AGB 2021.9 - Constellation Brands (STZ)
Highly Prized Mexican Beer Business
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Constellation Brands
Constellation Brands is the leading producer of imported beer to the U.S. under the Corona, Modelo and Pacifico brands and is a leading producer of wines (Robert Mondavi, Kim Crawford, Meiomi) and spirits (SVEDKA, Casa Noble) globally. The company has a long history of acquiring and divesting brands in the beer, wine and spirits categories, building scale and distribution expertise over time. Constellation continuously looks to optimize its portfolio of brands to take advantages of the broad trends within the beverage industry.
While Constellation has many brands and does deals within all three beverage categories, it’s best to focus on the Mexican beer business (and its two most popular brands – Corona and Modelo), which is the crown jewel of the company. Corona has many sub-brands like Extra, Light, Premier, Familiar, Refresca and now Hard Seltzer. In FY21, the company sold 154M (+3% y/y) cases of beer under the Corona brand. The Modelo brand family includes Especial, Chelada, Light and Negra. In FY21, the company sold 161M (+12% y/y) cases under the Modelo brand. To put these volumes into perspective, these two brands make up almost 65% of the imported beer market (in dollars) in the U.S. with Heineken in a distant 2nd place near 11%, according to IRI’s 2019 data.
The precursor to the Mexican beer business started in 1993 when Constellation acquired a beer importer (Barton Beer), which later became the west coast importer of the Corona brand. In 2007, Grupo Modelo decided that it wanted to partner with one importer for the U.S. and ultimately partnered with Constellation under a joint venture called Crown Imports. In 2013, when AB-InBev acquired Grupo Modelo, the regulatory bodies decided that AB-Inbev would need to sell the remaining ownership of Crown Imports to Constellation. This meant that Constellation had perpetual import rights to the U.S. for the Grupo Modelo brands (and future brand extensions) and would also acquire the brewery in Nava, Mexico.
There are a few tailwinds that have benefited the beer business since the acquisition in 2013. The first is premiumization. Coming out of the great recession, consumer preferences have continued to shift towards high-end beer, wine and spirits. High-end beer is defined by the company as anything above $25/case and high-end wine is anything above $11/bottle. By 2014, the high-end overtook the low-end in dollars. Constellation’s portfolio of brands skews more towards the high-end, resulting in dollar share gains in most categories.
The second tailwind is the demographic shift in the U.S. towards a larger mix of Hispanic adults. It’s expected that the Hispanic population will double by 2060 and become the 2nd largest racial group after whites in the U.S. This benefits Constellation’s beer business directly because (at least for now) Corona, Modelo and Pacifico sales are heavily skewed towards the Hispanic population. Hispanics have high affinity for specific sub-brands like Corona Extra (40% Hispanic), Modelo Especial (70%) and Pacifico Clara (35%).
In addition to these tailwinds, the company has also improved operations for its Mexican beer business over the past few years. The first way was increasing brand penetration into retailers and distributors. There are thousands of distributors in the U.S. and producers have to work with many different distributors to gain access to certain retailers. This is where scale has an advantage. Constellation has said that half of the beer business’ growth from 2015-2019 were from distribution gains. Within each retailer, the distributor has a lot of say to where product is placed on the shelves for the end-consumer to purchase.
Constellation has also improved margins by producing more of its beer in cans vs. bottles, even though Corona is well associated with its longneck beer bottle. The company still under-indexes to cans at 33% of volume vs. 70% for the industry. From FY14-FY21 the company’s mix of glass bottles decreased from 78% to 67%. While mix of cans vs. bottles isn’t the only contributor to margin improvement, gross margins increased from 40% to 56% during the same time period.
For the wine & spirits categories, the company is pruning and rightsizing the portfolio of brands towards the premium tier. Constellation recently completed the divestiture of many low-end wine brands to Gallo for $1B. The company’s strategy going forward is to focus on its 10 key brands (most of them high-end) like Meiomi, Kim Crawford, The Prisoner and SVEDKA.
These segments are not bad businesses by any means, but they just don’t compare to the Mexican beer business. There are also more variables to consider for wine & spirits like the variance in quality of inputs (grapes, grains, barrels). The wine & spirits markets are also more fragmented, resulting in fiercer competition. The depletion volume growth for the beer segment over the past 9 years has outpaced the wine & spirits segment by over 8% annually.
Constellation also made a bold bet to participate in the growing cannabis market in 2017 by acquiring significant ownership interest in Canopy Growth. The original intent was to participate in cannabis infused beverages but the company thought that the market opportunity was compelling enough to purchase a large equity stake in Canopy. The initial investment was small at $183M for 10% of the company. The second purchase in 2018 was much larger at $3.9B for an additional 26.7% ownership, warrants to purchase shares up to 50% ownership, and 4 out of 7 board seats.
Why is it a good business?
