Brown-Forman

Board Report
Potential Acquisition of Southern
Comfort Corporation

This board report summarizes the

arguments for why it is believed that the
acquisition of Southern Comfort
Corporation (including Caligrapo Inc.) is a
strategic fit that will increase shareholder
value through increased sales and
profitability

Vineshinee Perumal
CONTENTS

1. Executive Summary...................................................................2
2. Background..............................................................................3
1.1 An Industry Analysis.............................................................3
1.1.1 A Mature Industry...........................................................3
1.1.2 Key Success Factors.......................................................3
1.1.3 Competitor Analysis........................................................5
3 Qualitative Analysis...................................................................7
3.1.1 Strategic Analysis...........................................................7
3.1.2 SWOT Analysis...............................................................7
3.1.3 Strategic Fit...................................................................8
4 Quantitative Analysis.................................................................9
4.1 Comparison of Southern Comfort to its peers*.........................9
4.2 Increasing Shareholder Value...............................................10
4.2.1 Return rate (Gross Profit)..............................................10
4.2.2 The Earnings per share..................................................10
4.2.3 Share Value.................................................................10
4.2.4 Asset/Equity Ratio........................................................10
4.2.5 Cash Flows..................................................................10
4.2.6 Cost of Capital (WACC)..................................................11
5 Recommendations...................................................................11

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 1. Executive Summary

In 1978, Brown-Foreman Corporation was a successful producer and

marketer of alcoholic beverages operating mainly in the United States
market. The company through the acquisition of brands such as Jack
Daniels, Bolla and Canadian Mist expanded its premium product lines.
The company spent large sums of money advertising premium brands
and significantly less on low profit brands. In the late 1970’s, the
whiskey market declined and this presented Brown Foreman with
growth challenges in a mature dwindling market.

Brown-Foreman’s response to market pressures and competition was

to aggressively move into other faster growing segments of the
alcohol beverage market which required it to expand its product lines.
The company also intended to increase its advertising spend to $86
million to aggressively promote its alcoholic product lines. The
company also realised that future growth was very dependent on it
gaining access to foreign markets quickly.

The company was presented with an interesting offer to purchase

Southern Comfort for an amount of $94.6m. This report supports the
view that Southern Comfort is an attractive horizontal acquisition for
Brown-Foreman and provides the following value if acquired;

 One fifth of the Southern Comfort sales were overseas. Its

exports market also had the highest 5 year compound growth
rate of 37.8% than its other channel markets
 Much like the Jack Daniels brand, the company developed a
distinctive brand with loyal customers
 Southern Comfort being a liqueur does not need to age and
can be produced and sold much faster than the traditional
whiskey line
 Southern Comfort is a profitable company with a profit/sales
ratio as high as 7% on par with Brown-Foreman
 With an acquisition, shareholders value will increase with the
earnings per share earnings per share will increase 16% from
2.45 to 2.82 and the share value increases increase from
$16.9 to $18.2.
 Southern Comfort has a higher than average sales/assets ratio
of 2.49. This may be an indication of efficiency and could be
impacted by factors such as economies of scale where much
larger sales of a single line product may be able to gain the

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 economies by minimising the fixed cost per unit as a result of
higher production levels.

2. Background

1.1 An Industry Analysis

1.1.1 A Mature Industry

The distiller industry is in the maturity phase of its industry life cycle
(which is the supply side equivalent of the product life cycle model).
The increasing market saturation has caused tapered demand,
replacement products and fierce competition in the industry. As there
is limited market growth, the increase in demand for one product line
is at the expense of others. Cost efficiencies are increasingly being
sort through capital intensity, scale efficiencies and lower input costs.

Increased market saturation in developed markets has caused the

Distiller industry to focus its attention on developing markets. As price
competition increases in the saturated mass market, there is also
increased focus on attempts to differentiate through branding, quality
and increased brand loyalty to encourage repeat purchases.

