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

Good afternoon, everyone, I am Nik Modi, RBC's senior HPC, beverage, packaged food and tobacco analyst. I am pleased to introduce Garth Hankinson, Constellation Brands' Executive VP and Chief Financial Officer. Garth has been with STZ since 2001, has held a variety of roles across corporate development, business development and financial planning and analysis. Constellation Brands has been one of the most attractive top and bottom line growth profiles across our coverage with strong trends continuing for its beer business and the Wine & Spirits business that's stabilizing after the divestiture of the low-end business. A lot of the investor debate on Constellation over the last year has been on capital allocation. So we're very excited to have Garth to talk about all of these topics.

So I guess, Garth, by the way, thank you for being here. The question really is -- I want to open with this beer top line guidance, right? So you're sitting in that kind of 7% to 9% range, which is in line with your medium-term algorithm. Can you just talk about kind of how you think about that in terms of how conservative that number is given the operating environment that we find ourselves in?

Yes. Well, first of all, thank you, Nik, for hosting us, and thank all of you for being here. It's nice to see that people exist in 3D and not just on video screens.

Actually, this is -- these are just robots.

So look, Nik, I mean I think that we continue to be in a very enviable position as it relates to the portfolio of brands that we have in our performance. As we look at our first quarter, and I'll start with depletions. Our depletions are running in line with our expectations for the full year and in line with our expectations for the quarter. And that's taking into account that we have some really difficult overlaps, particularly earlier in the quarter if for the months of March and April. So we're on good track there. Moving on to consumer takeaway. If you look at IRI, the most recent trends, we continue to outperform the competitive set in the broader category. In the latest 4-week period, we're outperforming total beer by about 11 percentage points. We're outperforming on the high end by about 9.5 percentage points. We've increased our share, taking additional share of about 1.7% in the total category and about 2.4% in the high end. That -- those share gains are an acceleration over recent trends. So we're performing quite well. And I think that, that momentum is going to continue. We're very comfortable with our midterm growth algorithm, and we define our midterm period as kind of that 3- to 5-year period. We feel really good about being able to deliver that high single-digit growth at the net revenue line with 1% to 2% of that coming from pricing. So we're in really good shape as we head throughout the year.

And of course, being a premium-oriented portfolio and a leader in the high end, investors will always worry about consumer trade down in an environment of inflation. So can you just address that dynamic and kind of how you feel about the portfolio and the positioning within this kind of consumer landscape?

Sure. And this is obviously something that we pay particularly close attention to and sometimes that we're monitoring as we go through the fiscal year. Fortunately for us, we participate in a category that if we look back on historical sort of economic slowdowns or recessionary periods, that total beverage alcohol has been somewhat insulated, meaning that the rate of growth might slow, but it doesn't stop and it certainly doesn't start declining. That's true across all beverage alcohol. It's also true of the premiumization trends that premiumization continues, maybe at a bit of a slower rate, but continues to grow and that migration continues to occur. And then when the recessionary period or the weakness subsides, you get right back on kind of where you were -- that growth trajectory that you were historically at. So we feel pretty good about that. We also feel good as our research would indicate that if you look across all of the categories inside of grocery, the consumers have the least amount of concern around pricing as it relates to beverage alcohol products. So we feel like we're somewhat insulated in that front. And if you think about this in the context of the broader grocery basket and beverage alcohol only being about 2% of consumer spend, it doesn't represent a big part of a consumer's wallet. So we -- again, we think that that's a net positive for us. Obviously, as I said, this is something we're going to continue to monitor as we move throughout the year. Things like the continuing inflationary environment, the impact that higher interest rates could have as government programs that were in response to COVID sort of fall away, we'll see -- we'll monitor their impact, but so far, we've seen no indication that consumers are trading down or trading out.

Excellent. So Modelo Especial has obviously been the key growth engine of the portfolio. So one thing we've noticed as we've looked through the data -- some Numerator data is how the brand really recruited a much broader consumer demographic during the pandemic. And they tend to be actually higher income, quite frankly. So I'm just curious, when you think about the opportunity for Modelo going forward, can you just talk about it within the lens of broadening the profile going from kind of a more core Hispanic consumer group to kind of broadening the rings around different demographics?

