Tickers in this Article: STZ, BUD, SBMRY, DEO
Complaining about the high valuation of beverage stocks like Coca-Cola (NYSE:KO), Diageo (NYSE:DEO), and Anheuser-Busch InBev (NYSE:BUD) is largely a futile exercise. Investors prize the strong cash flows and returns on capital that these businesses can achieve, and many analysts and investors are completely sold on the idea that ongoing income growth in the emerging market will lead to both higher sales and higher scale-driven margins down the line.

I can accept all of that to a certain point, and I certainly can't complain if the market wants to award a rich valuation to the shares of SABMiller (OTCBB:SBMRY) that I own. In the case of Constellation Brands (NYSE:STZ), I can see multiple avenues for better long-term performance, particularly if the U.S. Department of Justice ultimately gives the “all clear” to the restructured Grupo Modelo transaction. That said, investors should ignore the strong performance expectations that are already built into the valuation and the risk that the shares could underperform the market as a result.

A Respectable Close To The Fiscal Year
Constellation came in with a pretty respectable fiscal fourth quarter, but it's pretty clear that investors more interested in the upcoming closing of the BUD-Grupo Modelo deal than the quarter-to-quarter performance.


Revenue rose nearly 11% this quarter, well ahead of the average sell-side estimate of 6% growth. Revenue rose 8% on an organic basis, with shipment volume of 5% and U.S. shipment volume growth of 6%. While most of Constellation's competitors in the wine business are private, Nielsen data for the U.S. suggests volume share growth for Constellation, as well as its leading rival E J Gallo.

Margins were definitely less impressive. Gross margin (on a comp basis) declined about 130pts from the year-ago level, and comparable operating income rose 9%. This margin performance was below expectation, as were the sales and operating income from the company's Crown joint venture (the beer business).


Will The DOJ Allow The Grupo Modelo Deal To Go Through?
The biggest near-term risk and opportunity for Constellation is also the one that's arguably out of their control – the closure of the deal whereby BUD wants to acquire Grupo Modelo. While the U.S. Department of Justice has raised objections to the deal, BUD and Constellation have worked to restructure their side of the deal in an attempt to get the regulatory green light.


As it stands now, it will be a nearly $5 billion transaction in which Constellation will get the other 50% of the Grupo Modelo U.S. joint venture and buy the Piedras Negras brewery. With this deal, BUD will effectively be divesting the Grupo Modelo business to Constellation, which likely suits BUD fine, as Mexican/Latin American business is likely what it really wants.

With full control, a lot of opportunities would open up to Constellation. In addition to greater control on pricing and distribution, Constellation would be able to innovate in terms of products (flavors and so on) and packaging. Moreover, there should be solid long-term synergies that would be good for margins.

SEE: Why Innovation Is Crucial To Success


Of course, all of that could be moot if the DOJ is resolute in spiking the deal – in such a scenario Constellation would almost certainly keep the JV, but would lose those incremental improvement opportunities. It's also worth noting that scale could still be an issue – Constellation struggled to generate good margins with a larger global wine platform, and comparisons to companies like Diageo or SABMiller may be too bullish in terms of what Constellation can hope to achieve.

The Bottom Line
Assuming the deal goes through (which the Street believes will happen), a lot of Constellation's future success is already priced into the stock. That said, I don't know that investors need or expect this to be a market-beating stock – an annual return in the 5% to 8% range would probably be fine for many investors. It's also worth noting that if Constellation can offset input cost inflation (grains for beer, grapes for wine, packaging materials, etc.) with operational efficiency and generate free cash flow margins more on par with industry leaders, a fair value in the $50's is not ridiculous.


Still, for the time being I think these shares are fully valued and don't represent a significantly undervalued investment opportunity.

At the time of writing, Stephen Simpson owned shares of SABMiller.

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