BROWN-FORMAN CORP CL A 10-Q 2010
Securities and Exchange Commission
Washington, D.C. 20549
For the quarterly period endedJULY 31, 2010
For the transition period from _______________ to _______________
Commission File No. 002-26821
(Exact name of Registrant as specified in its Charter)
(Registrant’s telephone number, including area code)
(Former name, former address and former fiscal year, if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes o No þ
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: August 31, 2010
PART I - FINANCIAL INFORMATION>
Item 1. Financial Statements (Unaudited)
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Dollars in millions, except per share amounts)
See notes to the condensed consolidated financial statements.
CONDENSED CONSOLIDATED BALANCE SHEETS
(Dollars in millions)
See notes to the condensed consolidated financial statements.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in millions)
See notes to the condensed consolidated financial statements.
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
In these notes, “we,” “us,” and “our” refer to Brown-Forman Corporation.
1. Condensed Consolidated Financial Statements>
We prepared the accompanying unaudited condensed consolidated financial statements pursuant to the rules and regulations of the U.S. Securities and Exchange Commission for interim financial information. In accordance with those rules and regulations, we condensed or omitted certain information and disclosures normally included in annual financial statements prepared in accordance with U.S. generally accepted accounting principles (“GAAP”). We suggest that you read these condensed financial statements together with the financial statements and footnotes included in our annual report on Form 10-K for the fiscal year ended April 30, 2010 (the “2010 Annual Report”).
In our opinion, the accompanying financial statements include all adjustments, consisting only of normal recurring adjustments, necessary for a fair statement of our financial results for the periods covered by this report.
We prepared the accompanying financial statements on a basis that is substantially consistent with the accounting principles applied in our 2010 Annual Report, although during the first quarter of fiscal 2011 we adopted new accounting guidance for disclosure of fair value measurements (Note 9). Our adoption of the new accounting guidance had no material impact on our financial statements.
We use the last-in, first-out (“LIFO”) method to determine the cost of most of our inventories. If the LIFO method had not been used, inventories at current cost would have been $218.6 million higher than reported as of April 30, 2010, and $223.2 million higher than reported as of July 31, 2010. Changes in the LIFO valuation reserve for interim periods are based on a proportionate allocation of the estimated change for the entire fiscal year.
3. Income Taxes>
Our consolidated quarterly effective tax rate is based upon our expected annual operating income, statutory tax rates, and income tax laws in the various jurisdictions in which we operate. Significant or unusual items, including adjustments to accruals for tax uncertainties, are recognized in the quarter in which the related event occurs. The effective tax rate of 33.1% for the quarter ended July 31, 2010 is based on an expected tax rate from operations of 32.0% on ordinary income for the full fiscal year, the recognition of additional tax expense related to discrete items arising during the period, and interest on previously provided tax contingencies. Our expected tax rate from operations includes current fiscal year additions for existing tax contingency items.
We believe it is reasonably possible that there may be a net increase in our gross unrecognized tax benefits of approximately $0.7 million in the next 12 months as a result of tax positions taken in the current period, expiring statutes of limitations, and settlements with taxing authorities.
We file income tax returns in the U.S., including several state and local jurisdictions, as well as in several other countries in which we conduct business. The major jurisdictions and their earliest fiscal years that are currently open for tax examinations are 1998 in the U.S., 2006 in Australia, Ireland, and Italy, 2005 in Poland, 2004 in Finland, 2003 in the U.K., and 2002 in Mexico. Audits of our fiscal 2006 and 2007 U.S. federal tax returns were completed during fiscal 2010. Although one matter from those audits remains open, we believe that we have adequately provided for it.
4. Earnings Per Share>
Basic earnings per share is calculated by dividing net income available to common stockholders by the weighted average number of all unrestricted common shares outstanding during the period. Diluted earnings per share further includes the dilutive effect of stock options, stock-settled appreciation rights (“SSARs”), and restricted stock units (“RSUs”). Stock-based awards for approximately 1,843,000 common shares and 428,000 common shares were excluded from the calculation of diluted earnings per share for the periods ended July 31, 2009 and 2010, respectively, because the exercise price of the awards was greater than the average market price of the shares.
