Raise a Glass to These Alcohol Picks
Our trip to CAGNY reinforced our bullish outlook on these alcohol picks.
Alcoholic beverage companies are typically great businesses, if they have adequate scale and the right brands. The threat of private labels is virtually absent, growth is stable, brand loyalty is very high, and most companies generate robust cash flows. However, not all alcoholic beverages companies are created equally. Today's environment, with soaring commodity costs and shifting consumer preferences, threatens some companies more than others. Like when distinguishing between Milwaukee's Best and Heineken, we think the competitive positioning of these companies can vary greatly.
During our recent trip to the Consumer Analyst Group of New York (CAGNY) conference, these industry themes were front and center, and our conversations with senior management and other financial analysts cemented our outlook for the alcoholic beverages companies we cover. My colleague Mitchell Corwin recently addressed some of the key themes affecting the consumer products world in his recent article; Morningstar stock analysts Greggory Warren and Lauren DeSanto also fleshed out these themes for the food and beverage and household products industries in their recent articles. Here, in the final installation of our takeaways from CAGNY, we'll take a look at the issues facing the alcohol industry and which companies stand to prosper in the years to come.
Who Isn't Affected by Commodity Costs?
If you haven't heard it enough already, here it is again: Commodity costs are up. Make no mistake about it--the soaring prices for hops and barley will be especially challenging for the brewers this year. Anheuser-Busch (BUD) and Boston Beer (SAM) have both warned that they won't be able to raise prices high enough in 2008 to fully offset higher commodity costs and that they will therefore take a gross-margin hit. Making up for this through operational efficiencies is easier said than done, but we think a few companies should fare well.
Given A-B's massive scale (the company dominates about half of the domestic beer market) and its demonstrated ability to trim back on operating expenses, we think the firm can hold operating margins this year. Also, pumping InBev's import brews like Stella Artois and Beck's through its system should benefit margins, since these products are higher-margin and growing faster.
In spite of these unprecedented input cost pressures, we see one firm not only expanding gross margins, but doing so in a big way. Through its joint venture with SABMiller (SBMRY), Molson Coors (TAP) will gain rich economies of scale in the U.S. market and a significant step up in margins, in our view. Since Molson Coors has a proven track record of delivering merger synergies ahead of schedule and above original estimates, we are convinced the company can do it again with SABMiller. And it's not hard to see why: A longtime source of inefficiency, Coors ships most of its volume from Colorado, but now it can reduce shipping costs by brewing in any of Miller's six U.S. breweries.
Boston Beer will likely have the toughest time with commodity costs. Accounting for less than 1% of the U.S. market, the company lacks the advantages its larger peers enjoy in procurement and distribution. Also, Boston Beer is in the middle of a huge brewery expansion in Massachusetts to give it the means to ship 100% of its own products rather than relying on contracts. Like Coors shipping from Colorado, we think Boston Beer's choice to concentrate all three of its breweries in the East was a poor one (Miller currently distributes Boston Beer's products in the West), and we expect shipping costs to escalate. In addition, we think A-B and Molson Coors have more flexibility in pulling back on operating costs, but the fast growth of the Samuel Adams brand should provide Boston Beer with some leverage over fixed costs.
The distillers will also face commodity cost pressures this year but not nearly to the same extent as the brewers. This is because agricultural commodities are a smaller percentage of the cost of producing liquors, and most distillers have premium positioning and more pricing flexibility.
What about a Slowdown in Consumer Spending?
With plenty of anecdotal evidence indicating a slowdown in consumer spending in the United States, the question of how consumer products companies are positioned in a macroeconomic downturn came up time and again at CAGNY. In general, alcohol is a classically countercyclical industry. Alcohol consumption per capita has stayed relatively flat over the past 50 years despite numerous economic ups and downs. While we would expect this to be the case in the event of a recession today, we think a mix shift among brands toward lower-priced products could occur.
For years now, consumers in the United States have been trading up to premium alcohol brands with virtually no end in sight. Consumers wanted trendy brands, something unique and different, and a brand that had cache. Volume growth soared for Samuel Adams to the detriment of Bud Light, and premium brands like Jack Daniel's (owned by Brown-Forman (BF.B)) and Jim Beam (owned by Fortune Brands (FO)) enjoyed a new-found popularity. We had always expected this trend to saturate at some point, and there is certainly evidence of slower growth today. For example, Brown-Forman recently announced quarterly net sales growth of 4%, softer than the firm's typical high-single-digit growth rate.
The difficulty in analyzing this slowdown (note that premium brands are still growing--only at a slower rate than in recent years) is in distinguishing between the secular and cyclical causes. While we think this softer growth could be evidence of the premium growth trends reaching a peak, words like recession and consumer spending slowdown have become convenient scapegoats. There is certainly evidence of a trading down effect in the alcohol industry. A-B disclosed at CAGNY that sales growth was accelerating for its lower-tier brands like Busch and Natural Light.
If this is the case, companies like A-B and Molson Coors stand to benefit with their broad portfolios of brands, but we don't think it will spell the end for premium alcohol brands. Jack Daniel's and Jim Beam, for example, have remained popular for more than 100 years, even surviving the 13 long years of U.S. Prohibition. (What could be worse than having your products outlawed?) We also don't see the potential for more than modest weakness. Sure, companies like Brown-Forman and Fortune Brands might struggle to boost sales growth domestically in the near term. However, we see no indicators that the demographic and social trends that have helped fuel the rise of these premium brands won't continue to do so over the long run.