1.1.2 Key Success Factors

According to Grant (2010), in order to proposer and survive
organisations must meet two important criteria that is, supply what
customers want to buy and survive competition by constantly evolving
and adapting the organisation to meet the dynamic external changes.
Applying this model to the distiller industry, we can identify the key
success factors required in order to survive and prosper in this
industry.

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4|Page
 Analysis of Demand Analysis of Competition

 Customers are willing to pay  The industry is characterised by

for premium, quality brands
 Customer are loyal to
brands, creating longer
product life cycles for
premium brands
 Product consistency and
quality is of high importance
 The mass market is price
sensitive requiring lower
prices for ‘inferior’ brands
 Convenience and location is
important for customers
high fixed costs (e.g. plants and
equipment) and high barriers to
entry (e.g. alcohol licensing fees
& high taxes) which means
fewer competitors and intense
competition whereby financial
strength and cost efficiencies are
essential
 Differentiation can yield a
substantial price premium and
can build loyalty

Key Success Factors

 Cost efficiencies are essential which requires large-scale plants and

equipment, low cost location and rapid adjustment for demand of
products.
 Emphasis on branding, advertising, loyalty and understanding of
customer preferences
 Economies of scale in marketing is essential with sales volumes
needed to offset high advertising costs
 Aggressive marketing and marketing skills is required to position
brands
 Increased channels of distribution and new markets are required to
leverage economies of scale needed to sweat assets and maximise
returns
 Understanding consumer preference and speed of response to
changing consumer preferences
 Extended product life cycles
 Expanding product lines

1.1.3

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1.1.4 Competitor Analysis
In comparison to its competitors*, Brown Foreman is in a good financial
position demonstrating the highest profitability amongst its peers. The
company has managed to achieve good growth in a slow mature market and
has managed to efficiently utilise its resources, giving its investors good
returns. The company has however not managed to achieve the same level of
economies of scale as some of its competitors but has managed to achieve
some sort of differentiation for the level of growth in their sales. Overall the
company is in a very strong market position and the market generally is
optimistic of the organisations potential.

Industry Brown- Comments

Average Foreman

Assets/ Equity 1.84 1.37 For every rand of equity they have less
assets then their competitor which could be
because the competitors have expanded
internationally. The average industry ratio is
1.84.

Sales/Assets 1.43 1.46 The sales to assets indicate the level of

sales that are generated by the use of
assets and can be seen as a measure of
efficiency. This indicator for Brown Foreman
slightly over the industry average of 1.43
indicating an average level of efficiency
when compared to its competitors.
Profit/Sales 0.04 .073 Brown-Foreman has the highest ratio of
profit to sales which indicates an excellent
performance with only Hirman Walker
coming close with a ratio of 0.069. The
industry average is 0.04. By converting the
most sales into profit Brown-Foreman is the
most profitable amongst its peers.
Price/Earnings 8.37 8.2 Generally all competitors are creating good
value for their shareholders.

Dividend Yield 0.06 .043 This ratio indicates the level of dividends
At 4/14/78 that are distributed as a % of the current
stock price. Brown-Foreman has a below
average dividend yield of 0.043 which in line
with its policy of distributing high levels of
dividends but in comparison to its
competitors is lower. Two competitors are
not paying dividends which are not
necessarily an indicator of profitability; it
could mean that there is investment taking
place for long term growth potential.
Self-sustaining 0.07 .102 Even in a market where there is a slowdown
 growth rate in whiskey sales, Brown-Forman has
managed to achieve the highest level of
self-sustained growth indicating that it has a
sustainable competitive advantage
1978 expected 0.06 .09 Brown-Foreman has the highest expected
sales growth sales growth amongst its competitors which
could indicate that the company has plans
to reinvest its retained capital in projects
that will generate high sales growth.
Market Book 0.88 1.26 This ratio looks at how the market values
Value the shares. Only Heubien and Brown-
Foreman have managed to achieve double
digit ratios which indicate a very good level
of the price compared to its underlying
assets and the way it is being used. The
views the company very positively.

