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Constellation Brands, Inc. (STZ)

F4Q08 Earnings Call

April 3, 2008 10:00 am ET

Executives

Patty Yahn-Urlaub – VP IR

Rob Sands – President, CEO

Bob Ryder – CFO

Analysts

Tim Ramey – D.A. Davidson & Co.

Kaumil Gajrawala – UBS

Judy Hong – Goldman Sachs

[Riza Zabazita] – Lehman Brothers

Lauren Torres – HSBC

Marc Greenberg – Deutsche Bank

Mark Swartzberg – Stifel Nicolaus

Jonathan Feeney – Wachovia Securities

Bryan Spillane – Banc of America

Operator

Good morning. My name is Bree and I’ll be your conference operator today. At this time I would like to welcome everyone to the Constellation Brands fiscal 2008 earnings conference call. (Operator instructions). Thank you, it is now my pleasure to turn the floor over to your host, Patty Yahn-Urlaub, ma’am, you may begin your conference.

Patty Yahn-Urlaub

Thank you Bree. Good morning everyone and welcome to Constellation’s fourth quarter and fiscal year end 2008 conference call. I’m here this morning with Rob Sands our President and Chief Executive Officer and Bob Ryder our Chief Financial Officer. By now you should have had an opportunity to read our news release which has also been furnished to the SEC. This conference call is intended to compliment 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 investor section. These reconciliations include explanations as to why management uses the non GAAP financial measures and why management believes they are useful to investors.

Discussions will generally focus on comparable financial results excluding acquisition related costs, restructuring and related charges and unusual items. We will also discuss organic net sales information which is defined in the news release and constant currency net sales information which excludes the impact of year over year currency fluctuations, currency exchange rate fluctuations. Please be aware that we may make forward looking statements during this call. While those statements represent our best estimates and expectations, actual results could differ materially from our estimates and expectations. For a detailed list of risk factors that may impact the company’s estimates please refer to the news release and Constellation’s SEC filings. And now I’d like to turn the call over to Rob.

Rob Sands

Thanks Patty and good morning everybody and welcome to our call. We have several items to discuss this morning, including our fiscal year 2008 results and our guidance for 2009. As I look back on 2008, I would characterize it as the year of significant accomplishments. We exceeded our key financial goals and achieved our strategic initiatives which most notably include premiumization of our brand portfolio, including the acquisitions of Svedka Vodka and the Fortune Brands US premium wine portfolio.

We formed a joint venture with Punch Taverns in the UK in order to strengthen Matthew Clark’s position as the UK’s largest independent drinks wholesaler serving the entreed industry. Although the Crown joint venture was formed in late fiscal 2007, Crown spent much of 2008 integrating the business and executing a smooth transition with the joint venture growing volume and profits across the Modello product portfolio. We divested the low margin Almaden and Inglenook value wine brands which will enable us to enhance the growth, profitability and ROIC of our US wine portfolio.

It also allows us to focus on the higher growth, higher margin premium wines within our portfolio. As part of our wine acquisition activities, we re-aligned our US sales and marketing force in order to focus on specific consumer segment opportunities which include fine wine, premium wine and specialty value wines. As part of this initiative we continue to rationalize our US wine product portfolio, primarily within the value segment. This includes smaller low margin regional brands at price points generally less than $5.00.

We are in the process of consolidating certain wine marketing operations in Australia in order to insure optimal asset utilization and produce greater efficiency from our global wine production infrastructure. We completed our US wine distributor inventory reduction initiative. Although it impacted sales and earnings for fiscal 2008, it was the right thing to do for the business as we achieved our objectives of creating supply chain efficiencies and enhancing our brand strength in the marketplace. From a financial perspective, we exceeded our comparable earnings per share goal and achieved record free cash flow for the year.

Overall, we are executing on our strategy and taking the appropriate actions to further position our business for success in the future. We expect this momentum to continue throughout 2009. And you’ll see from our guidance that we are on a path to further strengthen the growth and profitability of our business. And now I’d like to discuss our business and financial performance for fiscal 2008. My discussion today will primarily focus on full year results with the exception of the impairment charges recorded in the fourth quarter reflecting business challenges experienced in the UK and Australia.

And I’d like to spend a minute providing a little bit more context around the impairment charges which are primarily related to our Hardy’s business in Australia and the UK and then Bob Ryder will provide additional financial details about the charges. Constellation acquired Hardy’s in March 2003. The strategy was to take a leading position in one of the most important appellations for new world wines. Australia was and is considered a great source of quality wines at value prices.

However, at that time, the Australian dollar was much weaker versus most major currencies, the wine industry was experiencing shortages of key varietals and the UK had not had a wine duty increase for three years. Since then the Australian dollar has strengthened. Australia had the three largest harvests in its history which created a surplus of wine and in the UK which is Hardy’s largest market, the government implemented an annual duty increase beginning in April 2003. So where do we stand now? We have taken steps to improve profitability, operating efficiencies and our competitive position in both the UK and Australian markets. In January we implemented a UK price increase to cover cost increases, but immediately implemented an additional price increase to cover the recently announced duty increase.

Because we continue to invest in brand building in the UK, we are in a good position with retailers as we implement our pricing actions and we believe other suppliers are taking similar actions. The UK remains one of the world’s largest import wine markets, growing at a healthy rate of 7% on value in the multiple grocer channel per recent Nielsen data with Constellation’s growth exceeding the market growth rate. Overall, we believe the margin compression in the UK has bottomed, the market remains healthy and there is good momentum going forward.

The Australian wine market is also healthy, growing at mid single digits on a value basis. Australia is one of the largest exporters of new world wines and will continue to provide growth opportunities for Constellation going forward. We believe these are strategically important markets and are beginning to see some positive signs of recovery. I’d also like to note that the UK and Australian markets combined currently represent less than 10% of our total company EBIT and we expect to improve our operating results from this level in 2009 and beyond.

