In the past few years, Constellation Brands (STZ 2.57%) shareholders have been enjoying triple-digit returns as the company rapidly grows its top and bottom lines. Meanwhile, Yum China (YUMC 2.69%) has seen its own growth spurt since separating from Yum! Brands (YUM 1.86%) last year.
In this episode of Industry Focus: Consumer Goods, Vincent Shen is joined by Asit Sharma as they discuss the latest earnings reports from the two companies. Find out how Constellation Brands is dominating with its Mexican imported beer portfolio, and why Yum China has a long runway to expand in the world's most populous country.
A full transcript follows the video.
This video was recorded on Oct. 10, 2017.
Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Tuesday, Oct. 3, and I'm your host, Vincent Shen, here to discuss the consumer and retail sectors. I'm pleased to welcome senior Fool.com contributor Asit Sharma back on the show. He's joining us via Skype from Raleigh, North Carolina. Hey, Asit, good to see you, buddy!
Asit Sharma: Good to see you, man! Listeners, it's good to be back!
Shen: Our main topics for today are recent earnings reports. A bit early before the so-called official third-quarter earnings season kick-off. But before we get to that, Asit, I know that you wanted to talk about Adidas (ADDYY 2.35%) and the controversy surrounding the company recently due to some shady practices in the world of college sports. I've been following this as well. It's a very interesting look into the underbelly of the NCAA and college sports.
Late last month, federal investigators released details on what amounts to be pretty significant corruption in the NCAA, which included the arrest of a global marketing director at Adidas. There have been some resignations, there have been more allegations revealed. Asit, can you give us some details of what happened here?
Sharma: Sure. The complaint that you talked about was unveiled on Sept. 26. The one that we want to talk about related to Adidas alleges that senior executive Jim Gatto participated in a scheme to steer $100,000 to the family of a highly recruited player who is said to have been recruited by Louisville's basketball program. So our listeners who are avid basketball fans know about Louisville -- it's a very storied program, but it's had its little shades with scandal through its head coach Rick Pitino. And one of the consequences of this criminal complaint is Rick Pitino has been pretty much fired from Louisville. I don't know if he was formally fired yet, but he's out.
The other implication is for Adidas, which is a highly respected shoe company trying to make market share gains in North America against the almighty Nike. Adidas now has a little bit of shadow thrown into this, although management is saying that this is a lone wolf, and they are investigating. And you know what, if I was management, I think, of a global company like Adidas, I would have the same line. "We don't know anything about this, but we're investigating." So we'll see how all this shakes out.
But the point that I wanted to make today for listeners is, isn't this story familiar? Don't we seem to hear every few years that there's some money being passed under the table that emanates from these big sporting companies who want colleges to wear their brands so they can sell that gear? And the funny thing is, the NCAA, which has very strict rules, says its athletes are amateurs. They are a money-making machine. So I don't know if it's the big money that's chasing the NCAA that causes this kind of underhanded bad stuff that shouldn't go on. Is it just bad eggs that pop up every once in a while? But man, we just seem to hear this with a regular cadence every few years. What are your thoughts, Vince?
Shen: When it comes down to it, in terms of the bottom line, the opportunity or the potential that some of these star players present, even when they're just high school prospects -- you think about the fact that for 10 years now, the NBA has been unable to draft top talent directly out of high school. But when it comes down to it, the biggest sneaker brands, like Adidas, which is making a push, like Nike, which is the leader in the space, Under Armour, they still keep a very close eye on these youth leagues, these high school star players, and they have very strong incentive to push the best players to the schools that they're partnered with. You mentioned Louisville and how that's the center of this controversy. Well, Adidas paid $160 million for a 10-year deal with the university. It was the company's biggest ever college deal. As a result, the college players at these schools get outfitted with the sponsoring company's sneakers, so when the stars go pro, they already have some of that loyalty to the company.
You mentioned the bribe, it was around $100,000. Some of these other ones they've uncovered and are investigating were cited at $100,000 or $150,000, with implications that competing companies were making counter offers, bidding against each other for the best talent. So maybe this ends up unraveling and roping in other companies besides Adidas. But that $100,000 to $150,000 is a very small investment when you consider how lucrative it can be to sign the next NBA superstar. I'm dating myself a little bit here, but about two years ago, I dedicated an episode of Industry Focus to celebrity athlete endorsements and the return on investment that companies might actually see from these kinds of deals. And when you consider the fact that Jordan is a multi-billion dollar brand for Nike, companies are paying hundreds of millions of dollars to star players to give them their own sneaker lines. Of the biggest footwear deal earners in the past year, the top four, that's Jordan, LeBron, Durant and Kobe, they earned $183 million in the past year. Those are all supported by Nike. Adidas has been pushing its own efforts to lock down its own big deals in the past two years since the new CEO took over the company. When you have those kinds of numbers, and how much potential there is in the right name on a sneaker, and how that can boost demand for the consumers, it becomes obvious to me that a $100,000 bribe to win a player's loyalty early on in their career probably makes for a good investment, even if it's morally unacceptable, or in this case, might result in some of these legal issues. I'm not surprised to hear about this. We see it in the professional levels as well.
