True or false: alcoholic beverages companies are recession-proof? Contrary to popular belief, technically, the answer is false.
We would argue that alcoholic beverages companies are recession-resilient rather than recession-proof as they still experience cyclical demand. However, while consumers are trading down to lower-priced brands and curbing their consumption, especially at bars and restaurants, most alcohol companies are still highly profitable--evidence of the moats within the industry. (Click here to discover how Morningstar measures economic moats.) Given the right brands and adequate scale, producing and selling alcoholic beverages is a beautiful business: brand loyalty is high, growth is stable, and profits are robust in good times and bad. In fact, despite the effects of trading down, alcohol has comprised a very steady percentage of the United States consumer's total food budget for over 130 years, save for Prohibition, which lasted from 1919 to 1933.
Fortunately, the market appears to be overly discounting the attractive attributes of our alcohol beverage company coverage list. After baking the impacts of a stronger dollar and a weaker consumer environment into our valuations, the industry looks undervalued, trading at an average price/fair value estimate of 0.88 as of June 8, 2009. We do have a few favourites, which we'll detail later in the article. First we'd like to take a closer look at some issues facing the alcoholic beverages industry.
What goes up must come down
For the better part of the last decade, trading up has been a welcome
tail wind for alcoholic beverages companies. In the domestic beer
market, mainstream beers like Budweiser (made by A-B/InBev) and Coors
Light (made by Molson Coors) have been losing share to
premium-positioned beers such as imports and crafts, like Sam Adams, a
brand made by Boston Beer. Even in 2008, craft beer grew 5%-6% while the
total beer category grew just 1%-2%. It seemed that no amount of
innovation (anyone remember AB's caffeine-infused beer, B-to-the-E?) or
marketing could change that trend.
In spirits and wine, sales have gone nowhere but up over the past decade, increasing 6% annually on average since 2000. Consumers have been trading up to more sophisticated and premium-priced brands and in some cases forgoing beer consumption altogether in favour of spirits and wine. In certain categories, like super-premium vodka, companies were making up new brands, like Constellation Brands' Effen vodka, and fetching high prices through advertising and bottle design even though the quality differential between super-premium and value products was quite minimal.
Not surprisingly, however, these trends have hit the brakes. With the economy enduring a deep recession, consumers have become more selective with their purchases in virtually every category. Suddenly, more expensive craft beer doesn't seem worth the higher price. This price differential has been especially exacerbated as craft brewers, due to their lack of scale, are forced to take higher percentage price increases compared to their larger competitors to offset input cost pressures. This has only widened the price gap between, say, Sam Adams and Bud Light.
For example, during Boston Beer's latest conference call, Jim Koch, founder and chairman of the company, noted that he was in a convenience store recently where a six-pack of Sam Adams sold for $8.99 and a 30-pack of mass domestic beer sold for $7.99. With price discrepancies like that, it's not surprising that value brands are one of the fastest-growing categories in beer today.
The recession has also led to trading down to lower-priced brands in spirits and wine, where the premiumisation trend was more pronounced. In addition, growth in spirits consumption has slowed as consumers shift their consumption from on-premise (like bars and restaurants) to off-premise (supermarkets) channels. As consumers spend more of their alcohol pennies off-premise, they are more likely to purchase beer over spirits due to its lower price point and lack of the need to buy mixers.
Would you rather sell Keystone Light or Sam Adams?
What's the result of the weak consumer environment? Anheuser-Busch/InBev
and Molson
Coors, which have medium to lower-end priced brands, are reporting
great performance in the US. A-B is finally growing volumes again, and
for Molson Coors, Keystone Light is growing faster than Blue Moon.
Imports and crafts have been the losers for the most part across the
beer space. For example, Boston Beer, a company used to posting quarter
after quarter of double-digit volume growth, reported a 13% decline in
core shipments last quarter.
While there are winners and losers in beer, all companies in the spirits industry have seen their underlying sales growth slip, and most have lowered their forecasts for the year as consumers pull back on premium products. However, we have been very impressed with the robust cash flow and operating margins being reported by the better-run operators like Diageo and Brown-Forman despite weakening top-line growth. Meanwhile, Constellation Brands and Fortune Brands, which we consider weaker competitors, have seen their margins pressured.
Overall, we are not surprised to see the companies with the best brand equity and the portfolios with the widest moats in the spirits business fare well. For example, in the US the typical consumer of Johnnie Walker Black Label (made by Diageo) has an income of $100,000-$120,000 and consumes 2.5 bottles per year. It appears that this consumer is forgoing a vacation or a new car this year, but is not so strapped for cash that he or she is forgoing the affordable luxury of premium Scotch whisky. For Brown-Forman it seems that the enduring brand equity of Jack Daniel's and its "aspirational" qualities in emerging markets have helped to distinguish it from other brands and thus preserve its robust cash generation in good times and bad.
Bottoms up to these picks
Overall, the alcoholic beverages companies are not immune from the weak
consumer environment in this recession. However, we think the market has
placed several of them at attractive prices. Generally, we would steer
investors away from stocks with high financial leverage, such as Fortune
Brands, Constellation Brands, and A-B/InBev and toward the highest
quality, more stable names. In general, the premium spirits companies we
like, Brown-Forman and Diageo, are trading at attractive valuations in
spite of the low sales growth we foresee for them in the near term.
Finally, we like Molson Coors as it benefits from the trade-down
phenomenon and should continue to generate cost savings through the
MillerCoors joint venture.
Diageo
Diageo is hands-down the best spirits company on the planet. It has
scale, powerful brands, and the best emerging-markets presence. It is
also trading at attractive prices. At just 12.0 times earnings and a
4.2% dividend yield, we think this highly profitable wide-moat industry
leader, that turns every pound that comes through the door into 15 pence
of free cash flow, makes a great long-term holding.
Molson Coors
The benefits from the MillerCoors JV have already stood out in Molson
Coors' results. In its recently announced first-quarter results, Molson
Coors' reported operating income grew 50%, as savings from the
MillerCoors JV more than offset tough head winds from a 20% depreciation
in the Canadian dollar and a 28% depreciation in the British pound
versus the US dollar.
Brown-Forman
In our opinion, Brown-Forman's biggest opportunity is in markets outside
the US. The firm has been especially savvy in tailoring its marketing
message for Jack Daniel's in emerging markets. For the first time in the
company's history, more than half of fiscal 2008 sales came from markets
outside the US (up from 20% in 1994), and in fiscal 2008, the company's
sales increased 4% in the US, but 17% in Europe and 54% in all other
countries, such as Japan and South Africa. We think Brown-Forman will
continue to take the cash provided by its very profitable US business
and invest it behind expanding its presence internationally. Over time,
we think Brown-Forman's mix shift could approach something similar to
that of rival Diageo (split evenly between North America, Europe, and
all other countries), although we doubt the firm can gain as much scale
due to its smaller portfolio of offerings.
