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Morningstar | Brown-Forman's Underlying Performance Strong Despite Tariff Headwinds; Shares Not a Bargain

Wide-moat Brown-Forman concluded its fiscal year on solid footing, with full-year underlying sales growth of 5%, including a 2% contribution from price/mix, and 210 basis points of operating margin expansion to 34.4%, leading to earnings per share of $1.73, slightly above our $1.70 estimate. Excluding the impact of tariffs, which weighed on net prices in markets where the firm sells through distributors, underlying sales grew 6%. Management's optimistic fiscal 2020 outlook of 5% to 7% underlying net sales growth, in line with our previous estimate of 6.5%, bolsters our confidence that this top-line momentum will persist over the near term. We expect to increase our $45.50 fair value estimate by a low-single-digit percentage as we incorporate these results, but we don’t anticipate a material change to our longer-term outlook, which incorporates around 5% sales growth and mid-30s operating margin on average over our 10-year forecast.

Tariffs in markets where the firm owns its inventory and rising input costs, including agave prices, remain material headwinds to gross margin, which contracted 260 basis points to 65.2% for the year, including a 160-basis-point impact from tariffs. However, we remain encouraged by Brown-Forman's efforts to extract cost efficiencies from its operations, as evidenced by the full-year selling, general, and administrative ratio decreasing 430 basis points to 19.3% of net sales, which should help defend its bottom line against these external factors. While the firm's proportion of spending on advertising was less robust than in earlier years, falling 60 basis points to just under 12% of full-year net sales, we attribute this to a shift to more-efficient investments (management pointed to a decrease in agency fees and sponsorships and an increase in consumer-facing media) rather than a pullback in the firm's brand-related investments, which strikes us as prudent.

We were pleased to see 12% underlying growth in the firm's tequila portfolio thanks to distribution gains and categorywide strength and 23% growth in the firm's premium bourbon portfolio, which includes Woodford Reserve and Old Forester. We estimate the domestic tequila and premium American whiskey, defined as $20 a bottle and above, categories averaged 7% volume growth each between 2014 and 2018, versus just 2% growth for the spirits category, and we continue to think Brown-Forman's strong positions in these segments, as well as its limited exposure to less-attractive categories will benefit its top-line trajectory.

From a geographic perspective, emerging markets, which we estimate account for a high-teens percentage of sales, remain the key driver of growth, with underlying sales increasing 11% across these regions versus a 3% increase in the U.S. and 4% increase in developed international markets.