Like many other consumer facing businesses, the beer, wine and spirits industries are very competitive. There is brand affinity and loyalty that gets developed over many years, but there are many examples of hot brands that lose their appeal after a few short years (e.g. Ballast Point). Scale advantages help the large producers, especially in the beer market (AB-Inbev, Heineken, etc) because of the ability to spread the fixed costs of large breweries over more units of alcohol and the greater power over the relationships with distributors.
Within wine & spirits, it’s not as easy to achieve scale due to higher fragmentation of the market (maybe this is due to consumer preference) and variance in quality of the product by vintage is higher. So while it may be easier to get initial shelf space allocation for a new wine, it’s difficult to grow market share. Case in point, of the 25+ brands that Constellation owns in the high-end category, the largest in volumes is Meiomi which generated revenues of $140M. Robert Mondavi (a well-known brand below $11/bottle) did $167M. That compares to the $6.1B in revenues for the beer business.
Constellation benefits from scale advantages in its beer business and intangible assets for most of its brands. What’s great about the Mexican beer business is that brand equity is built internationally by AB-Inbev, which spent $6.9B in sales and marketing expenses (almost 15% of revenues) in FY20. Constellation gets to piggy back off that that brand equity somewhat, but still spends roughly 17.8% of revenues or $1.7B in SG&A expenses, roughly half of which is spent on marketing (BofA estimate is 9% of revenues).
Because the beer business has such strong brands in Corona and Modelo, the company is able to innovate with sub-brands within the same family with high success. For example, Constellation released Corona Premier in 2018 as a light beer targeted towards men. Sales of Premier was 75%-80% incremental, meaning only 20%-25% cannibalization of other Corona beers.
Similarly, the company recently launched Corona Hard Seltzer to target the fast growing ABA (alternative beverage alcohol) space. The hard seltzer market in the U.S. has grown from $150M in 2017 to $1.8B in 2020. The two leading brands in the space are White Claw (owned by Marc Anthony Brands) and Truly (owned by Boston Beer Company). Constellation views the Hard Seltzer market as 60% incremental to the entire alcoholic beverage market with roughly 20% switching over from beer, 10% from wine and 10% from spirits.
The company invested $40M in marketing to launch Corona Hard Seltzer in the spring of 2020. It quickly became the 2nd fast growing brand in the hard seltzer category with 80M cases sold in 2019 and 175M cases in 2020 (+119% y/y). Constellation expects to sell 450M cases by 2025 and aims to achieve 20% market share in this segment. ACV (all-commodity volume), which is a measure of availability across retail locations, quickly increased from 50% in F20Q4 to above 70%. The company estimates that Corona Hard Seltzer is 90% incremental (much better than the industry) due to its brand affinity with Hispanic population. Constellation plans to release more flavors of Hard Seltzer, including a variety pack this year.
Returns on capital?
Over the past 10 years, Constellation has spent 58% of its capital on acquisitions and 47% on capex (most of which is for the capacity expansions at the breweries in Mexico), offset by 6% sales of assets/brands. This makes sense as the company has a history of acquiring and selling brands in the beverages industry. In recent years, most of its capital was sourced from the profits from the Mexican beer business, which continues to show improving margins with increasing scale.
In FY13, Constellation acquired the remaining 50% of the Crown International JV from Grupo Modelo for $5.2B (which included the brewery in Nava and the perpetual licensing rights to sell in the U.S.). The company also spent $569M to acquire the brewery in Obregon in 2016 and $5.1B over the past 8 years to expand capacity in Mexico. This includes the $700M in capex spent on the brewery in Mexicali which had to be abandoned under the direction of the Mexican government after referendum results, for which Constellation is taking a $650M-$680M impairment charge.
The beer segment at the end of FY14 generated $2.8B in revenues and $803M in EBITDA (28% margins). In FY21, the beer segment did $6.1B in revenues and $2.7B in EBITDA (44% margins) or an increase of $1.9B in EBITDA over 8 years. So while the initial multiple of 13x EBITDA ($10.4B / $803M because the company only acquired the remaining 50%) may imply a 7.7% pre-tax return on capital, the total returns over an 8 year period are much better. For reference, the average M&A multiple in beer between 2011-2015 was 15.5x (median 14x).
Assuming that the value of the Mexican beer assets are $16.1B ($10.4B + $569M + $5.1B), using FY21 EBITDA numbers, the multiple would be closer to 6x, indicating a much better return profile. Obviously, the calculation isn’t clean because there is time value of money, a ramp up in EBITDA for the beer business and other investments in the brand during the 8 years but it just illustrates how good of a deal the original Crown Imports acquisition was.
For the wine & spirits acquisitions, the returns are lower, especially given that the size of these deals aren’t as large as the beer business but management has stated that the ROIC for the company’s wine business deals has been in the low-double digits %.
As of late, Constellation has had a mixed acquisition track record, but the company is constantly playing offense, which leads to some bad deals. The worst of the recent deals is Ballast Point. The craft brewer had filed to go public in 2015 prior to being acquired so we have access to some data. Revenues were growing +166% over the first three quarters of 2015, accelerating from a +85% revenue growth number in 2014. At the time of acquisition, revenues were $107M and EBITDA ~$32M.
