Description

Situation Background

Constellation Brands (“STZ”) is the largest multi-category beverage alcohol player in the U.S. with leading market shares in the beer, wine and spirits markets.  The company was founded as a wine business and grew through acquisitions to reach #2 share in the U.S. wine market by revenue.  In June 2013, STZ entered the beer business at scale when it acquired the U.S. business of Mexico’s Groupo Modelo.  As part of the deal STZ acquired a state-of-the-art brewery in Mexico and the exclusive rights to manufacture and market Modelo’s brands, including Corona Extra and Modelo Especial, to the U.S. market.  The opportunity to acquire Modelo’s U.S. business was the result of unexpected good fortune (as would appear to be the case based on the stock reaction), and came about when the U.S. DOJ forced Anheuser-Busch Inbev (“ABI”) to divest the assets as a condition for it to purchase Groupo Modelo. Today STZ is the #3 player in the U.S. beer market overall and the #1 importer, representing half of all imports.

While the stock has more than doubled following the announcement of the beer business acquisition and is up over 50% since nantembo629’s write up in July 2013, we believe the pro forma earnings power and cash generation of the business are still under-appreciated in the near and long term.  We believe this stems from the complexity of the transaction making it difficult to model and that the most significant cost savings are still two years away.   

Thesis

Today STZ operates its business in 2 segments—Beer (~55% of LTM pro forma EBIT) and Wine & Spirits (~45% of PF EBIT).  We do not take a differentiated view on the Wine & Spirits business, conservatively expecting it to grow EBIT at the low end of management guidance for low-to-mid single digits driven by category growth and no margin expansion. 

Our thesis is driven by the beer business.  The transformational acquisition has created a segment with sustainable above-category top line growth and a multi-year runway of EBIT margin expansion opportunities which we think can expand EBIT margins from 30% to closer to 40%.  Combined with meaningful financial leverage (target 3-4x Debt/EBITDA), significant FCF generation and a shareholder friendly management team, we think the business will compound equity value at >20% in the medium term and in the mid/high teens long term.  We estimate the business will generate approximately $6.50 in EPS in FY17, a 26% 3-year CAGR (the company has a Feb. fiscal year end so FY17 is essentially calendar year 2016).            

Beer Market Overview

The U.S. beer industry is structurally attractive to us with consolidated players, annual price increases and limited price competition.  Overall industry volumes have been stable but unspectacular at a 0.5% CAGR since 2000.  However the total growth number masks divergent trends below the surface which has seen a consumer trade up to quality.  Traditional domestic brewers ABI (48% share of volume) and Miller-Coors (30% share) have seen (1%) annual volume declines over the period, while premium-priced imports (+2% volume growth) and craft beers (+8%) have taken share. 

Today imports represent 13% of the U.S. beer market, with 54% of those imports coming from Mexico.  Mexican imports have consistently outpaced the overall imports category, growing at a 4.5% CAGR.  STZ’s brands dominate the Mexican import category, with ~80% share driven by its two largest brands Corona (50% share) and Modelo Especial (20% share). 

Corona is the #1 U.S. import brand with nearly double the volumes of #2 Heineken.  We believe its strength comes from consumption by the Mexican population in the U.S. (Corona is the #1 beer in Mexico with 26% share, more than double its closest competitor) and also its seemingly broad appeal across the general U.S. market.  Modelo Especial is earlier in its roll out to the U.S. market, but has rapidly become the #3 import brand despite little marketing to date. 

Beer Revenue Drivers

We project 8% revenue growth for STZ’s beer segment over the next 3 years driven by 6% volume growth and 2% price growth.  This compares to 4% revenue growth over the last 3 years driven by 4% volume and 0% price.  The main difference between the historical and projected values is the change in control transaction that transferred permanent ownership of the brands to STZ. 

Prior to 2013 Modelo’s brands in the U.S. were imported by Crown Imports, a JV between STZ and Modelo.  While the JV was nominally a 50/50 partnership, Modelo held all the power.  It controlled the brands, manufactured the product and had the right to “opt out” of the deal at specific intervals.  Crown’s relationship with U.S. distributors was also complicated by the fact that Modelo was partially owned by ABI.  In the U.S. most local markets contain two large beer distributors, one ABI-only distributor and one Miller-Coors (“MC”) distributor.  Imports are generally carried by the MC distributors.  We believe that because of ABI’s partial ownership of Modelo and the non-permanent nature of the JV, MC distributors were hesitant to go “all-in” promoting Modelo’s brands. 

