Constellation Brands: A Hold Amid Downturns In The Wine & Spirits Category

Investment Thesis

Constellation Brands (NYSE:STZ) reported full-year results on the 5th January. The price rose in the proceeding days after the results and then sold off where it is currently trading on the 200-day moving average. I am initiating a Hold on the company due to the strong performing Beer segment offset by headwinds in Wine & Spirits. However, STZ does have a strong capital allocation strategy, recently repurchasing $3.20 billion worth of shares and sporting a dividend yield of 1.4% with a payout ratio of just 29%, leaving room for dividend growth in the years ahead.

Background

STZ is an international producer of beer, wine and spirits with operations across the globe. They are a dominant player in the beer market, driven by sales of their iconic brands such as Corona Extra. Resulting in the company being one of the largest suppliers in the US beer market.

Beer forms 79% of revenue, with Wine & Spirits forming the remaining 21%. In the Beer segment, STZ is the #1 seller of imported beer in the US and boasts 9 of the top 15 top-selling beer brands, with Modelo Especial being the best-selling imported beer followed by Corona Extra that comes in second. In Wine & Spirits, the company holds a portfolio of higher-margin and higher-growth products.

The company’s strategy involves investing into manufacturing facilities and making strategic acquisitions to expand their leadership in the industry.

Financials

STZ accumulated $9.82 billion in revenues over the trailing twelve months and holds the third-largest market share in the Distillers and Vintners industry. 5-year CAGR stands at 4% slightly behind close competitors such as Diageo (DEO) and Pernod Ricard (OTCPK:PRNDY) that have growth rates of 6.26% and 5.30% respectively, but forecast sales are up on competitors driven by strong growth across the US beer market.

After subtracting costs, profitability shows a very prominent picture. Gross margins have climbed a staggering 2000 basis points since 2007 and well managed operating overheads have resulted in EBIT Margins that are leading the industry and ranked 5th out of 184 companies in the consumer staples sector.

Net margins are choppy. In 2017, STZ made a $190 million investment to acquire a 10% stake in Canopy Growth, a Canadian cannabis company, in an attempt to launch into the fast-growing cannabis market. The stake has not played out well, while the market opportunity in 2017 seemed attractive, with Canopy growing revenues over 200% in 2017, they bought in at a P/S ratio of 300x in 2017 and the share price performance has reflected that, with total returns over the last 3-years of -99%. This has resulted in significant losses for STZ, with cumulative impairment charges of over $1 billion in 2023.

When looking into the balance sheet, I can see the company holds net debt to sales of 118%. The most major debt repayment is behind the company, which it paid in fiscal 2023. The near terms principals for the company don’t offer much concern, with two senior note repayments of $900 million in 2024 and 2025, but with the company generating on average $1.5 billion in free cash flow over the last 3-years, they are in a fine position to service these principals.

In 2021, the Board authorized a $2.0 billion stock repurchase program that is well underway. After purchasing very little stock in 2020 and 2021, they have upped purchases substantially in fiscal 2022 and 2023, potentially signaling management believe the company is undervalued. They also pay a dividend of $0.80 per share that comes to a yield of 1.4% with a payout ratio of 29%.

Outlook

The beer segment stands out as a particularly compelling aspect. It delivered a very strong performance through Q3, with a notable acceleration in momentum towards the last week of the month, reflecting strong consumer demand. Modelo continues to gain market share, solidifying its position as the leading brand in the US, thanks to the introduction of new flavors and pack sizes. Pacifico has experienced significant growth, doubling its case sales over the past 5 years and maintaining its status as a top performer in the US beer market. These outcomes highlight the enduring appeal of STZ beer brands among consumers. Given the present market conditions, STZ anticipates a robust 7% to 8% growth in the beer business for fiscal year 2024.

On to Wine & Spirits. This category is facing an industry downturn that is forecast to continue into fiscal 2024. The environment is becoming increasingly pressured, with competitors such as The Duckhorn Portfolio suggesting the luxury wine market has grown an anemic 0% to 1% in the past 12-weeks. And The

National Alcohol Beverage Control Association (NABCA) states that spirit sales declined -0.3% in January. This weak market activity is putting pressure on revenues that declined -7% organically in Q3. However, STZ has been prudent in managing costs and gross margins increased 60 basis points, showing that the company has responded well with cost reductions and the trouble continues to be on the demand side. As a result, the company revised down forecasts in this category and now expects sales to decline -7%.

Valuation

Utilizing the multiple approach to valuation, I have a share price target of $250 with a P/FCF multiple of 25x. I can’t see how total company EBIT Margins can expand from here without better contributions from Wine & Spirits, even in light of the strong performance across the Beer business. They also already have some of the highest margins in the sector, so I have EBIT Margins constant at 30% across to 2028. One aspect of improvement is STZ’s working capital management that has dropped from 25% of sales to 17%. I have kept this constant across to 2028, but there might be room for a further decline, freeing up more cash flow. This share price target is flat on today’s price.

Risks

There are two outstanding challenges to my thesis. First is the potential recovery in the Wine & Spirits category. If that were to occur, I believe the company would be well positioned and I would upgrade my outlook. The second challenge is with the Beer segment. If demand across the US were to soften or any competing brands entered the marketplace, resulting in guidance being revised down, I again would change my outlook. However, the latter of those beer market concerns feels unlikely, given the improving share gains across the majority of their beer portfolio.

Conclusion

STZ is a dominant player in the beverages business and one of the most profitable companies in the consumer staples sector, driven by one of the most successful pricing strategies of any supplier. Margins show good resilience to macroeconomic headwinds, and the company pays a dividend yield of 1.4%. However, with downturns in the Wine & Spirit category, I am initiating a Hold on the company until further news is released that confirms the category has turned a corner.