Yes. Well, over the medium term, Modelo, Modelo Especial is going to continue to be our #1 driver of growth. It's now the #2 brand in the U.S. It's been on a 30-plus year really unbelievable tear. There's still a lot of upside for that brand if we look at it in the context of space and distribution. And again, to your point on the consumer makeup, on that point, specifically, about 4 or 5 years ago, we made the decision to start expanding or extending our marketing and advertising beyond the base Hispanic consumer to the broader market, to the more general consumer. Before we did that, the consumer makeup was about 80% Hispanic consumer, about 20% general market. Fast forward to where we are today, and that's 55-45. So I think that, that kind of gets to the point you were making about who the consumer is now and what that profile looks like. There's still room to be able to attract new and different consumers to that brand and that franchise. If you look at that in context to Corona, Corona right now is about 35% Hispanic and 65% general market. So again, I think that, that's an indication of where the brand can go. Beyond that, there's still an opportunity to increase household penetration. Well, Modelo is now bigger than Corona. It still only has about 80% of the household penetration. If we can close that gap, that represents another 2 million consumers that we can bring to the franchise. And then beyond that, we have, as I say, space and distributions continue to be a big driver of growth for us. It -- Modelo continues to have fewer points of distribution compared to its biggest competitor and also has fewer points of distribution compared to Corona. It's the #1 brand in a number of key markets and #2 brand in some other key markets, but we're seeing some really interesting growth for that brand in some of the middle-tier markets and in some of the interior of the U.S. We've seen some very strong growth in markets that historically haven't been strong with us, markets like Birmingham, Alabama, New Orleans. And so we think that there continues to be a lot of runway for both effective -- more basic and effective distribution. And as you know, basic distributions, meaning get on the shelf; and an effective distribution, meaning getting the amount of shelf space allocated that our brands deserve based on the turn, the profitability and its rate of growth. So that's a lot of runway left for there. And I haven't even touched on the ability to extend that brand. We've been pretty successful in extending the Corona brand to new variants that are consistent with the brand equity and consistent with the brand essence. We really haven't done much of that with Modelo -- outside Modelo Chelada, which has kind of been a sneaky big brand for us. There's a lot of runway for sure with Modelo Especial if you think of about awareness and extending that. That's a brand that this year, we're adding pack sizes, we're adding formats, we're adding flavors. So we think we'll continue to grow that brand family through Chelada. We've got some interesting things in test market, most notably in Modelo Oro, which is a light variant. That's in a few markets right now. It's too early to get a firm read on that, but the early indications are that, that's quite successful and additive. We're probably still a couple of months away before we make a decision. It's just how incremental that could be and where do we want to take the brand, but we're excited about that. So again, a long runway for us, a lot of growth opportunities still for Modelo Especial and the Modelo family.

And just going back to the whole distribution. I know it's been a long battle and struggle in terms of shelf space and really getting your fair share based on the velocity that your portfolio brings to the table. Are you finally seeing retailers start to open up in terms of rethinking how much spacing they allocate different suppliers?

Yes. We've had an initiative under way for last several years that we call Shopper-First Shelf, and that's ourselves, working with our retail partners using real data to try to influence how they think about shelf sets. And it's not just the shelf, it's the shelf, it's what's on the floor, it's what's in the cold box. And having retailers think about their shelf space as the most precious asset that they have and then allocating that asset to those brands that turn the fastest, grow the fastest, have the most profit associated with them. We've been very successful. Over the course of the last 2 years, we've been able to gain about 15% shelf space in each one of those years, then we're expecting to gain another 15% this year. So it's an initiative that we've focused on the last few years. We have had a lot of success, and we're expecting that continued success.

Excellent. Now Modelo obviously has been a great growth driver, but Corona has really accelerated. Can you just talk about why that happened? Like what is really driving the acceleration of that brand as large as it is?

