Alcoholic Drink Stocks: On the Rocks?

The economic slowdown and spiking fuel costs are hurting some segments, but liquor proves fairly recession resistant, even as prices go up

Like most consumer-discretionary products, sales of wine and spirits have been hurt by spiking fuel prices, rising unemployment, and pervasive worries about the U.S. economy. But alcoholic beverages, like cigarettes and other tobacco products, appear to be less discretionary than most nonessential items due to the lifestyle choices that drive demand for them.

"Beverage alcohol continues to be pretty recession-resistant," says Richard Hurst, an analyst at market-research firm The Nielsen Company. "Spirits are still showing tremendous resilience."

Data collected from the principle retail stores showed spirits sales up 5.4% in May on a dollar basis, and 3.6%

on a volume basis, which Hurst deems very healthy.

Top-Shelf Growth

"We're continuing to see the top end of the market for spirits outperform the rest of the market," he says. "Premium and ultra-premium brands—those that are $12 and above—are still seeing very healthy growth, and we're seeing those sectors increase their share of the total market."

Constellation Brands' (STZ) healthy profit report for the quarter ended May 31, posted on July 1, seemed to confirm that. The Fairport (N.Y.)-based company attributed a nearly 62% jump in earnings, to 34¢ a share, to wider profit margins that stemmed from price hikes in all markets and from selling more of higher-margin wine brands such as Clos du Bois than lower-margin ones such as Almaden. Including integration costs related to acquisitions, restructuring charges, and other nonrecurring items, Constellation reported earnings of 20¢ a share, vs. 13¢ a year ago.

Investors were encouraged by the earnings—and Constellation's reaffirmation of its $1.68-to-$1.76 EPS forecast for fiscal 2009—pushing the shares up 4.5% to close at 20.75 on July 1, while most of its competitors fell out of favor as the strength Constellation is showing in the face of a consumer pullback isn't being shared across the spirits industry.

After the market close on June 30, Fortune Brands (FO) issued a profit warning, saying it now expects earnings from continuing operations to be about 16% to 25% lower than the $1.51 a share it reported for the second quarter of 2007, instead of the 6% to 15% drop it had initially estimated.

Mixed Business

Granted, Fortune isn't representative of the spirits industry, given that its business portfolio also includes home and hardware products such as kitchen cabinetry, doors, and windows, and golf brands such as Titleist. Even its Beam Global Spirits & Wine business is atypical, with sales in Australia coming under pressure in the past two months since the government hiked the excise tax on ready-to-drink spirits, driving consumer prices for Fortune's Jim Beam products up 25% in that country.

Citing the rapid spike in gasoline prices and a decline in consumer confidence, Fortune Chief Executive Officer Bruce Carbonari says the company is seeing home-improvement purchases stay soft, deferred big-ticket purchases by golfers, and a slower rate of trading up to premium-brand hard liquor purchases. For the full year, the company now expects earnings before charges and gains to drop by roughly 6% to 19% from 2007 earnings of $5.06 a share rather than the flat to 9% lower estimate it previously made.

Fortune shares lost 13.3% of their value to close at 54.13 on July 1 and seemed to damp investor enthusiasm for other spirits stocks such as Diageo (DEO), which finished 2% lower at 72.38, and Brown-Forman (BFB), which ended down 3.7% at 72.80.

Analyst Robin Diedrich at Edward Jones & Co. says in a June 30 research note that Fortune's spirits division is less sensitive to the slowing economy than its home and hardware and golf divisions, which gives the Deerfield (Ill.)-based company "a good balance across its revenue base." (Diedrich has a buy rating on Fortune Brands.)

At London-based Diageo, strength in Eastern Europe and Russia should offset softer sales in Western Europe over the next two years, analyst Bryan Spillane wrote in a research note for Bank of America Securities (BAC) on June 25. He reaffirmed his forecast of 4.6% growth in operating profits in 2008 and 4.5% in 2009. (Spillane has a buy rating on Diageo and Bank of America Securities and/or its affiliates, and has done investment banking with Diageo in the past 12 months and expects to receive or to seek compensation for those services within the next three months.)

Trading Up

Spirits have been taking back market share from the beer industry since 2001, says David Ozgo, chief economist at the Distilled Spirits Council, the liquor industry's trade group.

"People drink less now but they tend to drink better. People have been continuously trading up in the last seven to eight years," he says.

Diedrich at Edward Jones says she expects the market-share gains the spirits industry as a whole has taken from the beer industry in the past few years will moderate, but she predicts industry growth will continue at almost 3% a year. "Spirits sales historically hold up well during economic cycles, although the mix of premium brands to lower-priced brands does fluctuate," her note says.

Fortune's popular brands and pricing power should help the company grow faster than the broader industry, bolstered also by the acquisition in 2005 of many Allied brands that give it global marketing opportunities as well as a joint venture to distribute Absolut Vodka in the U.S. through 2012, Diedrich says.

Hard Stuff

Nielsen's Hurst worries that if price hikes are aggressively implemented through the system from suppliers to distributors to retailers, it may put the brakes on industry growth.

He also suspects some of the growth in at-home consumption is being fueled by a shift from out-of-home consumption, as bar and nightclub owners have confirmed a drop in traffic. That shift has partly been fueled by higher gas prices, with consumers also making fewer trips to supermarkets and liquor stores, though they are spending more on each visit, says Hurst.

Some of the strength in sales of wine and hard liquors, as opposed to beer, stems from the fact that higher income groups are more disposed to those products, says Hurst.

"We think wine and spirits will be the last to be impacted, so some of this may be a delay," he says. "But there's enough strength in that income [group] that they can probably weather this pretty well."

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