Constellation Brands, Inc.
Q2 2009 Earnings Call Transcript

Published: 2 Oct 2008

[Operator:]

Welcome everyone to the Constellation Brands second quarter 2009 earnings conference call. (Operator Instructions) It is now my pleasure to turn the floor over to your host, Patty Yahn-Urlaub, Vice President of Investor Relations.

[Patty Yahn-Urlaub:]

Welcome to Constellation's second quarter fiscal 2009 conference call. I'm here this morning with Rob Sands our President and Chief Executive Officer, and Bob Ryder, our Chief Financial Officer. By now you should have had an opportunity to read our news release, which has also been furnished to the SEC. This conference call is intended to complement the release. During the call we will discuss financial information on a GAAP-comparable, organic and constant currency basis. Reconciliations between the most directly comparable GAAP measure and these and other non-GAAP financial measures are included in the news release or otherwise available on the company's at www.cbrands.com under the Investor section. These reconciliations include explanations as to why management uses the non-GAAP financial measures and why management believes they are useful to investors. Discussions will generally focus on comparable financial results excluding acquisition-related costs, restructuring and related charges, and unusual items. We will also discuss organic net sales information, which is defined in the news release, and constant currency net sales information which excludes the impact of year-over-year currency exchange rate fluctuations. Please be aware that we may make forward-looking statements during this call. While those statements represent our best estimates and expectations, actual results could differ materially from our estimates and expectations. For a detailed list of risk factors that may affect the company's estimates, please refer to the news release and Constellation's SEC filings. Thanks, and now I'd like to turn the call over to Rob.

[Robert S. Sands:]

Welcome to our discussion of Constellation's second quarter sales and earnings results. We are pleased with our quarterly results, which were in line with our expectations and clearly demonstrate that we are on track to achieve our fiscal 2009 financial goals. In second quarter, we generated strong free cash flow, significantly reduced our debt, improved our comparable basis operating margin and ROIC, and reaffirmed our comparable EPS guidance for the year. We are particularly pleased with our ability to rapidly deleverage using a combination of free cash flow and proceeds from the sale of assets. From an operational perspective, we improved operating margins for both our Wine and Spirits businesses by improving our sales mix and increasing prices to offset rising input costs. Collectively, these actions have been completed during a time of increasing financial market volatility and ongoing competitive challenges in some key markets. During the quarter, we began the process of right-sizing our Australian wine operation, which includes the planned sale of production facilities and vineyard properties, consolidation of bottling operations, and the rationalization of our extensive portfolio with the elimination of more than 30% of our SKUs. This initiative is part of our ongoing effort to enhance operating efficiencies and improve cash flow and return on invested capital. In the second quarter, we also sold U.S. wine brands and assets that were acquired with the Clos du Bois transaction as well as some of our Pacific Northwest facilities and brands from Washington State and Idaho. We received more than $200 million in proceeds from the sale of these assets, which were used to reduce debt during the quarter. Now looking at our U.S. Wine business, this will be the last period that we will be comparing for the cycling of our fiscal 2008 U.S. distributor wine inventory reduction initiative, which benefited this year's second quarter results by approximately $30 million in sales and $0.04 in EPS. Above and beyond this benefit, we've continued to improve the EBIT of the U.S. wine business as a result of the favorable product mix created from the acquisition of higher-profit premium brands, the divestiture of lower-margin value brands, and the resulting synergies generated by this ongoing portfolio transformation. Nevertheless, sales for our U.S. Wine business for the quarter were a bit below our expectations for the following reasons

[Robert P. Ryder:]

Our comparable basis diluted EPS came in at $0.45 versus $0.35 last year. This, combined with our Q1 results, puts us on a path to achieving our full year EPS goal of $1.68 to $1.76. We generated $125 million of free cash flow in the first half of the year and remain on track to reach our $310 to $340 million free cash flow goal for fiscal 2009. Our deleveraging efforts have driven more than a $400 million decrease in our total debt level since fiscal 2008 year end. Now let's look at our Q2 fiscal 2009 P&L performance, where my comments will generally focus on comparable basis financial results. First, net sales. As you can see from our news release on Page 13, our consolidated reported net sales increased 7%, primarily reflecting [inaudible] wine sales, including the net benefit of adding brands like [inaudible] and Wild Horse and divesting [inaudible] and certain Pacific Northwest wine brands. On an organic constant currency basis, which excludes the impact of acquisitions and divestitures, the growth rate was 6%. This growth rate includes the benefit of overlapping our initiatives to reduce distributor wine inventories in the U.S., which negatively impacted net sales in the first and second quarters of fiscal 2008. My commentary for the following net sales comparisons will be on a constant currency basis