Moving to the US wine business. We have undergone a major transformation in our US wine portfolio with divestiture of Almaden and Inglenook which represented 15-20% of our US wine volumes and the addition of the premium Fortune Brands, namely Clos du Bois, a super premium wine selling in the $8-$11 price category. As you know the total portfolio of acquired products is well positioned among fast growing super premium plus wines, solidifying our position as an undisputed leader in the US premium wine business. As a result of these portfolio changes, our value premium mix has changed dramatically.

Our US portfolio is now comprised of approximately 30% value wines and 70% premium wines on a volume basis and about 15% value versus 85% premium on a dollar basis. In addition, our portfolio rationalization initiative continues as we are discontinuing small regional value wine brands in the US. The culmination of these activities will result in the US wine portfolio we believe will be well positioned to drive sales growth, margin expansion and improved ROIC.

From a marketplace perspective, growth in the US premium wine market remains very healthy at about 9% on a dollar basis according to recent 12 week IRI data. In particular, the super premium plus segment where wines sell for $8.00 and above at retail and where Constellation has a leading market share continues to grow at double digit rates exceeding the trends of the total US wine market.

This segment includes Constellation Brands such as Estancia, Toasted Head, [see me] Robert Mondavi, Franciscan, Kim Crawford, Wild Horse and the newly acquired Clois du Bois brand. We are also seeing evidence that strong trading up activities continue in the marketplace. From an economic perspective, we are seeing some venue shift from on premise consumption to off premise consumption. Within the off premise channel, we are also seeing some shift at discount retailers including large mass merchandisers and wholesale clubs.

I’d like to remind everyone that we remain generally insulated from the impact of these venue shifts because we sell directly to the distributor tier in the US at the same margin regardless of the end user consumption. Our Canadian wine business posted strong results for the year, primarily driven by the premium wine portfolio including Jackson-Triggs, Sawmill Creek, Naked Grape and Inniskillin icewine products which all contributed double digit sales growth.

In the spirits segment, Svedka Vodka had a great year and generated phenomenal growth of greater than 40% versus calendar year 2006. It is not only the fastest growing major imported premium vodka in the US but according to recent impact data, Svedka is the fastest growing major premium spirit in the world with a five year [kagger] of approximately 50%. The base spirits business also contributed strong sales growth for the year driven by premium brands, including Black Velvet, Ridgemont Reserve 1792 Bourbon, the 99 Schnapps Family, recently launched new products and contributions from our production services business. Overall, approximately 30% of our spirits sales are represented by our premium product portfolio. Our premium spirits products are growing at the rate of 24% in the most recent 12 week IRI channels.

Moving to Crown imports joint venture. Calendar year 2007 was a transition year for crown as it completed its first full year of operation. During the company’s fiscal year 2008, the crown joint venture generated $2.4 billion in net sales and more than $500 million in operating income. Crown has the leading market share in the import category in the US with 5 of the Modello brands represented in the top 20 import brands.

Corona is the number one imported beer and Modello Especial is now the number three import. As we’ve previously indicated, volumes for the business have been impacted by price increases implemented at the end of calendar year 2006 and at the beginning of 2007. In addition, the second half of our fiscal year was impacted by challenging year over year Crown comparisons as we prepared for the joint venture transition during the same timeframe the previous year.

We are now beginning to lap this price increase for certain markets, but because of the staged nature of last year’s price rollout, we will not fully lap the increase until we have completed the first quarter of our fiscal year 2009. The good news is that in a number of markets where the pricing cycle has been completed, we are seeing a return to solid growth trends. While we are cautiously optimistic some of our key markets like California have been particularly hard hit by the economic downturn.

These markets will be a key focus for Crown as we move into the critical selling season. On the other hand in markets like Texas and in the East, we have seen double digit volume growth return in 2008. Going into the Cinco de Mayo holiday and the key summer selling season, Crown is well positioned to execute at retail with outstanding new creative and promotional materials and a strong fully staffed organization. As a result, Crown is confident in its ability to achieve mid single digit depletion growth for fiscal 2009.

Now before I turn the call over to our CFO Bob Ryder, I wanted to discuss our EPS guidance for fiscal 2009. As you can see our EPS range of $1.68-$1.76 clearly shows progress from where we ended fiscal 2008 and demonstrates that we are committed to enhancing the growth and profitability of our business. Our cash flow guidance also demonstrates a strong commitment to cash flow generation. I will provide an overview relating to other future business objectives and initiatives when we get together for our May 29th investor meeting in New York. And now I’d like to turn the call over to Bob Ryder for a financial discussion of our business results. Bob.

Bob Ryder

Thanks Rob, good morning everyone. Overall I’m pleased with our results for the year with comparable basis diluted EPS coming in at $1.44. We effectively hit our operational P&L goals for the year end and experienced some positive tax rate adjustments which contributed to the outperformance on a comparable basis expectations. I’m especially pleased with our record free cash flow generation which exceeded our goals. We are targeting another year of strong free cash flow generation in fiscal 2009.

But from an operational perspective, we believe we have taken many significant steps during the past year to increase our profit generation profile and drive improved financial results in fiscal 09. We believe our efforts throughout fiscal 2008 and our planned initiatives for fiscal 2009 better position our UK and Australian businesses for improved performance going forward. In addition, we added faster growing super premium and luxury brands like Clois du Bois and Wild Horse with average selling prices and margins that are greater than our base portfolio.

While also divesting lower price lower margin value brands like Almaden and Inglenook. Before I review our fiscal 2008 results and our guidance for fiscal 2009, I would like to discuss the $874 million of charges recorded in Q4. This amount is significant, however it is non-cash and has no impact on our debt covenants, our liquidity or our ability to execute our business strategies. These charges primarily relate to goodwill and intangible assets impairments associated with the company’s Australian and UK businesses in connection with the company’s annual fourth quarter impairment testing under SFAS 142.

As previously discussed, profits and cash flows for these businesses have been negatively impacted by competitive pricing pressures driven by the strength of the large grocery retailers, Australian wine oversupply and UK duty increases. As a result of the lower profit trends associated with these businesses, our SFAS 142 test required us to recognize and impairment charge. The charges primarily include goodwill and intangible impairments of around $800 million related to Australia and the UK and a $52 million Australian deferred tax asset valuation allowance.

