Brown-Forman - Earnings Call - Q3 2012

Transcript

Speaker 5

Good morning. My name is Kathy, and I will be your conference operator today. At this time, I would like to welcome everyone to the third quarter fiscal 2012 conference call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question and answer session. If you would like to ask a question during this time, simply press star, then the number one on your telephone keypad. If you would like to withdraw your question, press pound key. Thank you. I would now like to turn the call over to Mr. Mark Stegeman, Interim Director of Investor Relations. Sir, you may begin.

Speaker 0

Thank you, Kathy. Good morning, everyone, and thank you for joining us for Brown-Forman's fiscal 2012 third quarter earnings call. This is Mark Stegeman, Brown-Forman's Interim Director of Investor Relations. Joining me today on the call are Paul Varga, our President and Chief Executive Officer, Don Berg, Executive Vice President and Chief Financial Officer, and Jane Morreau, Senior Vice President and Director of Finance Management, Accounting, and Technology. Don will begin our call this morning with some thoughts on our performance and a few other topics of interest. Paul will then provide some additional remarks, and we will open the call up for your questions. This morning's conference call contains forward-looking statements based on our current expectations. Numerous risks and uncertainties may cause actual results to differ materially from those anticipated or projected in these statements.

Many of the factors that will determine future results are beyond the company's ability to control or predict. You should not place undue reliance on any forward-looking statements, and the company undertakes no obligation to update any of these statements, whether due to new information, future events, or otherwise. This morning, we issued a press release containing our results for the fiscal 2012 third quarter. The release can be found on our website under the section titled "Investor Relations." In the press release, we have listed a number of the risk factors that you should consider in conjunction with our forward-looking statements. Other significant risk factors are described in our Form 10-K, Form 8-K, and Form 10-Q reports filed with the Securities and Exchange Commission. During this call, we will be discussing certain non-GAAP financial measures.

These measures and the reasons management believes they provide useful information to investors regarding the company's financial conditions and results of operations are contained in the press release. With that, I'll turn the call over to Don.

Speaker 4

Thanks, Mark. Good morning, everyone. With our third quarter earnings release this morning, I thought I'd spend some time addressing a number of topics. Let me start with a 30,000-foot summary of our third quarter and year-to-date results. I'll talk some about our gross margin and the pricing environment. Following that, I'll highlight some of our portfolio and geographic performances. Lastly, I'll talk a bit about how we are thinking about the balance of our fiscal year. Starting with our third quarter results, we are pleased with the quarter's continuation of year-to-date high single-digit underlying growth in net sales and operating income and the acceleration compared to last year. So far, this fiscal year, underlying net sales has grown 8% compared to 4% last year, and underlying operating income has also grown 8% compared to 4% during the same time period in fiscal 2011.

Furthermore, we are also pleased that our year-to-date performance has essentially met our expectations and has continued to play out as we had outlined with our guidance at the beginning of this fiscal year. Now, let me talk for a bit about our gross margins and the slight erosion in the margin that we've experienced in the last couple of quarters. Historically, our top-line growth has come from a balance of price increases and volume gains. There have been times when price was the dominant driver of our net sales growth, improving our gross margin. In the recent few years, during and following the global recession, a number of factors skewed our top-line performance towards being essentially all volume-driven. First, as you'll recall, the consumer shifted their consumption to the off-premise, which is typically a more price-sensitive channel. Further, we were concerned about our consumer's ability to buy premium brands.

Finally, price competition intensified. Given the overall economic environment, we took very little price increase, absorbing higher input costs and, at times, excise tax increases. Today, the global economy, while a bit firmer, continues to experience a very fragmented recovery and, in some economies, continues to struggle. In some markets, the competitive pricing environment seems to have abated somewhat, and we have seen some return to trading up to premium and super-premium brands. As we think about pricing, there are really three key components we're thinking about. First, we capture a portion of the increase in the input costs of grain, glass, and fuel costs. Second, we believe for the positioning of a premium brand, price is a key component. Lastly, there is the delicate act of using price to help balance supply and demand, particularly as it relates to aged products.

Considering all of these factors, last quarter, we mentioned that we think the time is becoming more favorable to reinstate price increases more in line with historical levels. During the third quarter, we initiated a front-line price increase in France in conjunction with an excise tax increase, and we are in the process of taking a price increase in the important UK market on top of a tax increase there. Looking forward, we will proactively look for opportunities to take price increases in most markets over the coming fiscal year and across most of our brands. While we don't anticipate a lot of pricing improvement for the rest of this fiscal year, we are optimistic about the potential opportunity in fiscal 2013. We plan to talk about this more with our year-end conference call in early June, when we lay out in greater detail our expectations for fiscal 2013.

