Constellation Brands, Inc. (STZ) Earnings Call Transcript & Summary

So next up, we have Constellation Brands. We are happy to have CFO, Garth Hankinson; and Investor Relations Officer, Patty Yahn-Urlaub here with us for a Q&A session. We have a lot of ground to cover so I'm going to jump right in.

Very relevant topic has been across various stages of the pandemic has been inventory levels and out of stock. So like I said, I'm jumping right in. So Garth, on your first quarter call, you did talk about distributor inventory being lower than normal due to the severe weather in Texas early in the fiscal year, strong consumer demand. Out-of-stocks seem to have gotten worse since then. We saw news this week that you'd be taking steps to manage SKUs to take some pressure off the supply chain. But we'd love to get an update from you on inventory levels, out-of-stocks and when you expect inventory levels to return to normal.

Yes. Thanks, Lauren. Thanks for hosting Patty and I this afternoon. As we get started, I just want to give a kind of quick reminder to everyone listening in that our fiscal Q2 just ended last week, so we are in a bit of a quiet period. So throughout today's discussion, I won't be able to share specifics on results, but we do think that we can give a good color for how the business is performing overall. With that being said, on your question, well, you're absolutely right. We are a bit lighter on inventory than we would normally be during this time of year. And that really is primarily predominantly driven by continued robust demand, particularly for our core Mexican beer portfolio. Quite simply put, our demand has been outpacing our supply forecast. You see this in IRI, where CBI beer continues to outpace both the high-end segment as well as the broader beer segment. During these key summer selling months, that gap is actually been -- they've been widening. And in the most recent 12-week period that ended on 8/29, our beer business outpaced the high-end by roughly 5% and the total U.S. beer business by about 9%. In addition to the robust demand as we've talked about previously, we did experience a couple of exogenous events, in my mind, at the beginning of the year. First was the extreme weather event that occurred in Texas and had an impact on beer production in Mexico for about 10 days and resulted in less output than is typical. And then as a reminder, we had Obregon come on about 3 or 4 months later than we had originally anticipated and that was due to COVID-related construction slowdowns in Mexico. So it was that weather event and that -- and the delay in Obregon coming onboard that kind of exacerbated the issue of increased robust demand. We are in a spot where we're getting better. The worst of the out-of-stocks and the tightness in the supply seem to have occurred in August. And now that we're kind of past the key summer selling season, we are starting to be on a path to improve our inventory situation, both with distributors and in our own warehouses. Similar to last year, it will take us the better part of the second half of the year in order to get to more historical levels across the entire -- the network. But like last year, we fully expect that by the end of the year, we'll be back at historical levels, both with distributors and our warehouses. Where this situation has been a little bit different than last year is that last year, when we had this kind of 72-day disruption in output coming out of Mexico, when we came out of that, we had to prioritize our top 25 SKUs. This is -- this year, we haven't had to do that. We've been producing virtually every one of our SKUs. And so for this year, the out-of-stocks really are more of a SKU issue than they are a brand issue. And what I mean by that is if a consumer goes into a retail outlet looking for one of our brands, they're going to be able to find it. They just may not find it in the pack size in which they intended to purchase, right? So if they went in looking for an 18-pack, they might have to buy a 12-pack or a 24-pack. The good news in that regard is that what we learned as we lived through this last year is that the vast majority of the time that somebody goes into a retail establishment looking for one of our brands, one of our SKUs and they can't find it, they continue to buy sort of within the brand family. So that's obviously a net positive for us. On the Obregon front, the incremental capacity that came on at the beginning of the year, that's coming on as scheduled. Brewing capacity kind of leads packaging capacity. And so you bring up and you commission packaging kind of in a more measured approach. And so as we sit here right now, the expansion at Obregon is operating at about 85%, and we expect to be kind of at full output in the fall of this year. So we're making progress. The worst of the out-of-stocks, I think, are behind us. And as we move through the second half of the year, we'll get back to more historical inventory levels.

Okay, that's great. You're highlighting strong consumer demand and have been all year. Can you -- I know you mentioned quiet period, but are you in a position to sort of give us some insight into how volume and depletion trends have tracked?