Now, let’s look at our fiscal 2008 P&L performance where my comments will generally focus on comparable basis financial results. Let’s look at the net sales line. As you can see from our news release on page 15, our consolidated net sales decreased 28% reflecting the move of US imported beers to the Crown imports JV and the UK wholesale business to the Matthew Clark JV. Sales were also impacted by our initiative to reduce distributor wine inventories in the US. The growth rate was 5% after excluding the impact of acquisitions and joint ventures and 1% after adjusting for currency changes. Excluding an estimated $110 million net sale impact for the reduction of the distributor wine inventories, we estimate organic net sales grew in the mid single digits.

My remaining comments will be on a constant currency basis. Worldwide branded organic net sales decreased 2%. Please turn to page 14 of the release. Organic branded wine geographic net sales for North America decreased 3% reflecting solid growth in Canada, more than offset by the impact of reducing US wine distributor inventory levels during the first half of the year. As previously discussed, the goal of this initiative was to assure distributors have sufficient inventories to meet consumer demand but to reduce any permanent buffer stock in non peak periods. This [drew] a timing change in our US wine sales pattern.

After we completed the peak holiday selling season in the third quarter, we returned to the lower distributor inventory levels achieved at the end of Q2. This negatively impacted our Q4 rate. Our underlying sales to retailers were well within our range of expectations of low to mid single digits growth, excluding divested brands. For Europe, branded wine organic net sales increased 4% reflecting higher sales of popular priced wine to mainland Europe and a slight increase in net sales in the UK. Our Australian New Zealand branded wine net sales decreased 2%. Turning our attention to spirits, net sales increased 26% due to the Svedka acquisition and 9% increase in organic net sales driven primarily by higher average selling prices, an increase in our production services business and new products.

Now, let’s look at our profit on a comparable basis using information on page 17 of the release. For the year our consolidated gross margin was 34.9%, up 4.9%. This primarily reflects the benefits of shifting the lower margin UK wholesale and imported beer businesses to joint ventures which was somewhat offset by lower margin for the branded wine business in the UK and Australia and the impact of reducing distributor wine inventories in the US. Our consolidated SG&A for the year was 20.4% of net sales compared with 13.8% a year ago.

This increase was also primarily due to moving the imported beer and UK wholesale businesses to joint venture structures. In addition, we saw increased management incentive expense due to low bonus accruals in the prior year and higher stock compensation expense for the transition effects related to SFAS 123R. This year also included higher marketing support for branded wine in the UK. Consolidated operating income decreased to $545 million from $843 million for the prior year.

This change was primarily driven by the factors already mentioned combined with reporting $255 million of equity earnings for the Crown JV compared to last year when we recognized $39 million of equity earnings for Crown and $208 million of earnings for our imported beer business that was included in operating income. Now I’d like to turn to our segment operating income results on page 13 of the release. The year over year increase in beer business profitability reflects increased pricing and economic benefits of having a national platform for the Modello portfolio.

We saw lower total profit growth for the beer business in the second half of the year versus the first half of the year. As previously discussed, this was primarily attributable to a high level of sales in the prior year third and fourth quarters as the business was preparing for the Crown transition. Wine segment operating income decreased $72 million to $558 million. This was primarily due to the lower net sales associated with the reduction of US distributor wine inventories and UK and Australia business performance. For the spirits segment, operating income increased $7 million primarily due to the contribution from Svedka and higher sales for the base business, offset somewhat by higher material costs.

For the year, corporate and other expenses totaled $86 million compared to $61 million for the prior year. The increase includes additional management incentive and stock compensation expenses for the reasons I mentioned earlier. And higher outside service and professional fees related to management reporting system enhancements and transactions. Please turn to page 17 of the release. Equity investment earnings totaled $274 million versus $53 million last year.

Equity earnings for the year are comprised of $255 million from Crown and the remainder related substantial to Opus One. Interest expense for the year was $342 million, up 27% over last year. The increase primarily reflects the incremental interest from funding acquisitions and $500 million of share repurchases, net of the proceeds received from the Matthew Clark transaction.

Now let’s take a look at our debt. At the end of February, our total debt totaled $5.3 billion which compares to $4.2 billion of debt at the end of fiscal 2007. The increase reflects $386 million Svedka acquisition, $885 million for the Fortune Wine business acquisition, $500 million in share repurchases, partially offset by $186 million in proceeds from the Matthew Clark JV transaction, $134 million received from the sale of Almaden and Inglenook and our strong free cash flow generation during the year.

At the end of the year we had approximately $2.7 billion of bank debt under our senior credit facility. Our interest rates are generally tied to LIBOR plus a margin of about 1.25-1.5%. Approximately $1.2 billion of this debt is effectively fixed with interest rate SWAPs through 2010. The remainder of our borrowings is comprised of $2.6 billion of fixed term and other debt. Our average interest rate for 08 was just under 7%. We have received a lot of questions related to the challenging debt market and whether this will have any impact on our company.

We have $556 million of revolving credit available under our senior facility at the end of February. This provides ample liquidity and flexibility and is in place through June 2011. There is no issue with accessing this facility. Our debt to comparable basis EBIDTA ratio at the end of February was 5.3 times. Although on the high side of our historical range, we’re comfortable with this level. With the strong free cash flow planned for fiscal 2009, we believe we can reduce this ratio to the low to mid 4 times range over the next 12 months.

Our comparable basis tax rate came at 32.6% versus 35.6% last year. The rate decrease was driven by favorable foreign tax rate changes recognized in the fourth quarter. Our comparable weighted average diluted shares outstanding for the year totaled $223 million compared to $240 million last year, reflecting the benefit from a share repurchase. The wine brands acquired from Fortune produce $14 million of net sales for the two and a half months we owned them in the fourth quarter.

We estimate the results of the acquired business produced approximately $0.03 to $0.04 of dilution. As previously discussed, this was anticipated and primarily driven by high levels of product inventory in the distributor channel in the fourth quarter which resulted in net sales for the acquired business that were well below normal levels. Distributor inventories for these brands were at Constellation’s target levels at the end of February. Due to the many factors just mentioned, diluted EPS was $1.44 versus $1.68 last year.

