Even though Constellation Brands (NYSE:STZ) has faced some coronavirus-related headwinds as a result of restaurant and bar closures, the company is well-positioned for long-term stock appreciation. With increasing online alcohol shopping and beer sales growth at liquor stores, Constellation has been able to partially offset recent downturns. Furthermore, being the majority shareholder of Canopy could prove to be valuable in the future, as management has already started to improve the cannabis company’s strategy. As such, the company is in a favorable position to sustain its historical performance, suggesting equity upside may be likely.
A Growing Portfolio of Popular Brands
Since the firm’s announced acquisition of Grupo Modelo’s U.S. beer business in 2013, Constellation Brands, a producer, importer, and marketer of beer, wine, and spirits, has seen rapid stock price growth, rising from just $30/share in February 2013 to historical highs of $230+/share in April 2018, an increase of over 600%. Since then, momentum has stalled, with the firm’s stock price declining below $170/share to start 2019, as the firm struggled to refresh its alcoholic beverage portfolio and as its investment in Canopy Growth struggled to take off. Recently, a stock price resurgence led STZ to recover towards all-time highs again in early 2020, before the coronavirus pandemic temporarily derailed its progress.
This historically strong performance can be largely attributed to the highly diverse and highly profitable alcohol portfolio the firm has constructed over the past two decades. Constellation started as a bulk wine distributor, before gradually shifting its business model and building an impressive collection of beer, wine, and spirits. This includes staple beer brands from the Grupo Modelo acquisition, such as Corona and the namesake Modelo, as well as craft brewers such as Funky Buddha, that appeal to a variety of beer drinkers and has solidified Constellation as the US market leader for Mexican beers. In addition, the firm owns the rights to popular wine brands such as Kim Crawford, Ruffino, and Robert Mondavi and a range of spirits, including whiskey distiller, High West, and the vodka label Svedka. The company’s aggressive acquisition strategy has paid off, helping to provide diversified revenue sources and a portfolio of strong brands, leading to significant material stock appreciation over the past decade.
Investing in Cannabis... With Less Risk
Although the firm’s portfolio of alcohol assets had led to years of stability, over time, as the firm integrated its acquisitions, its growth started to slow in the face of a competitive industry. As such, Constellation has invested in a promising, yet volatile, area: cannabis products.
The company is betting big on cannabis, with an almost 39% stake in one of the largest industry players, Canopy Growth Corporation (TSX: WEED). Despite a recent rise in health-focused regulation of certain smoking products, such as electronic vapes, and slower-than-expected marijuana legalization in the U.S., there is reason to be optimistic about Canopy's future.
Canopy is close to capitalizing on cannabis beverages. The company reasons that if it can market its drinks as an even healthier alternative to hard seltzer, the new drinking craze, particularly among younger consumers, demand could be enormous. Since there is no fermentation process or alcohol within these drinks they can be zero carbs, zero calories, and taste good while having a more positive psychoactive experience.
Many investors have concerns about the cannabis industry due to its volatile nature and dependence on legalization. However, a safer way to invest in this up-and-coming market is through Constellation. With many established alcohol brands under its belt and experienced management, the stock is a much more stable option. Constellation's position in Canopy growth is unique in the cannabis industry, for no other established cannabis producer has a partnership with a major Fortune 500 company. This offers Canopy a luxury of resources, including competent management, which has started to shift the start-up’s focus from top-line growth to margin expansion. There have been a significant number of closures and layoffs in an attempt to isolate the most profitable parts of Canopy.
When we apply our Uniform Accounting metrics, the distortions from as-reported GAAP and IFRS accounting statements are removed - including the impact of goodwill, a purely accounting-based metric that does not reflect the operating reality of a firm - and we can immediately see just how beneficial the diversified portfolio of alcoholic beverages has been to the firm.
Since the Grupo Modelo acquisition in 2013, Constellation’s Uniform ROA has improved from 10% to peak 27%+ levels in 2017- 2020 contrary to flat as-reported return trends. This easily eclipses the firm's previous peaks seen prior to the Great Recession. This shows just how accretive the acquisition of the rights to Corona and Modelo was for the firm.
