Investment Thesis

Constellation Brands (STZ) is attractive for longer-term shareholders as the company recently completed a transformational acquisition that is underappreciated by most investors, has a strong brand portfolio in both wine and beer and is trading at an extremely attractive valuation on our forward estimates.  STZ’s end markets are attractive due to demographics as well as a relatively consolidated industry structure.  Constellation is a high-quality business with, what we believe is, limited downside based on its 7% pro-forma forward twelve month levered free cash flow yield.  We see greater than a 20% investment IRR to our FY2017 (really calendar 2016 as it should be noted that their fiscal years end in February) numbers which include expected operational improvement.

Clearly the stock is up substantially over the past year since the initial iteration of the deal was announced.  The deal, in its current configuration, has only been clear since February of this year.  There are many investors that made money on the “event” but have been recent sellers as the next evolution of the company (ie integrating the brewery) will take a couple of years.   However, we think the eventual upside is massive and not priced in at current levels.    

Overview

Constellation Brands (NYSE: STZ) is a leading global producer and marketer of alcoholic beverages. Its wide-ranging portfolio spans wine, spirits and imported beer. STZ is one the world's largest wine companies overall and is the largest global premium wine company. Key wine brands include Robert Mondavi, Clos du Bois, Blackstone, Arbor Mist, and Black Velvet. The company recently completed the purchase of 100% of the US import rights for Modelo brand beers including Corona, Corona Light, Modelo Especial, Modelo Negro, and Pacifico.  In addition to the import rights, the company has also purchased a modern brewery, Piedras Negras, in Mexico that is undergoing a large expansion program. 

STZ was historically, for the most part, a wine company that also held a 50% ownership in Crown Imports, a joint venture that marketed and imported Modelo beers from Mexico into the U.S. Modelo was the other 50% owner in the JV.  As part of Anheuser-Busch Inbev’s recent purchase of Modelo, the US Department of Justice demanded that Modelo’s 50% interest in Crown and also one of its major breweries (Piedras Negras) would have to be divested.  STZ held a right of first refusal on the Crown stake was able to purchase it at a reasonable multiple.  However, the bigger upside should come from the brewery purchase for reasons that will be discussed below.    

STZ’s wine segment, which should account for approximately 45% of EBITDA post-deal, has seen very steady, mid-single digit growth due to its dominant share of “premium plus” wines.  Management spent the last few years refocusing the wine business by expanding the “premium” brands and divesting a number of underperforming “value” brands.  Operating margins have been relatively stable at approximately 23 to 25 percent and the company does think it should see some margin leverage as the division continues to grow at 4-5% per annum.  In our numbers, we are not giving credit to any margin expansion in the wine segment as the main focus of our thesis is on the recently purchased beer division. 

As previously mentioned, STZ owned 50 percent of Crown before the deal was completed.  Under the terms of that JV agreement, Crown purchased beers produced from Modelo (at cost) and then marketed and imported the beers into the U.S.  It is important to note that the JV was not set up in perpetuity and could have been canceled at any time by Modelo.  Under the terms of the recent deal, STZ obtained U.S. import rights to all Modelo brands in perpetuity.  All else equal, STZ’s purchase of the other 50% of Crown would simply double the company’s current exposure to the JV economics.  The bigger part of the deal was the inclusion of the Piedras Negras brewery.  Instead of purchasing the beer at inflated costs from Modelo, STZ will be able to move all of its production to Piedras Negras, which will result in significant cost reduction that should allow margins to move closer to global peers. 

Constellation is spending approximately $600mm to double the capacity of Piedras Negras over the next three years with production volumes phased in over that time.  The result is that the majority of cost savings should occur in FY16/FY17 (calendar 2015/2016).Cost savings from consolidating beer production at Piedras Negras should result from three main factors.  First, there should be freight savings as Piedras Negras sits right on the U.S.-Mexican border versus the 25 percent of current production at a brewery that is 500 miles further from the U.S. border.  Second, and most significantly, savings should be achieved on overhead and labor as Piedras Negras is one of the most modern, automated breweries in the world, especially compared to the other two Modelo breweries that have accounted for 40 percent of Crown’s production.  Thirdly, the remaining area of cost reduction potential is packaging as Crown’s packaging costs are currently well above peers.  Crown was purchasing glass from a Modelo-owned supplier at rates significantly higher than market.  STZ will now be able to put contracts out for bidding; the proximity of Piedras Negras to the U.S. border should open it to plenty of competition. We incorporate these savings by increasing our gross margins in FY2016, FY2017 and FY2018. The majority of the margin improvement is expected to occur in FY2017 as that is when the bulk of the production migration to Piedras Negras will be completed.  All together, we think operating margins for the beer business should move closer to 35% from current levels of ~30.5%.