Now let’s turn to cash flow on page 12. For purposes of this discussion, free cash flow is defined as net cash provided by operating activities less capital spending. For fiscal 2008, we generated record free cash flow of $376 million versus $121 million in the prior year. The year over year increase reflects lower taxes paid, improvements in working capital and reduced capital spending. We anticipate following this performance with another strong cash flow year in fiscal 2009.

For fiscal 2009, we are targeting free cash flow to be in the range of $310-$340 million. This includes cap ex in the range of $150-$170 million. We expect free cash flow to be down slightly from fiscal 2008 as the benefits of higher earnings will be offset by higher cash taxes paid as some of the timing benefits from 08 reverse and higher working capital investment, primarily related to increased harvest requirements anticipated in 09.

Summarizing fiscal 2008, we made a lot of strategic progress. We are pleased with our results. We made progress with our initiatives to drive performance improvement in the UK and Australia. The acquisitions of Svedka and Fortunes Wine business combined with the Almaden and Inglenook divestiture have strengthened the company’s premium position. We also completed the Crown and Matthew Clark joint venture transitions and increased our focus on improving free cash flow. As a result of these efforts, we are enthusiastic about our prospects as we head into fiscal 2009.

Moving to our P&L outlook for the full year 09, we’re forecasting on a comparable basis diluted EPS in the range of $1.68 to $1.76. The significant improvement in projected results reflects solid underlying growth for our North American wine business and the Crown imports joint venture. In addition to anticipated performance improvement in our UK and Australian wine business. Earnings will also benefit from the completion of our initiative to reduce US distributor wine inventories.

We effectively completed this by the end of the second quarter of fiscal 2008 with an estimated one time impact of $110 million to net sales and comparable EPS impact of about $0.15, with approximately 75% of that impact coming in the first quarter and the remainder hitting in the second quarter. We expect reported net sales to increase mid single digits. Excluding the impact of acquisitions and divestitures, organic net sales are expected to result in an increase of high single digits. Organic net sales growth excluding the onetime benefit of completing the distributor inventory reduction is expect to be mid single digits.

We expect operating margin expansion for the wine segment in excess of 200 basis points for fiscal 2009, reflecting the impact of the various items we discussed earlier. Interest expense is expected to be in the range of $340 to $350 million. This is fairly level with fiscal 2008 as the full year impact of funding the share repurchase and the Fortune Wine business acquisition is offset by the $134 million received for the sale of Almaden and Inglenook at the end of fiscal 2008 and the free cash flow generation we are targeting for 09. We anticipate the tax rate to approximate 37%.

As a reminder, a very high percentage of our profits are being generated in the higher tax jurisdictions in North America. We’re seeing a weighted average diluted shares of approximately $222 million. We also expect stock based compensation expense to approximate 46 million versus 32 million in fiscal 2008, as we continue to recognize higher stock compensation expense for the transition effects of SFAS 123R.

Corporate expenses are expected to be in the range of $95-$100 million. The increase versus fiscal 2008 includes the impact of additional stock compensation expense and costs to support the growth of the company. In addition, we are still targeting a penny to two penny accretion in fiscal 09 for the Fortune Wine business acquisition offset by a penny to two penny dilution from the Almaden and Inglenook divestiture. Our comparable basis guidance excludes acquisition related integration costs, restructuring and related charges and unusual items which are detailed on page 19 of the news release. With that, we’re happy to take your questions.

Question-and-Answer Session

Operator

Thank you. (Operator instructions). Thank you, our first question is coming from Tim Ramey of D. A. Davidson.

Tim Ramey – D.A. Davidson & Co.

Good morning. You mentioned the IRI numbers on line growth which are encouraging but can you give us any further detail about what order patterns look like, the economic news is evolving quickly and is that seeming to have any impact on the line business or is it sort of business as usual?

Rob Sands

You know first I would say that I think that in general its business as usual. As I talked about, you know we do tend to see some venue shift and economic downturns. We’ve seen some shift from on premise to off premise. We’ve seen some shift within the off premise to the mass merchandisers away from some of the chain retailers and specialty retail accounts.

But in general I think that the wine business has been pretty strong and I do think that the IRI data for the last 12 weeks shows that, although I will say that that data, you should take into account the fact that Easter was early this year and within this 12 week period but wasn’t in the same 12 week period a year ago, so that did drive some of the positive results. Although I don’t think that that was indicative of anything, I think that the underlying sales trends at retail look to be pretty strong for wine.

Tim Ramey – D.A. Davidson & Co.

Terrific, thanks.

Operator

Thank you. Our next question is coming from Kaumil Gajrawala from UBS.

Kaumil Gajrawala – UBS

Thank you, hello everybody. Rob thanks for the update on the Crown but I have a couple follow up questions. First, in addition to the price increase from last year there was also some transition and some sales execution issues. Can you maybe talk about what you’ve done internally over the last 12 months and why fiscal 2009 will be different?

Rob Sands

Sure Kaumil, obviously when we put the Crown joint venture together we were in the process of filling in the organization primarily in the East. We had to hire over 150 people to fill out that organization. And you know although I think that the Crown team did a great job in making sure that we were covered, when you’re involved in transitional activities that big, you know there’s clearly going to be some transition issues.

Now as we move into this year, you know the organization is all up and running, we’ve got all teams and positions filled with people have gotten sufficient experience in their new positions and we think we’ve got great people by the way. So you know we’re pretty confident that any transitional issues that we have had are behind us and that Crown is up and running and should be 100% in terms of execution capabilities.

Kaumil Gajrawala – UBS

Okay great and then if I could ask an economic question, it seems like we’re seeing some of the sub-premiums in the beer categories start to do a little bit better. I’m curious if that’s related from the channel shift or if you’re seeing kind of fundamental trading down across beer? And then maybe if you could touch on what’s happening in wine as well.

Rob Sands

Well you know I think that as it relates to, did you say sub-premiums or premiums?