[Operator:]

(Operator Instructions) Your first question comes from Timothy Ramey - D. A. Davidson & Co.

[Timothy Ramey:]

You mentioned hedging losses. Was that currency hedges or what exactly was that and the order of magnitude, please?

[Robert P. Ryder:]

Yes, it was mostly transactional currency hedges, Tim, and the total for the quarter was probably around $8 million. So we had some ineffectiveness and some other things going on in the hedging portfolio, so we look at that as a onequarter aberration.

[Timothy Ramey:]

And I think your sales guidance implies an acceleration of kind of organic performance in line for the second half, if I'm not mistaken. I mean, seasonal is with us every year. What gives you that confidence that we'll see that?

[Robert S. Sands:]

Yes, your deduction is exactly right. There's a lot of things going on in the portfolio. Probably the most important thing is that, you know, we've taken a lot of pricing. Typically you see the effect pricing on volume occurring to a greater degree the closer to the actual pricing action we've taken and to a lesser degree as you start going out. So as we get farther away from the point in time when we've taken the pricing increase, then the market has adjusted to the pricing and competitors have reacted. We are expecting stronger sales growth in the second half.

[Operator:]

Your next question comes from Reza Vahabzadeh - Lehman Brothers.

[Reza Vahabzadeh:]

You talked about the grape cost increase in the U.S. and then also about the packaging cost increase as well for the Wine business. It wasn't clear to me what the total cost inflation is that you expect for next year and the price increase that you need to offset that for the Wine business and then the same thing, if it's possible, for the Beer business.

[Robert P. Ryder:]

Yes. What we said was that we are experiencing about mid single digit COGS increases and that we are more than offsetting that with price increases. Our price increases have been in the mid single digit range, so mid single digit price increase has more than offset mid single digit COGS increases. [inaudible] percentage on a smaller base versus a larger base. Then in Beer we have contractual cost increases from the supplier Modelo, and those contractual cost increases are very small, less than inflationary rates. And we're really not subject to a lot of other COGS or input cost pressures in the Beer business. We're pretty insulated from that due to the nature of the business.

[Reza Vahabzadeh:]

Would those cost and pricing dynamics, the COGS inflation and pricing dynamics for your Wine and Beer business in the U.S., would those relationships generally hold going forward, though?

[Robert P. Ryder:]

Yes. The relationship holds about 40%, 50% in the Wine business of our COGS of grapes. The rest is packaging and other components. And, as I said, we're seeing about mid single digit inflation and input costs across the board and pricing has been in the mid single digit range. So we see that kind of thing holding.

[Reza Vahabzadeh:]

And then Bob, obviously the company's deleveraged over the last 12 months to organic cash flow and also asset sales and you talk about more deleveraging going forward, but to the extent that there are attractive wine portfolios for sale in the next six months, how does the company gauge and characterize its interests in terms of acquisitions in U.S. wine assets?

[Robert S. Sands:]

Yes, you know, what our position on that is that our main focus at the current time is improving efficiencies, improving ROIC, paying down debt, deleveraging. What we've said is that we're not going to categorically say that we won't ever do an acquisition or we won't look at acquisitions, but the focus has been on driving efficiencies and generating free cash flow, and I think that you can see some pretty good results in our rapid deleveraging and ROIC improvement, so that's pretty much where we're at there.

[Operator:]

Your next question comes from Kaumil Gajrawala - UBS.

[Kaumil Gajrawala:]

Rob, so much of your commentary was around pricing. Could you, given what's going on with the economy, can you talk about if you're seeing any down trading and then also if strategically there's something that you might be doing differently given the economic situation that we're in. And then hopefully some insights by region instead of just an overall view.

