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A meaner and leaner Constellation Brands (STZ), can unlock the value in shares

|Includes:Constellation Brands, Inc. (STZ)




Constellation Brands Inc. (NYSE:STZ) –reported third quarter results were not enough in unlocking the value of shares. Poor top line showing indicated that the market leader in wines and spirits is lagging behind the industry growth rate in wine segment. The disappointing top-line results were attributed to an inventory overhang that resulted in extra promotional discounting along with weaker volume within their "below value" category (wines priced under $10). Despite a positive showing on the higher end wines, the street was disappointed with overall results and guidance going forward. Constellation announced they are introducing over 20 new offerings for their FY13 in attempts to offset lower volumes and hoping to gain pricing leverage on its existing premium brands. The company believes that the introduction will grow top line 2-4% for calendar 2012, slightly below the industry growth rate. While gross margins showed a solid increase of~ 400 bps in the quarter, this strength was attributed more to cost savings resulting from their divestitures in the UK and Australia. Further margin improvement for the quarter was a result of consolidating their distribution chain and increasing operational efficiencies. The street was looking to hear more positive news on margins due to sales trend; however the leverage on margins came from operating efficiencies instead. Only a small fraction of the increase in margins was attributable to price increases on their high-end wines.
Earnings guidance for the remainder of this year is expected to be $2.00-$2.10 per share. The company’s failure to provide much color for their upcoming FY13 resulted in the market continuing to discount the stock. Overall the company hinted at a 2-4% top line growth rate for FY13 and a reduction in overall Cap Ex for FY13. Constellation disclosed lower marketing and administrative expenses will help margins this year and free up additional cash to continue improving the financial profile of the firm. For the first 9 months of this year- FY12, FCF stood at $587MM and by end of next quarter should grow to $700-750 Million. The company’s liquidity picture continues improving and next year reductions in inventory and working capital minus one-time items this year should come in around the $500 Million range for FY13. As of now, the company is focusing on using their cash position on share repurchases. Under the current authorized program, which is about 50% complete, or about ~$281M worth of shares retired, at an average price of $18.79/share, added ~ $0.06 per share on the bottom line. For FY13, it can be implied they will continue repurchasing share and retiring their debt. As of the quarter, total debt stood at $3.1 Billion and any reduction would be favorable for company liquidity profile but may not be enough of a catalyst to push the stock price higher.

So while the company’s overall financial position continues to improve, the overall business is performing generally at mediocre levels. Constellation continues to lack the ability to drive sales in a meaningful way and set the price environment for the industry. Lack of pricing power and branding efforts will mean that earnings continue to fluctuate and remain volatile on quarterly basis. This lumpiness in sales and earnings performance is the primary reasons why shares trade at a discount to peers and the market as a whole. In the past, the street demanded Constellation to improve on their leverage profile by reducing its high debt levels. The company has been doing so over the past few years but now the marketplace is looking for another catalyst to drive shares higher. The company stock continues to sell at single digit multiples from P/E, P/S and CF/S metrics and maintains mostly a neutral rating. A more tangible catalyst for the shorter term to unlock the value in shares would require something meaningful. Besides taking out the lumpiness out of reported earnings, reducing their share count, improving their cash flow position and stronger margins, Constellation may need to take more aggressive steps.   
By divesting more non-strategic key assets, the firm would be able to better focus on setting prices in the wine space. With a narrower brand focus, volume would play less of a role on the fluctuation of company sales while still driving margin expansion. Other suggested alternative to unlocking the value in shares would include exploring potential buyers for their Modelo-Corona joint venture. Even though the JV has been very successful for Constellation, strategically it is not where the company should be focused. By selling their stake in the joint venture to other beer producers, Constellation would be able to use the proceeds into their spirits business which is more complimentary to their leading wine position. A larger focus on Svedka Vodka and Black Velvet whiskey would help company achieve scale in similar verticals. A new stock buyback authorization program would be beneficial but it would have to be over a multi-year period on much grander scale.
Regardless, investors are waiting for something positive out of Constellation on a grander scale. Otherwise investors will continue to be frustrated holding shares and riding the volatility associated with the stock. Value investors will find that shares may be a trap not getting caught up in.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Stocks: STZ