Yes. As you know, the Corona Extra in particular, in the recent past, it's kind of been in the low single-digit growth rate. Last year, it was about 9%. Last year, it benefited from the reopening of the on-premise that drove a lot of its outsized growth. That being said, we know that brand equity was sort of over indexes versus other brands in terms of the equity in it. So we think that there continues to be velocity gains there. That's a little bit of what I would say is the wildcard for us going forward is whether or not that 9% that we experienced last year is really just reflective of the reopening or whether or not there's some continued momentum over and above the recent past. That's Corona Extra. For the Corona franchise, we continue to think that there's a lot of -- and believe that there's a lot of room to grow Corona Premier. That's a segment within the high end that is very attractive. Since its inception a few years ago, it's had double-digit growth. And again, we continue to expect to enjoy strong growth going forward. Its growth last year was moderated a little bit due to some shortages of raw materials. And as a result, we had a few odd stocks there. We're now fully in stock with Corona Premier. So that will be a big focus for us going forward. Interestingly enough, Corona Premier is an opportunity first in the on-premise. That's starting to get real traction there. So we're going to invest in both draft beer and cans, light beer, premium light beer, high-end light beer. That can format is the dominant format there. So there's room for us to invest there and make good headway as it relates to cans. So that will be a key driver for the Corona brand family. Brand like Refresca, which was -- which is a smaller RTD or FMB, if you will, I should say, is a brand that prepandemic had started to grow quite nicely and exceeded our expectations. Unfortunately, as we went through the pandemic, we had our production slowdown out of Mexico, and we had to prioritize our top SKUs. That was one that we had to deprioritize. So we took it out of market. We reintroduced it last year. That's rebounding nicely. It's a very nice alternative drink, certainly an alternative to things like seltzer, which are lower flavor -- lower carbs and more full flavor, higher calorie but certainly has a consumer positioning that resonates with folks. So we think that's a real opportunity. And we continue to believe that we're going to play in the broader, what we call AAB space with the Corona franchise, whether that's with Corona Hard Seltzer or Limonada or Seltzerita. We think that AABs in general have had a long runway of growth or a long history of growth, I should say. It's a dynamic category. Things kind of come in and come out of it, but it's important to the high end and as a leader in the high end. We've got to compete there. We've got to be successful, and we think the Corona brand is the right brand to play in that space. We just have to do it in a very differentiated way. We probably didn't do that with our first offering of Corona Hard Seltzer, but certainly, we feel Limonada, Seltzerita and the reformulated repackaged Corona Hard Seltzers is more consistent with the brand and is differentiated versus our competitive set. So again, it's another strong brand franchise for us.

Yes. And then kind of rounding out the top 3 brand franchises, Pacifico, which has been kind of on and off. It was doing really well, then it kind of had a moment of time where it was a bit soft and now it's really recovering nicely. And I know you have some glass supply issues that you were dealing with. But just talk about that brand and the geographic opportunity that you have with that brand.

Yes. So that brand, I mean, historically has been very strong in Southern California, and it's really just been in the last couple of years where we started to expand that more broadly, more nationally and spend behind it. That's a brand that our Head of Beer, Jim Sabia, you know him well and prior to him taking over the role for running all our beer. He was our Chief Marketing Officer. He is a big advocate proponent for building brands the right way and building brands over time so that you're generating real equity and you're building a sustainable brand. So we'll migrate that in a very thoughtful manner across the country, focusing kind of on the West, not to say that you can't find it out east but focused on the West. It's a brand that's differentiated from the rest of the portfolio in terms of its consumer. It tends to be a bit younger and a more active lifestyle, and you see that in the way we position and the way we market behind it and where we promote it. It's a brand that given its growth potential, we're increasing our investment behind that brand by about 62% this year. So we're spending behind it strongly. And interestingly enough, it was the #1 draft grower last year in the on-premise. So we think that there's some real tailwinds for us in the on-premise with Pacifico. So it's a brand we have a lot of interest in seeing how that develops. And you're right, last year, growth has moderated a little bit, mostly due to brown glass shortages. That seems to be behind us at this point. And so it's full speed ahead.

