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Risk Analysis Project

Auditing 1

ACG 5637

Section 0197

Team 2

[March 20, 2012]

Professor Robert R. Tucker

Michael Box, Lori Brewster, Ray Busler, Amanda Carballo

mbox3465@ufl.edu, lori@ssequip.net, raybusler888@ufl.edu, acarballo@ufl.edu

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HISTORY AND BACKGROUND ................................................................................................................................ 3

COMPANY SIZE AND LOCATIONS .................................................................................................................................................. 6 PLANTS WORLDWIDE: .................................................................................................................................................................. 6 EMPLOYEES .................................................................................................................................................................................... 7 MANAGEMENT (CURRENT AND PAST) ........................................................................................................................................ 8 RECENT NEWS AND VARIOUS OTHER FACTS ............................................................................................................................. 8 MISSION AND VALUES: .................................................................................................................................................................. 9 COMPANY DESCRIPTION ............................................................................................................................................................. 10 MANAGEMENT STRUCTURE AND INCENTIVES .......................................................................................................................... 12 TAXATION OF ALCOHOL COMPANIES ......................................................................................................................................... 12 SUPPLY CHAIN:............................................................................................................................................................................. 13 COMPETITORS............................................................................................................................................................................... 14

FINANCIAL STATEMENT ANALYSIS .................................................................................................................. 14

Comparative Balance Sheet .......................................................................................................................................... 15 Comparative Income Statement ................................................................................................................................. 16

RATIO ANALYSIS ..................................................................................................................................................... 21

PROFITABILITY RATIOS ............................................................................................................................................................... 21 LIQUIDITY RATIOS ....................................................................................................................................................................... 25 LEVERAGE RATIOS ....................................................................................................................................................................... 28 ACTIVITY RATIOS ......................................................................................................................................................................... 30

ORGANIZATIONAL BUSINESS MODEL .............................................................................................................. 34

THE DISTILLED LIQUOR INDUSTRY ........................................................................................................................................... 34 CORE PROCESS ............................................................................................................................................................................. 34 STRATEGIC MANAGEMENT ......................................................................................................................................................... 36 RESOURCE MANAGEMENT .......................................................................................................................................................... 37 RESOURCES AND SUPPLIERS ....................................................................................................................................................... 37 COMPETITORS............................................................................................................................................................................... 38 STRATEGIC PARTNERS ................................................................................................................................................................. 39 EXTERNAL FORCES ...................................................................................................................................................................... 40 STRATEGIC POSITIONING ............................................................................................................................................................ 42 LIFE CYCLE OF THE INDUSTRY ................................................................................................................................................... 43 STOCK PERFORMANCE ................................................................................................................................................................. 46

EXTERNAL THREAT ANALYSIS........................................................................................................................... 47

SWOT ANALYSIS ......................................................................................................................................................................... 47 PORTER’S FIVE-FORCES MODEL ................................................................................................................................................ 51 PEST ANALYSIS ........................................................................................................................................................................... 54 AUDIT IMPLICATIONS .................................................................................................................................................................. 58

CONCLUSION ............................................................................................................................................................. 65

AUDIT FEE RECOMMENDATION ................................................................................................................................................. 66 WHY US?....................................................................................................................................................................................... 66 CURRENT AUDITOR ...................................................................................................................................................................... 67 PROFESSIONAL, ETHICAL, AND BUSINESS CONSIDERATIONS IF CLIENT IS ACCEPTED ........................................................ 67 STOCK ............................................................................................................................................................................................ 67

REFERENCES ............................................................................................................................................................. 68

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Brown-Forman Corporation

History and Background (Hoovers Company Records, 11781, 2012)

George Brown and John Forman founded Brown-Forman, in the form of a

single distillery, within the confines of Louisville, Kentucky in 1870. One specialty-

bourbon, Old-Forester brand, was produced from this distillery and was able to sell

well throughout the 1800’s because of the company’s innovation of packaging

techniques which included quality guarantees and safety seals.

George Brown and his family bought the interest that was of John Forman

once he passed away in 1901. This new direction for Brown-Forman Corporation

under the Brown family would prove to be a successful one throughout the years to

come. The Prohibition period before the world wars (early 1900’s), which sought

out to ban alcohol consumption in the United States, was a trying time for the

company. However, Brown-Forman was able to obtain a government approval to

sell its products for medical purposed during these times in order to avoid

bankruptcy. The company was also able to acquire its first company, Early Times,

and stored its whiskey in government warehouses and removed for sale only by

permit to avoid punishment under the prohibition laws. Soon thereafter, Brown-

Forman looked to establish themselves as an alcoholic company when the

prohibition amendment was repealed by popular vote in 1933.

Several years later, in 1956, the company looked to expand further than just

its Old Forester brand. Jack Daniels, with whom many associate as the company’s

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most popular and widely sold drink of choice, was acquired by Brown-Forman and

added a new twist to the company in the form of sour mash whiskey out of small

town Lynchburg, Tennessee. The management of Brown-Forman wanted to keep

this “small town” reputation to this particular whiskey and marketed this drink as

such.

Brown-Forman continued to expand its line of products throughout the

1960’s and 1970’s by acquiring the following alcoholic brands:

Korbel (champagne and brandy) Quality Importers (Ambassador Gin, Ambassador Scotch, and Old

Bushmills Irish Whisky) Bolla and Cella (wines) Canadian Mist (blended whiskey)

The company also expanded into new markets with the additions of several

non-alcoholic beverages as well, including:

Lenox (a leading US maker of fine china, crystal, gifts, and Hartmann luggage)

Kirk Stief (silver and pewter) Dansk International Designs (china, crystal, silver, and the high-

quality Gorham line)

After seeing growth within the Jack Daniels whiskey market share in the

following years after its initial acquisition, Brown-Forman decided to launch

Gentleman Jack Rare Tennessee Whiskey in 1988, the first new whiskey from the

Jack Daniels distillery in nearly 100 years. This was perceived from analyst as a bold

move to continue to strive for innovation and increased marketability.

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The 1990’s served as another growth period for Brown-Forman as several

other companies, such as Jekel Vineyards (1991), Fetzer Vineyards (1992), and

Sonoma-Cutrer Vineyards (1999). A joint venture with Jagatjit Industries, India's

third-largest spirits producer, was initiated in 1995 to expand upon international

relations.

Finally, the 2000’s were the era when Brown-Forman decided to determine

what they wanted their perception as a company to be from a standpoint of

products. Although a few more additions to the company were completed, such as

Australian spirits and winemaker Swift + Moore, a 45% ownership of Finlandia

Vodka Worldwide for $83 million, Chambord Liqueur (a black raspberry liqueur) for

$255 million, and Mexican company Grupo Industrial Herradura for $876 million

the company focused on becoming a sole alcoholic beverage company in this era by

selling off all brands that were not focused on alcohol. Those included were its

jewelry, collectibles, and gift seller Brooks & Bentley and the Hartmann luggage

subsidiary. Also, a select few of the alcoholic beverage brands were sold within this

era in order to create cash for future expenditures. Those included were Fetzer,

Bonterra, Five Rivers, Jekel, Sanctuary, and Little Black Dress brands and related

assets in California as well as Bolla and Fontana, and Fetzer Vineyards.

During 2004, a major setback for the company occurred when a decision to

reduce the alcohol level in its popular Jack Daniels Black Label whiskey from 90

proof to 80 proof. This decision was received with criticism on behalf of some of the

fans of the whiskey. Brown-Forman also announced in that year plans to close its

Dansk outlet stores over a two-year period. Due to a difficult competitive market in

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the US tabletop and giftware industries, Brown-Forman sold its Lenox subsidiary in

2005 to Department 56 for about $190 million in cash.

Company Size and Locations (Brown-Forman Corporation, 1998-2012)

Plants Worldwide:

North America: Europe: Australia:

Greenfield, CA Dublin, Ireland St. Leonard, Australia

Guerneville, CA Chagny, France

Hopland, CA Liyorno, Italy

Windsor, CA Verona, Italy

Louisville, KY

Versailles, KY

Lynchburg, TN

St. Croix, U.S. Virgin Islands

Collingwood, Ontario, Canada

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Employees

Total Employee Count: Nearly 3,900

Breakdown: (Brown-Forman Corporation, 1998-2012)

Job Type

Location

Age

Gender

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Management (Current and Past)

1870 – George Garvin Brown and John Forman, Founders

1917 – Owsley Brown, CEO

1945 – W. L. Lyons Brown, CEO

1951 – George Garvin Brown II, CEO

1966 – Daniel L. Street, CEO

1969 – William F. Lucas, CEO

1971 – Rob S. Brown, Chairman

1975 W. L. Lyons Brown, Jr., CEO

1993 – Owsley Brown II, CEO

2005 – Paul C. Varga, President and CEO

2006 – Brown Family (5th Generation) elected as company board of directors.

The majority of the company control is within the Brown family (70%) and is

determined by the Board of Directors to be under federal law labeled as a

“controlled company”. This makes the company easier to collude and makes the

company environment risker because of the related parties.

Recent News and Various Other Facts

Brown-Forman Corporation is listed on the NYSE as of March 13, 2012.

Two types of stock are issued for the company. Class A represents the

smallest but most important of the stocks, which is mostly owned within the

Brown family and gives voting rights. Class B stock is sold to the public but

has no voting rights.

The form of financing comes traditionally from the Class B stock in order to

raise capital without having to give up control of the company.

SAP technologies replaced WPM by Logisticon in 1999.

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Executive management incentive cuts to salary in the form of lower non-

equity incentive packages.

Jack Daniels, the world’s most popular whiskey drink, accounts for 30% of

the company’s revenues.

Alcohol consumption per capita has been on the decline for the past few

decades, falling 26% from 1980 to 2000. Data for the 2000’s show premature

growth in the industry.

