Constellation Brands F1Q10 (Qtr End 05/31/09) Earnings Call Transcript

| About: Constellation Brands, (STZ)

Constellation Brands, Inc. (NYSE:STZ)

F1Q10 Earnings Call

July 1, 2009 10:30 pm ET

Executives

Patty Yahn-Urlaub - Vice President of Investor Relations

Robert S. Sands - President, Chief Executive Officer, Director

Robert P. Ryder - Chief Financial Officer, Executive Vice President

Analysts

Analyst for Kaumil Gajrawala - UBS Warburg

Timothy Ramey - D.A. Davidson & Co.

Carla Casella - JP Morgan

Mark Swartzberg - Stifel Nicolaus

John Faucher - JP Morgan

Kevin Dryer - Cavelli & Company

James Watson - HSBC

Brian Hunt - Wachovia

Operator

Good morning. My name is Brandy and I will be your conference operator today. At this time, I would like to welcome everyone to the Constellation Brands first quarter 2010 earnings conference call. (Operator Instructions) Thank you. I would now like to turn the call over to Patty Yahn-Urlaub, Vice President of Investor Relations. Please go ahead.

Patty Yahn-Urlaub

Thank you, Brandy. Good morning, everyone and welcome to Constellation’s first quarter 2010 conference call. I am here this morning with Rob Sands, our President and Chief Executive Officer; and Bob Ryder, our Chief Financial Officer.

By now you should have an opportunity to read our new 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 website at www.cbrands.com under the investors 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 [inaudible] 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 exclude the impact of year over year currency exchange rate fluctuations.

Please be aware that we may make forward-looking statements during this call. Although 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 impact the company’s estimates, please refer to the news release and Constellation’s SEC filings.

And now I would like to turn the call over to Rob.

Robert S. Sands

Well, thanks, Patty and good morning, everybody and welcome to our discussion of Constellation’s first quarter sales and earnings results. We are generally pleased with our quarterly results, which were in line with our expectations and demonstrate that we are on track to achieve our goals for fiscal 2010. Despite the ongoing challenges of a difficult operating environment worldwide, we continued to reduce our debt and improve our operating margins.

We completed the sale of our value spirits business, which is consistent with our strategic focus on premium high growth, higher margin brands and utilized the transaction proceeds to reduce debt.

In addition, we began to reap the benefits of our cost reduction initiative, which was implemented with the goal of mitigating the negative impacts from the turbulent global economy and creating efficiencies that will drive performance benefits over the long-term.

This cost focus helped us to offset the unfavorable product mix created by ongoing shifts in consumer buying patterns. However, a continuation of our planned SKU reduction activities worldwide has tempered our top-line growth.

Our focus on driving operational efficiencies, as well as portfolio pruning through divestitures and SKU reductions, is absolutely the right strategy to pursue as one of our top priorities is to manage for improved profitability in this challenging environment. This helps to ensure the long-term health of our business.

And now I’d like to discuss the operational aspects of the quarter, beginning with the North American wine business.

During the quarter, we completed the integration of our remaining spirits business into our North American wine organization and [begin resigning] the structure of our U.S. wine business into a single, integrated organization, especially in the areas of sales and marketing. These actions will simplify our organizational structure, provide synergy benefits, and are intended to improve efficiency and effectiveness with our trade partners.

We are also progressing with our efforts to consolidate our U.S. distributor network in key markets and implement a new go-to-market strategy. This has been made possible through the dramatic transformation of our portfolio which has occurred throughout the last 18 months and has resulted in a much more focused set of premium, consumer preferred brands that also have a desirable margin profile for distributors.

We are currently in the process of negotiating with our distributors. The initial transition will encompass up to 17 states representing approximately 50% of our total U.S. volume for wine and spirits. The goal of our new U.S. organizational structure and distributor consolidation initiative is to gain better alignment of dedicated selling resources working on a focused set of priorities and processes aimed at driving execution and accountability. We will implement an enhanced distributor incentive structure with the objective of driving organic growth.

We expect to begin transitioning by the end of this summer and will provide additional details when we are ready to officially launch the program. This new level of increased importance to our key distributor partners is designed to position us for future growth in a consolidating market.

From a marketplace perspective, growth in the U.S. wine market remains healthy at about 5% on a dollar basis, according to recent 12-week IRI data. The premium plus segment of the market where wine sales for greater than $5 a bottle at retail continues to grow in line with the total category. And as you know, we have a strong portfolio of U.S. wine brands throughout all price segments and we continue to see consumers turning to trusted brands that represent quality for good value.

Many of our well-known premium wine brands performed well in the marketplace during the quarter, including Woodbridge and Rex Goliath, Blackstone, [inaudible], Clos du Bois, [Simi], Wild Horse, and Kim Crawford, just to name a few.

SVEDKA Vodka posted another great quarter and generated sales growth of more than 30% versus last year. According to market data, it has become the fifth largest vodka brand overall in the U.S. and now ranks as the third-largest import. Black Velvet also posted solid sales results for the quarter.

Our Canadian wine business posted positive results for the quarter, primarily driven by the premium wine portfolio, including Jackson Trigg, Sawmill Creek, and Naked Grape, which all contributed to solid sales growth.