The Importance of Owning Global Brands
The short-term macroeconomic issues in the United States demonstrate how important it is to be a global company. Like other consumer products companies that presented at CAGNY, alcohol companies must turn their sights globally for growth opportunities, since there will be little overall consumption growth in the mature U.S. market in the years ahead. Far and away, the leader in the global alcohol space is Diageo (DEO). With eight of the world's top 20 brands and unrivaled global distribution scale, Diageo reigns as the world's largest spirits maker. In addition to its dominant presence in Western Europe and North America, Diageo has left its competitors in the dust with its inroads into emerging markets such as Russia, China, Africa, and Latin America.
The key to success in emerging markets is having brands--usually Western ones--toward which consumers are seeking to aspire. Brown-Forman is especially savvy with its marketing of Jack Daniel's to build a premium image that resonates with each unique culture. In Russia, for example, the persona of Jack Daniel is a cowboy in the rustic and wild West, whereas in China, where rural life is neither a romantic nor American ideal, the brand is positioned as a chic, upscale, urban brand. In either case, the brand carries an aspirational perception.
In some cases, the desire to be an international company could destroy value. Fortune Brands is desperate to win the bid for Swedish-owned Vin and Spirit (V&S), maker of Absolut--the number-one premium vodka in the world. This acquisition would immediately propel the firm to the international stage, but we are concerned that it will pay a hefty premium for the bid and resort to massively diluting existing shareholders by issuing new shares to finance the deal.
So who wins on the international front? Overall, we think Diageo will continue to reign supreme, and Brown-Forman will keep picking up steam in international markets and begin to take shape as a truly global company. Most brewers, with the exception of South-American-based Compania Cervecerias Unidas (CU) and AmBev (ABV), will likely focus on the commodity cost pressures at home and make small international plays here and there. Finally, we think the prospects of a V&S-Fortune combination might create a force to be reckoned with 10 years from now, but we are especially cautious of near-term dilution from this potential transaction.
Standouts at Reasonable Prices
In general, the premium spirits companies are more insulated from spiking agricultural commodities, should not be significantly affected in an economic downturn, and have much stronger international prospects. For these three reasons, we think Diageo and Brown-Forman have the brightest long-term prospects. Additionally, we think A-B is undervalued relative to its cash flows and that the benefits of Molson Coors' margin expansion in the years ahead are not being priced into the firm's shares.
Risk Rating: Below Average | Price/Fair Value Estimate Ratio: 0.75 | 5 Stars
Spirits behemoth Diageo has it all: scale, powerful brands, and the best emerging-market presence. At CAGNY, the company's message was all about developing a portfolio of luxury brands. The company has certainly had a lot of success in charging $350 for a 750-ml bottle of Johnnie Walker Blue Label, which comes in a silk-lined box with a certificate of authenticity. Its core brands also carry tremendous equity and are growing at double-digit clips in emerging markets. My colleague Jim Sinegal recently highlighted Diageo in an article because some of our favorite all-star managers are buying up the firm's shares.
Risk Rating: Below Average | Price/Fair Value Estimate Ratio: 0.82 | 5 Stars
We see Brown-Forman as an infant version of Diageo. The firm has a solid portfolio, with brands such as Jack Daniel's, Finlandia, Casa Herradura, and Southern Comfort, and continues to seek other acquisitions to diversify its lineup. However, the brands do not have the same international presence as Diageo. This is where we see tremendous opportunity for Brown-Forman. While we don't think the firm can reach anywhere near Diageo's scale, we see a wide-open runway for Brown-Forman's brands to really take off outside the United States and for the firm to become a key player on the international-spirits front 10 years down the road.
Risk Rating: Below Average | Price/Fair Value Estimate Ratio: 0.85 | 5 Stars
We went to CAGNY most concerned about A-B. Volume growth for its core brands has been lackluster, and craft and specialty beers have been stealing market share. While we still believe the firm has a way to go in aligning its portfolio to better meet consumers' preferences, we were pleased with the company's admission at CAGNY that the domestic beer industry is different now. It's clear that management is well aware of the problems facing the firm and is committed to turning the ship. A-B is starting to tap the craft beer industry and leverage its unparalleled distribution scale to build a portfolio with faster growth potential. In the meantime, A-B is still the King of Beers. The firm throws off $2 billion in free cash flow every year and sells one out of every two beers consumed in the United States.
Molson Coors (TAP)
Risk Rating: Average | Price/Fair Value Estimate Ratio: 0.77 | 4 Stars
Molson Coors operates in markets with minimal growth opportunities, but its significant cost-cutting initiatives have boosted profitability and expanded margins in recent years. We think Molson Coors can extract further value from its operations with the compelling proposed joint venture with SABMiller in the United States. This should more than offset any pressure from higher commodity costs in the near term, and we think the firm's operating margins will start to approach something closer to A-B's (assuming continued consolidation of the U.S. assets).
Price/Fair Value Estimates are based on closing prices as of March 26, 2008.
Ann Gilpin does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.