Mission and Values:

Mission

“Corporate Responsibility at Brown-Forman means putting our values into action

throughout our business and in our relationships with suppliers, distributors,

customers, employees, consumers, and our shareholders. We must listen to

feedback on issues of shared concern and importance. We are committed to

promote social and environmental responsibility, transparency, and dialogue.”

Values

“Our past is defined by generations of visionary individuals and nearly a

century and a half of experience. We believe our future will be determined by

independence and continuity in our direction, commitment to our strategies, and

confidence in our capabilities.

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Over many years, we have developed and nurtured a set of core values that

have become deeply ingrained in our conscience and our culture. These time-

honored values — integrity, respect, trust, teamwork, and excellence — remain real

and relevant today, guiding us in the conduct of our day-to-day business.”

Company Description

Brown-Forman has always sought out as a part of its mission to be

corporately responsible as well as to promote social and environmental

responsibility, transparency, and dialogue. The company also has always and will

continue to seek out new visionary ideas and directions for its business. As we take

a look at the company history and current operations, these values and strategic

visions have been a top priority and it shows through numerous examples.

Corporate and Environmental Responsibility has always been a top objective

of Brown-Forman. That is why the recently launched corporate strategy, Building

Forever, was put into place to help guide the company into their 150th anniversary

in 2020. This strategy focuses on highlighting, “our social and environmental

ambitions, actions, goals, and performance.” (Brown-Forman Corporation, 1998-

2012).

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Figure 1.1 shows the Brown-Forman scorecard from 2011. This scorecard reflects the corporate responsibility measures for the company in the given year through a high-level breakdown.

Brown-Forman has also been able to achieve its sought after growth in

company market share and size by many different initiatives. In 1989, the company

decided to advance technologically by implementing a warehouse management

system (WMS) from Logisticon. However, this proposed way of allowing to the

company to become more efficient through technology advances took a swift turn

once Logisticon went bankrupt. Brown-Forman enterprise solutions consultant

Chris Ford was able to guide the company to install a much more efficient and

capable warehouse management system through SAP. This solution was able to

replace 20 disparate but linked systems into 1 very easy and efficient SAP system.

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The above example is just one of the ways Brown-Forman has chosen, and

continues to advance its technology and core service models in order to meet the

demanding alcoholic beverage industry and their strategic goals and visions.

Management Structure and Incentives

According to a Business First report, compensation packages for five senior

executives of Brown-Forman were down from fiscal 2010 (Business First, 2011).

For example, according to the report, “Total compensation for chairman and CEO

Paul Varga was $7.1 million, down from the $7.7 million Varga earned the year

before.” The decreases mainly included a decrease in non-equity incentive packages.

These packages serve as a main focus to allow executive to increase their

compensation with a high company pre-tax income, which to some auditors might

be a sign of a risk for incorrectly stated revenues or costs. This is just a recent

change however, which leads to state that the compensation package was more

heavily weighted using the non-equity compensation model in previous

management eras.

Taxation of Alcohol Companies

Brown-Forman Corporation does see a difference in the way they (and

others within the industry) are taxed in different countries. Not only are most

countries able to put a higher tax on the sale and consumption of alcohol compared

to other goods, some countries even put an excise stamp on the alcohol being sold

within country borders. These differences in taxation values on Brown-Forman can

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be found in the ICAP REPORTS 18 from the International Center for Alcohol Policies

in 2006.

Supply Chain:

Figure 2.2

Figure 2.2 above shows the countries where Brown-Forman Corporation imports their goods for production in their distilleries and plants (Import Genius, 2012).

The supply chain at Brown-Forman is like many other alcoholic beverage

companies models. First, they import the majority of their goods for a more

economic and cheaper production costs. After these goods are relieved, they allow

the internal plants and distilleries to produce their unique mixture of products. This

is where the “value-added” process takes place since every company has their own

secrets and recipes in making their drinks unique. Finally, Brown-Forman ships

their products, including Jack Daniels, Finlandia, and other products to be sold at

grocery stores and other retail units.

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Competitors

Listed below are the three biggest competitors in 2011 for Brown-Forman:

Beam Global Spirits and Wine. Constellation Brands Inc. Diageo plc.

These companies compete on a global basis and have locations worldwide, just like

Brown-Forman does. Brown-Forman currently owns 5% of the U.S. market share in

alcoholic beverages industry.

Financial Statement Analysis Brown-Forman has been a major contender in the Wineries & Distillers

Industry for over a century. To gain a greater understanding of the client, our audit

team assessed and analyzed the financial statements for the past five years.

Presented below in figures 3.1 and 3.2, are the comparative common sized balance

sheet and income statement for Brown-Forman Corporation respectively.

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Figure 3.1 Brown-Forman Corporation

Comparative Balance Sheet Common Size Period Ended 4/30/2011 4/30/2011 4/30/2010 4/30/2009 4/30/2008 4/30/2007

In millions of USD

Cash and Short Term Investments 15.27% 567 232 340 119 369

Change in Cash 144.40% -31.76% 185.71% -67.75%

Total Receivables, Net 13.36% 496 418 367 453 404

Change in Receivables 18.66% 13.90% -18.98% 12.13%

Total Inventory 17.43% 647 651 652 685 694

Prepaid Expenses 3.48% 129 99 84 -- --

Other Current Assets, Total 3.69% 137 127 131 199 168

Total Current Assets 53.23% 1,976.00 1,527.00 1,574.00 1,456.00 1,635.00

Buildings - Gross 8.54% 317 349 347 342 323

Land / Improvements - Gross 1.86% 69 89 89 88 88

Machinery / Equipment - Gross 12.02% 446 491 475 453 446

Construction in Progress - Gross 0.30% 11 15 14 24 27

Property / Plant / Equipment, Total - Net 10.59% 393 468 483 501 506

Intangibles, Net 18.05% 670 669 686 699 684

Other Long Term Assets, Total 1.29% 48 53 57 61 56

Total Assets 100.00% 3,712.00 3,383.00 3,475.00 3,405.00 3,551.00

Change in Total Assets 9.73% -2.65% 2.06% -4.11%

Accounts Payable 3.39% 126 97 96 129 118

Change in Accounts Payable 29.90% 1.04% -25.58% 9.32%

Accrued Expenses 7.70% 286 245 230 210 202

Notes Payable / Short Term Debt 0.00% 0 188 337 585 401

Current Portion of Long Term Debt / Capital Leases 6.87% 255 3 153 4 354

Other Current liabilities, Total 1.08% 40 13 20 56 272

Total Current Liabilities 19.05% 707 546 836 984 1,347.00

Change in Current Liabilities 29.49% -34.69% -15.04% -26.95%

Total Long Term Debt 13.58% 504 508 509 417 422

Deferred Income Tax 4.04% 150 82 80 89 56

Other Liabilities, Total 7.84% 291 352 234 190 153

Total Liabilities 44.50% 1,652.00 1,488.00 1,659.00 1,680.00 1,978.00

Change in Total Liabilities 11.02% -10.31% -1.25% -15.07%

Common Stock, Total 0.65% 24 24 24 19 19

Additional Paid-In Capital 1.48% 55 59 67 74 64

Retained Earnings (Accumulated Deficit) 73.01% 2,710.00 2,464.00 2,189.00 1,931.00 1,649.00

Treasury Stock - Common -16.11% -598 -476 -331 -304 -102

Unrealized Gain (Loss) -0.38% -14 3 4 -6 -4

Other Equity, Total -3.15% -117 -179 -137 11 -53

Total Equity 55.50% 2,060.00 1,895.00 1,816.00 1,725.00 1,573.00

Change in Total Equity 8.71% 4.35% 5.28% 9.66%

Total Liabilities & Shareholders' Equity 100.00% 3,712.00 3,383.00 3,475.00 3,405.00 3,551.00

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Figure 3.2

Brown-Forman Corporation

Comparative Income Statement

Common Size

Period Ended 4/30/2011 4/30/2011 4/30/2010 4/30/2009 4/30/2008 4/30/2007

In millions of USD

Net Sales 100.00% $ 3,404.00 $ 3,226.00 $ 3,192.00 $ 3,282.00 $ 2,806.00

Sales Growth 5.52% 1.07% -2.74% 16.96%

Cost of Revenue, Total 49.35% $ 1,680.00 $ 1,615.00 $ 1,615.00 $ 1,587.00 $ 1,325.00

Cost of Revenue Growth 4.02% 0.00% 1.76% 19.77%

Gross Profit 50.65% $ 1,724.00 $ 1,611.00 $ 1,577.00 $ 1,695.00 $ 1,481.00

Gross Profit Growth 7.01% 2.16% -6.96% 14.45%

Selling / General / Administrative Expenses, Total 27.61%

$ 940.00 $ 889.00 $ 931.00 $ 1,007.00 $ 898.00

Selling / General / Administrative Expenses Growth

5.74% -4.51% -7.55% 12.14%

Amortization of Intangibles 0.15% $ 5.00 $ 5.00 $ 5.00 $ 5.00 --

Depreciation / Amortization 0.15% $ 5.00 $ 5.00 $ 5.00 $ 5.00 --

Unusual Expense (Income) -1.12% $ (38.00) $ 12.00 $ (20.00) -- --

Other Operating Expenses, Total -1.12% $ (38.00) $ (5.00) -- $ (2.00) $ (19.00)

Total Operating Expense 74.88% $ 2,549.00 $ 2,516.00 $ 2,531.00 $ 2,597.00 $ 2,204.00

Operating Income 25.12% $ 855.00 $ 710.00 $ 661.00 $ 685.00 $ 602.00

Operating Income Growth 20.42% 7.41% -3.50% 13.79%

Interest Income (Expense), Net-Non-Operating, Total -0.76%

$ (26.00) $ (28.00) $ (31.00) $ (41.00) $ (16.00)

