It might seem like Constellation Brands (NYSE:STZ,STZ.B) stock simply was due for a pullback. STZ stock had been one of the market’s star performers for most of the decade: at last year’s highs, Constellation Brands stock had risen over 1,000% in less than seven years.
And so when the market turned south last October, STZ stock was one of the biggest victims. STZ lost over one-third of its value in about three months. A seemingly disappointing fiscal Q3 report earlier this month was the final straw, as Constellation Brands stock dropped 12% after the company cut its fiscal 2019 earnings-per-share guidance.
STZ stock has already eliminated all of those losses, however. A major stock purchase by the company’s outgoing CEO and strong backing from Wall Street have helped Constellation Brands stock rally. And I don’t think the rally is done. Even after a 15% bounce, STZ stock still looks reasonably cheap.
The guidance cut wasn’t as big a deal as investors believed at the time. And the value of the company’s large stake in marijuana producer Canopy Growth (NYSE:CGC) isn’t yet showing up in its earnings numbers.
The outlook of STZ stock is still positive, even after its recent rally. And while I’m not sure Constellation Brands stock can retake its 2018 highs immediately, I expect STZ to continue to rise in 2019.
Were Earnings That Bad?
From a headline standpoint, the post-earnings decline of STZ stock made some sense. The company cut its full-year EPS guidance rather sharply, from $9.60-$9.75 to $9.20-$9.30. One key reason for the cut was an increase in its interest costs due to its investment in Canopy, which lowered its EPS by roughly 25c, the company reported on its Q3 conference call. But investors and analysts already had priced that extra expense into their EPS estimates; analysts’ average EPS estimate heading into the report was $9.43.
The two changes to the operating business’s outlook do look potentially worrisome. The company cut its operating margin guidance for its beer business by 0.5 percentage points. And the sales and profits of its wine and spirits business will decline after the company previously predicted that it would grow modestly.
Both changes seem potentially worrisome. The beer sector is struggling across the board, as shown most obviously by the plunge of Anheuser-Busch InBev (NYSE:BUD). Weaker margins and slowing industry growth indicate that the profits of STZ’s beer business will stall out. And if competition in the sector increases or the U.S. enters a recession, the unit’s earnings could even shrink.
In wine and spirits, the declines already have begun. Canopy won’t contribute to profits for some time, and in the meantime incremental expenses caused by the investment will hurt Constellation’s EPS. And so the reaction to the Q3 report – and the subsequent, big decline of STZ stock – seems to make some sense. Constellation Brands stock was priced for growth at $225 in October. It doesn’t look like it’s delivering on that growth, however.
The Case for STZ Stock
Those concerns are real. At the same time, however, it’s too early to assume that STZ won’t grow at some point. And investors – perhaps helped by several Wall Street defenses of STZ stock after its earnings – seem to have realized that over the past few weeks.
Much of the margin pressure on the company’s beer business, for instance, is coming from higher freight expenses. Those higher costs will have some impact in fiscal 2020, but at some point the cost hikes will stabilize or even pull back. In the meantime, the unit’s top-line growth is hugely impressive.
Depletions (the change in wholesalers’ beer inventories, which more closely represents actual sales to end customers) are up 9% this year. Based on the industry’s history, that figure is incredible. Depletions are down for BUD’s Budweiser. They’ve been negative for Boston Beer (NYSE:SAM) flagship brand, Sam Adams, for some time. The depletions of Kona, Craft Brew Alliance’s (NASDAQ:BREW) only product that’s still growing, have increased about 7% so far this year, but the rest of CBA’s portfolio has compressed.
In the context of the industry, Constellation’s beer portfolio, led by Corona and Modelo, still looks like the best -in-class. Meanwhile, much of the weakness of its wine and spirits business is being caused by the low end of its portfolio. Constellation’s management still expect the business to generate long-term growth and higher margins, and, after the past few years, STZ deserves the benefit of the doubt.
In other words, the outlook of STZ stock really hasn’t changed all that much in the last few months. And in the marijuana business, CGC stock has moved higher, increasing the value of the CGC stock and warrants owned by Constellation. All told, there’s still a lot to like about Constellation Brands stock.
Has Constellation Brands Stock Run Too Far?
The question is whether the 15% post-earnings bounce has captured much – or all – of the potential upside of STZ stock. I don’t think that’s quite the case yet.
After all, STZ stock remains rather inexpensive. The stock trades at less than 19 times the midpoint of its fiscal 2019 EPS guidance. That’s not a bad multiple. It’s much cheaper than SAM (though I still believe that stock is overvalued, as I wrote almost a year ago). Diageo (NYSE:DEO) trades at over 20 times its forward earnings.
A PE ratio of around 20 for STZ’s operating business translates to a per-share value of over $180. And it’s worth remembering that the marijuana business is worth nothing if an investor just uses near-term earnings to calculate the valuation of STZ stock. Yet Constellation’s investment in Canopy is worth something like $6 billion, or another $30+ per share of STZ stock.
Add those two together, and Constellation Brands stock looks like it could – and maybe should – be valued at $210+, suggesting upside of more than 20%. And the average analyst target price on STZ stock of just over $210 suggests that the argument makes some sense.
There are valid concerns about Constellation Brands stock. The valuation of CGC stock looks a bit stretched to my eye at this point. The beer business may be further disrupted. A recession could hit Constellation’s earnings. And the company’s growth is slowing compared with the impressive results seen earlier this decade.
But STZ stock could still rally further. And for investors who like the long-term outlook of the beer and spirits space, even after a 15%+ bounce, Constellation Brands stock looks like the cheapest, and potentially the best, play out there.
As of this writing, Vince Martin has no positions in any securities mentioned.