So the short answer to that, Lauren, is yes, we are in a quiet period. So we'll definitely talk more about that in our 2Q earnings call, which is coming up here in 3 or 4 weeks' time in early October. But what I can tell you is that we continue to work with our distributors to ensure that we've got the right mix of products in the right places, to make sure that we can continue to supply the really strong demand that we've seen against our portfolio, most notably our core Mexican beer portfolio. As I mentioned, we're optimizing Obregon to get incremental capacity out the door, into trucks and onto shelves. And again, we expect to be fully optimized there in the fall. As we mentioned in our Q1 call, that depletion volume did exceed shipment volume during the quarter, and we expect distributor inventory levels to return to more normal levels at fiscal year-end as shipment volumes catch up to our depletion volumes as we exit the peak summer selling season.

Okay. I mean, is it fair to say that at this point or even through the end of the year, that you'll pretty much be shipping everything you can make, right, as you're trying to catch up? Did it make sense to be anchoring to what one might believe your capacity to be? And that's how we should be thinking about shipment volumes through the end of the year?

Yes. I mean we will ship, I mean, essentially everything that we make. Keep in mind that this is also the time of year when we do a bit of maintenance CapEx and things of that nature. But yes, we will essentially ship what we're producing for the balance of the year.

I mean, what you're able to produce is what I mean, like you'll be it? Okay. Okay. And we had been playing with a number around 100 million cases being at current quarter capacity as Obregon was building up. Does that seem like the right way to think about things again as we're all trying to figure out as Obregon is building? Is that a good way of thinking about this?

Yes. So I think that on a quarterly basis, as we see it right now, our current capacity output is in excess of -- slightly in excess of 100 million cases a quarter. But as we optimize Obregon and we do some other things to make our breweries more efficient, we'll continue to add on to that throughout the coming quarters. And then obviously, we talked about the expansions that we -- the further expansions that we announced last April, the 15 million additional hectoliters at Nava and at Obregon, those will continue to come online obviously as we move through the coming fiscal years. And so we actually feel really good about our ability to meet our medium-term demand based on the production capacity that we have in the ground now and what we are optimizing and then what we're putting into the ground.

Okay, great. Let's talk a little bit about consumer trends and specifically channel mix. We all can see scanner but we're curious to talk a little bit about what you're seeing with on-premise, how that maybe has shifted or slowed down a bit with Delta variant making its way through the U.S. And any read you can give us on kind of on-premise share trends and broad commentary, what you've already shared on track channels. So on-premise, I'd be curious about.

Yes. So on-premise continues to be kind of sort of an evolving channel, if you will. As we sit here right now today, we're seeing good growth out of the on-premise as consumers really are eager to sort of get out and be social and do those things that they haven't been able to do during the worst of the COVID shutdown. Like look, as we continue to move through the fall and what the Delta variant and maybe other variants could mean, I mean, obviously, we don't know what impacts that will have. But right now, people are getting out there and they're going to on-premise establishments. For our second quarter, we have details through the end of July. The details for the on-premise kind of an on-premise lag out of the off-premise, so that the most recent information we have is still in July. For our beer business, the on-premise is up 95% year-over-year, and it continues to make up roughly 11% of our business, which is kind of in line with where it was at the end of Q1. For our wine and spirits business, the on-premise was up sort of 73% in Q2 and that now makes up roughly 13% of our business. Regardless of what goes on with coronavirus and the Delta variant and other variants, one of the things, again, that we experienced last year is that when lockdowns or shutdowns occur, people are pretty fluid in terms of where they purchase and then consume beverage alcohol. And so it's not that they stop consuming. So even to the extent that we do see that there are further shutdowns that occur, we don't think that, that will have a meaningful impact on either the categories or our own performance.

Okay, great. And then taking a little bit longer term, right? You've spoken many times to the sort of medium-term 7% to 9% or that's for fiscal '22, consistent with past years. Can you walk us through kind of like the key drivers of achieving that target? And I was curious to what degree that depends on the success of seltzer over time.

