Fortune Brands: More Than Just Lucky
By Howard Choe
With interest rates at the lowest levels in nearly four decades, Americans have purchased new homes -- and remodeled existing dwellings -- at a frantic pace. And that has been a boon for Fortune Brands (FO ). With consumers focusing their home investments in kitchen and bathrooms, Fortune's Moen faucets and cabinet lines (which include such well-known names as Aristokraft) should continue to see strong demand.
A strong position in kitchen and bath products -- and several other markets -- is just one reason we at Standard & Poor's find Fortune's stock appealing. We also like its attractive valuation, the company's focus on shareholder value, and a solid track record of financial performance. We've assigned the shares our highest investment rating of 5 STARS (strong buy).
Fortune is likely to keep benefiting from healthy consumer spending patterns, with more than 90% of its sales derived from brands with the No. 1 or No. 2 positions in their respective markets. Of Fortune's four operating divisions -- home and hardware, spirits and wine, golf, and office products -- we believe the first two are likely to continue to be standouts in the near and intermediate term.
One other inducement for investors: Fortune pays a cash dividend of $1.08 per share, translating to a yield of 2%, which is at the high end of the range among its industry peers.
The home and hardware division (45% of sales and 46% of operating income) is a leader in kitchen and bath products in North America with brands including Moen faucets and Aristokraft, Schrock, and Omega cabinets. In February, 2002, this division was chosen by Home Depot (HD ) to produce the entire line of its Thomasville brand cabinets for all of its U.S. stores. Fortune also produces the Diamond line of cabinets for Lowe's (LOW ).
Recent housing data suggest that consumers are likely to continue spending on their homes. New-home sales increased 7.5% in 2002 and were up 12%, year-over-year, in April, 2003. Existing-home sales increased 5% and 3%, respectively, for the same periods. With kitchens and bathrooms widely considered the most important rooms (in terms of home value) for owners and buyers, we expect Fortune to remain a key beneficiary of the strong housing market. We see both sales and operating profit increasing in mid to high single digits in 2003.
Regardless of the economic climate, we at S&P believe that consumers usually rely on the quality and performance of leading brands. And Fortune's product lines fit that description. Among its portfolio are brands that hold either the No. 1 or No. 2 positions in their respective categories. In the home category, Moen is No. 1 among faucet makers, while Aristokraft, Schrock, and Omega collectively are No. 2 in cabinets. Masterlock is the leader in padlocks, while Waterloo, which supplies tool-storage products to Sears (S ) Craftsman, is No. 1 in its category.
Brands in Fortune's other operating divisions also sport market-leading positions. In spirits and wine (18% of sales and 36% of operating income), Jim Beam is the top-selling bourbon, while DeKuyper is the leader in cordials. In golf (18% and 17%) Titleist (balls) and Footjoy (shoes and gloves) are each No. 1. Fortune's office-products segment (19% and 9%) also features a number of market-leading brands.
Another thing that makes Fortune appealing to us is its solid history of financial performance, delivering consistent sales and earnings growth, attractive return on equity, and strong cash flow. Over the past six years, comparable sales and operating earnings have increased on average 3.5% and 6%, respectively. By Howard Choe
However, average annual earnings per share growth (before unusual items) for the same period was more robust, up nearly 15%. EPS growth has been boosted by share repurchases and lower interest expense. Fortune bought back 42 million shares at a cost of $1.4 billion during the past six years, and it repurchased 2 million shares in the first quarter of 2003.
It has worked down its long-term debt from more than $1.9 billion at the end of 2000 to $1.3 billion at the end of March, 2003, funded by its strong cash flow. Growth in annual return on equity and free cash flow (after dividends) has averaged around 18% and 36%, respectively, over the past six years.
Fortune, in our opinion, also has a solid history of increasing shareholder value by making acquisitions that add to earnings, cultivating higher-margin businesses, and driving down costs. Two recent strategic moves bear this out. In June, 2001, Fortune established a strategic alliance with Vin & Sprit, the makers of Absolut vodka, creating a leading global spirits and wine distributor. The distribution costs savings provided by this deal added over 20 cents to EPS in 2002, after contributing 11 cents in 2001.
And in April, 2002, Fortune acquired the No. 4 cabinet maker, Omega Group, for $538 million, adding custom and frameless semi-custom lines to its offerings. Benefits from the acquisition added more than 15 cents to EPS in 2002, exceeding the 8 cents to 10 cents that had been expected.
At S&P, we expect Fortune's 2003 sales to increase about 4%, reflecting a modest improvement in consumer spending, in line with a slowly recovering economy. Home and hardware sales should be supported by a resilient market for new-home purchases and remodeling, which is being bolstered by low interest rates. Solid demand for Jim Beam products and premium brands should drive a modest increase in sales at Fortunes' spirits and wine division.
We expect a pickup in golf-related sales, mainly reflecting new products. Industry softness should again put pressure on sales of the office-products division, which we see as down moderately in 2003. Profitability should improve modestly because of savings from consolidation and relocation of manufacturing facilities.
A BETTER BET?
S&P projects that EPS will advance 12% in 2003, to $3.56, and we see Standard & Poor's Core Earnings of $3.04 per share, mainly reflecting adjustments related to pension and post-retirement costs.
In light of management's strong execution and Fortune's robust financial condition, we find the shares attractively valued at a recent multiple of 15 times our 2003 EPS estimate, a 19% discount to the p-e of the S&P 500-stock index. Fortune also trades at a 22% discount to its peer, Brown-Forman (BF.B ), even though Fortune has what we view as superior and more consistent earnings growth.
Fortune's shares also trade at a large discount to our estimate of intrinsic value, derived from our discounted cash-flow analysis. Using a weighted average cost of capital of 8.62%, assuming free cash-flow growth peaks at 11% and declines to 4% over a 15-year time frame, and remains at 4% in future years, we arrived at a share value of $65, representing potential appreciation of 21%. Given that Fortune has generated a five-year compounded average growth rate for free cash flow of 21% ending in 2002, we believe our assumptions are conservative.
Standard & Poor's forecasts for Fortune Brands aren't without risks. We consider the primary one to be rising interest rates, which could slow the purchases of new homes and spending on remodeling of existing homes. A deteriorating economy could induce customers to decrease purchases of Fortunes many products. Also, implementation of higher excise taxes on spirits and wine could deter consumption growth.
Analyst Choe follows household-products stocks for Standard & Poor's