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Tuesday, January 12, 1999

An Investment Opinion
by Warren Gump

Slowly Building a Fortune

Sometimes good values are found on Wall Street when stocks can't be pigeonholed or fully understood by Wall Street analysts. Fortune Brands (NYSE: FO) falls into this category. This consumer products company may not be too familiar to you because the firm was reincarnated in May 1997. At that time American Brands spun off its major international tobacco operation, Gallaher Group PLC. The non-tobacco businesses of American Brands, consumer products brands generally holding one of the top two positions in their respective categories, became the renamed Fortune Brands.

You've probably heard of many of the products in the Fortune Brands stable. The home products division sells Moen faucets, Master locks, Aristokraft and Schrock cabinets. Ever bought a Swingline stapler, ACCO paper clips, Wilson Jones steno pad, or a Day-Timer? Those are also Fortune Brands products. In golf, the company sells products under the Titleist, Cobra, and Footjoy brands. Extremely socially conscious investors may be averse to the Jim Beam Brands Worldwide division, which sells its namesake bourbon, DeKuyper cordials, Whyte & Mackay Scotch, and Geyser Peak wines.

Before talking about the valuation characteristics of Fortune Brands, let me forewarn you that it isn't an Internet powerhouse. The company is not in any way, shape, or form a Rule Breaker that is transforming the business world. Instead, it is a relatively conservative company striving to achieve consistent low-double-digit EPS growth. Although traded for less than two years in its current form, the company has met these growth objectives despite significant challenges in international markets and in the golf business.

Fortune Brand's strategy is to build its brands via new product introductions while reaping cost savings from operating efficiencies and acquisitions. The company bolstered its market position this year by buying the Geyser Creek Winery, the Schrock Cabinet Company, and Apollo Presentation Products. Additional purchases are likely as opportunities arise.

The stock of Fortune Brands currently trades at about 18x consensus earnings estimates for 1999. Not too bad in today's market for a company expected to achieve low-double-digit earnings growth. In comparison, the S&P 500 (of which Fortune Brands is a member) currently trades at about 26x First Call consensus estimates for 1999. The long-term earnings growth rate for the index companies is projected to be around 5%. (Note: these are "top-down" estimates where analysts evaluate the S&P 500 companies in aggregate rather than the more aggressive "bottoms-up" where the -- often overly optimistic -- estimate for each company is combined.)

The reported earnings number for Fortune Brands is actually quite conservative. Acquisitions have created a significant amount of goodwill amortization, a noncash expense that hurts earnings but does not hinder cash flow. During the first nine months of 1998 this hit totaled $80.5 million on operating earnings of $197.7 million. Eliminating this expense would boost reported earnings by 23%-41%, depending on tax assumptions.

To get a better perspective of company composition, here is a breakout of sales and operating profit among the company's business segments during 1997 (the last full year for which numbers are available):

              Sales  Op. Earnings
Home Products: 29% 30%
Office Products: 27% 17%
Golf Products: 19% 19%
Wine & Spirits: 25% 34%

Last year, 73% of sales were domestic, 17% were in Europe, and 10% went to other countries.

Some of 1998's earnings growth has been from leveraging corporate SG&A expenses over increasing sales. Beyond that, the home and office products division has been the company's primary growth engine with revenues and earnings increasing 17% and 13%, respectively. Acquisitions and new product introductions caused most of this improvement.

Wine & spirits experienced basically flat results, which is not surprising as it is best viewed as a cash cow to fund growth at the other divisions. The golf division also had essentially flat profit, a disappointment as it is expected to provide growth. Significant weakness at Cobra, offset by gains for golf balls and shoes explains the lackluster performance. Considering the horrific results from other golf companies, however, flat results are not that bad. (If you haven't been watching, over the past year most golf equipment makers have seen earnings disappear and their stock prices have been knocked down 40%-70% or more.)

While the company appears attractive from an earnings valuation perspective, Fortune Brands' return on invested capital (ROIC) is not compelling. Based on last year's ending invested capital of roughly $5.5 billion, the company only achieved an overall after-tax return of 6.2% in 1997, assuming a 40% tax rate and adjusting net income from continuing operations for goodwill amortization and interest expense. This seemingly low figure suggests that further asset optimization strategies will need to be implemented. Investors concerned about this statistic should monitor it, as well as the company's marginal ROIC.

With powerful brands, a conservative balance sheet, and an outlook for steady profit growth, Fortune Brands may be worth a deeper look. Last year, the stock didn't really move because investors were concerned about the outlook for the golf market and international sales. Since the company doesn' t have a long track record as an independent entity, investors reasonably shied away from the stock. The company is now demonstrating that it can perform in a tough market environment. As other investors figure this out, the stock could move higher.

Despite all the turmoil in various markets, Fortune Brand achieved its earnings objectives last year. While formal results haven't been released, CEO Thomas Hays commented in a press release this morning that the company is "right on track" to meet expectations for both 1998 and 1999. That kind of statement, combined with the company's profile, leads me to believe this stock can be purchased now to provide growth for a long time. Let the tortoise beat the hare.

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