Interest Expense Growth -7.14% -9.68% -24.39% 156.25%

Net Income Before Taxes 24.35% $ 829.00 $ 682.00 $ 630.00 $ 644.00 $ 586.00

Net Income Before Taxes Growth 21.55% 8.25% -2.17% 9.90%

Provision for Income Taxes 7.55% $ 257.00 $ 233.00 $ 195.00 $ 204.00 $ 186.00

Net Income After Taxes 16.80% $ 572.00 $ 449.00 $ 435.00 $ 440.00 $ 400.00

Net Income Growth 27.39% 3.22% -1.14% 10.00%

Basic Weighted Average Shares $ 145.60 $ 147.83 $ 150.45 $ 153.08 $ 153.59

Basic EPS Excluding Extraordinary Items

$ 3.92 $ 3.03 $ 2.88 $ 2.87 $ 2.60

Basic EPS Growth 29.37% 5.21% 0.35% 10.38%

Diluted Weighted Average Shares $ 146.51 $ 148.58 $ 151.52 $ 154.51 $ 155.25

Diluted EPS Excluding Extraordinary Items

$ 3.90 $ 3.02 $ 2.86 $ 2.84 $ 2.58

Diluted EPS Growth 29.14% 5.59% 0.70% 10.08%

DPS - Common Stock Primary Issue $ 1.24 $ 1.18 $ 1.12 $ 1.03 $ 0.93

These financial statements are fairly represented and free from material

misstatements according to their current auditors, PriceWaterhouseCoopers.

Overall the statements give a very positive outlook for the company if it continues to

improve performance every year in such a manner. The Balance Sheet gives a look

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at all of the permanent accounts of the company at the company’s fiscal year end,

April 30. The activity in the cash and short term receivables account has been

somewhat erratic over the past five years, as shown in figure 3.3, but can be

substantiated by a brief look at the Statement of Cash Flows and additional Balance

Sheet analysis. The drop from 2007-2008 was due to a large long-term debt

reduction and dividend payment in the financing activities section, and the drop in

2010 can be explained by the same thing. The firm has a total of $3,172M in total

assets that have been growing at 1.2575% over the past 4 years, with 53.23% being

current assets, which is enough to place them at fourth in their industry.

Figure 3.3

Brown-Forman is financed with a slightly greater percentage of equity than

debt, which is good because debt is a riskier investment than equity because of the

financial obligations and interest payments. The liabilities are so volatile because

debts are constantly being reclassified to short term, and written off as well as a

number of leases over the past few years. Total equity on the other hand has been

on a consistent increasing trend since 2007 at an average increase of 7% per year,

0

100

200

300

400

500

600

2007 2008 2009 2010 2011

Cash and Short Term Investments

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and is primarily made up of retained earnings, which has also been on a consistent

increase every year.

Figure 3.4

The income statement gives a breakdown of the company’s operations and

tracks their performance for the fiscal year ended April 30. All of these accounts are

temporary because they are only open for a single year before they are written off to

the balance sheet accounts for final recording. As indicated by the performance of

the balance sheet accounts, net sales in figure 3.4 for Brown-Forman have been on

an average 5.2% increase every year. Increased demand for product and the

purchase of a new business in 2007 have attributed to this notable performance.

While costs are on the rise every year in such a competitive industry, Brown-

Forman has been able to maintain their costs over the past 3 years and give their net

income after taxes a steady increase. Figure 4.5 displays this trend over the past

five years, the jump in 2011 totaling a 27.39% increase from the previous year due

in part to increased sales and lower interest expenses.

$-

$500.00

$1,000.00

$1,500.00

$2,000.00

$2,500.00

$3,000.00

$3,500.00

$4,000.00

2007 2008 2009 2010 2011

Net Sales (in millions USD)

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Figure 4.5

As compared to the industry, Brown-Forman’s growth has nearly tripled its

closest competitor. Figure 4.6 below shows a stock growth chart displaying Brown-

Forman versus its top 3 competitors: Constellation Brands, Beam Incorporated, and

Diageo as well as the Dow Jones average. Brown-Forman’s growth has been on the

rise since about the first quarter in 2009 and is a promising indicator of future

performance in conjunction with the positive outlook of the financial statements.

Figure 3.6

Brown-Forman vs. Industry Averages

The statement of cash flows provides a more in depth look at all of the cash

transactions the company performed throughout the fiscal year. It considers cash

$-

$100.00

$200.00

$300.00

$400.00

$500.00

$600.00

2007 2008 2009 2010 2011

Net Income

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flows from the company’s operating, financing, and investing activities

encompassing nearly any and all transactions the company can make. A valuable

tool that investors use after is the dividends per share ratio which is the dividends

paid out by the company divided by outstanding common stock. Investors love to

see returns on their funds so any payment remitted back to them installs goodwill

within the company and keeps the investors happy. The low ratio in 2009-2010 can

most likely be attributed to affects from the recession and such trying economic

times.

Figure 3.7

Based upon this analysis of Brown-Forman’s financial statements, our audit

team has drawn the conclusion that it is a very profitable company with promising

growth potential in the future if they continue to innovate and stay competitive in

their industry. A 10% threshold for materiality has also been assessed as the most

efficient. On the statements themselves, any change over 10% was relatively drastic

and should have some sort of explanation so the same should hold true for the audit.

$-

$0.50

$1.00

$1.50

$2.00

$2.50

$3.00

2007 2008 2009 2010 2011

Dividends per Share

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Ratio Analysis According to the financial statement information for the past 5 years

provided by Brown-Forman Corporation, our audit group has calculated a number

of different financial ratios to assess management’s effectiveness in its corporate

objectives and obligations to stockholders. There are four types of ratios that assess

management’s effectiveness including profitability, liquidity, leverage, and activity

ratios. Each analyze a different aspect of managements overall performance so a

variety of each type of ratio was performed for the past 5 years to view trends and

improvements.

Profitability Ratios

Like most other corporations, Brown-Forman is most concerned with its

profitability within the market. Profitability ratios show a company’s overall

efficiency and performance and can be divided into two main types of ratios with

ratios that show margins and ones that show returns. Margins are the firm’s ability

to translate sales dollars into profits, whereas returns measure the firm’s ability to

generate returns for its shareholders, both of which are highly important aspects to

the company’s overall health and going concern.

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Figure 4.1

The gross, operating, and net profit margins are the three most commonly

used profitability ratios in assessing margins and are shown in figure 4.1. The gross

profit margin looks at the cost of goods sold as a percentage of sales and shows how

well a company controls the cost of its inventory and passes on the costs to its

consumers, typically the larger the better. Both the operating and net profit margins

take into account more expenses than the gross margin; the operating taking into

account all of the expenses of ordinary, daily business activity and the net profit

margin taking into account all of the expenses during the period including taxes,

interest and depreciation. As a general trend across all categories, there is a small

decrease in all three ratios from the years 2007-2009, which can most logically be

attributed to the financial recession that hit the economy in 2008. The margins have

been on a steady increase since 2009 though showing promising growth in the past

year which has even topped the numbers in 2007 in some instances. These ratios

affirm management’s ability to manage a variety of costs while maintaining a

respectable profit margin in such harsh economic conditions.

0.00%

10.00%

20.00%

30.00%

40.00%

50.00%

60.00%

2007 2008 2009 2010 2011

Margin Ratios

Gross Margin Operating Margin Net Profit Margin

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Figure 4.2

The two most common profitability ratios that show returns are the return

on assets and return on equity as shown in figure 4.2. Return on assets (also called

return on investment) measures the efficiency with which management is managing

investments in assets and using them to generate profit. The steady increase since

2007 is a good sign showing that management is getting consistently better at

generating profit from their investments. Return on equity measures the return on

the money that investors have put into the company, and are often the key ratio that

investors look at in determining whether to invest or not. Typically, the higher the

ratio, the better as it is an indication that management is doing a good job managing

investor’s money. The drop in the ratio can most likely be reasonably explained by

the recession in ’08-’09, so the positive trend over the past couple of years is

promising and is indicative of a solid investment.

Another measure to assess profitability is earnings per share, which is the

portion of a company’s profit allocated to each outstanding share of outstanding

stock. Diluted EPS expands upon the basic EPS by including convertible shares and

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

2007 2008 2009 2010 2011

Return Ratios

Return on Assets Return on Equity

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stock warrants while excluding dividends on preferred stock. Figure 4.3 shows that

the basic and diluted EPS for Brown-Forman is nearly identical and has been on a

steady increase every year since 2007. Greater earnings per share are preferable;

however EPS can be misleading because of earnings manipulation of net income.

The price-earnings ratio (P/E ratio) is the valuation ratio of a company’s current

share price compared to its per-share earnings. Also referred to as the price

multiple or earnings multiple, because it shows how much investors are willing to

pay per dollar of earnings. Meaning that in 2011, investors would be willing to

invest about $15 for $1 of current profit. The higher the P/E ratio, suggests that

investors are expecting higher earnings growth in the future. As a number of the

products that Brown-Forman owns are in the maturity stage of their lifecycle the

lower P/E ratio, in figure 4.4, in recent years is not out of the question as sales are

expected to slow at that point.

Figure 4.3

$-

$0.50

$1.00

$1.50

$2.00

$2.50

$3.00

$3.50

$4.00

2007 2008 2009 2010 2011

Earnings Per Share

Simple Diluted

25

Figure 4.4

Liquidity Ratios

Liquidity typically deals with a firm’s assets and liabilities, more specifically

liquidity looks into whether a firm can pay its current debt with its current assets.