 *Only the most relevant ratios were analysed, for all the complete list of
ratios refer to appendix 1.

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3 Qualitative Analysis

1.1.5 Strategic Analysis

Brown Foreman has clearly achieved a competitive advantage through
a differentiation strategy which places more emphasis on branding,
advertising, quality and understanding customer’s needs. The
company has managed to create premium brands such as Jack
Daniels through aggressive marketing and high advertising spend.
The company has also build strong marketing skills to enable the
organisation to differentiate its products based on brand positions. A
differentiation strategy offers a more secure basis for competitive
advantage clearly demonstrated by its strong sales growth than a low
cost strategy.

1.1.6 SWOT Analysis

In comparison to its competitors, Brown Foreman’s most outstanding
weakness is its lack of a global footprint to achieve economies of scale
and entry into new markets. It also needed to expand its product line
to cater for the changing consumer preference.
1.1.7 Strategic Fit
The possible acquisition could create a good strategic fit with
Southern Comfort addressing some of Brown-Foreman’s immediate
market and competitive pressures.

1.1.7.1 Achieving Economies of Scale

In order for Brown to achieve the economies of scale it needs to
improve efficiencies and increase profitability, the company needs to
look at international market expansion. In order to achieve this, it
needs an extensive global distribution footprint. Southern Comfort
has a higher than average sales/assets ratio of 2.49. This may be an
indication of efficiency and could be impacted by factors such as
economies of scale where much larger sales of a single line product
may be able to gain the economies by minimising the fixed cost per
unit as a result of higher production levels. It would be easier and
quicker for Brown to acquire an international footprint than to build it
and to leverage Southern Comfort proven capabilities in this area.

1.1.7.2 Achieving Synergy

The acquisition could see a duplication of functions which can be
reduced by sharing resources such sales staff, buildings and logistics
which will bring savings and lower overhead costs. The acquisition will
be beneficial to Brown Foreman if the combined organisation has
value greater than the sum of the values of the separate organisation.

Sьѕ > Sь + Ss
Where S= Synergy, B =Brown & S = Southern Comfort

1.1.7.3 Increasing Resources and Capabilities

Southern Comfort has a number of tangible and intangible resources
which will address the gaps in Brown Foreman growth strategies
through an acquisition. From a tangible resource perspective, its
plants is equipped with modern equipment, it has strong financials as
indicated by its net profit margin 7% in 1977. Its strong intangible
resources and capabilities are its secret recipe to expand Brown
Forman’s product line, its strong brand and its management and sales
team skills.

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 2 Quantitative Analysis

2.1 Comparison of Southern Comfort to its peers*

The company is in healthy financial state. Income from operations
went up by 15% indicating strong operational performance and the
company is able to sell more effectively than its peers. Refer to
appendix 2 for details.

Brown Southern Industry Comments

Foreman Comfort * Average
Profit/ 0.73 0.068 0.04 Brown Foreman has the
highest ratio of profit to sales
Sales
which indicates an excellent
performance. Southern
Comfort is on par.
Sales/ 1.46 2.49 1.43 Southern Comfort has a very
high ratio indicating that it is
Assets
very efficient using its assets
to generate sales which could
be a valuable capability for
Brown-Forman.
Debt/ .247 0.54 0.55 Southern Comfort has higher
gearing ratio than Brown’s
Equity
indicating a higher reliance on
debt than equity.

*Due to the lack of data, an indicative comparison the 1977 figures of Southern
Comfort were used to compare the company to the industry average figures of
1978.

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 2.2 Increasing Shareholder Value

2.2.1 Return rate (Gross Profit)

Currently Southern Comfort is showing a good average gross profit
growth rate of 7% which will enhance the shareholder value after the
acquisition. The company shows a healthy 5 year forecast but growth
slows and then declines in year 10 by -1.15 %( Refer to Appendix 3).
This slow down and decline could be attributed to the lifecycle of the
product. The product could have reached maturity and will need some
form of innovation.