[Robert S. Sands:]

Yes. I mean, the basic answer to your question is there really is almost no evidence of down trading. If you look at IRI data sort of segment by segment in the Wine business, you'd see the exact same pattern that we've seen in the past, which is value products are either flat, declining and then, as you start moving up the price tier, growth is occurring at faster and faster rates, largely. In Spirits, I think you're seeing some moderation in the premium segment, with the premium segment coming more in line with the value segment and the value segment increasing a little bit. So you might say that there's some trading down going on in Spirits even though, as a general proposition, there isn't trading down. In Beer, there isn't really trading down either. There's some shifting around. The imports have been weak, but that's driven largely by our portfolio being the largest in the import category and the factors that have affected our portfolio. Excluding our portfolio, imports are pretty strong. And [crafts] are very strong and, in the domestic front, the premiums and more premium are pretty strong. So we really haven't seen too much trading down as a general proposition. Now, you know, you can look at specific brands and you can see what could be trading down. Our SVEDKA Vodka, for instance, which continues to grow at huge rates, you know, 40%, 50% growth in SVEDKA on a very large base, it could be the beneficiary - it's the beneficiary of, I think, both trading up and trading down. You've got people that are trading up from, say, the domestic vodkas that are slightly below it, and then you might have people trading down from some of the very high-priced vodkas, which definitely have seen some slowdown. But, as I said, as a general proposition, trading up continues to be a pretty strong trend across all beverage alcohol categories. You asked me about regionally, I don't think that we're really seeing any huge regional differences that are worth noting. As it relates to our Beer portfolio, there are some states in the U.S. that have been particularly hard hit by the economic downturn, especially as it's impacted housing. I mentioned California, Florida and Arizona in that regard, some of the border states - Arizona and California, that is. So that's pretty much I'd say a good summary of the state of the industry as it relates to your question about trading down versus trading up.

[Kaumil Gajrawala:]

And then just any contingency plans or anything you might be doing differently? It sounds like you feel fine about the category, that there's nothing strategically you're changing given the economy, correct?

[Robert S. Sands:]

Yes. No, we're not. The beverage alcohol business, the growth remains pretty healthy in our industry. I would say that if you look at the growth rates across most of the categories, beer is actually growing very well at the current time. Wine, I think we've seen some moderation in growth overall, but I would say it's actually moderated to the more historical growth levels as opposed to the very high levels that you were seeing maybe eight, nine months ago. And, you know, Spirits growth is pretty healthy for Spirits, in mid single range. So it's a pretty healthy industry in general and pretty non-cyclical, so it doesn't really call for any strategic shifts to deal with the economic conditions as might be the case in other industries that are more clearly or directly impacted by what's going on.

[Kaumil Gajrawala:]

And then quickly for Bob, any contingency plans for the debt coming due in 2009? And given the credit environment, are there any issues with suppliers, grape suppliers, or anything that we need to be thinking about?

[Robert P. Ryder:]

Well, we're really not worried at all about any of our debt maturities. We have about $210 million coming due this year on Term A, I think 90, it happened, year-to-date. And yes, the sterling notes come up next year and really our discussion is do we put in more sterling notes or do it in U.S. is more the concern. I mean, you know, right now we've got zero drawn against the $900 million revolver, so we feel very comfortable with our liquidity position.

[Operator:]

Your next question comes from Lauren Torres - HSBC.

[Lauren Torres:]

Just first a housekeeping item. Bob, can you just go back and give us the reason why the tax rate was so low in the quarter?

[Robert P. Ryder:]

Yes. I mean, essentially, Lauren, it was just a fallout of a tax position that we had taken that has become more clarified. So, you know, under the new FIN 48 rules, you sort of have to sort out your tax rate on a quarterly basis. So we don't see an impact to the total full year tax rate, more just a timing thing.

[Lauren Torres:]

So for your tax rate, your comparable tax rate, to still be around 37% for the year, we expect more than that in the second half?

[Robert P. Ryder:]

Yes, because year-to-date you're less than that, correct.

