Constellation Brands, Inc. F3Q09 (Qtr End 11/30/08) Earnings Call Transcript

| About: Constellation Brands, (STZ)

Constellation Brands, Inc. (NYSE:STZ)

F3Q09 Earnings Call

January 7, 2009 10:00 am ET


Patty Yahn-Urlaub - Vice President of Investor Relations

Robert S. Sands - President, Chief Executive Officer

Robert P. Ryder - Chief Financial Officer


Kaumil Gajrawala - UBS

Judy Hong - Goldman Sachs

Reza Vahabzadeh - Barclays Capital

Lauren Torres - HSBC

Christine Farkas - Banc of America Securities

Carla Casella - JP Morgan.

Timothy Ramey - D. A. Davidson & Co.

Mark Swartzberg - Stifel Nicolaus & Company, Inc.


My name is Julianne and I will be your conference operator today. At this time I would like to welcome everyone to the FY 2009 Q3 Constellation Brands earnings conference call. (Operator Instructions) It is now my pleasure to turn the floor over to Patty Yahn-Urlaub, Vice President of Investor Relations.

Patty Yahn-Urlaub

Welcome to Constellation's third quarter fiscal 2009 conference call. I'm here this morning with Rob Sands, our President and Chief Executive Officer, and Bob Ryder, our Chief Financial Officer.

By now you should have had an opportunity to read our news release, which has also been furnished to the SEC. This conference call is intended to complement the release.

During the call we will discuss financial information on a GAAP comparable-, organic- and constant currency-basis. Reconciliations between the most directly comparable GAAP measure and these and other non-GAAP financial measures are included in the news release or otherwise available on the company's at under the Investor section. These reconciliations include explanations as to why management uses the non-GAAP financial measures and why management believes they are useful to investors. Discussions will generally focus on comparable financial results excluding acquisition-related costs, restructuring and related charges, and unusual items. We will also discuss organic net sales information, which is defined in the news release, and constant currency net sales information, which excludes the impact of year-over-year currency exchange rate fluctuations.

Please be aware that we may make forward-looking statements during this call. While those statements represent our best estimates and expectations, actual results could differ materially from our estimates and expectations. For a detailed list of risk factors that may affect the company's estimates, please refer to the news release and Constellation's SEC filings.

Thanks, and now I'd like to turn the call over to Rob.

Robert S. Sands

Good morning and Happy New Year to everybody. I hope everybody had a great holiday season and perhaps the opportunity to enjoy some of our fine products. Well, welcome to our discussion of Constellation’s third quarter fiscal 2009 sales and earnings results.

I am pleased to report that our third quarter marks the continuation of the momentum we gained in the first half of our fiscal year towards achieving our goals.

For the first three quarters of fiscal 2009 we generated strong free cash flow, reduced our debt, significantly improved margins, and enhanced our ROIC. And we are tightening our EPS guidance range now that we have only one quarter remaining in our fiscal year. Although we continue to meet our earnings expectations, the economic environment remains extremely challenging and unpredictable.

I would like to take a minute to discuss how are we managing the company in this environment. The following are some of the key strategies and actions we are taking to preserve the long-term health of the business:

First, we have taken a leadership role in taking prices with this key to managing cash, including taking all opportunities to optimize operating cash flow through working capital initiatives that focus on inventories, accounts receivable, and accounts payable.

Second, we are improving our capital structure through rapidly deleveraging as we use the combination of strong operating cash flow generation and proceeds from the divestiture of non-core assets to pay down debt and optimize our portfolio. And I am especially pleased that we have been able to prepay a portion of our debt obligation for the next year, the details of which Bob will review in a few minutes. This continued deleveraging of our debt portfolio is our first priority for free cash flow and is a prudent strategy, given this challenging economic environment.

Third, we are streamlining our organization through efforts such as the right-sizing of our Australian footprint to bring overhead in line with volume expectations. We have also started to reduce our European overhead structure to better reflect the realities of that market.

Last, in addition to optimizing pricing, we are reducing costs in supply chain initiatives and tightening controls on SG&A spending to continue to leverage sales growth and to higher EPS growth.

Collectively, these actions are being taken during the time of increasing financial market volatility and ongoing competitive challenges in our key geographies, a situation we are monitoring closely to ensure that we continue taking appropriate and timely actions in response to market place changes.

Now I would like to focus on our operational business results for the third quarter. Excluding the impact of foreign currency, our consolidated net sales in the quarter were a bit below our expectations, primarily as a result of the adverse economic conditions we are facing around the world.

Despite these challenges, we continue to execute our strategy by pruning our portfolio via SKU reductions and taking selective pricing actions to offset duty and cost increases. These efforts help us to protect profit margins, free cash flow, and ROIC, which ends the appropriate trade off in this environment.

The good news is the consumers tend to purchase well-known trusted brands that represent good value during these challenging economic times. As you know, we offer an extensive selection of these kinds of well-established brands at varying price points that appeal to consumers.

Looking at our U.S. wine business, overall we continued to improve the EBIT of the U.S. wine business as a result of the favorable profit mix generated from the acquisition of higher-profit premium brands, the divestiture of lower-margin value brands, and the resulting synergies generated by this ongoing, strategic portfolio transformation.

However, as I indicated earlier, our sales are a bit below our expectations for a number of reasons. We continue to experience a slight slowing of the U.S. wine category’s market growth and category trading activity has slowed a bit. As you know, we have increased prices across the majority of our wine portfolio in the U.S. in order to enhance financial returns for the business. However, these pricing actions have unfavorably impacted volumes in the short term.