Moving along to our portfolio and geographic performances, let me start with a few comments about our A&P spending. As we have spoken about in the past, a few years ago, we shifted some of our brand investments outside of what gets traditionally reported as A&P to things like packaging, promotional activities, value-added products, route-to-consumer changes, as well as product development expenses related to ready-to-pour products, RTDs, new line extensions, and new product innovations, all to capture consumers with convenience and great-tasting products where they were buying in the off-premise. Our investment has continued to be reflected in other lines in the P&L besides A&P, but this fiscal year to date, we have also invested more in our brands, resulting in a higher increase in our underlying A&P as we reallocated some funds to more traditional media and to capitalize on trends with social media.

We also saw a significant increase in spend levels in support of a number of product introductions, including Jack Daniel's Tennessee Honey. Through January, our underlying growth in A&P spend year to date is almost triple last year's. Given the sizable upfront investment in A&P to launch Jack Daniel's Tennessee Honey, both at the end of last fiscal year and during the beginning of this fiscal year, we expect full-year underlying A&P to moderate significantly over the balance of the fiscal year, with the fourth quarter expected to be essentially flat compared to the same period last year. Continuing the discussion of our portfolio, both Jack Daniel's family of brands and Finlandia's family experienced double-digit net sales increases on a constant currency basis for the nine months, while the Southern Comfort family declined in mid-single digits, a slight improvement compared to the first half.

In many ways, Southern Comfort was the first flavored American whiskey, and it remains a very important brand for us. According to recent U.S. Nielsen results, on a three-month basis through February 4, Southern Comfort commands about half of the value in volume when combining all of the top flavored whiskeys. We are progressing in reinvigorating this brand with new communications along with flavor extensions, including SoCo Lime and SoCo Fiery Pepper, and we are now introducing Cherry in the UK in the fourth quarter. The good news is that flavored whiskeys continue to explode in the U.S., fueled by Jack Daniel's Tennessee Honey. We are firming up our plans to expand Tennessee Honey into several international markets in fiscal 2013, including the UK, South Africa, and Australia. While we will be cycling against the U.S.

brand launch and pipeline fill in this year's fourth quarter and at the beginning of next fiscal year, we believe opportunities still remain to build Jack Daniel's Tennessee Honey velocity in both the off-premise and on-premise markets in the U.S. Our super-premium brands also continue to perform very well globally, with Gentleman Jack, Herradura, Woodford Reserve, and Jack Daniel's Single Barrel all increasing year-to-date constant currency net sales at double-digit rates. In the U.S., our super-premium wine brand, Sonoma-Cutrer, also continued to expand. New brand and marketing innovation investments continued this quarter as we launched a product line of Little Black Dress vodkas. We retained the Little Black Dress trademark for spirits when we sold the Hopland-based wine brands last year. Little Black Dress vodkas were developed by women for women and deliver several flavorful products primarily targeted to calorie-conscious consumers.

A couple of other examples of recently launched innovative brand extensions include, in Germany, Jack Daniel's introduced Winter Jack, a Tennessee apple whiskey punch, a seasonal ready-to-pour Jack Daniel's with a taste of apple, cinnamon, and cloves. In addition, building on the brand equity that Finlandia has built in Poland, we recently launched a new line extension, Finlandia Spice, to play in the spice vodka arena where we previously did not participate. Shifting gears to our international markets where we continue to make broad-based progress. Looking at the nine-month constant currency net sales for our top 30 markets, once again, over half of them grew at double-digit rates. The brands that have been resonating internationally and also grew constant currency net sales double digits for the nine months were Jack Daniel's Tennessee Whiskey, Finlandia, El Jimador, Gentleman Jack, Jack Daniel's Single Barrel, Early Times, and Woodford Reserve.

Now, let's spend a minute talking about Europe and our larger markets there in terms of fiscal year to date constant currency net sales. Unlike many of our competitors, particularly with respect to Jack Daniel's, we have been seeing positive results in Northern Europe. For both the quarter and year to date, the UK was up mid to high single digits, with Germany and France both up double digits. Some of our super-premium brands also grew in these markets, although on a small base. We have continued to invest in the European markets, which have remained a growth vehicle for our brands. With respect to what we refer to as emerging markets, which for us is a broad array of countries, we continue to record double-digit growth in year-to-date constant currency net sales through January in the majority of the emerging market countries where we do business.

This would include Russia, Brazil, Turkey, Mexico, and Ukraine, just to name a few. All combined, emerging market countries grew year-to-date constant currency net sales 16%. Lastly, in the U.S., net sales on a constant currency basis for the year through January increased mid-single digits led by the Jack Daniel's family of brands. Finally, looking at our guidance for the full year, we confirmed our guidance and narrowed our EPS range to $3.50 to $3.65. As we look forward to our fourth quarter, we expect to see similar growth in the high single digits in our underlying net sales and operating income. As a reminder, the fourth quarter reported numbers will be noticeably affected by the impact of last year's sale of Hopland-based wine brands.

