This Spinoff Stock Could Get a Takeover Offer -- and Deliver Big Gains

When a company breaks itself apart, investors get a number of unique opportunities to profit. First, there's an initial financial information vacuum, since it takes time for the new, independent businesses to report results on their own. Second, spinoffs can result in better-run businesses or lead to an outright acquisition from a larger player, which usually pays a nice price for the deal.

In February, I covered the numerous benefits of corporate spinoffs in more detail. I also reported that a company -- Fortune Brands -- had decided to split itself into three separate companies. The spinoff made total sense: Fortune Brands' operations were completely unrelated, and no one really understood why one company would simultaneously venture in the home-improvement, golf-equipment, and spirits and wine markets.

 

As three separate entities, each business has now a better ability to grow market share and reduce costs on its own. But of the three, the spirits and wine unit is likely to generate the best returns for investors. Here's why...

The spirits and wine unit owns a powerhouse of high-end bourbon, whiskey, tequila, rum and vodka brands. This business has been appropriately named Beam Inc. (Nasdaq: BEAM), after its leading bourbon, Jim Beam -- the largest bourbon brand in the world. It also carries widely-known names such as Maker's Mark and Effen vodka, to name a few.

Beam will report its first quarter of earnings as an independent firm in November, but I was able to dig up some financial information from a recent Securities and Exchange Commission (SEC) filing. Buried in one 8-K filing, I found that Beam reported nearly $2.5 billion in sales and about $235 million in net income during 2010. This worked out to be roughly $1.55 in earnings per diluted share.

Given Beam was just spun-off, previous years of financial performance are difficult to gather, and sometimes aren't! very us eful when trying to project performance to the new entity. But analysts currently project flat sales and $2.11 in earnings per share (EPS) for 2011, which translates to a whopping 36.1% improvement compared with last year. These trends are encouraging, but they aren't indicative of the company's long-term growth potential -- at least for now. It can take at least a couple of years for a newly-formed spinoff to hone its strategy and really take off.

What is certain is that the business is strong and steady. Spirit brands in general are highly profitable and relatively recession-resistant products -- people consistently consume alcohol in good and bad times. In addition, they are able to command even higher selling prices. And Beam has still plenty of room to grow the bottom line: its net profit margin was 9.4% last year, while  the wider industry average is 15%. This margin will likely increase as management looks for ways to cut costs and boost growth.

Beam is now the fourth-largest premium spirits firm in the world, and the largest in the United States. It makes 10 of the top 100 high-end spirits brands in the world. And because premium brands are also growing strongly in emerging markets, where a burgeoning number of consumers can now afford more expensive products, the company has the potential to grow sales in the double digits going forward. In addition, hard liquor has been stealing market share from beer for a number of years now, as higher-end brands have come into vogue across the world. Health trends have also discouraged demand for beer, which tends to have a higher number of calories than liquor.

It's easy to see Beam's organic growth appeal, but the primary motivation for the breakup from Fortune Brands was to free the spirits business for a potential acquisition. The market for high-end brands is extremely competitive, and it's rare for such an impressive portfolio to become available on the market long enough before an acquisition offer is announ! ced. In this case, the leading acquiring candidates are France-based Pernod-Ricard and U.K.-based Diageo (NYSE: DEO), the two largest spirits companies in the world by market capitalization (both are about $18 billion, more than double Beam's current market cap of $8 billion).  

The average acquisition premium for an alcohol-related business has been about 30%, and Beam will need to convince its shareholders before it closes a deal. I don't think it will be long before we see a potential suitor offer to pay a hefty premium, since Beam has the fundamentals to boost margins closer toward industry averages.

Risks to Consider: Given high-end spirits have been experiencing the bulk of their growth in emerging markets, a recession in these countries could slow the adoption of premium alcohol brands in the marketplace.

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