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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

Kaumil Gajrawala - UBS Warburg

Lauren Torres - HSBC

Bill Leach – TIAA-CREF

Timothy Ramey - D.A. Davidson & Co.

Lindsey Druckerman – Goldman Sachs

Marc Greenberg – Deutsche Bank

Kevin Dryer - Cavelli & Company

Mark Swartzberg - Stifel Nicolaus

Constellation Brands, Inc. (STZ) F3Q10 Earnings Call January 7, 2010 10:30 AM ET

Operator

Welcome everyone to the Constellation Brands third quarter 2010 earnings call. (Operator Instructions) I would now like to turn the conference over to Ms. Patty Yahn-Urlaub, Vice President of Investor Relations. Please go ahead.

Patty Yahn-Urlaub

Thank you. Good morning everyone and welcome to Constellation’s third 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. This call complements our news release which has also been furnished to the SEC.

During the call, we will discuss financial information on a GAAP comparable organic and constant currency basis. However, discussions will generally focus on comparable financial results. 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.

Please also 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 Sands

Thanks Patty. Good morning everybody and Happy New Year. I hope that everybody had a great holiday season. Welcome to our discussion of Constellation’s third quarter fiscal 2010 sales and earnings results. Before we get started I would like to thank those of you who attended our recent New York City Investor Meeting. I hope one of your key take aways from that meeting is that Constellation is evolving as a fundamentally different company that is better positioned than ever to deliver value.

We are focused on executing a strategy into the foreseeable future that delivers this value through organic growth, enhanced profitability, free cash flow and ROIC. The third quarter is evidence of the fact we continue to make progress against our strategic goals of generating cash, paying down debt and reducing costs. During the quarter we advanced our portfolio transformation with the announcement of our agreement to sell our U.K. cider business to C&C Group for approximately $70 million.

The Gaymer Cider Company was originally acquired in 1998 with the Massey Clark business. This transaction is consistent with our strategic focus on premium, higher growth, higher margin wine, beer and spirits brands. The deal is on track to close by mid-January and we expect to use the proceeds to further reduce our borrowings.

During the quarter we also progressed with transition activities associated with our US distributor consolidation effort which now encompasses 22 states representing approximately 60% of our total US wine and spirits volume. As you know, the initial distributor transition commenced September 1st with the second quarter benefiting from the implementation of this program. At that time, actions were taken to ensure maximum levels of customer service between distributor and the retail customers during the transition period.

Now these actions had the planned effect of moving a portion of third quarter sales into the second quarter and resulted in some inventory build at the distributors. During the third quarter consumer take away was softer than expected at the beginning of the quarter but it is improving as our new selling model and promotional efforts take effect. As a result, at the end of the third quarter distributor inventories were higher than historically targeted levels. However, as you can see from the latest IRI data through December our US wine trends have improved from where they were early in the third quarter as our promotional activities have returned to more normal levels.

From an overall marketplace perspective, in the IRI channel growth in the US wine market remains healthy at about 4% on a dollar basis according to recent 12-week data with the greater than $8 price segment growing in the high single digit range. The on-premise channel remains challenging although we believe it is stabilizing and the mass merchandise club channel is outperforming the food and drug channels.

Despite the fact that many of our planned promotional activities were not implemented until late in the quarter many of our leading, well known brands continue to perform well in the marketplace throughout the third quarter including Robert Mondavi’s Private Selection and brands like [Goliath] and Kim Crawford. And we recently received some noteworthy portfolio awards. Two of our wines were selected to be served at President Barack Obama’s prestigious Nobel Prize banquet in Oslo and included the 2003 Inniskillin Gold oak aged Vidal Icewine and the 2005 Robert Mondavi Napa Valley Cabernet Sauvignon.

In addition, Wine.com recently released their top brand list for 2009 showcasing the top wines sold through their website. Five Constellation wines made that list. Five made that list including Robert Mondavi, Kim Crawford, [Shimi], Hogue and Clos du Bois.

Our third quarter spirits net sales results are not representative of strong underlying performance because SVEDKA Vodka shipments this quarter are being compared against last year’s third quarter which was impacted by some unique circumstances. Glass shortages related to new bottling changes for SVEDKA in last year’s second quarter drove strong shipments in last year’s third quarter creating the difficult comparison.

Despite this issue, SVEDKA posted another strong quarter of double digit depletion growth with our year-to-date net sales increasing more than 40%. We continue to build SVEDKA’s on premise brand awareness by leveraging new distributor roots to market. We are growing our national accounts in on and off-premise channels and are expanding in other core markets outside the US.