Last June, we pointed out that the reduction in profit from this business in fiscal 2012 would reduce our EPS about $0.16 for the full fiscal year. We now expect this full-year impact to be closer to $0.18 due to less than expected agency income on these brands through the transition. $0.14 of that $0.18 was in the first three quarters, and we anticipate there is around a $0.04 impact remaining to go for the balance of the fiscal year. In addition to this, last year's reported fourth quarter benefited from a gain on the sale of that business of about $0.26 per share. In terms of our foreign exchange exposure, considering our hedged positions and recent spot rates, we estimate that a 10% strengthening of the U.S. dollar would penalize EPS by about $0.01.

On the other hand, if the dollar weakens by 10%, we expect it would benefit EPS also by about the same $0.01. Turning to some uses of cash, we intend to use some of our available cash balances to fully pay off the 5.2% $250 million bond when it matures on April 1st. In addition, we still anticipate capital expenditures to come in between $60 to $70 million on the year, slightly lower than we thought last quarter due to some timing differences. To summarize, we are pleased with our consistent story of accelerating underlying sales led by Jack Daniel's. We've invested in new products and line extensions, made investments in A&P across the portfolio of brands, and made progress in growing our international distribution.

All of these factors are expected to help drive continued high single-digit underlying operating income growth in line with our plan or guidance for this fiscal year. With that, let me turn the call over to Paul.

Speaker 2

Hi, everyone. I'll just add a couple of comments to what Don has already said. The first point relates to the significance of the Jack Daniel's Tennessee Honey performance. It's, of course, exciting to have a brand extension accomplish what it has in the marketplace in less than one year. In addition to that, however, it has played the very important role of being the impetus to Brown-Forman's improved performance in the United States, which is our most important country and today the industry's most valuable distilled spirits market. Just one year ago, Brown-Forman and its two most important trademarks, Jack Daniel's and Southern Comfort, were all losing share and struggling to grow in the United States. Today, the company and the Jack Daniel's trademark are both growing nicely and gaining share of their relevant competitive segments.

These gains have been driven by the Jack Daniel's Tennessee Honey introduction and success. Importantly, the Tennessee Honey success has not come at the expense of either Jack Daniel's or Southern Comfort. In fact, from what we've observed thus far, the parent Jack Daniel's brand has performed slightly better in the United States since the introduction of Honey, as we believe this line extension has provided what we sometimes call a positive halo effect for the trademark. While Southern Comfort has not yet returned to growth, we believe this trademark's performance has also improved in the U.S. since the introduction of the Jack Daniel's Tennessee Honey brand.

This is noteworthy as we were naturally anxious to see if Honey's success would come at the direct expense of Southern Comfort, which has long been one of the leading brands in this category referred to as either flavored brown spirits or flavored whiskey. To date, this has not been the case, as the parent Southern Comfort performance in the U.S. has been essentially unchanged since Honey's introduction, and the trademark's overall performance has, in fact, improved due to the introductions of Lime and Fiery Pepper. As a result of all of this, our company has grown and gained share in the U.S. over the last year, and today we have a strong leadership position with two trademarks in one of the most exciting growth segments of the world's most valuable distilled spirits market.

This is important progress, and I'd like to publicly congratulate the many people at Brown-Forman who have led and contributed to it. In addition to the successful launch of Jack Daniel's Tennessee Honey in the U.S., the accelerated and impressive global growth of Jack Daniel's in both developed and emerging international markets has been the driver of this year's accelerated growth in underlying net sales, gross profit, and operating income versus what we experienced for the full fiscal year 2011. Importantly, our company's year-to-date growth in underlying operating income of 8% approximates our historical high single-digit long-term growth rate on this same measure. We found the return of the company's underlying growth rate to this level to be very encouraging for the future.

Looking ahead a bit, we will remain focused on further improving Southern Comfort's performance and continuing the company momentum we've created this fiscal year, which includes the continued growth of our super-premium brands and the recent improved trajectory of Finlandia's performance. As Don Berg mentioned, the planned further expansion of Jack Daniel's Tennessee Honey, both within the U.S. and into new international markets, and the improving pricing posture across our company are additional encouraging signs as we finish up fiscal year 2012 and finalize our plans for fiscal year 2013 and beyond. Thanks. That's all for our prepared commentary, and now we're happy to take any questions.

Speaker 5

Thank you. At this time, if you would like to ask a question, please press star one on your telephone keypad. We'll pause for just a moment to compile the Q&A roster. Okay, your first question comes from a line of Kamille Garwala with UBS Investment Bank.

Speaker 3

Hey, guys.

Speaker 1

Good morning.

Speaker 3

Morning.

