Constellation Brands’ (STZ) CEO Robert Sands on Q2 2015 Results – Earnings Call Transcript

For a detailed list of risk factors that may impact the company’s estimates, please refer to the news releases and Constellation’s SEC filings.

Now, I’d like to turn the call over to Rob.

Robert Sands – President and CEO

Thanks, Patty and good morning to everyone. Welcome to our discussion of our second quarter financial results, as well as other important events that will shape the strategic direction of our company going forward.

It has certainly been an exciting few months at Constellation. Since last quarter, we announced the acquisition of the Casa Noble tequila brand, an award-winning handcrafted super premium tequila which will be a great addition to our portfolio. Adding Casa Noble to our portfolio is important because tequila and Mexican beer share similar target consumers and drinking occasions both on and off premise. This fast growing tequila brand naturally complements our Mexican beer brands and fits well into our existing wine and spirits distribution infrastructure.

Now during the quarter, we were challenged by a Corona Extra product recall, which was caused by defects in glass models caused by a production error at a glass plant run by one of our glass suppliers. I’m very proud of the dedication and hard work of our employees, distributors and retailers who have worked tirelessly and diligently to remove potentially affected product from our retail and distribution system. While the recall impacted our financial results slightly for the quarter, we expect to replenish second quarter loss sales in the third quarter and we are currently working with our glass supplier to recover the costs of the recall.

We announced this morning that we have begun a new 5 million hectoliter expansion at our Nava brewery in Mexico that will expand production capacity of that facility to 25 million hectoliters by the end of calendar year 2017. This project is being driven by the exceptional portfolio momentum of our beer business, which has significantly outperformed the U.S. beer market and our own expectations. Lastly, we are pleased to announce that we are in the process of finalizing the long-term glass strategy for our beer business under favorable terms with key industry players.

The multi-faceted approach of this strategy includes the following components. We have agreed to purchase from ABI their state-of-the-art glass plant in Nava, Mexico, which is located adjacent to our brewery in that location. While this facility currently has one operational furnace, we plan to initially scale it to four furnaces, which will ultimately be able to supply us with more than 50% of our glass requirements. This transaction also includes the purchase of a high-density warehouse, land and well infrastructure and is subject to U.S. Department of Justice and Mexican regulatory approvals both of which we expect to receive by the end of this calendar year.

We have also agreed to enter into a 50/50 joint venture with Owens-Illinois to own and operate the glass plant that we are purchasing from ABI. As the world’s leading glass producer, O-I has more than a 100 years of experience in producing glass containers. They have built and expanded dozens of plants and participate in joint ventures in several different countries throughout the world. We also currently use O-I as a glass supplier for our wine business. O-I will primarily have responsibilities for plant operations including purchasing, technical services and the plant expansion. O-I is also expected to become a secondary glass supplier outside of the joint venture arrangement.

The final piece of the strategy, we have entered into a long-term seven-year supply agreement with Vitro who is a well [established] (ph) leader in glass manufacturing in Mexico and we will expect – we’ll ultimately supply 25% to 30% of the glass needs for our beer business. Overall, this sourcing strategy provides the best outcome in terms of quality, flexibility, cost effectiveness and control for this critical area of our beer production.

Now because it will take some time for the glass plant to become fully operational at optimal capacity, we will continue to work with ABI to purchase glass supply needed for production at the Nava brewery under our existing Transition Services Agreement through mid calendar year 2015. In addition, we plan to continue to procure finished product from ABI under our Interim Supply Agreement until the initial Nava expansion to 20 million hectoliters is complete in calendar 2016.

Overall, our additional investments in production capacity and glass sourcing are designed to ensure that we are well positioned to capture the continued momentum and growth opportunities we see in the marketplace for our beer portfolio well into the future. Our second quarter beer results are a testament to this portfolio momentum, as we achieved depletion growth of 8% and posted the 18th consecutive quarter of market share gains for our U.S. beer business.