Despite the slowing market growth I’ve just mentioned, according to recent 12-week IRI data the overall U.S. wine market, including the premium segment, remains healthy at mid-single digit growth rates. And many of our premium brands are exceeding this market growth trend, including Woodbridge, Nobilo, Estacsia, Toasted Head, Simi, Kim Crawford, and Wild Horse, just to name a few, all of which posted strong dollar growth during the latest 12-week IRI reporting period.

As a reminder, the sales growth trajectory of our U.S. wine portfolio has also been impacted by the ongoing brand and SKU rationalization currently underway for our value wine portfolio, which is expected to negatively impact the growth rate of the portfolio by more than 2% in the fiscal year 2009, as it represents more than 25% of our U.S. wine SKUs. The massive majority of this initiative will be completed as we head into fiscal 2010.

However, we may proactively discontinue additional, selected SKUs as we continue our efforts to focus on growing those products that generate ROIC enhancing growth and are incremental to our returns. Overall, we have been able to achieve significant operating leverage from EBIT growth despite a reduction in volume.

We expect our sales growth for the U.S. wine business to return to levels that are more consistent with market growth as we lap price increases, which we expect to incur in the next few months.

From an international perspective, our Canadian wine business posted strong results for the third quarter, primarily reflecting sales growth from our premium portfolio lead by brands such as Jackson-Triggs, Sawmill Creeks, Inniskillin, and Naked Grape.

Our European sales are less than our expectations, driven by extreme market conditions, including the worsening economic climate in the U.K. and mainland Europe, price wars amongst U.K. off-premise retailers, and planned SKU reductions. In addition, unanticipated duty increases were recently implemented by the U.K. government in order to compliment their economic stimulus package. We immediately implemented additional price action to cover this duty increase.

We are managing the situation in the U.K. by working to align our costs with our sales expectations, including the recently announced elimination of 50 positions. We intend to continue reducing our investment in the U.K. in the form of capital and operational costs as appropriate.

In the short term, we are reviewing our strategy and assessing the alternatives for dealing with the challenging situation which continues to impact this business. We plan to stay the course in the growing U.K. market place and will continue to focus on increasing operating efficiencies and improving product and channel mix.

We are currently in the process of bringing our new state-of-the-art distribution and bottling facility online in the United Kingdom. We expect to fully leverage the benefits of this investment, which will reduce the cost of production and distribution and significantly increase capacity and efficiencies and result in an improved environmental footprint.

In Australia we have already taken actions to align the business with market place reality. This market place remains healthy and we are continuing our efforts to further premiumize our product portfolio.

I would like to reiterate that our U.K. and Australia markets combined currently represent less than 10% of our total company EBIT and should therefore not cause a significant amount of operational volatility.

During the third quarter the spirits segment posted a 5% organic sales increase, driven primarily by strong double-digit top-line and market growth for Svedka vodka, which continues to gain momentum in the form of increased distribution, national accounts penetration, and Clayburk SKU expansion within the product portfolio. In addition, Ridgemont Reserve 1792 bourbon, Black Velvet Reserve, Cara Bella, the [Viamari] family of products also delivered solid sales performance.

Moving to the Crown Imports joint venture, the Crown portfolio generated 1% net sales growth in the third quarter. Improved sales for Corona Light, Modelo Especial, Negra Modelo, and Pacifico products were offset by weaker results for Corona Extra, which continued to be impacted by the adverse economic conditions in the larger volume Corona markets and unfavorable trends in the on-premise segment where Corona products are more heavily weighted versus the industry.

We are beginning to benefit from narrowing price gaps versus competitors as they increase their prices to cover rising interest costs. Crown continues to explore new product introductions and packaging options across the portfolio. Modelo Especial and Negra Modelo Draft continue to be successful in test markets.

During the third quarter operating income from the Crown Joint Venture remained unchanged versus last year’s third quarter as they have closely managed marketing and SG&A spend during these challenging economic times.

In closing, we are working diligently to manage through an increasingly tough economic environment worldwide. Despite the challenges, beverage alcohol remains a growing, healthy consumer category and I am pleased with our ability to continue to deliver solid results and execute our strategy.

And now I would like to turn the call over to Bob Ryder for a financial discussion of our third quarter business results.

Robert P. Ryder

I think the third quarter reflects good performance in relatively challenging times. Despite some softness in our branded wine net sales performance, we were able to expand our profit margin and grow our comparable basis EBIT, EPS, and free cash flow.

The higher margins generated by the pricing actions and portfolio transition in our U.S. wine business are evident in our income statement and help offset the challenging environment we face outside North America.

Our comparable basis for diluted EPS for the quarter came in at $0.60 versus $0.50 per share last year and these are targeted former EPS goal to $1.68 through $1.72.

We generated $235.0 million in free cash flow through Q3 and we remain on track to reach our $360.0 million to $390.0 million free cash flow goal for fiscal 2009.

The combination of free cash flow generation and asset sales has helped us decrease our total debt level by more than $475.0 million since the end of fiscal 2008 and increase our cash position more than $160.0 million. This has driven a significant reduction to our leverage and provides us with ample liquidity as we enter Q4 and fiscal 2010.

Now let’s look at our Q3 fiscal 2009 P&L performance and my comments will focus on comparable basis financial results.

