Is Constellation's Star Too Bright?

Oct. 09, 2017 2:48 PM ET1 Comment
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Douglas Adams


  • Constellation Brands, maker of high end branded and craft beers, posted a record market high at Friday's closing bell in the wake of the company's soaring fiscal 2nd quarter earnings.
  • Beer sales were up 10.44% through August and shipment volumes rose 12%.  Resulting gross profits rose 21% while EPS were up 37% over the period.
  • Gains appear tied to one-off tax adjustments, a weak dollar and rock bottom borrowing costs that will be challenged as Fed tightening takes hold on current market bliss.

US-based Constellation Brands (STZ), maker of high-end branded beers such as Corona and Modelo and a variety of craft beers, posted a record market high at Friday's closing bell (5 Oct). The market surge was in response to the company's fiscal 2nd quarter earnings report through the end of August which saw net income climbed 39% to $499.5 million in the three months to August, bolstered by bumper sales in its beer segment over the course of the summer. Beer sales were up 10.44% in the six months through the end of August, year-over-year (YOY) and were up just under 13% since June. Beer shipment volume rose 11.7% to 80.3 million 12-ounce case equivalents through the end of August, up from 71.9 million cases YOY. Gross profits from beer sales came to $747 million, up 21% through the end of August YOY. Consolidated net sales through the end of the company's 2nd quarter (through the end of August) came to $2,084 billion of which 66.2% of sales were attributable to beer. The company claims to be the third largest beer producer and distributor to the US market and holds exclusive and perpetual brand licenses to import, market and sell its Mexican beer portfolio in US markets.

Figure 1: Constellation Brands and STZ/SPDR Consumer Staples (XLP) Ratio

Just over 29% of consolidated sales for the quarter was attributable to the company's wine segment, which includes table, sparkling and dessert wines retailing from $5 to $25/bottle. Spirits comprise just under 5% of consolidated sales. Net sales of the company's wine and spirit segment fell just short of 12% through the end of August with a post of $705.6 million in sales juxtaposed against $798.7 million YOY. Shipment volume fell just over 19% for the period to 14.7 million 9-liter case units, down from 18.2 million YOY. The decline was due mostly to a divestiture of Canadian assets of just over $100 million. At the same time, shipment volume lagged inventory depletion growth during the quarter.

For the quarter, operating income increased by just over 10% for the first six months of the year while net income for the quarter was up 33% YOY. Earnings per share of class A stock came in at $4.67/share, up 37% for the period. The stock has fared well for the past five months, positioning itself above its 50-day trading average by the second week in February and sustaining the path throughout the period. Factoring out SPDR Consumer Staples (XLP) portfolio mix, STZ has outperformed for much of the period (see Figure 1, above).

Figure 2: US Dollar and the Mexican Peso

Are these gains in the beer segment sustainable? There are three factors to consider in answering this question:

  • The company's effective US tax rate in the 2nd quarter fell to 20.4% from 31.7% YOY. The decrease in the company's effective tax rate is due to lower rates on foreign holdings. Further, the company made a declaration in the 2nd quarter that earnings from these foreign holdings would be reinvested in these foreign holdings indefinitely. The tax savings dropped an estimated $150 million to the company's bottom line
  • Interest expense for the quarter fell to $81.3 million for the period, down from $94.1 million YOY. This is a decrease of $12.8 million or 14% YOY. The company issued in December 2016 and again in May 2017 senior notes at an average interest rate of 2.1% which allowed the company to pay off higher interest rate notes issued in August 2006 and January 2008 at 7.25%. The combination of tax and interest expense savings were primary driving forces of the net income increase for the quarter;
  • Another important factor of the income increase for the period resides in the weakness of the dollar in relation to the peso for much of the period. Approximately 72% of the company's balance sheet was hedged using foreign exchange contracts through the end of August. Through the end of the company's 2nd quarter, these contracts carried a market value of $1.585 billion, up from $1.371 billion, or about 16% YOY (see Figure 2, above).

Figure 3: Aluminum, WTI, Corn and Wheat Indices

Commodity price exposure includes aluminum, heating oil, natural gas, corn and wheat-and all of these items are priced in US dollars. With a weak US dollar for much of the year, the notional value of these contacts fell for the period to $157.2 million, down almost 16% from $186.3 million YOY. For the month of September, the US Dollar Index (DXY) increased just over 2% as markets continue to price in the Federal Reserve's program to reduce its $4.5 trillion balance sheet that went live in October. The program will remove $6 billion of Treasury notes and $4 billion of mortgage backed securities (MBS) that would have otherwise been reinvested in their respective markets, effectively tightening the level of liquidity in those respective markets moving forward. At the September meeting of the FOMC, the committee signaled strongly that a third uptick of the federal funds rate remains on the table, with the market probability of such a move now residing north of 90% through Friday's closing bell. Aluminum prices have soared since mid-June and now trade well above its 50-day trading threshold. Corn and wheat prices have been trading beneath their respective 50-day trading measures since August but have largely closed in on these thresholds since the beginning of the 4th quarter. Higher energy prices, driven by a strengthening dollar, continues to face down demand that stubbornly remains below current world supply and will likely continue to do so for the foreseeable future (see Figure 3, above).

The company's 2nd quarter gains will be difficult to sustain given the likely increase in the relative strength of the US dollar in world currency markets moving forward. The dollar is at its strongest point since the first week in June and is trending to the upside. The peso is now trending to the downside. Borrowing costs are on the rise as central banks across the developed world landscape push interest rates higher. The relative sweet spot created by low inflation, rock-bottom borrowing costs and sustained by copious flows of accommodation from central banks is slowly on the reverse. The environment where central banks become net sellers of assets after a $14 trillion buying spree worldwide over the past decade has yet to be charted. The forex dynamic alone coupled with a dollar driven uptick in commodity prices appears destined to challenge the company's 2nd quarter gains as the dollar flexes its muscles in the coming months. Expect a 5 to 7 percentage point decrease in the company's current market price of $210.11 by the end of its fiscal year in February.

This article was written by

Douglas Adams profile picture
Douglas Adams specializes in macro-economic research and turning theory into practical portfolio applications for clients over the past seventeen years. Mr. Adams recently formed Charybdis Investments International based in High Falls, New York where he is the managing director of a fee-only investment advisory practice with clients throughout the United States. As an author, Mr. Adams has commented widely on a diverse array of topics from Brexit to monetary policy to forex to labor productivity and wage growth. He holds an undergraduate degree from the University of California, a master’s degree from the University of Washington and an MBA in finance from Syracuse University.

Disclosure: I am/we are short STZ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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