Recently, Canada’s Le Clos Jordanne chardonnay captured the top spot for chardonnay in the judgment of Montreal expert’s blind tasting, surpassing wines from France and other parts of the world.

And now moving to our international business, as you know, Australia and the U.K. continue to be challenged by a myriad of issues that have negatively impacted our business in these locations. These challenges do not relate to Constellation alone but to all suppliers who do business in these geographies.

We often discuss these markets in the same vein and we ship approximately 70% of our Australian exports to the U.K. marketplace. Although the U.K. and Australia combined represent a small percent of our total profits, our goal is to minimize operational variability for these businesses and our overall results going forward.

Therefore we are now running the U.K. and Australia business with a focus on cash. We will continue to take out costs, decrease our networking capital investment, and increase efficiencies by consolidating as much production as possible. Our goal is to generate cash, improve gross profit, and variabilize the business model.

As you know, we recently announced changes in our international management structure aimed at better aligning our businesses in the U.K. and Australia to provide opportunities for cost savings and increased efficiencies. We are working on developing the appropriate long-term strategy for these businesses and will move rapidly to implement these plans once finalized.

In the U.K., positive year-over-year sales trends in the first quarter were primarily the result of a year-over-year pre-buy and timing related to the duty increase. The 2009 grape harvest in Australia is now complete. Although final data is not yet available, it appears that the current harvest estimate is approximately 1.7 million tons, versus a harvest of about 1.8 million tons last year. However, overall supply continues to outstrip demand.

The cost of Australian grapes has decreased significantly for the calendar 2009 harvest due to the fact that last year many growers paid for water supply during the growing season due to the drought conditions in the region at the time.

Moving to the Crown imports joint venture, Crown experienced positive momentum during the Cinco de Mayo holiday driving year-over-year improvement in case sales through excellent execution at retail. However, this positive momentum was offset by the economic driven trends, particularly in the on-premise and convenience channels and an overall mix shift away from imports.

In addition, competitive price discounting has become prevalent in the form of mail-in rebates offered at retail as Crown enters the busy summer selling season. More recently, however, Crown is beginning to see some improving trends in the grocery channel from national chain stores as a result of targeted marketing efforts and programming against those key channels.

These efforts include the reprisal of Corona Extra’s iconic television ads from the 1990s following considerable analysis and consumer research. This is a very cost-effective approach to media investment.

Overall, Crown is focusing on optimizing promotional activity and media support into and through the peak seasonal periods when consumers buy the most.

Crown is also seeing some success with a number of new SKU and packaging introductions, expanding distribution to additional states with Modello Especiale, Corona, and Corona Light 18-packs, Corona Light 12-pack cans, and Modello Especiale 24-packs. And the next phase rollout for Modello Draft will begin in late July.

Modello Especiale continues to be one of the few major super premium brands that is experiencing double-digit market growth.

Now in closing, we’ve been impacted by the global slow-down but are taking the necessary actions to fortify the company short-term. The culmination of everything we are doing positions us well to drive sales growth, margin expansion, and improved ROIC once we clear the headwinds from this challenging external environment. Overall, our business strategy remains intact. We are executing and taking the appropriate actions designed to further position our business for success in the future.

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

Robert P. Ryder

Thanks, Rob. Good morning, everyone. Given the continuing difficult global economic and market conditions, I am generally pleased with our results, which were in line with our expectations. Our comparable basic diluted EPS for the quarter came in at $0.33 a share versus $0.34 last year.

The quarter saw quite a bit of change due to foreign exchange rates. The dollar strengthened dramatically versus our key currencies when compared to the prior year. In dollar terms, this reduced our international sales and SG&A expenses.

The state of the global economy also impacted our sales mix as consumers across the beverage alcohol category gravitated towards lower priced products. For us, this generally means a lower gross profit margin.

The profit margin for our international business also continues to disappointing. We began to see the sales mix trend at the end of last year and we took some dramatic offsetting actions. We sold our value spirits and other businesses and eliminated the associated standalone SG&A. We began our global cost reduction initiative, tightened down on marketing and general expense, and continued to focus on debt pay-downs and interest expense reduction.

These tactics were generally successful in Q1 as our SG&A and interest savings offset gross profit reductions resulting in slightly higher pre-tax income versus the prior year.

We also continued to pay down debt and are well on our way to achieving a comparable basis debt-to-EBITDA ratio by the end of fiscal 2010 in the high three times range.

Now let’s look at our Q1 P&L performance, where my comments will generally focus on comparable basis financial results. First, the net sales line -- as you can see from our news release on page 13, our consolidated reported net sales decreased 15%, primarily due to the impact of year-over-year currency exchange rate fluctuations and the divestiture of our value spirits business, spirits contract production services, and certain Pacific Northwest wine brands.

On an organic constant currency basis, which excludes the impact of acquisitions, divestitures, and for-ex rate changes, net sales increased 1%.

My commentary for the following net sales comparisons will be on a constant currency basis. Our worldwide branded wide organic net sales increased 1%. Organic branded wine net sales for North America, which appears on page 12 of the release, decreased 1% while Europe and Australia/New Zealand increased 6% and 7% respectively.

Our global branded wine business continues to be impacted by ongoing SKU reductions in a challenging economic environment which is driving unfavorable sales mix. However, the SG&A reduction efforts are having the expected benefit of offsetting much of the reduced gross profit margins from the negative mix.