We have granted restricted shares of common stock to certain employees as part of their compensation. These restricted shares, which have varying vesting periods, contain nonforfeitable rights to dividends declared on common stock. As a result, the unvested restricted shares are considered participating securities in the calculation of earnings per share.
The following table presents information concerning basic and diluted earnings per share:
5. Dividends Payable>
On July 22, 2010, our Board of Directors approved a regular quarterly cash dividend of $0.30 per share on Class A and Class B Common Stock. The dividend will be paid on October 1, 2010 to stockholders of record as of September 7, 2010.
We operate in a litigious environment, and we are sued in the normal course of business. Sometimes plaintiffs seek substantial damages. Significant judgment is required in predicting the outcome of these suits and claims, many of which take years to adjudicate. We accrue estimated costs for a contingency when we believe that a loss is probable and we can make a reasonable estimate of the loss, and then adjust the accrual as appropriate to reflect changes in facts and circumstances. No material accrued loss contingencies are recorded as of July 31, 2010.
7. Pension and Other Postretirement Benefits>
The following table shows the components of the pension and other postretirement benefit expense recognized for our U.S. benefit plans during the periods covered by this report. Information about similar international plans is not presented due to immateriality.
8. Comprehensive Income>
Comprehensive income is a broad measure of the effects of all transactions and events (other than investments by or distributions to stockholders) that are recognized in stockholders' equity, regardless of whether those transactions and events are included in net income. The following table adjusts net income for the other items included in the determination of comprehensive income:
Accumulated other comprehensive income (loss), net of tax, consisted of the following:
9. Fair Value Measurements>
Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants at the measurement date. We categorize the fair values of assets and liabilities into three levels based upon the assumptions (inputs) used to determine those values. Level 1 provides the most reliable measure of fair value, while Level 3 generally requires significant management judgment. The three levels are:
The following table summarizes the assets and liabilities measured at fair value on a recurring basis in the accompanying balance sheet as of July 31, 2010:
The fair values of our commodities futures and options contracts are primarily determined using quoted contract prices on futures exchange markets. The fair values of these instruments are based on the closing contract price as of the balance sheet date. The fair values of our interest rate swaps, forward contracts and foreign currency options are determined using standard valuation models. The significant inputs used in these models are readily available in public markets or can be derived from observable market transactions. Inputs used in these standard valuation models for both forward contracts and foreign currency options include the applicable exchange rate, forward rates and discount rates and for interest rate swaps include interest-rate yield curves. The standard valuation model for foreign currency options also uses implied volatility as an additional input. The discount rates are based on the historical U.S. Treasury rates, and the implied volatility specific to individual foreign currency options is based on quoted rates from financial institutions.
We measure some assets and liabilities at fair value on a nonrecurring basis; that is, we do not measure at fair value on an ongoing basis, but we do adjust them to fair value in certain circumstances (for example, when we determine that an asset is impaired). The fair values of assets and liabilities measured at fair value on a nonrecurring basis during fiscal 2011 were not material as of July 31, 2010.
10. Fair Value of Financial Instruments>
The fair value of cash, cash equivalents, and short-term borrowings approximates the carrying amount due to the short maturities of these instruments. We estimate the fair value of long-term debt using discounted cash flows based on our incremental borrowing rates for similar debt. We determine the fair value of commodity, foreign currency, and interest swap contracts as discussed in Note 9. As of July 31, 2010, the fair values and carrying amounts of these instruments were as follows:
11. Derivative Financial Instruments>
Our multinational business exposes us to global market risks, including the effect of fluctuations in currency exchange rates, commodity prices, and interest rates. We use derivatives to manage financial exposures that occur in the normal course of business. We formally document the purpose of each derivative contract, which includes linking the contract to the financial exposure it is designed to mitigate. We do not hold or issue derivatives for trading purposes.
