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Constellation Brands: Drunk on Beer, Hungover on Wine

Back in January, I wrote that Constellation Brands (STZ) was about to fall flat.  I didn’t expect it to crash, mind you.  But given its dependence on the flat U.S. market for its Corona and Modelo brands and the relative overpricing of the entire brewing industry, I didn’t expect STZ stock to do much.

Swing and miss.  Immediately after I wrote the January article, STZ jumped 15% on a better-than-expected earnings report. And STZ has continued its run with another better-than-expected earnings report this morning, along with improved guidance for the rest of the year.

STZ’s net income rose to $206.7 million, or $1.03 per share, in the first quarter.  The consensus estimate was 93 cents per share.  But the news that sent STZ stock soaring was management’s EPS forecast of $4.10 – $4.25 for the year, up from its previous estimate of $3.95-$4.15.

Let’s dig into the numbers.  Following the Modelo merger last year, which brought the Corona and Modelo brands into the fold, beer continues to be a bigger and bigger piece of Constellation’s business.  Constellation gets about 57% of its revenues from beer and the remaining 43% of its sales from wine and spirits (almost entirely wine; STZ has only a handful of small liquor brands).

Significantly, beer accounts for literally all of STZ’s growth.  Its traditional wine business actually declined year over year by about 2%. STZ expects beer sales to finish the fiscal year with sales growth of about 10%.

STZ made a critical strategic move by diversifying out of wine.  As I wrote back in 2012 (see Whiskey and Beer Better Long-Term Bets than Wine),

Outside of, say, Coca-Cola, beer and spirits are probably the most recognizable and valuable brand names in existence.  Not surprisingly, premium beer and spirits businesses tend to enjoy high margins and high returns on equity… Wine is a different story.  The attractiveness of a given vineyard varies from year to year, and few have national or international brand awareness.  Wine connoisseurs know their favorite vintages, but there is little brand loyalty at the mass-market level.

What has repeatedly surprised me over the past year is how much mileage Constellation has managed to get out of the Corona and Modelo brands.  Imports and microbrews have been gaining in popularity over mass-market domestic brands (think Bud Light) for the better part of two decades now.  Corona and Modelo are “old” import names, and the only place I see them anymore is at Tex-Mex restaurants.  (A cold Corona really does go down smoothly on a hot summer day in Dallas.)

Perhaps I spend too much time in snobby bars, or perhaps my view is biased by the abundance of “it beer” microbrews and imports that seem to spring up every week.  But I would expect Corona’s sales growth to slow to the flattish “big beer” growth rates seen by the major domestic brands within the next couple of years.

Where does this leave STZ stock?

At the current price around $90, STZ trades for about 21 times earnings.  That’s expensive but not ridiculously so based on the broader market’s frothy valuations these days.  It’s also more or less in line with its Big Beer competitors: Anheuser-Busch InBev (BUD), Heineken (HEINY) and SABMiller (SBMRY) trade for 19 times, 18 times and 22 times forward earnings, respectively.

After trading sideways for most of 2013 and early 2014, Big Beer has been showing signs of life since February.  BUD and HEINY are up about 20% since February, and SABMiller is up a little over 30%.

If you’re looking for a short-term trade, STZ might be your best bet for the remainder of this year.  But as long-term holdings, I would suggest accumulating shares of HEINY and SMBRY on any pullbacks.  Unless STZ, which depends on the mature American market, HEINY and SBMRY have excellent exposure to the fastest-growing beer market in the world: Africa.  I should also reiterate that none of the Big Beer competitors have STZ’s wine business bogging them down.

I’m not wildly enthusiastic about any of the above at current prices.  But I do consider HEINY and SMBRY to be suitable “buy and forget” investments for the next 5-10 years.

This article first appeared on InvestorPlace.