Let’s look at net sales. As you can see from our news release on page 13, our consolidated reported net sales decreased 6%, primarily due to the impact of year-over-year currency exchange rate fluctuation. If anything, adding Clos du Bois sales was essentially offset by the divestitures of Almaden, Inglenook, and certain Pacific Northwest wine brands and in certain spirit contract production service business.

On the organic constant currency basis, which excludes the impact of acquisitions, divestitures, and foreign exchange rate changes, net sales increased 1%.

My commentary for the following net sales comparisons will be on a constant currency basis.

Our worldwide branded wine organic net sales decreased 2%. Organic branded wine net sales for North America, which appears on page 12 of the release, increased 2%. Branded wine organic net sales for Europe and Australia/New Zealand decreased 11% and 2% respectively.

As Rob mentioned, our growth has been impacted by a challenging worldwide economic environment, our price increases, and planned SKU reductions. We believe the price increases and SKU reductions were the appropriate actions to take and they are contributing to some pretty dramatic worldwide wine margin and ROIC enhancement.

Our North American business remains very healthy and they are a leader in a profitable and growing category which holds up relatively well in most economic conditions.

The international business, primarily in the U.K., continues to be very challenging. We are undergoing various initiatives in the U.K. and Australia to increase our returns in these markets.

Turning our attention to spirits, organic net sales increased 5%, led by a 60% growth in Svedka vodka.

Now let’s look at our profits on a comparable basis using information on page 14 of the release. For the quarter, our consolidated gross margin was 40%, up an impressive 3.7%. This reflects the benefits of implementing price increases across our markets and favorable product mix shifts from adding higher margin brands, like Clos du Bois and Wild Horse, and divesting the lower margin Almaden Inglenook brand.

These actions reflect the benefit of our ongoing premiumization strategy and should drive long-term improvement to Constellation’s profit profile.

Our consolidated SG&A for the quarter was 18.8% of net sales compared to 18% a year ago. Although actual SG&A expense decreased versus last year, due to the translation of foreign expenses, this FX impact was somewhat offset by higher marketing and stock compensation costs. These changes, combined with the negative impact of FX rates on sales drove the increase in SG&A as a percent of sales.

Consolidated operating income increased 9% to $219.0 million and our operating margin increased a healthy 2.9% to 21.2%.

I would now like to turn to our segment operating income results on page 11 of the release which will provide highlights of this theme.

Wine segment operating income increased $20.0 million to $222.0 million. Profits benefited from pricing and targeted mix shift in the U.S. organic brands and the addition of Clos du Bois and Wild Horse, somewhat offset by the U.S. wine divestitures and U.K. performance.

For the spirit segment, operating income decreased $3.0 million, primarily due to higher G&A costs.

For the quarter, corporate number expenses totaled $22.0 million compared with $23.0 million for the prior year.

Equity investment on the Crown Imports totaled $62.0 million which was even with the prior year. For the third quarter, Crown generated net sales of $555.0 million, an increase of 1% and operating income of $124.0 million, or flat with last year.

Consolidated equity investment earnings totaled $76.0 million versus $75.0 million last year. Equity earnings for the quarter are comprised of $62.0 million from Crown with the remainder generated primarily from our Opus One Joint Venture.

Interest expense for the quarter was $78.0 million, down 5% versus last year. The decrease in interest primarily reflects a decrease in our average interest rate during Q3 versus the prior year quarter, and LIBOR decrease for our variable rate debt.

Now let’s take a look at our debt and cash. At the end of November our debt totaled $4.8 billion, which represents a $476.0 million decrease from our debt level at the end of 2008. During the same period our cash position increased $161.0 million to $181.0 million. The changes in debt and cash were primarily driven by strong free cash flow generation and proceeds from asset dispositions.

At the end of the quarter we had approximately $2.2 billion in bank debt under our senior credit facility and $2.6 billion of fixed term and other debt. Our average interest rate for the third quarter was around 6.5%. We had $868.0 million of revolving credit available under our senior facility at the end of November.

In December we prepaid $195.0 million in term loans due in calendar 2009 under our senior credit facility. This represented our tranche A term loan payments that would have come due in March, June, and September 2009.

Factoring in this activity, we have only $79.0 million of tranche loans due in December 2009. In addition, $155.0 million of sterling notes are due in November 2009. We currently expect that both of these debt requirements will be met through next year’s free cash flow generation.

As you can see, we are deleveraging at a rapid pace as our debt to comparable basis EBIT ratio at the end of November was 4.5 x versus the 5.3 x level at the end of February. This reflects our [inaudible] improvement and debt reduction. If you factor in the $195.0 million in debt prepayment that I just mentioned, the ratio decreased to 4.3 x and gets us to our low 4.0 x target for the year.

Our comparable basis tax rate came in at 39% compared to 37% last year, as a higher percentage of our earnings are coming from North America. The higher rate was expected and already factored into our full year tax rate estimate as we continue to project our full year comparable basis tax rate to proximate 37%.

Our weighted average diluted shares for the quarter totaled 220.0 million compared to 219.0 million last year.

Due to the many factors just mentioned, diluted EPS was $0.60 a share versus $0.55 last year.

Now let’s turn to our cash flow on page 10 of news release. For purposes of this discussion free cash flow is defined as net cash provided by operating activity less capital.

For the first nine months of fiscal 2009 we generated free cash flow of $235.0 million versus $173.0 million in the prior year. The improvement in net cash from operating activities reflects the benefit of approximately $85.0 million in pre-tax proceeds related to the favorable settlement of certain foreign currency hedges, which we announced in early December.