This level of growth for Constellation’s beer business represents the most significant contribution to total U.S. beer dollar growth in IRI channels across all suppliers during our second quarter. These results were driven by Corona Extra’s momentum of increased media support during the summer as well as the success of our Fill your Summer advertising campaign that was our first-ever multicultural, bilingual summer program.

In IRI metric channels, Corona Extra continues to gain share and is currently the number five beer brand in the U.S. market. In addition, Corona Extra and Modelo Especial teamed up this year a broadcast sponsorship of World Cup games on Spanish language TV. Modelo Especial Hispanic Real World campaign helped to propel the continued growth of this brand, which posted consumer retail dollar takeaway trends in IRI channels of more than 30% during the quarter. In addition, Modelo Especial’s summer soccer sweepstakes promotion surpassed all sales and consumer engagement targets set for this initiative.

Modelo Especial Chelada has already become the number seven Mexican import brand in less than a year since launch. The growth of this product is being driven by Spanish language TV ads on national Spanish networks, consumer sampling at retail, PR events in key markets, social media engagements and C-store print trade ads. Lastly, the draft beer format continues to have significant momentum achieving sales growth of more than 40% during the quarter driven by the continued market expansion of Corona Light.

The five core brands within the Constellation beer portfolio all experienced growth in the quarter and are ranked in the top 15 U.S. imported beer brands. From a brewery and operational perspective, all areas of brewery expansion are well underway and preceding on schedule from both a timing and budget perspective. Key performance metrics are being achieved with no disruption to existing brewery operations. In many areas, crews are working around the clock.

In fact, the brewery recently achieved record capacity utilization with a record number of cases produced and shift in August. Brewery tank fabrication and installation are being completed on schedule and the packaging building is tracking the plan with steel erection in process. A new line was recently installed which is one of the largest in the world and the first beer run from this line is expected to come in coming weeks.

From a wine and spirits perspective, the business performed well during the second quarter with depletions improving sequentially as expected. The depletion growth in the quarter was driven by excellent performance by a number of our fast-growing brands including Mark West, Kim Crawford, SVEDKA Vodka, Ruffino, Black Box and The Dreaming Tree. Our expectation is that you should continue to see improving depletion trends as we progress throughout the year similar to last year.

As we head into our key holiday selling season in the second half of the year, we will be executing programming to ensure that we drive growth for our key brands that are mix and margin accretive, have scale and the greatest growth potential. We are well positioned to achieve this goal with initiatives that include the launch of our first-ever holiday TV advertising for Woodbridge by Robert Mondavi. After the success of last year’s combined Corona, Woodbridge, Butterball turkey promotion, we will once again repeat this program in advance of the Thanksgiving holiday.

We have committed to incremental feature and display activity on several margin accretive brands including Clos du Bois, Robert Mondavi Private Selection and Rosatello and we have dedicated more sales focus on the roots to market for our spirits business now that we have Casa Noble tequila as part of the portfolio.

During the second quarter, we received several awards for some of our key brands. Some of the most noteworthy accolades include the Leaders’ Choice Award which recently saluted the industry’s hottest new product in wine and spirits by awarding the best new wine product to honor our Thorny Rose brand. Wines across the Constellation portfolio earned a total of 47 medals at the 2014 San Francisco International Wine Competition including double gold and 98 point score for the 2011 Clos du Bois milestone.

In addition, gold medals were awarded for the 2013 Woodbridge Chardonnay, 2012 Ruffino Chianti, 2012 Robert Mondavi Private Selection, Cabernet Sauvignon and the 2012 Robert Mondavi Coastal Crush. We are also proud to receive a 90 point score from both the Wine Spectator and wine and spirits for some of our well known wines including Robert Mondavi 2012 Oakville Fume Blanc and the 2010 Mount Veeder Reserve and the Franciscan Estate Magnificat.

