5 Points Constellation Brands' Management Wants to Emphasize

By Markets Fool.com

International wine and beer manufacturer Constellation Brands announced fiscal 2016 results last week, marking the completion of another strong year, in which its top-line revenue expanded by 9% to $6.5 billion, and net income increased 26% to $1.1 billion. Is it time for the company to take a breather from a string of acquisitions alongside heavy investment in capacity expansion? Below we review the most significant points management made on its April 6 earnings call, which address how Constellation Brands intends to move forward over the next year.

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It's considering an IPO for its Canadian wine business

[Our Canadian business'] size and scale across Canada includes eight wineries in key wine regions, approximately 1,700 acres of Canadian vineyards, and a network of growers to support their Canadian-produced brands. And they are the largest holder of independent retail licenses in Ontario, with more than 160 wine rack stores.
-- CEO Rob Sands

The Canadian wine business has been an important part of Constellation Brands' income statement for several years. The company hasn't yet filed its fiscal 2016 annual report yet (its fiscal year ended on Feb. 28), but a glance at least year's annual report shows that non-U.S. sales, which the company describes as "primarily Canada," reached $668 million, out of a company total of $6.0 billion.

Why would the company want to divest such a large segment from its operations? Management indicated on the earnings call that it would use initial public offering proceeds to tackle debt on its balance sheet. As I've described in the past, Constellation Brands actively employs debtto increase its return on equityand also to increase market share. So we can infer that if management wants to put IPO proceeds in service of deleveraging its balance sheet, the company essentially intends to sell one revenue opportunity (Canadian wine) in order to re-tap its borrowing capacity for other, higher-margin revenue opportunities.

Constellation is taking no prisoners in the high-end wine market

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Detail from an image of the hand sorting of grapes, from the Prisoner Wine Company website.

[T]he Prisoner acquisition aligns with our portfolio premiumization strategy and enables us to capitalize on U.S. market trends that favor high-end wine brands with accretive margin profiles. In particular, it strengthens our position in the dynamic and margin enhancing super luxury wine category and can be easily integrated into our existing portfolio of brands.
-- Sands

On the morning of its earnings release, Constellation announced its intention to acquire Prisoner Wine Company's "super-premium" portfolio of five wines from Huneeus Vintners, for anticipated cash paid at closing of $285 million.

This acquisition follows the company's purchase of the Meoimiluxury pinot noir and chardonnay portfolio in August of last year for $315 million. In just a few months since the purchase, evidence of Constellation's penchant for scaling production of newly acquired premium brands has surfaced. In its 2016 earnings filing from last week, Constellation revealed that it's already sold $74 million of Meiomi label wines in just seven months since the closing of the transaction.

Look for a similar trajectory for Prisoner Wines. The acquisition didn't include land; Prisoner sources its grapes from some 80 vineyards in Napa Valley. This makes for an ideal Constellation acquisition. That is, the company buys an extremely popular, high-end (and high-margin) wine with surging sales, then attempts to meaningfully increase case volume, using its grape purchasing power and connections, high capacity production facilities, and wide distribution network.

Capacity plans are proceeding at pace

Now, these investments in Mexicali and Nava will ensure that we have the capacity, quality, control and flexibility to meet expected demand for our iconic beer brands well into the future, and position us to capture the continued momentum and growth opportunities we see in the high end of the U.S. beer market.
-- Sands

Sands reported above on the company's brewery in Nava, California, which will have 20 million hectoliters of capacity up and running within the next few months. The plant's eventual capacity will reach 27.5 million hectoliters in 2018. The Nava plant will be complemented by a sister brewery in Mexicali, Mexico, located not far from the California border. This brewery will have an initial capacity of 10 million hectoliters, scaling up to 20 million hectoliters by 2020.

Constellation Brands is about $1.5 billion deep into its massive $4.5 billion Mexican beer capacity expansion. Steady progress on this initiative is extremely important, as the build-out is largely financed by debt, but also because long-term revenue expectations are tied into new capacity coming on line over the next five years. So far, management has delivered on its capacity promises on, and in some instances, beyond, schedule.

Constellation is raising outlook for fiscal 2017

"The beer business is targeting net sales and operating income growth to be in the range of 14% to 17%. This includes the anticipated incremental benefit from the Ballast Point acquisition...We expect organic net sales and operating income growth to be in the 10% to 13% range. Our projections include 1% to 2% anticipated pricing benefit for our Mexican portfolio."
-- CFO David Klein

The company's mix of popular Mexican beer brands in the U.S., and a focus on growing craft beer companies such as Ballast Point Brewery after acquisition (similar to its wine purchases) is resulting in an annual growth rate in beer that far exceeds the rest of the industry.

According to some projections, the global beer market is projected to grow at a compounded annual growth rate, or CAGR, of 6% through 2020.The company's own recent CAGR is double this rate. As you can see from the second part of Klein's quote above, this success is pushing the overall business forward. Expansion of its beer business well in excess of the global industry is one of the reasons Constellation's stock has attracted so much interest since the organization started its beer acquisition spree in 2013.

It's not just about acquisition and capacity, but operating leverage as well

And for the third consecutive year, we plan to execute price increases for select products within the portfolio...we plan to continue to optimize COGS through global blend management initiatives, productivity improvements, and lower grape costs.
-- Sands

The statement above indicates that for all its acquisition activity, Constellation is still working on improving its operating leverage, by leaning into price increases where the market allows, improving productivity, and using its purchasing might to reduce inventory costs. Over the last two years, the company's operating margin has normalized to roughly 25%, which supports fairly robust profitability. Such focus provides great cash flow which shareholders currently applaud, but it's also a sort of insurance policy for a day when the company's organic growth and acquisitions cool. And in the wine and beer business, such periods are not only to be expected; they're inevitable.

The article 5 Points Constellation Brands' Management Wants to Emphasize originally appeared on Fool.com.

Asit Sharma has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.