Speaker 1

Just on the splits for advertising, Don, that you spoke about, should we then assume that you're happy with how you report the numbers on advertising as a percentage of sales? That number going from 13% to about 11% over the last few years, is 11% the right number given the reclassifications that we should be thinking about over the long run?

Speaker 3

One of the things we talked about quite a bit over the last couple of years is just how much we really want to stay flexible in how we use our A&P and to make sure that we're being responsive to what's going on in the environment. I think as we move towards taking more price increases, one of the things that we think about in all of that is, as we think about our A&P and supporting our brands and supporting those price increases, oftentimes you'll look at shifting your mix more towards pull-type marketing efforts rather than push. The more you get into the pull type, the more you're driving more expense through what goes through that traditional A&P line. I would expect that we'll probably be seeing more increases going in that way.

All in all, I think we feel pretty comfortable about the balance that we've got right now in terms of the investment behind our brands generally. What you might just see is a little bit more mix shifting going on more towards the pull versus the push.

Speaker 2

Yeah, I think we're still firming up a lot of our F13 spending priorities, which will have an influence on that. I think Don's directionally correct on it that we frequently will move depending upon what we see the best opportunities between monies, between things that reside in cost of sales or in discounts to A&P and back if we think it can be impactful. Probably the prevailing theme that Don mentioned in his comments about the pricing environment, we could see the advertising % of sales fluctuate a little bit based on where we allocate our investment.

Speaker 1

Got it. Also, on pricing, you've now taken pricing in a variety of markets. In some markets, I guess the price to consumer has gone up significantly more than even your price increases because of excise taxes. Could you give us a read on how well it's sticking, what the consumer response has been so far? You may need to go region by region on that, but overall maybe for the United States, then maybe for Western Europe.

Speaker 3

Yeah, in the U.S., pricing for the most part has been fairly flat in the U.S. We've seen some occasional mix improvements here and there, but for the most part, on average, our pricing has been pretty flat. The two markets that I had identified today, both France and the UK, it's really just too early to tell yet. With the buy-ins and everything, it usually takes about a month or two for everything to kind of make its way through the marketplace before you can really get a good strong read on what's happening. I would say generally, to the extent that we've seen excise tax increases, which we've been seeing in a number of markets for the last couple of years, and in some markets like Australia, for example, they automatically take excise tax increases every year. In fact, they take it twice a year.

We've generally seen not that large of an impact in terms of the health of our industry and our business overall. To that extent, it would appear that consumers have been able to absorb it. There have been some markets where we haven't been able to pass them on because it wouldn't stick. It ends up being kind of a market-market situation. Overall, when you look at how the industry is doing generally, it continues to grow and do pretty well on a global basis.

Speaker 2

There's a real difference too between tax-related increases in prices where the whole market goes up, and it has a real different effect we observe. That'll vary from market to market, which is different a little bit than just the conscious decision to take your prices up based on a desire for a premium price position or the input costs that you've been absorbing. They're very different in those circumstances in terms of the impact. I would say it, with the caveat that it varies brand by brand and market by market, our experience as a company is that it's been typically, looking at our history, a very positive financial decision when Brown-Forman has implemented price increases in an appropriate manner. I mean, implemented well, thought through in terms of all the components of SaaS by SaaS and market by market, and then typically supported well as well.

We don't anticipate it being any different this time, although I think we're going to need to be even more sharp than we historically have because of all the changing global economic conditions that exist out there and how they are prone to varying pretty quickly. Does that help you?

Speaker 1

Yep, that's helpful. Just the last very quick one, you gave us some guidance on distributor inventories and the expectations into this quarter. Are you happy with where they are now, or is there potentially some further drawdown in Q4?

Speaker 3

Yeah, I mean, if you look in the earnings release that we put out there, you know, we provide a Schedule A, which kind of gives a reconciliation between the reported and the underlying. When you look there on a year-to-date basis, it basically shows our distributor inventories are today pretty much in line with where we started out the fiscal year, which we're comfortable with at this juncture. When you look forward, these things have the tendency to vary a little bit up or down. A lot of it just depends upon what's happening in individual marketplaces, and it's always kind of hard to sit here and to guess in advance what might happen. There could be some fluctuations on this as we get into the fourth quarter. At this juncture, we think that our inventories are pretty much in balance with where we started the year.

Speaker 1

Yeah, so you've worked off the pre-buy-in from last quarter. Sounds like it's generally been worked off, correct?

Speaker 3

Yeah, I mean, there's nothing we see at the end here at Q3 like we did see at Q2 that we've talked about. They're certainly better in balance, but that remains to be seen, of course, right?

Speaker 1

Got it. Thank you, guys.

Speaker 3

Thank you.

Speaker 5

Your next question comes from a line of Judy Hong with Goldman Sachs Group.

