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

Hi. Good morning, everyone. I'm Dara Mohsenian, Morgan Stanley's beverage and household products analyst, and we're thrilled to welcome Bill Newlands, Constellation Brands' CEO; and Patty Yahn-Urlaub, Head of Investor Relations here. Before we get started, I have to run through disclosures. For important disclosures, please see the Morgan Stanley website at www.morganstanley.com/researchdisclosures, and you can reach out to your sales representative if you have any questions. Constellations also asked me to remind you that they do not comment on rumors, so we'll not be answering questions around press reports regarding Monster recently. Getting back to the business, STZ had a great track record of growth historically over time, particularly in their beer business. And Bill, thanks for being there -- here, and maybe we'll jump right into that topic to begin with.

On the last earnings call, you indicated that September beer depletions were in line with Q2, which was in the 7% range despite a pretty difficult 20% comparison there. Can you just provide us with a bit of update on the demand environment here, how October and November looking, particularly given a lot of COVID volatility or Q3 from an overall perspective?

Well, as you know, this is the last day of our quarter, so we're still adding it all up. But what I would say is that we continue to see very strong depletion profile for our business. And we think that when this quarter is all added up, it's going to be at least consistent with what we've seen coming into this quarter. So it remains a very strong demand environment. As you can see on an ongoing basis from IRI or Nielsen, our business continues to radically outperform both the high end as well as the overall beer category. And I think this quarter is going to reflect that as well despite, as you know, a very tough comp from last year.

Right. Okay. Great. And we've been seeing strong demand behind your business for a while, obviously there's been some supply constraints that have limited your ability to fully supply that demand level. So, can you give us a bit of update on inventory levels now that you're, as of today, 9 months through the fiscal year? Are you having continued out of stock and supply challenges, particularly on certain SKUs? Are things getting better at this point sequentially? And when do we sort of get back to normal from an inventory standpoint, understanding the demand environment is fluid, but when do you think we get back to a more normalized type of environment?

It's improving as we speak. As we noted on our last call, we expected to see some improvement in Q3 and sort of get back to normal by the end of the year. It really is going on a SKU-by-SKU basis. We've seen challenges with brown glass, and that's impacted a bit our Pacifico, our Modelo Negra and our Victoria businesses as an example. So despite the sort of very, very strong results we're seeing, we obviously leaving some on the table because of some of those supply chain issues. The good news is they are all dissipating. Premier is a great example. Premier had a little dip where we had some issues around supply capability a few months ago, and you're already seeing a pretty radical increase in that business and the takeout of that business as we get that back to sort to more normal levels. So we continue to make improvements. We think it's going to be back to fairly normal levels by the end of the year. But again, as you know, it's largely going to be a bit on a SKU-by-SKU basis, and there likely will be some challenges sort of right up to the end of the year.

Okay. Great. And one of the disadvantages of having such strong demand and running all out is you don't have much time for brewery maintenance and downtimes and things like that. As that comes in place post the peak season, is everything going smoothly there? Has there been any production hiccups, the new capacity you brought online, has that been ramping up? Just give us a bit of update on how you're proceeding and how things are proceeding at the production level?

Capacity has gone very well. You're right, we brought capacity on this year. That has come up as planned. We did our maintenance -- our annual maintenance in Q3, the quarter we're just ending this year. Last year, we did it in Q4, just various timing and when it was most appropriate. And that's all done and that went fully according to plan and is back up and raring to go to meet all this strong demand. So we're really in good shape, and we're excited as we get into the fourth quarter. Obviously, we will not have the downtime we had last year because of the normal maintenance schedule that we ran last year. So it will be a good guide in the fourth quarter relative to shipments.

Okay. Great. That makes sense. And maybe taking a step back and thinking about beer demand here. Obviously, there's been a lot of volatility with COVID in the last couple of years. But as you take a step back and look at the volume growth in your business, what have been the biggest drivers behind that and apply that going forward? So how do you think about the sustainability of those drivers? Are there certain areas that ramp up going forward maybe relative to history as you look at your overall beer business?