[Lauren Torres:]

And also I'm not sure if you mentioned this, Rob, when talking about Corona imports, but as you expected better second half performance and you expect your competitors to pass through some pricing, can you talk about, if you can, what your pricing strategy is for the remainder of the year?

[Robert S. Sands:]

Yes. Our pricing strategy is not to take any pricing. We took our pricing last year. We have no plans to take any pricing this year. So, you know, this is going to be, I think, a pretty favorable - this is going to be pretty favorable relative to growth of the portfolio in the second half of the year. Domestics are taking pricing now. In anticipation of that pricing, there's probably been some buy-in at the retail level. That will dissipate. Price gaps are closing. And, you know, look, I mean, I said what I said about anticipated growth for the year, which we're now saying it's flattish to slightly up, but I would say that the second half of the year we're pretty optimistic about the portfolio. And we're already seeing some signs of growth returning to the portfolio but, given the performance in the first half of the year, you know, the math doesn't get us to the previous guidance of mid single digit growth. It's as simple as that. But the portfolio is healthy and we're seeing growth return and we're pretty optimistic, and I think that the headwinds are diminishing significantly.

[Lauren Torres:]

So looking at the costs that you're facing this year in the Beer segment, you're comfortable with not taking that pricing?

[Robert S. Sands:]

Cost? Yes, we don't have much cost increases; very, very little, as I think Bob pointed out in his talk and as we pointed out to you all before. The only real cost increase we have is contractually dictated cost increases from the brewery, and those are very small cost increases. It's below U.S. inflationary rates. So we don't suffer from the same kind of thing that manufacturers suffer from in the Beer business. When I say we, I mean the Crown joint venture.

[Robert P. Ryder:]

If you look at the Crown operating margin versus a year ago, it's down a bit, and 60% of that is timing due to just how the marketing flows through the P&L.

[Lauren Torres:]

And if I can ask just one more question on your Wine business - I think you mentioned this, Bob, too - if you exclude the inventory reduction a year ago, your North America branded wine sales would have been up what? Did you say low single digits?

[Robert P. Ryder:]

Yes.

[Operator:]

Your next question comes from Unidentified Analyst - J.P. Morgan.

[Unidentified Analyst:]

Just to clarify, you beat down $400 million of debt this quarter. Could you break it out between [results] in terms of [inaudible] was?

[Robert P. Ryder:]

Yes. Most of it came out of the revolver. The only other piece is the Term A loan. We paid off $90 million. The rest came out of the revolver. And as I said, I think, you know, as of right now, we really have nothing drawn down against the revolver.

[Operator:]

Your next question comes from Mark Swartzberg - Stifel Nicolaus & Company, Inc.

[Mark Swartzberg:]

Rob, I was wondering if you could give us a kind of state of the union on the restructuring exercise, if I can simplify it that much. You've been engaging in restructuring for several years now and, with the exception of Crown, it's kind of covered, I guess, to an extent - with the exception of Spirits - it's kind of covered all your businesses. What inning do you think you're in in this whole restructuring process of the company now that you're more focused on internal performance versus acquisitions? And then, if you're not in the seventh or eighth inning, where do you think there remains significant opportunity and what sort of magnitude are you seeing?

[Robert S. Sands:]

Well, Mark, as you pointed out, we've done a lot in this regard, and it's touched a lot of different parts of the business. Yes, I'd say, you know, seventh, eighth inning is probably as good a characterization as any. Clearly we're way beyond any beginning stages of restructuring activity. And it's not to say that there isn't opportunities as we go forward, but we've been knocking off the opportunities fairly rapidly. I would say that over time we'd really like to get away from having to do restructuring. That's why we've been pretty aggressive in getting as much done as we can upfront. But, you know, we look at restructuring as an investment. We analyze it in terms of return on - we analyze restructurings in terms of return on investment, and we're also pretty conservative in that regard in that our restructuring, we demand very high returns on restructuring activities. So to the extent that we would have more restructuring activities in the future - which I'm not really commenting on other than I did say that I would agree with your characterization of seventh, eighth inning - but to the extent that we have them in the future is going to be a positive thing, not a negative thing, in that our restructurings are high-return investments. So that's, I guess, the state of the union that I would give you.

[Operator:]

Your next question comes from Bill Leach - JWL Capital.