Speaker 1

Good morning. Just in terms of the Tennessee Honey, you know, obviously you guys had a pretty successful launch. As you're sort of lapping that into next year, can you give us some perspective on the opportunities within the U.S. in terms of the increase in velocity that you're planning to have both on the on-premise and off-premise? Maybe you can give us a bit more color just internationally, how you size up the opportunity for a product like Honey. Over time, do you have a sense of how big sort of the flavor portion of the whiskey, you know, could get? Is this something that we could see getting as big as some of the other categories like vodka or rum where just the flavor portion is pretty sizable?

Speaker 3

Okay, let's see. I'll start with opportunities in the U.S. The first one was sort of opportunities in the United States. I think that the main comment there is while it has been a wonderful success, we believe, particularly because of things like the distribution in the marketplace, it doesn't occur overnight. It takes a while to phase that in. Typically, you have to get authorization with whether it's chains or with control states, some of that. It doesn't just happen overnight. We think that there was a more phased pipeline that we built going in at the early stages of the fiscal year. When we observed in terms of really the most dramatic difference in performance for our particular brand relative to what we're seeing from some of our competitors, we are skewed more to the off-premise and really have only scratched the surface thus far in the on-premise.

We think there's an opportunity both on on-premise distribution and velocity. We think that there continues to be interest. The one thing I would observe about not only our introduction, I commented a little bit about the impact it's having on other Brown-Forman brands, but we observed that the segment, in addition to what the volume we're contributing, continues to grow. A number of the competitors who were enjoying success before our entry are continuing to grow nicely. I just think those are indicative of a real significant growing interest by the trade and consumers for these offerings, of which we happen to be in a wonderful leadership position with our two trademarks. That also tips a little bit to your last question, which is where could this go? We frankly don't know.

It's one of those things that we know that the interest in distilled spirits, very much so in the United States, but increasingly globally, whether it's on vodka and here more recently in this example with whiskeys, is skewing very much to the variety that comes from flavors. People like them for their, I mean, just very interesting flavors and different flavors, but also the convenience oftentimes that comes in preparation of their drinks. We think there's a lot of growth here. If you just look at the long-running success of flavors related to most notably vodka, if it reflects any of the opportunity that might be there for the whiskey trademarks, it would be a real exciting thing for the industry. Don, do you want to talk about the international piece of things?

Speaker 1

Sure.

Speaker 3

On the international side, we identified some of the markets that we're looking at for next year. We're continuing to look at where we think the best opportunities lie. Part of it, part of what you look to is what Paul is alluding to, those markets where consumers seem to be interested in flavors and where you've been able to establish the brand fairly well. We've seen some interest in markets like Australia, Germany, and South Africa and a lot of places where you see the RTD market working. It tends to give you some sense as to where flavors are hitting a sweet spot with consumers. That's pretty much how we're looking at it. We'll continue to look to see where we think opportunities, where there might be opportunities along those lines, and continue to look for ways to go after them.

Speaker 2

Judy, I would add to that that, I mean, one real fact, since the introduction of Jack Daniel's Tennessee Honey in the United States, the global demand for it or call for it has been ahead of our willingness and actual desire, to be honest, to fulfill that simply because it's a Jack Daniel's trademark expression. We really wanted to understand and learn how it was performing in the United States, as you can imagine, before we thought about any expansion plans. As we sit here and prepare for FY 2013, we're in a better position to sit and consolidate those ideas and plans. It's been our experience throughout the course of this year that many international markets have had a demand for this ahead of our willingness to supply.

Speaker 1

As you think about fiscal 2013, you know, obviously you still have one more quarter to go, but given the improving trends that you see in Finlandia and maybe even Southern Comfort and potential for pricing to accelerate in 2012, can we see this high single-digit underlying sales growth accelerate even further? Or is the Tennessee Honey launch in fiscal 2012 somewhat of a hurdle just in terms of the lapping?

Speaker 2

We will confirm all of the guidance that's related to, you called it, I think you were referring to calendar year 2012 with some of your comments there, but we will be updating our FY 2013 forecast and look when we speak with you all, I think in early June when we report our Q4 and full-year results. What you mentioned there and what we've mentioned here this morning certainly are influences to us confirming our guidance and narrowing it here this morning. We are pretty much focused on that right now, the development of plans into the next fiscal year. We are aware of the reality of introductory pipeline associated with Jack Daniel's Tennessee Honey. That will very much be considered as we develop our plans for FY13.

It is just premature for us to be, I think, commenting on any of that because frankly, we haven't finished up all our plans yet.

Speaker 1

Okay, great. Thank you very much.

Speaker 2

Thank you.

Speaker 5

Your next question comes from a line of Lauren Torres with HSBC.

Speaker 1

Good morning.

Speaker 3

Hey.