Excellent. So obviously, with going from a pandemic to endemic, I think, at least for now, the on-premise has been recovering. Can you just talk about that because that took a real big hit, obviously, like it did for the rest of the beverage industry or beverage alcohol industry. So where are we, what's the state of the union on on-premise?

Yes. So on-premise, just in general, we think is about 90% recovered from the pandemic. for us and as a channel, you're seeing rates of growth there in recent periods of really high double digits and in some instances, triple digits. So again, the channel is strong. As you know, prepandemic that made up about 15% of our sales portfolio wide. At its low point during the pandemic, it got down to 3%. We finished last year for the full year at about 11%. But in Q4 of last year, we ended it at about 12%, and we think we'll get back to that mid-teens in relatively short order. We think that this is a big opportunity for us. If you look at a brand like Modelo, which is the #2 brand overall, it's only the #5 draft brand on-premise and only has about 11% distribution. So it was the #2 growing draft bread behind Pacifico last year. So again, we think that there's an opportunity there. Corona continues to be a strong brand on-premise. That has about high teens percentage of its sales come on-premise. So if you just suppose that with Modelo. Modelo can get up to where corona is, a big opportunity for Corona. Corona Premier is really taking off in the on-premise. So it will be a focus there. And as I mentioned earlier, Pacifico, given its growth rate on-premise, we think that, that's another opportunity for us. So the on-premise is, in short, the on-premise is coming back and coming back strongly. We think it will be -- for us, we think it will be -- it will make up a similar percentage as it did prepandemic over the course of the next few several months, and we think it's a real opportunity for us going forward.

Now there's been a lot of debate controversy, if you will, around Constellation's pricing strategy. And I think it's because maybe people don't have the right context of what the company has done over time, right? So you have several of your peers or competitors taking up pricing at a rate that is much more dramatic than what Constellation has indicated in its public commentary. So can you just talk about that? So it's just kind of clear like what is actually driving some of your strategy?

Sure. And I think you're right, there's a lot of questions on this. And the question is really, why aren't we taking more pricing given the inflationary environment that we're in, particularly what you're hearing from not only our competitive sets but what you're hearing from other companies in consumer packaged goods. And so our response to that has been and continues to be that, look, we have a very disciplined approach to pricing. And we use the same disciplined approach year after year. And as we've said in our growth algorithm, we're going to get high single-digit in net sales growth and 1 to 2 points of that is going to come from pricing. And historically, we've gotten to the -- usually at the higher end of that range. When we're looking at taking price, we do it on a brand-by-brand, market-by-market, SKU-by-SKU basis. And we don't often take pricing on the same SKU in the same market in 2 consecutive years. So when we are taking price on a particular SKU in a particular market, it's more than that 1% to 2%, it just so happens that that's what it averages out over the entirety of the portfolio. Again, we do that every year. And so some of our competitors within the beer space don't necessarily do it every year. Some do, some don't. Some do it every year. We do, right? And so those that are taking more are perhaps playing a little bit of catch-up as a result of the inflationary environment. We also tend to think that when you look at the headline price increases from some of our competitors versus what they will actually achieve, their goals might end up being different in terms of where you price up and then how you promote back. When we tell you what our pricing algorithm is, that's the net effect. And so we think that, that's -- and that's clearly a difference between us and other consumer packaged goods categories. We know that other things, particularly in the food space haven't been able to take price now because of the rising input costs. They've played catch-up for the last couple of years. So it's a little bit different. I think I just want to round out this response to is, again, we take this disciplined approach because we want to -- we have the consumer in mind and we're thinking about price. What we don't want to do is we don't want to price our consumers out of the franchises that we have. We don't want to lose the momentum that we have on the top line. And if you look at from the consumer lens, sure, real wages are growing, but they're not growing as fast as inflation and the gap between those 2 things has actually widened over recent periods. And when you also consider that our consumer still tends or over-indexes to Hispanic consumers and that Hispanic consumer tends to get harder in periods of economic uncertainty and slowdown and recover more slowly, we have to be very mindful of that. And that's why we're going to continue on the very disciplined approach, Nik.

