Fortune Is Busting out All Over


By Howard Choe What do bartenders, handymen, and golfers have in common? There's a good chance they turn to products made by Fortune Brands (FO

; recent price, $86), a diversified holding company with interests in several consumer-related businesses, including home and hardware, spirits and wine, and golf.

Standard & Poor's finds the shares of Fortune -- the name behind such top-shelf brands as Jim Beam, Moen, and Titleist -- appealing, based on a variety of factors. We like what we consider the company's strong market position and focus on shareholder value.

UNDERVALUED SHARES. In our view, Fortune also has a strong record of making strategic and financially advantageous acquisitions, including a July, 2005, deal to acquire spirits brands from Pernod Ricard. In addition, we believe the company is likely to benefit from healthy consumer-spending patterns in the home/hardware and spirits/wine segments over the next 12 months.

We also find the shares attractive based on our view of the company's history of financial performance -- namely, consistent sales and earnings growth, attractive returns on equity, and strong cash-flow growth. Given our view of the strength of its brands and the attractive categories in which it operates, we believe Fortune is poised to extend its record of strong profit growth.

The company's management team will likely continue to focus on enhancing shareholder value through portfolio optimization as well as dividends and share repurchases. We view the shares as undervalued and have a 5 STARS (strong buy) recommendation on the company.

CORDIAL BUSINESS. Fortune's largest segment in terms of sales and profits is home and hardware products, sold through the MasterBrand Industries subsidiary. In 2004, this segment accounted for 51% of total sales and 50% of operating company contributions (before corporate expenses). Its major units include MasterBrand Cabinets, Moen faucets and sinks, Master Lock locks, Waterloo tool storage, and Therma-Tru entry doors.

Spirits and wine products (16% of 2004 sales; 28% of operating profit) are sold through the Jim Beam Brands Worldwide subsidiary. Leading products include Jim Beam Bourbon whiskey, DeKuyper cordials, Gilbey's gin, Kamchatka vodka, and Geyser Peak wine. Principal markets consist of the U.S., Britain, and Australia. About 25% of the division's sales come from international markets. We estimate that the spirits and wine segment will account for about 33% of sales in 2006, due largely to the recent acquisition of brands from Pernod.

Golf products (17%; 13%) operations are conducted through Acushnet, a leading producer of golf balls (Titleist, Pinnacle), golf shoes (FootJoy), golf clubs (Cobra, Titleist), and golf gloves. Other products include bags, carts, dress and athletic shoes, socks, and accessories.

CATEGORY WINNERS. The company spun off its ACCO office products unit (16%; 9%) in July, 2005, through a merger with General Binding Corp.

More than 90% of Fortune's sales come from products that hold either the No. 1 or No. 2 positions in their categories. In the home and hardware categories, Moen faucets, Therma-Tru entry doors, Master Lock locks, and Waterloo tool storage products for Sears Craftsman (SHLD) hold No. 1 positions. In spirits and wine, Jim Beam bourbon resides at No. 1, while DeKuyper cordials and Courvoisier cognac rank as No. 2. In the golf category, Titleist golf balls and FootJoy golf shoes enjoy No. 1 status.

Over the past eight years, comparable sales and operating earnings have increased on average 6% and 16%, respectively. Return on equity and free cash flow growth (after dividends) have averaged around 20% and 19% per annum, respectively, over the same period.

HIGH SPIRITS. We think Fortune Brands has a solid history of increasing shareholder value through accretive acquisitions, cultivating higher-margin businesses, and driving down costs. Over the past five years, the company has established a strategic alliance with Vin & Sprit (the makers of Absolut vodka), and acquired complementary businesses including the Omega Group, Wild Horse Winery, Master Lock, and Therma-Tru doors. These acquisitions have largely been accretive, contributing to strong profit growth.

In July, Fortune Brands completed its largest acquisition when it purchased various spirits and wine brands from Pernod Ricard for $5 billion in cash. This transaction will more than double the sales of the company's spirits and wine segment and, we believe, add key brands in key markets.

The acquired Pernod Ricard brands have been increasing sales at a faster pace than the company's own brands and are expected to expand their presence in international markets. Fortune Brands will also gain additional sales and distribution operations in North America and Europe.