So if we think about beer, I think there's a couple of things that are sort of what I would describe as mega trends, meaning bigger than our business that are certainly working in our favor. The premiumization, we've talked about it for a long time. It's true across a lot of consumer businesses, but the consumer trading up is a very strong element of our long-term sustainability program. We've talked about the High-End now for a number of years, and you see it developing more and more. That is where the growth profile is, and we're obviously there to take it. Second mega trend is the growth in the Hispanic community, just as an ongoing growth of that demographic. And as you know, we over SKU, whether it be Corona or Modelo and there's some variances there, but both Corona and Modelo overskewed to the Hispanic demographic. So as that demographic grows, that's certainly advantageous and a tailwind for our business as well. And then when you start to sort of break it down on a brand-by-brand basis, you got to be excited about Modelo. Modelo just continues to be the engine that can. It continues to grow double digits. As you know, Especial is now the #2 overall brand from a dollar standpoint, take out. And we're just really getting started in the broader market. We've been advertising now for 4 to 5 years in the general market, and we've seen the SKU, which was 80-20 Hispanic, evolved to 55-45. It still pales of what Corona is. Corona is 30-70, Hispanic to non-Hispanic. So there's just a tremendous opportunity that we see going forward for Modelo Especial in the overall Modelo franchise. It still only has about 75% of the household penetration of Corona, as an example. So the upside that we see in Modelo is immense. You then add in the fact that we really haven't done any innovation to speak of other than different package -- other than package, configurations, and by the way, I don't consider that innovation. That's just package extensions. There's just a lot of opportunity to fill some other gaps that we see. The Chelada business, which we developed over the last few years, now the #2 Chelada in the marketplace, has been a great example of where that brand can easily go. And there's a lot of opportunity there as well. So you got to be excited about Modelo for many, many, many years to come as to where that business can go. And we're still optimistic about Corona. Corona is very developed on both coasts, but there's still plenty of opportunity to develop in sort of middle America and in the heartland of America, it's not as developed there as it is along the coast. When you then add in that we've done a pretty solid job of innovating in that area, whether it's Premier or Refresca or some of those things, we've gated to that franchise and we still see that having legs over time. And then one of my -- when I was like talk about -- I always like to talk about Pacifico. Pacifico is, again, one of those earlier stage brands that looks a lot like Modelo looked 10 to 15 years ago. A lot of upside with Pacifico. It's 60% of its business today is in the State of California. It's the #7 brand out there. That's a lot of the feature kind of given about Modelo back then. So we're very excited that that's going to be why I think one of the franchises that we talk about a lot going forward.

Right. Okay. And as you think about Modelo, I mean the growth on larger numbers is pretty unprecedented in terms of the brand not slowing down. As you look going forward in terms of sustainability, what gives you confidence that can continue? You mentioned the growth in the non-Hispanic consumer, right? There's probably some regional opportunity, too, probably some shelf space. But what do you think are the key factors driving sustainable growth in that brand going forward? And as it gets larger, are you seeing any greater cannibalization of the rest of the portfolio or Corona brand or your other brands? Or is it still pretty incremental to franchise even when you're getting to these much larger numbers?

Well, you put out a very important point, which is how do you look at what the cannibalization is? And honestly, it really hasn't changed much. And because of the sheer growth that you're seeing, it almost washes away in many respects within the numbers because the growth profile is so strong. And then you start to say, well, we're really can it go? Are we as broad and as deep as we should be in the marketplace? We only have 70% of the points of distribution for Modelo that Corona has. And you start to think about that, the sheer size of it, and you say that in and of itself is something we need to have a long chat with the sales force about. It's a great opportunity to continue to expand that franchise. And then as you pointed out and we talked about a couple of minutes ago, that doesn't even take into account the fact that the household penetration opportunity remains immense for Modelo Especial in particular. And you're seeing that grow exponentially. So as we look out into the future, it's very hard to come up with anything other than a long range plan of double-digit growth for the Modelo franchise. Everything goes in its favor. And then you have, again, some of those mega trends that we talked about earlier, premiumization, the Hispanic community growth, all of those add in and our tailwinds to some of those other more tactical opportunities that I just mentioned.

