Gavin Graham writes:
Last year I recommended buying Constellation Brands (STZ), the world's largest maker of premium (higher priced) wines. At the time, Constellation also owned 50% of Crown Imports, the company that handles the best-selling imported beer in the U.S., Corona, as well as the third-best selling brand, Modelo Especial. Crown is a hugely successful company. In the year to Feb. 29, it sold 164 million cases of beer, generating $2.47 billion of revenues and $431 million of operating income. (Figures in U.S. dollars.)
In June it was announced that InBev (BUD), the world's largest brewer and the owner of Anheuser Busch, the largest beer maker in the U.S., as well as Ambev (ABV), the biggest brewer in Brazil, had made an offer for Corona's Mexican owner, Grupo Modelo SAB. This triggered a clause in the joint venture which allowed Constellation to buy Modelo's 50% of Crown Imports for $1.85 billion. CEO Rob Sands noted that "the deal will dramatically enhance the financial profile of our company and it will solidify Constellation Brands' position as... the third-largest beverage alcohol company in the U.S."
The shares jumped $5 to $27 when the deal was announced and have since risen another $5+ to close at $32.19 as at Sept. 14. The deal, combined with Constellation's cost-cutting program and its disposal of its lower margin U.K. and Australian businesses, will undoubtedly see earnings moving sharply higher. But after a rise of more than 50% since the initial Buy recommendation at $20.40, which was reiterated after the shares sold off last April on what was wrongly regarded as disappointing results, investors should take their profits as most of the good news is reflected in the price. Therefore, I am issuing a Sell signal on Constellation Brands for a return of 52.9% since the original recommendation in February 2011.
That said, I believe we should maintain exposure to a sector (wine and spirits) that benefits both from the maturing tastes of the aging baby boomers and the growing middle class in emerging markets. Therefore, I am recommending the second-largest spirits company in the U.S. and the market leader in the fast-growing bourbon segment, Beam (BEAM).
As its name suggests, Beam has been making the eponymous bourbon whiskey Jim Beam since 1795. But that's only part of the business. It also owns Maker's Mark bourbon, Teacher's and Laphroaig Scotch whisky, Canadian Club whisky, Sauza Tequila, Cruzan rum, and Courvoisier cognac.
It also owns the fast-growing line of Skinnygirl flavoured cocktails targeted at women (as the name suggests) and in January purchased Cooley Distillery, maker of the Kilbeggan and Connemara brands and the last remaining independent Irish whiskey maker, for $95 million. It then bought Pinnacle Vodka, the fourth-biggest imported vodka brand in the U.S. with forecast sales this year of three million cases, for $605 million in June, thus filling the last major gap in its range of spirits.
In 2011, Beam sold 34 million nine-litre cases of spirits, generating $2.7 billion in revenues and pre-tax income of $455 million. This year's acquisitions of Cooley and Pinnacle will add significantly to both the top and bottom lines.
Beam is one of two successor companies to one of the original conglomerates, Fortune Brands. It was an unwieldy collection of businesses that included Beam, Titleist golf equipment, Moen faucets, Masterbrand Cabinets, Master Lock, and American Lock. Having traded at a discount to the value its parts for many years, management, with some urging from activist shareholders, finally broke up the company. They sold off the golf business and split the remainder into two businesses in October last year: Beam and Fortune Brands Home & Security (FBHS).
Both Beam and FBHS have done well since the split, proving that the activists who had urged such a move knew what they were talking about. But while the smaller FBHS has seen its share price more than double, Beam (whose stock is the renamed Fortune Brands), while up a very respectable 40%, is still below where Fortune Brands stock traded five years ago.
The Cooley and Pinnacle acquisitions demonstrate that the Beam management team is focused on growing the business. Freed from the conglomerate shell, it is able to use its strong balance sheet to make accretive purchases. Pinnacle, for example, will be neutral to earnings per share this year but will add $0.05 to $0.10 a share in 2013. That's a 4%-8% increase to the $1.17 Beam earned last year. That included a number of special charges arising from the split-up of Fortune Brands and the company has indicated that, excluding those, earnings per share would have been approximately $2.12. This makes its trailing p/e ratio at 27.8 at a price of $58.97. Its forecast p/e for 2012 is 22 times.
The real attraction for investors, though, is Beam's rising exposure to the fast-growing overseas markets, where iconic western spirits brands are seen as attractive ways to demonstrate rising living standards and style by the emerging middle class. While 58% of Beam's 2011 sales came from North America, 22% was derived from Europe, the Middle East, and Africa (EMEA) and the remaining 20% from Asia Pacific and South America (APSA).
About 60% of its sales last year were from what it calls its seven "power brands", each with more than $100 million in sales. These include its two bourbon brands (Jim Beam and Maker's Mark), Teacher's and Canadian Club whisky, Sauza Tequila, Courvoisier, and Pinnacle vodka. Another 20% comes from "value creators", essentially cash cows like Gilbey's gin and Ronrico rum, which generate cash for reinvestment in faster-growing areas. Those fast-growing areas are dubbed "rising stars" and include Kilbeggan, Laphroaig, and Skinnygirl. This group accounts for 10% of totals sales. The "local jewels" segment - local brands such as Larios gin and DYC whisky - also contributes 10% of sales.
Over $400 million (15%) of Beam's 2011 revenues came from emerging markets. Sales in the BRIC countries of Brazil, Russia, India, and China were up by strong double digits in the first half of both 2011 and 2012, with brands such as Teacher's in India and Brazil and Courvoisier in Russia and Asia enjoying strong penetration, Beam plans to distribute bourbon and high-end tequila through the same network, intending to grow emerging markets to 25% of sales in a few years.
Meanwhile, its cost-cutting efforts have reduced expenses by $25-$30 million per year, enough to offset raw material cost increases. Beam estimates it can reduce Pinnacle's costs by 20% of sales in the next twelve months by merging it into its distribution system. Vodka accounts for one-third of U.S. spirits sales and is growing faster than the market as a whole. Irish whiskey, its other acquisition this year, grew by 23% in the second quarter of 2012 after 26% growth in the same quarter last year.
All in all, Beam's prospects for the next few years look attractive. Its sales on a comparable basis in the first half of 2012 grew 6% against 3%-4% for the market as a whole. The U.S. bourbon market grew 11% in the second quarter of 2012 after 9% growth in the equivalent quarter of 2011.
The stock even pays a reasonable dividend of $0.82 per year after an 8% increase in January. That equates to a 1.4% yield. With the board having set a payout ratio of 35-40% of earnings, future dividend increases appear likely.
Investors looking for a relatively defensive investment with decent growth in revenues and earnings over the next few years and growing exposure to emerging markets should buy Beam. There are rumours that a major beverage alcohol company such as Diageo, which lacks exposure to bourbon, may be willing to acquire Beam. But even without such an event to crystallize value, Beam should prove a profitable investment.
Action now: Sell Constellation Brands for a profit of 52.9%. Buy Beam at the current price of $58.97.
- end Gavin Graham