Business context and reporting period
Brown-Forman Corporation’s unaudited Form 10-Q covers the third quarter and first nine months of fiscal 2014, ended January 31, 2014. Comparisons are with the corresponding periods ended January 31, 2013, unless otherwise noted. The company sells spirits and other beverage alcohol products, including the Jack Daniel’s family, Finlandia, Southern Comfort, and super-premium brands.
Financial performance
| Metric | Three months | Nine months |
|---|---|---|
| Net sales | $1.078 billion, +5% | $3.053 billion, +5% |
| Operating income | $255 million, +7% | $783 million, +9% |
| Net income | $177 million, +12% | $526 million, +10% |
| Diluted EPS | $0.82, +13% | $2.45, +10% |
| Gross margin | 49.3%, unchanged | 51.9%, up 0.7 percentage points |
| Operating margin | 23.6%, up 0.5 percentage points | 25.6%, up 0.9 percentage points |
| Effective tax rate | 28.8%, versus 31.3% | 31.2%, versus 32.1% |
Management’s non-GAAP underlying net sales growth was 8% for the quarter and 7% year to date, versus reported growth of 5% in both periods. Underlying operating income rose 16% and 14%, respectively. Foreign exchange and lower estimated distributor inventory changes reduced reported growth; management estimates price/mix contributed about three percentage points to underlying sales growth in each period.
For the nine months, operating cash flow was $390 million, compared with $367 million; capital spending was $87 million, compared with $59 million. Cash and cash equivalents increased $83 million from the fiscal year-end balance to $287 million. Financing used $214 million, including $171 million of dividends and $49 million of treasury-share purchases. The prior-year period included a $4-per-share special dividend.
At January 31, 2014, total assets were $3.993 billion and stockholders’ equity was $1.889 billion. Long-term debt was $997 million and short-term borrowings were $9 million; no commercial paper was outstanding at period-end. The company reported $287 million in cash, including $156 million held by foreign subsidiaries that it expects to reinvest indefinitely outside the United States. Its $800 million bank credit facility was undrawn. The company reported a 27-to-1 EBITDA-to-interest covenant ratio against a 3-to-1 minimum.
Material changes and operating trends
- Jack Daniel’s family growth was supported by volume gains across many markets, pricing, and expansion of Tennessee Honey; the United States, Europe, and developing markets contributed. Woodford Reserve also grew strongly.
- Finlandia sales benefited in part from customer inventory build-ahead of a Polish excise-tax and price increase. Management expects those elevated inventories, as well as customer inventories built ahead of January price increases in Poland and Germany, to weigh on fourth-quarter reported and underlying sales.
- Southern Comfort declined, particularly in the United States and Australia, amid weaker demand and competition. New Mix RTD sales were affected by elevated customer inventories early in the year; management said normal trading resumed after the first quarter.
- France distribution activities began on January 1, 2014. The transition affected distributor inventories and reported sales; management included an expected negative $0.06 per diluted share impact in its full-year outlook.
- Year-to-date advertising expense increased 7% reported (8% underlying), reflecting investment in Jack Daniel’s and super-premium brands. Management expects fourth-quarter SG&A to rise faster due to strategic investments and organizational changes.
Outlook, risks, and unusual items
On March 5, 2014, Brown-Forman updated its fiscal 2014 diluted EPS outlook to $2.95–$3.05. The outlook included estimated negative impacts of $0.06 per share from the France distribution-change inventory effect and $0.01 per share from foreign exchange. Management expected high-single-digit underlying sales growth, advertising expense growth faster than sales, mid-single-digit full-year SG&A growth, and low-double-digit underlying operating income growth.
In the quarter, the company recorded a $95 million deferred tax benefit, primarily from releasing deferred tax liabilities related to an intercompany asset transfer. The benefit was deferred for financial reporting and is to be amortized to tax expense over approximately six years. The nine-month effective tax rate also reflected discrete tax items and interest on previously provided tax contingencies; management expected a 31.6% full-year rate on ordinary income before applicable adjustments.
Risks cited include foreign-exchange movements; changing consumer preferences and demand for brown spirits; dependence on continued growth of the Jack Daniel’s brands; distributor inventory fluctuations; regulatory, tax, and excise changes; supply and production disruptions; competition; and litigation. The company said no material accrued loss contingencies were recorded and did not expect contingencies to materially harm its financial position, results, or liquidity. It guaranteed an importer’s bank obligation: approximately $12 million of actual exposure and a maximum possible exposure of approximately $43 million; it also had about $32 million of receivables from that importer, which it expected to collect in full. No impairment was identified in brands reviewed, but Chambord’s estimated fair value exceeded its $116 million book value by only about $21 million; management described impairment sensitivity to assumptions, including cost of capital.
The company used currency derivatives for risk management, not speculation; outstanding currency derivative notional value was $1.042 billion at January 31, 2014. Management reported no material changes in market-risk disclosures since its prior annual report. Disclosure controls were deemed effective, with no material change in internal control over financial reporting during the quarter.
Important facts for investors to verify
- How much of underlying growth reflects sustained consumer demand versus distributor inventory movements, especially in Poland, Germany, and France.
- Whether fiscal 2014 EPS guidance of $2.95–$3.05 is achieved and whether the stated FX and France transition impacts develop as expected.
- Whether rising advertising, SG&A, input, and capital costs remain consistent with margin and operating-income expectations.
- Cash availability and debt funding needs, including the treatment of foreign-held cash and the planned pace of share repurchases under the $250 million authorization.
- Chambord brand valuation assumptions and the importer guarantee and receivable exposure.