Description

Constellation Brands (STZ) is a $32B market cap producer of beer, wine and spirits best known for their full ownership of the manufacturing and distribution of the Modelo portfolio of beer products in the United States. These include the various products under the Corona, Modelo and Pacifico brands. These brands are some of the fastest growing in the U.S. beer space. Of note, 85% to 90% of all Constellation sales are purchased for use in the home with only 10% - 15% exposure to on-premise use (restaurant/venue). Thus, Constellation does not suffer greatly from lost sales due to widespread restaurant closures and it has benefited from consumers conducting more of their beer drinking at home.

From a sales perspective, Constellation offers investors a growth component as their beer brands continue to take share, but also exposure to a product with a reasonable (though not perfect) degree of sales stability in a downturn. Put another way, even if when the PPP payroll checks end, and when the $600 weekly unemployment bonus becomes simply a footnote of moral hazard history, should the world resume coming to an end, Constellation’s underlying business may remain relatively consistent.

Perhaps weighing on the stock (other than a pandemic) is the potential for extended Mexico supply disruption, but I believe this will abate. The company also is an option on the cannabis industry via its 38% ownership of Canopy Growth. I give them no value for this, thus far, colossal waste of good money. Fortunately, a new CEO is executing a new game plan with regard to this and other past capital allocation errors.

The business has not suffered from it key brand having what is suddenly the unfortunate name of “Corona”. Though it did not impact sales, it may have added to some of the stock’s volatility in March.

Over the past two years Constellation traded at an EV/EBITDA of roughly 16.5 to 19.0 (in my spreadsheet). Applying a 17.5 to 18.0 EV/EBITDA multiple to roughly 2.8B in FY2021 (Feb year-end) EBITDA yields a fair value of $195 to $202, or ~20% upside and with annual growth ahead tied to their consistently performing beer business. EBITDA and debt might be a little less should they soon close the sale of their slower growth wine brands as the sales proceeds are earmarked by management to paying down debt. Given the dragging on of the wine portfolio sale process and my belief that nothing in a time of pandemic is certain, especially acquisitions, I have not included it in my numbers. My numbers equate to a roughly a 23 p/e on forward once one strips out the non-consolidated Canopy losses.

Though the near-term upside at STZ is roughly back to its old highs, it is the case that those old highs are not that old and the business has not changed. However, for an investor there is also a long-term story tied to growth in the U.S. Hispanic adult population that is not at all impaired by covid and which should provide both a medium and long-term upside well beyond the next 12 months.

Note, a very real near term risk is Mexican supply chain disruption which if fully realized would impact the stock, but also likely be a buying opportunity as the Mexican covid lockdown driving this event will necessarily need to end.

Regarding potential supply disruption:

Constellation’s production plants are situated in Mexico. Mexico is a few weeks behind the United States in terms of timing of covid shutdown. The Mexican lockdown started later and will end later. Beer production has been designated non-essential in Mexico and this impacts STZ. Management notes that as of April 8 they have closed down most of their production to meet government lockdown demands. https://www.cbrands.com/news/articles/constellation-brands-provides-update-on-mexico-brewery-operations-in-the-midst-of-covid-19-outbreak

Management states they have ~70 days of inventory before they begin running out of supply which gets them to mid-June. However, they need time to bring production back up and make new supply available. By mid-May I assume they need to be producing again in order to keep inventory stockouts from moving from sporadic to widespread.

However, lockdowns of people and shutdowns of businesses have not continued indefinitely around the rest of the world and they can’t continue indefinitely in an emerging country such as Mexico. Some of that is due to pressure from the United States which is already having success pushing to reopen auto plants and other manufacturing plants owned by U.S. companies and located in Mexico (see link): https://mexiconewsdaily.com/news/coronavirus/mexico-to-reopen-automotive-plants/

However, the most critical reason that shutdowns cannot last long in Mexico is that much of the population lives hand to mouth and will not eat if they don’t work. Furthermore, widespread bankruptcies will commence and soon. There is no unemployment insurance, no additional $600 per week special pandemic pay to the unemployed, no trillion dollar small business PPP program, no central bank buying the municipal market. People need to get back to work ASAP or there will be riots. (I believe the only thing limiting protests thus far is that President Obrador is considered to be on the side of the people. Those most impacted tend to trust him and give him benefit of the doubt for now)

If U.S. companies (not STZ thus far), are already succeeding in opening their Mexican plants, I suspect other companies (both Mexican and U.S. controlled) will not be far behind, though I don’t know exactly when. I am assuming that the lockdown could extend to late May and that there will be some supply breaks. Should that occur and if it impacts the stock price I consider it a buying opportunity so long as the U.S. reopening is continuing forward as it would then be likely Mexico would soon enough open, too.

Regarding STZ ownership of Canopy Growth (WEED-TSE, CGC-NYSE) and new STZ CEO:

Constellation the company and the stock should benefit from the retiring in 2019 of the previous CEO, Rob Sands, who served in that role since 2007 and was replaced with the current CEO Bill Newlands.