In general, the higher the liquidity ratio, the larger the margin of safety that the

company possesses to cover short-term debts - which is of the utmost importance to

creditors. In figure 4.5, the most basic liquidity ratio, the current ratio, shows how

many times over the firm can pay its current debt obligations based on its assets. As

long as this ratio remains above 1.0X then the company remains solvent, meaning

that the firm can meet all of its debt obligations. Brown-Forman’s current ratio has

been increasing ever since 2007, even reaching above 2.0X meaning that the

company can settle its debt obligations twice over. This could mean that

management should utilize their credit power more to expand the company, but in

the maturity stage of the business life cycle a higher current ratio is perfectly

acceptable.

0

5

10

15

20

25

30

2007 2008 2009 2010 2011

Price-Equity Ratio

26

Figure 4.5

Figure 4.6

The second most commonly used liquidity ratio is the quick ratio or acid test.

The difference between the quick and current ratio is that inventory is subtracted

from the numerator of the current ratio calculation. Inventory is not taken into

account because financial analysts argue that inventory is the most difficult thing to

get rid of when liquidating a company and is often the last thing to go; thus firms

want to be able to meet their short term obligations without having to sell their

inventory. Like the current ratio, if the quick ratio is above 1.0X then the firm is able

to pay its short term debt without having to sell inventory. Figure 4.6 shows that

0

0.5

1

1.5

2

2.5

3

2007 2008 2009 2010 2011

Current Ratio

0

0.5

1

1.5

2

2007 2008 2009 2010 2011

Quick Ratio

27

the quick ratio has increased dramatically over the past 5 years, especially in the

past two years as the ratio has exceeded 1.0X indicating a highly liquid, well-

managed company.

Another measure of both efficiency and short-term financial health is a firm’s

working capital which is whether the company is able to pay off its short-term

liabilities. If current assets don’t exceed current liabilities, company’s run into a

variety of problems from paying back creditors in the short run and possibly

bankruptcy in a worst case scenario. Luckily in figure 4.7, Brown-Forman has had a

substantially growing working capital meaning that between cash, accounts

receivable and inventory the company can pay off short-term debt obligations

immediately with money to spare. Money tied up in inventory or owed to the

company cannot be used to fulfill obligations however and must be taken into

account when analyzing this financial ratio. Inventory has remained constant,

accounts receivable has steadily increased as sales have increased but so has cash

which has nearly doubled in the past year, meaning the company’s financial position

is getting better as that liquid cash balance increases.

28

Figure 4.7

Leverage Ratios

There are a number of ways to raise capital for a corporation, the two largest

being through equity or by debt. Liquidity ratios are what creditors utilize to assess

whether to give a loan but leverage ratios are used by the company to get an idea of

the company’s methods of financing or to measure its ability to meet financial

obligations. Figure 4.8 showcases the debt to assets ratio which shows how much of

the company’s asset base is financed with debt, the goal being to keep this ratio in

line with the industry and watching for trends in historical data. The ratio is being

compared to the major competitors in the Wineries and Distillers Industry: Diageo,

Beam Inc., and Constellation Brands. The trends indicate that Brown-Forman has a

low amount of its total assets financed by debt as compared to the other companies

which is good in the sense that debt is far riskier for the firm than using equity

financing. However, it could also indicate that Brown-Forman needs to take on

more debt to have capital to develop better products, and acquire smaller distillers

to stay competitive in the industry.

$-

$200.00

$400.00

$600.00

$800.00

$1,000.00

$1,200.00

$1,400.00

2007 2008 2009 2010 2011

Working Capital (in millions USD)

29

Figure 4.8

Figure 4.9

The debt to equity ratio is another leverage ratio, measuring how much debt

is used to finance the corporation in relation to the amount of equity. As previously

stated, debt financing is far riskier for the company than using equity financing, so

as this ratio increases and the amount of debt financing increases so too does the

risk of the firm. Figure 4.9 shows Brown-Forman’s debt to equity ratio as compared

to the lead industry competitors: Diageo, Beam Inc., and Constellation Brands. It is

clear that Diageo and Constellation Brands are heavily financed by debt, as over

100% of their capital structure is debt. Brown-Forman and Beam Inc. on the other

0.00%

10.00%

20.00%

30.00%

40.00%

50.00%

60.00%

2007 2008 2009 2010 2011

Debt to Assets

Brown-Forman Diageo Beam Inc. Constellation Brands

0.00%

50.00%

100.00%

150.00%

200.00%

250.00%

2007 2008 2009 2010 2011

Debt to Equity

Brown-Forman Diageo Beam Inc. Constellation Brands

30

hand, are more balanced between debt and equity, which is indicative of a stable

and consistent investment. The decrease over the years can be due to a variety of

aspects but the notable drop between 2007 and 2008 is from the payment of a large

portion of debt that had come to the end of its term. Debt entails the payment of

interest throughout the term of the debt, so a company must at least be able to cover

the debt in order to maintain good credit standing. The times interest earned ratio

or interest coverage ratio displayed in figure 4.10, tells the company how many

times the company can pay over its interest expense in a given year. Since Brown-

Forman’s debt ratios are relatively low comparatively, the times interest earned

ratio is going to be much higher because it is easier to cover the company’s interest

expenses. The drastic change from 2007 to 2008 can be attributed to an unusually

high interest expense for that year which tapered off in consecutive years.

Figure 4.10

Activity Ratios

Often called turnover or efficiency ratios, activity ratios measure the

effectiveness of how the business is managing its assets to produce sales. There are

0

2

4

6

8

10

12

14

2007 2008 2009 2010 2011

Times Interest Earned

31

a variety of different ratios used to evaluate these more specific business operations.

Figure 4.11 shows the catch-all activity ratio that encompasses all other activity

ratios. The total asset turnover demonstrates how efficiently the company’s assets

generate sales the higher the ratio the better and more efficiently the company uses

assets. If there is a problem with inventory, receivables, working capital, or fixed

assets then it will show up in the total asset turnover ratio. The ratio itself doesn’t

give much of an indication of performance; however when compared to industry

leaders the ratio becomes much more telling. Brown-Forman’s ratio is significantly

greater than that of its competition meaning that management is extremely effective

in managing assets to produce sales. The ratio has hit a plateau over the past few

years which indicate a steady investment and a reasonable estimate of how

efficiently management is going to manage assets in the next few years to come.

Figure 4.11

Perhaps the most important activity ratio for any company that includes the

sales of physical products is the inventory turnover ratio. It is the ratio of net sales

to total inventory, which is the number of times inventory is sold and restocked

every year. If the number is too high then there is a danger of stock outs and if the

0

0.2

0.4

0.6

0.8

1

1.2

2007 2008 2009 2010 2011

Total Asset Turnover

Brown-Forman Diageo Beam Inc. Constellation Brands

32

number is too low then there’s a danger of obsolete inventory. There has been a

steady increase in the number of times that inventory is converted throughout the

year as shown by figure 4.12, which is indicative of selling more inventory that is on

hand or making smarter purchases to cut costs. Figure 4.13 takes the inventory

turnover ratio and divides it into 365 days, to find the exact number of days that it

takes the company’s inventory to convert on average. The shorter the better, so the

downward trend is a positive sign for Brown-Forman in that they are getting

progressively more effective at converting its inventory into sales in shorter time

periods.

Figure 4.12

Figure 4.13

0

1

2

3

4

5

6

2007 2008 2009 2010 2011

Inventory Turnover

0

20

40

60

80

100

2007 2008 2009 2010 2011

Inventory Conversion Ratio

33

Like the inventory turnover ratio, the receivables turnover ratio looks at how

many times a certain business function is performed throughout the course of the

business year. It measures how fast the company can collect on sales or, on average,

how many times each year the company totally collects accounts receivable. In

general the higher the better, which means that accounts receivable is collected on a

timely basis. In figure 4.14, the spike in Brown-Forman’s receivables turnover in

2009 could be resultant from a large number of collections on account and not as

many sales throughout the year or perhaps a large write-off. The lower ratios in

other years could mean that Brown-Forman should assess its credit and collections

policy to make sure that it is on target, but it is still within an acceptable range since

2007 so there is not much reason to worry.

Figure 4.14

0

1

2

3

4

5

6

7

8

9

10

2007 2008 2009 2010 2011

Receivables Turnover

34

Organizational Business Model

The Distilled Liquor Industry

The distilled liquor industry is a global business where larger companies

compete on economies of scale and brand recognition, and smaller companies

compete by specializing in high-end or unusual spirits. Brown-Foreman is one of

the top three distillers in the U.S. thus relies on its brand recognition. The global

alcoholic beverages industry is mature, posting growth rates of only about 2 to 3

percent annually over the past decade. Due to this, the industry leaders compete

primarily for existing market share through acquisitions. Many also focus on the

development of innovative products to differentiate themselves from the

competition such as mixed drinks and/or creative packaging.

Core Process

Distilleries make liquor by cooking (mashing) its raw materials such as

wheat, rye, and corn, which are then strained leaving behind a sweet liquid. The

liquid is fermented in tanks for three to ten days. Then, the fermented grain alcohol

mixture is transferred to a well until it is distilled; a process that separates the

alcohol from the fermented mash. The alcohol then matures in oak barrels. The

aging of the alcohol gives it its distinct aroma, flavor, and color. The maturation

process can last for several years before finally the alcohol is filtered and bottled

(Anonymous, 2010).

The resources needed for production of alcoholic beverages include water,

natural gas, glass, cartons, and grains. Food inputs depend on the final product and

35

include items such as wheat, rye, corn, beets, potatoes, botanicals, coffee beans,

herbs, and various fruits. Grains are the industry’s largest input and expense. The

distillation process hasn’t changed much throughout the years; so to increase

profitability the industry relies on creating efficiencies in its production processes

and having strong distribution channels. Technology advances have contributed to

increased efficiency in packaging and bottling such as the use of mechanized

bottling lines and lighter, standardized bottles (Encyclopaedia Britannica Inc.,

2012). Brown-Forman relies on many factors that influence the outcome of its

success or failure as a business. Figure 5.1 below is a model representing the

different forces that contribute to its business performance.