Speaker 1

Hi. Just to follow up on some of your pricing comments, I'm just curious about timing. Why is next year the right time? Is it because some of your cost pressures are getting tougher or is it because your competitors are taking pricing? With that said, just thinking about how consumers may react, just curious if you think some behavior is firming up that you do think it's the right time just based on how the consumer's doing.

Speaker 3

Sure. I mean, that's really a good question and one I suspect a lot of people are thinking about. I think there's three areas that we might think about. There's some general environmental things, some influences and considerations that I think are more specific to the industry in which we operate, and a few others, of course, that are more specific to our company and the brands that we own. On the general side, just using the U.S. as one surrogate for the environment, we think there's just a little bit better environment, whether it's the consumer confidence numbers you look at or the job reports that come out. There's always something that's a counter to that, whether it's higher fuel prices, but you're constantly looking at the macro environment to try to observe what is its changing nature and how does that prepare you. We study that.

We would, I think, in general, even though it varies all over the world, generally say it's a little better today than it would have been in the prior couple of years. Probably more importantly are these things that are specific to our industry and our company. Last call, we talked a lot about the improving momentum in the United States and increasingly worldwide for bourbon and the whiskey segment generally. Given that we have a strong leadership position in that, I think that bodes well for the industry or the companies, frankly, in this case, the ability to think about improved pricing because the momentum happens to be there in a segment or category that's very important to us.

We've observed over the course of time here that the growth rates for premium and super premium price segments have continued to improve versus a couple of years ago where there were much reduced growth rates compared to what we're seeing today, particularly in this U.S. market where the super premium segment is doing extremely well. Then something I think you noted, you always are looking at the competitive behavior to see if they're pricing down or up in some directional way and how that might influence you. I think Don mentioned that we basically feel that that environment is a little bit better today as well. I think probably the most important thing is those factors related to Brown-Forman. I mean, we noted in here the strong momentum for Jack Daniel's in our super premium brands and the momentum the company has today versus a year ago.

We have noted the higher costs, which are grain-driven, but also I think something that helps us is that those also incorporate higher investments in packaging, which actually helps support some of the pricing plans you might have out in the marketplace. I think Don mentioned this, and it's just so important for a company like us, which is that you're always thinking with these products that are aged, the balance of the value generation between volume and margin. When you're laying down inventories for many years into the future, a dollar of revenue generated from pricing is more valuable than that of volume. You're always looking at the recipe for delivering value. When it gets skewed one way or the other, you should take note. Sometimes that's appropriate.

In this case, we think that because of the environment, because of some of the margin pinch we've observed, we just think we're in a much better position today and the opportunities there to go out and get improved pricing. That's probably the summary of all of it.

Speaker 1

Yeah. Taking all that in, I guess we should assume that looking into fiscal 2013, we should see margin improvement as a result of this flowing through.

Speaker 2

I mean, we'll be guiding that when we come out with F13, but just as we said last quarter, we'll say now it certainly is our aim to shore up and improve our margins.

Speaker 1

Okay, great. Just one follow-up too, you mentioned where we are with the inventories. Where are you with respect to promotional activity? Is that pretty much played through? We'll see more of that in the next quarter.

Speaker 2

Do you mean as it relates to, give me a little more information so I can help you with the answer to that?

Speaker 1

Yeah, I mean, in the quarter, the third quarter, you mentioned the impact of the distributor levels and also the promotional activity that was flowing through, the timing of promotional activity. I was curious if that's still flowing through your business or if that was something that was more in your maybe second and third quarters of this year.

Speaker 2

Yeah, those comments, Lauren, were really more directed towards the timing of promotional activities that we were seeing through the holiday period.

Speaker 1

Okay, so that's done.

Speaker 2

Yeah.

Speaker 1

Okay, great. Thanks.

Speaker 2

Thank you.

Speaker 5

Your next question comes from a line of Tim Raime with D.A. Davidson.

Speaker 1

Good morning. Thank you. As we think about the whiskey category, maybe it was growing 2%, 3%, 4% over the last couple of decades and then seeing this tremendous acceleration. I guess the obvious question is supply and how well prepared do you believe you are as well as the category? I know Beam takes the point of view that if we start running out, pricing will be the break. Do you have a comment on that?

Speaker 2

That's the comment you referenced from Beam. Anybody who's been in the aged businesses that are aged over any prolonged period of time have always had both that challenge, but also that tool of trying to balance the pricing and volume. I think most companies, I can't speak for them specifically, but it's been my experience that if you're operating in a good industry and particularly with the brands that we have positioned at the premium price points, the economics of selling more of your product are so attractive that you always try to plan for that success. We always try to build that in as it relates to, and of course, the only thing we know about this forecasting process is that it's always wrong. You can't with precision predict it.