Sands should be considered a true master of destructive capital allocation much of which was glossed over by the strong underlying cash flow of the beer business. Sand’s benefited from Constellation controlling the import rights to the Modelo portfolio and then the good fortune to have drop in his lap the opportunity to purchase the U.S. ownership of the brands from Anheuser-Bush InBev as part of AB-InBev’s deal to purchase Modelo. The AB-InBev deal to buy Modelo required divesting Modelo’s U.S. business in order to maintain the AB-InBev plus Modelo U.S. beer share below a certain percentage. The beer business is a cash flow generator. A growing beer business even more so. Sand’s proceeded to use much of this cash flow and more cash he borrowed to make a series of poor acquisitions. 

The most significant of these misadventures was the billions spent on Canopy Growth at the peak of the cannabis bubble. In 2017, Constellation made its first investment in Canopy, acquiring 18.9M shares and 18.9M warrants at a price of $245M CAD.  Constellation made a further investment in 2018 for 104.5M shares and various warrants for a price of 5,079M CAD. This second investment entitled Constellation to nominate four of seven directors. In April of 2019, the companies entered an agreement to modify warrants as a result of Canopy’s intent to acquire Acreage Holdings.  The original 18.9 warrants were unchanged with an expiry of 5/1/2020.  The remaining warrants were extended to expiries of 2023 and 2026.  

To date the Canopy business does nothing but vaporize cash at speeds that would fail to make only WeWork blush. Here is a Seeking Alpha note on the sadness: https://seekingalpha.com/article/4338945-canopy-growth-spending-cuts-and-write-downs

That’s the bad news on Canopy. The good news is that the money is spent. The new STZ CEO, Newlands, has ousted the Canopy CEO and founder and replaced him with the now former CFO of STZ and with an objective to stop the cash hemorrhage. STZ may exercise the May 1, 2020 options at a price of CAD$12.98 which would be a cash cost of CAD$245m (USD$184m). Given a WEED.TSE stock price of over CAD$23 maybe they will exercise the warrants. I don’t know. However, after that I am assuming STZ does not provide any further cash unless it comes at onerous terms to Canopy and might result in STZ purchasing the remainder of the company at a bargain price.

For the purposes of this write up I am assuming Canopy is worth zero, in part because I haven’t done the work on it. I also admit that I don’t like marijuana, cannabis and the legalization of pot. Though I may not approve, the libertarian in me believes it’s none of my business what people do and I favor legalization to get the government out of picking and choosing which vices are legal and absolutely want out of the cost of policing, prosecuting and jailing for marijuana related crimes.

Getting beyond my biases, I concede there may someday be a substantial market for cannabis and that the winners will be those who have the ability not to grow the plant, but the ability brand products in the same way that there is not much money in growing corn the commodity, but much to be had by concocting corn into Fritos. Legalization in the U.S. is where this begins. I suggest subscribing to the daily email from the website Marijuana Moment at https://www.marijuanamoment.net/. Aptly self-described as “The only daily cannabis update you need” I found it to be eye-opening how widespread legislative efforts are at the state level to push for various levels of legalization. I get the impression that should Democrats achieve broad wins at the state level many more of these bills would pass (all bills are not for full legalization and vary state to state). I also suspect that a Democrat in the White House would not be sleepy at all when it comes attempting to change Federal law/regulation to permit states to decide for themselves on legalization. Technically state legalization is not recognized by the federal government and banks avoid doing business with any business involved in marijuana for this reason regardless of what the rules are in the states they operate. This federal ban would need to change before Constellation could be seriously involved in the U.S. marijuana market.

Finally, to the issue of branding. Canopy has come out with its first line of CBD drinks. Constellation knows something about beverage distribution. Being early with Canopy, should give Constellation an opportunity to figure out how to do cannabis right and get a jump on the branding. For now, however, it is an unmitigated disaster in terms of capital allocation.

As an aside, the Toronto Exchange symbol for Canopy is WEED. I’m in favor of changing that to something akin to the CGC used on the NYSE so the company can further shed any ties to the stoner image that symbol may connote.

More on poor capital allocation and a mention of wine and spirits:

My discussion of Constellation’s ownership in Canopy began as a discussion of poor capital allocation. To wrap up that discussion it worth noting that the previous CEO also spent $1B to purchase Ballast Point brewery in 2015.

https://www.brewbound.com/news/constellation-brands-makes-a-1-billion-bet-on-craft-beer

Unfortunately, he purchased it just as Ballast Point’s business was about to collapse. The new Constellation CEO has quickly taken action to clean up this and other messes. As noted, he tossed the Canopy CEO and is trying to get that business to cash flow breakeven. He has also sold Ballast Point for what is believed to be a meager sum of ~$100 million, a 90% loss.

https://www.forbes.com/sites/chrisfurnari/2019/12/03/constellation-brands-will-sell-struggling-ballast-point-brand-to-small-illinois-brewery/#7768a197741e

The new CEO also has a deal to sell the slower growing brands within their wine business to Gallo. I believe many of these were also purchased by the retired CEO Sands. The sale of these wine brands has been dragging due to regulator demands and now due to covid. It may still be on. It may net something south of $1B, but I am waiting to see if this happens and at what price. The objective is to shrink the wine and spirts business to only growing brands. The new CEO plans to apply the proceeds to pay down debt.

