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As early as this fall, beer, wine, and spirits manufacturer and marketer Constellation Brands, Inc. (STZ +1.89%) may spin off its Canadian wine business in an initial public offering on the Toronto Stock Exchange. Bloomberg News, which reported the details on a move management had previously disclosed it was considering, reports that the IPO could be worth $1 billion in Canadian dollars, or about $787 million at current exchange rates.
If the executive suite does end up greenlighting the spin-off, some shareholders may wonder about the rationale. In Constellation's fiscal 2016 annual report, filed in April, the company reaffirmed its self-description as the "the leading wine company" in Canada, as it owns eight of the top 25 wine brands. The noted beverage giant lists among its impressive Canadian assets eight wineries spanning 1,700 total acres, one distillery, a production facility, and a distribution center.
Reviewing a bit of history may bring perspective to the proposed deal. The Canadian wine business was formed in 2006 upon Constellation's mid-year acquisition of Vincor International, Inc. In Constellation's first complete fiscal year of operating the new division, sales hit $449.8 million, which, at the time, accounted for nearly 12% of total company revenue of $3.78 billion. Significantly, the transaction enabled Constellation to pick up important brands that still enjoy appreciable market share today, including Jackson-Triggs and Inniskillin, the No. 1 wine and ice-wine labels in Canada, respectively.
Since the purchase, completed at a price of nearly $1.5 billion, the Canadian wine business has grown steadily, but not in dramatic fashion. Revenue peaked in fiscal 2014 at approximately $698 million. This past year, in part because of the U.S. dollar's strength against the Canadian dollar, the top line reached only $587.5 million. That's a compounded annual growth rate, or CAGR, of 3.5% over the past eight fiscal years. Today, given the recent acquisition of Mexican beer brands and the scaling up of Constellation's beer business, Canadian wine sales account for just under 9% of total annual revenue of $6.5 billion.
But why spin off a market-leading business?
During the company's fiscal fourth-quarter 2016 conference call on April 6, CEO Rob Sands offered management's reasoning behind its exploration of the IPO:
"As we continue to transform the company, the focus and resources we've put behind strategic initiatives to support sustainable, value-generating, long-term growth are also evolving. This effort would provide better visibility to the Canadian business, which delivered excellent financial performance in 2016."
We can glean a few cogent points from this statement. First, Sands hints that the internal rate of return for the Canadian wine platform doesn't measure up to the return of the overall business. Recall the rather middling revenue growth rate, and consider that Canadian dollar weakness also hurts profits when they're converted into greenbacks on the company's quarterly reports.
The second inference is that under new public ownership, and fueled by its own cash and borrowing capacity, the Canadian business wouldn't have to compete for resources with other Constellation revenue streams to grow. Factor in the faster revenue growth and higher profits Canadian shareholders would see as returns get expressed solely in Canadian dollars, and the deal begins to make sense.
Persuasively, in the quoted earnings call, Sands mentioned that Constellation would use its share of the IPO proceeds to reduce debt on the parent company's books. Constellation is a serial purchaser of alcoholic beverage brands and actively invests in expanding manufacturing capacity. Thus, we can assume that after divestment, Constellation will essentially free up more borrowing for new acquisitions, or for capital expenditure, either of which will theoretically produce a higher return on capital than the Canadian operation.
In sum, it appears that despite holding the dominant market position in Canada, the wine business north of the border is underperforming its internal peer groups. Confirmation of this hunch can be found in the unconfirmed IPO pricing. If the offering indeed raises just under $800 million, the market will value the wine division's sales at about 1.3 times fiscal 2016 sales. Compare this with Constellation's overall business, which currently trades at nearly 4.75 times fiscal 2016 sales. This gap provides more than enough reason to set the wine business free and to allow it to increase its long-term value independently.
