It's always fun to own a stock that Wall Street wants to like, and that seems to be the case for Constellation Brands (NYSE:STZ). I can appreciate at least some of the enthusiasm; the company learned its lesson from rampant over-expansion by M&A and the acquisition of Crown Imports give the company not only more balance, but legitimate organic growth opportunities. Even so, investors have to pull out all of the stops for this stock to look cheap and I'd be cautious about going that far.
A Slight Operating Miss For The Fiscal First Quarter
Constellation Brands didn't have a bad first quarter, but the results weren't anything special either. All told, I doubt it will do much to dent investor enthusiasm for the stock unless there's a larger exodus away from consumer staples.
Revenue rose 6% as reported, the wine and spirits business up about 4% on an organic basis. Reported case volume rose about 6%, or just under 5% on an organic basis, while revenue per case was up about 1%. Crown sales (beer) were up about 5% for the period.
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Gross margin fell about 130bp on an adjusted basis, more than a point below expectation as the company saw higher grape costs and less benefit from mix shifts. Operating income declined 5% on an adjusted basis, and the two-point operating margin decline was about five points shy of Street expectations. Wine segment earnings declined 4%, while beer profits were up 9%.
All told, Constellation would have missed by about five to six cents per share, were it not for the benefits of higher equity income, lower interest expense, and lower tax costs.
Now A More Balanced Player With Growth Options
Anheuser-Busch InBev (NYSE:BUD), Constellation, and Grupo Modelo did what they needed to do to satisfy regulators, and Constellation now has complete control of the former Crown Imports JV, as well as the U.S. business of Grupo Modelo and a brewery in Mexico. With that, beer and wine are close to 50/50 contributors to both revenue and income going forward.
This transaction is not just about balance, though. Constellation now has legitimate growth opportunities within its own control. Grupo Modelo was relatively sluggish with the development of new products and packaging, and Constellation is going to look to introduce new products over time as well as getting more of the beers available in draft and cans.
I can also see Constellation investing more resources to build this business over time. I don't think the company is going repeat the frenetic growth-by-acquisition strategy it once tried in the wine business, but I do believe Constellation could add select brands in one-off transactions.
Are Expectations Reasonable?
If I have a major concern for Constellation, it's that expectations are quite high and most of the sell-side seems happy to go along with it. I know that other brewers like BUD, SABMiller (Nasdaq:SBMRY), and Molson Coors (NYSE:TAP) have been getting more optimistic about the North American market, but growth has been challenging here for some time. Perhaps Constellation will benefit from being more like Boston Beer (NYSE:SAM) or Craft Brew Alliance (Nasdaq:BREW) in the minds of consumers and investors, but I don't see underlying consumption trends changing all that much.
It's also interesting that Constellation management has been talking about investing in new products, packaging, and brand development, but also pretty exceptional margins and free cash flow production. At a recent analyst day, management laid out a target for $1 billion in free cash flow in fiscal 2017, which would represent a pretty dramatic improvement – particularly given the aforementioned investments.
The Bottom Line
The only real issue I have with Constellation Brands today is the tenor of expectations. Unless you're willing to basically just ignore the debt on the company's balance sheet, even the expectation of 10% compound annual growth in free cash flow doesn't get you into the $50s with the fair value.
To be fair, though, there really aren't many (if any) undervalued or bargain-priced stocks in the alcoholic beverage space unless you look at those companies with serious performance issues. So while I'd have a hard time buying Constellation Brands today for my own account, I can't pretend that the stock I do own (SABMiller) is cheap either. So while I'd probably hold Constellation if I already owned it, I would start keeping a close eye on the operating performance and perhaps consider protective stops in case Wall Street suddenly falls out of love with the space.
Disclosure – As of this writing, the author owns shares of SABMiller.