Kaumil Gajrawala – UBS

I said sub-premiums.

Rob Sands

Yeah I think that we have seen an increased performance in the sub-premium category. There’s no doubt about it. At the same time, you know crafts continue to do well and I think that as Corona and the Modello portfolio laps the price increase, we’re beginning to see some strong growth in some of our key markets as well and being such a large percentage of the import and therefore the import category, we should see improved trends there as well. But definitely sub-premiums in the most recent data have also turned up versus their historical performance.

There’s no doubt about that. In wine we continued to see much of the same as what we’ve seen in the past, we see extremely strong growth in the premium plus categories and especially in the super premium plus which is $8.00 and above where we have leading positions. We continue to see very, very strong double digit growth in those categories and we continue to see strong trading up trends in the wine business. You know some of the very highest priced tiers in the wine business may see some slight softness as a result of the economy but basically that’s immaterial to the wine business as a whole. So you know it’s super premium plus, $8.00 and above, $20 and below you know where we have the leading position, as I said, strong double digit growth.

Kaumil Gajrawala – UBS

Okay, perfect, thank you.

Operator

Thank you, our next question is coming from Judy Hong from Goldman Sachs.

Judy Hong – Goldman Sachs

Good morning. I wanted to ask a couple of questions on wine and beer. First on the wine side, I guess I’m still trying to reconcile the 5% decline in the sales number, organic sales number in the fourth quarter with seemingly solid underlying depletion numbers. So first question is what was the depletion number in the fourth quarter in North America wine?

Rob Sands

Right, we don’t give depletion numbers but we had positive depletion growth in the fourth quarter for North American wine and yes there was a 5% decline in sales but as we’ve told you in the past, that was primarily related to the change in shipment patterns as a result of the distributor inventory reduction. Historically we shipped much more product in the fourth quarter than our new shipment patterns than will be our new shipment patterns and consequently, the sales downturn was fully expected and is not in any way reflective of the underlying sales trends which as we said, depletion trends were positive.

Judy Hong – Goldman Sachs

Was there any change in the depletion trends from third quarter to the fourth quarter at all?

Rob Sands

Depletion trends from third quarter to fourth quarter improved.

Judy Hong – Goldman Sachs

Okay because, okay. And then on the beer side, you know I think obviously you know you’ve talked about the price increases and you’ve talked about the transition issues hurting the 08 performance, I’m just wondering I mean obviously there was a lot of competition as well from some of the new product and [takatis] performance was also stronger when you kind of look back in the past 12 months or so.

I’m just wondering if you think that there’s been any impact on the competitive front and then you alluded to the comment about California being pretty weak and that you’ve got some initiatives in place to restore growth in that market, so if you could just talk about what you’re trying to do in California and then whether you expect to see even more impact from competition as Bud rolls out their Bud Light with lime.

Rob Sands

Right, yeah we specifically said just to be clear that we expect mid single digit growth in our imported beer business this year. And that’s going to be accomplished in a number of ways but I guess specifically to some of your questions, first of all competition from new products, the Modello portfolio and Corona has always had competition from new products every year or two, there’s always products that are introduced that are geared or aimed to compete with Corona. And I think that we’ve been very successful in competing against those products.

You know we have very strong marketing programs, very strong sales and promotional programs with both retail and with our distributors and you know although we take competition seriously, it’s really been a fact of life almost forever. Now a lot of the competition that you see is in the area of flavored malt beverages, thinks like Bud with lime and Miller Chill and things to this effect. And generally our experience has been that customized products generally haven’t been highly serious competition for Corona because the consumer generally as it relates to lime and lemon like to customize the product themselves.

That’s also been some of the experience in the soft drinks industry as well. But you know that said, you know as I said we always take competition seriously. Southern California is a tough market. It has been particularly hard hit by the economic downturn. And all I can say relative to that is that it’s a market we’re going to be working extra hard in and looking at very closely to make sure that we optimize our performance in that market. In general and in a lot of our markets where we’ve lapped the price increase, we’re seeing good positive growth return to the brand and that’s why we’re pretty confident that we can accomplish mid single digit growth rates this year.

Judy Hong – Goldman Sachs

Okay and then just a follow up on beer, if you pro forma last year’s number to include the full three months of Crown, could you tell us what the sales line would have been in the fourth quarter?

Bob Ryder

Judy this is Bob, as you know they’re not comparable because of the weakness in the back half for Crown which was attributable to frankly last year’s high. The sales for the full year will be slightly negative. But it’s all driven by the previous year’s activity because of the formation of the Crown JV. And that’s not a depletion number, that’s a sale number.

Judy Hong – Goldman Sachs

Right and can you tell us what the depletion would have been?

Bob Ryder

Depletions would have been positive in the low single digits.

Judy Hong – Goldman Sachs

Okay, thank you.

Operator

Thank you. Our next question is coming from [Riza Zabazita] from Lehman Brothers.

[Riza Zabazita] – Lehman Brothers

Good morning. Just I’m wondering if share repurchases of any size is something that you would consider, obviously your stock is where it is and this time last year you had some share repurchases conducted when the stock was I guess in this range, how do you think about share repurchases?

Bob Ryder

In general we’re right now we’re focused on debt repayment, we’re not going to rule anything out. But debt repayment is probably where we’re focused right now.

[Riza Zabazita] – Lehman Brothers

Okay so you don’t have an appetite for it and is there any restrictions on that as well?

Bob Ryder

Not really. It would be an internal decision.

[Riza Zabazita] – Lehman Brothers

Okay and then how do you think about acquisitions? Obviously you’ve been opportunistic in the past including the Fortune Wine. Is there a thing that could come out of the recent consolidation activity in the industry or are you still focused on the base business?

Rob Sands

Yeah I mean I think as Bob pointed out that we’re pretty focused on optimizing our existing business and generating efficiencies within our business, cash flow generation, debt pay down, but you know acquisitions remain a part of our strategy so we wouldn’t categorically rule out acquisitions at this point. But you know we’ve made a lot of acquisitions and we’re very well positioned for the future so you know it remains to be seen if we have any specifics we’ll certainly let you know at the time. But in the meantime the focus is on the organic business and again as Bob said debt reduction and cash flow generation.

