3 Reasons Why Constellations Brands' Glass Acquisition Is Bigger Than You Think

| About: Constellation Brands, (STZ)
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Cheap transportation costs.

Glass is more expensive than beer.

STZ’s quality control lab ordered a recall that prevented a potentially very dangerous situation caused by STZ’s third-party glass supplier.

Sometimes if you want something done right you have to do it yourself. While I'm normally not a big fan of vertical integration, in the case of Constellation Brands (NYSE:STZ) I find it to be a much welcomed and badly needed move for three reasons you may not have thought of.

STZ has partnered 50-50 with Owens Illinois (NYSE:OI), considered one of the best, if not the best, in the beverage glass manufacturing business. The $300 million joint investment plant is located adjacent to STZ's brewery in Nava, Coahuila, Mexico. STZ's Corona and other Mexican beer portfolio are sold by the bottle for 80% of the company's Mexican beer volume. Once this plant is scaled up, STZ and OI expect this plant will supply STZ with over 50% of the volume needed for its U.S. beer business.

The first expected benefit should be a bit obvious. By having the glass plant next to the brewery, there can be significant savings in transportation costs. Overall, according to this conference call from last year, around 25% of STZ's cost of goods sold is simply transportation costs. While the bulk of the costs will still be there - which is shipping the finished product to distributors - STZ expects eliminating or reducing this one step will add materially to the bottom line.

Second, glass is an expensive business for the Corona maker. Did you know that the cost of around two-thirds of a bottle of Corona is just the glass itself? Around 50% of the company's overall costs for a case are packaging. Around two-thirds of that is the glass with the rest going to other raw materials and labor. This makes the glass around 33% of the cost, transportation around 25%, and the beer itself is something south of 25%. Control over glass costs, quality, and quantity is arguably more important than the beer itself.

Third, last quarter illustrates the potential problem and handicap of relying on suppliers. STZ had a $9 million charge last quarter thanks to a glass recall from one of its suppliers Corona Extra "where certain glass bottles contained defects." According to the 10Q, the defect "could cause small particles of glass to break off and fall into the bottle." That's dangerous. The company expects to recover the costs but it also lost some sales in the process. Likewise, the company expects to replenish the lost sales in the following quarter, but I have to figure there may have been pockets of shortages here and there that hurt. Regardless and far more importantly, a future recall has the potential of being more devastating. It was STZ's own internal quality control lab that spotted the defect and not the supplier. Had STZ already had that same supply in-house, the quality control lab may have spotted the problem earlier and not have to undergo a costly recall.

STZ's beer business has been rapidly growing and it expects to continue to rapidly grow it. The company can't afford to completely rely on third-party suppliers who may not have their best interests in mind or may not be able to spot problems early. With STZ having more control, it can be more confident about the quality of its products as it grows. Since glass transportation and manufacturing is such a major part of its business, reducing risks in this supply chain is vital. According to CFO Robert Ryder in the most recent conference call, operating profit margins should expand from 32% to mid-30s. That might not sound like much, but it should add at least 10% more profit to the bottom line.

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