Moving to the Canadian wine business, the overall business continues to be impacted by economically driven negative mix trends. However, positive sales results were recorded by Naked Grape during the quarter which is one of the leading premium brands in our wine portfolio. As you know, Vincor is a sponsor of the upcoming Winter Olympic Games scheduled for mid-February in Vancouver. We expect to fully capitalize on the brand building opportunities we have planned in connection with this event.

Now moving to our international businesses. The challenges impacting the operating environment in Australia and the U.K. have not subsided. However, as you know we continue to execute the previously announced restructuring of our businesses in these geographies in order to align them with the reality of their respective markets. This includes continuing to focus on cost reductions, decreasing network and capital investment and consolidating our overall footprint in these markets in order to increase efficiencies.

In the short term, we are optimistic about our marketplace performance especially in the U.K. during the holiday selling season. In early November we announced we were working towards the potential combination of portions of our U.K. and Australian operations with Australian Vintage Limited in an effort improve the prospect of these businesses going forward. I have nothing new to report at this time as we continue working to bring this transaction to a successful conclusion.

Moving to the Crown Imports joint venture, as you know we recently received notice of legal action by Modello pertaining to the funding of the JV partners of an immaterial amount of incremental promotional and marketing dollars for the upcoming calendar year 2010. Previously Modello provided this incremental spending and had agreed to do so once again for the 2010 business plan year. My point in addressing this issue is to remind everyone that the Crown joint venture is not a party to this legal action. Crown’s 2010 business plan has already been agreed upon by Modello and Constellation and the JV will go forward with a focus on growing the business through the entire term of this contract.

We intend to continue working closely with Crown to support the joint venture as it continues to operate its business and deliver products in a manner designed to meet or exceed the expectations of consumers, distributor and retail customers.

Now moving to Crown’s operational results for the third quarter, during the quarter sales and operating income for the Crown joint venture continued to be impacted by economically driven challenges in the on-premise and convenience store channels. Operating income in particular was unfavorably impacted not only by the volume decline but by the timing of national media programming for Major League Baseball and the National Football League that occurred in the third quarter. However, depletion trends outpaced shipments in the quarter due in part to the favorable impact of these media programs and resulted in temporary wholesaler inventory reductions.

Crown is also realizing stabilizing trends and import category share gain in the grocery channel where it is performing in line with the US Beer industry and outperforming the imported beer category. We believe this is a result of targeted marketing efforts and programming against its key channel. Recent IRI data coinciding with the end of our third quarter confirms improved performance across the Crown portfolio.

For fiscal 2010 we continue to estimate a decrease in Crown depletions in the mid single digit range with profits expected to decline in the high single digit range. What gives us confidence we can achieve these goals? Crown continues to execute well at retail with solid promotional activity, marketing programs and the rollout of new products and packaging. Expanded distribution has helped to increase selection, retail impact and price point options for consumers. These efforts have resulted in over 60,000 new points of distribution since August 1st.

We continue to expand the rollout of Modello Especial and Negro Modello Draft in key markets throughout the US. Modello Especial, the number three import in the US, continues to be one of the few super premium brands experiencing double digit market growth.

Before I turn the call over to Bob many of you have seen the press release we issued earlier this week mentioning that Jose Fernandez, who was our CEO for Constellation Wines North America, has passed away after a courageous battle with cancer. He was a great leader who will be missed by everyone across our organization. As you know, Jay Wright, President of our North American Wine Organization who many of you met at our recent New York investor meeting will continue to lead the business as we have cultivated strong management continuity in the face of Jose’s passing.

In closing, despite the impact from the US distributor consolidation activities on this quarter’s results, we feel confident regarding our ability to harvest the ultimate benefits from the execution from the strategic initiative of profitable organic growth. As I have indicated, this transition may not be particularly smooth as you have seen from our performance in both the second and third quarters. However, we believe it is absolutely the right strategy to pursue for the long-term growth and profitability of our business.

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

Robert Ryder

Thanks Rob. Good morning everyone. Our Q3 comparable EPS came in at $0.54 versus $0.60 in the previous year. The quarter witnessed quite a few unfavorable timing impacts across most product categories.

US wine was impacted by the shift of sales from Q3 to Q2. Spirit sales growth was impacted by a previous year glass shortage for SVEDKA and Crown’s profits were impacted by unfavorable sales timing and marketing expense timing in the quarter. In addition to these quarterly timing-related items, North American wine depletion did not begin to improve until late in the quarter, our international business continued to experience gross margin pressures and Crown’s beer business continued to be impacted by the economy.

