A lot has changed for Constellation Brands (STZ) this year. The company’s decision to take a plunge into the legal marijuana space earlier this year came as a surprise to many who expected the Canopy Growth (CGC) stake to be a minor part of the portfolio. Now, sales of wines and spirits are slowing, while beer remains the main attraction and investors are divided on the prospects of weed as a future growth engine.
After the previous earnings release, the stock hit its lowest price this year - $198.85. STZ missed earnings estimates by Wall Street and the ticker got punished. Management published Q2 fiscal 2019 results, reporting $2.87 earnings per share. That’s a lot higher than analysts' estimates of $2.58 to $2.61 per share. In fact, the company even adjusted its 2019 guidance to $9.60 to $9.75, an increase of roughly 2.5%. The stock was up nearly 5% yesterday.
Investors could find more good news in the filing. Operating cash flow was up 21% to $1.3 billion while free cash flow surged 62% to $968 million. It seems management saw a buying opportunity after the stock plunged following the last quarterly results. They’ve bought 1.9 million shares of common stock throughout the second quarter, spending $404 million from their budget.
The filings give investors an opportunity to check in on STZ’s four verticals:
Beer shipments were up 8.7% this quarter.
Shipments of beer wasn’t a problem last quarter. This time, however, margins seem to be expanding. Beer margins hit 41.3%, a record high for the company. CEO Rob Sands says it's because they focus on being the “high-end leader.”
Corona Premier and Corona Familiar, the two new brand additions to the Corona family, have higher selling prices which have increased sales for the company’s most important brand. Meanwhile, the company’s bet that Hispanic families will drive market share for the Modelo Especial brand has panned out. It gained a lot of market share this quarter.
So, beer is fine and it’s the core business. How’s the rest doing?
Wine & Spirit
Wine and spirit sales recovered this quarter, perhaps because of the run-up to the holiday season. The company seems to have successfully applied the same premiumization strategy to wine, with its Focus Brands basket of wine products mostly priced above $11. This group has been growing at triple the growth rate of the national wine market and now contributes 70% of STZ’s net sales and profitability.
Meanwhile, spirit sales grew by an impressive 9.5% QoQ. However, this segment still accounts for only 4.4% of the company’s total sales. Combined with the wine segment, the two contribute exactly one-third of the sales (33.5%). Gross margin is lower at 26%. Considering the fact that Rob Sands said the projected annual growth of the segment is still 2% to 4%, which implies that the company doesn’t rely on this segment to drive growth considerably.
Instead, the management has made it clear that the growth engine of the future is cannabis.
I’ve said before in an article on Seeking Alpha that STZ is a great proxy for exposure to the legal weed market. On this recent earnings call, Sands confirmed the reasons why I believe Canopy Growth is the gold standard in the weed market and why STZ is a low-risk bet for investors who believe in the potential of legal pot.
Sands said the legal weed market was “opening up much more rapidly than originally anticipated,” and that canopy was best positioned to dominate it. It already has 35% of the recreational weed supply contracts Canadian provinces have been giving out for the past year.
It’s important to note that the $4b deal hasn’t closed yet, and is thus not reflected entirely in the quarterly filing. Once the deal is closed, STZ will own 35% of the company and have warrants to purchase more than 50% of the company. At the current rate, the $4b represents less than half of the total shareholders’ equity ($11.5b) at the end of the quarter. That should tell you how big a bet this is for the company.
Of course, this large investment was funded by debt. From the company’s recent 10-Q:
“In September 2018, we entered into financing arrangements to partially fund the Canopy Transaction consisting of (I) $1.5 billion in delayed draw unsecured term loan facilities available under our Term Credit Agreement (as defined below), and (II) a C$3.143 billion , or approximately $2.4 billion , bridge credit agreement (the “Bridge Credit Agreement”). The unsecured term loan facilities and the bridge financing are available until April 1, 2019, unless no loans are needed for the Canopy Transaction, the transaction does not occur, or we elect to terminate the commitments.”
That means $4b will be added to the $9.2b in long-term debt the company currently has. Since the deal will most likely close by the end of October, you can expect to see STZ’s debt-to-equity ratio move from 0.8x to 1.147x in the next quarter.
Debt is now a concern, no doubt. But the company is generating nearly $1 billion in operating cash flow every quarter. With half of that going to investments in CapEx and the company expected to pause acquisitions till the debt level is lowered, it is reasonable to assume that they can pay off the excess debt within a few years.
Here’s a statement confirming this from the company:
“Constellation Brands remains committed to its investment grade rating and therefore, has no plans to engage in mergers, acquisitions or share repurchase activity until the company returns to its 3.5x leverage target, which is expected to occur within 18-24 months of deal closing.”
So with the debt sorted out, the cost of debt (60% of capital) is at 4.5%, a required rate of 8% for equity (40% of capital), and an effective tax rate of 15%, the WACC is 5.8%.
With a terminal growth rate of 3%, the intrinsic value works out to $44b. That’s a price target of $232.5. The margin of safety is barely 5% at this point, which means the company is fairly valued.
It’s hard to say whether STZ can sustain beer margins, growth in wine & spirits, and a reduction in debt. The biggest looming question is whether the Canopy Growth acquisition will turn out to be a master stroke or an epic blunder.
With these lingering questions, the current price simply doesn’t scream ‘BUY’ for me.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.