[Riza Zabazita] – Lehman Brothers

And then lastly will cash flow from Crown imports roughly approximate the earnings from that business that’s running through your P&L?

Bob Ryder

Yeah, it will roughly equate to it. There’s a separate line item on the cash flow statement where you can see the difference between the two. I think this year was about $20-$30 million difference and that had actually something to do with just the startup of the JV. But generally we both partners sweep the cash from Modello pretty regularly.

[Riza Zabazita] – Lehman Brothers

Thank you.

Operator

Thank you. Our next question is coming from Lauren Torres from HSBC.

Lauren Torres – HSBC

Good morning. Just a clarification Bob, you talked about good earnings growth but a decline, year over year decline in free cash flow. Is that all due to just taxes you’re getting hit with or that the change in taxes year over year?

Bob Ryder

Yeah it’s pretty much attributable to taxes Lauren. And a lot of its timing. We paid again because of timing extremely low cash taxes this year. That cannot be replicated in future years. So we’ll be paying a lot more cash taxes next year than this year. And that’s sort of driving the year over year reduction in cash flow, although the number I still think I’m very happy with, it’s still a very strong number even with those cash tax payments in 09.

Lauren Torres – HSBC

Okay and also if I could just ask a question or two on your wine business? Obviously we saw a number of these wine inventory reductions last fiscal year, if you could just talk about Rob maybe where you are now, are you comfortable at these levels even with the Fortune Brands coming in. Is everything complete, what you expected to have done in the fourth quarter as we look into this year?

Rob Sands

Yeah, we completed the inventory reduction pretty much in the second half of last year and we’re very comfortable with distributor inventory levels and have no intention at this stage to reduce distributed inventory levels further or to operating on any different basis, so that’s pretty much history.

Bob Ryder

And Lauren the other one that you referred to is the reduction in the Fortune Brand inventories and that was also completed by the end of our year.

Lauren Torres – HSBC

Okay and just quickly, lastly also on wines, we’ve seen the sale of value brands. Are there more types of sales like that to come and how should we think about that in our numbers for this year?

Rob Sands

You know we’re always looking at our portfolio. You know obviously we can’t talk about specifics when it comes to dispositions until such time that we have something to announce. But you know I would say that if as we continue to examine our portfolio if it makes sense to dispose of anything and there’s a buyer and the right purchase price can be obtained, that’s always a possibility in the future.

Lauren Torres – HSBC

Okay, thank you.

Operator

Thank you, our next question is coming from Marc Greenberg from Deutsche Bank.

Marc Greenberg – Deutsche Bank

Good morning. My question relates to the $822 million write down in overseas assets. You noted that that was primarily Hardy’s. That’s a significant portion of the $1.4 odd billion that you paid for the asset in 2003. I know these are non cash in nature, but I really wanted to have a return discussion with you, that was about 14 times LTM EBIDTA in 03, in my mind a write down of this size highlights deal risk.

I was hoping you could talk about how we should think about return that you’re getting on your acquisitions in light of this kind of a write down and should we be concerned about other non cash charges and maybe as an example, since then you’ve both Mondavi, Vincor and Fortune in the US and how should we think about, I know we’re not seeing it, the risk to further write downs were we to see significant weakness in the US wine market and what that might say about returns on acquisitions, thanks.

Bob Ryder

Sure, logical question Marc. You know as we’ve been talking over the last two years, you know we’ve been subject to some unique things happening between the UK and the Australian market with the excess Australian wine, the retailer pressure, the duties in the UK and frankly what’s happened to foreign exchange rates. So we think that the Hardy acquisition itself, it’s a unique circumstance that we have to take this reduction. The US wine acquisitions we’re very happy with. We’re nowhere near any kind of impairment charge and as you guys know, the calculation for SFAS 142 is different than a calculation you would do like if you were deciding to buy a business or not.

It’s different in a lot of ways but one of the big ways is the discount rates assumed. So you know the SFAS 142 impairment charge had a much higher discount rate than we would assume if we were looking to buy something. That all being said, look the profits that we’re generating from Australia and the UK are a lot less than we assumed when we bought the Hardy business, that’s just a fact and as the SFAS 142 calculation looked at it, the future cash flows, although we expect them to grow, they would not grow enough to support that large of an asset base, which is what drove the SFAS 142. But I would also say that this impairment hit really would have no reflection on the other acquisitions that we have done. This one is unique.

Marc Greenberg – Deutsche Bank

Okay and so you know Rob you talked about the $8.00-$20.00 wine segment continuing to perform well and that really is a sweet spot for you guys. If we began to see market deterioration within those price points and prior wine cycles certainly there’s been some volatility there. And it had a negative impact on profitability, would you then based on this impairment stuff be forced to go back and look at your asset value in that kind of a scenario?

Rob Sands

Yeah we don’t anticipate having any impairment issue with any other acquisitions period. I don’t agree that that segment is as negatively affected in economic downturns, I actually don’t know what history you’re referring to there. But I can tell you that for instance the luxury segment is growing at over 20% at the current time. And as I said, the other super premium category and super premium plus in general is high single digits. You know this is not, these are not categories that are beyond what I would refer to as affordable luxuries.

You’re not talking about $50.00 bottles of wine. So we don’t anticipate that these categories should show any different momentum than they’ve shown in the past. And you know we’re, our acquisitions in general are performing extremely well, they’ve added a lot of value to the company. And you know I don’t anticipate any issues whatsoever outside of, as Bob pointed out, the pretty unique circumstances that we’ve talked about in great detail as it relates to Australia and the Australian business in the UK. That’s a very specific set of circumstances and I think that the good news there is you now really twofold.

Number one, I think that that’s bottomed out, I think that we’re pretty optimistic that at this stage you know it’s only, there’s only upside as opposed to downside and at this stage we’re talking about 10% of our EBIT. So its importance has greatly diminished. So when you combine those two factors that it looks like its bottomed out, there’s only upside, it’s only 10% or so of our EBIT, I think that you know we’re pretty optimistic as we move forward here.