[Bill Leach:]

I just wanted to follow up on this tax rate question. [To reach 37%] for the year, pretty much the tax it would be around 41% in the second half. Why would it be so high?

[Robert P. Ryder:]

Again, it's all around timing, okay? So the second quarter is sort of abnormally low, and the things that are reversed aren't necessarily for this year; some are for prior years, some are for future years. So it's very difficult to deal with quarterly tax rates so I would say for your models and everything just assume a 37% for the full year.

[Bill Leach:]

So my [inaudible] correct, I expect over 40% in the second half?

[Robert P. Ryder:]

Yes. You can't really look at it on a quarterly basis. I know you're supposed to but tax rates aren't specific for the quarter. There's a lot of things that hit a quarter that actually belong in other quarters. So I would do whatever you have to with the math, which might make us around 41, to keep your full year at 37.

[Operator:]

Your next question comes from Judy Hong - Goldman Sachs & Company, Inc.

[Judy Hong:]

I'm just trying to understand better the possibility of [inaudible] U.S. Wine business. I know a large part of that is really driven by [inaudible] impact as you've been sparring and changing your portfolio, but beyond that, if you can talk about how some of the efficiencies that you've indicated before, [inaudible] margin, other than mix, if you look at sort of your - or other than acquisition, if you look at your underlying Wine, are you seeing [inaudible] improvement there and what's the [inaudible]?

[Robert S. Sands:]

Yes. You kind of cut in and out a little bit, but I think your basic question was about mix shift and how is that impacting efficiencies and what's going on beyond the acquisition front. In general, we've got a pretty significant mix shift occurring. It's occurring both organically as well as through acquisitions and dispositions, you know, the Clos du Bois acquisition and the Almaden, Inglenook disposition. But going back to the point about premium products growing at a faster rate than value prices, this is also driving mix shift in the business. We've been able to take advantage of that and drive efficiencies in our production organization as we've move out brands, as I said, like Almaden or Inglenook, or we have discontinued brands through our SKU reduction initiative. We're making room in our premium portfolio without having to add extra PP&E. That's really the key there. That's what's driving the efficiency. Therefore we're getting a higher and better use out of our assets all the time as the mix shift occurs, both organically and through acquisitions and dispositions. So this is a trend that we're taking advantage of and do something that's driving efficiencies in the business both organically as well as not organically, as I've stated.

[Robert P. Ryder:]

Just to add on with what Rob said, it's a combination of things. If you just take - this is all sort of delivered  if you just take the Clos du Bois, Inglenook transactions, okay, we bought Clos du Bois in the portfolio, which of course, has a much higher margin than Almaden and Inglenook, the combination of those two things improved our gross margin in the U.S. Wine business by 250 to 300 basis points. And remember, you know, net-net we've almost paid off all that incremental debt, okay, because we paid like $880 for Clos du Bois. We brought in about $130 for Almaden and Inglenook. We're generating cash flow and we've paid off $420 million of debt year-to-date. So we're sort of left with a faster growing, more profitable portfolio, and with those higher gross margins, we're able to leverage our SG&A infrastructure better as well. That sort of what we're trying to do.

[Judy Hong:]

Okay, and then just quickly, I know - can you give us your ballpark, just [inaudible] the numbers, for U.S. wine and Crown Imports?

[Robert S. Sands:]

Ballpark numbers for what?

[Judy Hong:]

Ballpark depletion - depletion trends.

[Robert S. Sands:]

Well, we're sticking to the guidance that we've given.

[Judy Hong:]

For the third quarter, Rob, third quarter.

[Robert S. Sands:]

Third quarter?

[Judy Hong:]

Yes.

[Robert S. Sands:]

We don't give - well, obviously we don’t give quarterly guidance in any event, but we're looking for mid single-digit growth in Wine, and Beer, we're looking at flattish to slightly up.

[Judy Hong:]

I'm sorry. In the second quarter, was the depletion trend - how does that trend in the second quarter, sorry, for the Wine and the Beer business?

[Robert S. Sands:]

Beer was a little bit on the downside. And, you know, Wine sales have been lower than we expected primarily due to, as we said, the price increases. So, you know, slightly down.