Now from a spirits perspective, we experienced strong sales growth in our spirits business during the second quarter driven by the recent launch of new flavor line extensions across our portfolio including SVEDKA Mango, Pineapple and Strawberry Lemonade as well as the Paul Masson Grande Amber Brandy peach flavor.

As is typical at this point in the year, I would like to provide an update relating to the California grape harvest, which is currently underway running nearly a month ahead of last year with more than 70% complete at this time. The current California industry estimate is for a total harvest yield of 3.8 million to 4 million tons versus approximately 4.4 million tons last year. The quality of this year’s harvest looks to be very good if not excellent. From a pricing perspective, we continue to expect great pricing to be flat to down slightly compared to last year depending on the variety, location and demand.

Before I close, I would like to take a minute to discuss our assessment of the impact of the recent California earthquake that occurred near Napa. We have assessed the extent of the earthquake’s impact on our operations and we are very fortunate that the impact is minor. Most importantly, we are relieved that our employees and their families are safe as the earthquake occurred overnight when our facilities were closed. While there was minor damage inside some of our northern California wineries, none of them have sustained structural damage and our vineyards have not been impacted.

In closing, we are excited about the favorable outcome of our glass sourcing strategy as we look forward to working with our excellent supply partners as they support our efforts to build upon our leading, important beer position in the U.S. We are working diligently on the Nava brewery expansion in Mexico while maintaining the strong momentum of the beer commercial business. And within our wine and spirits business, we are well positioned to drive our grape portfolio brands during the upcoming holiday season.

I now would like to turn the call over to Bob for a financial discussion of our second quarter business results.

Robert Ryder – EVP and CFO

Thanks, Rob. Good morning, everyone. We have a lot of significant good news to talk about today both for the quarter and the longer term. First off, we continue to deliver beer sales that greatly outpace the industry. And despite the glass recall, we are affirming full year beer guidance. In addition, we are providing medium-term volume guidance that also outpaces our estimate of the total beer industry growth. We believe we have good portfolio and demographic evidence to support our projections.

We’ve also completed a comprehensive year long glass sourcing strategy project. The outcome of these efforts are expected to provide Constellation a continual and diversified source of beer, glass supply from leading industry providers at a cost lower than that we currently pay today. We’re also increasing our medium-term operating target for beer which indicates considerable margin upside from our fiscal ’15 year-to-date run rate of 32%. As a result of these factors, we foresee a continuation of a fast-growing top line and an increase to our already healthy beer profit margin.

Finally, we will discuss increased capital spending in brewery and glass capacity to support the robust growth we are targeting. This represents investments with very high returns as the beer segment enjoys strong and growing margins and quite a high operating ROIC. I’ll provide more details on the longer term items just highlighted, but now let’s start looking at our second quarter results where my comments will generally focus on comparable basis financial results.

Our comparable basis diluted EPS for Q2 came in at $1.11, a 16% increase versus Q2 last year. We continued to see robust marketplace momentum for our beer business with depletion growth of 8%. Depletions were essentially not impacted by the recall, as wholesalers worked to replenish supply at retailers before the end of Q2 from their existing inventory levels. However, the recall impacted our sales as we reversed shipments to wholesalers for approximately 2 million cases of Corona Extra.

This translated into a reduction of approximately 37 million of net sales and $0.06 of diluted EPS for the quarter. This reduction is reflected in the $1.11 Q2 EPS. We expect to replenish this volume with shipments to wholesalers primarily during the third quarter, as we work to bring wholesaler inventories back to more normal levels.

Wine and spirits results for Q2 benefitted from higher volume and lower promotional expense during the quarter. Both businesses remain on track to reach their full year profit goals and we are affirming our fiscal ’15 comparable basis EPS outlook of $4.10 to $4.25 a share. Given those brief highlights, let’s look at Q2 performance in more detail.