Right. Okay. And on the distribution side, taking a step back and thinking about the overall beer business again, if you look at track channels, the last couple of years, we've seen more flattish type of distribution trends versus mid-teens growth, if you go back a few years before that. Obviously, you've had supply challenges. So that's been a big part of it. Some of it was probably a big shift to seltzer, which now expectations there have down. So as you look at the business going forward from here, would you expect a big distribution ramp up again, maybe back to those high growth levels we saw historically going forward? Now that, in theory, you're back in a much better situation from a supply standpoint and particularly given some of the strength that we're seeing in your market share numbers recently, which have accelerated in the last couple of quarters in tracked channels. So how do you think about that? Is this year coming up sort of more of a tipping point this calendar year where you start to regain shelf again? And what sort of constraints during the last couple of years here?

I think it is going to be a year where we do regain strength. The other variable sort of went into all those things you just mentioned, there's a lot of retailers didn't do a lot of shelf work because of the pandemic. It was more of sort of maintaining shelf position as you could rather than building on those opportunities. And as you point out, we -- I think we're under shell versus what we could be given the growth profile of our business and ongoing growth profile of that business. So we still think that roughly 50% of our growth profile is going to come from opportunities in distribution. We think probably -- which is a little less than it used to be, but we still think there's lots of opportunity there across a number of our brands and sub-brands therein. We also think the innovation pipeline is still going to be an important part. That was probably 20%. And historically, we think that's going to be a little more going forward, probably in the 30% range and then we still have the demographic profile benefit that we see going on. But going back to your original point, there's a lot of shelf opportunities and we're starting to see retailers be more interested in going back to things like Shopper First that we've talked about for a number of years as they start to work more aggressively coming out of the pandemic to get their shelves in order.

Okay. Great. And then obviously, the biggest theme in consumer staples really for the last few quarters here has been the inflationary pressures we're seeing. There's been supply chain challenges in general. Yours have been more from a demand standpoint. But can you just provide an update on the inflationary outlook, the impact you're expecting to full year results? And I think it's more along the lines of -- is this an area where you feel like you have visibility? Or is there still a lot of volatility at this point?

It's fair to say there's more volatility than what we would experience in a normal environment. What I would say is we're viewing in the near term, and by that, I mean in the next 3 to 6 months, we're probably going to see mid-single-digit inflationary pressures. But we have a lot of things that sort of work in our favor, and we have some that are challenges like most people. So let's talk glass, first of all. We make about 60% of our glass in conjunction with our joint venture with Owens, which again helps to mitigate some of the short-term challenges that other people might have who are buying all their glass externally because we control that. We also have about 70% of our shipping that goes by rail on long-term contracts, okay. So we don't have the same amount of volatility to people who are more reliant on trucking. As I'm sure everybody tells you, trucking has been a bit of a problem. We don't really have that issue to the degree that others do. On the other hand, we do have pressures on things like brown glass, which we tend to buy and you've seen it. We've left some growth on the table in things like Pacifico and Modelo Negra because we weren't able to access the amount of brown glass that we would like to have seen. We're seeing a little bit with some of the ports. I talked earlier today with a couple of investors about this 60 minutes thing where they were talking about all the challenges in Long Beach and trying to get things through the ports. We've seen that problem with some of our Kim Crawford and our Ruffino businesses on the wine side. So there are remaining challenges around all of those topics and more challenging than normal. But we believe that we have put that and bake that into what our expectations are. And again, that likely means for at least another quarter or 2 mid-single-digit inflationary challenges.

Okay. And as you think about levers to offset cost pressures as you look out, let's say things continue to move up from here and we see more cost pressures looking forward beyond the next couple of quarters, how do you think about your ability to offset inflation if it continues at this rate or even accelerates? And what are the strategies you guys can employ on that front?

