted in significant pricing power, particularly in the super-premium segment where it is not uncommon to find a plethora of bottles in the $50+ range and rarer bottles going for well over $100.

BF has done a good job of positioning itself to capture these trends over the years (although at a meaningful cost), divesting non-core brands like Southern Comfort and Hopland wines, developing/buying brands like Slane Irish Whiskey, BenRiach and Woodford Reserve, and developing brand extensions like Jack Daniel’s Tennessee Fire and Honey. That being said, its over-indexing to the whiskey/bourbon category, while a tailwind over the last decade, is likely to create issues for them going forward, as I’ll discuss below.

1. BF gets a rich valuation because it is the closest thing to a pure-play bet on the bourbon boom, although this logic is misguided

It is well-understood that the bourbon category is booming, and with a very heavy skew to the bourbon/whiskey category, the thematic bull case for BF is that they are likely to be a beneficiary of this trend. As a result, BF trades at a nosebleed valuation of 27x EPS and 21x EBITDA on consensus forward estimates. To put this valuation in perspective, I’ve graphed the relative P/E multiple for BF vs. the S&P going back to 2006. At a current premium of 80% to the S&P, BF is near all-time highs. Before bourbon started booming (say 2006-10), the average premium was 30%, since then it has averaged 65% - compared to either things look frothy.

BF also trades at a premium to the other global spirits companies – while BF trades at 21x EV/EBITDA, the average comp is at 17x. Pre-2011, BF traded in-line with the group, which at the time was a low double digit multiple (~10-13x EBITDA).

So why is the thematic bull case logic misguided? In addition to structural supply/demand issues that I will explore later, put simply, Jack Daniels (the vast majority of BF’s bourbon portfolio) is basically the worst-trajectory brand in bourbon right now. If you look at the underlying drivers of the bourbon renaissance (cocktail culture, premiumization, desire for complex flavor profiles), Jack Daniels really doesn’t play to these themes at all. This is why, despite new brand extensions like Honey and Fire, the Jack Daniels brand is losing ~100-150 bps of market share every year like clockwork and their overall share has gone from the low 40s in 2014 to the low 30s currently, as measured by Nielsen. While the rest of the bourbon category has grown volumes at ~8% p.a. over the last 5 years, their core JD Tennessee Whiskey is only managing growth of 2-3% in the midst of the greatest whiskey boom ever. In addition to having a brand that is less “on-trend” than others, I believe this share loss is also due to a cumulative advertising deficit – BF/B has significantly underinvested in advertising for close to a decade now, and this is finally catching up with them:

Bottom-line is that if you are an investor who wants to invest behind the bourbon boom, BF is a completely misguided way to do so given the relative weakness of the Jack Daniels brand and its persistent share losses.

2. Competition is exploding, with a proliferation of new craft brands and massive capacity expansions announced and completed

In addition to share losses to established brands, BF faces an explosion in competition from new craft brands and massive capacity expansions. For a good primer on this, see please spike945’s excellent short pitch on MGPI from a few months back which outlines a daunting list of capacity expansions announced in the last few years – this includes expansions from well established brands (Four Roses/Wild Turkey/Heaven Hill/Buffalo Trace ALL doubling capacity), as well as meaningful investments from craft and new brands (Wilderness Trail, Rabbit Hole, Bardstown Bourbon, Kentucky Owl). These capacity expansions, largely announced in the last 2-3 years, represent ~$1B of total capital invested and a ~30-40% addition to total American Whiskey production capacity (not just bourbon). Meanwhile, BF is not even attempting to keep up, with only $120M of capex per year, most of it maintenance related and not all of it ascribable to whiskey – it seems guaranteed that BF will continue to lose significant share given these figures.

3. Nature of aging requirements means that there is a huge bourbon glut building – supply will soon overwhelm demand

The most daunting aspect of the capacity expansions mentioned above is that the impact from them has barely been felt yet. This is partially due to the required construction time to build capacity, but is mostly due to the aging requirements for bourbon, which typically stay in the barrel for 4-6 years after being distilled. A timeline of this length to see a supply response is a classic precondition for boom/bust cycles, and means that by the time the bourbon industry realizes it has built too much capacity, it will be much too late and they will have doomed themselves to structural excess capacity, likely for a decade or more.