Let's move on to our first earnings story, after that interesting sports apparel update. This one is looking at the alcohol industry. We have Constellation Brands. That's ticker STZ. The company reported its fiscal second quarter results on Oct. 5. Shares popped about 4% to 5% following the release. Looking out further, Constellation is actually up over 21% in the past year and almost 500% in the past five years, easily beating out the broad S&P 500 and also its alcoholic beverage peers. Asit, can you give us a rundown of the latest quarter and some of the big takeaways that jumped out to you that are really driving such impressive numbers for the company?
Sharma: In this latest quarter, you mentioned the company grew revenue 3%. That's not a lot of revenue growth. However, part of that was, the company sold its Canadian wine business last year, which was a slow growth part of its revenue stream. So it let go of some revenue, but its beer business managed to grow 13%. So that made up for a lot of that difference. The company, as of its latest quarter, is about two-third committed to beer revenue and one-third wine and spirits. And what we saw in this most recent quarter was not just very good growth on the beer side, which we'll talk about in just a moment but also growth in the wine and spirits business, even though it let go of the Canadian wine business. Depletions were up 5%.
Now for listeners, I want to read to you a definition of what depletion is. You might hear us talk about this term sometimes on Industry Focus. Hats off to Rich Smith. If you were to google "beer depletion", Rich Smith, who's a colleague of ours, long-time Fool writer, wrote an article several years ago, it must have been five years ago, and his article comes up as one of the first search results, because he's given such a great definition. It "refers to the rate at which beer, already shipped from a producer like Boston Beer to a distributor leaves the distributor's warehouse en route to end users, i.e. drinkers." So here, we're talking about wine. The Constellation Brands wine business saw depletions of 5% depletion growth. That simply means that distributors are sending more wine to their own retail outlets at that rate of growth of 5%. So we always try to track two things: how much is the company actually selling, and how much are the distributors selling? And depletions gives you that number. So, positive sign there. I like that very much because the beer business is really driving Constellation forward. So if the wine and spirits business is also growing, it takes some of the pressure off that concentration. Vince, to flip it back to you, let's talk a little bit about what beer has meant to Constellation Brands over the last five years or so.
Shen: It's the most significant part of the business. When I checked, I think it was about 60% of their top line. Keep in mind that Constellation very proudly says that they lead the high end of the U.S. beer market. This is powered significantly by their imported Mexican brand portfolio. That includes big names like Corona, Modelo, Pacifico, Corona being the biggest imported brand, while Modelo is the fastest-growing. The company said in the last quarter that its beer portfolio alone drove 60% of the growth in the premium U.S. beer market.
On top of that, they're also expanding into some craft and specialty beers, as we've seen a lot of the big brewing companies have done. They've done that through acquisitions, much like their competitors. Their craft beer portfolio now includes also Ballast Point Brewing, which they acquired two years ago for $1 billion, and Funky Buddha, which is the latest recent addition. This is also an interesting case of, while that imported portfolio is very large and doing very well, very strong, craft was also kind of the shooting star for a long time for the beer industry. But several of the megabrewers are probably coming to regret the price tags that they ended up paying in that race to acquire all these craft breweries. Constellation itself took a $90 million impairment charge during the quarter on Ballast Point, and I would say that brand is probably no longer the focus it once was for the company, especially when you consider that the Mexican imports like Modelo and Corona are driving so much growth and winning shelf space with retailers. And they're taking that space not only from the big domestic brands but also from some craft names as well.
In terms of specific plans they have for this recent Funky Buddha acquisition, I thought it was interesting to note during the latest earnings call, management does speak to how they're going to try to take a more "professional approach" to growing the brand. So they're going to stick to certain key tenets, like focusing on a handful of key product offerings rather than expanding with a bunch of products and seeing what resonates with customers. They're also going to try to consolidate the distribution network and not expand geographically, because Funky Buddha is best known in Florida, before awareness of the brand itself has actually spread enough to sustain their expansion efforts. Otherwise, there's also been a push in investments at the company, in terms of their operations and their brewing facilities, and how they hope to see efficiencies come out of that to also help sustain this incredible growth they're seeing in their beer business. Could you tell us a little bit about that, Asit?