We estimate that SKU reduction actions negatively impacted North American sales growth by approximately 2 percentage points.

Sales for Europe benefited from year-over-year timing related to customer buying prior to the U.K. duty increases.

Australia and New Zealand saw some improvement, albeit on a small base, driven by sales in the Asia-Pacific region.

Spirits organic net sales increased 13%, led by 33% growth from 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 34.9%, down 1.5 percentage points. This reflects the unfavorable sales mix that I discussed earlier, partially offset by the sale of the lower margin value spirits business.

Our consolidated SG&A for the quarter was 19.3% of net sales compared to 22.3% a year ago. The 3 percentage point decrease was primarily driven by previously mentioned cost reduction actions, lower advertising and marketing expense, and gains on foreign currency hedges.

Consolidated operating income decreased 6% to $123 million but our operating margins increased 1.5 percentage points to 15.6%.

I would now like to turn to our segment operating income results on page 11 of the release to provide highlights of these changes.

With the sale of the value spirits business and the integration of the remaining spirits business into our North American wine organization, our segment reporting has changed accordingly and the spirits business is now included in the wine segment. Prior periods have been classified in our press release and our segment history schedule on our website reflects this change.

Wine segment operating income decreased $8 million to $148 million. The decrease is primarily due to the divestiture of the value spirits business and certain Pacific Northwest brands, negative mix, and a decrease in international profitability, partially offset by our SG&A reduction initiatives and foreign currency gains.

For the quarter, corporate and other expenses totaled $24 million, which was level with the prior year. Higher stock compensation was offset by cost savings.

On page 14, you can see consolidated equity investment earnings totaled $63 million versus $72 million last year. Equity earnings for Crown totaled $63 million versus $70 million. For the first quarter, Crown generated net sales of $636 million, a decrease of 5%, and operating income of $126 million, a decrease of 9%.

Similar to the wine category, we have seen consumers gravitate towards lower priced beers. Sales were impacted by soft performance in the convenience and on-premise channels which have seen a more dramatic impact from the economy. In addition to the sales decrease, operating income was primarily impacted by a contractual cost increase and negative sales mix.

Interest expense for the quarter was $67 million, down 23% versus last year. This decrease was driven by our significant debt reduction over the past 15 months and a decrease in our average interest rate for the quarter, versus the prior year as LIBOR decreased for our variable rate debt.

Now let’s take a look at our debt position -- at the end of May, our debt totaled $4.3 billion, which represented $112 million decrease from our debt level at the end of fiscal 2009. The decrease reflects proceeds received from the sale of the value spirits business partially offset by the use of free cash flow in the quarter. I’ll talk about free cash flow in a few moments.

Our average interest rate for the quarter was down to about 6%.

Our debt to comparable basis EBITDA ratio at the end of May was 4.3 times, consistent with the ratio at the end of fiscal ’09. The benefit of the debt reduction was essentially offset by lower EBITDA, reflecting our softest financial performance over the last two quarters.

Our comparable basis tax rate came in at 39% compared to 37% last year. We are still targeting a full-year tax rate of 38%.

Due to the many factors just mentioned, diluted EPS was $0.33 versus $0.34 last year.

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

Due to seasonal factors, we’re normally a first quarter user of cash and for the first quarter of 2010, we used free cash flow of $102 million versus a use in the prior year of about $55 million.

The higher use of cash was due in part to higher CapEx spending for the quarter due to timing. In the working capital area, inventory benefited from lower grape harvest in Australia and New Zealand versus the prior year.

The majority of the higher cost fiscal year 2009 harvest is rolling through cost of goods sold in this fiscal year, contributing to our reduced international profits.

Receivables were higher due to the timing of sales in the quarter. For fiscal 2010, we are still targeting free cash flow to be in the range of $230 million to $270 million. This includes CapEx in the range of $150 million to $170 million. As a reminder, free cash flow for 2010 was expected to be negatively impacted by higher taxes paid primarily due to the $65 million tax payment related to the sale of the value spirits business, which we expect to make in Q2.

We expect to continue to utilize free cash flow to reduce borrowings.

Moving to our P&L outlook for full year 2010, as reflected in the outlook section of the press release, we continue to forecast comparable basis diluted EPS in the range of $1.60 to $1.70 a share. Interest expense is expected to be in the range of $265 million to $285 million and we’re assuming weighted average diluted shares to be about 222 million.

Our comparable basis guidance excludes acquisition related integration costs, restructuring charges, and unusual items which are detailed on page 16 of the news release.

During Q1, we recorded approximately $0.12 in charges for restructuring and related activity, including our global cost reduction initiative announced in April. We also recorded a $0.17 charge associated with the sale of the value spirits business.

Before we take your questions, I would like to note that in these uncertain times, with difficult economic and market conditions, we remain focused on margins and ROIC, reducing debt and keep leverage at manageable levels. I believe the strength of our portfolio, combined with our SG&A reduction efforts, positions us well to work through the current environment and take advantage of opportunities when conditions improve.

With that, we’ll open up the line for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Kaumil Gajrawala with UBS.

Analyst for Kaumil Gajrawala - UBS Warburg

Good morning. This is [Seth] standing in for Kaumil. [Regarding the distributor] transition that you mentioned would be taking place this summer, should we be concerned about any disruption in 2Q or 3Q because of that?