As we continue to refine certain international businesses we have been reducing our foreign exchange exposure by adjusting corporate parent loans for operating companies around the world. We accelerated these activities by narrowing to take advantage of the in-the-money hedges driven by the sudden strength of the U.S. dollar.

The tax payment associated with these transactions are expected to occur in Q4 and we expect to realize approximately $50.0 million in after-tax proceeds for this activity this fiscal year.

Operating cash flow has also been impacted by higher inventory, reflecting an increase in our Southern Hemisphere harvest intake.

Additional capex for the first three quarters of fiscal 2009 totaled $96.0 million compared to $80.0 million for the same period last year.

As mentioned earlier, for fiscal 2009 we are targeting free cash flow to be in the range of $360.0 million to $390.0 million. This includes capex in the range of $150.0 million to $170.0 million.

Moving to our P&L outlook for fiscal year 2009, given the challenging economic environment impact in our key markets, we are adjusting our sales expectations for fiscal 2009. We expect to continue mitigating this impact by taking actions to reduce operating and borrowing costs. As a result, we are tightening our comparable basis for diluted EPS range to $1.68 to $1.72 from our previous estimate of $1.68 to $1.76.

As reflected in the outlook section of the press release, we now expect reported net sales to decrease in the low- to mid-single digits, versus our previous mid-single digit estimate.

For organic net sales we expect an increase of mid-single digits versus our previous mid-to high-single digit estimate.

These estimates include the benefit of lapping the distributor inventory reduction initiative completed in the first half of fiscal 2008.

Due to some anticipated favorability in average debt balances, interest expense is now expected to be in the range of $315.0 million to $320.0 million versus our previous guidance of $325.0 million to $335.0 million. This improvement, combined with cost containment efforts, helps offset the impact of lower net sales growth.

We are now assuming the weighted average diluted shares will proximate 220.0 million.

Our comparable basis guidance excludes acquisition-related integration costs, restructuring charges and unusual items, which are detailed on page 17 of the news release.

While favorable settlement of certain foreign currency hedges that I discussed earlier did not have an impact on income before taxes, in the quarter we recognized $0.15 of diluted EPS impact associated with income tax expense related to these transactions. This amount has been excluded from comparable earnings. We anticipate an additional $0.03 diluted EPS impact when income tax expense related to this activity to be recognized in Q4.

The remaining charges recorded in the third quarter were primarily related to previously announced restructuring and business [inaudible].

Before we take your questions, I would like you to know that given the challenging environment, I am pleased with our results and I believe our actions and results continue to demonstrate our overall focus on improving our sales mix, increasing operating efficiencies, and implementing pricing to enhance overall margins and profitability. Our Q3 operating margin has improved 2.9%. Generally strong free cash flow as we target $360.0 million to $390.0 million for fiscal 2009 and paying down debt will rapidly reduce our debt to comparable basis EBIT ratio to 4.5 x.

With that, we are happy to take your questions.

Question-and-Answer Session


(Operator Instructions) Your first question comes from Kaumil Gajrawala - UBS.

Kaumil Gajrawala – UBS

Just listening to the SKU rationalization, do you feel that you have identified all the SKUs you will be discontinuing or are there more studies ahead of us and potentially a further cut in your brands and packages?

Robert S. Sands

As we discussed before, we are looking at three detailed, sort of gross margins are not alike SKU by SKU. That process continues and actually we will continue to that. So I would think we are going to continue to scale back on SKUs which can’t cover their inventory investment or just don’t make money for us. We want our sales guys focused on our most profitable products.

Kaumil Gajrawala – UBS

As you think about your portfolio long term is there an overall margin you’re aiming for, after you are complete with this process, specific just to the wine business?

Robert S. Sands

No, I don’t think we are that far along in the process to say where we want our overall profit margins to be. I would say that is an ongoing effort.


Your next question comes from Judy Hong - Goldman Sachs.

Judy Hong - Goldman Sachs

If you can just give us a little bit more color in terms of consumer behavior across different price segments for all of your portfolio.

Robert S. Sands

You know, if you’re really talking about market conditions, I think starting in the United States, market conditions remain pretty healthy as measured by consumer take-away in our mid-single digit value growth for the wine business.

The spirit business has probably been impacted to the greatest extent with growth getting near flattish. But that hasn’t affected us particularly because we’ve got some very hot brands and they’re just on fire.

The beer business has actually accelerated in general during the economic downturn, as you are probably aware, but driven I would say by the domestic premiums and the next tier up, which is in that market place.

If you look around the world, you are seeing somewhat similar trends.

The U.K. has slowed down, I would say, to the greatest extent in terms of consumer take-away, on wines, which is really all we track in the U.K. and has gotten much closer to flattish in that market place.

There is not a lot of data that has been published, just in the last year or so, on the holiday season. It’s probably on the top of everybody’s mind how was the holiday season. I would characterize it as is follows:

In the U.S., in particular for beer, it wasn’t necessarily a stellar holiday season, but a lot of the IRI data that has been quoted is through 12/28 and whereas last year it was through 12/30. It does not include the last few days of selling prior to New Years. And one of the things that characterized this holiday season is consumers definitely waited until the last minute to do their shopping. So on beer I think that in the end it will probably wrap up to not be a fantastic holiday season but on the other hand I don’t think that it is going to wrap up to be as bad as the sort of currently published IRI data suggests.