2.2.2 The Earnings per share

The level of value created for shareholders individually is not only
dependant on the company’s results, but also the number of shares
held. If the acquisition goes ahead, the number of Brown-Foreman
shareholders stays the same and as such shares are not diluted. This
means that earnings per share will go up from $2.45 to $2.82 that is
a 16% increase (assuming the net income growth for Southern
Comfort will be the same for 1978 as the growth rate from 1976-
1977). Refer to appendix 2

2.2.3 Share Value

After acquisition share value will increase from $16.9 to $18.2 due the
fact that there is no increase in share amounts. The shares are not
being diluted so shareholders will be getting more from each share
held. Refer to appendix 2

2.2.4 Asset/Equity Ratio

There will be an improvement in the asset/equity ratio from 1.37 to
1.44 after a merger implying the assets have increased in relation to
shareholders equity. These increased assets can be used to generate
more revenue for the company. Brown-Forman’s ratio pre-merger was
below industry average.

2.2.5 Cash Flows

Both Companies show positive cash flow from operations. Southern
Comfort Cash flows was done for 1976-1977 and would be indicative
of the following year provided nothing drastic occurs. The cash flow for
these companies both look strong and this will be good for Brown-
Foreman in an acquisition. This also implies that they will be able to
finance the $70 million easily from cash flows. Refer to appendix 4

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 2.2.6 Cost of Capital (WACC)
Using the CAPM model, the cost of equity for this project worked out to
14.27% and the cost of debt 4.31%. Together the cost of capital worked
out to 6.50% which is low compared to their hurdle target rate of either
14% or 12% for new and existing projects. Although this project does
not mean Brown-Forman’s long range financial target goals, it is a
project that has a good strategic fit and could be a strategic acquisition.

3 Recommendations

 Brown Foreman is not geared heavily in relation to its peers. The debt
to equity ratio is 24.7%. Industry average is 55%, the company can
afford to take on more debt to finance this acquisition.
 Southern Comfort is not listed, the brothers want $94.6m for the
company but the book value in 1977 was $16.7m. It is recommended
that this acquisition be further investigated more as a strategic
acquisition rather than a pure financial one.
 Brown- Forman wants to use finance and debt to fund this acquisition
($20 m cash and $70m debt); it is recommended that company
considers financing a higher debt than $70m to get the additional tax
shield benefits. Currently tax is very high is this industry at 50%.
 Brown-Forman’s hurdle rate is too high implying that the company is
very conservative in their choosing of projects. It is recommended
that the company revise this hurdle rate as they could miss out on
important strategic opportunities such as Southern Comfort.
 It is recommended that the company proportions a significant amount
of its planned advertising spend to market the Southern Comfort
brand more aggressively.
 It is recommended that the company considers carefully the culture,
systems and processes of the Southern Comfort in the acquisition.
The people aspects are especially important post-merger to ensure
that skills and capabilities are not lost. The management team is
especially valuable as they have shown that they are able to run an
efficient profitable business with no shareholder involvement and
should be returned to ensure a successful merger.

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 Appendix 2: Key Ratios
   
Industry Analysis: Southern Comfort 1977
  Profit/Sales 6.81%
Appendix 1: Competitor Analysis
  Sales/Assets 2.49
    Book Value 15m
    Debt/Equity         0.539          
BROWN-FORMAN  DISTILLERS Debt/Total Assets
CORPORATION 0.35
Comparative Financial
  Data, 1978
   
