Cheers for Constellation Brands


By Anishka Clarke Constellation Brands (STZ

; recent price: $27) carries Standard & Poor's highest investment recommendation of 5 STARS, or strong buy. This stems from our view of the company's long-term growth potential as well as our positive outlook for the wine, spirits, and imported-beer categories.

On top of moderate internal growth expectations, we believe Constellation's ongoing acquisition strategy will support strong expansion in the long term.

PREMIUM PUSH. Furthermore, our fundamental outlook for the distillers and vintners subindustry is positive, reflecting what we see as favorable demographics, strong consumption trends, and a possible easing of pricing pressures as the oversupply of grapes reverses.

Over the past several years, we believe Constellation Brands has pursued an aggressive and effectively managed growth strategy, which has led to consistent double-digit earnings gains. After becoming the leading wine producer, with the acquisition of Australia's BRL Hardy in 2003, the company went on to acquire the Robert Mondavi winery in the U.S. in 2004.

The Mondavi transaction, in our opinion, has enabled the company to round out its alcoholic beverage offerings in the premium category and develop a meaningful position in the superpremiums.

MORE ACQUISITION OPPORTUNITIES. We believe Constellation has already begun to leverage its distribution strength with Mondavi's brand portfolio, which includes top brands Woodbridge and Robert Mondavi.

In its most recent quarterly results, Constellation's sales rose 18% (7% internal growth, 11% Mondavi), and earnings per share climbed 15%. The company says, however, that it has yet to fully leverage the Woodbridge brand, the largest popular brand in the U.S., through its extensive distribution network in Britain.

Thus, with the addition of Woodbridge and its growing portfolio of wines from the U.S. and Australia, we look for strong top-line growth throughout Britain and the U.S., as these regions' demand for wines remains strong. We see further acquisition opportunities for Constellation to successfully build out its spirits portfolio, given the popularity and growth of spirits in recent times.

WISE TO SAY NO. Despite the company's stated growth strategy and very aggressive purchases in the last two to three years, we view positively its decision not to pursue a counteroffer for Pernod Ricard, owner of a very large spirits and wine portfolio in Europe.

Given Constellation's high leverage position -- 104% debt to equity as of fiscal year 2005 (ended February) -- assumed after the Hardy acquisition, we think the company was prudent to avoid an acquisition as expensive and large as the Pernod deal, which would have potentially limited its growth prospects.

However, we believe acquisition opportunities still exist, including smaller beverage labels with which Constellation can leverage its broad distribution network. All told, we expect the outfit to seek out brands in the spirits and champagne categories within the next five years.

Furthermore, we see Constellation continuing the development of new brands like 1792 Ridgemont Reserve, a small-batch bourbon whiskey introduced in 2005, fully funded from creation through to marketing and distribution.

THE GOOD LIFE. As a major distributor of the leading imported beer and the leading wine producer -- and given its focus on growing its spirits category -- Constellation Brands is well positioned to take further advantage of growth momentum in imported beer, wines, and spirits.

We believe U.S. distilled-spirits shipments will post strong gains in 2005, following a 4.1% rise in 2004, on continued innovations and aggressive on-premise marketing to first-time drinkers, the 21-to-29 age group, and Baby Boomers. We see continued growth for spirits, wines, and imported beers, as recent surveys indicate that younger drinkers now favor these beverages over domestic beer.

Furthermore, we see benefits from the Baby Boomer category. As this demographic approaches retirement age, we believe Constellation, with its large and diverse cache of wines and spirits, can benefit from an anticipated increase in leisure activity. We believe aging Baby Boomers will seek more dining-out occasions, greater travel opportunities, and additional entertainment activities, all of which bode well for increased alcohol consumption.

DOMESTIC-BEER BUST. Although the marketing focus will likely increase brand investment levels, we see Constellation's profit margin benefiting from pricing, strong demand, and improved mix. We expect further gains from "trading-up" activity, with Constellation's increased focus on developing its fine-wine category and the maintenance of its dominant position in the imported beer category.

Boomers tend to trade in their saving mentality for a more luxurious lifestyle, suggesting a movement away from midprice alcoholic products to the fine-wine, superpremium-spirits, and imported-beer categories.

Finally, we see a natural shift away from softer alcoholic beverages to harder liquor and a more refined taste palate, which prompts us to believe the weakness in domestic-beer consumption and the solid growth in wines and spirits will continue in the long term.

LOCK ON VINEYARDS. Despite a possible stabilization in wine prices as grape costs begin to recover, we think wine volumes will increase in 2005, following a 3.4% rise in 2004, driven by greater off-premise consumption. We see Constellation benefiting from its exposure to Australian wines and their anticipated competitive strength, along with wines from Spain and Chile. However, we expect stabilization in grape costs and rising interest rates to partially offset likely price recovery and improved cost structures from consolidation.

The company's Constellation Wines segment produces and markets table wines, dessert wines, and sparkling wines. It's the second-largest producer and marketer in the U.S., the largest producer in Australia, and the largest marketer in Britain.

The outfit sells wines in the popular, premium, superpremium, and ultrapremium categories. Constellation has developed a premium-wine portfolio through acquisitions since 1999. These higher-category wines are supported by vineyard holdings in California, Australia, New Zealand, and Chile.

IMPORTED-BEER PURVEYOR. The company ranks as a leading independent beverage wholesaler to Britain's on-premise trade. It primarily distributes wines and, to a lesser extent, branded distilled spirits, cider, beer, ready-to-drink beverages (RTDs), and soft drinks.

Constellation is also the second-largest maker and marketer of cider in Britain and produces and markets Strathmore, the leading bottled-water brand in the on-premise market. The company also produces and sells bulk wine and other related products and services.

