Constellation Brands

Constellation Brands is the #2 player in one of the world's largest, yet, still relatively immature wine markets and yet it still only trades at a 10x earnings and a 10% free cash flow yield.  The company is undergoing a shift in its distribution strategy which has caused some recent earnings volatility; however, it is a strategy that should reap significant margin and market share rewards going forwards.  This fear of temporary earnings volatility has lead to a valuation discrepancy of significant proportions, providing an excellent opportunity to purchase a company with a potential for 20-50% returns in the next year.

Company Description

Constellation Brands is one of the world's largest wine companies, with $3.4 bn in net sales.  The company operates in approximately 150 companies, with a portfolio of over 100 brands.  It's most recognizable brands are Mondavi, Clos Du Bois, Vendange, and Arbor Mist.  While the wine industry is fairly fragmented overall, Constellation enjoys a dominant position with EJ Gallo in the US, with 16% of the overall market in STZ hands and 18% in the hands of EJ Gallo.  The next closest competitor controls a mere 7% of the market.  The US market has historically been focused upon beer, which has resulted in significantly lower per capita consumption than Europe.  However, the younger generation's tastes have moved away from beer, which supports the wine industries greater than GDP growth trends in the upcoming decades. 

In addition to its core wine business, Constellation brands has diversified its sales through the ownership of a small spirits franchise, dominated by its ownership of Svedka ("r u bot or not?").  Svedka is the fastest growing vodka brand in the US, with 40% organic growth so far this year.  Constellation also distributes all the Modello beer brands (such as Corona) through a JV, Crown Imports, with which it has a 50% ownership.  Crown Imports dominates the fast growing US imported beer category with 40% share.  Imported beer has been steadily taking share from domestic beer over the last decade, with an average growth of 5.3% vs 2.5% from '01 to '09

The company has been family controlled since its inception.  It was founded by the patriarch, Marvin Sands in 1945 and was taken public by Marvin in the seventies.  Upon becoming public, the company chose to have two share classes, with the family maintaining control of the company through the high vote class B shares.  While this voting control has diminished over time, they continue to have > 50% control of the overall vote, and the right to appoint a majority of the board of directors.

Marvin Sands remained CEO of the company until 1993 when he turned over the reins to his son, Richard Sands.  Richard proceeded to transform the company through dozens of acquisitions into the powerful wine conglomerate it is today.  The company shifted its focus to branded wines and entered the international markets during his tenure.  In 2007, Richard retired as CEO and handed the reins to his brother, Robert Sands.  Robert's focus has been to prune the portfolio of underperforming brands as well as lower its ROIC business lines.  He has sold of Constellation's operations in the lower premium wine space, as well as its non-core spirits business.  These sales have also allowed the company to repair its balance sheet which was under some strain during the credit crisis due to some tight covenants.

Potential Catalysts

1)      Lack of distribution noise: The company changed its distribution strategy mid-late 2009 from having 2-3 distributors per market to have a total of 5 "super" distributors.  The advantages of having a super distributor are clear: 1) the distributor places increased investment behind Constellation's brands has increased by offering exclusive relationships and 2) the company is able to demand overall better margins by exploiting its market scale through more concentrated distribution as well as outsource sales expenses formerly paid for by the company to its partners.  While this is a new strategy for the wine business, this distribution strategy has been implemented in the beverage industry prior to Constellation.  Both Diegio and Hans have implemented similar distribution models.  While both underperformed the market for a period of 2-4 quarters after implementation, both out-performed the market by at least 200 bps for several years after implementation.  As it is now about three quarters after Constellation implemented this change, we should see the benefits of this new strategy start rolling through shortly.  The recent IRI data (while only representing 30% of the wine market) does seem to show some early signs of STZ outperformance, with them beating the market by several hundred basis points in August.

2)      Resolution of the Grupo Modello litigation:  During 2009, Crown Imports reduced marketing spend on Crown Imports due to the overall poor market conditions.  Modello took this opportunity to sue Crown Imorts/Constellation for breach of contract in an effort to end this contract prior to its termination in 2016.  The conspiracy theory behind this action also implies that Modello is attempting to take this business back in order to force InBev to pay a higher price in their presumed eventual buyout of Modello.  Given Anheuser Busch/InBev already have their own distribution relationships in the US, they would have no need for a separate entity such as Crown Imports and would probably terminate the contract at the end of 2016.  However, the presence of this contract would defer the realization of significant synergies between Modello and InBev.  Therefore, it does seem likely that Constellation will be able to demand a fair settlement from Modello in order to exit the JV early.  Especially as the presumed multiple on the incremental EBITDA might be 14x in comparison to a max buyout price to Constellation of approximately 8x.

3)      Potential MBO:   The family owns a considerable portion of the equity.  Current leverage stands at approximately 4.0x debt to EBITDA and the long term bonds yield approximately 6%.  The company's ability to generate FCF is significant, and there is an option of a significant near-term settlement with the resolution of the Grupo Modello litigation that would provide a nice short term de-levering event.  It would seem an excellent opportunity for the current brother in charge, Robert Sands, to enrich the family fortune as well as allow the family to profit from the temporary valuation pressure due to the distribution noise and the Grupo Modello litigation.

Valuation

* Note : Crown EBIT estimates are only those per

• Comps in the beverage industry average approximately 14-15x EPS and 9-10x EPS.  Given currently estimates are pressured by disruption in their distribution and restructuring costs, I adjusted EBITDA for more normalized sales and margin trends.  In addition, I assumed that the Crown JV is worth approximately $1.2 bn on a DCF basis (with the terminal value based on a 50/50 chance of either being purchased at book or at 8x EBIT).