As you can see from our earnings news release, consolidated net sales grew 10%. This result included 73 million of incremental beer net sales as we consolidated an additional week of sales in Q2 fiscal ’15 versus Q2 fiscal ’14 as a result of the timing of the beer business acquisition. Excluding the benefit of these acquired sales, consolidated organic net sales growth for the quarter was 5%.

For the full quarter of Q2 fiscal ’15 versus the full quarter of Q2 fiscal ’14, beer segment organic net sales increased 9%. This was primarily from volume growth driven by strong consumer demand. This result includes the impact of the recall that I just outlined. Wine and spirits net sales on a constant-currency basis increased 3%. This primarily reflected volume growth of 1% and lower promotional expense.

For the quarter, consolidated gross profit increased $109 million and our consolidated gross margin was 43% versus 40% from the prior year second quarter. The increase in gross profit primarily reflects 33 million of incremental benefit from consolidating the beer business for one additional week in Q2 of fiscal ’15 as well as growth of the base beer business and lower promotional expense and favorable mix for wine and spirits. The increase in consolidated gross margin primarily reflects higher brewery profits, beer volume and pricing benefits in the wine and spirits gross profit factors that I just mentioned.

SG&A for the quarter increased $48 million. The incremental SG&A associated with consolidating the beer business was 12 million. The remainder of the increase was primarily due to higher marketing and SG&A for the beer business. Due to the factors just mentioned, Q2 consolidated operating income increased 62 million and consolidated operating margin improved 160 basis points. Interest expense for the quarter was 85 million, down 6% versus Q2 last year. The decrease was primarily due to lower average interest rates.

That provides a good spot to discuss our deposition. At the end of August, our total debt was 7.2 billion. When factoring in cash on hand, our net debt totaled 7.1 billion, an increase of 131 million since the end of fiscal 2014. The increase primarily reflects the funding of the 558 million post-closing purchase price adjustment payment made during the quarter for the beer transaction offset by our free cash flow generation.

We have 500 million of 8 3/8 senior notes coming due in December. We’re evaluating funding alternatives for the repayment of this debt including utilizing existing credit facilities and tapping into the senior note market. Our comparable basis effective tax rate came in at 32% and compares to a 29% rate for Q2 fiscal ’14. The Q2 fiscal ’14 rate included the favorable outcome of various tax items. We continue to expect our full year fiscal ’15 comparable basis tax rate to approximate 30%.

Now let’s discuss free cash flow, which we define as net cash provided by operating activities less CapEx spend. For the first half of fiscal ’15, we generated 360 million of free cash flow compared to 440 million for the same period last year. Operating cash flow for the first half of the year totaled 668 million versus 489 million for the prior year period. This increase was primarily due to the incremental cash generated by the consolidated beer business.

CapEx for the first half of fiscal ’15 totaled 308 million compared to 49 million last year. CapEx for the beer segment totaled 229 million as activities for the initial 10 million hectoliter brewery expansion continue to progress. For fiscal 2015, we are updating our free cash flow projection and now expect free cash flow to be in the range of 275 million to 350 million versus the previous range of 425 million to 500 million. The change was primarily driven by additional CapEx requirements for the incremental 5 million hectoliter brewery expansion and glass sourcing initiatives that Rob mentioned earlier.

Total CapEx is now projected to be in the range of 725 million to 775 million versus a previous 575 million to 625 million. Our new CapEx projection includes 600 million to 650 million for the beer segment. We view this as very positive news as we have the opportunity to invest in a growing, high margin, high ROIC business. We are still targeting operating cash flow to reach at least $1 billion for fiscal ’15 and we expect to continue deleveraging.

Now let’s move to our full year fiscal 2015 P&L outlook. We continue to forecast comparable basis diluted EPS to be in the range of $4.10 to $4.25 a share. For fiscal ’15 we continue to target net sales growth for the beer segment to approximate 10% with high single digit shipment and depletion volume growth and operating income growth in the range of 25% to 30%. When factoring an estimated full year of brewery for fiscal 2014, underline operating income growth for the beer segment is still expected to be in the mid teens.