Meanwhile, the firm has been able to couple its profitability expansion with Uniform asset growth. STZ’s Uniform asset base grew by 45% in 2014, coinciding with the aforementioned acquisition, and since then, the firm has seen positive asset growth in five of the past six years. This growth track record demonstrates the firm's ability to enter new end markets and product lines, including cannabis products and malt liquors. This asset growth, accompanied by robust profitability, helps explain why Constellation has grown to be one of the largest alcohol producers in the world.
Coronavirus Woes Greatly Exaggerated
Since the coronavirus pandemic began, Constellation’s stock has been hit hard. The market was concerned about material operating headwinds due to a perceived reliance on restaurants and bars along with the pandemic and an anticipated recession that would cause widespread shutdowns. The firm’s stock fell as much as 50% from peak to trough and currently sits 10% lower than its February highs.
However, pre-coronavirus trends indicate the firm is well-positioned to rebound quicker than anticipated. Only about 10-15% of the firm’s sales volume comes from on-premise businesses, and an increase in online orders has somewhat mitigated the impact of coronavirus headwinds.
Furthermore, roughly two-thirds of the company’s net sales come from beer, which spells good news for potential investors, as the firm’s most recent 10-K revealed STZ saw 8% growth for beer sales in 2020, a trend management claimed they could continue before the pandemic hit.
And just because there are shutdowns, it hardly means Constellation will be crushed. Overall sales of beer have actually been on the rise over quarantine, especially from online orders. For Constellation, specifically, even Corona-branded beer sales have increased over this time, despite rumors that the negative association with the “corona”-virus pandemic would turn off would-be buyers.Therefore, Constellation may have a reliable crutch as the country reopens.
As the stock has since rallied from its March lows, investors may be wondering if STZ can continue its momentum. Before making any decision about a company's valuation, it's vital that investors understand exactly what the market expectations are for future performance. Without an understanding of the market's expectations for a company, it's impossible to know if an investor’s thesis is different from the market’s. We can understand this by looking at the market's embedded expectations for future performance at a company's current valuations.
By cutting out the "noise" of as-reported accounting, we can back into the future levels of Uniform ROA and asset growth the market expects at current stock prices and valuations. The embedded expectations chart below shows Constellation’s historical corporate performance levels in terms of Uniform ROA and asset growth (dark blue bars) versus what sell-side analysts think the company is going to do for its next fiscal year and fiscal year 2022 (light blue bars) and what the market is pricing in at current valuations (white bars).
As evidenced by the chart, market expectations for Constellation are bearish. At current valuations, the market expects STZ to see Uniform ROA decline from 28% in 2020 to 20% by 2025, while maintaining a modest 6% growth rate going forward.
Historically, even as Constellation has expanded its asset base, its profitability has also continued to improve. So, if market expectations are for a moderation in growth, one could stand to reason that profitability may likely begin to plateau. Instead, market expectations are for Uniform ROA to remain at low levels forecast to occur for a short-time in the midst of the recession.
Given Constellation’s diverse portfolio of low to mid-end beer, wine, and hard liquors along with promising investments in the cannabis industry, expectations for both Uniform ROA and Uniform asset growth to remain depressed, or even fall as much as they are forecast to fall, seem overly bearish. Furthermore, market expectations for the coronavirus pandemic to cause long term headwinds for the firm are likely unwarranted, partially due to robust online and non-bar related alcohol sales, suggesting significant upside potential for Constellation.
Conclusion
Even though Constellation faces near-term headwinds, such as restaurant and bar shutdowns, the company is in a prime position to sustain its current performance. The Canopy investment is an enormous opportunity for Constellation to capitalize on the fast-growing cannabis market, and an increase in beer and online sales are positive indicators that coronavirus will not cripple the company, as the market expects.
At current valuations, markets are overly bearish, pricing in expectations for the firm’s profitability to collapse, along with a slowdown of its asset growth. As restaurants reopen, the company’s resiliency becomes clear, and the firm’s stake in Canopy begins to generate more cash flow, equity upside may be warranted for the name.
