With China Clamoring for Tequila, Should Beam Shareholders Hang on to Their Shares?

Leading spirits manufacturer Beam has been a good investment for investors that held on to their shares after the company's split from former parent Fortune Brands in 2011. This is because the company has ridden a wave of higher global demand for liquor. With China recently loosening up its tequila import rules, Beam is well positioned for greater growth in that product area through its Sauza brand, the no. 2 player in tequila worldwide. However, Japanese beverage kingpin Suntory Holdings is looking to capture Beam's future upside for itself, recently offering to buy the company for roughly $14 billion. So, should investors hold on to their shares?

What's the value?
Beam has leveraged its top-selling bourbon franchise, including brands like Jim Beam and Maker's Mark, into a well-diversified spirits portfolio with strong positions in scotch and whiskey. The company also wisely moved aggressively into the tequila segment in 2005 through its acquisition of major competitor Allied Domecq, a transaction that doubled Beam's size and added the Sauza tequila brand. Tequila sales have been on the upswing lately thanks to seemingly unquenchable U.S. demand, a trend that has boosted top-line results for spirits manufacturers with strong tequila franchises.

In its latest fiscal year, Beam continued to feed off of rising global demand for spirits products. It reported a 3.6% top-line gain that was aided by a strong performance in its key power brand portfolio, highlighted by a double-digit sales increase for its Maker's Mark bourbon product line. The company also generated higher sales in the tequila area, benefiting from growing U.S. industry imports of the liquor. More importantly, consumers' increasing preference for premium-priced products across the liquor product spectrum allowed Beam to generate higher average prices and better operating profitability, evidenced by a double-digit gain in operating income during the period.

The benefits of size and scale
While the entire tequila industry has benefited from rising consumer demand, the biggest beneficiaries seem to have been the multinational players that have used their marketing muscle and global distribution networks to capture market share. Like Beam, competitor Brown-Forman has used a powerful singular brand (Jack Daniel's in this case) to build solid positions in other liquor categories, including its El Jimador and Herradura brands in the tequila area.

In FY2014, Brown-Forman has taken advantage of strong underlying spirits demand to propel a continuation of its multi-year growth trajectory, reporting a 4.4% increase in overall sales. The company's strategy of pursuing a huge operating footprint, 160 countries at last count, has allowed its core Jack Daniel's brand to continue finding new customers all around the globe. This has led to strong sales growth for the iconic brand. More notably, the success of the Jack Daniel's brand has led to greater sales opportunities for Brown-Forman's other segments, like its growing tequila franchise, which has created sales efficiencies and better overall profitability for the company.

Likewise, global spirits kingpin Diageo has used top-selling product lines, including Johnnie Walker in the scotch whisky and Smirnoff and premium vodka categories, to drive volume gains for less prominent, niche members of its product portfolio. While the company's overall sales volumes have been down lately, due primarily to weakness in its beer segment, Diageo has reported pockets of strength, including a 29% sales gain in the 2014 fiscal year for its tequila segment.

Of course, Diageo's tequila franchise was clearly hurt by the June 2013 expiration of its product marketing relationship with the Jose Cuervo brand, the #1 player in tequila worldwide. On the upside, though, the company's solid operating cash flow has allowed it to continue investing heavily in new product development and innovative marketing initiatives like its sponsorship of Academy Award parties. This should give its remaining brands unmatched marketing opportunities and allow Diageo to capture incremental market share.

The bottom line
In the U.S., spirits consumption outpaced beer and wine consumption by a wide margin between 2007 and 2012, according to the Wine and Spirits Wholesalers of America trade association. A continuation of that trend, combined with strong growth opportunities in international markets like China, would imply higher future profits and valuations for the major spirits franchises. While Suntory seems to be offering a fairly rich price for Beam, roughly 20 times EBITDA, the company's position as one of the last public, pure-play spirits franchises means that selling investors are probably selling too soon.

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The article With China Clamoring for Tequila, Should Beam Shareholders Hang on to Their Shares? originally appeared on Fool.com.

Robert Hanley owns shares of Beam. The Motley Fool recommends Beam and Diageo plc (ADR). Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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