Robert S. Sands

You know, we don’t expect any disruption at this time as a consequence of our distributor activities. You know, we’ve put a lot of things in place to ensure that things remain intact during the transition period so right now, we feel pretty good about that.

Analyst for Kaumil Gajrawala - UBS Warburg

Thank you.

Operator

Your next question comes from the line of Timothy Ramey with D.A. Davidson.

Timothy Ramey - D.A. Davidson & Co.

Good morning. Congratulations, guys. As you get into the latter half of the year, have you -- I know you don’t give quarterly guidance but have you given thoughts to how the currency impacts shake out and what that might mean for you, particularly with regard to your new strategy in Australia and the U.K.?

Robert P. Ryder

You know, we do look at that stuff but if we were real good on anticipating for-ex rates, we’d be working down on Wall Street but what we try to do with all our -- with our hedged activities is we try to offset the volatility, so for instance in this quarter, we actually saw some positive impact from our hedges, whereas in last year’s first quarter, we saw some negative impact from hedges specifically. Now, there are offsetting things helping the other line items. But we don’t -- it’s not really a big number. We expect for-ex volatility to be maybe a positive/negative of about $0.01 in any quarter.

Timothy Ramey - D.A. Davidson & Co.

Okay, and then just on some of the mid-tier brands, you know, can you kind of more fully flesh out a little bit on what you are seeing in terms of trade down and -- I mean, you described a couple of the results as solid but I’d rather have numbers than letters.

Robert S. Sands

In terms of our mid-tier brands, we are seeing some positive results. We see brands like Woodbridge continuing to grow in the high-single-digit range. We see brands like Clos du Bois, for instance, we’re seeing about 8% volume growth on that particular brand. So you know, there’s ups and downs in the portfolio and we do see a trend towards what we would describe as better known and trusted brands that represent good value for money. I think that some of our brands are benefiting from that in general.

We do see volume basis trading up continuing in the industry with total wine in the lower single digit range. Premium plus and super premium in the mid and moving up into the higher single digit range on a volume basis.

On a dollar basis, interestingly enough, in the value business we continue to see a lot of pricing being taken in the marketplace, so while we see value wines growing at a lower percentage on a volume basis than premium and super premium plus wines, on a dollar basis they are actually growing faster because I think the major players in that industry, in that segment, of which we are not one, are taking the opportunity to take pricing in the value segments.

Timothy Ramey - D.A. Davidson & Co.

Thanks.

Operator

Your next question comes from the line of Carla Casella with JP Morgan.

Carla Casella - JP Morgan

Hi. One clarification question -- you mentioned the gain on FX hedges that was in SG&A. Did you give the amount that was in this year and last year?

Robert P. Ryder

No, but I’d say you can figure it out -- it was about a penny positive this year and about a penny negative last year, so the -- so again, in any quarter it’s about a penny but this quarter when you look year over year, the delta is a positive to a negative so it sort of makes it look bigger than it is.

Carla Casella - JP Morgan

Okay, and then in the other segment of sales, I guess it’s wholesale and other, it looks like some of the businesses you sold might have been included in that. Can you just say -- the run-rate is about $43 million this quarter. Is that a good run-rate to use or was that seasonally low or somewhat otherwise affected?

Robert P. Ryder

I think the biggest product in that category is our cider business in the U.K. and the cider business in the U.K. is very much a summer product, so you might see like a higher number in say the second quarter. You also have a lot of translation going on because most of those sales are overseas.

Carla Casella - JP Morgan

Okay. That’s helpful. And then one question on gross margin -- can you clarify anymore how much of the gross margin change was affected by mix versus any promotional activity versus packaging or other cost increases?

Robert P. Ryder

Well, we sort of look at it all as one big bucket but obviously as we said, negative mix shift had a pretty big impact on us in the quarter because -- and this is a general statement -- as you move down the price ladder, the gross profit margin tends to be less.

The thing we are really happy about is we sort of saw this coming and we took some pretty dramatic cost-out actions and those cost-out actions are offsetting most of the negative mix shift up in gross profit. You can see the SG&A coming down.

Carla Casella - JP Morgan

Okay, so it sounds like it’s more mix than any promotional activity?

Robert P. Ryder

It’s more mix than promotional activities, yes.

Carla Casella - JP Morgan

Okay, and then just one last question -- June weather we know has been pretty bad and a lot of retailers have been hit. Have you seen -- has that affected any certain segments of your business that are dependent on outdoor summer activities, et cetera?

Robert S. Sands

I think it’s a little early to tell how June weather will affect the business. Obviously the beer business is heavily skewed towards the summer selling season. This is the big time and we are going to have to see how -- we are going to have to see how the -- you know, our brands in particular fair over the summer selling season. We’ve got a lot in place relative to that.

You know, other than beer, obviously, in the U.S. and Canada in particular -- actually, worldwide wine sales don’t tend to be affected by weather. It’s not a weather related --

Robert P. Ryder

It’s not a thirst-quencher.

Robert S. Sands

-- beverage. Right.

Carla Casella - JP Morgan

Right. Okay.

Robert S. Sands

So it’s really the beer business and it’s too early to tell how we’re going to do during the summer selling season.