Volume growth comes from:

• Distributors going “all in”:  We believe that STZ’s brands are among the most attractive to beer distributors because they are both high margin and high volume.  This compares to core domestic brands which are high volume but low margin and craft brands which are high margin but volume is fragmented among hundreds of players.  With STZ’s ownership now permanent, distributors have started to ramp their long-term investment in promoting STZ’s brands.  Since June 2013, STZ’s volumes are up low double digits year-over-year according to Nielsen data.   
• Secular & cyclical Hispanic population exposure:  40-50% of STZ sales are to Hispanic consumers, mostly those of Mexican descent.  The U.S. Census bureau projects the Mexican population to grow 3% annually through 2020 and the overall Hispanic population 2.4%.  Additionally, Hispanics over-index to construction jobs in the U.S. by 5 percentage points,11% of Hispanic jobs are in the construction industry vs 6% in the non-Hispanic population.  We expect that a housing and construction rebound should help drive a recovery in discretionary spending by Hispanics.
• Continued Modelo Especial growth:  Modelo Especial (“ME”) has grown to become half the size of Corona and continues to grow volume 20%+ per year, accounting for a large portion of STZ’s total beer growth.  Management thinks the brand will eventually be as big as Corona.  Currently ME is only carried in 2/3 of the retail locations that sell Corona, and when it is carried it only has a small footprint.  The company is just starting to invest marketing dollars in the brand, and today 54% of general beer drinkers are still unaware of the brand and 77% have never tried it.   
• Promote smaller brands/product innovations:  STZ has the U.S rights to Modelo’s other brands including Corona Light, Pacifico, Negro Modelo and Victoria, which provide additional upside opportunities.  It also has the right to develop product line extensions.  For example, it is in the process of launching a product called Modelo Chelada (tomato juice/beer combo popular in Mexico) that alone could provide a 5-10% lift to volumes based on sales of Bud Light’s similar product.  Draft beer is another opportunity where STZ is very underpenetrated.     

Additionally, we expect STZ to realize 2% annual price increases, in line with the industry average.  Prior Modelo ownership shied away from price increases, against STZ’s and distributor’s wishes.  In the fall of 2013, STZ pushed through a 2% price increase with no apparent negative impact to demand.  Management has pledged to hold its “price gap” with competitors by taking pricing each year.

Beer Margin Drivers

The beer business that STZ acquired from Modelo has a suboptimal cost structure today.  Our base case assumes that over the next three years STZ will be able to drive EBIT margin expansion from 30% to nearly 40%.  Cost savings should come from two main sources that don’t require aggressive assumptions:

Consolidating production in its wholly-owned manufacturing facility.  Today STZ sources ~54% of volume from its state-of-the-art brewery in Piedras Negras (PN) Mexico which is among the most automated and efficient in the world.  It is procuring the other ~46% from ABI through a transition supply agreement (TSA).  Over the next 2 years STZ will invest $600m to double the capacity at the PN facility to eventually produce all of its volume in-house.  Cost savings include: 

• Product cost savings:  The PN brewery is significantly more efficient than the legacy ABI facilities producing in the TSA.   Once manufacturing moves completely in-house we calculate STZ could realize 15-20% manufacturing cost saving on the 46% of volume outsourced today.
• Transportation savings:  Transportation is ~25% of the cost structure today.  The PN brewery is on the U.S. border, whereas legacy ABI facilities are hundreds of miles deep in Mexico.  We estimate moving all production to PN could save 20% on freight costs.
• Operating leverage:  Labor and overhead make up 15% of costs.  As production is centralized and volume grows the company should realize meaningful operating leverage.

Glass packaging cost savings.  Glass bottles represent 33% of COGS.  Historically Modelo sourced its bottles from a supplier owned by the controlling Modelo family.  Our work indicates the glass supplier marked up the cost of these bottles above what an arms-length supplier would charge.  This glass supplier continues to supply glass bottles as part of the TSA at the historical prices paid, however STZ has the freedom to find an alternative source going forward.  STZ should be able to leverage its glass purchasing scale (with the wine business) to find a lower cost supplier and save at least 15% on packaging costs. 