We use currency derivative contracts to limit our exposure to the currency exchange risk that we cannot mitigate internally by using netting strategies. We designate most of these contracts as cash flow hedges of forecasted transactions (expected to occur within three years). We record all changes in the fair value of cash flow hedges (except any ineffective portion) in accumulated other comprehensive income (“AOCI”) until the underlying hedged transaction occurs, at which time we reclassify that amount into earnings. We designate some of our currency derivatives as hedges of net investments in foreign subsidiaries. We record all changes in the fair value of net investment hedges (except any ineffective portion) in the cumulative translation adjustment component of AOCI.
We assess the effectiveness of our hedges based on changes in forward exchange rates. The ineffective portion of the changes in fair value of our hedges (recognized immediately in earnings) during the periods presented in this report was not material.
We do not designate some of our currency derivatives as hedges because we use them to at least partially offset the immediate earnings impact of changes in foreign exchange rates on existing assets or liabilities. We immediately recognize the change in fair value of these contracts in earnings.
As of July 31, 2010, we had outstanding foreign currency contracts with a total notional amount of $378.0 million, related primarily to our euro, British pound, and Australian dollar exposures.
We also had outstanding exchange-traded futures and options contracts on four million bushels of corn as of July 31, 2010. We use these contracts to mitigate our exposure to corn price volatility. Because we do not designate these contracts as hedges for accounting purposes, we immediately recognize the changes in their fair value in earnings.
We manage our interest rate risk with swap contracts. As of July 31, 2010, we had fixed-to-floating interest rate swaps outstanding with a notional value of $250.0 million and a maturity matching our bonds due April 1, 2012. These swaps are designated as fair value hedges. The change in fair value of the swap not related to accrued interest is offset by a corresponding adjustment to the carrying value of the bond.
The following table presents the fair values of our derivative instruments as of July 31, 2010. The fair values are presented below on a gross basis, while the fair values of those instruments that are subject to master settlement arrangements are presented on a net basis in the accompanying consolidated balance sheet, as required by GAAP.
This table presents the amounts affecting our consolidated statement of operations for the periods covered by this report:
We expect to reclassify $2.1 million of deferred net gains recorded in AOCI as of July 31, 2010, to earnings during the next 12 months. This reclassification would offset the anticipated earnings impact of the underlying hedged exposures. The actual amounts that we ultimately reclassify to earnings will depend on the exchange rates in effect when the underlying hedged transactions occur. The maximum term of our contracts outstanding at July 31, 2010 is 24 months.
We are exposed to credit-related losses if the other parties to our derivative contracts breach them. This credit risk is limited to the fair value of the contracts. To manage this risk, we enter into contracts only with major financial institutions that have earned investment-grade credit ratings; we have established counterparty credit guidelines that are regularly monitored and that provide for reports to senior management according to prescribed guidelines; and we monetize contracts when we believe it is warranted. Because of the safeguards we have put in place, we believe the risk of loss from counterparty default to be immaterial.
Some of our derivative instruments require us to maintain a specific level of creditworthiness, which we have maintained. If our creditworthiness were to fall below such level, then the counterparties to our derivative instruments could request immediate payment or collateralization for derivative instruments in net liability positions. As of July 31, 2010, the aggregate fair value of all derivatives with creditworthiness requirements that were in a net liability position was $1.1 million.
Item 2. Management’s Discussion and Analysis of Financial Condition
and Results of Operations
You should read the following discussion and analysis along with our 2010 Annual Report. Note that the results of operations for the three months ended July 31, 2010, do not necessarily indicate what our operating results for the full fiscal year will be. In this Item, “we,” “us,” and “our” refer to Brown-Forman Corporation.