Sharma: Sure. Very interesting, listeners, the company was a $3 billion company in 2013 when it acquired these rights to Grupo Modelo's Mexican beer portfolio from Anheuser-Busch InBev, the world's largest alcoholic beverage company. Some of you listeners know it very well. What's so interesting is, $3 billion in 2013 was their annual revenue. Constellation Brands has grown that revenue to almost $8 billion through expanding this Mexican portfolio, not just acquiring it and putting it out there but adding innovation to the product lines and scaling the distribution. There was a clue when the company made this purchase that revenues would continue to soar. It was a really subtle clue. The company laid out a timeline of investing a couple of billion dollars in manufacturing.
Here we are five years later, the company will spend almost $4.5 billion in a five year period which ends in 2019. It now has three breweries in Mexico and a glass making facility. This is something that you can use as an investor, if you want to know, this age-old question, will a company keep being able to sell so much, and the stock will keep popping? Well, if a beer manufacturer is investing billions of dollars in capacity over a five year period, you know the demand is there. They wouldn't make that capital investment if they didn't think the demand was tremendous. And lo and behold, year after year, they exceeded their earnings numbers. But I want to make the point, to those of you who are out there who puzzle over these companies, if they had not made that investment, they wouldn't have had the sales. You can have a great product, but if you don't have the means to produce it and the demand is out there, you can't meet the demands, so your revenue can't grow. They did two things very well. Constellation Brands management recognized that Mexican beers would continue to explode in popularity in the U.S., and they recognized that if they spent the money, they would be able to make those sales. And that's what happened.
Shen: Yeah, they were able to see, in terms of the subcategories within the beer industry, imported, craft were driving growth, and they made their investment where they thought it would give them the best returns. And in terms of the efficiencies and the profitability that they're seeing from these investments in these facilities, gross margin at Constellation is already up 7 percentage points over just the past three fiscal years. And it continues to trend upward. The same goes for the bottom line, as well.
But you mentioned the investment that the company's made in order to meet that demand and how it should be a good indicator of at least their long-term outlook for the strength of that Grupo Modelo portfolio that they acquired. I also see a challenge there going forward, beyond the discipline that they're able to maintain in terms of the specialty and craft segment, the acquisition that they made, whether they wanted to make other deals, I feel like we've seen with how craft has gone through this incredible period of growth, all these companies were acquiring popular craft brands, but now we're seeing craft lose shelf space with retailers, lose some of that cachet that it had. Ultimately, I feel like the industry and its consumers can be a little bit fickle, so it'll be interesting to watch whether this Mexican import portfolio will be able to deliver this impressive growth year in, year out. I think it's important, what you mentioned earlier, Asit, the fact that they had beer, wine, and spirits at Constellation. So the fact that, right now, the beer business is about two-thirds of the company, as they can hopefully diversify and right size that in terms of their wine business, in terms of their spirits, and expand that as well, hopefully that reduces some of the risk that the company sees there. Any final thoughts from you before we move on to our next earnings take?
Sharma: Those are all great points. I know you and I were trading some notes before the show. We're talking about the Chelada drinks that Constellation Brands has introduced. Michelada, forgive my pronunciation, those of you who speak Spanish and speak it well --
Shen: You got it well.
Sharma: It's a type of very delicious preparation of beer where you rim the glass with salt, add lime, some spices, sauces. The company is trying to recreate that experience in a bottle, which it has a Modelo line, and it calls those Cheladas. This is an example of really focused innovation. What happened with the craft beers, which Vince was talking about, was the company got really excited about the soaring popularity of craft. And after the Ballast Point acquisition, it built a plant on the other side of the country, it threw a whole bunch of new brands out of Ballast Point at the market. The problem was, craft drinkers don't like beers which lose their taste after a few months. If you see six brands where you're used to seeing one great brand out of Ballast Point, you're not necessarily going to pick up those other ones. And then, the next craft guy or girl who comes in next week, he or she sees when it came in, and doesn't want to buy the product. And they have a lot of product sitting on shelves. So, two examples. Focused innovation and just throwing something at the wall. And the company was chastened in their most recent conference call. I think they'll be fine if they focus on what they know how to do well.
Shen: Yeah. I think that's why they spoke about that more professional approach that they wanted to take, that more disciplined approach they wanted to take with these new brand acquisitions, be it in the craft segment or some of the other parts of the business in terms of spirits and wine as well.
For our second piece of earnings coverage, a company I don't think we've discussed too often on prior episodes of Industry Focus, we have Yum China, ticker YUMC. Yum! Brands spun off its China business this time last year. Yum China licenses now the KFC, Pizza Hut, Taco Bell and other smaller brands from its former parent company. What amazes me about this company is, it's the largest restaurant player in China with over 7,500 stores. KFC and Pizza Hut make up the large majority of those locations, though they are testing with some smaller concepts. But that kind of leadership position definitely has its benefits.
