While you are welcome to read this article as a stand-alone, there is a reason that we start at item #4. Part One of our review of Brown-Forman (NYSE: BF.B) ran in this space yesterday. I promise that I am not recycling any of yesterday's bad jokes in today's column, so feel free to give that one a read first!
Today we're looking at the financial performance of Brown-Forman by running through the remaining Rule Maker criteria. Yesterday's look painted a picture of a highly protected, well run company that has somewhat questionable potential to grow boundlessly. Let's see if its past financial performance measures up.
For those who want to work off of the same financials, I used the 2001 10-K, available at FreeEdgar or on the Brown-Forman website.
4. Annual sales growth of at least 10%
Nope. Over the last 10 years Brown-Forman's revenues have grown a total of 45%, for a compound annual growth rate of only 4%. That's not very high, and for Rule Makers we demand that a company show that it is able to sell more and more of its stuff. Over the last three years the company's top line looked like this:
1999 2000 2001 Net Sales ($B) 2.009 2.134 2.180
On an historical basis, this doesn't quite cut it, and further calls the open question from Part One: "Does Brown-Forman have expanding possibilities?" It may well be that the cost of entering new markets is too great, and that Brown-Forman should be content with the amount of cash it creates in its existing businesses and existing markets. Fortunately, management disagrees and has made considerable efforts to expand the company's brand offerings and geographical power. But they ain't there yet.
5. Gross margins better than 50%
Back to happy stuff. Brown-Forman's gross margins have grown consistently, from a none-too-shabby 48% in 1992 to more than 52% this past year. Last year, Brown-Forman instituted a price increase for many of its brands. We'll see a sure sign of its power shortly: watch to see if the company can grow both its net sales (top line) and its gross margin numbers. If both increase, this is a company that has some real power in its markets.
6. Net profit of at least 10%
Producers of alcoholic beverages are hit by some additional levies by the U.S. government, thus making their ability to achieve the minimum level of net profits that much harder. In the case of Brown-Forman, its excise tax of $256 million in 2001 accounted for 12% of total sales, an expense that most other companies do not have to face. Still, on a net, after-tax basis, Brown-Forman's profit was $233 million, for a net margin of 10.6%. It passes the minimum level, but not by much.
7. Cash King Margin of greater than 10%
The Cash King Margin is similar to the net margin, except that instead of measuring profits with net income from the income statement, we use free cash flow from the cash flow statement. The advantage of measuring profits with free cash flow is that cash flow isn't as easily manipulated as net income. Brown-Forman's numbers for 2001 look like this:
Brown-Forman Fiscal Year 2001 Sales $2.18B
Free Cash Flow* $135M
Cash King Margin 6.1% *FCF = Net Cash provided - Additions to Plant, Property & Equipment
As you can see, Brown-Forman is not quite there. Still, with that extra impediment of $200 million in excise taxes, this return is not half bad. I don't think that it would be a good bet to count on excise taxes ever being lowered, so unless Brown-Forman drops its advertising budget (a bad idea), I doubt that it's possible that it could ever reach that minimum Cash King level. That's just a reality of its business.
8. Cash no less than 1.5X total debt
Here we're looking for a strong balance sheet. As we explain in the Rule Maker criteria, we're looking for companies that can grow their operations out of cash from operations and do not have big debt loads. Brown-Forman passes the test, with $86 million in cash, compared with $40 million in short- and long-term debt, for a ratio of 2.15 cash-to-debt. Still, $86 million is not a whole lot of cash for a company of this size to have on hand. Even though it passes this criterion, I'd like to see the company with more cabbage in the bank for a rainy day.
9. Foolish Flow Ratio of 1.25 or lower
I'm going to let you review the reasons for the Flow Ratio here, if you're interested. This measures how a company uses its working capital, and is figured by the formula:
(Current Assets - Cash*) Flow Ratio = -----------------------------
(Current Liabilities - ST Debt**)
* Cash = cash & equivalents, marketable securities, and short-term investments
** Short-term Debt = notes payable and current portion of long-term debt
Brown-Forman's Flow Ratio is $908 million / $538, or an unacceptable 1.68. However, just as Mike Trigg explained the peculiarities of the jewelry industry as they affect Tiffany & Co. (NYSE: TIF), Brown-Forman has an impediment that will mean that it is unlikely to ever meet our Flow Ratio limits.
When a company sells spirits such as whiskey, the product is barreled for several years prior to being available for sale. Jack Daniel's, for example, is barreled for a minimum of seven years. This means that the company's inventory levels are by necessity going to be enormous. In this case, we could back out $219 million (represented by the account "barreled whisky") and the Flow Ratio would immediately be reduced to 1.28. This, of course, still fails to pass our minimum threshold, but it does allow us to make an apples-to-apples comparison.
10. A reasonable purchase price (2x5y)
Whew! This one's tough. Right now Brown-Forman trades at a market cap of $4.5 billion, or more than 2x sales. With a historical growth rate of 7% and free cash flow of only $135 million, this is a company that is priced quite expensively. Still, there's a wild card that makes me believe that 2x5y is possible: Brown-Forman has a history of using its free cash to buy back big blocks of shares.
In 1992 the company had 82.7 million shares outstanding, today there are 68.5 million. Should the company continue to take shares out of circulation at times when the share price is cheap, the chances of shareholders achieving this goal are not half bad. This is no slam-dunk, but I wouldn't throw it outside the realm of possibilities, either. Under the assumption that the current share count and growth rates are maintained, I think a double in five years is quite a reach.
The roundup
To round up, Brown-Forman passed seven of the 10 Rule Maker criteria, by my estimation, and failed on three. At least one of its misses had to do with the higher taxes that it must pay on its sales of alcohol. However, even excluding whiskey inventories, Brown-Forman falls short on the Flow Ratio, and its rate of sales growth is significantly lower than our minimum. This means that Brown-Forman would have a tough time making its case as a Rule Maker.
But is it a good investment? I believe so. The stability of the company's sales and the aforementioned power its brands command will mean that Brown-Forman has a grand chance of providing its shareholders with outsized returns. A quirky story in the The Wall Street Journal highlighted some of Brown-Forman's efforts to gain acceptance for its brands overseas, in this case South Africa, where Jack Daniel's is still a largely unknown quantity. Still, the Rule Maker criteria are tough for a specific reason: In those instances where we have ignored non-compliance with several criteria, we have generally been sorry.
Dear Brown-Forman, I gladly accept bribes. At time of publishing, Bill owned shares of Tiffany. The Motley Fool is investors writing for investors.