Excellent. And just kind of dovetailing into the cost side, right? So obviously, you're still feeling inflation. Several companies that have been at this conference, have indicated that they're expecting it to remain inflationary over the next 12 months right? So not betting on deflation. What's your philosophy in terms of the overall inflation environment? Where should we be thinking about potential movers in terms of things that could get worse or could get meaningfully better? So any perspective on that would be helpful.

Yes. So I mean, first, as a general comment about the inflationary environment. And like, look, I'd like to be able to tell everyone what the outlook for that really is, but we've been wrong, not just Constellation but all of us have been wrong for the last year. I mean when we were together a year ago, we were talking about inflation where we said, okay, inflation was going to spike in the summer and then it was going to start reverting to its mean at the end of the summer. As we move to the summer, we pushed that out 3 months and we pushed another 3 months. And so I still think that there's an expectation that the inflationary environment gets better at the second half of the year. But again, I think we've been wrong for the last year. We've -- we think that we're managing rising input costs in a pretty responsible way. As we announced in our last earnings call, we entered the year more hedged, more -- highly hedged than we typically do. Taking a step back, we typically plan on inflation in any year -- in any given year as being right around 3% plus or minus a little bit. This year, we're expected to be in that high single digit to low double-digit range. On that last call, I went through a whole range of input costs. And on the low end, they're going up 5% and the high end, they're going 36%. It averages out to that high single digit, low double digit. That's why we entered the year more highly hedged. We typically enter the year at about 50% to 60% hedged. We entered this year around 60% to 70% hedged, and then we've continued to layer in some hedges when we've seen some softness in the commodity markets. Right now, we're about 90% hedged on diesel, about 75% on aluminum and about 70% on natural gas. So again, higher than we would typically be. So that's one of the keys for us to be able to manage through the inflationary environment. Where we have some exposure and where we might continue to see some pressures is even though we're highly hedged in diesel, things like trucking, domestic trucking continues to be an area that there's tightness. There's certainly a shortage of drivers, particularly over shorter hauls. That's certainly where there's greater exposure there on our Wine & Spirits business and there is on our beer business. For our beer business, about 70% of our freight is down via rail. Those contracts are largely fixed, but we do have some exposure to diesel surcharges. Again, we think based on the contracts and relationships we have, plus the hedging, we think we're well covered there. But it's a pretty volatile commodity market. If things move around pretty wildly at times. And in experience, we'll continue to have some headwinds as it relates to international shipping. Obviously, Kim Crawford and Ruffino are big brands for us. And just given the congestion in ports and the costs associated with that, those costs continue to be a headwind. So that's another area. Those are some of the biggest areas. But we'll likely have more to say on that to hear in a couple of weeks when we get to our Q1 earnings. We're just there, we're kind of in day 2 of closing out our first quarter of the fiscal year as well as doing our first sort of latest estimate for the balance of the year now that we're a quarter in. So it could be more to come on that here in a few weeks.

Excellent. Excellent. We'll look forward to that. Wine and Spirits, a lot of stuff going on, a lot of activity, right? You have the low-end divestiture. You've done a couple of bolt-on deals. You have the transition to Southern Glazers, but the business has been under pressure because of some onetime issues. So just kind of talk about what the prospects are. When do you think you'll get back to your kind of normal algo and when we can expect some of those margins that you guys were anticipating a couple of years ago?