  Earnings Per Share for Brown Foreman 1978
America
  Projected net income for Southern Comfort** 5 245 754
  n Brown- National Publicker Hiram Average Comments
  Net income of BF for 1978 31 247 000
  Distilling Forman Heublein Distilling Industries Seagram Walker
  No of Shares 12 908 739
  -------- -------- -------- -------- -------- -------- --------
Net Income* of BF + Net Income of SC**/no of
Beta 1.41 1.10 1.71 0.79 1.63 1.04 0.65 1.19 Lower volatility than average
  shares 2.826981
Marginal tax rate 0.30 0.50 0.49 0.47 0.40 0.46 0.50 0.45 Tax Rate higher than average
     
Debt/equity 1.14 0.247 0.55 0.34 0.84 0.53 0.20 0.55 Much lower Debt to equity
  *Divided the earnings by EPS to get the no of shares
Debt-cash/total
capital 0.50
** Net income 0.11
growth bet0.28 0.16 is 20% based
1976 and 1977 0.44 on this0.32
we assume0.12 0.28 Debt to total capital is the lowest
Assets/equity   2.46 1.37 2.16 1.65 2.04
that it will have the same growth rate bet 1977 to 1978 1.76 1.43 1.84 Lowest Assets to Equity of its peers
Sales/assets 1.66 1.46 1.80 1.35 1.49 1.22 1.04 1.43 Asset utilization used to create sales is average
Profit/sales Assets/Equity
0.012 0.073Ratio after merger 0.052
0.035 0.005 0.038 1979
0.069 0.04 Highest Net profit ratio
Price/earnings   SC9.4assets forecast
8.2 growth9.6
at 5.52% for 1979
6.5 NMF 8.8 28 668 651
7.7 8.37 Creating good value for their shareholders
Dividend yield at   BF assets forecast growth at7.2% for 1979 352 339 000
4/14/78 NIL 0.043 0.056 0.080 NIL 0.042 0.062 0.06 Lower than competitors
  Combined Assets of BF+ SC 381 007 651
Self-sustaining
growth rate   SC equity forecast
0.049 0.102 growth at 23% for0.079
0.053 1979 0.015 0.041 25 4530.054
654 0.07 Highest rate amongst its peers
 
1978 expected sales BF equity forecast growth at 9.72% for 1979 239 436 000
growth   0.02
Combined 0.09 of BF +0.06
Equity SC 0.08 0.04 0.07264 889 654
0.06 0.06 The market has good expectations of sales growth
Market value/book
  Assets/Equity after Merger 1.4
value 0.46 1.26 1.53 0.79 0.63 0.75 0.77 0.88 Relatively higher market to book value.
Share Value 1978
                         
  Share Value for Brown Foreman before acquisition 16.9
  Share Value for Brown Foreman after acquisition 18.2
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Appendix 3: Projections
BROWN-FORMAN DISTILLERS CORPORATION
Assumptions Used in Southern Comfort Cash Flow Forecast