We believe the negative timing events will correct themselves this year and we also believe we have strategies in place to improve the more fundamental challenges facing the business. We have continued taking steps to strengthen our organic business model and we are seeing good progress in a number of areas. As we continue to reduce costs which has helped offset the impact of consumer shifts to lower margin products in this challenging economic environment, focus on generating free cash flow as we are targeting to be in the high end of our full-year free cash flow guidance range, reduce debt and interest expense and work with our consolidated distributor base in the US to drive improvement in our organic sales and mix trends.

We saw good promotion and displays for our brands during the holiday season and began to see some improving depletion and marketplace trends in US wine and beer as the quarter progressed. Our comparable basis effective tax rate for the quarter was 35%. We also project a full year rate of approximately 35% versus our previous targeted full-year rate of 38%. The Q3 rate drove about $0.03 to $0.04 of EPS favorability in the quarter when looked at in relation to the previous full-year tax rate projection of 38%.

Now let’s look at our Q3 P&L performance in more detail where my comments will generally focus on comparable basis financial results. Let’s go to the net sales line. As you can see from our news release on page 13, our consolidated reported net sales decreased 4% primarily due to the divestiture of our Value Spirits business partially offset by the positive impact of year-over-year currency exchange rate fluctuations.

On an organic constant currency basis which excludes the impact of acquisitions, divestitures and forex, net sales were even with the prior year. My commentary for the following net sales comparisons will be on a constant currency basis. Our worldwide branded wine organic net sales which appear on page 12 of the release were even versus last year. This included a 3% decrease for North America offset by an increase of 12% in Europe and 2% in Australia and New Zealand.

North American sales were impacted by continuing economic challenges, higher levels of promotional spending and the shift of sales from the second quarter to the third quarter as part of the US distributor transition activities. We estimate this shift represented approximately $40-50 million in net sales and about $0.05 to $0.07 of EPS.

For Europe sales benefited from increased volumes for our value priced product offerings in the U.K. and an easier comparison versus Q3 last year. Spirits organic net sales decreased 2% for the quarter. Rob has already discussed the difficult comparison item we faced in the quarter.

Now let’s look at our profits on a comparable basis using information on page 14 of the release. For Q3 our consolidated gross margin was 35.4% versus 40% in the prior-year quarter. This reflects lower sales driven by the shift of US sales from Q3 to Q2, higher promotion costs in the US, higher Australian COGS due to the flow through of the more expensive calendar 2008 harvest and negative sales mix in the U.K. and Australia. On a year-to-date basis gross margins are down 2.3 percentage points, much less than the Q3 figure, again reflecting the many unfavorable timing aspects of Q3.

The higher promotion costs in the US represented a proactive effort to shift more promotion dollars into the second half of the year as we transition to our new distributor partners. Our consolidated SG&A for the quarter was 16.1% of net sales compared to 18.8% a year ago. The reduction was primarily driven by our global initiatives, lower marketing expense and the elimination of our spirit SG&A commensurate with the sale of the Value Spirits business.

Consolidated operating income decreased 13% to $190 million and operating margin decreased 1.9 percentage points to 19.3%. Given some of the shifts between Q2 and Q3 that I have discussed it is important to look at our Q3 year-to-date operating margin of 18.1% which is up 1.1 percentage points versus Q3 year-to-date last year. Our appropriate stewardship of SG&A spend more than offset the reduction in our gross profit margin on a year-to-date basis.

I would like now to turn to our segment operating income results on page 11 of the release to provide highlights of our Q3 operating income change. Wine segment operating income decreased $22 million to $218 million. The decrease was primarily due to the Q2 sales shift, higher promotion costs in the US, divestiture of the value spirits business and the decrease in international business profit margins due to negative mix and higher grade costs for our Australian wine. These items were partially offset by savings from our SG&A reduction initiatives.

For the quarter corporate and other expenses totaled $28 million versus $22 million for the prior year. The increase was primarily driven by costs related to project fusion, our multi-year program designed to strengthen our global business system and processes as well as our efforts to improve our U.K. and Australian businesses including the possibility of combining portions of these businesses with Australian Vintage Limited.

On page 14 you can see consolidated equity investment earnings totaled $60 million versus $76 million last year. Equity earnings for Crown totaled $46 million versus $62 million. The remainder of equity earnings in Q3 fiscal 2010 and Q3 fiscal 2009 are primarily generated by Opus One.

For the third quarter Crown generated net sales of $499 million, a decrease of 10% and operating income of $91 million, a decrease of 26%. Economic challenges continued to drive soft performance in the convenience and on-premise channel and consumer movement to lower price beer. Q3 witnessed an unfavorable sales timing which we expect to reverse in Q4 as depletion trends improve and outpace shipments during the quarter.