Important Note on Forward-Looking Statements:
This report contains statements, estimates, and projections that are "forward-looking statements" as defined under U.S. federal securities laws. Words such as “aim,” “anticipate,” “aspire,” “believe,” “envision,” “estimate,” “expect,” “expectation,” “intend,” “may,” “potential,” “project,” “pursue,” “see,” “will,” “will continue,” and similar words identify forward-looking statements, which speak only as of the date we make them. Except as required by law, we do not intend to update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise. By their nature, forward-looking statements involve risks, uncertainties and other factors (many beyond our control) that could cause our actual results to differ materially from our historical experience or from our current expectations or projections. These risks and other factors include, but are not limited to:
Results of Operations:
First Quarter Fiscal 2011 Compared to First Quarter Fiscal 2010
A summary of our operating performance (dollars expressed in millions, except per share amounts) is presented below.
On a reported basis, net sales for the three months ended July 31, 2010 were $744.9 million, up $7.0 million or 1% compared to the same prior year period. The stronger U.S. dollar, which reduced net sales by approximately $5 million, and a decrease in estimated trade inventory levels, were more than offset by a 3% underlying growth in net sales.
The primary drivers contributing to our underlying growth in net sales for the quarter were volumetric gains for several brands in our portfolio including Jack Daniel’s & Cola, Jack Daniel’s Tennessee Whiskey, el Jimador, and New Mix. Gains were also registered for Sonoma-Cutrer, Woodford Reserve, Tequila Herradura, and Finlandia. Lower volumes for Southern Comfort, Southern Comfort Ready to Pours (negatively affected in part by comparison to the initial sales into the market in connection with their introduction last year), Fetzer, and an agency brand we sell in Poland, partially offset these gains. On a geographic basis, growth in several markets including Australia, Spain, Mexico, the U.K., and Turkey contributed to the underlying growth in net sales for the quarter. The increases in these markets were partially offset by lower net sales in the U.S., France, and Poland.
1 Underlying change represents the percentage increase or decrease in reported financial results in accordance with generally accepted accounting principles (GAAP) in the United States, exclusive of other items impacting period-over-period results. We believe presenting the underlying change helps provide transparency to our comparable business performance.
2 Refers to net gains and losses incurred by the company relating to sales and purchases in currencies other than the U.S. dollar. We use the measure to understand the growth of the business on a constant dollar basis as fluctuations in exchange rates can distort the underlying growth of our business (both positively and negatively). To neutralize the effect of foreign exchange fluctuations, we have historically translated current year results at prior year rates. We believe it is important to separately identify the impact that foreign exchange has on each major line item of our consolidated statement of operations.
3 Refers to the estimated financial impact of changes in wholesale trade inventories for our brands. We compute this effect by using our estimated depletion trends and separately identify trade inventory changes in the variance analysis for our key measures. Based on the estimated depletions and the fluctuations in trade inventory levels, we then adjust the percentage variances from prior to current periods for our key measures. We believe it is important to separately identify the impact of this item in order for management and investors to understand the results of our business that can arise from varying levels of wholesale inventories.
The following discussion highlights net sales and depletion4 results in the first quarter for several brands compared to the same prior period:
Gross profit for the three months ended July 31 was $378.8 million, a decrease of $1.3 million compared to the first quarter of last year. The stronger U.S. dollar, which reduced gross profit by approximately $10 million, and a decrease in estimated trade inventory levels, were essentially offset by a 3% increase in underlying gross profit. The same factors that drove the increase in underlying net sales for the quarter also contributed to the underlying growth in gross profit for the same period. Gross margin of 50.9% declined slightly compared to 51.5% in the prior year period due to the stronger U.S. dollar.
The following table shows the major factors influencing the changes in gross profit for the quarter:
4 Depletions are shipments direct to retail or from distributors to wholesale and retail customers, and are commonly regarded in the industry as an approximate measure of consumer demand.
5 Constant currency represents reported net sales with the cost/benefit of currency movements removed. Management uses the measure to understand the growth of the business on a constant dollar basis, as fluctuations in exchange rates can distort the underlying growth of the business both positively and negatively.