1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988
------ ------ ------ ------ ------ ------ ------ ------ ------ ------ ------
PROFIT PER CASE
U.S. domestic
Revenue $49.62 $50.62 $51.42 $52.42 $52.92 $53.92 $54.92 $55.92 $56.92 $57.92 $58.92
Cost of goods 33.52 34.10 34.75 35.41 36.14 36.93 37.78 38.70 39.70 40.77 41.93
Advertising 4.07 4.01 3.80 3.68 3.83 3.89 3.92 3.97 3.33 3.18 3.37
Selling
Regular 0.55 0.58 0.59 0.60 0.61 0.62 0.63 0.63 0.65 0.67 0.70
Transition 0.71 0.34 0.15
PROFIT PER CASE 10.77 11.59 12.13 12.73 12.34 12.48 12.59 12.62 13.24 13.30 12.92
Export
Revenue 19.21 20.32 21.50 22.55 23.21 23.80 25.16 26.15 27.15 28.15 29.15
Cost of goods 7.08 7.65 8.26 8.92 9.63 10.40 11.24 12.13 13.10 14.15 15.29
Advertising 1.44 1.38 1.37 1.37 1.37 1.36 1.37 1.37 1.37 1.37 1.37
Brokerage 2.75 2.76 2.75 2.85 2.72 2.69 2.68 2.67 2.67 2.67 2.67
Selling exp. 0.05 0.05 0.05 0.06 0.06 0.06 0.06 0.06 0.07 0.07 0.08
PROFIT PER CASE 7.89 8.48 9.07 9.35 9.43 9.29 9.81 9.92 9.94 9.89 9.74
Canada
Royalty 3.48 3.48 3.48 3.48 3.48 3.48 4.00 4.00 4.00 4.00 4.00
Concentrate profit 1.55 1.55 1.55 1.55 1.55 1.55 1.55 1.55 1.55 1.55 1.55
PROFIT 5.03 5.03 5.03 5.03 5.03 5.03 5.55 5.55 5.55 5.55 5.55
CASE VOLUMES (in thousands)
U.S. 1140 1225 1315 1410 1510 1615 1725 1835 1923 1984 2015
Export 325 350 380 405 425 445 463 480 490 500 500
Canada 115 125 138 150 160 170 180 190 200 210 220
Total Case volumes 1580 1700 1833 1965 2095 2230 2368 2505 2613 2694 2735
CORPORATE LEVEL
G&A Expense 1665 1800 1944 2100 2268 2449 2645 2857 3086 3332 3599
Transition 430 380 180
Settlements 400 400 400 400
Interest expense 113 122 132 142 154 166 179 194 209 226 244

Total Revenue for US Domestic(In 000's) 56566.8 62009.5 67617.3 73912.2 79909.2 87080.8 94737 102613.2 109457.16 114913.28 118723.8
Total Revenue for Export(In 000's) 6243.25 7112 8170 9132.75 9864.25 10591 11649.08 12552 13303.5 14075 14575
Total Revenue for Canada(In 000's) 578.45 628.75 694.14 754.50 804.80 855.10 999.00 1054.50 1110.00 1165.50 1221.00
Total Revenue In Millions 63388.50 69750.25 76481.44 83799.45 90578.25 98526.90 107385.08 116219.70 123870.66 130153.78 134519.80

Costs for US 44289.00 47811.75 51666.35 55962.90 61275.80 66925.60 73019.25 79455.50 83996.64 88526.08 92690.00
Costs for Export 3679.00 4142.74 4722.68 5345.50 5857.46 6458.22 7104.77 7792.26 8435.15 9131.48 9702.59
Cost of Sales 47968.00 51954.49 56389.03 61308.40 67133.26 73383.82 80124.02 87247.76 92431.79 97657.56 102392.59

Gross Profit 15420.50 17795.76 20092.41 22491.05 23444.99 25143.08 27261.06 28971.94 31438.87 32496.22 32127.21
Appendix 4
Indication of cash flow strength

1977-1978 Appendix 5: Cos

Brown forman Cash flow $
Using CAPM
Ebit 69 151 000  
Increase in accounts recievable -19 313 000 Cost of Equity
Increase in inventories -18 348 000 Rf rate =
Increase in accounts Payable and accrued expenses 7 148 000 Beta =
Increase in accrued taxes 4 816 000 Rpm*=
Decrease in deferred taxes -1 109 000
 
Increase in deferred taxes 1 668 000
Re =
 
 
Cash Flow from operations 44 013 000
Cost of Debt
Strong Cash flow from operations
Tax rate =
 
1976-1977 Interest rate
Southern Comfort Cash Flow $ Cost of Debt
Ebit 8 175 522  
Decrease in accounts recievable 186 306 WACC
Increase in inventories -811 499 Percentage of eq
Decrease in Prepaid expenses 23 266
Percentage of de
Decrease in aaccounts payable -412 120
WACC
Increase in income taxes payable 165 798
 
Cash flow from operations 7 327 273 *The 10 year tre
Cash flow from operations positive and strong
premium
Retained earning