BUD - Constellation Brands Still Gaining Share But Depletion Volume And Margins Are Still Near-Term Risks

2023-04-04 12:13:19 ET

Summary

• Constellation likely saw weaker depletions in March on adverse weather, and guidance for FY'24 depletions will be key to sentiment.
• I expect Constellation to offer healthy volume guidance for FY'24 (with beer revenue up 7%-plus), but 38%-plus operating margin could be too much to ask.
• Constellation's key brands continue to outperform the larger beer category, and with expanding distribution and product offerings, I believe the company will continue to see market share growth.
• Constellation looks undervalued on a longer-term basis, but investors should be alert to the risk of near-term volatility on depletion and margin guidance.

The last few months have been better for the shares of Constellation Brands (STZ), with the stock outperforming the consumer staples group (as represented by the Consumer Staples Select Sector SPDR Fund (XLP)) since my last update , but the stock has modestly underperformed over the last year, largely on concerns about slowing volume growth and margin pressures in the beer business.

I continue to believe that the short-term concerns about volumes and margins are obscuring a stronger long-term growth story. Constellation continues to outperform the beer category (in terms of Nielsen data), suggesting market share growth, and the company continues to be under-leveraged to markets outside of West/Southwest United States. As distribution expands and the company continues to work on brand/product innovation, I expect mid single-digit revenue growth and high single-digit FCF growth to drive high single-digit annualized total returns for investors.

Fiscal Q4 Results (And FY 2024 Guidance) Await…

Although Constellation beat by about $0.10/share in the fiscal third quarter, management's $0.30/share lower guidance for FY'23 and increased caution and nervousness around depletion trends led to a roughly $0.40 cut in analyst expectations for FY'23 after the last quarter. Since there has been a very mild downward drift in expectations for FQ4 earnings of about $0.04/share, despite generally positive trends in the quarter.

Depending upon the data source, the average sell-side earnings estimate for the fiscal fourth quarter is now around $1.81 to $1.91, with revenue expected to be down about 3%. Core beer revenue growth (depletions + price/mix) is expected to be up around 7% (on almost 7% shipment volume declines), or about 9% on a days-adjusted basis. Price is expected to be up around 3%.

Beer depletions are expected to be up around 4% (third-party reporting services show a range in average - or "consensus" - estimates of 3.8% to 4.3%), which should work out to around 5% to 5.5% on a days-adjusted basis. That's a further slowdown from the prior quarter, which already was the second-worst result in a decade of quarterly reports, though the multi-year comparable stacks are more favorable.

Overall operating income is expected to decline around 11%, with beer margin coming in around 33.5% and wine margin coming in close to 29%.

Looking at 2024 expectations, beer revenue is expected to grow over 6% in FY'24 (the average estimate is around 6.4% now), with beer operating income up 5% to 7% and operating margin around 38%.

Still Gaining Share, But Depletions Could Be Disrupted By Weather

Recent Nielsen data suggests that Constellation's portfolio of beer brands continues to gain share in a still-soft beer market. Sales grew 11% over the past 52 weeks through the end of March, with volume up more than 7% - well ahead of the 4% growth at Molson Coors (TAP), the roughly 2% growth at Anheuser-Busch InBev (BUD), the roughly 1% growth at Boston Beer (SAM), and the greater than 6% decline at Heineken (HEINY).

Shorter-term comparisons are likewise still favorable for Constellation. While volume was weak over the last month (sales up 3% on a 1.6% volume decline), sales were up 8% over the last 12 weeks, comfortably ahead of the 3% growth for the beer category (including roughly 2% growth for Molson Coors and AB-InBev).

Depletions had reaccelerated earlier this year, with management talking about 6%-plus growth in January and February when it presented at the Consumer Analyst Group of New York (or CAGNY) meeting in late February. Since then, though, the exceptionally unusual and adverse weather in California likely had a meaningful negative impact on momentum in depletions. With that, I think the Street is braced for a relatively unimpressive number for the fourth quarter (on a long-term historical basis), but I do think the stock will need more positive commentary on depletion growth in FY'24.

I do see valid growth drivers for that depletion growth. First, expanding distribution continues to be a meaningful long-term opportunity for Constellation. As I've written in prior articles, Constellation significantly lags rivals like AB-InBev, Heineken, Molson Coors, and so on when it comes to national distribution, more so with its Modelo and Pacifico brands than with Corona . With awareness-building ad campaigns, new product innovation, and a growing Hispanic population in states that haven't historically had large Hispanic populations, though, distribution is starting to improve.

Second, I expect further momentum from new product introductions. Constellation has launched Modelo Oro , a new light beer version of Modelo , nationally, and I expect this to become a strong product over time. Management also is expanding its Modelo Chelada lineup, and with a recent trial win against AB-InBev over Constellation's rights to innovate in "near-beer" categories (specifically related to Corona Hard Seltzer and Modelo Ranch Water ), I expect further innovation down the road.

The Outlook

I do still have some near-term concerns, and a lot of that is concentrated in margins. I believe depletion numbers can be misleading in the short term, so even if depletion guidance for FY'24 isn't perfect, so long as market share figures continue to move in the right direction, I'm not too concerned. With margin, though, I see limited pricing leverage (Constellation already prices much of its beer portfolio at a premium), and I see sticky input costs threatening 38%+ beer margin in FY'24.

Longer term, I'm still expecting Constellation to grow revenue at a 6%-plus rate, with growth coming not only from underlying growth in the Hispanic market, but also expanding share among non-Hispanic customers as awareness and distribution improve. I do also expect beer margin to improve over the next three to five years (toward 39%, I think 40% could be a bit too ambitious though it's still part of management's target), and I think wine/spirits margin could offer some upside as management has been "premium-izing" that portfolio. At the bottom line, I think free cash flow margins can eventually reach the mid-20%'s, helping to drive nearly 10% long-term annualized FCF growth.

Discounted back, those free cash flows suggest long-term annualized total return potential of more than 8%, while a shorter-term approach based on margins and returns (ROIC, etc.) supports a 15.5x forward EBITDA multiple and a fair value over $240.

The Bottom Line

I think I understand the bear argument that Constellation's run of market outgrowth is petering out and that growth is more likely to retreat back toward the lackluster long-term trend line for the beer category. I don't agree with it, though, as I think there are still gains to be seen from expanded national distribution and further market share growth. Should depletions reaccelerate (or at least stabilize closer to 6%) and investors get more comfortable with the margin outlook, I believe these shares can still outperform from here.

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