Crown continues to execute on its targeted promotional marketing support and new package introductions to drive share improvement in the grocery channel import category. Operating income for Crown was impacted by lower net sales, marketing expense timing related to national media for Corona Extra and Corona Light and a contractual cost increase.

Interest expense for the quarter was $64 million, down 18% versus last year. The decrease was primarily driven by our significant debt reduction actions during the last 12 months.

Let’s take a look at our debt position. At the end of November our debt totaled $4.1 billion which represents a $336 million decrease from our debt level at the end of 2009. The decrease primarily reflects the proceeds received from the sale of the Value Spirits business and positive free cash flow. Our average interest rate for the quarter was around 6.2%. Our debt to comparable basis EBITDA ratio at the end of November was 4.2 times versus 4.3 times at the end of fiscal 2009. Proceeds from the pending sale of our U.K. Cider business combined with targeted free cash flow generation in Q4 should reduce this ratio to the high 3 times range by the end of fiscal 2010.

We feel that our strong cash flow, reduced leverage, improved credit profile and much improved credit markets make this quarter and appropriate time to offer to extend our revolving credit facility. We will most likely initiate this process in the very near term.

Our comparable basis effective tax rate came in at 35% which reflects the favorable outcome of various tax items. The rate for Q3 fiscal 2009 was 39%. As mentioned earlier, we now project our full-year comparable basis tax rate to approximate 35% which is much improved versus the previous guidance of 38%.

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. For the nine months of fiscal 2010 we generated free cash flow of $100 million versus $235 million in the prior year. The lower cash generation is due primarily to higher taxes paid including approximately $65 million related to the sale of the Value Spirits business.

In addition, timing of sales in the quarter resulted in higher US receivable balances. This higher receivable balance more than offset by inventory reductions and lower fiscal 2010 grape harvest costs in Australia, New Zealand and the US versus the prior year and less interest paid. As a reminder, free cash flow for the first nine months of fiscal 2009 reflected a benefit of approximately $85 million in pre-tax proceeds related to the favorable settlement of certain foreign currency hedges.

For fiscal 2010 we now expect CapEx to be in a range of $130-150 million versus our previous $150-170 million projection. The reduction in planned CapEx spending is contributing to free cash flow targeted at the upper end of our $230-270 million guidance range.

Moving to our P&L outlook for full year fiscal 2010, we still expect comparable basis EPS to be in a range of $1.60 to $1.70 with reduced full-year expected tax rate of approximately 35%. Our comparable basis guidance excludes acquisition related integration costs, restructuring charges and unusual items which are detailed on page 17.

During Q3 we recognized approximately $60 million of impairment and other charges related to Rufino, an Italian wine company in which we have a 40% ownership interest. This includes a $25 million non-cash impairment for this equity method investment as the financial performance of this business continues to decline due in part to the strengthening of the Euro versus the US dollar. In addition a $45 million charge was reported as a 10% shareholder of Rufino gave notice of its intent to exercise a put option to Constellation at a contracted option price determined at the 2004 acquisition date. This put essentially represents the deferred purchase price from the 2004 investment that we expect to pay in the first quarter of fiscal 2011.

Before we take your questions I would like to note we are working to leverage the benefits of our distributor consolidation initiative and leverage our P&L through expense management and increased operational efficiency. We plan to use free cash flow to further de-lever and reduce interest expense. All of this activity should drive improvement in our organic business model and ROIC.

With that we will be happy to take your questions.

Question and Answer Session

Operator

(Operator Instructions) The first question comes from the line of Kaumil Gajrawala - UBS Warburg.

Kaumil Gajrawala - UBS Warburg

You brought the tax rate down quite a bit but no change to guidance with only eight weeks left or so in this quarter. Can you help give us a read on why the range is as wide as it is?

Robert Ryder

We kept the EPS range at $0.10 when normally in the third quarter we might tighten it a little bit by $0.02 or so. I think it was because of the continued vibrations in the economy and perhaps if it follows through the potential cost of the refinancing of the revolver. They are the two big reasons.

Kaumil Gajrawala - UBS Warburg

So it is not related to spending or marketing or anything like that. It is just more terms of lack of visibility on what core trends are versus where they would have been six months ago?

Robert Ryder

I think that is fair. We just felt we would like to keep the range at the $0.10 given all the uncertainty as our depletions continue to improve in both beer and in wine but we are not sure what is going to happen in the economy and we are still fine tuning our distributor transition.