Carla Casella - JP Morgan

Okay, great. Thanks a lot.

Operator

Your next question comes from the line of Christine Farkas with Bank of America.

Christine Farkas - Bank of America-Merrill Lynch

Thank you very much. Good morning, Rob and Bob. I think, Bob, you might have answered this a little bit but I want to get a little more color on your North American or the overall wine margin, I should say. In the fourth quarter we saw margin contraction of about 180 basis points on the operating profit line. It sounds to me that cost controls are coming in maybe even stronger. Can you tell us if your margin contraction was better or worse than what we saw in wine in the fourth quarter?

Robert P. Ryder

The fourth quarter generally had some anomalies that caused the margins to be lower year over year but I’d say in Q1, we saw slightly better margins than in Q4 so it’s getting a little bit better and I think you got the point, Christine, of the cost-savings initiatives that we began at the end of last year are really starting to kick in in Q1. You know, in Q1 we had to take out quite a few Constellation associates and that will continue through the balance of year and we are also taking some facility actions and we are being really cautious on our marketing spend. On spending that we can hold back on, we are holding back on.

Christine Farkas - Bank of America-Merrill Lynch

Can you quantify -- sorry, I was going to ask if you can quantify what your targets were for SG&A or I should say overall cost reductions and how much you have achieved so far?

Robert P. Ryder

Sure. So what we said, and this is just for the global cost initiative that we announced I think in the fourth quarter call last year, we will be taking out savings this year, $25 million, full-year run-rate is $50 million because we will only have about a half-year of savings this year, so again you will see our savings as we go through the year pick up. I mean, again unfortunately just last week we announced 100 people would be leaving the U.S. wine business and that will be happening in Q2 and forward quarters, so it continues to --

Christine Farkas - Bank of America-Merrill Lynch

And these are all part of your already announced global initiative program as we see these headlines?

Robert P. Ryder

That is correct.

Christine Farkas - Bank of America-Merrill Lynch

Okay, and a final question, if I could, on your international wine business -- certainly your comments are clear about a challenging environment and SKU reduction, yet we saw positive sales growth in both Australia and Europe. Can you give us just a little bit of color -- and I know that mix is hurting the profit, but can you give us a little bit of color on the strength of the top line?

Robert P. Ryder

Yeah, so what I’d say is -- and if you compare it to prior quarters, both Europe and Asia-Pacific sales were up a lot. I wouldn’t get too excited about that, I guess. In the U.K., or in Europe the big thing driving that is in the previous year in the fourth quarter when the governments announced the duty increase, which as you’ll recall was pretty sizable. They gave a decent amount of time between the announcement and the implementation of the duty increase, so it gave everybody quite a while to sort of buy in a lot of product ahead of the duty increase, and what that ended up doing was it sort of kept our first quarter sales lower as that inventory sold through. This year when the duty increase was announced, there was no time between announcement and execution, so that duty buy-in didn’t happen. So it’s sort of a technical year-over-year selling activity which should even out over time. Really what happened is inventory got built up, so that’s sort of Europe.

And in Asia-Pacific, it’s more related again to some timing of sales into mostly the Japanese market, which I think will also even out over time. The other thing to keep into account is unfortunately sales in these two regions have a much lower margin than sales in North America, so as sales growth accelerates versus North America in any quarter, that tends to be a negative geographic mix shift for us.

Christine Farkas - Bank of America-Merrill Lynch

Got it. Thanks a lot.

Operator

Your next question comes from the line of Mark Swartzberg with Stifel Nicolaus.

Mark Swartzberg - Stifel Nicolaus

Thanks. Good morning, everyone. Rob, I was surprised to hear you comment that you didn’t expect disruption this summer with the plans to consolidate wine and spirit sales into fewer distributors. Could you -- I may have missed it but could you tell us when that was announced for the trade? Is that happening today?

And then talk a little bit about why you don’t expect too much disruption and I take it if you don’t, that you don’t have disruption in your guidance of $1.60 to $1.70?

Robert S. Sands

I think you asked when we’re announcing for the trade, is that was you asked?

Mark Swartzberg - Stifel Nicolaus

Yeah.

Robert S. Sands

You know, we expect that we should be announcing for the trade actually fairly shortly, within the next 30, 60 days, something to that effect, and it might not be all at once, so it’s not necessarily a big kind of a thing. And then to your second question, you know, in planning for how we would handle the changes that we are going to be making related to the consolidation, operationally we obviously put in place some mitigation plans and there are some natural things that occur when you make these movements that tend to offset each other, such as when you are moving the brands, you’ve got inventory moving around, shipments to new distributors, et cetera. So when you balance everything out, we really don’t think that it will have a huge impact on retail sales. We think that depletion should be somewhat stable. There might be some loss from distributors who are losing brands, some pick-up from distributors who are gaining brands and actually the same kind of thing on the shipment side.

So we expect it at this time to balance out. You know, if there were any timing issues, which is probably the worst-case scenario, you know, we -- well, let me just put it this way; at the current time, we don’t expect any significant timing issues related to the distributor transition between second quarter and third quarter. And as we move into third quarter, it should be largely complete. I think the thing should be stabilized, which was part of the idea, which was to get this done before OND -- October, November, and December, which is one of the key selling seasons.

So a lot of operational planning has gone into this, Mark, to ensure that we mitigate any possible disruption.