The Constellation Beers and Spirits segment imports and markets a diversified line of beer, and produces, bottles, imports, and markets a diversified line of distilled spirits. The company is the largest marketer of imported beer in 25 mostly Western U.S. states. It distributes 6 of the 22 leading imported-beer brands in the U.S., including Corona Extra, the best-selling imported beer.

LITTLE CURRENCY EFFECT. We expect fiscal year 2006 net sales to advance 20%, reflecting acquisitions and internal growth. We see sales benefiting further from sustained growth in global wine sales, driven by the popularity of Australian and U.S. wine exports and a stronger fine-wines portfolio following the purchase of Mondavi in 2004. The acceleration in Britain's wholesale business should also benefit Constellation.

We look for spirits momentum to continue growing as Constellation invests in new products and seeks acquisition opportunities. We expect mid-single-digit growth in beer volumes for fiscal 2006, benefiting from marketing efforts, and anticipate a smaller impact from currency gains.

Operating margin is likely to expand in fiscal 2006 on controlled growth in selling, general, and administrative expenses and likely distribution synergies. We expect some pressure on margins from the expansion of the British wholesale business and continued brand investments. We see higher interest expense due to the Mondavi acquisition.

NICE PRICE. Despite an increased anticipated share count and excluding unusual items, we project a 23% rise in fiscal year 2006 earnings per share, to $1.60. We project a compound annual growth rate in earnings of about 15% for the next five years.

Our fiscal year 2006 and fiscal year 2007 Standard & Poor's Core EPS estimates of $1.46 and $1.74, respectively, mainly reflect the negative impact of stock-option expenses with only minor adjustments for pensions. We are not overly concerned about the dilution from stock options and expect the impact to remain consistent for the foreseeable future.

Both our discounted cash flow (DCF) analysis and our relative valuation model support our 12-month target price of $36 for the shares. Our DCF analysis, which assumes a 9% discount rate and 12% annual sales growth for five years, calculates an intrinsic value estimate of $36 a share. Combining our DCF model with an above-historical-average p-e multiple of 20 applied to our calendar 2006 EPS estimate of $1.83, we arrive at our 12-month target price of $36.

IN THE BOARD ROOM. We have concerns about several corporate governance practices of Constellation Brands. We see the existing dual-class stock structure with unequal voting rights as a negative. Also, we believe the company's board of directors, made up of an insider majority, may conflict with shareholders' best interests.

However, we view positively certain board committees composed solely of outside directors. In addition, we take encouragement from the presence of stated and published governance policies.

We believe the main risks to our recommendation and target price include continued pricing pressures in the U.S. wine market due to the oversupply of grapes and rising competition from the influx of imported new world wines.

Furthermore, we believe Constellation may face future resistance to additional beer-price increases in the imported beer segment, limiting its top-line growth potential.

Required Disclosures

In the U.S.

As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services U.S. have recommended 30.2% of issuers with buy recommendations, 57.5% with hold recommendations and 12.3% with sell recommendations.

In Europe

As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services Europe have recommended 34.4% of issuers with buy recommendations, 46.8% with hold recommendations and 18.8% with sell recommendations.

In Asia

As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services Asia have recommended 33.3% of issuers with buy recommendations, 47.2% with hold recommendations and 19.5% with sell recommendations.

Globally

As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services globally have recommended 31.0% of issuers with buy recommendations, 55.4% with hold recommendations and 13.6% with sell recommendations.

5-STARS (Strong Buy): Total return is expected to outperform the total return of a relevant benchmark, by a wide margin over the coming 12 months, with shares rising in price on an absolute basis.

4-STARS (Buy): Total return is expected to outperform the total return of a relevant benchmark over the coming 12 months, with shares rising in price on an absolute basis.

3-STARS (Hold): Total return is expected to closely approximate the total return of a relevant benchmark over the coming 12 months, with shares generally rising in price on an absolute basis.

2-STARS (Sell): Total return is expected to underperform the total return of a relevant benchmark over the coming 12 months, and the share price is not anticipated to show a gain.

1-STARS (Strong Sell): Total return is expected to underperform the total return of a relevant benchmark by a wide margin over the coming 12 months, with shares falling in price on an absolute basis.

All of the views expressed in this research report accurately reflect the research analysts' personal views regarding any and all of the subject securities or issuers. No part of the analysts' compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report.

Additional information is available upon request to Standard & Poor's, 55 Water Street, New York, NY 10041.

Other Disclosures

This research report was prepared by Standard & Poor's Investment Advisory Services LLC ("SPIAS"), and may have been provided to you either by: (i) Standard & Poor's under a license agreement with The McGraw-Hill Companies, Inc., which holds the copyright to this report; or (ii) a Standard & Poor's client who is granted a sub-license by Standard & Poor's. This equity research report and recommendations are performed separately from any other analytic activity of Standard & Poor's. Standard & Poor's equity research analysts have no access to non-public information received by other units of Standard & Poor's. Standard & Poor's does not trade in its own account. SPIAS is affiliated with various entities, which may perform services for companies covered by the recommendations in this report. Each such affiliate is operationally independent from SPIAS.

Disclaimers

This material is based upon information that we consider to be reliable, but neither SPIAS nor its affiliates warrant its completeness or accuracy, and it should not be relied upon as such. Assumptions, opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice. Past performance is not indicative of future results.

This material is not intended as an offer or solicitation for the purchase or sale so any security or other financial instrument. Securities, financial instruments or strategies mentioned herein may not be suitable for all investors. This material does not take into account your particular investment objectives, financial situations or needs and is not intended as a recommendation of particular securities, financial instruments or strategies to you. Before acting on any recommendation in this material, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice.

Analyst Clarke follows beverage stocks for Standard & Poor's Equity Research


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