Why I steer clear of whisky – and distillers

Just how do you value a company like Lark Distilling (ASX: LRK), whose main asset (award-winning Tasmanian whisky) is locked up for years, but increases in value as it matures? 

The answer: it’s hard.

Alcohol. While for many it’s a source of great pleasure, for others it’s a quandary. No less so after the World Health Organisation, in January this year, published a statement in The Lancet Public Health that stated: “when it comes to alcohol consumption, there is no safe amount that does not affect health” adding, “Alcohol is a toxic, psychoactive, and dependence-producing substance and has been classified as a Group 1 carcinogen by the International Agency for Research on Cancer decades ago – this is the highest risk group, which also includes asbestos, radiation and tobacco. Alcohol causes at least seven types of cancer, including the most common cancer types, such as bowel cancer and female breast cancer.”

This is not a treatise, however, on the health or social impacts of alcohol. Instead, we seek to determine if ASX-listed whisky producer and distributor Lark Distilling Company Limited (ASX:LRK) might be good value at its current price of $2.10, down 61% from its October 2021 peak of $5.44. Note, I don’t drink whisky.

A different kind of inventory

Just as I am interested in the way accounting depreciation for aircraft fails to appropriately account for the cost of running an airline, I am equally fascinated by the fact a whisky distilling company’s inventory appreciates through no input but time. For most businesses, as their inventory ages, it becomes less valuable. Not whisky. One broker recently commented on this contrarian move in inventory value: “Lark’s whiskies will often mature in-barrel for at least five years, we see this “lock-up” of capital as highly rewarding, with estimated gross profit return on investment at 47-109% p.a. depending on the release. We see Lark adding significant value to its whisky bank every year, supporting both its valuation and ability to scale sales.”

The older the whisky the more valuable it is deemed. That’s certainly the case in both Japan and Scotland where whisky is a source of national pride and record prices. Indeed, Scotland’s Macallan is described as whisky’s “holy grail” and cask #263 is the holy of holies. A Macallan Fine and Rare 60-Year-Old is the most expensive bottle of whisky ever sold at auction. In 2019 it sold for US$1.9 million at Sotheby’s in London and remains part of the most coveted whisky collection to this day.

Meanwhile, a more pedestrian visit to Japan’s Hanyu Ichiro website reveals individual bottles for sale for as much as A$53,000.

Just how big is the market for whisky

The global whisky market is estimated to be worth US$80 billion in 2020 and growing at a medium to long-term rate of between six and eight per cent (if the WHO’s pronouncement doesn’t dissuade younger people from drinking).

The whisky market in Australia is forecast to reach US$1.71 billion (in retail prices) by 2024 and US$1.85 billion by 2027, increasing beyond that at a CAGR of just over two per cent per annum. Australia is also a top ten market for Scotch whisky.

Importantly, in 2022, 50% of the Australian whisky market was bourbon with Jack Daniels accounting for 26% of the total and 52% of American whiskies sold here. Jim Beam commands a 10% and 20% share respectively and Makers Mark is third.

Meanwhile, Australians consume only an estimated one per cent of locally made spirits with our excise tax regime an obstacle to growth. A standard 700ml bottle attracts nearly AU$30 in tax depending on alcohol concentration.

Despite this, there are over 330 registered whisky distillers operating in Australia with more than 50 offering products to the public. Of total domestic whisky sales, Australian whiskies represent just one per cent, with Starward commanding two-thirds of those sales.

Global success is therefore necessary for any Australia distillery to become a serious investment success for passive investors. Encouragingly, Australian whiskies are garnering a reputation on the global stage, particularly after the emergence of the craft whisky scene in the 1990s. In 2014, Australia’s Sullivan’s Cove French Oak single cask won the world’s best single malt whisky at the World Whiskies Awards. It was the first time a distillery outside of Scotland or Japan had won the category. In 2018, Archie Rose began releasing rye malt whisky, and was awarded the world’s best rye whisky in 2020 (rye whiskies are 0.72% of Australian whisky sales).

It’s easy to get excited, if not intoxicated by the growth, the record prices and the growing value of inventory, but is all of that enough to warrant an investment in Lark, putting aside the ethical considerations alluded to earlier?

Valuing Lark

At a share price of $2.108, Lark Distillery enjoys a market capitalisation of $159 million. This is 61 per cent lower than its all-time high of $5.44 and 128 per cent high than its first-day closing price, in May 2020, of 92 cents.

The company is estimated to have equity at June 30, 2023 of between $105 and $110 million, on which it is not expected to earn an after-tax profit until 2024. While reported profits are expected to grow by 50 per cent per annum, they reach $3.2 million by 2027.

I could go through the process of valuing this company but foreseeable returns on equity are less than the discount rate that one should reasonably use, which would not produce a flattering valuation.

One sell-side analyst valued the company, instead, by taking the future sales value of the inventory (2.2 million litres at Dec ’22) and discounting it for costs, producing a valuation for the company that was double the current market capitalisation.

Valuing companies on inventory, even rising inventory, has its risks; just ask a cattle farmer whose cattle increase in weight and therefore value every day. (Beef prices do go through bear markets too).

Some years ago, the price of corn reached such lofty levels it was more rewarding for U.S. cattle farmers to sell their inventory of corn directly, rather than feed it to their cattle. The same can be observed in business. High-quality inventory can be worth less when it’s run through a business with poor management, high overheads, or both. And there are risks associated with reputation, execution, regulation, competition and so on.

Notwithstanding the inability to predict sentiment and therefore share prices, it may be that Lark Distillery’s management are world-class and the overheads very low. But given the long runway needed before the value of the inventory translates into profits to shareholders, potential investors will need the patience of maturing whisky to be comfortable or confident.