Mark Swartzberg - Stifel Nicolaus

Okay, great, and am I right that today’s comments on this call are the first the trade’s actually hearing of these intentions?

Robert S. Sands

No, no -- the trade is well aware of our intention and is well aware of what we are both doing internally with the sales organization, meaning the consolidation of the operating companies in the sales organization and we’ve been involved in an intensive RFC, request for -- we call it a request for commitment as opposed to a request for proposal. We’ve been involved in a heavy RFC process with the distributors now for several months and are in the process of final negotiations as we sit here right now. So there’s -- everybody knows what’s going on, basically.

Mark Swartzberg - Stifel Nicolaus

Great. Thank you, Rob, that’s helpful.

Operator

Your next question comes from the line of John Faucher with JP Morgan.

John Faucher - JP Morgan

Good morning. I apologize; I seem to be getting confused about something. You started off the conference call by saying I believe that the category was up about 5% and high-end was growing at the same pace, and then you talked about a shift into some of the higher priced wines, at least from a volume standpoint. And it sounded like the category mix was coming down at the -- sort of at the very low end, of if -- I apologize. I’m trying to figure out why the mix is such an issue when what continues to come up, it seems like, is the high-end stuff seems to be holding up and growing at roughly the same pace as the category. And if you could talk about that sort of on a total category basis, as well as just for your portfolio. Thanks.

Robert S. Sands

What is the case as you look at the total industry, you see the total industry growing at lower -- about 3%. When we said 5%, I was talking dollars, not volume, so 3% on a volume basis, 5% on a dollar basis, which in and of itself, this is total wine, would be indicative of the continuation of the general trade-up trend. So you see super premium plus, which starts at $8, growing at about 6% both in volume and dollars versus the total industry at 3% volume and 5% dollars. I’m quoting IRI figures.

Now, within our -- that doesn’t mean, however, that within the respected categories that there might not be -- and in fact I think that there is to some degree some trading down. So take the super premium category, okay, which might -- which ranges from $8 to $12. The highest end of that category is being more negatively affected or being negatively affected versus the lower end. People are looking for bargains even within the respective categories. So when we talk about trading up in general, it does continue to be a phenomena in the marketplace as measured by either the difference of the total business in volumes and dollar sales or by looking at say the whole super premium plus category versus the value category.

Now, there’s also some trading down going on from the high-end of the segment of the wine business, so wines over $15, over $20, there’s clearly some trading down that’s going on in those categories as well, and our high-end portfolio, which is our highest gross margin portfolio, sold by Icon, which is -- what we used to call Icon; well, it still is Icon, actually. It won’t be much longer but the white table cloth on-premise branded brands are definitely being hurt in the economy. You can call it trading down, you could say that it’s also an impact that the economic downturn is having on the on-premise in particular.

So the highest margin brands in our portfolio, which are more on-premise oriented, are being negatively affected by the economic impact, especially on the restaurant business.

So it’s hard not to confuse sort of general trends with what is very specifically going on; in our case, as I said, the highest end of our portfolio is being negatively affected and some of the -- even within premium, some of the lower premium products, everyday products like Woodbridge, which is premium by definition, are growing at a fairly rapid rate. So this is what’s causing the negative mix shift.

Robert P. Ryder

So John, just a little bit of background math, when we are talking negative mix, we’re talking to previous year, okay? So what we are seeing is what Rob just said -- the total wine category is growing pretty consistently with prior years, say 4% to 5%. The brands below $5 are going a lot faster than they were last year, okay? The brands above $5 a bottle at retail are growing slower than last year but the brands above $5 a bottle are still growing in line with the total category. They used to grow faster than the total category.

So when we say mix shift, we’re talking year over year and you can see if you look at IRI or Nielsen data that the lower priced brand -- this is across beverage alcohol, right? We see the same thing in our beer portfolio -- the lower priced brands are now growing much faster than they were last year. The higher priced brands are not growing as fast as they did last year. They are all still in growth.

John Faucher - JP Morgan

Okay, so to be technical, what’s really going on is it’s actually a lack of a mix shift -- you’ve been getting the more positive mix shift in the past. If everything is growing at the same pace, and I realize that’s a generalization, then you are not getting the positive mix shift that you are used to, so I think that’s -- is that -- if everything -- if the low-end and the high-end are both growing 5%, then it’s the lack of a positive mix shift as opposed to a mix shift?

Robert P. Ryder

That is correct.

John Faucher - JP Morgan

Okay.

Robert P. Ryder

We’ve had less of a positive mix [shift] -- that’s a fine way to put it.

John Faucher - JP Morgan

Okay, I got it. Great. Thanks so much.

Operator

Your next question comes from the line of Kevin [Dryer] with [Cavelli] & Company.

Kevin Dryer - Cavelli & Company

I just have a question on your margin -- on your margin changes. What kind of driving -- you’re saying that you’ve got efficiency initiatives offsetting the negative mix shift. Should that accelerate then as the year goes on, since you said you’ve got this $25 million coming in this year, going to $50 million next year?

Robert P. Ryder

Yes, I think that’s true because we will have -- of the $25 million in savings, okay, we’ll see much more of that in Q2, Q3, Q4. We would also hope that the gross margin might improve a bit if the economy starts to improve a bit but we’re not really relying on that.

