My recommendation for Brown-Forman (NYSE:BF.B) is a hold rating as the growth outlook is not positive. The spirits industry is likely to go through a tough period in the near term as the macro environment is unfavorable and consumers spend less. I also expect management to continue spending a lot on marketing, which will impact bottom-line performance as well. Note that I previously rated a hold rating for BF.B due to the high valuation that it was trading at. Despite the share price reaction after the 1Q24 results, the stock remained at a high valuation. My concern was that 2Q24 performance would remain weak and could drive another round of share price declines.
Recent results & updates
As I was concerned about, BF.B reported a weak 2Q24 quarter relative to expectations. BF.B reported sales growth of 1.2%, which is way lower than what the street expected (5.8%). Even if we adjust for the impact of net changes in distributor inventories, which caused a 400bps headwind to sales, BF.B sales are still lower than expectations (1.2% + 400bps = 5.2%). By segment, organic growth disappointed across the board, including the United States down 1.4%, developed international markets down 4%, and global travel retail down 8.6% (this is especially disappointing considering that international travel has recovered a lot since last year). The only market that grew was emerging markets (8% growth). The positive part of the results is that gross margins saw an expansion of 458 bps to 60.6%. That said, EPS still came in below expectations by 1c ($0.50 vs. $0.51).
Overall, 2Q24 results were disappointing, with major misses at the top line and modest misses at the bottom line. The market clearly did not react positively to these weak results, as the share price fell by more than 10% post-earnings. The weak results confirmed the overall slowdown of the US spirits market (which management acknowledged in the call), and I believe this is going to continue impacting BF.B results over the near term. This weakness is likely to cause distributors to slow down their inventory rebuild, causing BF.B to continue facing tough competition compared to last year. These weaknesses also come at a time when BF.B is investing heavily to support its launch of Jack & Coke Ready-to-Drink [RTD]. In good times, consumers are open to trying new products as they have more disposable income, which also means that BF.B might not need to spend as much on marketing. However, now that the consumer spending environment (i.e., the spirit industry) is weak, BF.B will probably need to spend more on marketing to drive adoption. I note that the product is already made and resources have already been invested; as such, I believe management is heavily incentivized to make this product work (or at least to clear inventories if it doesn’t work). Hence, I think the marketing spend is going to remain elevated in the near term. For reference, BF.B investing in brand building was up 10% y/y on an organic basis.
While management sounded confident that the headwinds are transitory, their cautious tone and the pressures on the whiskey and tequila categories are very concerning. I also highlight the fact that management BF lowered its FY24 organic sales growth outlook by 200 bps to 3% to 5%, from the prior 5% to 7%. With the deceleration in underlying demand trends, particularly impacting U.S. performance, which management expects to continue, and the continuous macro pressure impacting consumer spending, I have reasonable doubts that BF.B might even miss FY24 guidance (or further guidance down). Some bullish investors might point to the fact that BF.B has the faster-growing Gin Mare and Diplomatico rum (as management called out in the earnings call), but I think the impact is going to be somewhat limited by the lapping of the sell-in period for Jack & Cola, which was launched in 4Q23. In other words, 4Q24 is going to lose the benefit of new Jack & Cola sell-in sales.
Valuation and risk
I built my model to showcase the possible downside from here if growth and margins remain subdued in the near term. Using management’s revised FY24 growth guidance, I assumed 4% growth in FY24 and that this weakness would continue into FY25 (4% growth as well). As I mentioned above, the current consumer spending environment means that BF.B needs to spend more on marketing. I do not expect any improvements in margins. My assumptions translate to BF generating $915 million of net income in FY25.
As I expected previously, BF.B valuation was too high, and indeed, it traded down after the weak performance to the current 26x forward PE. I am assuming BF.B trades at 26x, which is the low end of its historical trading range. However, I reiterate my point that valuation could further match industry peers’ median level of low 20s forward PE if the market deems that BF.B no longer deserves a premium as growth continues to slow.
I think the upside risk to my recommendation mainly anchors on the industry turning around, which depends on the macro conditions and consumer confidence level. If these two recover, BF.B will see an improvement in growth, which will certainly drive a better stock price narrative. In addition, if BF.B successfully drives larger than expected adoption for its new product, it could also accelerate sales growth.
I reiterate my hold recommendation for BF.B. The recent results were very weak, reflecting lower-than-expected sales growth and declines across various segments, notably in the U.S. and global travel retail. Earnings are unlikely to see any major inflection as I expect management to continue its heavy investment in marketing, especially for the Jack & Coke Ready-to-Drink product, in the current weakened consumer spending environment. Management’s cautious tone, lowered organic sales growth guidance, and continued industry challenges raise concerns about meeting FY24 guidance.