The new CEO has been at Constellation first as EVP, chief growth officer, then ultimately chief operating officer and then president. He is hardly blameless. However, right out of the gate since taking on the CEO role he has moved fast to put the company on a course to get behind these mistakes.

Regarding Constellation’s Mexicali plant:

Constellation produces beer in Mexico at plants in Nava, Coahuila (near the Texas border) and in Obregon, Sonora on Mexico’s west coast. The company has spent $700M thus far to build a new brewery in Mexicali on the California border when the project was halted based on a truly dodgy public referendum earlier this year. The opposition exists because the plant will use too much water, or so claim the opponents. On the most recent call the CEO said they had met with the Mexican President to discuss how to settle the matter and was hopeful an agreement could be reached. Though covid has delayed a settlement, I suspect it will be worked out and the plant will continue.

How, you might ask, could there be an agreement to let the plant continue given that there has been a “referendum” that has voted to cancel the project? Have not the people spoken? How can the will of the people be overturned? For starters, the referendum which stopped the project had no legal basis and can itself be overturned just as easily and arbitrarily as the referendum itself null and voided the duly issued permits to build the project in the first place. And when I say the permits were “duly issued” I assure you that process, like the referendum, was a joke (and probably illegal). I live in Mexico and can assure this is the only way anything works here. There was no fully legal process behind issuing the permits, no basis for a referendum to stop the nearly complete project, and there is no legal or regulatory due process one could follow to sort the matter out. Yes, there may be something on the books that makes it look that way, but it is not how it actually works 98% of the time. What exists is massive and pervasive corruption in every aspect of this process from permit and environmental approval, to the voiding of the permit, to the likely eventual reauthorization of the project. Constellation will be squeezed at every step with all participants seeking their share of enrichment. A deal of some sort will likely be cut and the plant will be completed and put in operation. I want to make it clear I am not accusing Constellation of anything. If they want to make beer in Mexico, they have no choice but to navigate the system that exists and what exists is a process prone to stick-ups such as this even this late in the game.

Should no deal be cut, Constellation has enough capacity for the next couple years. They would likely need to build a new plant. That they need new capacity is a testament to the fact they have a growing business. Just me, but I recommend they build a plant in the U.S. I kind of like the idea of, “Mexican beer imported from the United States.”  The difficulty however would be the cost differential of producing in the U.S. versus south of the border.

Finally, I believe Mexico does not really want this plant turned away. They need foreign investment and I believe they really do want these jobs in their country. Those in charge also don’t want to send large, foreign companies the message that, after issuing permits, they would arbitrarily pull the rug out from under a ~$1B investment.

Valuation

FY 2021 (Feb) growth is difficult to pin down given covid impact. Business in 2008-2009 dropped ~3%. However, the beer portfolio was not as fully developed and into growth mode as it is now and there was not a massive trend to eat and spend time at home due to pandemic. This stay at home trend may be positive though it could be offset by joblessness especially as unemployment benefits and PPP run out. Depletions and retail sales have been running ~8% annually. Regardless of what happens in this fiscal year, it stands to reason the business would soon return to trendline growth. The recent decline in the peso may also help costs in the margin.

As I complete this writing the stock is at $167. Assuming $2.8B in EBITDA in FY2021 the stock trades at 15.6 EV/EBITDA based on $12.2B in debt, $81m in cash and a market cap of $32.5B. The stock has traded in a range of 16.5 to 19.0 EV/EBITDA over the past two years. At 17.5x the stock is worth $195. At 18x the stock is worth $202. That is the near-term opportunity.

Though not in my valuation, I can at least frame out the current value of Canopy Growth. Canopy’s USD market capitalization is $5.8B which values STZ’s 38% ownership at USD $2.2B. Half of that would be $1.1B, divided by 195m shares settles at USD$5.6 per share. From there one can increase or haircut it as seen fit.

Constellation is not an under $5 dollar blown up name that will double or quadruple if the economy bounces straight up out of covid. In fact, near term upside may be only back to its recent pre-covid highs or about 20% higher from here. However, the long term is bright as growth levered to the Hispanic community should continue for years to come. The new CEO has also taken steps to move beyond the previous CEO’s poor decisions and is signaling that the company is moving to a more conservative period of focusing on existing brands and paying down debt. I have more confidence that he will execute given the new paradigm developing in which markets will favor stocks that limit debt and favor using cash to strengthen balance sheets. The old ways of doing things aren’t the option they once were. And regarding options, the company's investment in Canopy provides exactly that on the cannabis industry.

Risks: Key near term risk, and a real one, is that the Mexican shutdown continues beyond May and materially impacts supply. Intermediate term risk would be an extended recession which softens growth as consumers trade down.

Catalyst

Beer brands among the fastest growing in the U.S., levered to growth of the U.S. adult hispanic population and only ~10% of sales via the on-premise channel. Business should come out other side of pandemic intact and growing back to trendline.