Beer revenues should continue to grow in the mid-single digits due to favorable demographics and market conditions. STZ has an extremely strong beer portfolio with high market shares.  Corona is the #1 imported beer in the US, Corona Light is the #1 imported light beer, Modelo Especial is the #3 imported beer and Pacifico is the #13 imported beer. Altogether, STZ will control ~50% of all beer imports into the US. The top five companies control about 88% of the U.S. beer market with Anheuser-Busch Inbev (BUD) controlling ~48% of the market.  BUD institutes 3% price increases every year and most of the players follow BUD’s lead.  In fact, Crown was one of the worst offenders when it came to discounting to drive market share growth in the past. 

As volumes of the Crown beers are now more saturated (volumes are likely to ~2-3% per year), STZ is making it clear that it will follow industry leaders in pricing as the practice would be much more attractive at this point.  STZ volumes are also helped along by demographics as the Hispanic population of the U.S., a significant consumer of STZ’s beer brands, is growing at 3-5% per annum; well above overall U.S. population growth. Corona and Modelo Especial are two of the top beers demanded by Hispanic consumers and this provides potential upside to our volume assumptions.       

The combination of revenue growth and margin expansion should result in a jump of over 30% in annual operating income in just the next two and a half years. We think that most investors do not appreciate the upside in margins due to the Piedras Negras brewery consolidation.  Also, some investors are reluctant to own shares of STZ today after a strong run and the thought that the profitability transformation is too far away.  While the large step-up in profitability for the company is still around two and a half years away, we believe there is limited downside in the shares today due to a relatively low valuation and stable end markets.  Furthermore, we believe that investors will start to discount the large improvement sooner rather than later. 

Valuation

After incorporating the other 50% of Crown but prior to the full benefits of the Piedras Negras brewery expansion in FY2017 (calendar 2016), we see STZ trading on reasonable, not super-cheap multiples.  On our FY2015 estimates (calendar 2014), STZ is trading at approximately 13x EPS and approximately 10x EBITDA.  While these numbers do not yet factor in much of the beer margin upside, these multiples are still at a significant discount to global peers trading at about 17x EPS and about 12x EBITDA.  However, there is a significant step-up in profitability that will occur in FY2017 (calendar 2016).  At the same time profitability improves, capital spending will ramp down dramatically as the Piedras Negras expansion is completed.  Annual capex spend should move down from ~$300mm in FY2015 and FY2016 to ~$100mm maintenance capex in FY2017.  This, along with margin expansion on the beer side, should result in free cash flow per share of approximately $6.00 in FY2017.  Therefore, we see the stock currently trading at ~12% normalized free cash flow yield.  This free cash flow number should continue to grow at high single digits going forward.             

Management

The current management team, led by CEO Bob Sands, took over in late 2007 and has transformed the wine portfolio by divesting “value” brands and expanding, organically and through acquisition, its “premium” brands.  This strategic move has led to above-market growth rates and margins. 

The founding Sands family, of which the Chairman and CEO are members, own about 11% of the company and hold voting control though B shares.  Management has been very shareholder friendly and bought back about 25% of the shares outstanding in the past few years (at prices well below current levels).  Management has made it clear that its focus will be on paying down debt and then initiating a dividend so that it is in-line with other global beverage companies.  Members of management have also said that they would potentially look at some smaller strategic acquisitions but would be inclined to buy back more shares, if the price was right.  Any of these latter options are a few years away due to the need for deleveraging.   

Major Risks

Major risks include:

-          Delay and/or cost-overruns on Piedras Negras brewery expansion

-          Competitors price aggressively for market share

-          A recession would likely cause consumers to trade-down to value brands in both wine and beer