Using data on U.S. Whiskey production and bottling from the TTB (https://www.ttb.gov/spirits/spirits-stats.shtml), I have been able to build a whiskey supply model which highlights that an oversupply situation is imminent. In the below chart, the red line is the amount of whiskey distilled and put into aging, while the blue line is the amount taken out of aging and bottled. The big takeaways here are:

• Annual whiskey production is currently outpacing annual consumption (proxied by bottling) by ~60-70%

• From 2012 to 2017, consumption/bottling has grown 30-35% in aggregate while production has grown 70-75%

• Over the next 5 years, the supply of whiskey coming out of aging will grow at an ~11% CAGR rate, approximately double the 5-6% rate of consumption seen over the last 5 years in the midst of an unprecedented cultural shift towards bourbon/whiskey

The obvious question here is – where is all of this whiskey going to go? I’ll try to do my part, but I’m not sure my liver can take an 11% increase in whiskey coursing through it each and every year. When I’ve posed this question to industry participants and sell-side analysts, I more or less get a shrug accompanied by a hopeful “international markets?” response. No one I’ve spoken to has meaningfully disputed that there is a massive growth in supply coming – most just choose to ignore it.

4. Tariffs target bourbon and both impose costs on BF and exacerbate the supply/demand issue

One of the hopes for U.S. whiskey producers has been that the international market would absorb a meaningful amount of the new supply coming out of aging. While I believe it is pretty obvious that there would be a supply issue even if international markets really took off, recent developments are calling into question the ability for them to do so. The primary issue is the impact of retaliatory tariffs on U.S. bourbon (targeted along with Harleys and blue jeans as quintessential “American” products) which in mid-2018 went into effect. The largest impact to BF has been the EU and Mexico’s 25% tariffs on American whiskey, while other tariffs such as those imposed by Canada, Turkey, and China have had a lesser impact given lower exports to those countries. BF has chosen to absorb the costs of these tariffs to avoid losing competitiveness vs. foreign whiskey/spirits in these markets, causing them to reduce their FY19 EPS (April year-end) by $0.10. If the tariffs are not repealed, the FY20 impact will be ~$0.20, which the consensus estimates are not fully reflecting (when FY19 was adjusted for the partial-year tariff impact, they merely took down the FY20 by the same partial-year amount). Furthermore, for producers who do not have the ability to absorb tariffs, volumes that were originally destined for export markets are now trapped domestically, exacerbating the supply/demand dynamics in the U.S. (see: https://www.washingtonpost.com/business/economy/whiskey-sour-us-craft-distillers-say-trade-war-with-europe-is-killing-exports/2019/01/02/4c8a7b64-054f-11e9-b5df-5d3874f1ac36_story.html).

Even if/when tariffs are lifted, I’d question whether the value proposition of bourbon in international markets will have been permanently impaired. Bourbon is a quintessentially American product, and I would be surprised if America’s rapidly diminishing standing and global reputation did not have a lasting impact on the attractiveness of bourbon vs. Scotch/Irish/Canadian/Japanese/etc. whiskey for global consumers.

5. Recent results and disclosures suggest the above issues are already starting to impact the business, although it has not yet affected the market narrative

While everything I’ve said so far would be interesting enough to justify a longer-term secular case against BF, I also think it is particularly timely to bet against the company today as the underlying issues are already beginning to play out, with recent commentary on increased competition and pricing pressure, as well as poor execution in recent quarters.

Recent commentary re: increased competition and pricing pressure:

• Risk factor addition to the most recent 10-K filed in Jun 2018: “For example, we are facing an increasingly competitive pricing environment, and our competitors may have more flexibility to adjust to such challenges.”

• Q1 call, Aug 2018: “… as it relates to the pricing environment that we see around the world, I would say that it remains very intense, very competitively intense … So we have determined that we’re not going to take price increases right away in many of these markets because of this intense competitive pressure. And not only that, our other competitors do not have the same pressures that we have as it relates to this”

• Q1 call, Aug 2018: “… on the Jack Daniels side of it, we are not going backwards on … pricing while some of our competitors are. And so, we’re going to hold firm on that.”

• Q2 call, Dec 2018: “… our relative price positioning went up over the last few months. So, we were going up a bit and our competitors were going down, so the differential got spread and that hurts volumes a bit. We’re getting a little bit sharper with that now.”

• Investor Day, Dec 2018: “So it is a very challenging price environment in the United States … there is a tremendous amount of price pressure, I would say in particular directed in the Jack Daniels type price point … so it’s a bit of a price war that’s going on right now.”