Yes. And I got to be honest with you. I'm more bullish on the wine business than maybe folks who are just looking at it from the outside. Number one, I think that there's room momentum building in wine business. And let me just remind you that the reason that we're falling short of our top line growth algorithm this year is because of those onetime impacts from last year being selling a [indiscernible] bulk wine and some of the route-to-market changes that occurred. But if you look at recent IRI data, right, for the last several periods, you'll see that there's real momentum building in our portfolio. We're now outperforming the broader category. We're outperforming at mainstream wine, we're outperforming in high-end wine, brands like Meiomi, Kim Crawford, The Prisoner showing really good signs of growth. Woodbridge, which has had -- which is fallen under pressure in the last couple of years, and we've been doing some repositioning of that brand. We're starting to see the fruits of that. And that's in a price category that's been under pressure. That now an IRI data, if you look at is back to growing. So I think that there's momentum building for our Wine & Spirits division, and we fully expect to be back in our top line range next year. And to get into the range that we've stated for margins, we intend to be there on a run rate basis by the end of next fiscal year.

Got it. Okay. And then just to round out the question set here, a final question on capital allocation, which is, of course, a topic that investors love to talk to Constellation about. So A lot of stuff has been in the marketplace. You guys have been very clear. Can you just talk about capital allocation priorities? Just remind us this whole notion of bolt-on versus large scale? And then any perspective around share repurchases and the A2B conversion that was recently announced?

Sure. And like, look, I hope when we talk about capital allocation, I'm going to be a bit of a boring answer because you've heard me say it before. But we have sort of 4 priorities within our capital allocation, considerations, if you will. First is we remain committed to being investment grade. This is something that we think provides us a lot of flexibility. It's important to us. We've said that over the sort of midterm, our target leverage ratio is right around 3.5x, might be times we're a little bit below that, might be times we're a little bit above that. We ended last year at 3.1x. So we're in a very good position there. Priority #2 is to continue to return capital to shareholders through the combination of dividends and share repurchases. Last year, we made fantastic progress on our share repurchase program. We bought back almost $1.4 billion worth of shares. We entered the year, I think we're going to buy back $1 billion. And in Q2 of last year, when we saw some real weakness in our share price, we got a little bit more aggressive, and we upped our spend for the full year by the tune of almost 40%. Obviously, we announced earlier this year, the ASR for $500 million, and we'll have more to talk about our share repurchase activity when the quarter closes this year or when we announce our earnings in a few weeks. We also, for that matter, on a rate per share basis, increased our dividend. So again, I think that, that just goes to show the commitment we have in terms of both share repurchases and dividends. Then we're going to continue to invest in the growth of the business. Again, we're in a very enviable position that we have a growing portfolio. And we're in a enviable position that it's highly profitable and generates a lot of cash so we can -- that we can act on all of our priorities. And again, the third one of those is investing behind the business. The most notable piece of that is the $5.5 billion that we announced earlier this year, in January this year. The expansion that's going to take place over 5 years in Mexico to build out capacity so that we can continue to supply the robust demand we have for the brands. And then on the line Wine & Spirits, we've invested in front of things like DTC and 3-tier e-commerce. Again, which we think is going to be a big growth driver for us moving forward. And then the final piece of our capital allocation strategy is rounding out the portfolio, doing some GAAP portfolio gap fillers, bolt-on acquisitions. We're going to utilize our venture arm to the best extent that we can. We did that last year. Last year, we had 3 M&A transactions, Booker wine company, awesome cocktails and lingua franca. All of those were relatively small dollar amount, but they represent big opportunities for us from -- if you look at that from a consumer positioning perspective. And we were able to fund those almost entirely through the divestiture of one noncore venture investment. So net-net, those 3 M&A transactions only resulted in a net $20 million outlay when you take into account the inflows we had from the divestiture. So that's how we've been prioritizing our capital and how we're going to continue to prioritize our capital allocation.

And any update on the A2B conversion? Or are we still waiting to get...

There's -- Nik, that's just something that there's not an update really. That's something as we said on the last call, management is not involved in that. that's a discussion that takes place between the family and the special committee. And I just -- I don't have anything to share.

Well, thank you for that anyway. And thanks for being at the RBC Consumer Conference. We're out of time. Thanks, everyone, for coming. And thanks again.

Thank you.