CONSTELLATION BRANDS, INC. annual report, FY2014

Constellation Brands, Inc. — FY2014 Form 10-K

Reporting period: Fiscal year ended February 28, 2014. The filing also reports the fourth quarter ended February 28, 2014; amounts are in U.S. dollars unless noted.

Business context

Constellation is a beverage alcohol company operating in Beer and Wine and Spirits, with corporate operations reported separately. In June 2013, it acquired the remaining 50% of Crown Imports, a Mexican brewery business and exclusive U.S. rights to Modelo’s Mexican beer brands. This transaction made Constellation the independent U.S. importer and marketer of those brands and brought the acquired business into consolidated results from June 7, 2013.

Financial results and key metrics

Metric	FY2014	FY2013
Net sales	$4,867.7 million	$2,796.1 million
Gross profit / gross margin	$1,991.7 million / 40.9%	$1,108.3 million / 39.6%
Operating income	$2,437.7 million	$522.9 million
Net income	$1,943.1 million	$387.8 million
Diluted EPS, Class A	$9.83	$2.04
Cash from operating activities	$826.2 million	$556.3 million
Capital expenditures	$223.5 million	$62.1 million

• Reported sales rose 74%, primarily reflecting consolidation of the acquired beer business; the acquired business contributed $2,022.2 million of FY2014 net sales. Beer segment sales were $2,835.6 million, up 10%; Wine and Spirits sales were $2,845.5 million, up 2%.
• Reported operating income and net income include a $1,642.0 million non-taxable gain from remeasuring Constellation’s former Crown Imports investment at acquisition-date fair value. Results also include $300.9 million of Canadian Wine and Spirits goodwill and trademark impairment. These items materially distort year-over-year comparisons.
• Beer segment operating income was $772.9 million versus $448.0 million; Wine and Spirits operating income was $637.8 million versus $650.2 million. Reported equity-method earnings fell to $87.8 million from $233.1 million as Crown Imports became consolidated.
• Interest expense, net, increased 42% to $323.2 million, mainly because of higher borrowings to finance the acquisition. The effective tax rate was 11.8%, affected by the non-taxable remeasurement gain; management expected a 30%–32% effective rate in each of the next three fiscal years.
• FY2014 cash from operations was $826.2 million; investing cash outflow was $4,863.8 million, including $4,681.3 million net cash paid for businesses. Financing provided $3,777.0 million. Cash and cash investments ended at $63.9 million, down from $331.5 million.
• Total debt was $7,020.5 million at year-end, including $57.2 million of bank notes; cash was $63.9 million. The balance sheet reported $2,747.2 million of current assets and $2,025.7 million of current liabilities. Revolver availability was $836.0 million at year-end and $835.2 million on April 22, 2014.
• For the fourth quarter, net sales were $1,291.2 million, gross profit $548.9 million and net income $157.2 million, compared with $695.9 million, $261.8 million and $81.7 million, respectively, in the prior-year quarter. Acquisition timing significantly affects this comparison.

Material changes and outlook

• The company planned to expand its Nava, Mexico brewery from 10 million to 20 million hectoliters of annual capacity by December 31, 2016. Estimated total project cost was $900 million–$1.1 billion; FY2014 spending was approximately $123.5 million. FY2015 capital expenditures were forecast at $575 million–$625 million, including $450 million–$500 million for the Beer segment.
• Until the brewery expansion provides sufficient capacity, beer supply depends on the brewery and an interim supply agreement initially covering three years. Any extension beyond three years requires U.S. Department of Justice approval.
• For FY2015 Q1, management expected Wine and Spirits net sales to decline by a low-to-mid single-digit percentage year over year as an exclusive distributor reduced inventory. The company said gross profit was not expected to be significantly affected because the distributor was contractually required to compensate it approximately for lost profit.
• Management described U.S. wine supply as generally balanced and said the 2013 grape harvest could ease some varietal supply tightness. Its stated long-term financial priorities were sales growth, margin expansion, increased cash flow, EPS growth and debt reduction.
• The acquisition’s final purchase-price adjustment was finalized at $558.0 million, including imputed interest, and was expected to be paid in FY2015 Q2. No cash dividends had been paid since the 1973 IPO; management said it intended to retain earnings.

Risks, contingencies and unusual items

• Leverage increased substantially to fund the acquisition; debt covenants restrict, among other matters, additional borrowing, investments and dividends. Long-term debt principal and interest, purchase commitments and other contractual obligations are significant.
• The beer business relies on a single brewery in Mexico, interim supply from ABI, and transition services and materials supplied under agreements. Delays or disruption could constrain product supply and sales.
• Other key exposures include consumer demand and competition, distributor and retailer concentration, commodity and packaging costs, grape and water availability, weather and climate conditions, foreign exchange and interest rates, regulation and taxation, and possible damage to facilities or brands.
• Management reported the Canadian impairment after revising its business strategy and forecasts; further changes in forecasts or valuation assumptions could result in additional impairment. The filing also describes ongoing regulatory inquiries and ordinary-course litigation; management did not expect pending matters to have a material adverse effect, while noting outcomes cannot be predicted.
• KPMG issued unqualified opinions on the financial statements and on internal control over financial reporting. The acquired Brewery Business was excluded from the internal-control assessment, and the company said integration of its controls was expected to be completed in FY2015.

Important facts for investors to verify

• How much of reported earnings growth reflects recurring operating performance versus the $1,642.0 million remeasurement gain and other acquisition-related items.
• Progress, cost, timing and funding of the brewery expansion, and the company’s ability to secure adequate beer supply during and after the transition.
• Debt repayment capacity, covenant headroom, the FY2015 purchase-price adjustment payment and planned capital expenditures.
• Whether distributor inventory reductions, Wine and Spirits trends, and the Canadian business strategy affect shipments, margins or future impairment assessments.
• Execution of Brewery Business internal controls and resolution of the disclosed litigation, regulatory and tax matters.