Kaumil Gajrawala - UBS Warburg

At Crown, how do you feel about where the inventory levels are currently at the distributors? There is obviously a big spread between your trends in depletions. What should we expect in the relationship between the two over the next quarter or so?

Robert Ryder

Generally in the beer business, shipments and depletions are prealigned. This is actually a good news story in that we feel that we were able to get some pretty good media buys because the prices came down in the advertising market over some peak sporting events and actually the sporting events had pretty high ratings. They were actually some pretty good games if you remember back to that. So we think they were good buys and we do think that drove some increased depletions in the quarter. The level of increased depletion surprised us a little bit so we had a slight de-stocking in the beer channel which I think will be replenished in the fourth quarter.

Operator

The next question comes from the line of Lauren Torres – HSBC.

Lauren Torres - HSBC

In your prepared remarks you mentioned that you are seeing trends improve both in beer and wine in the US particularly late in the quarter. I guess I am just trying to get a better sense of with the holiday season obviously being more promotional maybe there is some discounting in there and is that really just driving that momentum or do you think it is coming from somewhere else? So with on-premise still being weak and convenience stores being weak is it just kind of consumers buying in here at lower prices and your lower price brands doing better or do you feel you are really seeing some difference here versus last quarter?

Robert Sands

First of all that comment was relative to our business, not the industry in general. The industry in general although is performing well. I would say it has been fairly consistent as opposed to there being an uptick. In our business on the wine side yes we are seeing some improved performance. I think that is generally as a result of the fact that a lot of our efforts for instance our distributor consolidation and the increase of our promotional activities in the third quarter these things are now kicking in and we really are starting to see some positive impact on that in late third quarter and we have seen some of the positive impact of that into December and the holiday season.

We are pretty optimistic that things are working pretty well at this stage on the wine side. On the beer side, as much as Bob said we had some very good media. The media I think drove some pretty strong sales particularly in grocery. We are seeing some stabilization on the on-premise side. I would say the convenience sector still remains highly challenged.

On beer, I would say that while we are generally pleased and optimistic with the performance we are nevertheless still believing that we will be down from a depletion perspective mid single digits for the year because in general that segment, the import segment although we are way outperforming the competitors. That segment still remains pretty challenged in the beer business.

Lauren Torres - HSBC

So would you say for beer and wine both on-premise and convenience that generally it has been stable, not getting worse?

Robert Sands

Well convenience isn’t a big factor for wine. For beer it is the largest channel. So two completely different things. In terms of, no I don’t think it is getting worse but as I said it remains a pretty challenged segment but let me just reiterate for wine it is not a factor. For beer it is a significant factor.

Lauren Torres - HSBC

Lastly, from a price sensitivity standpoint I know you talked about trading down and certain price points doing better than others. Any real changes there from your comments last quarter?

Robert Sands

Not really. By the way in general I would say trading up has picked up and fundamentally there isn’t trading down in that the higher priced segments are now growing much faster than the lower price segments with the super premium plus category growing high single digits again. That said, I still would say that within category there is some trading down going on. I would say categories mean price segments. So if you look at the $10-15 segment within that there will be some trading down towards the lower end of that segment versus the higher end or if you are looking even the higher end segments there will be some trading down.

Fundamentally there is trading up although within segments there is trading down and therefore there can be some negative mix shift which is the case. There is some negative mix shift in the business even within categories some of the lower price products are selling better than the higher priced products and of course margin tends to go with the price point.

Operator

The next question comes from the line of Bill Leach – TIAA-CREF.

Bill Leach – TIAA-CREF

I wanted to follow-up on the question about the fourth quarter guidance. You only made $0.21 in the fourth quarter last year so you have a $0.10 which is almost a 50% variability and you are basically guiding from anywhere from a 10% decline to a 20% gain which is essentially meaningless. Can’t you flesh that out a little bit? Also if you do expect Crown to be down in earnings high single digits, 12% in nine months, does that mean you actually expect it to be up in the fourth quarter?

Robert Ryder

Part of that for the quarter and for the full year we did have the tax rate upside. Offsetting that might be some slightly weaker EBIT throughout the businesses. We are still a bit tentative on what sales are going to do so we thought it was prudent to keep the full $0.10 range. Remember, if we are successful in refinancing our debt there will be costs associated with that as well which would hit the fourth quarter.

Bill Leach – TIAA-CREF

Wouldn’t that be these nonrecurring charges?

Robert Ryder

Pardon?

Bill Leach – TIAA-CREF

Wouldn’t that be due to a non-recurring charge?