You have to develop forecasting and cushion tools and all kinds of other things that help you as a manufacturer and a brand builder plan this. Ultimately, pricing is one of the tools that can be deployed to help you with that. If your question was about whether or not we anticipate the industry to be challenged on this front or our company, our plans right now don't anticipate it being a problem for Brown-Forman. We are sitting at, you know, we're more than anything, particularly with this report, we're excited about the kind of progress we're seeing. The additional actual sort of recent success through innovation has been a real help for the company.

The other thing that we've got, which I think is a real help, is being a company that has a portfolio of brands, to be able to go and where you have products that aren't in the aged business, which we always oftentimes refer to as our sort of rest of portfolio at Brown-Forman beyond Jack Daniel's. It's really exciting to go have the opportunity to develop the vodkas or the liqueurs and try to accelerate those growth rates in tandem with the whiskeys. At least in our planning, we feel pretty good about where we are. I just, more than anything, consider it one of the most exciting developments for the company and the industry just to see what's happening with this category overall.

Speaker 1

If I could just ask a granular question about the fourth quarter, should we assume any discontinuity on executive compensation or bonus accruals in the fourth quarter given a flattish kind of year, or sort of hold the course on that?

Speaker 3

Yeah, I'll tell you, the way I think about that, I mean, Judy, based upon our performance through this third quarter, all those accruals have been made. It depends on how the fourth quarter ends up coming out, that will determine kind of what the final accruals end up being.

Speaker 2

We hope we have to surprise you positively with that.

Speaker 1

To the upside, you're saying?

Speaker 2

Yeah.

Speaker 3

Sure.

Speaker 1

Okay. If you said this and I missed it, I apologize, but are you seeing a halo effect from Tennessee on the core business? I assume you are to some degree, but it'd be nice to know if the growth is more broad-based then.

Speaker 2

Yeah, I mean, that's what I tried to reference in a couple of my comments. Of course, the first thing you look for are the signs of cannibalization. You study that close. In fact, then you see that it's the opposite of that, that you actually get little boosts of momentum. You know, of course, you can never attribute this stuff so directly to one brand's introduction, how much of a halo effect is contributing to any improvement you might note in the parent brand. There's a fair amount of guesswork in that, but at a minimum, you start with the prospect that these always have the potential to cannibalize or to just actually take something away from the brand. I can say with confidence that Jack Daniel's Tennessee Honey has largely, not only on its own merits, but also very much helped the trademark.

If anything, we see an improved position of the Jack Daniel's brand, parent brand in the U.S. market today. I also mentioned that we were concerned that it would directly impact Southern Comfort, just given the size and position Southern Comfort has in the U.S. market. To date, that's holding up really well too.

Speaker 1

Thanks.

Speaker 2

Okay, thanks for your questions.

Speaker 5

Your next question comes from a line of Anne Gurkin with Davenport.

Speaker 1

Good morning.

Morning, Anne.

I wanted to start with your comments about expanding overseas and how you see expanding that distribution. Is it through joint ventures, internally developed networks? Can you just give me an update as to where we are with that distribution plan?

Speaker 2

Are you talking about in the expansion overseas just generally, not necessarily for Tennessee?

Speaker 1

Yeah, yeah.

Speaker 2

Yeah, okay, thanks. I mean, we are in the process this year, I mean, it's a little bit in our results, but most of the major route to consumer and distribution changes in recent years here. We had a handful of them that occurred last year. Because they were staged at different times of the year and the transitions take a little bit longer, they will affect your year-over-year comps. Russia is one that comes to mind in that regard this year. In terms of activity, there's a few, but we would call them more ongoing regular things that are just good improvements. Probably the most significant one was the January launch of our own company in Turkey that we talked about, I think a couple of... That was probably the biggest singular change this year.

Last year, we had Germany and Russia, Brazil, I think Canada phased at a certain point. There's less activity this year on that front. They've continued a long-term trend, Anne, that we think is important where we just can be, you know, appropriately influential over our business for the plans we have developed. Sometimes that's in partnerships. Sometimes we have the opportunity to go out and work on our own and capture some of the full margin and actually the cost associated with that. It continues to be a hybrid model all over the world, and we're always looking at that.

Speaker 1

Great. Paul, I'd be interested in your comments or opinion on do you think the global spirits industry is ready for another round of consolidation? What do you think could happen there?

Speaker 2

In a general sense, I don't know what the last sort of round was, because it's oftentimes thought of. I mean, there's periodically acquisitions and mergers in this industry. It's a very attractive industry. I don't see it as buoyant in our industries when you compare it to a bunch of other industries where this stuff is very, very frequent. I mean, it'd be hard for me to predict where the industry on that particular front is going to head. To be quite honest, we pretty much got our heads down building the business organically and have the benefit of an ownership structure that really has a long-term view on this business. We try to put that to use each and every day in the marketplace.

