EUR 850.00 For Business Accounts Only

Morningstar | Tariffs Continue to Pressure Brown-Forman's Net Sales and Gross Margin in 3Q; Shares Not a Bargain

We aren't anticipating a significant change to our $45 fair value estimate for Brown-Forman after reviewing third - quarter results, which included 4% underlying sales growth, driven by accelerating sales performance in the firm's super-premium American whiskey (up 24% year to date, and lapping 16% growth in the prior-year period) and tequila (up 13% year to date) portfolios. However, retaliatory tariffs on American whiskey in the EU, Mexico, Canada, Turkey, and China continue to weigh on both net sales (in markets where the firm sells through distributors) and cost of goods sold (in markets where it owns inventory). While we expect tariffs to impede near-term results, we're holding steady on our longer-term forecast for mid-single-digit sales growth and operating margin around 33% (versus 32% in fiscal 2018) on average over the next five years.

Management estimates tariffs have had an impact on year-to-date underlying net sales (up 5% on a reported basis) by approximately 1 percentage point, as it has lowered net prices to distributors in certain markets in order to maintain its top-line momentum. Year to date, gross margin has contracted 190 basis points to 65.3% (below our 66% full-year estimate), which includes a headwind from tariffs of 130 basis points; higher input costs for wood and agave also hampered profitability. We appreciate the firm's efforts to extract cost savings from its business to mitigate the impact of tariffs on its bottom line, with operating margin declining only 30 basis points (to 35.5%) year-to-date. In tandem, these factors didn't alter management's outlook for 2019 earnings per share between $1.65 and $1.75 (our estimate falls at the midpoint of this range), which assumes that tariffs persist for the remainder of the fiscal year. Despite a mid-single-digit decline in shares on the announcement, we'd suggest investors wait for a more favorable entry point.

From our vantage point, management's decision to absorb some of the tariffs in its key markets seems prudent, as this should allow Brown-Forman to support its strong trajectory of growth abroad (since it is often competing against other whiskey producers that are not facing the same tariffs). In this context, underlying sales in developed international and emerging markets were up 4% and 10%, respectively, in the first nine months and on top of strong comparisons (6% and 15%) in the prior-year period. However, we continue to believe the firm will be able to leverage its brand equity (which forms the basis for our wide-moat rating), as well as a growing contribution from more premium fare, to help offset this pressure. We foresee 2% annual improvement in price/mix longer-term, in line with the level seen year to date, supporting roughly 5% net sales growth on average over our forecast. We were also pleased to see performance in the U.S. accelerated during the third quarter, with underlying sales growth of 5% above the low-single-digit rate seen over the prior two quarters.