Figure 5.1

At the center of the model are the core processes as described above.

Management is also central to the business, and can be defined by the strategies it

36

incorporates to compete in the marketplace, the customers it wishes to target, and

the brand image it wants to portray.

Strategic Management

Brown-Forman previously tried to vertically integrate by acquiring non-

beverage companies such as Lenox, Kirk Stief, and Dansk International Designs.

However, because of the difficult competitive market in these industries, it has sold

all of these companies, and since 2007 concentrates all of its efforts only on its

alcoholic beverage business (Hoovers Company Records, 11781, 2012). It continues

to grow now through acquisitions of other alcohol lines and vineyards.

Strategic management involves the markets, customers, and products in its

decision-making. Because Brown-Forman holds a large market share for its Jack

Daniel’s brand whisky and bourbon, its target market traditionally has been a

middle-to-upper class male. Today, its base is growing in its sales of vodka, gin, and

rum, which are used, in fruit-based cocktails that are increasing in consumption by

women and entry-level drinkers. Brown-Forman has a presence in 135 countries

besides the U.S. and is looking to expand in the future to a large target market in

China, Brazil, Russia, and India. U.S. regulations do not allow a distiller to sell

directly to restaurants, bars, retailers, or individuals, so these are all indirect

customers. Additionally, it carries a wide variety of liquors to appeal to its users,

but their main focus is on producing premium products that compete at a

reasonable price. They do carry higher-end super-premium products as well, but

they mostly look to serve a wide population rather than a narrow high-end market.

The industry faces risks from consumers through preference changes, liability

37

claims, and weakening economic conditions, which lead to fewer sales of super-

premium brands.

Resource Management

The resource management of Brown-Forman also lies in the center of its

organizational business model. These managers are tasked with making sure the

resources needed for production arrive on time, at a reasonable price, and are of

good quality. They must consider risks faced with obtaining the resources needed,

and look for ways to minimize costs. There can be volatility in the markets for the

grains and natural gas that is central to their core processes. Therefore, purchasing

futures and options is one way to manage that volatility and provide a

predetermined price for the inputs needed. Providing consistency and manageable

costs aids in the decisions management must face regarding pricing and overall

demand for their products in the future. This becomes very important because the

aging process for their liquor takes several years, so the costs of purchasing its

production materials will have consequences for many years down the road.

Resources and Suppliers

Besides the basics needed for production such as water and natural gas,

farmers play a huge role in getting the resources and supplies needed to make their

products. As previously mentioned, many grains, fruits and other food inputs are

used and must be of good quality to produce the best liquors. There are also laws

that regulate the amount of certain inputs that must be used in the production of

38

liquor products. For example, by law bourbon must be a minimum 51% corn and it

must be aged in charred new oak barrels.

There are many risks the distiller industry faces from its suppliers. Because

grains are the distillery’s larges input, there exists risks of rising prices or shortages

from droughts and natural disasters of the farmer’s crops. Yet, even with no natural

causes, the industry also faces risks caused by other industries in competition for

those same resources. The biggest such threat they are facing comes from the

ethanol fuel industry. In recent years there has been a growing demand for ethanol

fuel, which uses corn as its main source of input. To meet this demand, many

farmers have switched from growing other grains such as barley, wheat, and rye, to

growing corn. Since the supplies have fallen for those less demanded grains, their

prices have risen. Moreover, the liquor distillers must compete for corn from the

ethanol fuel producers as well. Futures and options contracts are one way Brown-

Forman addresses the volatility of their resources.

Competitors

At the bottom of Brown-Forman’s organizational model are the outside

forces of competition. There are over 80 distillers in the U.S., with the top 20

accounting for over 90% of industry revenues (Distilleries-Quarterly Update

11/21/2011, 2011) Brown-Forman’s top direct competitors include Diageo,

Constellation Brands, and Beam Global Spirits & Wine (Hoovers Company Records,

11781, 2012). The pie chart on figure 5.2 shows how Brown-Forman compares

against its main U.S. competitors in market share, coming in third out of the top four

39

U.S. distillers when

compared to its direct

competition (Hoovers

Company Records,

11781, 2012).

Their direct

competition comes from

other whisky, bourbon,

and spirits distillers, as well as non-U.S. firms; however, they also indirectly compete

with beer and wine producers for alcohol spending which are substitutes for its

products. Because Brown-Forman is in the top three U.S. distillers of spirits, their

focus on growth comes from name recognition. That has played well to their

strengths as their Jack Daniel’s brand holds the top spot in whiskey sales in the U.S.

(Strenk, 2011).

Strategic Partners

Besides name recognition, having strong distribution networks is essential to

a distiller’s success and profitability. Wholesale Distributors are strategic partners

with worldwide distillery’s, but especially so in the U.S. because government

regulations require distillers to use a three-tiered distribution system. It cannot sell

directly to restaurants, bars, retailers or individual consumers, but must use a

wholesale distributor to carry and represent its products. Moreover, there are 18

states where the state itself is the sole distributor of liquor because of their

stringent regulations of the liquor industry (Distilleries-Quarterly Update

Figure 5.2

40

11/21/2011, 2011). Because of regulation, wholesale distributors are a critical part

of strategic management planning, and the distillers success somewhat lies in the

hands of these distribution networks.

External Forces

Finally, Brown-Forman’s organizational business model includes outside

external forces that contribute to its outcome. Customers, public perception, the

media, nature, government regulations, and court decisions all play a role in how the

company operates. As mentioned previously, customer’s preferences and available

discretionary spending effects demand for their products. News articles,

entertainment and celebrity trends, and health concerns all play a role in

consumer’s preferences. Management must provide a product mix that meets

changing trends and tastes because something that is popular today might not be

popular next year. Since liquor must be aged, this can become a major factor as

inventory is waiting to be sold.

Likewise, public perception and the media can play a role in demand as well.

The public has balked at having television advertising of distilled spirits because of

the influence it may have on children. The industry voluntarily banned all television

advertising for 48 years up until Seagram Americas aired an ad for Crown Royal

Canadian whiskey on a television station in Texas in 1996 (The Gale Group, Inc.,

2012). That was when the Distilled Spirits Council and most major television

networks rescinded the voluntary ban, and once again the controversy was opened

up to debate from those such as President Clinton, Mothers Against Drunk Drivers,

and the chairman of the Federal Trade Commission. The Federal Trade Commission

41

soon afterwards began to investigate the ad placement and content of the Seagram’s

ads.

Government regulation and legislative actions are another such external

force that the liquor distiller industry faces, as seen from the FTC’s investigation of

Seagram Americas. The Alcohol Tax and Trade Bureau regulates the blending,

bottling, marketing, labeling, and transport of distilled products while the EPA

regulates the ethanol emissions from the distilling process. Besides federal

regulations, each state also establishes their own rules regarding distribution, retail

sales, production, labeling, transportation and alcohol-by-volume limits. Moreover,

local laws can put additional restrictions on alcohol sales, and there are hundreds of

counties in the U.S. that still have a ban on alcohol sales. Not only regulation, but

taxes also contribute greatly to the cost of alcoholic beverages. Distilled beverages

are taxed at more than half the price of a typical bottle of spirits through excise or

income taxes; one of the most heavily priced consumer products in the U.S.

(Distilleries-Quarterly Update 11/21/2011, 2011).

Big losses are a threat to the distiller industry from outside forces from

things that can’t be controlled - like weather, natural disasters, and consumer

preferences - or even from things such as lawsuits, which the court systems claim

liquor distributors do have control over. However, even when the industry follows

all the regulatory guidelines, there are still cases that are brought against them

merely from the nature of the business. Lawyers have begun to bring product-

liability cases against liquor companies stating that the industry has failed to warn

consumers of the dangers of alcoholism. They claim that at least tobacco companies

42

place warning labels on their products, and liquor manufacturers should be doing

the same by labeling it as a drug that is addictive and potentially deadly. Brown-

Forman faced such a lawsuit in 1986 when a 24-year-old man, Wayne Hoover, filed

suit against them and the G. Heileman Brewing Company. Mr. Hoover wanted

compensation for his seven years of alcohol addiction, which caused him to lose his

driver’s license and suffer multiple job losses (Lewin, 1986). Besides individual

suits such as this, other lawsuits have been pursued to finance education and

research on alcoholism.

Strategic Positioning

The Brown-Forman organization follows a low cost strategy focusing

on a broad market. This is a large organization that already has widely accepted

products in the marketplace. In order to keep costs low to stay competitive they

must look for places in their production process where they can become more

efficient. This has meant large capital purchases in machinery such as those used in

bottling. Having effective purchasing and distribution contracts is another strategic

device that distilleries use to maximize profit margins. A long-term contract on raw

materials purchases creates security by having price stability. Larger companies are

able to use options and futures to reduce the volatility in their raw materials

purchases as well. These efficiencies help to keep prices stable so that its products

can be sold at the lowest possible price to its customers to keep or gain in market

share.

Market share is very important in the distillery industry. There are only

about 20 top companies providing over 90 percent of the industry’s revenue

43

(Distilleries-Quarterly Update 11/21/2011, 2011). This concentration of large

companies makes it difficult for new companies to compete in the marketplace.

Smaller organizations must then rely on having a highly differentiated product that

appeals to a narrow market; usually in the form of the more expensive super-

premium beverages. Because of its long history and continuing growth through

acquisitions, Brown-Forman continues to be among the leaders in the industry.