Robert Ryder

Some would and some wouldn’t.

Bill Leach – TIAA-CREF

You have to admit that is an unusually wide range for a quarter.

Robert Ryder

I guess. $0.08 versus $0.10. I don’t know some may be passionate about it. I don’t know.

Bill Leach – TIAA-CREF

Do you expect Crown to be up in profits in the fourth quarter?

Robert Ryder

I wouldn’t expect that. No. Profits have been negative for Crown. You can back into it our stated guidance for Crown is profits will be down high single digits. It may be high single digits to maybe very low double digits.

Bill Leach – TIAA-CREF

Can you give us some guidance about the tax rate for next fiscal year? Will it go back up to 38%?

Robert Ryder

We can try. We will be giving full-year guidance at the year-end call. It is interesting you say that because all of our planning meetings with our business units happen very shortly and after that the tax guys start wrapping up what we think geographies and profits are going to come to. So it is a whole process. We will be talking about that on the April call.

Bill Leach – TIAA-CREF

Because we have to make an earnings estimate for next year which starts shortly. What would you suggest we plug in as a normalized tax rate? Your previous guidance was 38% for this year. Would that be a good number going forward?

Robert Ryder

That will be your choice. Right now I can’t anticipate any significant changes here. Remember there are some pretty big swingers in the air like if our transaction goes ahead with Australia Vintage Limited that can have an impact on tax rates. So there are a lot of moving parts. I don’t envy you because you are right you have to make a call and you don’t have all the information. Sorry about that.

Operator

The next question comes from the line of Timothy Ramey - D.A. Davidson & Co.

Timothy Ramey - D.A. Davidson & Co.

Just thinking ahead to try and get a handle on the growth in the branded wine business, it is awfully difficult to march through given pretty good reported numbers on the IRI stuff but we know that is the best performing segment and on-premise declining. What do you think the outlook is for the wine segment for calendar 2010 forgetting your fiscal year? Are we going to have growth in calendar 2010?

Robert Sands

I would say somewhere between really we can only talk volumetrically because you don’t have a lot of insight into dollars beyond the IRI channel which is only about 30% but volumetrically I would say that around 1% would be a good guess. It could be a bit higher than that. It could be a bit lower than that depending on the state of the economy. That is for the total wine industry in the US. We will see IRI grow faster than that. We will see mass merchandise grow faster than that. We will see on-premise grow slower than that. There is going to be puts and takes. Volumetrically about 1% and then in dollars will be higher than that because of the general trends towards trading up which continue.

Timothy Ramey - D.A. Davidson & Co.

I know you are not going to give us guidance today but given your more premium mix is there any reason why you shouldn’t exceed the industry growth in 2010 versus 2009?

Robert Sands

Our goal is to equal or exceed industry growth on a weighted basis. So you have to take into account what categories you play in and so on and so forth. That is our goal. So equal or greater.

Operator

The next question comes from the line of Lindsey Druckerman – Goldman Sachs.

Lindsey Druckerman – Goldman Sachs

I was hoping you could clarify the underlying wine trends in the US in the third quarter

Inventory shift that moved into the second quarter and hurt the third quarter. You reported up 3% in the second quarter and down 3% in the third quarter so it sort of implies that underlying the second quarter including the inventory shift you were down low to mid single digits and in this quarter you were up low to mid single digits which is a nice sequential uptick. Is that a fair way to read that?

Robert Ryder

It is a little confusing. Probably the easiest way to look at it is the year-to-date numbers. If you look at year-to-date in the press release for North America I think sales were essentially flat. Right? That is pretty much in line with where our more recent depletion data has been. So that is probably the best way to look at it.

Lindsey Druckerman – Goldman Sachs

Is it fair to say at all you saw a sequential improvement in an underlying basis in the third quarter versus the second quarter?

Robert Ryder

From a depletion standpoint maybe a little bit.

Lindsey Druckerman – Goldman Sachs

From a sales standpoint? We are seeing more promos and discounting.

Robert Ryder

I think sales if you iron out the movement in Q2 to Q3 again sales were sort of flat in North America similar to the year-to-date trend. Okay? Depletions have gotten better since just before Thanksgiving I would say versus what they were from the second quarter through the first part of the third quarter.

Lindsey Druckerman – Goldman Sachs

On the gross margin performance in the third quarter you mentioned promotional spending, the inventory shift in Australia as some of the drivers. You also mentioned that the promo spending didn’t really hit until or at least impact your sales until the end of the quarter. Is this something you booked for the entirety of the third quarter?

