Bottoms Up to These Alcohol Picks

It seems today that everywhere you turn, the headlines have nothing but bad news: rising food prices, weakening consumer spending, and collapsing markets. Over the past weeks, this fear in the market has punished stocks in one of our favorite industries--alcoholic beverages. While there are legitimate concerns about commodity costs and a weak consumer environment, we think the sell-off has been excessive. Alcoholic beverages is a great business, given the right brands and adequate scale--brand loyalty is high, growth is stable, and profits are robust. But even in this uncertain environment, how are the alcohol companies faring and which are our best picks?

In this article, we will take a closer look at the alcoholic beverages industry since our last update and highlight our favorite picks that are trading at attractive prices. In general, we are anticipating that consumers will trade down to lower-priced brands during this economic downturn and that most alcoholic beverages companies will experience short-term margin pressure from rising commodity costs. Even after baking these assumptions into our valuations, however, the industry still looks undervalued and is trading at an average price/fair value of 0.77 as of Oct. 16, 2008.

The Changing Landscape of Beer
For the better part of the last decade in the United States, mainstream beers like Budweiser (made by  Anheuser-Busch (BUD)) and Coors Light (made by  Molson Coors (TAP)) have been losing share to premium-positioned beers such as imports and crafts (such as the Sam Adams brand, made by  Boston Beer (SAM)). Last year, craft beer grew 12% while other beers were mostly in decline. It seemed that no amount of innovation (anyone remember B-to-the-E?) or marketing could change that trend. Now it appears that two seemingly negative developments--rising commodity costs and a weak consumer environment--will actually benefit the incumbents to the detriment of the smaller, trendier players.

For beer, it began with rising commodity costs. Starting in 2007, costs for inputs like hops and barley started shooting up, and since beer is a scale business, smaller brewers were feeling more of the pain. Companies like A-B, with 50% share of the U.S. beer market, and Molson Coors, which operates in a rational oligopoly in Canada with  AmBev  and now shares 30% of the U.S. beer market with SABMiller through a joint venture, have procurement advantages far and beyond those of their trendy rivals (Boston Beer, for example, is the largest craft brewer in the U.S. but has less than 1% market share). Because of this large discrepancy, big brewers haven't had to raise prices as much as smaller players have. For example, Boston Beer raised prices 5% while A-B has raised prices around 2.5% to 3.0%. Additionally, Boston Beer expects gross margins to drop 300 basis points this year while A-B is forecasting that gross margins will be flat to down modestly.

Another advantage to the big brewers is that their brand portfolios are better positioned for a weak economy. With food and fuel costs up and real estate and market prices down, consumers are more selective with their purchases in virtually every category. Suddenly, now that more expensive craft beer doesn't seem worth the higher price, especially as craft brewers are forced to take higher percentage price increases on already higher price points, thus widening the price gap between Sam Adams and Bud Light.

What's the result? A-B and Molson Coors, which have medium to lower-end priced brands, are reporting great number in the U.S. A-B is finally growing volumes again and might actually expand gross margins this year, and Keystone Light is growing faster than Blue Moon. In the end, we think the incumbents can steal back lost share and regain equity in their brands, and we expect high costs and lower volume growth to hurt, and possibly eliminate some, craft brewers. Also, the U.S. brewing giants will only get stronger, in our opinion, as A-B's acquisition by InBev will give it greater international opportunities and Molson Coors' joint venture with SABMiller allow for significant cost savings and profit growth.

What about Spirits and Wine?
The story is more nuanced in spirits and wine. Commodity costs are less of an issue, but premiumization over the past several years has been more pronounced. We think trading down will occur, potentially all over the globe, due to macroeconomic head winds affecting consumer spending. However, unlike in beer, the premium-priced spirits and wine companies are usually the bigger players. Overall, we think the companies with the best portfolio of brands, strong balance sheets, and economic moats will fare the best.

Sales of spirits and wine have gone nowhere but up over the past decade. Consumers have been trading up to more sophisticated and premium-priced brands and also foregoing beer consumption in favor of spirits and wine. However, just like with beer, we think some consumers on the margin and those in weak markets like California and Florida will trade down to lower-priced brands or forego consumption during this tough economic period. We also suspect that many regions that have experienced supersized growth recently, such as Russia and Eastern Europe, could begin to show signs of a slowdown given certain economic red flags, like weakening currencies and crumbling stock markets.

However, we think the companies with the best brand equity and the moatiest portfolios will fare well. For example, in the U.S. the typical consumer of Johnnie Walker Black Label (made by  Diageo (DEO)) has an income of $100,000 to $120,000 and consumes 2.5 bottles per year. This consumer may forego a vacation or a new car this year, but it is unlikely that this consumer is so strapped for cash that he or she will forego the affordable luxury of premium Scotch whisky. For  Brown-Forman (BF.B), the enduring brand equity of Jack Daniel's and its "aspirational" qualities in emerging markets should distinguish it from other brands and help Brown-Forman preserve its robust cash generation in good times and bad.

Standouts at Great Prices
The market is making virtually every alcohol company more attractive from a valuation standpoint, but we would steer investors away from stocks with high financial leverage, such as AmBev,  Fortune Brands , and  Constellation Brands (STZ), and toward what we feel are the highest-quality names. In general, the premium spirits companies are more insulated from spiking agricultural commodities and have much stronger international growth prospects. For these reasons, we like Diageo and Brown-Forman. As scale becomes more paramount for success in mature beer markets, we think Molson Coors is a great way for investors to capitalize on that trend. We think Molson Coors will benefit from greater scale through the MillerCoors joint venture, something the market is not currently pricing in, in our view.

 Diageo  (DEO)
Uncertainty Rating: Low | Price/Fair Value Estimate Ratio: 0.63 | 5 Stars
Spirits behemoth Diageo is hands-down the best spirits company on the planet. It has scale, powerful brands, and the best emerging-markets presence. In some markets, Diageo is pursuing a luxury positioning. For example, for roughly $550 one can purchase a 750-milliliter bottle of Johnnie Walker Blue Label King George V Edition that is packaged in a crystal decanter in a plush silk-lined box with a certificate of authenticity. Not surprisingly, such products are highly profitable.

 Molson Coors  (TAP)
Uncertainty Rating: Medium | Price/Fair Value Estimate Ratio: 0.55 | 5 Stars
Over the past few weeks, the market has wiped out virtually all of the benefits of the SABMiller joint venture in Molson Coors' stock price. We think Molson Coors on a stand-alone basis without the Miller Coors JV is worth somewhere in the low $50s, with the JV easily adding another $20 per share in value. With the stock trading in the high $30s to low $40s today, investors can buy Molson Coors at a discount and get a free option on the earnings benefits from MillerCoors.

 Brown-Forman  (BF.B)
Uncertainty Rating: Medium | Price/Fair Value Estimate Ratio: 0.77 | 4 Stars
In our opinion, Brown-Forman's biggest opportunity is in international markets. The firm has been especially savvy in tailoring its marketing message for Jack Daniel's in emerging markets. For the first time in the company's history, more than half of fiscal 2008 sales came from markets outside the United States (up from 20% in 1994), and in fiscal 2008, the company's sales increased 4% in the United States, but 17% in Europe and 54% in all other countries such as Japan and South Africa. We think Brown-Forman will continue to take the cash provided by its very profitable U.S. business and invest it behind expanding its presence internationally. Over time, we think Brown-Forman's mix shift could approach something similar to that of rival Diageo (split evenly between North America, Europe, and all other countries), although we doubt the firm can be as big.

Price/fair value estimates are based on closing prices as of Oct. 16, 2008.