So we look at it in a couple of ways. One is, let's take aluminum. Well, we are a little bit underdeveloped in cans in our beer business compared to some of the competition. We're also 60% hedged in aluminum. And hedging is the way that we're ongoing try to make sure we at least balance what our expectations are on the cost. So hedging is one avenue. We're taking a bit more pricing than our normal algorithm. We've always said 1 to 2. We still believe 1 to 2 in the longer run is the right answer. It will probably be on the high end of that, maybe even a little above it for this year. And what that tends to mean some markets are taking more. Some markets you're seeing 4% or 5% pricing increase, but we look at it on a market-by-market, SKU-by-SKU basis, and we're very sensitive to the -- not getting outside what we expect that the elasticity models that we have are going to handle because we're not looking to chase consumers away in this process just because we have inflationary pressures. So we take a look at it really on an input-by-input basis and see everything we can possibly do to mitigate the cost structure. But that's why we're modeling in mid-single digits in the near term, which is frankly a little higher than we normally see because we are going to see some of that inflationary pressure.

Right. Okay. And where you are taking pricing, particularly some of the markets where you're taking more pricing, what are you seeing in terms of demand elasticity? I mean, generally, what we're hearing across CPG, categories that have been a lot more elastic even historically than beer is we're not seeing a lot of consumer demand reaction from a volume standpoint. So a, maybe you can touch on consumer demand elasticity, are things different here relative to history? And b, what are you seeing from a competitive standpoint? And how are you sort of thinking about price gaps if you do see competitors move more aggressively than yourselves?

We've seen demand, as you know, continue to be very, very strong for our products despite the fact we have had some out of stocks and we have had some supply chain problems. What I would say is every competitor needs to look at this on their own basis. We have the beauty of growth on our side, and we want to make sure that the consumer elasticity models. What tends to happen in these things is if you're not careful you reach a point where the consumer just says, no. So it's not that they do a little less necessarily, they may just say no. And our intent is to make sure that as we take that 1% to 2% annually then we continue to bring our consumers along with us and not chase them off to someone else in the process, and we're very sensitive to that. And I think that's the right way in the long term to manage the business, and that's how we plan to manage it.

Okay. That makes sense. What are you seeing in general from competitors out there as you look at pricing in the industry?

Well, I read the same thing you do, which is I think some people are going to be more aggressive than we just said. And everybody has to make their own decisions on those topics. We're pretty comfortable with what we're going to do.

Right. Okay. And then earlier, we spoke about the depletion momentum continuing, can we break that down a little bit more into channel dynamics on-premise? Can you talk a little bit about the recovery you're seeing there? There's obviously been some volatility in COVID cases, which have ramped back up again after coming down and lots of news flow. So maybe just take us through what you're seeing in the on-premise channel? And also longer term, can that channel fully recover? How do you think about that? Has some capacity coming out of the industry? And then maybe after that, we can talk about the off-premise side, which obviously strengthened and how sustainable that is and maybe tracked versus untracked and off-premise, but maybe we start with the on-premise side.

I think if we learned anything during the pandemic, its ability to predict has been a little squirrely than usual. We were down at the very trough of the percentage of our -- all of our business, particularly our beer business and about 3% of our volume going through that channel. That was down from 15% at pre-pandemic levels. That's a huge drop. We're almost back, we're back to 12%, skewing up to 13%. So we're not really back to exactly where we were, but we're seeing a pretty radical uptick as you would expect. I think the real thing, and this goes right to your question of prediction is, what's going to happen now that we're heading into the winter months, particularly in Northern places. I read something just this week that said, more and more consumers are getting comfortable eating out and eating inside, which for those of us who live in the northern half of the country, that's pretty good because I don't know about you, but I'm not too anxious sit outside when it's 30 degrees out, Fahrenheit. And I think that's a dynamic that's just not clear how that's all going to play out just yet. You're still heavily driven by individual markets and individual growth rates of COVID-19. So I'm getting out of the business of predicting how that will all play. It is getting more back to normal. What I do think, going to your question about off-premise is the channel mix is going to be interesting to watch. More and more people have done Click & Collect and 3-tier e-commerce and direct deliveries. And it will be interesting to see over time how much of that maintains itself. The alcohol beverage business, by and large, was not a category that had done a lot of direct-to-consumer, wine had done more. But take the beer business, the beer business had done very little of that, even though I would argue many, many households view beer as an item that they have in stock at all times. But they haven't thought about buying it in the same way that they might buy their other household goods and that collected at their local retailer. So as you've seen that sort of thing develop, it will be interesting to see how much of that behavior continues going forward versus that being reverting back to the norm. My personal opinion and our opinion overall is that it's likely to continue. Now at what level, remains to be seen. But I think we certainly have invested a lot in 3-tier e-commerce capability. I think the big retailers around the country are doing the same and the wholesale networks, whether it be beer or wine & spirits, are investing much more in the capability in that area as well. So I think everybody expects that you're going to see some continued evolution of how people get their product, and that will be a big change to watch going forward.

