Constellation Brands FY 3Q17 Earnings Call Notes

Constellation Brands’ (STZ) CEO Robert Sands on Q3 2017

Border adjustability could potentially disallow a deduction for foreign COGS

“One specific aspect of a proposed Republican tax reform plan called border adjustability could potentially disallow a deduction for foreign sourced COGS or cost of goods sold. As you know, our imported Mexican brands can only be authentically produced in Mexico and sold in the U.S. In order to understand how different tax reform proposals could impact our business, we have modeled several different potential scenarios that include border adjustability as well as some of the positive facets of a corporate tax reform plan based on what we know today. Overall, there are many unknowns related to future legislation and it’s still too early to make a definitive call on final outcomes and timing because the legislation has not been written. As more details develop on these policies and legislation materialized, you can be assured we are prepared to respond accordingly. As you would expect, we are closely monitoring the situation and we have significant resources dedicated to this effort.”

Consumer takeaway for products is accelerating

“The simple fact is that consumer takeaway for our products is accelerating, okay, sequentially as we look at our results. So I don’t think that we believe or see any softness whatsoever in the business and in fact I would say, it’s the opposite, okay, at the consumer level to the extent that it can be measured. We are actually seeing acceleration and I am sure that that will shake out from a depletion point of view over the medium term meaning throughout the year and into next year. So very, very, very strong results.”

Big craft brands are down a lot, everything else is rising

“And as far as craft goes, look, I mean craft is a tale of two cities, right. You can’t look at the craft number as a total number. I mean what continues to go on in craft is the major brands, Sam, Sierra Nevada, Blue Moon, which are all on the craft numbers, those continued to be down big time, right, like in the, I don’t know, about 8% range. And then you have sort of everything else which continues to be up significantly and is not being dragged by those numbers. And you have also got the, what I will call, the local effect which is a lot of the smaller local craft players eating up many of those larger older brands, which are now 25 years old.”

60% of our COGS is from Mexico

“Our understanding is that U.S. based COGS will be deductible. And right now our U.S. based component of our beer COGS, inclusive of freight, is about 40%. I mean 60% of the COGS is from Mexico. Now we have things that we can do within our supply chain over time, but we are talking about long-term supply agreements. We would have to take into account changes in freight and of course, any changes or fluctuations in currency between the countries before you make final plans like that.”

We’re at the forefront of thinking about these tax issues. The Senate side isn’t as clear right now

“Well, I think that Hatch made some comments yesterday saying that he doesn’t know yet what their view or opinion is on any of this. I have talked to Schumer myself personally and I would say that on the Senate side everybody is pretty reserved as to where this whole thing is going. So I would say that there is a lot less clarity on the Senate side than there is on the House side. And I would say we know a lot more about it than anybody else and that we are told that other companies that should be concerned about this are just waking up to the whole matter whereas we have been focused on it from the very beginning, having met ourselves with Ryan several months ago, really over the last summer. So we have been quite aware of this and thinking about it.”

Tax reform is probably a year off at best. First thing that’s going to happen is Obamacare

“I mean it’s probably a year off at best…We can only tell you what our legislators have been telling us, right. But the first thing that’s going to happen in Congress, which you are seeing right now is Obamacare…So Congress has a lot on its plate right now. And to work through all of the details and get legislation like that passed, well, Congress is telling us it’s going to be a while in any event. And it is clear cut and again this is literally what we have been told by the leaders that Obamacare is the first thing on their plate…And that’s going to take a while.”

The Mexicans are being measured

“And I guess my comment on the Mexicans and of course we do talk to the Mexican politicians as well as Peña Nieto, et cetera, et cetera. I think they are taking a measured view of the whole thing. Not necessarily being overly aggressive in their comments about what they will do other than they are prepared to engage in reasonable negotiations. And they do not believe that the U.S., in the end, will enter into or will take actions that would violate WTO principles and other principles of that nature.”

David Klein

Thoughts on how to address potential tax changes

So Dara, when we look at the tax changes and I just really want to caution everybody because we are talking to people in Congress on this topic and the border adjustability provision haven’t even been written, right. So it’s hypothetical and of course, we are trying to understand the effects that could take place, but it’s hard to get into a lot of specifics when answering. But I would say that we still would suspect that our pricing algorithm would remain consistent where it’s been in the past in the range of 1% to 2% a year and in order to mitigate any sort of a border tax, we would be more inclined to address elements of the supply chain that we would put into the deductible category. So for example, if you look at elements of our cost inputs that currently come from the U.S. that we could make deductible, I would put, say, the energy cost of producing glass in Mexico. That’s just one example of things we can do in our supply chain. So we turn that into a U.S. cost instead of a Mexican cost and we then have a deductible expense for U.S. tax purposes. We think that combined with a lower U.S. tax rate and a reasonable phase-in period for any border adjustment tax would be a more appropriate and value creating approach than to really just jump on the price lever.

Mexican COGS decline with peso. Not seeing any issues within Mexico

“Yes. So about 25% of our costs are peso denominated which disconnects a little bit from the percentage that I said earlier, so 60% of our COGS being Mexican. And the difference is dollar denominated contracts for goods that we purchase in Mexico, those contracts themselves really have an underlying FX component to them. They are denominated in dollars and it may take longer for any benefit from that to flow through. And as it relates to the Mexican economy, we are not seeing any issues from a hiring or a labor standpoint or costs within Mexico. So we are seeing no problem. We are also not seeing any significant benefits.”

This would be massive tax reform

” in terms of phase-in, the last time there was tax reform, I think the phase-in period was four years. But this sort of tax reform really isn’t about just setting up back office accounting departments to manage the new tax code. This kind of tax reform would require a time horizon that would allow companies to change their entire supply chain. So our expectation is that it would at least be four years and our objective would be to advocate to make that as long as possible so that we could actually get through up in supply agreements and so forth”