Brown-Forman Must Decide Whether or Not to Case Study

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Brown-Forman must decide whether or not to purchase Southern Comfort. The brand is a good fit strategically -- similar origins, strong growth trajectory, and complementary product. If Brown Forman can apply the same marketing skills to Southern Comfort as effectively as it has with Jack Daniels, the brand's growth could conceivably be even better in the future than it has been in the past. There are marketing, distribution and potentially even production synergies that can come into play as well.

The offer on the table is based on the current book value of Southern Comfort. Brown Forman, however, should value the offer based on the present value of the expected future cash flows. A net present value calculation should be conducted on the basis of those expected flows. Fixed costs and financing costs should not be included. The possible purchase of some assets back by the Fowlers following the sale will not be included, as this may not come to pass. The company's 14% hurdle rate is valid, even if the WACC comes in slightly lower. The revenue estimates for Southern Comfort are far below historic averages, so the NPV calculation should include more realistic -- but still conservative -- figures.

From a financial perspective, the deal has a positive NPV of over $26 million. The deal also makes sense strategically for Brown Forman. Therefore, it is recommended that Brown Forman accept the purchase of Southern Comfort. The brand comes in at a good price for BF, and is a great strategic fit.

Background

Brown-Forman is the fifth-largest distiller in the U.S., with Jack Daniels as its leading brand. The company has the opportunity to purchase Southern Comfort for an asking price of $94.6 million. Brown Forman has recently instituted some changes to its long-range financial goals, and these changes are expected to help guide strategy going forward. The goals were based on ongoing operations, with no expansion plans. The company does have a target for its capital structure in the 26% range. The company set a target hurdle rate of 14% for new projects. These elements of the financial plan should be re-evaluated in the context of the potential acquisition; the decision should be evaluated with the firm's financial objectives in mind. The ultimate objective of the new financial objectives is to increase shareholder wealth. It should be noted as well that the company's current financial position relative to its competitors is strong and this is seen as a source of competitive advantage.

Qualitative Analysis

One of the reasons why Brown Forman has stronger financials than its competitors is that it has better brands. Jack Daniels in particular has been successful, but in total the Brown Forman product line has grown even during an industry-wide slump. One of the sources of this success is something that can help to build future acquisitions. The success of Jack Daniels has been built on the long-term branding strategy employed by Brown Forman. This strategy has built name recognition for Jack Daniels, has created a mystique and other positive associations with the brand and has enhanced brand loyalty.

When considering acquisitions and the fair value thereof, firms need to understand both what the acquisition is worth on paper today, and what the acquiring firm can add to that. Under normal circumstances, the price a firm pays for an acquisition is fair market value, often defined as the present value of future cash flows from the acquisition at a fair discount rate. However, such a purchase would have a net present value (NPV) of zero. The value in an acquisition lies in what the acquiring firm can add to the brand. In this case, if Brown Forman can apply its marketing formula to Southern Comfort, can it deliver returns in excess of 14% of investment in perpetuity. If it can, then Brown Forman should purchase Southern Comfort.

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What Brown Forman needs to ask is what role Southern Comfort plays in its long-term strategy. The company currently has a strong presence in Tennessee whiskey and has made inroads into Canadian whiskey. Southern Comfort, by contrast, is a spiced spirit that originally contained whiskey. This liqueur shares Southern roots with Jack Daniels and is a whiskey product. There are likely to be synergies in distribution and marketing with the new acquisition and the target market is different, but possibly complementary to Jack Daniels.

To this point, Southern Comfort has been a success, owing to (unpaid) celebrity endorsement. The brand is at a high right now, but if the momentum can be maintained there is significantly greater potential for Southern Comfort. The brand has also experienced strong foreign growth, something that mirrors Jack Daniels. It is worth considering, however, that Southern Comfort has been rejected for purchase at the price it is asking of Brown Forman.

Also worth considering is that Brown Forman has predicated its decision in part on the method of financing. Modigliani and Miller (1958) argued that the method of financing is irrelevant to the investment decision; only the revenue streams and costs associated with the project determine its value. However, knowing this essentially precludes Brown Forman from using financing as the basis for its decision on the Southern Comfort purchase. Instead, the financing decision comes afterwards and is driven by the firm's view of its optimal capital structure and its cost of capital using specific instruments.

From a qualitative perspective, Southern Comfort looks like a good fit for Brown Forman. The brand has some positive momentum, but in the long-term it needs a big marketing push. Brown Forman's track record with Jack Daniels, if applied successfully to Southern Comfort, should deliver positive results. The other two distilleries may have passed on Southern Comfort because they did not have the marketing savvy to extract value from the brand, or because they were unsure of the fit that a liqueur would have in their lineup. For Brown Forman, another Southern drink with panache and strong sales growth seems a fairly natural fit, perhaps more so than for the other distilleries.

Quantitative Analysis

The value of Southern Comfort for Brown Forman is based on the present value of expected future cash flows. The key is that fair value for the brand is going to be what those cash flows are today; if Brown Forman can improve on those cash flows then the purchase is going to have a positive net present value. The offer that is on the table from Southern Comfort, however, is derived from an entirely different methodology. The Fowlers are basing their price based on the book value of the assets, including the brand equity.

To analyze the value of the future cash flows, Brown Forman needs a discount rate. The company's hurdle rate is 14%, so the first thing to do is test whether that figure is reasonable. Using the capital asset pricing model, we derive the cost of equity for Brown Forman as follows:

Ra = Rf + ? (Rm-Rf); or Ra = 8 + (1.1)(5.7) = 14.27%.

The cost of debt is 8.75% currently. The current capital structure for Brown Forman is 33.6% debt and 66.4% equity. Thus, the weighted average cost of capital is as follows:

WACC = (14.27)(.664) + (8.75)(.336) = 12.4%. This is more in line with the previous hurdle rate used by Brown Forman. The new hurdle rate can be used, however, because it is more in line with a riskier, faster-growing Brown Forman, such as the one that would emerge following the prospective purchase of Southern Comfort. Thus, the 14% hurdle rate is reasonable and will be used as the discount rate in the NPV calculation. The assumptions in the cash flow forecast are very.....

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