Advertising expenses were essentially flat for the three month period on a reported basis, but increased 2% when adjusting for foreign exchange. Spending behind several brands increased in the quarter including Jack Daniel’s Tennessee Whiskey, Gentleman Jack, Jack Daniel’s RTDs, Herradura, el Jimador, New Mix, and Chambord. We continued to endeavor to optimize our mix of total brand investment by reallocating resources among brands, geographies, and channels that we believe enable us to effectively and efficiently reach consumers around the world. Off-premise activities and international markets continued to receive increased focus. We expect to remain flexible in directing brand spending and resources to activities that support the business in the current environment while positioning our company for long-term growth.
Selling, general and administrative expenses increased $14.7 million, or 13%, for the first quarter largely as a result of an increase of $4.6 million in pension expense, which is expected to recur each quarter throughout the remainder of the fiscal year, influenced by a lower discount rate, and costs associated with changes to the route-to-market planned for Germany and Brazil during the second quarter, such as system and procurement-related expenses.
Operating income of $172.7 million declined $19.3 million, or 10%, for the three months ended July 31, 2010 compared to the same period last year. Operating income was hurt by a stronger U.S. dollar, which reduced operating income by approximately $12 million, expenses associated with changes in route-to-market, and a decrease in estimated trade inventory levels. Although we grew both net sales and gross profit 3% on an underlying basis for the quarter, underlying operating income was down modestly as higher brand investments, an increase in pension expense (lower discount rate), and some selling, general and administrative investments concentrated in the first half of the fiscal year offset these gains.
Net interest expense decreased by $0.9 million compared to a year ago reflecting lower net debt and a greater percentage of floating rate debt at lower interest rates.
The effective tax rate in the quarter was 33.1% compared to 34.4% reported in the first quarter of fiscal 2010. The decrease in our effective tax rate was driven by a reduction in tax expense related to discrete items arising during the period.
Reported diluted earnings per share of $0.76 for the quarter decreased 6% from the $0.81 earned in the same prior year period. The same factors that reduced operating income also contributed to the decrease in earnings per share. A lower effective tax rate and a reduction in shares outstanding attributable to the share repurchase activity authorized in December 2008 and June 2010 partially offset these declines in operating income.
6 Expenses associated with route-to-market refers to expenses associated with the changes to the company’s distribution structures primarily in Germany and Brazil. We believe that identifying these costs allows management and investors to better understand growth trends.
Our full-year outlook remains unchanged from the earnings guidance provided in early June of $2.98 to $3.38 per share. We remain cautious given the many uncertainties that we believe will continue to influence our overall financial performance for the year, including the ongoing volatile macroeconomic conditions and the resulting effect on consumer spending, particularly in the U.S. and Western Europe and on our Southern Comfort brand overall. Additionally, consumer responses to our innovation activities, and those of our competitors, better than expected success or disruption from upcoming route-to-consumer changes, and fluctuations in foreign exchange rates could affect our performance for the year. We anticipate a continuation of underlying operating income growth in the mid-single digits for fiscal 2011.
Liquidity and Financial Condition
Cash and cash equivalents increased $29.2 million during the three months ended July 31, 2010, compared to a decline of $53.6 million during the same quarter last year. Cash provided by operations was $96.6 million, down from $117.8 million for the same period last year, primarily reflecting a $23.8 million increase in cash used to fund our pension plan obligations. Cash provided by investing activities increased from last year by $11.5 million, largely reflecting $11.0 million in proceeds from the sale of property, plant, and equipment. Cash used for financing activities was $110.3 million less than last year, primarily reflecting a $105.4 million decrease in net debt repayments. The impact on cash and cash equivalents as a result of exchange rate changes was a decrease of $3.5 million for the three months ended July 31, 2010, compared to an increase of $14.3 million for the same period last year.