CONSTRUCTIVE GROWTH. Some of the key brands acquired are Sauza tequila, Courvoisier cognac, and Canadian Club whiskey. We estimate that the purchase will add an extra 25 to 35 cents to 2006 earnings per share. We view the deal positively, as it should increase the company's exposure to the fast-growing and more profitable (than overall company margins) spirits and wine categories.

According to industry reports, the value of spirits shipments rose nearly 9% in 2004, driven by increased marketing and brand innovation. As Fortune Brands integrates the assets acquired from Pernod, we expect it to derive synergies for several years by maximizing the efficiencies of the combined sales, distribution, and administrative units.

Our outlook for the company's two other segments is positive. With mortgage rates still low and sales of new and existing homes at record levels, we believe the home and hardware segment should enjoy solid growth. Two-thirds of the home-products market is driven by repair and remodel work -- given the aging housing stock and homeowners' focus on kitchen and bath projects, which typically deliver a high return on investment. We also note the typically 12- to 18-month lag for this type of work following the purchase of an existing home.

"FORE!" AND "CHEERS!" In golf products, we believe Fortune's innovation has helped to increase sales growth at a faster rate than the industry. Tournament successes by pros and user-friendly technologies for amateurs have created strong demand for Titleist balls and clubs, Cobra clubs, and FootJoy shoes, in our opinion. We expect the company's R&D investments to continue to fuel innovation, helping to sustain its leadership position in golf.

We expect Fortune's companywide sales to increase approximately 17% in 2005, reflecting the recent Pernod acquisition and moderate growth for all business segments. We expect home-product sales growth to draw positive momentum from a still-resilient market for home repairs and remodeling. Thanks to new products and brand strength, the golf division should see continued strength. Strong consumption trends for wine and spirits should drive solid demand for the larger wine and spirits segment, in our view.

We think profitability will improve modestly, due to synergies stemming from the Pernod acquisition and improved operating efficiencies. We are projecting about a 70-basis-point expansion in gross margin due to the larger contribution of the more profitable spirits and wine business.

GOOD EARNER. Due to higher amortization and marketing expenses tied to the acquisition, we are projecting a slower rate of operating-margin expansion. We project that operating EPS will increase 13% in 2005, to $4.67, from the $4.12 (adjusted for the ACCO office products spin-off) earned in 2004. Our 2006 EPS estimate of $5.41 assumes 16% sales growth and a 21% increase in operating profit.

Because of the relatively low impact of stock options and pension costs, we view the quality of Fortune Brands' earnings as above average. After adjustments made to the company's GAAP-based net income from continuing operations -- and before extraordinary items to conform to S&P Core Earnings methodology -- 2004 operating EPS of $4.12 would be lowered by about 2% to $4.03. (We note that 2004 EPS has been restated to reflect the recent spin-off of the office products division.)

This negative variance compares favorably to the 16% negative variance of the S&P 500 companies recorded in 2004. For 2005, we project S&P Core EPS of $4.45, about a 5% reduction from our operating EPS estimate of $4.67.

SOLID RECORD. Fortune has had a strong record of generating earnings growth at a higher level than peers and the S&P 500, and yet the shares trade only in line with the p-e-to-growth ratio of the S&P 500.

Given the company's track record of operating performance and the healthy near-term growth prospects, we believe the shares should trade at a relative premium to that of the S&P 500. Consequently, we view Fortune's shares as undervalued, recently trading at a p-e-to-growth ratio of 1.6 times, in line with the S&P 500 but well below our 12-month target price of $104, or 19 times our 2006 EPS estimate of $5.41.

Fortune also trades at a large discount to our estimate of intrinsic value, derived from our discounted cash-flow analysis. Using our DCF methodology, we arrive at a value of $113, some 30% above current levels.

STILL SOME RISKS. We view Fortune's corporate governance practices positively. The company's board comprises a majority of independent directors. The audit and compensation committees consist of independent directors. In addition, the company does not a have a "poison pill" or dual-class capital structure in place.

Risks to our recommendation and target price, in our view, include a significant increase in interest rates, which could slow the purchases of new homes and spending on remodeling of existing homes; a deteriorating economy, which could induce customers to decrease purchases of the company's home and hardware, spirits/wine, and golf products; and integration risk tied to the acquisition of the Pernod brands. Analyst Choe follows shares of consumer products companies for Standard & Poor's Equity Research Services


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