They look to expand their market share as they are able to expand into large

populations such as China in the future. The lowering of tariffs in the 2000’s helped

U.S. distillers to surge in exports to other countries around the world.

Life Cycle of the Industry

Both seasonal cycles and life cycles are important in the distilled beverage

industry. Brown-Forman appears to follow the same type of cycles as the rest of the

industry, which should be expected since they have such a large share of the market.

There are two peak seasons in the industry, first during the summer and second in

the winter gift-giving season. The following chart, figure 5.3, shows the seasonal

cyclical nature of Brown-Forman’s sales revenue for 2009 – 2011.

44

Figure 5.3

The life cycle of the industry, as well as

Brown-Forman, is one that has reached the

maturity stage. According to NetMBA, the

maturity stage of a production life cycle is

defined as the most profitable stage in which

sales continue to increase, but at a slower

pace. Brand awareness is strong and

competing products may be very similar creating difficulty in differentiating the

product. In this stage, companies will place their efforts in encouraging customers

to switch from a competing brand, increasing the amount consumers’ use, and

converting non-users into customers. During the maturity stage, the primary goal is

to maintain market share and extend the product life cycle (NetMBA.com, 2002-

2012).

Figure 5.4

45

Brown-Forman’s sales have continued to increase year after year. There are

not accurate records to show how fast they grew during their growth stage because

it was decades ago, however, we can evaluate their current stage in the life cycle of

the industry by looking at the other factors, which describe the maturity phase.

First, their brand awareness is very strong. That is one thing that has kept them in

the top few liquor distilleries in the U.S. and what has kept it Jack Daniel’s brand

whisky in the number one spot among all whisky brands. Second, there are many

competing brands in all of the products it offers, and holds a large share of the

market for each product in manufactures. They have acquired multiple different

liquor brands to add to their selection. One of the reasons for doing this is to gain in

customer base. Finally, they have started producing flavored liquors to market to

women and entry-level drinkers, such as their new product: Jack Daniel’s Tennessee

Honey. All of these factors indicate that Brown-Forman, as well as the liquor

distiller industry, has reached the maturity stage. They still have room to grow in

the future as the ability to enter new markets across the world opens up to them.

The industry as a whole has reached the maturity stage and has been in a

decline since the early 1980’s. Alcohol consumption per capita fell 26 percent

between 1980 and 2000 (Semida, 2012). The peak year of consumption for

alcoholic beverages was 1981 and has steadily declined since then (The Gale Group,

Inc., 2012). The decline is due largely to the aging baby boom population who is not

consuming as many alcoholic beverages.

46

Stock Performance

Although the industry is declining, Brown-Forman’s profits have continued

to rise because of their successful strategies. Their stock price has outperformed

the S&P500, and its top major competitor, Diageo, as shown on the following graph.

Figure 5.5

The stock price of Brown-Forman has grown over the shown fifteen year

period from March 1997 to March 2012 344.60%. During the same period their top

competitor, Diageo, grew 148.84%, and the S&P500 grew just 74.43% (Google

Finance, 2012). This shows the strength that the company has provided to its

investors.

47

External Threat Analysis

SWOT Analysis

We will begin our external threat analysis of Brown-Forman by discussing

some of its strengths, weaknesses, opportunities and threats in the form of a SWOT

analysis.

Most of the company’s strengths can be attributed to its size and wide

geographical presence. Because it is a worldwide company that markets its products

in over 135 countries around the globe, Brown-Forman has established exceptional

brand recognition and loyalty from their customers – one of their largest strengths

(GlobalData, 2012). The company’s most popular brand, Jack Daniels, is a prime

example of this. Jack Daniels has become the fifth largest premium spirits brand and

is the largest selling American whiskey brand in the world (GlobalData, 2012). Some

other widely recognized Brown-Forman brands include Finlandia vodka, which is

the sixth largest selling vodka, Southern Comfort, which is the third largest selling

liquor, and Canadian Mist, which is the fourth largest selling Canadian whiskey

(GlobalData, 2012).

Another of Brown-Forman’s strengths is its very strong distribution network.

The company operates most prominently in the United States, the United Kingdom,

Australia, Mexico, Poland, Germany, Spain, Canada, France, the Czech Republic, Italy,

South Africa, China, Japan and Russia, in addition to over a hundred more countries,

where they sell both directly to retail stores and to wholesalers (GlobalData, 2012).

Its strong international footprint helps Brown-Forman to reduce many of the risks

associated with overdependence on one particular market. Although the United

48

States remains Brown-Forman’s largest market – responsible for 47 percent of the

company’s net sales – it is followed by Europe, which is responsible for 27 percent

of the company’s sales, and the other 26 percent comes from everywhere else

(GlobalData, 2012). This is an excellent indication of their international presence.

In addition to these great strengths, the company is also threatened with

some weaknesses – many of which, they have only begun to encounter recently.

Over the years, Brown-Forman has had several lawsuits filed against them

regarding accusations of their engagement in deceptive marketing practices, as well

as the targeting of underage buyers due to careless marketing and a lack of control

in their selling methods (GlobalData, 2012). Lawsuits such as these could potentially

damage the company’s reputation and brand image, and could subsequently affect

customer loyalty.

Another threat that Brown-Forman is facing is in regard to sales of some of

their most popular brands. Within the last few years, the company has been seeing a

decline in the sales of Finlandia (a one percent decline) and Southern Comfort (a

twelve percent decline) due to the addition of flavored whiskeys, vodkas and spiced

rums into the U.S. market, as well as a decrease in demand in Eastern Europe, where

consumers were tending to purchase less expensive liquors – many of which were

local brands (GlobalData, 2012). These declines could have the power to seriously

impact Brown-Forman’s revenues due to its reliance on both local and foreign

markets.

Despite these weaknesses, Brown-Forman also has several opportunities

available to them. In 2010, the company decided to start its own distribution

49

company in Germany, where they currently use Bacardi as their distributor

(GlobalData, 2012). In doing this, Brown-Forman will be able to introduce their own

sales and marketing operations, which will subsequently accelerate the

development of their brands in this region (GlobalData, 2012). They will continue to

work with Bacardi in various other markets where expanding is not yet feasible, but

this is a positive step toward continued expansion, which is an excellent opportunity

for Brown-Forman that has the ability to give them a significant advantage against

their competition. For example, the fact that the markets of Asia Pacific and the

Middle East region are experiencing recent economic growth could be of importance

to Brown-Forman (GlobalData, 2012). Also, with an already strong presence in

China and Russia, the company has also begun development in India and Brazil

(GlobalData, 2012).

Additionally, the fact that consumers in the U.S. are becoming much more

likely to dine at fast food restaurants rather than sit down and dine in shows that

sales are shifting from on premise sites to off premise sites (GlobalData, 2012). This

shift is an important opportunity for Brown-Forman, and by making their products

equally as available in supermarkets and alcohol outlets as well as restaurants, they

could be able to capture this shift in sales, rather than lose these customers.

One major opportunity that Brown-Forman has already begun taking

advantage of is the introduction of new flavored whiskeys – specifically Jack Daniel’s

Tennessee Honey Liqueur. While whiskey drinkers have typically consisted of

middle to upper-class men, the introduction of these new flavored whiskeys has

broadened the whiskey audience and has begun to appeal to nontraditional

50

demographics such as African-Americans, Hispanics, and women (Meece, 2011).

Brown-Forman has also taken advantage of the opportunity to appeal to women and

more entry-level drinkers with some of their other liquor brands such as vodka, gin,

and rum – all popular choices for mixed drinks, which have been increasing in

popularity over the years (Distilleries-Quarterly Update 11/21/2011, 2011). Also,

because wine consumption in the U.S. is growing rather quickly, this offers the

company an excellent opportunity to expand within their home market. The

increasing appeal of the wine market will be discussed in further detail within

Porter’s five-forces model.

Finally, we will discuss some of the major threats that Brown-Forman could

be facing in the near future. The recent growth of counterfeit and imitation goods

could have the ability to significantly decrease the company’s sales as people begin

to purchase the less expensive versions of these well-established brands

(GlobalData, 2012). This could also have very negative effects on the images of these

brands, as these look-alike products have the power to potentially shed negative

light on the products that they stem from.

Another threat to the company is the great deal of competition that

companies in the alcohol business are faced with – many of which have much

greater financial and manufacturing resources than Brown-Forman (GlobalData,

2012). With the amount of current competitors, plus the possibility of new entrants,

this threatens to significantly affect sales and Brown-Forman’s overall financial

position. This will be discussed further in the discussion of Porter’s five-factor

model to follow.

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Brown-Forman faces another threat, which stems from the fact that they are

dependent on other wholesalers and spirit producers, such as Bacardi, to distribute

their products in regions where they have not been able to establish their own

distribution network (GlobalData, 2012). This makes it difficult for Brown-Forman

to fully understand these markets and the opportunities and threats that may be

available to them. It also limits their ability to market successfully and to actively

pursue customers in order to gain a larger market share in these regions.

Finally, Brown-Forman must also comply with many laws and regulations

ranging from labeling laws to tax rates. Noncompliance with these regulations could

be detrimental to the company, resulting in large penalties and fees, which could

have significant effects on their profitability. The raising of taxes on alcohol is also

being considered, which could have a negative effect on both the alcohol industry, as

well as the hospitality industry. Both of these threats will be discussed further in the

PEST analysis to follow.

Porter’s Five-Forces Model

Next, we will begin to discuss some of the risks that are derived from various

external industry forces. We will classify these risks based on Michael Porter’s five

categories: customers, suppliers, substitutes, competitors, and new entrants.