Charles Lewis Sizemore, CFA, is the editor of Macro Trend Investor and chief investment officer of the investment firm Sizemore Capital Management. Click here to receive his FREE weekly e-letter covering top market insights, trends, and the best stocks and ETFs to profit from today’s best global value plays. 

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Will “Safer” Cigarettes Save Big Tobacco Stocks?

Philip Morris International (PM) recently announced plans for a $680 million factory in Italy to produce less-lethal cigarettes.

Notice I said “less-lethal” and not “nonlethal.” Unlike the popular new e-cigarettes, which produce a nicotine vapor mist, the Philip Morris variety will contain real tobacco to appeal to smokers who crave the taste of a real cigarette. Though unlike with traditional smokes, the tobacco is heated rather than burned.

So, is this a big deal? Might Philip Morris’ efforts stem the terminal decline of smoking in the developed world?

Maybe … but I’m not buying it.

We’ve seen this before. In fact, Jeff Middleswart wrote about this very topic in Behind the Numbers this week. Writing about Reynolds America (RAI), Middleswart noted that:

“In 2000, RJ Reynolds rolled out the Eclipse cigarette, which was designed to heat the tobacco rather than burn it. The result was much less smoke and in advertising it claimed that was less harmful than other cigarettes. Studies did not substantiate that and states started to sue over the claims. RAI just paid Vermont $14 million to settle these claims.”

Oops.

Throughout 2013, I made the argument that tobacco stocks no longer represented an attractive investment on a value basis. I maintain two long-term positions in PM stock and Altria (MO) in a dividend-focused portfolio, but I don’t recommend adding new money to those positions at current prices.

Big Tobacco isn’t disappearing any time soon. It’s still a wildly profitable business, and tobacco stocks are some of the most reliable dividend payers traded on the market today. But anyone expecting tobacco stocks to deliver market-beating returns going forward needs to take a step back and look at the numbers.

Thankfully, Middleswart has done the heavy lifting for us. Writing again about Reynolds American in his Jan. 9 issue, Middleswart commented that Reynolds traded at a 7.6% yield in September 2002 and at a P/E ratio of just 40% of the broad market.

And today? Reynolds yields 5.2% and sports a P/E that is 90% of the broad market, roughly in line with its peers.

If you’re buying Big Tobacco stocks at current prices, then you are implicitly assuming that one or both of the following must be true:

  1. U.S. stocks — which are already looking expensive based on the cyclically adjusted P/E ratio (CAPE) — will command a significantly higher valuation than they do today.
  2. Tobacco stocks will trade at a substantial premium to the broader market.

Do either of these scenarios seem likely to you?

Again, I’m not a permabear on tobacco stocks. At this right price, I love tobacco stocks as consistent dividend payers.

But that’s the key; the price needs to be right. Tobacco stocks should trade at a substantial discount to the broader market given that they are in terminal (albeit slow) decline.

But what about e-cigarettes? Might they offer a source of new growth for the battered industry?

Yes, and in fact, they already are. But the e-cig market is not big enough to replace declining sales of traditional cigarettes. As I wrote last year, the era of regulation-free e-cigs is quickly coming to an end, and in any event, e-cigarettes only account for about 1% of total tobacco sales.

If you insist in owning tobacco stocks, then PM stock and Altria are easily the “cleanest dirty shirts” of the lot. Philip Morris International’s emerging-market business has a much longer shelf life than those of the domestic sellers, and Altria owns nearly 30% of SAB Miller (SBMRY), the diversified global brewer.

Charles Lewis Sizemore, CFA, is the editor of Macro Trend Investor and chief investment officer of the investment firm Sizemore Capital Management. Click here to receive his FREE weekly e-letter covering market insights, global trends, and the best stocks and ETFs to profit from today’s exciting megatrends. This article first appeared on InvestorPlace.

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Pour Beam Down the Drain and Pick Up Some Diageo Instead

In case you had any doubts, it’s official. Diageo (DEO), the world’s largest spirits maker, will not be buying Beam, Inc. (BEAM) for its bourbon portfolio.