Robert Ryder

I guess we talked about this a bit at the second quarter. Because of the distributor strategy we sort of held back some promo spending in Q1 and Q2 so we could sort of do it with the new distributors in Q3 and Q4. So that did flow through our income statement in Q3. Now you don’t see that. It is in the net sales number. So Q3 of this year we did spend in the US more promotions money than we did in the previous year. So that did impact the P&L.

Lindsey Druckerman – Goldman Sachs

Can you quantify how much the distributor pre-sell for holiday hurt your margin in the third quarter?

Robert Ryder

Can you repeat that?

Lindsey Druckerman – Goldman Sachs

You had year-over-year gross margin compression. How much of that was a function of loading or pre-selling for holiday in the second quarter for your distributor transition? The other elements would presumably would continue…Australia cost of goods would flow through in February. You are still promoting for the February quarter so I am just wondering how much of that year-over-year compression is one-off.

Robert Ryder

I don’t know if I would call any of it one off. Because of the noise between Q2 and Q3 both in wine and remember the comment we had around SVEDKA it is probably better to look at the year-to-date P&L where you will see a gross margin reduction but that is more than offset by our SG&A initiatives and on a year-to-date operating profits are up about 180 basis points. Gross profit margin was down about 230 basis points or something like that. The SG&A saved it. We think and we took these actions in the fourth quarter of last year. We think we have been relatively diligent about bringing SG&A down to offset the gross margin compression.

Lindsey Druckerman – Goldman Sachs

Lastly, with respect to the Crown JV, the current lawsuit aside can you comment on whether there is anything in your contract whereby if Constellations director who sits on Crown’s board will be not acting in good faith for the entity it would damage your participation in that JV?

Robert Sands

No. There is nothing to that effect.

Operator

The next question comes from the line of Marc Greenberg – Deutsche Bank.

Marc Greenberg – Deutsche Bank

My question relates to Crown. As you know, the litigation surrounds a relatively small dollar amount and I am wondering if this doesn’t suggest that the broader partnership agreement may not be on steady footing. Maybe you could offer some perspective on how we should consider the potential risk to Constellation based on any deterioration here and is there any point in which you might say look it is not working, let’s move on? And how we might think about what that could mean to shareholders?

Robert Sands

I think Lindsey asked the question and my answer was a definitive no. The litigation has no impact whatsoever on the contract. There is no impact on the term. It is a dispute over money which was said an immaterial amount. Clearly again in an answer to your question my answer is no. I am not even clear on what you mean by calling it quits. No, we won’t. We can’t do that. As you know the contract’s initial term runs through the end of 2016. We have certainly no reason to believe or expect that anything different will occur other than the business will continue to be operated and generate the kind of results it has historically.

The results of course historically it has been a very strong performer. With the downturn in the economy the import business has been negatively impacted. I would say as the economy improves there is upside in that business in particular being a bit more cyclical than some of our other businesses. There is no impact on the business that is Crown and there is no impact really on the JV agreement or the term related to the lawsuit which as I said is what we stated is an immaterial amount of dollars.

Marc Greenberg – Deutsche Bank

To follow-up is it fair to characterize the current relationship with Modello and Constellation as maybe not seeing eye to eye on certain things? I guess that is kind of why I asked that question. I know the business risk is the business is being run separate and distinct from this. I wouldn’t contest this at all. But I am trying to think about the value of this asset and in the past you have talked about the fact you don’t feel that at times the value of the Crown JV is reflected in the value of your share price. I guess with this lawsuit maybe it puts a bit of a cloud on that.

Robert Sands

First of all nothing about the lawsuit would impact my previous statements with regard to the value of the JV not being appropriately reflected in Constellation’s valuation for all the reasons I have stated in the past because nothing has changed in that regard with respect to what happens at the end of the contract and the issues around recognizing the terminal value. Nothing has changed at all.

Obviously there is a disagreement between us and Modello on the point that is being litigated in the lawsuit. I would say as a general proposition that both partners recognize we have to get along and we have to work together as it relates to the overall operations of Crown to maximize its success. No, we can’t ignore the fact that there is a dispute over something very specific which is being litigated but we are all reasonable people and we all understand that we have to get along and operate with respect to ensuring that the operations of the business are maximized. That is basically where things stand.

Operator

The next question comes from the line of Kevin Dryer - Cavelli & Company.

Kevin Dryer - Cavelli & Company

On the increase in accounts receivable I think you said something about that being related to some of the timing issues. Is that related to the change in distributors?

Robert Ryder

Essentially the shipment to distributors happened at a point in the quarter where we won’t collect the receivable until the fourth quarter so that is why you have a very high receivables balance and you have an increased use of cash in the accounts receivable line item on the cash flow statement.

