Description

Constellation (STZ) has underperformed recently due to more transitory concerns and is now attractively valued relative to peers, its historical valuation and its growth rate.  The stock was at $260 in early December but recently traded as low as $208 due to concerns around slowing beer revenue growth and FY23/FY24 beer operating margin pressure.  The stock has recently bounced back to $225 but still remains attractively valued.  The slowing growth concerns are valid (Modelo most specifically) and worth monitoring but STZ’s valuation now more reflects these concerns as long term versus short term.  In addition, the focus on potential slowing growth has lessened the focus on more tangible and positive longer term changes.  The two most important being the elimination of the Sands controlling share class and STZ’s commitment to improved capital allocation (e.g. lower net leverage, no incremental capital to Canopy, W&S divestitures).  STZ is trading at 14.7x FY24 EV/EBITDA and 13.3x FY25 EV/EBITDA.  This compares to staples trading at 14.1x FY2 EV/EBITDA and beverages at 16.7x.

STZ has been written up in the past on VIC with the most recent one on April 28, 2020.  These writeups provide a good background of the company and its capital allocation disasters (e.g. Ballast Point, Canopy).  Much has changed for the better in the past couple of years though the stock price has remained flattish at $225 (now and in 2018).

The Constellation beer portfolio consists of Modelo, Corona, Pacifico, Victoria and Funky Buddha.  Modelo is the largest brand at $4.1 bn retail or 55% of Constellation’s portfolio.  Coronia is the second largest brand at $3.0 bn or 40% and Pacifico is the third largest brand at $290 mm or 4%.  Modelo remains under distributed relative to brands like Corona and Budwieser and this is the long term growth opportunity for the company.  E.g. Modelo $ velocities are almost 2x that of Corona and Budweiser but distribution when measured by # of items, ACV or total distribution points (TDPs) lags both Corona and Budweiser.

The company’s two largest brands have experienced decelerating growth in the past couple of months (November and December).  It’s impossible to pinpoint exactly what has caused the deceleration but  potential reasons include a difficult weather compare in CA (25% of the business, much hotter last year relative to this year), a difficult omicron lap as beer consumption shifted to at home a year ago, increasing elasticity due to higher prices and more general macro/trade down weakness (Modelo and Corona are more premium priced).  Constellation’s beer consumption data shows outsized pressure in CA which suggests weather might be part of the issue but industry checks also indicate higher pricing has been an issue.  Many retailers and distributors took incremental pricing on top of STZ’s pricing.  This caused the on shelf price to consumers to move up rapidly and significantly.  At a recent beer conference, several distributors/retailers noted rolling back on shelf prices modestly given the outsized impact to STZ’s volumes.  It’s early but the response has been positive with respect to STZ’s beer volumes improving.  Historically, STZ has taken +1-2% pricing per year.  Retail pricing in recent weeks has been +5-6% y/y.  As noted above, there are several potential drivers of the recent slowdown and only time will tell whether it is a short term or long term issue.  That said, STZ’s valuation at 14.7x EV/EBITDA seems to reflect these issues as more long term in nature so any improvement should drive a re-rating in the shares.

In addition to the beer rev growth concerns, STZ has been dealing with outsized cost inflation similar to peers (+DD cost inflation in FY23).  The company recently (as of FY3Q) provided disappointing beer margin guidance for FY24 – management said the beer margin should be roughly in-line with FY23 so 38%.  The primary driver is another year of elevated inflation (+HSD) and incremental costs/depreciation associated tied to beer capacity expansion.  Packaging and raw materials are ~60% of COGS and still inflationary given buying/hedging programs.  The company’s LT beer operating margin target is 39-40%.  The five year average through FY22 is 40%.  STZ will take longer to rebuild its margins than peers given its more limited pricing relative to peers.  E.g. some staples are realizing low double digits to mid-teens pricing while STZ has guided pricing this year in the +2-3% range.  In any case, consensus estimates now reflect a 38% beer margin segment in FY23 and FY24 so any improvement towards 39-40% would be upside to estimates.

As noted in prior write ups, Constellation’s capital allocation track record is poor.  Ballast Point and Canopy are the best examples of the company setting cash on fire.  That said, this has been improving in the past couple of years with the divestiture of lower margin, non-core wine and spirits (W&S) brands.  The company has also been returning capital to shareholders via repurchases and dividends.  In addition, management has publicly stated it will not deploy incremental capital to Canopy.  Lastly and most recently, the company eliminated its Class B common stock which eliminated the Sands family control of the company.  It came at a cost ($1.5 bn to the Sands) but should be a positive move over the long term given STZ’s issues with corporate governance.

There are several debates now with Constellation but the result is a more attractive risk/reward and a reset margin profile for next year with potential upside.  This write up has mostly focused on the beer business given this is the key value driver.  The W&S business is 23% of rev and 16% of EBIT (FY22) and should get smaller over time as STZ’s beer organic rev algo is +7-9% versus the W&S organic rev algo at +2-4%.  STZ’s net leverage is now 3.5x after the $1.5 bn cash payment to the Sands.  The new net leverage target is 3x versus 3.5x in the past.  The stock is trading at 14.7x FY24 EV/EBITDA and 13.3x FY25 EV/EBITDA.  The company’s fiscal year end is February so in the next 3-6 months, the valuation focus should shift to FY25.  The 13.3x is attractive relative to the company's 15.3x average over the last 5 years (range is 14.3x to 16.4x).  On a relative basis, the stock is trading at a 12% discount to beverages versus an 8% discount on average over the past 5 years.  The discount has widened in recent years due to the capital allocation mishaps.  In the 2015-2018 period, the stock traded more in-line with the beverage sector.  In addition to multiple expansion, there is the potential for better profitability/EBITDA if beer segment margins can revert to the 39-40% range versus 38% this year and next.

Risks include a more significant recession and trade down, continued poor capital allocation, more limited long term beer growth as a landlocked business.

Catalyst

Improving beer consumption data, FY24 guidance.