Capital Allocation

The business generates significant free cash flow with an estimated 6% forward FCF yield to equity (backing out one-time brewery expansion capex).  Management plans to use near term FCF to fund the brewery expansion and reduce leverage, before initiating returns of capital to shareholders.  Current management has been shareholder friendly, buying back ~20% of outstanding stock from 2009-2012, divesting underperforming assets and not deploying capital on bad acquisitions.    

Today Debt/EBITDA is 5.3x on a trailing reported basis, but only ~4.6x on a pro forma basis adjusting for a full year of beer profits.  Management has committed to reducing debt to levels below 4.0x (officially a 3-4x target) before returning capital to shareholders.  We expect that with cash flow generated in FY15 (calendar 2014) and continued EBITDA growth, the company will be well below the 4.0x leverage target 12 months from now.  At that time we expect the company to announce a dividend and substantial buyback. 

Equity Compounding

We expect EBITDA to grow 12% per year over the next 3 years, driven by 18% Beer growth and 3% Wine & Spirits growth.  With the levered capital structure (1.4x TEV/Mkt cap) and 6% cash flow yield we expect 23% annual compounding over the next 3 years.  After that period, we expect STZ to be a relatively fast growing (5%+ topline) and stable consumer staple business with attractive margins, margin expansion opportunities, 3.5x leverage and strong FCF generation.  We believe the business will likely compound equity value in the mid/high teens long term.

Valuation & Target IRR’s

STZ currently trades at 14x EV/EBITDA and 21x P/E on FY15 street numbers (again basically CY14).  This PE multiple is a ~10-20% premium to international brewing peers which seems reasonable given what we see as STZ’s vastly superior growth outlook and no emerging market exposure, but is a meaningful discount to other high growth beverage alcohol companies (SAM, BF.B, BEAM for example).  

We also think the FY15 street numbers will need to be revised upward.  Current consensus EBITDA of $1.68bn and EPS of $3.95 only projects 7% EBITDA growth and 6% EPS growth vs. pro forma FY14 results that include 4 full quarters of the beer results (we estimate pro forma FY14 EBITDA would have been ~$1.57bn and EPS would have been ~$3.72). 

Our case generates approximately $6.50 in EPS in FY17 (CY16) and $1.3bn in Free Cash Flow.  Using an NTM valuation range of approximately 18-21x P/E and 5-6% FCF yield implies a valuation in two years of $115-130 per share, or an 18-26% IRR from today. 

Biggest Risks

• Beer business execution:  We believe that STZ has executed well since acquiring the beer business but is just starting construction on the brewery expansion and will need strong execution to continue to capture margin upside.
• ABI supply agreement:  STZ will be dependent on ABI to procure up to ~46% of beer volume and all of its raw materials for the next couple of years.  We believe that ABI has been a good partner to date but STZ will need to depend on ABI until brewery construction is complete.
• Consumer product risk:  STZ’s beer and wine products have enjoyed long periods of growth that appear to have secular drivers but consumer tastes could change.
• Capital allocation:  Once it has reduced debt and finished funding expansion capex, management might pursue a less shareholder friendly capital allocation strategy than we expect.
• Wine margin volatility:  Grape prices, like those of other agriculture products, are hard to predict and volatile.  Over the long term STZ should be able to pass on grape cost inflation, but margins could be squeezed in any short term period. 

Disclaimer: will579 had long exposure to STZ at the time of publication 3/27/14.  will579 has no obligation to update the information contained herein and may make investment decisions that are inconsistent with the views expressed in this presentation.  will579 makes no representation or warranties as to the accuracy, completeness or timeliness of the information, text, graphics or other items contained in this presentation.  will579 expressly disclaims all liability for errors or omissions in, or the misuse or misinterpretation of, any information contained in this presentation.  Discussions regarding potential future events and their impact on any issuer are based solely on historic information and our estimates and/or opinions, are provided for illustrative purposes only, and are subject to further limitations as specified elsewhere in this write-up.  No guarantee can be made of the occurrence of such events or the actual impact such events would have on any issuer's future performance.

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