Kevin Dryer - Cavelli & Company

What drove the increase in the EBIT margin for the wine and spirits division this quarter? What were the costs you took out, or did you pull back on marketing or -- what were the specific items that helped it this quarter?

Robert P. Ryder

Most of it was around SG&A, okay? The two big things were -- the first was our global cost initiative, which we started last year. We saw a reasonable amount of savings of that in Q1. The other piece --

Kevin Dryer - Cavelli & Company

-- people?

Robert P. Ryder

Yes, primarily people, I’m sorry, yes. And the other thing, the other big ticket item, which again was primarily people, when we sold our value spirits business, which used to be an entire segment with a lot of very capable people in mostly Chicago running the business, we took the two largest, highest gross profit margin brands and we plugged them into our North American wine business to leverage that SG&A and unfortunately again, we had to eliminate the spirits SG&A, which resided in the ex spirits segments. That actually for this quarter provided quite a bit of SG&A savings for us. That’s a permanent savings that the people are no longer within the company.

Kevin Dryer - Cavelli & Company

Okay, and then in terms of the distributor transition, I guess I’d have to agree with the previous comment, not totally clear to me why there wouldn’t be some disruption but I guess all that being said, what’s the reason for it? Why -- what are you seeing in your business that makes you decide you need to go with fewer distributors now and what’s changed versus how you did things previously?

Robert S. Sands

It’s really very related to the dramatic change in our portfolio. When we had a significant value wine and spirits portfolio with many brands that competed with each other and that were fairly generic and low margin in nature, the only model that really worked for selling that was to put brands that competed against each other in different -- with different distributors. Okay, we had a huge number of brands as well, so it made sense to split the portfolio in a given market between different distributors to get better prioritization against each set of brands that each distributor had and then to also get more effort against competing brands. So you have two vodkas selling at the same price that are basically what we call well products, meaning they don’t go on the back bar, nobody knows what brand it is. Okay, you were better off having two distributors sell the two different brands that one, because you’d get more exposure to different outlets.

With the elimination of our value spirits portfolio and our value wine business, and the really the narrowing down of our portfolio to a relatively small number of brands that are fairly well-differentiated -- I mean, really just about 10, 12 brands that are the key Constellation brands, you know, we are able then to focus -- one distributor can number one, prioritize those brands and we don’t have the issue of selling largely generic inter-competitive product.

At the same time, if we consolidate our portfolio with a single distributor in a market, Constellation today is in the top three largest operating profit providers to the U.S. distribution network in general and in the top two largest gross profit providers to the U.S. distribution network.

Now, if you’ve got your portfolio split in half, half of it with one distributor in a market and half of it with another distributor in a market, you know, you don’t get the full benefit of your size and strength and the contribution that you are making to the distributor, because they only have 50% of the business and thus 50% of the margins, whereas today, many of our -- many of the major spirits producers are consolidated in the marketplace, so it was really two-fold, as I said. It was the change in our portfolio facility facilitated the change with a narrower portfolio of much more highly differentiated brands. And then number two, it gives us -- it increases dramatically our level of importance to each individual distributor that we are consolidated with.

Kevin Dryer - Cavelli & Company

Great. Thank you. And then maybe just one final one -- on [inaudible] big brand, continues to grow at a very healthy clip. How much of that is new distribution versus just increased consumption, you know, where you are already selling it, share gains versus other brands? And also, how much of that do you think is just benefiting from some trade-down within premium vodkas from the luxury vodkas down to a price point like SVEDKA?

Robert P. Ryder

I’d say yes, yes, and yes. SVEDKA is really hitting on all cylinders, so even in places like New York City where it has heavy penetration, okay, we still see per capita consumption increases. We’re also focusing on increasing penetration on the West Coast where it’s under-represented in the Vodka category. And the marketing and sales guys are spending a lot of time on that and we are seeing some success there.

And also the economy is certainly helping SVEDKA because it is at a price point for a 750-millilitre, save off $10 a bottle, so my guess is is getting some sales from products like the Kettle One and Grey Goose, which are say $20 to $30, so two to three times that price point, because SVEDKA offers the premium positioning. It has all the marketing glitz and it’s a great tasting product like those others. It’s just more affordable.

So I’d say it’s a very good product in general and it’s an even better product in these economic times and we are seeing the results of that. I mean, it will be above 2 million cases at the end of this fiscal year. That is a sizable spirits brand and it’s still growing in the high double-digits. We’re -- it’s pretty amazing. The team there, the commercial team is doing a fantastic job with that product.

Kevin Dryer - Cavelli & Company

Great. Thank you.

Operator

Your next question comes from the line of James Watson with HSBC.

James Watson - HSBC

Good morning, everyone. I had a question about the cost environment in the quarter. You mentioned -- well, we saw the gross margin come down but you also mentioned that value wines in the U.S., the prices were being taken up. I mean, is that -- are they both caused by the same thing, by any underlying increase in grape costs? Or are they just separate from [inaudible]?

Robert P. Ryder

So within cost of goods, we did see some increase in grape costs and we did see some increase in glass costs, okay, across the portfolio. But we also saw generally a mix shift to -- even if those were the same, we saw mix shift towards lower gross profit margin product, so that -- those three things were the big movers in the gross profit mix shift. But again, we offset most of those with our SG&A reduction initiatives.

