EUR 850.00 For Business Accounts Only

Morningstar | Constellation Brands’ Shares Tumble on Weak Wine Sales in 3Q; Shares Look Attractive

Shares of narrow-moat Constellation Brands fell around 12% after the firm reported third-quarter results, which included sales growing 9% and operating margin expanding 100 basis points to 28%. We primarily attribute this reaction to weak performance in the firm’s wine business (roughly one third of sales), which posted a 3% decline in depletions. Management now expects full-year sales in this business to decline by a low-single-digit rate, versus a 2%-4% increase prior. Accordingly, it estimates comparable earnings per share will fall between $9.20 and $9.30, versus its prior outlook of $9.60 to $9.75 and our $9.63 estimate. We plan to trim our fiscal 2019 earnings per share estimate and near-term outlook for the firm’s wine business, which should reduce our $204 fair value estimate by a low-single-digit percentage. However, our longer-term outlook, which calls for around 6% sales growth and mid-30s operating margin on average, remains intact. Even with these revisions, we think shares offer a compelling entry point for investors.

Constellation’s wine performance was hampered by the sub-$11 price point, which approximates a third of volume in its wine portfolio. While our longer-term outlook for the wine segment has already been quite muted, at just low-single-digit growth, we remain constructive on opportunities within the high-end. Over the last several years, the firm has made several efforts to refocus its wine portfolio on more profitable fare, divesting its lower-margin Canadian wine business in late 2016 and rationalizing lower-margin, value-priced SKUs. Premiumization trends within the wine market should support momentum for Constellation’s higher-end wine brands; according to management, retail sales in the above $11 price point grew at a 13% compound rate between 2012 and 2017, versus 5% for the overall category. As evidence, higher-end brands like Kim Crawford and Meiomi have posted double-digit retail sales growth over the trailing 12 months.

Further, management now expects higher full-year interest expense (expected to dilute full-year earnings by around $0.25) resulting from the leverage it took on for its incremental $4 billion investment in Canopy Growth, which closed in November. We surmise that investors remain concerned about capital allocation given the premium paid for this deal, as well as the higher risk inherent to the cannabis category. As we detailed in August 2018, we concur that the price paid for the deal was excessive but appreciate Constellation’s efforts to be an early mover in the nascent recreational cannabis market in Canada. We posit that the firm will be able to leverage Canopy’s distribution relationships and research and development capabilities to expand into the cannabis beverage category, which could augment its alcoholic beverage portfolio, though we aren’t blind to the regulatory risks of this venture and the uncertainty around the path to decriminalization in the U.S.

Performance in the beer business (around 60% of sales) remained strong during the quarter, with depletions growth of 8%, driven by the Modelo and Corona brand families. We continue to appreciate the firm’s focus on innovation within these brands, as evidenced by the successful launches of Corona Premier and Familiar, which it has supported through sustained investments in marketing (amounting to 10% of sales year-to-date). From our vantage point, this spending will support Constellation’s brand intangible assets and entrenched retail relationships (which form the basis of our narrow moat rating), enabling the firm to gain distribution and expand its customer reach. As such, we expect this segment will average above 7% volume growth, with around 150 basis points of improvement in pricing, over the next five years.