We have access to several liquidity sources to supplement our cash flow from operations. Our commercial paper program, supported by our bank credit facility, continues to fund our short-term credit needs. Our commercial paper continues to enjoy steady demand from investors. Alternatively, we expect that we could satisfy our liquidity needs by drawing on our $800.0 million bank credit facility (currently unused). This facility expires April 30, 2012, and carries favorable terms compared with current market conditions.
Under extreme market conditions, it is possible that the banks may not be able to fully fund this credit facility. While we are alert to this uncertainty, we believe the banking market has improved considerably. Also, we believe that the markets for investment-grade bonds and private placements are very accessible and provide a source of long-term financing that, in addition to our cash flow from operations, could be used to pay off our short-term debt if necessary.
We have high credit standards when initiating transactions with counterparties and closely monitor our counterparty risks with respect to our cash balances and derivative contracts (that is, foreign currency and interest rate hedges). If a counterparty’s credit quality were to deteriorate below our acceptable credit standards, we would either liquidate exposures or require the counterparty to post appropriate collateral.
We believe our current liquidity position is strong and sufficient to meet all of our financial commitments for the foreseeable future. Our $800.0 million bank credit facility’s most restrictive covenant requires our consolidated EBITDA (as defined in the agreement) to consolidated interest expense not be less than a ratio of 3 to 1. At July 31, 2010, with a ratio of 26 to 1, we were within the covenant’s parameters.
As we announced on June 8, 2010, our Board of Directors has authorized us to repurchase up to $250.0 million of our outstanding Class A and Class B common shares before December 1, 2010, subject to market and other conditions. Under this program, we may repurchase shares from time to time for cash in open market purchases, block transactions, and privately negotiated transactions in accordance with applicable federal securities laws. As of July 31, 2010, we have repurchased a total of 799,101 shares (6,400 of Class A and 792,701of Class B) under this program for approximately $47.0 million. The average repurchase price per share, including broker commissions, was $58.89 for Class A and $58.82 for Class B.
On July 22, 2010, our Board of Directors approved a regular quarterly cash dividend of $0.30 per share on Class A and Class B Common Stock. Stockholders of record on September 7, 2010 will receive the cash dividend on October 1, 2010.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
We hold debt obligations, foreign currency forward and option contracts, and commodity futures contracts that are exposed to risk from changes in interest rates, foreign currency exchange rates, and commodity prices, respectively. Established procedures and internal processes govern the management of these market risks.
Item 4. Controls and Procedures
The Chief Executive Officer (“CEO”) and the Chief Financial Officer (“CFO”) of Brown-Forman (its principal executive and principal financial officers) have evaluated the effectiveness of the company's "disclosure controls and procedures" (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)) as of the end of the period covered by this report. Based on that evaluation, the CEO and CFO concluded that the company's disclosure controls and procedures are effective to ensure that information required to be disclosed by the company in the reports filed or submitted by it under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms; and include controls and procedures designed to ensure that information required to be disclosed by the company in such reports is accumulated and communicated to the company’s management, including the CEO and the CFO, as appropriate, to allow timely decisions regarding required disclosure. There has been no change in the company's internal control over financial reporting during the most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the company's internal control over financial reporting.
PART II - OTHER INFORMATION
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
The following table provides information about shares of our common stock that we repurchased during the quarter ended Jul 31, 2010:
As we announced on June 8, 2010, our Board of Directors has authorized us to repurchase up to $250.0 million of our outstanding Class A and Class B common shares before December 1, 2010, subject to market and other conditions. Under this program, we may repurchase shares from time to time for cash in open market purchases, block transactions, and privately negotiated transactions in accordance with applicable federal securities laws. 799,101 of the shares included in the above table were acquired as part of this program.
The remaining 12,954 shares included in the above table were received from employees to satisfy income tax withholding obligations triggered by the vesting of restricted shares.
Item 6. Exhibits
31.1 CEO Certification pursuant to Section 302 of Sarbanes-Oxley Act of 2002.
31.2 CFO Certification pursuant to Section 302 of Sarbanes-Oxley Act of 2002.
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.