Yes. So I'll walk you through that, but I'll also start by saying you just see your last -- the last part of that question, right, is that our medium-term algorithm -- growth algorithm remains unchanged. We continue to target this or expect 7% to 9% top line growth, which includes 1 to 2 points of pricing, which means volume is going to be growing kind of in the mid- to high single-digit range. We have a lot of confidence in this medium-term outlook. And importantly, it's not dependent upon seltzer, our ABA success, right? I mean, just based on our core beer portfolio, we can get into this range. And so anything that we do in seltzers and ABA is additive. So now let me kind of walk you through a little bit on a brand-by-brand perspective as to why we feel good about this growth algorithm and we'll start with the Modelo brand family. So first of all, there's just a lot of distribution upside for this brand. Modelo Especial is now the #1 imported brand in the U.S., but it's still not as fully distributed as Corona Extra. So there's room for both what we call simple distribution and effective distribution. Simple distribution meaning just getting the product on a shelf and effective distribution meaning we get the right placements, whether that's on the shelf or on the floor in the cold box, the right amount of shelf space and allocation reflective of our growth in our profit dynamics. There's also a good amount of distribution gains to be had in the on-premise for Modelo Especial. Modelo on the on-premise has only about 70% of the total points of distribution relative to Corona Extra. So again, an area of opportunity. Moving on from distribution, we have the general market opportunity. For Modelo, we really only started spending behind this brand in a broad manner about 4 or 5 years ago. And prior to this shift in spend, our consumer makeup was about 80% Hispanic, 20% general market. In that 4-, 5-year period of time, with the increased spend and support behind the brand, that makeup now is kind of 55% Hispanic, 45% general market. And so that's important. This is an important opportunity for us because the non-Hispanic households represent about 85% of the U.S. population, so it's a big chunk of consumers to go after. And Modelo Especial, again being the #1 imported brand in the U.S., from a household penetration perspective, while it's increased over the last few years, it's still only about 75% of what Corona's household penetration is. So again, leaving a lot of runway for growth. Then we have the opportunity for increased innovation and line extensions for Modelo, for the Modelo brand family. We've been successful using the Corona name and extending the Corona brand to things like Refresca and Premier and Hard Seltzer. We really haven't done much of that with Modelo outside of Cheladas and maybe with some size offerings. So we do think that there are some real areas of opportunity from us from a brand extension and innovation standpoint. And those will all be things that kind of are in keeping with the brand essence of Modelo. And then finally, we have favorable macro trends for Modelo, and for that matter, our entire Mexican beer portfolio. The Hispanic demographic is expected to double by 2060. And so that's just kind of a long-term tailwind that we'll be able to take advantage of. Again, not just for Modelo, but for the broader portfolio. If we move on to the Corona family, there's still some distribution gains to be had for Corona Extra, especially in the interior of the country. We're well distributed along the coast. So if we can move that -- achieve that same kind of presence across the middle part of America, that will provide distribution gains in growth. And interestingly, just kind of to underscore the opportunity that a Corona Extra has is if you look at the latest 12 weeks, Corona Extra has about half of the total points of distribution that the largest and most distributed brand in the U.S., Bud Light has. So that's just -- I'm not saying that we can get to that level of distribution but that's proof positive that there's more distribution gains to be had for Corona or Corona Extra. And then we have to continue to sort of leverage and exploit the brand extensions that we've done under the Corona banner. Corona Premier now is in its fourth year in the market, and it's achieved double-digit growth in every year since launch. And so we still think that there's a lot of runway for distribution, obviously, volume gains there, especially when you compare it to its major competitor. We think that there are continued gains to be had for Refresca. We're quite excited about that brand. We had deprioritized that last year when we had production slowdowns in Mexico and we reintroduced that this year, but we're excited for what that can be. And we continue to be -- to see the hard seltzer category, Corona Hard Seltzer as an opportunity to drive increased growth for the Corona brand family. And then we still have some interesting other innovation around Corona, right? Just in June, we introduced Limonada, which has a different taste profile and different occasions that that's tailored to. And so this is another engine of growth for us as it relates to Corona. And then finally, I'll just wrap it up with Pacifico. We've been talking about Pacifico now for a couple of years as really being on its way to becoming the next scalable national brand. It's a brand that consistently, throughout our FY '21, has seen 4-week trends that are up very significantly kind of in that 20%, 30% range. Now candidly, those figures have kind of come down in the most recent sort of 4-week period, but that's because it's overlapping some tough comps. But this is a brand that we're excited for. It's a brand that historically has been really kind of a California brand, and it's just been with the last few years that we've gotten behind rolling it out more broadly across the country. It's a brand that's got a bit of a unique consumer versus the rest of our portfolio, really over-indexes to Gen Z in that sort of independent spirit. And you see this in how we support and invest behind the brand and through our sponsorships and through our marketing activities. So for all of those reasons, we continue to be really committed to our medium-term growth algorithm. And again, we're going to get there on the backs of our core Mexican beer portfolio and what we do in ABAs and seltzer will be additive to that.