James Watson - HSBC

Okay, and this increase in value pricing was in the U.S. -- have you seen it anywhere else? I mean, especially the U.K. or is the environment in the first quarter in the U.K. just as competitive as it was in the fourth quarter?

Robert P. Ryder

Yeah, when we see the pricing, really we can see this in the spirits, the beer, and the wine category in the value segments. You actually see pricing and I guess positive mix shift in the value segment. We see that in North America across all the beverage alcohol categories. The U.K. is a very different market in that there’s kind of a price ceiling there that’s put in mostly by the retailers who use beverage alcohol to sort of just get people in the stores.

So although -- you know, we do see a general, a mix shift positive in the U.K. In our category and in wine, we’re still seeing a pretty much in total a stabilization of that price point. There’s kind of a ceiling there, which impacts everybody’s margin in beverage alcohol in the U.K.

James Watson - HSBC

Great. Thank you, guys.

Operator

Your final question comes from the line of Brian Hunt with Wachovia.

Brian Hunt - Wachovia

Thank you. I’m glad to make it under the wire. I was wondering if you could just talk about the potential costs associated with your distribution transition. It sounds like there’s a lot of moving parts. And also if you could clarify whether or not -- again, this will be something where you flip a switch and all these states at one time [or are you going] by a state-by-state basis and execute this plan?

Robert S. Sands

Yeah, you know, in terms of costs, there’s a lot of puts and takes and obviously that’s all built into our guidance for the year. Patty or [Bob] can talk to you more about that if you would like but you know, nothing that you should be particularly concerned about. And relative to flipping a switch, as I said it will all be put in place over the next say 60 days-ish, you know, not everything will happen simultaneously but it will be in place prior to the beginning of the key selling season, beginning with October. So 60, 90 days.

Brian Hunt - Wachovia

Okay, and my last question would be looking at your organic net sales growth on North American wine relative to the IRI data you’re recording, it appears that [the overall losses] of share during the period, could you maybe clarify that -- those statements that you made and where do you feel like, if you did lose share, where were you losing share? In what segment? And maybe why?

Robert S. Sands

Yeah, well, you know, our growth is a bit behind the general growth but in general, we don’t really operate the business, okay, on the basis of maintaining share, especially in the short-term in a largely fragmented category. You know, it’s not the same kind of thing as if you are selling potato chips. Now, we’ve also taken pricing during the period, so if you look at our average pricing versus the same period a year ago, it’s up and that always has an impact on share and also that if you just look in general at our volume growth versus our dollar growth, our dollar growth is ahead of our volume growth. Again, related to pricing, which will have some impact on share. You know, we’re growing generally in line with our respective categories. We could be off a bit here and there but again, we are much more concerned about striking the right balance between profit and volume as opposed to just worrying about share per se.

Also, we have had -- as a -- there’s probably a couple hundred basis points of impact on SKU -- of SKU rationalization that -- we know that that’s flowing through at least on the shipment side and flowing through to depletion. You know, retail sales lag a little bit but you know, there is an impact of SKU rationalization on the retail numbers as well.

So you know, we have large brands, large brands aren’t going to grow as fast as small new brands, so in general we are happy and tend to look at our growth rates for our brands on an absolute basis, meaning are they growing at the rate we think is important. Like a brand like Woodbridge, as opposed to, you know, is it taking share versus all the little brands that are coming and going in the marketplace.

Robert P. Ryder

The other -- I’ll just add another math comment in that we are under-represented share wise in the below $5 a bottle, and as we said earlier, that is growing much faster than the above $5 a bottle, so if you look at total wine category and our share of wine category, a lot of our share loss would be the fact that we’ve chosen not to participate heavily in the under $5 a bottle at retail and we’ve made that decision because the profit margins at that level are kind of less than we would want.

So that’s kind of one of the math reasons why we are losing share total. In the premium plus category, so $5 a bottle and more, we’re pretty close to growing with that category. It’s much less demonstrative.

Robert S. Sands

And when Bob talks about the value category growing faster, it’s on a dollar basis, not on a volume basis. It’s growing slower on a volume basis and faster on a dollar basis.

Robert P. Ryder

Correct. I was talking all dollars, sorry.

Brian Hunt - Wachovia

Well, thank you for clarifying that and thanks for taking my questions.

Operator

At this time, I will turn the call back to Rob Sands for closing remarks.

Robert S. Sands

Well, thank you, everybody, for joining our call today. I would say that we are off to a solid start in fiscal 2010, despite the ongoing challenges from a tough macro environment that everybody is facing.

Now, during the quarter, we did decrease debt, we realized the benefit from our cost reduction efforts and in doing so, we improved our operating margins. I believe we are well-positioned to achieve our free cash flow and EPS goals for the year. I am especially excited about the implementation of our new distributor initiative and go-to-market strategy. We’ll certainly have more to say about this in the next coming weeks and next quarter when we talk to you again.

Now in addition, we are planning on an investor day in New York for the early to mid November timeframe, so stay tuned for the details on that. And thank you again for your participation and we hope you are able to enjoy some of our great products during the upcoming Fourth of July weekend.

Operator

This concludes today’s Constellation Brands first quarter 2010 earnings conference call. You may now disconnect.

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