The more pressure that customers can exert on a company, the more

bargaining power they have over that company (Brown-Forman Corporation

Marketing Study). This bargaining power is affected by the multitude of styles,

varieties, prices, and the general diversity of products that are available within the

market. The more products that customers have to choose from, the greater the

52

bargaining power that they have over the companies in that market. Because the

alcohol industry – and the wine industry in particular – is composed of such a large

number of producers and sellers, all providing a wide variety of products at various

prices, customers have very strong bargaining power over this industry (Brown-

Forman Corporation Marketing Study). For this reason, Brown-Forman faces the

risk of losing sales to several different producers, many from overseas – and in the

case of wine, particularly to producers in Australia, who have been known to

produce very low cost wines due to their lower cost base of production (Brown-

Forman Corporation Marketing Study).

Similarly, the more pressure that suppliers can exert on a company, the more

bargaining power they have over that company. Prices for agricultural products

have recently been on the rise due to the fact that farmers are decreasing their crops

of things like grains, corn, barley, wheat, rye, and other agricultural components in

order to meet the demand for the ethanol fuel industry (Distilleries-Quarterly

Update 11/21/2011, 2011). This has had a significant effect on the alcohol industry,

especially since grain is a distillery’s largest input and greatest expense. However, in

Brown-Forman’s favor, brewers have suffered worse than distillers, since more

agricultural products are necessary for the production of beer than for liquors. This

has allowed Brown-Forman to compete with huge companies like Anheuser-Busch

Company and Molson Coors Brewing Company, as many of their products are now

less expensive than many beers (Brown-Forman, 2011). Also, in terms of wine sales,

consumers play a large role in the bargaining power of suppliers because, as

competition increases due the wide varieties available, costs have been driven

53

down, giving overseas wine suppliers the advantage due to lower costs (Brown-

Forman Corporation Marketing Study). In addition, consumers’ expectations of wide

varieties makes it very difficult for suppliers to specialize in order to cut costs,

making it nearly impossible for U.S. suppliers to beat their foreign competitors in

terms of the wine industry (Brown-Forman Corporation Marketing Study).

There is a very substantial threat of substitutes in the alcohol industry due to

the incredible variety of products available to consumers. Not only must they

compete with their own kind, but also with competing varieties of alcohol (Brown-

Forman Corporation Marketing Study). For example, Brown-Forman’s Fetzer wines

must not only compete with other varieties of wines, but with beers, distilled spirits,

and malt beverages as well. Despite this competition, the wine industry has proven

to be a potentially profitable industry, largely due to the fact that it is seen as a more

healthy option due to the lower caloric levels as well as the lower levels of alcohol

content (Brown-Forman Corporation Marketing Study). Also, with wine prices

continuing to decrease due to great competition, consumers have proven it to be a

popular choice over many other potential substitutes (Brown-Forman Corporation

Marketing Study).

The alcohol industry is a very competitive one and the number of

competitors is large. Because the global market for alcohol has reached the maturity

stage, established companies must compete on very small levels such as advertising,

creative packaging, new trends such as mixed drinks, and other innovative ways of

creating a competitive advantage (Brown-Forman, 2011). An example of a creative

opportunity is to promote whiskeys and other products that are typically seen as

54

stand-alone drinks before a meal as accompaniments to specific foods, as is done

with wines (Distilleries-Quarterly Update 11/21/2011, 2011). This opportunity to

create food pairings has the potential to improve the image of these brands and

make the products a more natural and desirable choice in restaurants and in the

home. Some of Brown-Forman’s largest competitors of wines and spirits include

Constellation Brands, Diageo North America, Beam Global Spirits & Wine, Heaven

Hill, Fortune Brands, and E. & J. Gallo Winery (Distilleries-Quarterly Update

11/21/2011, 2011). Indirect competitors also include producers of substitute

products such as beer (Brown-Forman, 2011).

Finally, although there is a threat of new entrants – which is demonstrated by

the fact that the level of competition has been steadily continuing to grow – the

large, established companies within the industry have made it difficult for new

entrants to gain a significant enough market share to be successful. However,

although competing with larger companies with great amounts of resources,

positive brand images, and large distribution channels make it difficult for these

new entrants to compete on price, it is possible that they can compete as far as

differentiation is concerned, by focusing on making more expensive, yet elite,

products (Brown-Forman Corporation Marketing Study).

PEST Analysis

We will now discuss some of the risks associated with the macro

environmental forces of the PEST analysis. The factors included in this analysis are

political, economic, social, and technological.

55

Alcohol consumption has been steadily declining in the United States over

the years. For example, from 1980 to the year 2000, there has been a 26 percent

decrease in alcohol consumption (David J. Hanson, 2011). As illustrated in the figure

6.1, the number of abstainers from alcohol consumption is extremely high in the U.S.

when comparison to other countries around the globe (David J. Hanson, 2011).

From a social standpoint, this decline can be attributed to many things. For

instance, the aging of the population of older generations who tended to be heavier

drinkers has had a significant effect on alcohol consumption, as have rising levels of

education (David J. Hanson, 2011).

Figure 6.1

Also, consumption seems to be moving away from beer – although beer is

still the most popular alcoholic beverage, accounting for over 50% of the market –

and more toward wines and spirits (Distilleries-Quarterly Update 11/21/2011,

2011). This is especially true as smoking in restaurants and bars is becoming

56

increasingly illegal, pushing alcohol consumption out of these places and into the

home, where wines and spirits are the most popular purchase choices (Brown-

Forman, 2011).

Because economic conditions in the U.S. are poor, emerging economies

elsewhere in the world are proving to be the primary market for capturing sales

from wealthy consumers (Brown-Forman, 2011). For this reason, an international

focus is extremely important. These wealthy consumers are becoming the targets

for premium and super-premiums liquors (Brown-Forman, 2011). By responding to

these trends and expanding their international presence, Brown-Forman could

significantly increase sales. To illustrate the successfulness of these expansions,

Brown-Forman’s international sales have increased from 22% to 53% from the

years 2000 to 2010 (Brown-Forman, 2011). Another example is the fact that

Finlandia vodka’s primary market is Poland (Brown-Forman, 2011).

There are also many political factors affecting the alcohol industry – and

distilleries in particular – most of which are related to federal, state, and local

regulations. Distilleries face very strict regulation from a variety of state and federal

government agencies. The Alcohol and Tobacco Tax and Trade Bureau regulates

within the areas of production, bottling, marketing, labeling, and transport of all

products (Distilleries-Quarterly Update 11/21/2011, 2011). The Federal Trade

Commission (FTC) investigates claims of deceptive advertising or

misrepresentation, which is something that Brown-Forman has had issues with in

the past with activist groups such as Mothers Against Drunk Driving (MADD) and

the Center for Science in the Public Interest (CSPI) constantly monitoring their

57

marketing efforts (Distilleries-Quarterly Update 11/21/2011, 2011). Also, the

Environmental Protection Agency (EPA) is responsible for regulating the ethanol

emissions that come from the distilling process. States also set policies regarding

areas such as distribution, retail sales, production, labeling, transport, and alcohol-

by-volume limits (Distilleries-Quarterly Update 11/21/2011, 2011). Some local

laws also have the power to ban or restrict alcohol sales at stores, restaurants, and

bars. Noncompliance with these regulations can lead to serious issues such as

litigations, fines, and in extreme cases, orders to discontinue business if the

problems are not addressed.

Also, the raising of excise taxes on alcohol has the potential to detrimentally

affect the alcohol industry’s profits. Over half of the retail costs of alcohol account

for taxes and fees, however, most consumers are not aware of this fact.

Subsequently, when taxes are raised, these alcohol companies do not always have

the ability to raise their prices because consumers would misconstrue the reasons

for doing so, and the demand for their products would decrease (Gruenewald,

2006). Because of this, unless these companies decide to raise prices despite the

decreases in demand that will result, they are forced to absorb these costs, which

could drastically affect Brown-Forman’s revenues – especially in the U.S. as this is

their largest market.

Finally, technological advances in machinery have significantly improved the

operating effectiveness of distilleries. These new technological advances have

created machines that can bottle and package much more efficiently, saving these

58

companies a significant amount of money by reducing their production costs

(Distilleries-Quarterly Update 11/21/2011, 2011).

The risk map on Figure 6.2 illustrates the likelihood and magnitude of all of

the risks that have just been discussed using the SWOT analysis, Porter’s Five Forces

Model, and the PEST analysis. The risk numbers used are documented in the chart

within the audit implication section below.

Figure 6.2

Audit Implications

With so many different risks coming from various industry and macro

environmental factors, there are many audit implications that should be taken into

Hig

h

Mod

erate

L

ow

High Moderate Low

Likelihood of Potential Risk

Magn

itu

de

of

Po

ten

tial

Ris

k

RISK 1

RISK 2

RISK 3 RISK 5

RISK 4

RISK 8

RISK 7

RISK 10

RISK 9

RISK 6 RISK 11

RISK 12

RISK 13

RISK 14

59

consideration when determining how to effectively audit Brown-Forman

Corporation. Some of these implications are documented in the table below.

The first of these issues that deserves attention lies in the possibility of

government induced excise tax increases on alcohol. Excise taxes have not been

significantly increased in over a decade and their value has dwindled over the years

due to inflation (Why Raise Alcohol Excise Taxes?). Due to the current economic

conditions in the U.S. and the need for additional revenues, there is an extremely

high possibility of tax increases, which is believed to have the ability to assist

various states overcome their deficits (Why Raise Alcohol Excise Taxes?). Also,

organizations such as the Center for Science in the Public Interest, the Community

Anti-Drug Coalitions of America, and other public interest organizations have been

pushing for these tax increases for many years, saying that they will deter many

alcohol problems with adults and youth, reduce the frequency of liver disease and

other alcohol related illnesses, and help fund alcohol prevention, treatment, and law

enforcement programs related to alcohol use and abuse. They also believe that the

decreases in alcohol consumption that they expect to see if taxes are increased have

a correlation with college graduation rates and reduced crime rates (America).