Okay, that's great. I wanted to take a look closer at beer margins. In the first quarter, your operating margins were up 110 basis points to, I think, 42.8%, but you're still guiding the full year to 39%, 39.5%. I mean, does that still feel right? I guess, can you remind us of the key puts and takes to margins for the year and kind of timing cadence of when we should start to see that margin compression actually happen?

Yes. So this is -- as we're in the process of closing out Q2, this is one that we continue to sort of do further analysis on and are kind of refining our expectations not only for Q2 but for the full year, so we'll have a lot more to say on this topic at our Q2 earnings call here. But with that being said, I can walk you through kind of sort of the current lay of the land and what some of the puts and takes really are. One of the things we mentioned was that depreciation would be a drag this year. As we've gone through the year, we've kind of refined our estimates for depreciation. And while we still expect there to be a significant increase in depreciation on a year-over-year basis, some of that depreciation will start later than initially -- was initially expected. So that will be a net positive for the balance of the year. We expect that we're going to be able to take some incremental pricing over and above what we had planned. So that will be, again, a net positive and tailwind for us. As you can see, as everyone can see from the scanner data, again, our core Mexican beer portfolio continues to do well, and that's driven by Modelo especially on Corona Extra. And certainly, that's mix accretive. You might recall that one of the big buckets of margin pressure this year was related to mix and related to ABAs and seltzers, both the strength of our core beer business, that certainly will be mitigated. We also had some cost headwinds that we were expecting in both the first half of the year as well as for the full fiscal year that did not materialize, and so we'll see the benefit of that. Kind of just kind of going back to that mix accretive point I made on the strength of our core Mexican portfolio, with the hard seltzer category moderating, we will see that we'll sell less Corona Hard Seltzer this year than we had anticipated. And so again, that will have a positive mix benefit for us. So those were kind of the cost tailwinds, if you will. The cost headwinds or margin headwinds are -- there still are inflationary factors that are at play for the balance of the year and that's true of us. It's true of the entire consumer packaged goods segment. As we talked about it at the -- both at our Q4 and Q1 earnings calls, those -- for us, a lot of that impact hits in the second half of the year as we had some of our hedges roll off. So those will continue to be a headwind for us. And then while selling less Seltzer has a positive mix benefit for us, the slowdown in the segment has resulted in us having some excess inventory. And we have that excess inventory because given some of the production constraints we had, we had a prebuild inventory in advance of our plan in advance of the key summer selling season. And with the slowdown in the category, some of that growth isn't going to materialize. And so we're expecting to take a relatively significant obsolescence charge in Q2. And so those are the drivers of margin headwinds that we're facing. Bottom line is that when we sort of add all of this together, again, we'll provide more detail and more color on this at our Q2 earnings call. But if you look at the headwinds and the tailwinds, we think that we're still expecting to deliver beer margins for the full year within our 39% to 40% medium-term operating margin range, which again, continue to be best-in-class margins.

Yes, absolutely. Would that include or exclude the obsolescence charges that's going to be compared one time...

That would be included. Yes.

Including the charges? Okay. Great. And then the inflation that you touched on with timing on hedges rolling off, but is there an appetite to take pricing above the 1% to 2% range that's kind of been the historic trend line? I think BMI reported in August that ABI was going to take more significant pricing in '22. And given demand is so solid, I would think the environment would be pretty constructive.