On wine, the anecdote right now, and I say anecdote because again we’ve got some IRI data through 12/28 that still lacks the last few days which are critical to understanding the holiday season, but anecdotally from our wholesalers and so forth, it appears that the wine consumer take-away was pretty good over the holiday season. So when everything is reconciled, we are hopeful that it is going to look pretty good.

That’s pretty much where things stand as it relates to our principal product categories and markets.

Judy Hong - Goldman Sachs

And then, if we look at your branded wine organic growth in North America in the third quarter of 2%, the way we should think about that number is, if you adjust for the SKU rationalization, you get to about 4% and that compares to about a mid-single digit growth for the category and the difference, maybe, that you’re taking more pricing for that [inaudible] brand a little bit in the near term, is that a fair assessment?

Robert S. Sands

I would say that that is a fair assessment. I wouldn’t say that our sales results were optimal, but clearly at the lower end of our range of expectations, or slightly below. I don’t think that they are bad, given the market place and the economic conditions.

And more importantly, as you pointed out, given our pricing, we have led in pricing in every market that we’re in in the world. And in this economic environment I would be the first to say that our pricing actions have probably impacted volume to a slightly greater degree than we anticipated and that’s why we said that our sales were being affected by the economic environment.

That being said, we are 100% positive that the pricing actions that were taken are the right thing to be doing. Worrying about a point of volume growth, or two points of volume growth, in this environment, in certainly our opinion, is not where our focus should be. Our focus is on improving margins, generating free cash flow, paying debt, and improving our ROIC. And we think that that is the key and prudent course of action in managing the business in difficult economic times.

So yes, our sales results are being affected by our pricing to a greater degree than we anticipated, whereas the lower end is slightly below, actually, our previous range of expectations on sales growth. We have modified that to low-single digits. We are taking into account, or adding back, the distributor inventory reduction last year. But we don’t see this as being a material issue for the company, given the economic environment.


Your next question comes from Reza Vahabzadeh - Barclays Capital.

Reza Vahabzadeh - Barclays Capital

You talked about the price mix improvement driving your earnings. What was the blended average price mix that you may have realized? Is there such a data point that you could come up with?

Robert S. Sands

I would say there are a couple of things going on. I would say a shift in sales and profits from Europe where the fundamental markets are lower to the U.S. helps increase the total portfolio gross profit margin, but also if you focus on within North America, if you say that our margins went up close to 400 basis points, probably 60% of that is price mix and the other 40% is the Almaden, Inglenook, Clos du Bois impact.

Reza Vahabzadeh - Barclays Capital

You’ve been paying down debt and obviously reducing leverage, creating more financial flexibility the last 6 to 18 months. Is there more to do on that front for the next quarter or are you close to where you want to be from a leverage standpoint?

Robert P. Ryder

We anticipate continuing paying down debt. The fourth quarter is generally our largest cash flow quarter and we anticipate using that free cash flow to pay down additional debt.

We also, as we’ve done this year, we will continue to look at our portfolio to see if there are other assets that we should be monetizing. Just to look at it from a shareholder value perspective, if they can’t cover our weighted average cost of capital, we should be liquidating them and paying down debt.

It’s an ongoing strategy but I would say overall we would be much happier with a EBITDA leverage ratio around the 3.0 x to 3.5 x.

On an ongoing basis, if a great acquisition opportunity popped up, of which there are none right now, we want to have powder dry in order to drive after those.

Reza Vahabzadeh - Barclays Capital

And speaking of that, do you see any potential M&A activity occurring in the alcoholic beverage space that would be of interest to you in the foreseeable future?

Robert S. Sands

It’s hard to comment on that because these things come in fits and spurts. Clearly, as I’ve said in the past, right now our focus is on the things that I’ve said that we’re focusing on, i.e. cash flow generation, debt pay down. We have consistently said that we are not categorically saying that we won’t do acquisitions, but the environment hasn’t been particularly conducive to that at the current time and we made some great acquisition, we’ve got a lot to do and continue to do with the company in our portfolio. So we don’t feel compelled to have to go out and do anything.

And as Bob said, relative to dispositions, we’re going to continue to look at the portfolio and keep working, making adjustments to favor our higher growth, higher ROIC businesses, and to eliminate businesses that don’t cover their cost of capital and are a drag on our ROIC growth.

Hence, you are seeing very good progress in ROIC growth in the companies. We are fundamentalists into what drives shareholder value. And we believe what, on a fundamental basis, what drives shareholder value is in driving ROIC in excess of the weighted average cost of capital. So that’s what we are going to continue to strive to achieve as a corporation. That is the key in the end and is the most fundamental thing to improve shareholder value.


Your next question comes from Lauren Torres - HSBC.

Lauren Torres - HSBC

In the quarter there was a notable decline in your cost of goods as a percentage of sales. And I assume much of this is attributable to SKU reductions and your mix changes. But you also talked about supply chain improvement. I was just hoping you could give us a sense of how much of this came from these changes in your portfolio versus your ability to manage costs better going forward?

Robert P. Ryder

I would say that the wide majority of that is coming through pricing and eliminating unprofitable or lower gross profit margin SKUs and the mix shift. Sort of the organic mix shift that is happening generally in the wine category as people trade up to higher priced wines. The higher priced wines generally have the higher gross profit margin. And the relatively big shift from taking on Clos du Bois, which is at the higher end of wine gross profit margins and selling Almaden and Inglenook, which was on the lower end of wine gross profit margins.

