STZ - Constellation Brands: Demand And Margin Concerns Drive A Selloff

Summary

• Constellation Brands disappointed the Street with weaker-than-expected beer depletions and lower margin guidance for FY'24 on persistent cost inflation.
• Given the intersection of pricing, cost inflation, and the need to support ongoing brand development and product launches, there could be further risk to FY'24 EPS estimates.
• Constellation continues to take share in the beer category and still has a meaningful long-term opportunity to gain further share through improved distribution.
• The near-term outlook is clouded by risks to depletion numbers and margins, but the shares do look attractively priced on a long-term basis.

There has long been above-average volatility at Constellation Brands ( STZ ) around quarterly earnings reports, and going into this fiscal third quarter report there were some elevated concerns about slowing volume growth. With weaker-than-expected depletions and worse cost guidance from management, Constellation's earnings/guidance report was disappointing, leading to sharp underperformance (around 800-900bp) relative to the S&P 500 and the consumer staples group.

While I had written about some risks going into this quarter a month ago , Constellation's performance was weaker than I'd expected. Still, I believe these are short-term issues that while not trivial, don't impair the long-term thesis for the company or stock. I still see Constellation as a share grower (with long-term revenue growth in mid-to-high single-digits) with meaningful untapped opportunities in improved retail and on-premise distribution. I do still have some concerns about FY'24 guidance (which I'll discuss), but I think this is a name well worth considering.

A Beat, Yes, But Not What The Street Wanted

Constellation did beat at both the top and bottom lines (revenue and earnings per share), but the nature/quality of the beats weren't what the Street was looking for, particularly in the context of weaker guidance. In particular, the weaker-than-expected depletion number for beer will keep discussions of the company's volume trends front-and-center in the bull/bear debate. Relative to my own expectations, depletions were meaningfully worse while margins were better.

Constellation reported 5% revenue growth that was closer to 6% on an organic basis and about 2% to 3% above expectations (different services report slightly different "consensus" expectations). Gross margin declined 150bp year over year and 30bp quarter over quarter to 51.4%, coming in a bit below expectations (10bp-30bp). Operating income fell almost 7% yoy, with margin down 390bp yoy and 160bp qoq; operating income missed expectations by about 1%, with margin missing by 130bp. At the bottom line, Constellation beat by $0.09/share (or $0.05/share relative to the average sell-side estimate at the time of my last article).

The beer business saw 8% top-line growth that was 4% better than expected. While pricing was healthy (up 5%), depletions rose 5.7%, missing the 7.3% sell-side target. Like many, I was surprised to see these depletions miss given still-strong Nielsen data, and it appears that untracked on-premises consumption was one of the drivers of this weakness.

Beer gross margin declined 240bp yoy and 130bp qoq to 52.3%, slightly beating expectations, while operating income declined 2%, with margin down 380bp yoy and 300bp qoq to 37.5% and slightly ahead of expectations (by about 10bp).

The wine and spirits business saw revenue decline 1% in organic terms (accounting for divestments), missing by 2%. Price rose about 13%, but volume declined almost 13%, including a 5.6% decline in depletion that was worse than the 1.4% decline expected by the Street; it's unclear to me to what extent the divestment (and mis-modeling that impact) drove downside.

Wine gross margin improved 70bp yoy, with operating income down 7%. Wine operating margin declined 60bp yoy but improved 550bp qoq to 24.8%, missing expectations by more than three points.

Guidance Creates Some Problems… And Further Revisions May Be On The Way

The softer beer depletion number was going to be an issue for sentiment coming out of this quarter no matter what, but management's subsequent guidance and commentary certainly didn't help.

Management lowered FY'23 expectations (with one quarter to go) by $0.30/share, with $0.15/share from higher interest expenses tied to the share consolidation program (expected by most), $0.10/share from the wine divestment, and $0.05/share from higher corporate expenses.