Kevin Dryer - Cavelli & Company

In terms of the tax rate, while I understand you won’t give fiscal 2011 guidance, can you explain again why the rate came down to 35% from 38% for this year?

Robert Ryder

Sure. It was essentially some positive outcomes on some tax audits essentially. So the tax audits were cleared. When they are cleared we reflect either the positive or negative in the P&L and this quarter it was a positive.

Kevin Dryer - Cavelli & Company

So these weren’t like one-time reversals from prior years or something like that?

Robert Ryder

Actually yes they were. The auditors are usually about 3-4 years in arrears and when the audits get cleared up and these related to previous years’ tax expense that was taken that can flush through the P&L. So if they get cleared positively that reduces this year’s tax rate. If they don’t get cleared then you should have that actually covered and you won’t see a change in the tax rate.

Kevin Dryer - Cavelli & Company

Finally, I want to know if you can comment again another question on Crown. With Modello’s lawsuit within that it is not just about money. They seem to allege you are trying to use this marketing budget to renegotiate the terms of the JV. Can you comment on that at all? If you were looking to renegotiate what are you looking to do? Extend the term for instance?

Robert Sands

The answer is no I really can’t comment on that. It is a matter that is being litigated. It is really not appropriate for me to comment on that point. I apologize for not being able to give you more information on that but clearly that is not something we discuss at this time.

Operator

The next question comes from the line of Mark Swartzberg - Stifel Nicolaus.

Mark Swartzberg - Stifel Nicolaus

On CapEx, 130-150 is the guidance for the current fiscal year but the 150 number seems rather large unless you have something large in the way of spending happening in the current quarter. That is part one of my CapEx question and then I have a follow-up.

Robert Ryder

I would say we are a pretty big business and in every industry I have been in the wide majority of your capital spend occurs in the fourth quarter because sometimes it is the engineering school training that happens. I have been in a couple of different businesses so that is kind of happening. The other thing going on is the fusion ERP project we have going on that certainly we will be spending around that in the fourth quarter and there was very little if any in last year’s fourth quarter. So that is probably the answer to that.

Mark Swartzberg - Stifel Nicolaus

That is the low visibility item back on the line of questioning Bill had? You would think that in January you would know what you are going to spend on that. Is that the item that has uncertainty to it?

Robert Ryder

There is a lot. Again as I said, the way you do a capital forecast there are thousands of projects that sort of roll up and it is very difficult to get…the engineers always want to hold onto that capital forecast so we do the best we can to try to isolate the numbers and give the best guess we can. But you never know. So it could be a lot of projects get spent against and also the fusion project is a new project so there is no history against which we can look. We are relatively comfortable in bringing down that CapEx number and again the range is $20 million in a $250-270 million number. So there is a lot of moving parts in the cash flow forecast.

Mark Swartzberg - Stifel Nicolaus

I think you answered my follow-up. As we think longer term it sounds like last year the number was just shy of 130. There are some unusual items this year regardless of whether it is 130 or 150 for the fiscal year. It sounds like long term you think the number is closer to 130 than 150?

Robert Ryder

I think that is a pretty narrow range for a long-term forecast. I think if I was you the long term forecast a fair number would be 130-150 and again because of where we are in the wine business we are pretty mature. We have all our facilities so our big use of capital is more around inventory than it is around capital spending. 130-150 I think is probably about 3.5% to 4% of sales which for us isn’t a real big number.

Operator

There are no further questions at this time. I will turn the floor back over to Mr. Robert Sands for any closing remarks.

Robert Sands

Thanks for joining our call today. Let me summarize what I think are the highlights of the third quarter as follows: First, we continued to benefit from our global cost reduction initiatives. Our full year free cash flow is targeted to be at the upper end of our guidance range. We reduced debt by more than $335 million since the beginning of our fiscal year. We continued our portfolio transformation efforts with the proposed sale of our cider business, the proceeds of which we expect to be used to further reduce our debt. We are experiencing improving depletion trends in our US wine, spirits and beer business. Lastly, we continue to progress with our distributor consolidation initiative. Our plan is to continue execution of our strategic initiatives throughout the final quarter of the year.

Finally, we will be providing guidance for our fiscal year 2011 during our next quarterly conference call scheduled for early April. Thank you again everybody for joining our call.

Operator

Thank you all for participating in today’s conference call. You may now disconnect.

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Source: Constellation Brands, Inc. F3Q10 (Qtr End 11/30/09) Earnings Call Transcript
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