Right. Okay. And then thinking about the track channel business beyond on-premise and beyond e-com, obviously that's accelerated during COVID. Is there a chance it's sort of a bit stickier here coming out of COVID and you don't necessarily see volume gains in on-premise completely coming out of off-premise. Just how do you think about that channel?

I think that's likely to be a true statement. And I think it's going to be heavily driven by what the scenario is around COVID, and it will be a market-by-market basis. I'm not sure that you're going to be able to say a broad generalization trend as I think it's going to be very sort of localized in terms of what's going on in particular markets. I'd say, on a halo basis, it's likely to be yes relative to your answer because people form habits. And if they're comfortable with those habits, those habits often continue.

Right. Okay. Maybe we could switch to the innovation side in beer and particularly your seltzer ABA strategy, expectations have retrenched a bit for the Corona brand in terms of Corona Hard Seltzer. Premier has obviously done well. Refresca has been okay, but some supply challenges there, et cetera. So maybe just in general, innovation focus going forward, how confident you are you can drive innovation, but then also specifically talk about the seltzer ABA strategy in general from here for your business?

Well, I think the one thing we learned around the seltzer scenario is this, you better have products that are distinctive and it have real reason for being and not be need to. I think in the hindsight, I think we might have been too anxious to play in the category versus making sure we have products that were distinctive. I would argue Refresca is distinctive. We obviously didn't produce that for a while. If you look at the sales rates in Refresca at the moment, they're phenomenal. We're getting right back to where we were a year ago before we didn't produce it for a period of time. That one to me is distinctive. I think Lemonade is distinctive. We have some other things in the queue that are coming that are distinctive and they're not me too. I think that's where we're going to play and that's how we're going to win and that's how we're going to play in places that have strong price realization rather than playing in areas that are met too. And we're doing a lot around that to make sure we're prepared to actually get that done. You saw we have said, there's a lot of consumers that would like some more robust flavor in the seltzer arena. And we're bringing that to the table, and you're going to see that early in the new calendar year. So we're doing a lot because we still think despite the fact that, that category has slowed substantially that it's still going to be an important category, probably at smaller growth rates than what we've seen. There's undoubtedly going to be some shakeout, much like there was several years ago in craft beer. It got over shelved, and then it got back to a more normal level that was reflective of its percentage of the business. I think you're going to see the same thing when it comes to seltzer here in the coming year. And our expectation with the strength of particularly our Corona brand is that we're going to be a player in that arena.

Right. Okay. And then could you discuss your capital allocation priorities right now? You recently acquired the Paso Robles based My Favorite Neighbor business. But just in general, specifically focused on M&A and where that fits into your capital allocation plans, you've also started to repurchase pretty aggressively shares recently. So maybe give us an update there. And in terms of M&A, are you looking at larger scale type of deals? Is that on the table? How do you think about that?

Sure. We've been quite specific during the 3-plus years now that I've been the CEO as to what we expect to do. First and foremost, we said we wanted to make sure we were investment grade. In fiscal '21, we reduced our debt structure by $1.7 billion against that goal. We then said we're going to take $5 billion and give that back to shareholders in the form of stock repurchases and dividends. And through the second quarter, we were 60% of the way there. That's well ahead of where we expected to be at that point in time. We'll have another statement around that as we get to our earnings call here in January, but that's been an important one. Because this is such a cash-generative business, you can do both of those while still having our critical third priority, which is investing behind our beer capacity. We've also learned with the strong demand that we have that we need some more redundancy in that business. We shouldn't be as susceptible to some of these quirky things that have happened as we have been. So we're going to continue to invest and make sure that we're prepared for this great acceleration that we're seeing in consumer demand. So that's our third priority. Relative to M&A and using the My Favorite Neighbor Booker as an example, that came out of our venture portfolio. We really don't see ourselves aggressively in the M&A business other than small bolt-ons that would largely come out of our venture portfolio. My Favorite Neighbor franchise was part of our venture business. Every venture business that we made a minority investment in has a very strict outline as to where we might invest further, we're taking on. And frankly, if you haven't had that line, you should have it, it's outstanding. That business radically outperformed what our investment profile was when we made the initial investment. So we went ahead and brought it in. But again, that's coming directly out of something that we'd already invested in and it should be really viewed as a bolt-on. The focus of our intention is returning money to shareholders and investing behind our beer capacity.

