Constellation Brands' (NYSE:STZ) stock has hit a rare patch of resistance following the June 29 release of its fiscal first-quarter 2019 report. The manufacturer and distributor of beer, wine, and spirits surprised investors with a slight but atypical weakening of profitability in the period that ended May 31. After adjusting reported operating income for acquisitions, restructurings, market adjustments to investments, and other costs, the company's comparable operating income dipped 4% from fiscal Q1 2018. In the first of this two-part series, we'll look at the factors that impacted its operating margin, and isolate two items with the potential to weigh on Constellation's profits beyond the current year.

Rows of wooden wine barrels in well-lit cellar.

Image source: Getty Images.

Weakness in wine

Management had previously cautioned investors that revenue growth in the company's wine and spirits segment would be limited to the low single-digit percentages in Q1. The segment was in for a difficult comparison against the first three months of fiscal 2018, which saw unusually high volume as Constellation replenished supply of its popular, upscale Meiomi wine brand following a shortage in fiscal Q4 2017. 

The actual results, though, were worse: Wine and spirits revenue dipped 2.5% to $672 million. That, combined with a higher cost base, pushed wine and spirits operating income south by 17% to $167.8 million. Segment operating margin declined by 430 basis points versus the prior-year quarter. Management cited an uptick in cost of goods sold (COGS) stemming from higher freight and grape costs, along with "marketing investments for key focus brands and innovation initiatives."

These investments include new products in the trending rose wine category, and brand extensions in established labels like SKEDVA vodka and Cooper & Thief blended red wine. Constellation is also devoting resources to expansion of its "boxed wine" brand, Black Box, into spirits -- it launched whiskey, tequila, and vodka variants in recent months.

Additional brand and marketing investments are partially a function of external factors. Management pointed to a slowdown in the overall U.S. wine market as one factor weighing into its meager forecast for segment sales growth in the 2% to 4% range this year.

Over an extended term, Constellation's favored formula of premium product innovation accompanied by serial bolt-on acquisitions will likely spark sales growth. Still, in the present environment, the wine and spirits business must allocate sustained resources to marketing just to stay ahead of the industry's generally sluggish sales.

A blemish on beer

Constellation's beer segment experienced similar margin pressures. As the larger of the two divisions -- it booked $1.375 billion in sales this quarter -- the beer business provided roughly two-thirds of total company revenue. While the beer segment's top line improved by 11% year over year, its operating margin slumped 230 basis points due to "planned marketing investments, higher transportation costs and unfavorable foreign currency [effects]," which offset attractive pricing power.

Those "planned marketing investments" were primarily related to the recent launch of two Mexican beer products: Corona Premier and Corona Familiar. Constellation noted in its earnings press release that the two beverages are the first innovations to the Corona line in 25 years. The company acquired the Corona brand, as well as the Modelo Especial, Pacifico Claro, and Victoria labels, through its purchase of the Grupo Modelo U.S. beer portfolio in 2013. 

While Constellation has achieved market share gains in the Mexican beer category over the last four years, its beer segment is showing signs of maturity. After achieving a growth rate in the mid-teen percentages in fiscal 2016 and 2017, revenue expansion dropped to 10% in fiscal 2018, and is projected to land between 9% and 11% in fiscal 2019. As in wine and spirits, shareholders should expect higher investments behind each beer sales dollar in the near future.

An additional amplified expense

If slightly curbed revenue gains in both of Constellation's operating segments make the need for heavier marketing obvious, the second area where expenses are rising is more subtle. Constellation's focus on the beer division as its primary source of growth will result in higher depreciation expenses over the next several years. During fiscal Q1 2019, depreciation expenses jumped 20% to $84.2 million versus the prior-year quarter.

This is a result of management's overarching business strategy to expand production capacity in an effort to meet the ever-growing consumer demand for imported Mexican beers. Constellation's annual capital expenditures have increased by several magnitudes since it acquired its Mexican beer stable, and its property, plant, and equipment spend now averages roughly $1 billion per year.

STZ Capital Expenditures  (Annual) Chart

STZ Capital Expenditures (Annual) data by YCharts

With $3 billion spent on manufacturing expansion in the last three years alone, the company's depreciable asset base has ballooned, driving up yearly depreciation expenses. The organization's Mexican production facilities in Nava and Obregon have reached a combined 31.5 million hectoliters of annual capacity, and construction proceeds on a new 5 million liter plant in Mexicali, Mexico. Constellation has also embarked on additional expansions at Nava and Obregon; by 2023, it expects to reach total annual production capacity of 44 million hectoliters of Mexican beer. 

Ramped-up marketing expenses and depreciation from capital expenditures represent value-creating cash outlays that will run through the income statement on a quarterly basis. Investors appreciate this, but they may be exhibiting skepticism that Constellation's top line will maintain its resiliency. That's a topic we'll explore in the second part of this series.