Speaker 1

Great. Finally, may I just get an update on your outlook for the tequila category and your plans there for this year, calendar year?

Speaker 2

Yeah, it's a bit of a mixed picture through the first nine months. I mean, actually, the Herradura brand has seen some nice sales improvement going back almost a year now or so. El Jimador is a bit mixed by country because it's been much more competitive in the U.S. market. There's been a lot of competitive activity at that 100% agave level at lower price points. It's made it competitive, and that's impacted some of our depletion trends. El Jimador continues to, you know, be in, I think, a good position in the United States and have a lot of growth opportunity, but there's just been a lot of competition there. The Mexico El Jimador business is always in a competitive arena, and it's sort of flattish.

Particularly, we've stabilized over the last couple of years, I'd say, some of the takeaway trends that we were observing, which were a little more negative going back toward the 2008-2009 period. We've been enthused about that. The news in Mexico as it relates to our tequilas is really Herradura's improvement over the last, you know, year or so and the continuing progress of our New Mix ready to drink brand down there.

Speaker 1

That's very helpful. Thank you very much.

Speaker 2

Thank you.

Speaker 5

Your next question comes from a line of Edward Mundy with Numis.

Speaker 1

Morning, gentlemen. A couple of questions from me. Back to A&P. As you move back towards traditional forms of advertising, could you remind us what proportion of your marketing spend is in digital, and do you see digital becoming a greater part of the piece?

Speaker 2

I don't have offhand what % is in that. Like almost every company, I'm sure it's a growing, it certainly is a growing %. What I've been impressed with on our work in the digital arena, particularly around the Jack Daniel's brand, is not so much that it's required massive amounts of investment as much as it has leveraged the ability to directly communicate with consumers through things such as Facebook. The launch of Jack Daniel's Tennessee Honey in the United States would be example number one in the way that it brought new friendships to the Jack Daniel's brand where you could communicate with them in far more efficient and direct ways than oftentimes is available to mass communicators. I think that's the gold in this.

It's not only that you're communicating directly through the new technological formats, it's you're so efficient in your ability to talk to people who are predisposed to you. We're fortunate that Jack Daniel's is the type of brand that people really want to interact with, and that's an advantage in the world that we call social media.

Speaker 1

Great, thanks. Secondly, on China, I know it's a small part of the overall group, but can you just provide some color on the decline of net sales in the quarter and how you look at the longer-term opportunity for American whiskey in the Chinese market, in particular, and training consumers up to more premium variants of it?

Speaker 3

Yeah, we've talked about China for a little bit now where we've actually struggled there a bit of late. We continue to see China as being a very big opportunity. They certainly have an interest in whiskey. We're taking a real look at that market in terms of what we've got there as far as an organization and how we're approaching it. We've been seeing, I would say, when you look at kind of our emerging market world, a lot earlier opportunities for Jack Daniel's in a number of other places than what we've seen for China up to this point in time. It's certainly one that continues to be on our radar screen and one that we're trying to figure out.

Speaker 2

We still think we're, even though we're struggling there, we do think we're one of the, there's not a lot of brands at the volume levels that are at Jack Daniel's and above. We sometimes refer to that as acceptable brands in that still relatively small international spirit market there. We are definitely in a transition period right now where everything from strategy to implementation to organization, we're having a fresh look at it to make sure that we can approach that market so that it can be growing in the way that we experienced through most of the 2000s. It's a competitive market and getting all aspects of it lined up well, the strategy, everything all the way down to your pricing and promotional spending plans and implementation, the media support you put behind it.

We'd have to think our way through it and maybe in some different ways than we have the last couple of years.

Speaker 1

Got it. Just a final question from me. We're hearing quite a lot about innovation in U.S. beer this year, new flavors, new pack sizes, etc. Do you see this threatening the current trend of spirits getting share away from beer in the U.S.?

Speaker 2

We certainly understand the response. To date, we haven't seen anything. I didn't actually check some of the more recent figures in advance of this call, but no, you totally expect people to fight for share of the beverage alcohol market. Same from wine at various price points. None of it will surprise me in terms of particularly in the formats that beer is typically served. I think obviously observed the appeal of the variety that comes from spirits consumption or trying to tap into that in some way. I think the innovation, the beer companies have long been innovative in packaging and many of those. I think innovation to the spirits industry in the last five or six years is relatively new. Consumers seem to enjoy it. I mean, they seem to be responding to it.

A measure we keep an eye on is what percentage of the incremental growth is coming from new products in the industry. It remains at a very high level.

Speaker 1

Thanks very much.

Speaker 2

Thank you.

Speaker 5

Thank you. At this time, there are no questions.

Speaker 3

Okay. Thanks everybody.

Speaker 1

Thank you. Thank you.

This concludes today's conference call. You may.