• Investor Day, Dec 2018: “… the price pressure tends to be more in the bigger brands and larger companies … essentially in the $15 to $25 price point … I’d say one in particular is choosing a different model … and we just need to keep being very sharp on this price-value relationship as we’re going through it, recognizing there are some competitors that are playing on, I don’t know, just a different game than we are.” [Note: Beam Suntory is likely the competitor they are referring to that is utilizing disruptive pricing]

Poor execution in recent quarters:

• Q1 2019 (July quarter) – took guidance down by $0.10 (6%), blamed on tariffs but most of the sell-side expected them to be able to pass on tariffs in the relevant markets

• Q2 2019 (October quarter):

• Very low quality EPS meet

• Sales missed by 3%, blamed on greater-than-expected fall-off from Q1 tariff-related pull-forward (international markets pre-buying)

• Gross margins missed by 70bps, with most of this due to “underlying” margin compression, not tariff-related or one-time

• A&P (advertising & promotion) quite a bit lighter than expectations, helping soften the impact to operating profit and EPS (but is not sustainable LT)

• 200bps lower tax rate than consensus

• Without the benefit of lower tax rate and lower A&P, would likely have missed EPS by at least 3-4%

6. Plenty of other risks & red-flags exist

In no particular order:

• CEO of 15 years recently retired from the company, was only 55 years old

• Increasing move to legalize marijuana represents a secular risk – study suggests that after states legalized medical marijuana, alcohol purchases declined by 15%: https://trello-attachments.s3.amazonaws.com/5859e37507a31d4c894a91b6/5a21b2c2c1bcb8c4f60dd1a9/3e5393c5236099c85c694d7f7361874e/SSRN-id3063288.pdf

• Increasing DSOs suggest possibility of mild channel stuffing (DSOs of 61 days at Q1/Q2 up from average of 55 in 2016/17

• Recent Nielsen data has been ugly:

• BF: 12-week trailing volumes of -2% growth, down meaningfully from 0% 2-year average

• Bourbon broadly: 12-week = +5%, up slightly from 2-year trend

• Spirits broadly: 12-week = +2%, up slightly from 2-year trend
  

Valuation & Risk/Reward:

The risk/reward to shorting BF is very attractive. In a reasonable downside case, there is likely to be both margin contraction (driven by pricing pressure) as well as multiple contraction (likely to de-rate to parity or discount vs. group as bourbon narrative changes).

EBITDA margins in the 2007-10 period (pre-boom) averaged 30% vs. ~34-35% today. On an underlying basis (adjusting for M&A, FX, etc.) margins have expanded even further (~600-900bps). In a pricing pressure environment, I believe a 30% margin seems reasonable although admittedly this is a bit of a guess. Consensus expectations are for EBITDA margins to expand to 35.7% by FY21.

BF used to trade in-line with global spirit peers before it became a way to play the bourbon theme. On a breaking of this narrative, I see them trading at a small discount to the group, say 16x EBITDA. The resulting P/E multiple would reflect a 35% premium to the S&P which if anything could be generous given that it traded tighter than that pre-2011.

In such a scenario I view fair value as $29/sh, or 38% downside from the current valuation.

From an upside perspective, I have a hard time seeing multiple expansion – BF is already the most richly valued spirits company and trades at near-peak valuations vs. the S&P. The relevant question then becomes how badly BF accretes value against you as you wait, and the answer is – not that badly. It is illuminating to look at BF’s underlying EPS growth historically. From 2013-18, BF’s EPS grew at only a 7.8% CAGR, of which 1.5% was driven by a change in tax rates, 0.3% was driven by lower A&P spend, and 2.4% was driven by SG&A leverage. Going forward I’d estimate an EPS algorithm of only ~4-10% (depending on whether spirits growth moderates and whether bourbon continues to gain share). The reason this is so weak is that BF will continue to see share losses, margins are probably maxed out (i.e. limited operating leverage), and FCF conversion at only ~70% (high capex requirements, structural investment in inventories) means that there is not much of an opportunity to reduce the outstanding shares. Add in a ~2% dividend yield and the resulting total return of ~6-12% in an upside scenario will probably only keep pace with the S&P even if BF is able to retain its premium multiple.

Bottom-line, I think there is minimal upside risk (S&P-like returns) and in exchange you are playing for a very meaningful de-rating when the bourbon narrative shifts.

Catalyst

Continued competitive and pricing pressure flowing through to sales and margin misses

FY20 guide