Management also guided to flat beer margins in FY'24 - around 38% versus an average Street estimate of closer to 39%, and below management's longer-term target of 39% to 40%. The company blamed high-single-digit inflation in ingredients and packaging, and this is something that has concerned me about a range of companies/sectors heading into calendar 2023 - despite the Fed's efforts to stamp out inflation, I do see risks of more persistent cost inflation in at least some areas. This is a driver well worth monitoring as other players like ABInBev ( BUD ), Boston Beer ( SAM ), Carlsberg ( CABGY ), Heineken ( HEINY ), and Molson Coors ( TAP ) report their earnings.

I'm also concerned that this may not be the only cut to FY'24 earnings. Management talked about pricing growth of 1% to 2% in FY'24, so I'm having some trouble seeing how beer margins stay flattish in the face of high single-digit cost inflation unless the company can cut back on SG&A items. Given that marketing/advertising spending is already on the low end and the company needs to continue to push for distribution growth, I'm not sure how that math works.

Depletion/Volume Remains A Near-Term Risk, While Distribution And Innovation Are Longer-Term Opportunities

Slowing volume/depletion growth at Constellation has been a talking point for some time now, and the depletion miss in the fiscal third quarter is going to keep that issue front-and-center in the minds of investors.

Management did indicate that pricing had an impact, particularly with some retailers raising prices on top of STZ's own pricing actions. There's some evidence that depletions can rebound as this eases (the California market saw a bounce back as price hikes eased), but a weaker economy in 2023 could still threaten premium beer consumption.

Weather was also implicated as a driver of weakness, and it's hard to know the extent to which that will impact consumption in the fourth quarter (recent weather in California has been nasty). I'm also concerned, though, about what I see as signs of weakness in the on-premises market - comparing Nielsen numbers to the depletion numbers and factoring in third-party data on restaurant volumes suggests a weaker on-premises market, and this too could be a risk factor throughout 2023.

On the positive side, and as I discussed in that December 2022 piece, Constellation still has positive drivers that can sustain share growth in the beer market. The company is still underweight in terms of U.S. distribution, and particularly with its premium Pacifico brand. There has been steady progress here over time, and I see no reason to expect this to stop. Constellation has also benefited from product innovation, and that should continue in fiscal 2024 with the launch of Modelo Oro and new Chelada products.

The Outlook

Constellation continues to grow well ahead of the beer category, with Nielsen data through mid-December showing 13% growth in the trailing 52-week period versus category growth of just over 2.2%. While the most recent data aren't as favorable, the trailing four-week spread of +10.1% for Constellation versus +4.7% for the category is still quite positive. Add in the opportunities to benefit from ongoing distribution growth and product innovation, and I don't think the 6%-ish long-term revenue growth rate that comes from my year-by-year modeling is out of line.

Margins are likely going to be lower over the next 12-24 months than I'd expected, and that's definitely a disappointment. It's going to take a few years to get back to 37%-plus EBITDA margins and 20%-plus free cash flow margins, but I do expect both to happen over time, and I still see long-term FCF margin potential in the mid-20%'s, driving FCF growth of around 10%.

Discounting my cash flow estimates back, I believe Constellation is priced for a long-term annualized total return of around 9% - a rather high prospective return for an alcoholic beverage company. Near-term valuation driven by margins and returns (ROIC, ROTA, et al.) is not as supportive, but I'm using a below-consensus operating margin assumption for FY'24 (31%) that weighs down my forward EBITDA multiple (15x) and drives a fair value around $220.

The Bottom Line

The near-term outlook is dicey for Constellation Brands. The Street definitely didn't like the negative surprise on beer depletions and a potential one-two punch of weaker demand and persistent cost inflation in calendar 2023 is likewise not conducive to a higher share price. The "but" is that I still see a meaningful runway for growth, driven by improved distribution, increased brand awareness, and volume-driving product launches. I can understand investors being cautious about jumping on this pullback given the ongoing risk to FY'24 estimates, but I do think the long-term return potential here is attractive.

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