Marc Greenberg – Deutsche Bank

Thank you.

Operator

Thank you our next question is coming from Mark Swartzberg from Stifel Nicolaus.

Mark Swartzberg – Stifel Nicolaus

Thanks. Good morning everyone. A couple questions, cash flow balance sheet and then a beer question. But on the cash flow side of things, when you talk about your interest expense assumptions for fiscal 09 Bob, what assumption are you making regarding sale of non-core assets, is that number zero, $200 million, $300 million, I mean just I appreciate what you said earlier Rob but could you just give us an idea of what your assumption there is?

Bob Ryder

Yeah we’re not assuming any sale of core assets in our guidance.

Mark Swartzberg – Stifel Nicolaus

Okay, great. And then if we shift over to free cash flow and look at how its unfolded in the year that just wrapped, obviously very nice and very healthy number, that $376 number, it was quite a bit higher than what you had guided to when you came out of the third quarter. And a little bit of that’s earnings related but it seems like most of that is more working capital related. Can you talk a little bit more about what is going on, I think receivables is a big variable there.

What’s going on there, was it a big customer, what’s going on there? And then if we think about working capital just as a larger area of opportunity, we’ve heard from you Rob about comping folks more on the basis of really delivering the free cash flow, what’s changed in terms of how persons running his or her respective business to make them really just consistently generate cash flow off a given level of sales?

Bob Ryder

Yeah, I’ll handle the first half of that. But you know cash flow did come in higher than we had guided on the third quarter call, I think we said it would be $280-$300. And you know Mark as you know, cash flow because it’s just a snapshot at the last minute of the year tends to be a little bit more volatile than earnings and I’d say that we had some positive timing. Some of it around working capital in 08 but also a lot of it around tax cash flows, I think that’s probably the big driver here and you know in our K we actually give cash taxes paid and you’ll see it’s a very low number. So that was probably the biggest positive surprise to us versus the guidance that we gave in the third quarter.

Mark Swartzberg – Stifel Nicolaus

Okay and practice wise can you just comment on you know all of us are trying to figure out how much of this is kind of one-off in nature and how much of it is just you know a higher level of core free cash flows than most of us thought about before?

Bob Ryder

So I guess some general things and then some specific things. And general things is we are making cash flow, we have made cash flow a component of management incentive which does in my experience does tend to change focus and mentality of the business. So I do think we will see improvements there, we are talking about I call it manageable cash flow which I’ll sort of separate into a couple buckets. And working capital is a big buckets, capital spending is a big bucket and taxes are a big bucket. They’re sort of manageable. So we are focusing a lot more on that.

I would also say that this year mother nature probably helped us a little bit because of the low harvests, primarily in New Zealand and Australia and somewhat in the US. So and that’s a big driver, you know we have an agro piece of our business that we’re exposed to. But even there we’re trying to get more of that within our control and as we speak we’re launching a project to try to see how much we can reduce our investment in inventories. So we’re focusing on our reducing our net investments in working capital. So that’s about it.

Mark Swartzberg – Stifel Nicolaus

That’s very helpful. Thanks for that. And then Rob on the beer business the scanner data for March is showing a nice pickup in depletions for Corona, do you think that’s representative of depletion rate that we can all see is more broadly occurring across all channels including those that are not captured by the scanner data in March? And then obviously Easter helped but in your experience is Easter a big mover of a given month’s depletions versus a prior period or latter period depletions?

Rob Sands

Yeah I think that Easter being early definitely had some impact on that but it is only one month, so we’re talking about 12 week period which is, so that kind of balances it out a bit. And then you know we’re expecting mid single digit growth so I think that the trends that you site are demonstrative that we should be able to achieve our targets. So you know we take also as a positive sign and the brand is continuing to exhibit much of the same patterns as its exhibited in the past which is flattened out sales growth in the 12-15 month period following a price increase with growth returning to the brand thereafter but perhaps at a slightly lower rate or a bit lower rate than the growth where it was before the price increase.

So you know all indications are that brand strength is still strong. You know you’re probably read in the paper today that you know Nielsen was quoted as saying that in the 21 year to 35 year old group that Corona is still sighted as the strongest brand and you know that’s pretty indicative of the strength of the brand for the future. So you know we feel pretty good about where we are right now with Crown and the beer business.

Mark Swartzberg – Stifel Nicolaus

That’s great and real quick, on California you’re kind of highlighting that as an area that’s kind of more challenging than some other markets but sequentially if you look at March for California how is that doing for you again at depletion level versus what you’ve been seeing prior to that?

Rob Sands

Yeah, California has not bounced back at this stage. You know we don’t want to look like we’ve got our head buried in the sand but not take into account the fact that California has been particularly hard hit by the economy and that could have some effect on the brand in California. On the other hand, you know balancing that with other parts of the country that are not as hard hit and the cycling through of the price increase we think it’s going to get us to the growth that we’ve indicated in our guidance of mid single digit. If California wasn’t as hard hit as it was we’d probably be talking about higher growth rates than that for 09. So our guidance in that regard or the growth rates that we’re indicating that we expect take into account potential softness in that particular market.

Mark Swartzberg – Stifel Nicolaus

Great, thanks Bob, thanks Rob.

Operator

Thank you, our next call is coming from Jonathan Feeney from Wachovia.

Jonathan Feeney – Wachovia Securities

Thank you very much. Rob I wanted to, as far as the economic sensitivity of branded wines I wanted to clarify you know the performance of the Mondavi brands, because I remember back in 01, 02 recession, looking at my old model here, it looks like revenues were down 8, cases were down 6 and operating profit was down 16 in fiscal 02. And I guess I know that’s probably at most one-quarter of your business right now but it seemed like that was pretty sensitive. I know you have broader distribution and some probably better marketing but I mean that was a pretty big impact. I mean what do you think has changed about that portfolio in the past five or six years that it’s going to allow it to hold up in a tough macro environment much better?