Just prior to the IPO, Constellation acquired Ballast Point for $1B, which implied an acquisition multiple of 9.3x trailing revenues or 32x trailing EBITDA. That’s a high price to pay, especially since the national craft beer brand started to show declining revenues soon after the acquisition. It’s estimated that by 2019, revenues had declined to just $45M when Constellation sold Ballast Point to Kings & Convicts for $41M or less than 1x revenues.
There’s also the issue with Canopy Growth. The company has spent $4.2B to acquire 38.6% of Canopy Growth in the form of direct investments + warrant exercises and the company still has unexercised warrants that gets them above 50% ownership. Constellation effectively controls the company with its 4 out of 7 board seats and David Klein was Constellation’s CFO prior to becoming the CEO.
The market cap of Canopy is just over $10B, which implies that Constellation is underwater on its original investment by 6%. However, given that the structure of the deal allows the company see how this market develops over time, it may still be a good investment years down the line. From an accounting perspective, it’s simple because the financials are not consolidated.
We estimate that Constellation has generated between 14%-19% returns on incremental capital over the past 5 years. This includes all of the great returns on capital from the Mexican beer business, offset by poor acquisitions and divestitures.
Reinvestment potential?
Constellation’s highest returning investment opportunity is further expansion of brewery capacity in Mexico. Brewery capacity was 10M hectoliters at the time of the acquisition in FY14 and the company has expanded capacity by increments of 5M hectoliters over the years. For reference, a hectoliter is enough capacity for just over 10.5 cases of beer. By FY21, capacity was 34M hectoliters and the company plans to increase capacity to meet demand for the core businesses and new category expansions like hard seltzer. The company is projecting that capacity will increase to 54M hectoliters by FY25.
The next area of reinvestment is continuing to build out the sub-brands within the core Corona, Modelo and Pacifico brands. Currently, the company has stated that there is no intention to create a Modelo hard seltzer product. We’ll see if the market continues to shift towards hard seltzer over the next few years or if it’s just a fad that normalizes over time.
Other areas of reinvestment include deals within wine & spirits, especially smaller brands that can benefit from Constellation’s distribution relationships. Through Constellation Ventures, the company invests in up-and-coming brands. So far there have been five deals announced with the latest one (Nelson’s Green Brier) being the first to leverage Constellation’s sales and distribution capabilities.
With reinvestment rates averaging between 70%-90% over the past 5 years (though FY21 was a low investment year), we estimate that the company has increased intrinsic value between 13%-15% annually.
What else is important?
Three-tier distribution system
In the U.S., alcohol is sold through a three-tier distribution system, and the specifics vary by state. Importers or producers are only able to sell to distributors which then sell into retail (both off-premise like grocery stores, liquor stores, etc. and on-premise like bars, restaurants, etc.). This is why both shipments (units sold to distributors) and depletions (units sold from distributors to retail) are relevant metrics to measure.
There are a few work arounds but the most common one is the brewpub exception. This is a producer that also sells alcohol as a retailer at its brewery location. Brewpub licenses generally allow customers to purchase alcohol directly online as well, if that service is offered. There are usually volume limitations for brewpubs, which means that this exception only works for boutique producers with a small batch of volumes each year. For example in the state of Georgia, brewpubs are limited to production of 5,000 barrels of beer per year.
That is why e-commerce for alcohol generally still falls under the three-tier distribution system. Companies like Drizly aggregate purchase options for consumers from a collection of nearby retailers. Constellation actually has an e-commerce program, which aims to help retailers become e-commerce ready. You can read more about it here.
Class A, B and 1 shares / Sands family control
Constellation’s multiple share classes allow for family control. Robert and Richard Sands (executive chair and executive vice chair of the board, respectively) own 97.7% of the Class B shares that have 10 to 1 voting rights vs. Class A shares. Collectively, the family controls over 59% of the voting rights. The Class 1 shares have no voting rights and are only convertible to Class A shares to be immediately sold.
The dividend policy is for Class A to have a 10% premium over Class B or Class 1 shares, and these classes can only receive a dividend if Class A shareholders receive one. Class B and Class 1 shareholders must always receive the same dividend payment, if there is one.
Canopy warrants revised
When Canopy Growth bid to acquire Acreage (a multi-state operator in the U.S.) in a stock transaction, the original warrants that Constellation owned were diluted to under 50% ownership. However, with the deal being announced, Constellation amended the outstanding Tranche A and B warrants to new Tranche A, B and C warrants, with extended exercise dates to 2023 and 2026. This gives Constellation more time to assess how Canopy executes and how the cannabis market develops and it extends the period in which Constellation needs to come up with the cash for the warrant exercise.
Optionality
The areas of optionality in the near-term for Constellation are successful extensions of the Mexican beer brands (like Corona Hard Seltzer) and acquiring or investing in a new brand prior to it becoming much larger.
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