If these increases do, in fact, occur, they could have the power to significantly

decrease the profit margins for companies in the alcohol industry. The obvious

choice to deal with such a situation would be to increase prices of their products in

order to maintain their current profit margins. However as discussed previously,

companies commonly choose to absorb these costs in order to maintain demand

from their customers who do not understand why prices are being raised, as these

60

taxes are built into the price of the products. Because of this, there are a multitude of

audit implications that can be associated with these issues. If Brown-Forman did

choose to raise their prices, there could be a possible issue with the company as a

going concern, as the resulting decreases in demand could have drastic effects on

their profitability. On the other hand, if Brown Forman chooses to absorb these

additional costs, there could also be potential going concern issues that we would

need to be wary of during our audit of this company. There would also be incentives,

in this case, to overstate revenues in order to appear more profitable in the eyes of

shareholders, competition, and other interested parties. This is also something that

we would have to take into consideration when creating an audit plan to ensure that

we are paying special attention to revenue accounts and testing them thoroughly.

Finally, we may also need to be aware of any possible tax evasion tactics that could

be associated with these increases.

Another risk that we face with Brown-Forman – and the alcohol industry as a

whole – is the increasing trend of the cost of commodities, which was discussed in

detail above. With the prices of the agricultural products needed to produce Brown-

Forman’s wines and spirits on the rise, these companies face yet another form of

increased costs. Similarly to the cost increases regarding excise taxes, this could also

provide motivation for Brown-Forman to overstate revenues and could also

potentially pose a problem for the company as a going concern – another reason

that the revenue account seems to be Brown-Forman’s riskiest account in terms of

an audit, which we would need to pay special attention to when creating our audit

plan. In terms of revenue overstatement, extra special attention should be paid to

61

the sales of Jack Daniels, as it is their largest revenue account and the biggest

indicator of their successfulness as a company. If there were overstatements

occurring, this would be a likely place to find them.

There are many other risks which have the ability to pose threats for Brown-

Forman as a going concern. One of these risks is the tremendous amount of foreign

competition that they face from other companies in the alcohol industry. As

discussed previously, these companies have a much lower cost base and therefore,

make it nearly impossible for Brown-Forman to effectively compete on price with

many of them, leaving the company to rely mostly on their brand image and

customer loyalty to bring in sales. Another threat that could affect the company as a

going concern is the various lawsuits and litigations that the company has already

been, and could possibly be subjected to in the future, due to deceptive marketing

practices and the targeting of underage buyers. These things not only pose a

problem for the company from a social standpoint in terms of decreased brand

image and reputation, as well as angered activist groups, but also from a monetary

standpoint, in terms of the effects of these litigations, such as hiring attorneys and

the possibilities payment of substantial fees as penalties.

In addition to these risks, the competition of counterfeit and imitation goods

could also affect the company in terms of going concern, as these things have the

power to both cannibalize sales of the authentic brands, as well as shed negative

light on these brands when people begin to associate the knock-off products with

the brands that they emulate. Similarly, substitute goods could also affect the

62

company as a going concern if significant enough sales are lost to other competing

liquors, wines, and beers.

Brown-Forman’s largest competitors in the U.S. could also affect the

company as a going concern, since many of them have the capability to outperform

Brown-Forman due mostly to the fact that they have larger financial and

manufacturing resources and can produce and market more quickly and effectively

than Brown-Forman in many cases. Significant outperformance could lead to

serious issues for the company and affect its ability to continue as a going concern.

Additionally, Brown-Forman’s dependence on other distributors in regions where

they have not been able to fully establish themselves could also affect the company

as a going concern in these areas. Furthermore, the decrease in alcohol levels in the

U.S. and the minor declines in sales over recent years could affect the company as a

going concern – especially due to the fact that this is their home market and is

responsible for the majority of their sales.

Finally, the tremendous amount of government regulation that Brown-

Forman and all companies in the alcohol industry must face is a very large risk

regarding going concern. Because everything that these companies do is under such

heavy and strict regulation, any act of noncompliance, whether intentional or

unintentional, could have devastating effects on the company. As discussed

previously, production, bottling, marketing, labeling, transportation, distribution,

retail sales, alcohol-by-volume limits, bans and restrictions on sales, and more, are

all subject to regulation, and with such little room for error, any minor mistake

63

could lead to tremendous amounts of litigation and extremely hefty penalties in the

form of fines.

The valuation of assets is also an audit implication that arises for Brown-

Forman, as their whiskey is barrel-aged for several years at a time. This whiskey is

classified on the company’s balance sheet as a current asset and therefore, it is

important to pay special attention to how correctly this whiskey is being valued.

This is an area that could be easily overstated. Another audit implication of this

would be that it is important to ensure the existence of this whiskey, as it may be

harder to keep track of and the company could be overstating their current assets in

terms of the whiskey that is aging at any point in time.

Another audit risk that could require attention is in regard to cutoff for sales.

In terms of seasonality, the summer months and “gift giving” months are the most

popular times for alcohol sales within the alcohol industry. According to their 2011

financial statements, their first quarter sales from May to July totaled $745 million,

their second quarter sales from August to October totaled $906 million, their third

quarter sales from November to January totaled $962 million, and their fourth

quarter sales from February to April totaled $791 million. According to their typical

seasonality patterns, the fourth quarter should be the quarter with the least amount

of sales, as it falls neither in the summer nor “gift giving” season, however last year,

the fourth quarter is reported to have had higher sales than the first quarter, which

is the summer season. This could be indicative of overstatement and

understatement of revenues in the form of revenue shifting for whatever reason.

64

This is something that should be looked into during our audit as a possible cutoff

issue.

Finally, the fact that Brown-Forman is still somewhat of a family owned

corporation – with members of the family on the Board of Directors and as Class A

Stockholders – could be a potential risk that attention should be paid to. This could

lead to the family having a large degree of control over the company in terms of

voting rights, as well as high possibilities of management override and possible

collusion from family members that hold high positions within the company.

Although we would need to inquire of management and perform an analysis

of their internal controls in order to determine whether or not Brown-Forman has

the proper controls in place to mitigate these risks effectively, Management’s Report

on Internal Control Over Financial Reporting, as found in the company’s 10-K

report, states that their “internal control over financial reporting is designed to

provide reasonable assurance regarding the reliability of financial reporting and the

preparation of financial statements for external purposes in accordance with

accounting principles generally accepted in the U.S.,” which would suggest that they

do have controls in place to mitigate these exposures. The company has also been

issued unqualified opinions by PricewaterhouseCoopers, LLC, and therefore, we

should be reasonably assured that effective controls do exist.

The risks that could possibly affect Brown-Forman’s revenue accounts, as

well as those regarding management’s integrity in terms of family members that are

owners and those that are on the Board of Directors, could potentially have an effect

on financial reporting risk, and must be carefully examined to prevent audit failure.

65

These risks could have an impact on how we set our materiality levels, as we may

desire to lower the audit risk that we are willing to accept if risks are detected that

could substantially affect financial reporting risk. With risks that could also affect

the going concern of the company, we may desire a much lower level of materiality.

In this case, we would most likely select a very small percentage of net income to be

our level of materiality – ensuring the fact that the level be small enough to capture

any misstatements within the Jack Daniels account – which accounts for 30 percent

of Brown-Forman’s sales – and view them as material, as this is what we have

deemed to be our riskiest account.

Conclusion

Upon further review of our risks analysis of Brown-Forman Corporation, our

recommendations would be to accept the company as a client. The risks analysis

included that of several impressive financial ratios, low risks to the audit firm, and a

low business risk of the client. Brown-Forman has shaped them to be a key

competitor in the alcohol beverage industry for many more years to come by

continuously striving to acquire well-positioned smaller competitors and to broaden

their sense of community involvement and social and economic responsibility.

These factors all add up to what we have researched to be a profitable and

reliable company for our firm to discuss further initiatives into acquiring this

company as a future client.

66

If Brown-Forman was already an existing client, our group recommends

continuing to associate and audit their financial records. The company has proven to

be very successful at meeting their vision and strategic goals and they would

continue to be a viable client for years to come.

[[Audit risks, business risks, etc.]]

Audit Fee Recommendation

Our group analysis of a recommended audit fee for this company is suggested

at $260 per/hour with a 2% increase in cost every year thereafter. This fee was

determined by historical figures for companies of comparable size and like audit

firms. The price is undercutting the national norm in order to secure business.

Why Us?

The following reasons are why we believe as a reputable audit firm, that

Brown-Forman would switch to us:

Benefits

More personable service Undercut in audit fee for initialization. Fresh perspective on accounting principles and practices. Compliance with government regulations. (Switching auditors)

Costs Learning curve for new auditors. Possible loss of information between switches. High switching costs. New relationship risks.

67

Current Auditor

PwC is the current auditor and they have audited Brown-Forman since April 30,

2006.

Professional, Ethical, and Business Considerations if Client is Accepted

Professionally – A solid move, as this adds to our client lists and more contacts

with a reputable company. There is no need to be sly in order to undercut much

business from another large audit firm because Brown-Forman has to switch

auditors anyways per government standards.

Ethically – It is the publics need and wants for clear and concise financial

information. However, some individuals may find that the association with an

alcohol production company sends the wrong image.

Business-Wise – The addition of Brown-Forman would provide more capital for

our firm and would allow us to expand into a market that is considered to be a

major industry in the foreseeable future.

Stock

As an auditor, we would not be able to purchase their stock due to

compliance with the independent standard of generally accepted auditing standards

(GAAS). However, from an investor viewpoint, Brown-Forman stock is a great

investment opportunity. The research on the stock price and value shows that the

addition of the stock to any portfolio would be good.

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