Lauren Torres - HSBC

What we saw in this quarter, as a percentage of sales, that’s kind of low because of the change and that should get higher or something back to where we were before or stay at that level?

Robert P. Ryder

If you look at year-to-date gross profit margins, it is also much improved. I think you will be seeing, certainly the Almaden, Inglenook, Clos du bois transactions, that’s a permanent increase to our gross profit margin as a company.

And that was the purpose of it. Number one, the category that Clos du Bois and Wild Horse participate in, that category of wine in the U.S. is growing faster than the category, the price points, of Almaden and Inglenook. So it helped our sales growth profile and it helped our gross profit profile because the Clos du Bois has a much higher gross profit margin than Almaden. And that is a permanent improvement in the U.S.’s gross profit.

Lauren Torres - HSBC

Rob, on the last call you talked about grape supply coming in and prices going up. I was curious if there was any update there with respect to grape prices going forward.

Robert S. Sands

No. Obviously we are way away from the next U.S. harvest. We are getting closer to the Australian harvest, which is a big piece of our grape costs, which will start occurring early spring. And we expect grape prices in the Australian harvest to go down dramatically. So we would be looking at double-digit declines in grape pricing in the Australian harvest.

Again, it hasn’t happened yet. Harvests are very unpredictable. No one can tell you what any harvest is actually going to be much before the harvest has actually happened, but the belief is that the Australian grape harvest will result in significantly reduced grape costs.

Now, that being said, remember that the grapes go into making the wine, the wine goes into inventory, and therefore the lower grape costs are delayed in terms of when they flow through the P&L. You get a small benefit in the current year and then you start seeing the benefits in the subsequent years.

So, Australian harvest, lower cost. California harvest, no one knows what the California harvest is going to look like in next August, September, October. But I would say most people believe that the California harvest is going to remain in a fairly balanced state to slightly favoring under-supply, which might suggest that there should be some cost inflation in grapes out of California, especially on certain varieties that are tending to be in shorter supply.

So if I were going to predict anything on the California harvest, as I said, balance to slight under-supply therefore some cost increases and of course, that’s what we’re sort of planning on. We don’t see it as a problem. On the other hand, the pricing environments align, we’re certainly leading price increases, others are taking price increases, so moving to slight under-supply is not a bad thing.


Your next question comes from Christine Farkas - Banc of America Securities.

Christine Farkas - Banc of America Securities

Bob, back to costs, but moving to the operating expense line, you talked about higher marketing spend on a dollar-for-dollar basis, yet you talked about lower investments in the U.K. and I imagine Australia. So where is the spend growing and in what form? Is it largely spirits? Is it feet on the street? How should we look at that higher marketing spend by segment?

Robert P. Ryder

Actually the U.K., year-over-year, did have a higher marketing spend in this quarter. The statement that I made that we are looking to reduce costs in the U.K. is more around we recently took 50 heads out of the business. So it’s more me looking at that. But a big piece of the marketing increase for the quarter was in the U.K. Basically in the U.K. and the U.S. and a little bit in the spirits business.

Christine Farkas - Banc of America Securities

And in terms of marketing spend going forward or allocating that, because your pricing is up so we’re not talking about promotions, how should we look at that marketing spend? Again, is it feet on the street or direct sales? Is it increase in advertising on particular brands? How should we look at that, generally?

Robert S. Sands

It’s marketing and therefore it’s not sales and therefore it’s non-price related. So it is various forms of marketing activity, on-premise mostly.

Christine Farkas - Banc of America Securities

And just moving to Corona, you talked about the trends there. Perhaps you can talk about geographic movements. Are there any surprises in terms of what markets may have recovered, may not have recovered by now?

Robert S. Sands

Recovered in terms of what?

Christine Farkas - Banc of America Securities

Just with price gaps potentially narrowing, lapping price increases in prior years. There could have been some recovery in the Corona brand in some geographic pockets. I’m just curious if you have any commentary as to what’s slower than expected or what’s better than expected.

Robert S. Sands

First of all, the data that is flowing in, up to the very most recent period, which I told you is somewhat problematic because there are some comparison issues, have shown in general I would say some constant improvement in the Crown business. You are talking beer, right?

Christine Farkas - Banc of America Securities

That’s right.

Robert S. Sands

There is some improvement in the business. Again, on a general basis, our competitors are all taking pricing. We took our pricing going on a couple of years ago and we really don’t have any need to take any further pricing at the current track. We are seeing the price gap, pretty much all over the country, declining and narrowing.

We have a fairly aggressive program that we are putting in place in the beer business around the country and therefore I would say that as we move into 2009 the competitive environment for the Crown portfolio is going to improve very significantly. So we’re optimistic in terms of seeing some rebound and regains of momentum in that portfolio in 2009.

And as I said, the economic conditions aside, the competitive conditions should be very favorable for that. Now the economy, that’s another story and it’s not something that’s in our control so we’re focusing on what is in our control and that’s monitoring the market very closely, monitoring those price gaps, execution in the market place, and executing, as I said, new and aggressive promotional programs that should drive results.


Your next question comes from Carla Casella - JP Morgan.

Carla Casella - JP Morgan

I missed one comment you made on the revolver availability, and did you also give the outstanding amount under the revolver?

Robert P. Ryder

There’s no outstanding amount under the revolver because we have a net cash position at the end of the quarter. So we paid the entire revolver down.