During the most recent quarter, same-store sales were up 6% across the company. Most of that strength was delivered by KFC. Total revenue was up 8% as well, topping $2 billion. One year into the spin-off, it appears that we have a very smart deal. Yum originally spoke to the idea that an independent China business would allow that entity to focus more on the conditions that are unique to the Chinese market. Asit, that seems to be proving out here. What is it about the Chinese market that made this such an effective split? What were some of the considerations that they had to make?
Sharma: Yum! Brands, when it owned the total business, had a few stumbles. Consumers may remember that if you saw headlines in 2012, 2014, and 2015. These were primarily supplier problems. Yum! Brands had a really fast-growing business in China, but it hit a wall with trying to manage the business from afar. Management finally realized that the strength that it had been posing to investors for years as this save all for the company was actually both a strength and a huge weakness, and that the unit which exists on the mainland would be better-managed by its own self. And given the chance to expand and focus locally, it would prosper, versus Yum! Brands trying to control it and simultaneously make that huge North American business continue to grow. We talk about this a lot on the show -- comparable store sales, that's always the market that you have to meet every quarter. The company decided, let's spin-off Yum China, which, as you said Vince, the symbol is YUMC, and let that take its innovations into the market without us having to prove it from the United States. And that's worked out very well.
I want to talk a little bit about some other considerations that come into a decision like this that are particular to China. China is a really hard market to crack, as you've probably heard if you invest in any companies that are over there. No. 1, the Chinese government has a love-hate relationship with foreign brands. It wants those brands to come in, because China is gearing its economy from manufacturing towards consumption, it wants people to consume, so look more like the U.S., which is less of a manufacturer now and more of the consumption-based economy. But it's a tightly controlling governmental apparatus, and there's a lot of red tape. Companies find themselves very often -- McDonald's has had this problem, Starbucks even has had problems with the Chinese government -- that they can very arbitrarily come in and put pressure on a certain city's restaurants so that that company then has to lose comparable store sales and regroup to whatever the government is asking it to comply with.
No. 2, the consumer in China loves foreign brands as well but has a deep-seated loyalty towards the Chinese economy. So once a Chinese consumer becomes bored of a KFC, which is owned by Yum China, that consumer will start looking for what local brands are around, and out of a sense of, whether it's nationalism or patriotism, this is something you have to grapple with when you do business in China. You have the customer's loyalty only so long. You're only as good as your next innovation.
Third is the supply chain problems that I referenced. You have to have a very tight control over your suppliers. In China, what we've seen over the years is, suppliers don't have the same standards that are already in place maybe in the U.S. or in Europe. And that's not saying anything bad about the supply in China or how their rules operate, it's just a younger economy. It's not had the decades of regulation that you would see here in the U.S. So you're going to have people who cheat sometimes. Again, this also happened to McDonald's. A bad supplier, especially with chicken, seems to be endemic to these companies. If you're doing business in China, watch your chicken supplier. I think that's the message. But this is something that is very difficult to keep an eye on through third parties, or manage from a remote location like the U.S. So all of these problems were solved a bit when Yum China became its own company and could manage things locally in China.
Shen: Thanks, Asit. I think that's a good rundown on some of the risks that you face, even though you have a company that appears to have such strong tailwinds behind it, shares are up over 60% just in 2017. Management says the company is on target to hit expansion of 550 to 600 restaurants this year. They just initiated a dividend at $0.10 per share. Management continues to repurchase shares. But overall, I think they definitely have a very positive environment to work in this as well, that they've been growing their store base for several years at a compound annual rate of 11% thanks to this market's growing middle class. They're not running into the kind of saturation issues that U.S. chains have encountered with the so-called restaurant recession. We have our last minute or so here, any last thoughts from you from this earnings report or for the company before we close out?
Sharma: I love that Yum China is pursuing a lot of innovation. This is what investors may want to keep an eye on. There's a new store in the city of Hangzhou, China, which is KFC Pro. In this store, you smile to pay. You walk up to a machine, and in partnership with Alibaba's Ant Financial, KFC China will take a picture at the kiosk, you enter your phone number, you have to smile so it sees that you're not a static photo, and that's the way that you pay for your meal. They offer roast chicken, a brand-new menu. They're constantly innovating, testing prototype stores for this younger generation of Chinese consumers. Just one batch of these is a couple of hundred million people. So you have to like that if you're a long-term investor of Yum China. Free from their parent company, they're pursuing innovation in a pretty aggressive way. That's something else that will show up in future earnings reports, in my opinion.
Shen: Alright. Thanks, Asit, for joining us. And thanks, Fools, for listening. Remember that people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against any stocks mentioned, so don't buy or sell anything based solely on what you hear during the program. Fool on!