Rob Sands

You know I think that the Mondavi brands are really strong brands and have even gotten stronger since that time. I think that you know our having acquired them and our execution against those brands has really been superlative and strengthened the position of those brands. In fact we’ve seen performance in just about any period that you’re talking about that even exceeds our expectations you know, brands like Woodbridge grew 6% last year. I can tell you right now that you know that, we would not have conservatively estimated that the brand would have grown at that rate. But we’re very pleased with the way that it’s been performing.

In the time period that you’re citing, there’s really a big factor that’s a big difference between now and then, in 2001 and that timeframe, there was a big oversupply of grapes at that particular time you know which created some of the phenomena in the marketplace like Two Buck Chuck and that kind of thing. The world is a lot different today, we’ve moved from an oversupply cycle into a cycle where we’re probably moving into undersupply, so you don’t have the same kind of pressures of marginal players that you had during that particular timeframe. So you know that’s one of the big differences and the other big difference is that you know we’ve got the, I believe the strongest organization in the industry selling marketing the Mondavi brands today and I think that’s also a major difference and we’re seeing the results of it.

Jonathan Feeney – Wachovia Securities

Thanks and just if you wouldn’t mind for Bob just one follow up question on the $310 to $340 09 free cash flow guidance, can you give us a ballpark figure how much cash taxes you plan to pay within the context of that guidance?

Bob Ryder

No, not really because again there’s a lot of timing year over year. We are going to update at our May meeting, we’re going to spend a little bit more time on taxes because I think if you look historically our cash tax rate is well below our effective tax rate. So I would say that next year our cash take tax rate again will be below our effective tax rate. But I’m not ready to give a number right now.

Jonathan Feeney – Wachovia Securities

Okay, thank you very much.

Operator

Thank you our final question is coming from Bryan Spillane from Banc of America.

Bryan Spillane – Banc of America

Hey, good morning guys. A couple of things, first a clarification. You said low single, fourth quarter low single digit depletion growth for beer, low to mid single digit for wine, did you give a number for spirits as well?

Rob Sands

We said positive for wine or low single digits.

Bryan Spillane – Banc of America

Okay and then spirits, did you give a depletion number for spirits as well?

Rob Sands

No but spirit depletions would be very high. Our spirits growth is both with Svedka and without Svedka is pretty strong Bryan.

Bryan Spillane – Banc of America

Okay and then Bob were there any, was there any influence of hedges in your P&L in the fourth quarter? So any mark to market gains or losses?

Bob Ryder

Nothing material.

Bryan Spillane – Banc of America

Okay and then as we look into next year could you just talk a little bit about where you stand now in terms of hedges, is there anything that we should be thinking about that might influence results next year in terms of hedges?

Bob Ryder

No I mean we’re keeping our normal hedging policy and I think you know actually year over year, we’re sort of overlapping when dollar sort of reduction in 08, so 09 over 08 there shouldn’t be as much Forex volatility, if we stay where we are now versus what we saw 08 over 07.

Bryan Spillane – Banc of America

Okay and then finally you know as you, Rob as you look out over you know over 09 and in 2010, how would you weight how you’re incenting your managers, meaning what’s the weighting between how much you want to see volume growth, revenue growth, free cash flow improvement and you know improvement in margins and efficiencies, if you could just kind of talk to what the weightings are for your managers now and maybe what that was like, what that is now relative to what it was a year ago or two years ago.

Rob Sands

Well as I’ve talked about quite a bit, we’ve added a significant free cash flow component to the weighting of our incentives for our managers. Now they also have a significant weighting in EBIT and so that’s a little bit of a double up you could say alright because EBIT is a large portion or a significant component of free cash flow in addition to the balance sheet elements. And then we also have a good weighting or a significant weighting in depletions and depletion growth for our managers.

Because you know obviously we really want them focused on driving that. So the exact weighting it really differs depending on what level you’re talking about in the company and it’s not the same for everybody because you know we tailor it somewhat to what we’re trying to accomplish in various division and segments and this and that. But those are the three things that in general would be the areas that we focus on for our people when it comes to their incentive plans.

Bryan Spillane – Banc of America

And just relative to what incentives look like previous, it’s you know less volume oriented and more profit and cash flow oriented, is it fair to say that?

Rob Sands

More cash flow oriented and therefore less of the other two because to include cash flow obviously, something had to be reduced. But in general and historically, our incentive comp has been pretty much focused on EBIT and depletion growth and we added the cash flow component to get more focus in particular on the balance sheet, you know people were focused on EBIT generally in any event and as Bob pointed out they’ve become you know the cash flow component has people more focused on what we call controllable cash flow which in addition to the P&L would basically be the areas of working capital and cap ex and you know it really gets people focused on the nuts and bolts of working capital.

I mean you know there’s no silver bullet to any of it but when people start looking at all of the elements of cash flow and thinking about how they can impact each one of those elements, you know it’s a little bit here and a little bit there and you know before you know it you’re talking about real money and I think that that’s one of the reasons why we feel pretty good about the fact that you know the kind of cash flow we generated last year is going to be sustainable as we move into this year, albeit a little bit less, our guidance was a bit less but still in the $300 plus range, $310-$340 million which you know I think is pretty indicative that you guys can expect more conversion of EBIT to cash flow and is consistent with our focus on generating cash flow and debt pay downs. So that’s where we’re at.

Bryan Spillane – Banc of America

Okay, great, thanks guys.

Rob Sands

Okay well thank you all for joining our call today. As I indicated I’m really very pleased with the progress that we’ve made during the year on all fronts. Our accomplishments in fiscal 2008 position us well for success in the future and I’m very optimistic about where we’re headed in 2009. We feel that we’re well on the way to meeting our mid to long term goals that I’ve talked about which we’re certainly going to discuss more in detail when we get together at our upcoming investor meeting in New York, scheduled for late May. So we’re looking forward to seeing you all then and thanks again for your participation today.

Operator

Thank you, that does conclude today’s Constellation Brand’s fiscal 2008 earnings conference call, you may now disconnect your lines and have a wonderful day.

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Source: Constellation Brands, Inc. F4Q08 (Qtr End 02/29/08) Earnings Call Transcript
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