Carla Casella - JP Morgan

And availability, that is the full $900.0 million less how much you now [inaudible]?

Robert P. Ryder

Yes, it’s like $870.0 million available.

Carla Casella - JP Morgan

And then, I’m wondering if you could comment on any potential acquisition opportunities. Is it completely off the table for now or is there anything in the spirit side that you would look at, given Fortune’s comments that they may divest some more brands?

Robert S. Sands

What I said was our focus is not on acquisitions but we are not categorically rejecting it. On the other hand, if acquisitions come up on an opportunistic basis, there is really nothing to comment on relative to acquisitions unless and until something develops to state where we would be, when we would normally comment on it.

So not a focus for the company at the current time. On the other hand, we’re not categorically rejecting the idea. But the current environment hasn’t been one that necessarily favors M&A. And in the past we’ve been very aggressive in M&A so we’re focused on integrating the acquisitions that we made a year plus ago and bringing home the bacon on those deals. Clos du Bois, Wild Horse, those are the things that right now we’re focused on.

Carla Casella - JP Morgan

If you look across your different geographies, can you give us a sense of what percentage of the business is on-premise versus off-premise? How much that varies market by market?

Robert S. Sands

It depends on the category and this and that. U.S., talking wine, it’s probably about 70% off premise, 30% on-premise. Beer is a higher percentage than the 30%. If you go to the U.K. I would say it’s still around that 70/30, maybe a little less. Again, talking wine, which is all that matters really. And much beyond that you’re starting to talk about pretty small markets where there’s not much to talk about.

And our spirits business is a very small percentage of our business overall, so the spirits business in general is, while we’re in the more popular end, being in the more mid-premium to value end of the business, we would be skewed more off-premise than the normal spirits business would be. So the majority would be off-premise for us.

Carla Casella - JP Morgan

On interest rates, have you locked in on your term loans any of your LIBOR rates?

Robert P. Ryder

We have interest rates locked in place, about $800.0 million of our bank debt is floating and we can lock that in on a 30/60/90 day LIBOR basis. We should be benefiting from that as we go forward. But again, it’s a pretty small piece of our debt portfolio.


Your next question comes from Timothy Ramey - D. A. Davidson & Co.

Timothy Ramey - D. A. Davidson & Co.

You made a big push in Walmart and the clubs and just those categories or those channels have been hot. Can you give us an update on how that’s working out for you?

Robert S. Sands

We are definitely seeing those categories perform and grow for our business as well as in the market place in general at a higher rate, but our business it is a significantly higher rate. Those channels are to a much greater extent outperforming pretty much other channels in general. It’s no surprise those channels are growing in the U.S. in general.

One of the aspects of the economic downturn is not only venue shift from on-premise to off-premise but then within the off-premise from the more traditional retail channels with chains to the mass merchandisers. So from an alcoholic beverage standpoint they’re benefiting and our business is benefiting there.

And we are a leader and we are a leader in that category. We are one of the key one or two players in those channels. We are either category captains or we’re validating. It’s an important channel for us and we’re doing well in it.

Timothy Ramey - D. A. Davidson & Co.

You have talked a few times about the U.K. is getting small enough so that it doesn’t really wag the dog too much but is there a risk that you could lose money there on a sustainable basis or are you pretty on top of that to make sure that we don’t have losses.

Robert S. Sands

The latter. We’re on top of that to make sure that we don’t have losses.

Timothy Ramey - D. A. Davidson & Co.

Just in spirits, you mentioned the great performance with Svedka, which I have to take my hat off to you since I criticized that acquisition, but Baron and Black Velvet, any specifics on performance there? I understand Black Velvet has been fairly strong as well.

Robert S. Sands

Yes, Black Velvet is outperforming the market place. I think it’s up about 6% right now, which for a mature brand is huge. Tremendous great margins on that product. If you look at Svedka and you look at Black Velvet, that’s 50% of our spirits business. At least from a profitability basis.

And Svedka, I’ve got to tell you. Before we used to say it’s one of a couple of major premium spirits brands that are growing at these very high rates of 50% to 60%. Today it is the only major premium spirits brand that has continued to grow at that rate. The Gray Goose’s of the world, [other premiums], they have all slowed down tremendously; still growing, still healthy, but slowed down to more normalized growth levels.

Svedka, if anything, is accelerating as we sit here speaking. It’s up in the 60% growth range and a multi-million case brand.

And Black Velvet, as mid-premium spirits brand, is also clearly benefiting from this economy. As well as I think superlative execution by our people and we are looking at opportunities for that brand, for new packaging and ways to continue to make that brand relative to the consumer and actually take advantage of the current trend towards mid-premium spirits brand.

So we’re pretty excited about, especially, those two brands, Black Velvet and Svedka.


Your final question comes from Mark Swartzberg - Stifel Nicolaus & Company, Inc.

Mark Swartzberg - Stifel Nicolaus & Company, Inc.

On North American wine, it sounds like you’re happy with how that pricing has worked out and what that’s meant on the volume side. It’s kind of a good trade. Can you talk a bit about what you saw over the holidays from the competition in terms of promotional activity in the wine business? And as I ask that, it seems like there’s a bit of an analogy here between where beer was a year or a year and a half ago with having taken price. Thought it was the right thing to do for the brand but in time it proved to create some volume problems that were greater than what you had anticipated. I’m just trying to get my arms around the risk, if you will, that these price, which has been good for you in the wine business, has to come off to an extent simply because of what’s going on with the consumer and because it creates some opportunity for competitors.