[Operator:]

Your next question comes from Christine Farkas - Merrill Lynch.

[Christine Farkas:]

Just a quick one on inventory levels or working capital issues at your distributors. Are you seeing anything going on there with respect to the credit crisis and just a greater desire to manage working capital? Is that hurting shipmenttodepletion ratios?

[Robert P. Ryder:]

No. There's a constant to and fro between us and the distributors on inventory level, but we took our distributor inventory down last year and we're really not seeing anything out of the ordinary. Now maybe our competitors, many of whom have higher inventory balances, are seeing that, but we really are not.

[Christine Farkas:]

We're hearing basically high-end products, so those where the cost of carry might be higher. So I know you've taken your inventory levels down. I'm just wondering if perhaps some of your higher-end Spirits are facing some of those issues.

[Robert P. Ryder:]

No, we're not seeing that.

[Operator:]

Your next question comes from Bryan Spillane - Banc of America Securities.

[Bryan Spillane:]

I guess a follow up on Judy's question on the profitability of the U.S. Wine business. First question, the $8 million hedging loss that you recorded, what segment did you record that in?

[Robert P. Ryder:]

It was mostly in the Wine division.

[Bryan Spillane:]

Mostly in the Wine business.

[Robert P. Ryder:]

I'm sorry, I didn't catch the last [inaudible], Bryan.

[Bryan Spillane:]

All right, so you recorded - the $8 million loss was recorded in the hedge - in the Wine business?

[Robert P. Ryder:]

Yes, most of that is in the Wine segment.

[Bryan Spillane:]

And that's $8 million pre-tax?

[Robert P. Ryder:]

That's pre-tax, yes. It's $6 to $8 million, in that range.

[Bryan Spillane:]

Okay. And then in terms of going forward are there other hedges? Do we have to think about other hedges as we're modeling out margins for the back half of the year?

[Robert P. Ryder:]

No, we think that will be much reduced in future quarters.

[Bryan Spillane:]

And then, so as we're looking at the - because when you look at the margin in the back half of the year, as you've now pretty much lapped the impact from the inventory de-stocking last year, I guess the question's going to be what's your confidence in your ability to grow margin off of sort of a higher margin base? And, if I'm thinking about this right, your margin performance in the second quarter would have been better had you not have recorded the hedge loss, but are there any other factors we should think about in terms of margins in the back half of the year that would sort of give confidence to be able to grow margins off a higher base?

[Robert P. Ryder:]

I mean, it's sort of the back half of the year. I would agree with you. I would expect our margins to get a little bit better in the back half of the year. I think there was some timing stuff in the SG&A for this quarter that we expect to [inaudible] balance of the year. And I do think that distributor inventory reduction is behind us, so that actually helped our margin versus prior year this year. But you sort of have enough of those numbers. So I would expect the balance of the year margins to get a little bit better.

[Bryan Spillane:]

Okay. And then just one follow up. In terms of the price increases that you put through on your Wine business generally, has all of that pricing now been put through or are there going to be more price increases between now and the end of the year?

[Robert P. Ryder:]

I think that we're always looking at pricing and its impact on volumes, so I don't know if we've made those decisions. I'd say the majority of them are behind us, but we may be looking at some incremental ones. Probably it won't be an overall increase like we've had. It might be on specific brands.

[Operator:]

At this time, there are no further questions and this does conclude today's Q&A session.

[Robert S. Sands:]

Okay, well, thank you all for joining us for our call today. And I apologize for our little fire alarm here, but I think that we were able to hear the questions and I think that you were able to hear us. In general, I'm very pleased with our continued execution towards meeting our financial and operational goals for the year, especially given the tough macro environment we're facing. During the quarter I'd point out we generated strong free cash flow and rapidly deleveraged. We improved our comparable gross profit and operating margins, and we enhanced the profitability of our U.S. line of spirits. Our plan clearly is to continue this strong execution throughout the remainder of the year. We will be participating in investor conferences through the year end, so we look forward to seeing many of you while we're out on the road. Our next quarterly call is scheduled after the New Year, so please be sure to enjoy some of our excellent products during the upcoming holiday season. So thank you again for your participation in the call.