The past market developments have shown us that the spirit and beer industry are always preferable investments compared to the lower margin wine industry. Thus, in the past I’ve recommended investing in companies like Beam Inc. (BEAM, Financial), Diageo Plc (ADR) (DEO, Financial)Â or Anheuser-Busch Inbev SA (ADR) (BUD, Financial). However, there is one total alcohol company, known for its premium wine brands Robert Mondavi, Ravenswood and Arbor Mist, which has turned from a slow paced uncertain stock, to an interesting investment option. The talk is of Constellation Brands Inc. (STZ, Financial), and investment gurus Andreas Halvorsen (Trades, Portfolio) and Eric Mindich (Trades, Portfolio)’s recent acquisition of the company’s stock makes me think there is a bright future ahead for this firm.
A Scenario-Changing Acquisition
Previously, earning most of its profits through the fragmented and crowded wine segment, Constellation was having a difficult time generating excess returns for its shareholders, as well as retaining customers loyalty. With fierce industry competition from peers like Willamette Valley Vineyards Inc. (WVVI, Financial) and Vina Concha y Toro S.A. (ADR) (VCO, Financial) constantly pressing on margins, the company made the wise decision to shed its low-margin brands and restructure its distribution network, in order to boost long-term profits. Furthermore, the firm’s spirit portfolio, including Svedka vodka and Black Velvet Canadian whiskey, enjoys stronger brand loyalty and higher margins, but still lacks the scale and pricing power of competitor Brown-Forman Corporation (BF.B, Financial).
Therefore, I consider Constellation’s $4.75 billion purchase of the remainder of Crown Imports joint venture to be a very wise move, which will strongly improve the company’s competitive position in the high profit domestic beer market. By acquiring the Piedras Negras brewery, as well as the brand rights for the popular Modelo beers, the firm now enjoys a narrow economic moat. Crown only supplies 6% of all beer consumed in the U.S., but its brewery accounts for 40% of imported beers, including Corona Extra, Modelo Especial and Corona Light (three of the top 20 brands). Moreover, these intangible assets should allow the firm to out earn its cost of capital in the medium-term future, thereby boosting returns. Looking forward, Constellation will continue to invest $600 million in its brewery, hoping to double its capacity and improve profitability. This should also allow the firm to pay off its current debt in less time.
Valuation
Constellation’s acquisition of Crown is bound to boost 2012’s weak financial results, boosting the negative 8.3% revenue growth to a positive 5%, as the beer business’ volume growth and pricing power will offset the modest top-line growth in the wine and spirits segment.
Furthermore, the previous average operating margins of 18% will increase substantially to a solid 32% by 2017, due to logistics savings from the brewery’s production capacity, as well as its ownership. With earnings outgrowing the current cost of capital, returns on invested capital will jump from 2012’s 5.10% to well above 20%, making the company overall more attractive to shareholders.
Despite the risk of sales declines triggered by a possible recession in the U.S., and the high debt levels which are expected to remain over the next two years, I feel bullish about Constellation's long-term future. With management’s $1 billion free cash flow target by 2017 in mind, debt payment shouldn’t be an issue, and the current EPS of $3.17 will hit the $5.14 mark by 2017. Furthermore, with the stock currently trading at an attractive 54% price discount relative to the industry average of 19.2x, I believe investors would be wise to buy this company’s shares now, before the price drives up.
Disclosure: Patricio Kehoe holds no position in any stocks mentioned.