Okay. And can you talk about the capital required to build out your next brewery in Southeast Mexico and how that might impact your priorities?

We've said we're probably going to be in the $700 million to $900 million range over the next few years as we build out capacity, both at our 2 existing facilities and whatever we do in the Southeast. And as you know, we're continuing to work with the government to define where our next exploring operation will be in Mexico. So that's a good range as we see it. It might be a little more, a little less, depending on how things come on stream, but that's roughly what we expect to see over the next few years.

Right. Okay. And Canopy's recent results have been weaker than expected, and they pulled the time frame around when they expect to achieve profitability. So can you talk specifically about how you're thinking about the upcoming warrant expiration and which is less than 2 years away at this point? And how you'd address concern that perhaps you double down in an area that's more uncertain, particularly when you look at the strength of your base business and the momentum you're seeing in the beer business today as we've talked about during this discussion?

We'll be very disciplined about that topic, as you would expect. If the warrants are not in the money, I wouldn't expect that we're going to deal with them as they currently sit and currently they're not in the money. But we'll also look is the cannabis business developing in the way that we thought is Canopy in a position to be the winner. And we challenge ourselves about that all the time. Are they in a position to be the winning play? What level of ownership should we have as part of that process? Those are all things that will go into the equation. But first and foremost, we continue to feel like that's going to be an important business over the course of time, particularly as regulations to open up and you have the opportunity more aggressively enter the United States. Certainly, it's taken longer than we had initially anticipated, but we still are optimistic that it's going to be a big business over the course of time.

Right. Okay. And maybe last, we can touch on the advertising spend side. You're one of the few companies that didn't really cut back during COVID. You continue to spend at pretty healthy levels. You've laid out your long-term expectations as a percent of sales. But given the strong growth in the business, right, you're still seeing strong growth in advertising spend, even if you remain in the same percent of sales range. So just curious for your view of share of voice in the category at this point, if there might be some opportunity to lever that advertising and lower ad spend as a percent of sales over time, particularly given we've heard from some companies coming out of COVID that maybe they don't need to go all the way back to the spending levels they were at previously in terms of ad spend. So how do you guys think about that for your business?

Well, I would argue part of the reason you're seeing the great growth profile that you're seeing within our business and versus the competition is because we did advertise during that window and have seen a significant share increase in our overall -- in our brands because of that spend. I think we're going to -- we believe in it. It's worked for us. We have, as you know, a very algorithmic drivers and drags where we look at how much value we get out of our spend in all sorts of different areas of our business, and we're very disciplined about looking at that. So far, we continue to believe that the major media spend that we do is very additive to our business, and it's a great return on our investment. What I will say is, we are looking aggressively at things like digital and doing much more of that than we had historically done. And I think you're going to continue to see that evolution go on as we go forward, as we get more refined and we get much more of that one-to-one relationship with consumers that I think a lot of people are doing today. So we believe in advertising. We think that's been a growth driver of our business. We think finding the beach has been a great campaign. It's continued for years for Corona. And I think the Modelo campaign is one of the all-time grades and whether how you think about or how I think about it, everybody can have -- can really have that campaign speak to them individually. And I think that makes a great campaign.

Right. Right. All right. Well, with that, we're out of time. Really appreciate you joining us today. It was a very helpful discussion. And thanks, everyone, for joining us, and we'll end things there.

Thanks, Dara.

Thank you. Good to see you.

You, too.