For wine and spirits, we continue to target net sales and EBIT growth for fiscal ’15 to be in the low to mid single-digit range. Our comparable basis guidance excludes unusual items, which are detailed on the last page of the press release.

Now I’d like to provide some financial highlights related to our strategies around glass sourcing and beer production capacity that Rob outlined. Our beer business has great momentum in the marketplace growing ahead of our expectations since the acquisition and well ahead of the total beer category.

We believe we are positioned to continue outpacing the beer category behind positive demographic and portfolio factors, some of which include consumers trading up to high-end beer, growth and increasing influence of the Hispanic consumer who have a high propensity for our brands, great alignment with our goal to distributor network, distribution gains for all brands, draft and can format expansion and packaging and product innovation.

As a result of these factors, we are targeting annual volume growth to be in the mid-single-digit range over fiscal ’16 to fiscal ’18 timeframe, a sales trend that we believe would outpace growth projections of the total U.S. beer industry.

To ensure we are best positioned to capture this growth opportunity, we have begun a new 5 million hectoliter expansion at our Nava brewery, which will take it to 25 million hectoliters of production capacity. The estimated cost for this investment is 450 million to 550 million and is expected to be completed by the end of calendar 2017. When you combine this with our initial 10 million hectoliter expansion, our total brewery capacity investment is estimated to be $1.45 billion to $1.65 billion.

As part of our beer, glass sourcing strategy, we have reached an agreement with ABI to acquire their glass plant, warehouse and rail infrastructure and land that is adjacent to our Nava brewery for an acquisition purchase price of about $300 million. We’ve also agreed to form a 50/50 joint venture with Owens-Illinois to own and operate this glass plant. O-I will contribute approximately 100 million for its 50% share of the joint venture. The joint venture will not include the acquired warehouse, rail infrastructure or land. The JV will provide bottles exclusively for the Nava brewery.

The glass JV partners plan to expand the capacity of the plant from one furnace to four furnaces over the next four years at a cost of approximately $300 million to $400 million. The expansion costs will be shared equally between Constellation and Owens-Illinois. Since we expect to consolidate the JV results, the full expansion costs would be included in our CapEx line in our statement of cash flows with O-I’s contribution being displayed as a separate benefit in the financing section of our cash flow statement. Constellation also expects to spend approximately 175 million to 225 million outside of the JV to enhance the site infrastructure for the rail and warehouse at the newly acquired site.

For the beer business projects just highlighted, we have summarized the associated tax assessments and timeframes in a table that was included in our glass sourcing and capacity expansion press release issued earlier today. Given the collective activities just outlined, we are targeting our beer segment operating margin to be in the mid 30% range in fiscal ’18, which we believe is best-in-class among the North American competitors.

With the incremental CapEx investment, our goal of exceeding free cash flow generation of $1 billion is now targeted to move out in fiscal ’18. Even with the higher CapEx requirements, we still expect to delever at a good pace and reach our goal of debt to comparable basis EBITDA ratio below four times in fiscal ’16, as operating cash flow and EBITDA growth of the business allows to delever despite the increased capital spend.

Operating within our three to four times target leverage range provides us the financial flexibility to access the initiation of a dividend and/or additional stock buybacks. Once we move past the heavy fiscal ’16 and ’17 peak CapEx spend years, free cash flow should growth dramatically, which will provide us even more financial flexibility while we stay within our targeted leverage ratio range.

In summary, we’re very pleased with how fiscal ’15 is progressing. The wine segment is expected to grow EBIT in line with sales and see strong execution in the marketplace during the key holiday season. Our beer business has tremendous momentum in the marketplace and continues to gain market share. It has a very strong financial profile and is among the industry leaders from a sales growth and profit margin perspective. Our high return investments in beer production capacity position us to support the momentum and significant growth opportunity we see for the beer business.

With that, we’ll open up the line for questions.

Question-and-Answer Session

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