Robert S. Sands

I will answer that in a couple of different ways. First of all, promotional activity is fairly intensive in the wine business and the holiday season and it certainly has benefited some of the lower end brands and lower end companies, like the Sutter Homes wine group, Gallo. But not anything that we’re particularly concerned with and often in price categories and price segments that we’re not that interested in, low margin, low return kind of stuff.

Now, relative to your analogy to the beer business, number one, what you said about the domestic beer business I would say is true. There is one notable and very important exception to that. I think that the domestic beer business started to rely upon pricing to the exclusion of innovation. And the pricing was probably the right thing to do in the beer business but it should have been coupled with continuous innovation.

Then they woke up one day, duh, we forgot part two, and they started going very heavy on part two and you’ve seen a lot of the benefit of that actually, in the beer business, over the last year or two as they have kind of gotten back on track. So that didn’t render the pricing initiatives that they had taken historically the wrong decision to make, it’s just that they kind of took their foot off the innovation pedal and then they put it back on.

The wine business, okay, we’re taking the pricing, but we are continuously also refining the portfolio with new products, new innovative brands that are taking advantage of new consumer trends. Whether it’s the single variety kind of brands that are taking advantage of trends for consumers wanting to drink new varieties, like Argentinean malbec, so we have a new Argentinean malbec brand. Consumers discovering Spanish tampranillo. We’ve got a relatively new Spanish tampranillo brand which is focused purely on the brand, that variety.

Without belaboring the point, pricing without innovation, yeah, you’ll eventually, if you don’t do anything, you will start seeing consumer resistance and you will see volumes hurt. So you have to couple that with new product extensions, new packaging. I’m not here to taut any competitors, but as a Coor’s has done, or others, this type of action is when pricing coupled with innovation I think is what really works. So that’s what we’re focused on.

Another example is something like our Black Box, which has turned into a multi-million case brand. Premium, 3-liter, bag in the box. It has really taken off in this particular market place.

And new packaging.

Mark Swartzberg - Stifel Nicolaus & Company, Inc.

As it relates to beer, you commented about new and aggressive promotions planned for the various Modelo brands. Can you give us a better understanding of what you mean by that and within that to what extent is it shifting money around from using more at the consumer level to moving it more to the trade level and to what extent it’s really an absolute increase in the amount of dollars per case that you’re putting behind your brand?

Robert S. Sands

There will be some increases in that regard which we expect to drive additional volume so more plug. It’s not so much a shift because we’re going to maintain our strong consumer marketing program, but there will be additional promotional activity in the market place, which we have found to be very effective in terms of driving volume, and from our profitability perspective as we have tested certain configurations of promotional activity and marketing.

Clearly, when we talk about a promotional activity, what we’re talking about are efforts to really drive merchandising activity. Features and displays, coupled with strong consumer offers at retail. This is the key to driving basically volume growth in beer and in the beverage/alcohol business in general. Strong merchandising, which is giving featured displays, coupled with ads, coupled with strong consumer promotional activity.

So this is what we are focusing on and when we talk about strong execution in the market place, what we mean by that is the degree to which we are able to achieve that three-pronged type of activity at retail which drives consumer take-away.

Mark Swartzberg - Stifel Nicolaus & Company, Inc.

On restructuring, looking at the whole scope of the organization, BCG has been helping you in some regards. You talked a little bit about SKU rationalization, but did you think about opportunities from where you are right now to take out further structural costs, whether it is here in the U.S. or in another part of your business. I know there are constraints to what you can say here but can you give us some idea about what opportunity remains and any incremental color about what you see going forward?

Robert S. Sands

As you said, and first of all, when it comes to restructuring activities, until we have a restructuring activity to comment on, we’re not going to comment in advance on restructurings that haven’t happened. So, we don’t have any at the current moment in time but that being said, we are looking at the business and we are looking at ways to optimize the business. Our preference is to do it outside the context of restructuring if we can, not that we don’t look for restructuring, at least from a financial perspective, per se. We would rather be able to optimize the business through organic activities.

But if restructuring opportunities come down the line, which represent good investment, and I have told you this before, we look at restructuring opportunities strictly as investments, and we look at it strictly from a return on investment point of view. If a restructuring opportunity comes down the road that represents a very high return project, and we don’t do those things if they are a moderate return or a low return. We look for high double-digit return when we execute restructuring activities. And if those kind of opportunities come down the road, just like any other investment, if you’ve got the opportunity to make an investment that has a high probability of generating a double-digit return, we will take advantage of that. But nothing planned at the current time that we can talk about.


There are no further questions at this time.

Robert S. Sands

Thank you for joining our call today. Needless to say, I’m pretty pleased, especially in this economic environment, with our results for the quarter. And I summarize the highlights as follows: number one, we’ve led the market in pricing; number two, we have significantly improved gross margins and operating margins, generated some free cash flow, delivered improved profitability of our North American wine business, improved ROIC to targeted levels for the year; and in addition we have increased our free cash flow guidance for the year and prepaid a significant portion of next year’s debt obligation.

Our plan is to continue this strong execution throughout the final quarter of the year and finally, we will be providing guidance for our fiscal year 2010 during our next quarterly conference call scheduled for early April.


This concludes today’s conference call.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to All other use is prohibited.


If you have any additional questions about our online transcripts, please contact us at: Thank you!