Yes. We take a very disciplined approach to the pricing actions we make. And we do this really kind of on a market-by-market basis, and we look at sort of the dynamics that exist in those markets. We look at what our competitors are doing, and we look at the impact of the economy sort of on our consumers. So it's a very, very sort of disciplined approach. We think that this approach is the right approach on a year-over-year basis, and it doesn't -- it really enables us to do a number of things. It enables us to cover increases in costs that are related to inflation. It allows us to, some years, drop profits to the bottom line. It allows us to sort of continue to have funds available to invest behind our fast-growing portfolio of brands. And so we'll continue to utilize this very, very disciplined approach. Now in a year like this year, with the dynamics being what they are, we will look very closely at being more aggressive where it makes sense to be more aggressive. That might be -- that, that might result and that we'll take a bit more pricing in a market than we otherwise thought we would have. But -- so again, I mean, I think as we mentioned in the -- during your question on margins, we do think, at the very least, there's certainly benefits over and above for what we had in the plan for this year. It is one of those things that we have to balance quiet -- we have to be very careful with how we balance that because what we don't want to do is we don't want to do anything that's going to impact or impair the long-term growth trajectory of our brands. And it is an interesting environment because while you're seeing an increase in inflationary costs and people talking about the ability to take pricing across the entire consumer packaged goods segment, you also have costs increasing at a rate higher than wage growth. So all of those things have to be weighed and we'll go into that very disciplined approach.

Okay, great. I only have time for one more. I'm going to ask about share buybacks and capital allocation priorities. You started in Q1, you have the ASR in Q2. And I think you had also mentioned on the last call that there was potential upside to share repurchase in the second half beyond what was in the guidance. So can you just provide an update on your thoughts on share repurchase and also kind of what your plans might be beyond '23 after you complete the $2.5 billion buyback?

Yes. So from a capital allocation standpoint, I mean, I think we've been pretty clear with what our intentions and what our priorities are over the past couple of years, right? So a little over 1.5 years ago, Bill and I talked about as COVID was sort of -- at the outset of COVID, we said like, what we were going to prioritize in the near term was making sure that we managed our leverage ratio to ensure that we maintained our investment-grade rating and really got -- kind of gotten into that rating much more comfortably. And because no one knew what COVID had in store for us, we wanted to make sure that we had ample liquidity to be able to manage through whatever kind of came our way. I'm happy to say that throughout the year, we did exactly as we said we would. I mean, we paid down over $1.7 billion worth of debt and we ended the year at 3.1x -- with 3.1x leverage ratio. Liquidity was never a concern. But obviously, we were prepared in case it was. We said once we were more comfortably in our investment-grade rating range and once the Gallo transaction was behind us, that we would pivot and start to aggressively meet our commitment to return $5 billion of capital to shareholders through share repurchases and dividends. And I think that we showed in our Q1 conference call that we've done just that, purchasing more than $500 million throughout Q1. And then the ASR that was announced in Q2. And then as you rightfully know, we said that for the balance of the year, we'd spend another $0.25 billion, call it a bit opportunistically. We didn't give any guidance for what the timing of that might be or how many shares that, that might account for again because that was going to be a bit more opportunistic. I would say that -- and again, we'll have a more fulsome update on the share repurchase program when we get to our Q2 earnings call. But I would say that given where our share price is, and I can't believe our share price is where it is, we are thinking through how do we continue to be aggressive and opportunistic and to be able to maximize the shares we can repurchase under this program. And so near term, we're really focused on meeting that commitment. If I look beyond FY '23 and into what that could mean for continued share repurchase, I would say that, that's something that we continue to look at, we continue to refine. Obviously, we have plenty of firepower left under our existing board authorizations to go beyond on that. But then again, that's something that we'll get through this program, we'll assess it and decide where we want to go to next.

Okay, that's great. Unfortunately, we have to end there. But thank you both very much. This has been great.

Thanks, Lauren. Appreciate the time.

Thanks, Lauren. Bye-bye.