CEO Ivan Menezes said this week that Diageo would be expanding its existing portfolio of whiskeys and launching new ones, and adding for emphasis that “we don’t need to” buy Beam.

I told you so.

Late last year, Diageo had recently lost its distribution deal with Jose Cuervo, leading to wild rumors that DEO would buy Beam for its tequila assets. Beam’s Sauza is the No. 2 global tequila brand by sales.

Apart from the obviously backward logic of buying a large bourbon distiller to get a relatively small tequila brand, Diageo would have a hard time swallowing an acquisition of Beam’s size. Beam has a market cap of $11 billion (Diageo’s is more than $80 billion), and after years of pricey purchases, DEO and its shareholders have acquisition fatigue.

Purists will point out that Diageo is still very weak in bourbon and that acquiring Beam — and its Jim Beam, Maker’s Mark and Knob Creek brands — would fill that gap. Diageo currently only has one bourbon brand, Bulleit, and it is a relatively small player.

All of this is true, but there are a couple points to keep in mind:

  1. Bourbon is a very small market outside of the United States.
  2. Most drinkers make litter distinction between Kentucky straight bourbon, Tennessee whiskey and Canadian whisky.

Per the first issue: Yes, the United States is the single most important market to be in globally. That’s not changing anytime soon. But it’s also a mature market and one where demographics are not necessarily moving in the right direction. Younger drinkers tend to prefer vodka cocktails, not whiskey.

And in any event, DEO is focusing its expansion efforts in emerging markets, where it plans to get more than half of its revenues by 2015.

Diageo’s scotch brands, such as Johnnie Walker, tend to be far more popular overseas. Most emerging-market consumers have literally never heard of bourbon. Try ordering one in a bar in South America or the Middle East and observe the confused look on the bartender’s face.

This brings me to point No. 2.

There are plenty of aficionados out there who take the distinctions between Kentucky straight bourbon, Tennessee whiskey and Canadian whisky seriously. In Kentucky, you might be required to give satisfaction in a duel for confusing bourbon with neighboring Tennessee whiskey. (I’m joking … Sort of. )

But all three whiskeys have a sweet flavor (as opposed to scotch’s smoky flavor) due to their use of corn as a major ingredient. And most drinkers are only vaguely aware that they are different products. I have no stats to confirm this, but anecdotal experience has shown me that 95% of the patrons in any bar in America wouldn’t know that Jack Daniel’s (a Tennessee whiskey), Jim Beam (a bourbon) and Crown Royal (a Canadian whisky) are different types of whiskey.

And on top of all that, Diageo is planning on expanding its bourbon offerings anyway.

This is a long way of saying that Diageo CEO Menezes is absolutely right.

Diageo doesn’t need Beam.

And that causes a little problem here. You see, Beam has had an elevated valuation for years in the belief that it would be acquired by Diageo or Pernod Ricard (PDRDY). Beam trades for nearly 30 times earnings, compared to 20 times for the larger and better diversified Diageo.

My advice? Pour BEAM down the drain and stock up on DEO.

Charles Lewis Sizemore, CFA, is the chief investment officer of the investment firm Sizemore Capital Management. As of this writing, he was long DEO. Click here to receive his FREE 8-part investing series that will not only show you which sectors will soar, but also which stocks will deliver the highest returns. This series starts Nov. 5 and includes a FREE copy of his 2014 Macro Trend Profit Report.

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Wine shortage? Doesn’t matter. Liquor beats wine as an investment.

A wine shortage? Say it ain’t so.

Alas, one might be upon us. Production has been falling since 2005, even while demand has held steady. The result has been a widening gap between supply and demand that gave us a shortfall of about 300 million cases last year, according to Morgan Stanley.

The culprits? Rising demand from the U.S. and China and falling production in France, Italy and Spain, which collectively account for just under half of all world production, according to the Wine Institute. (Interestingly, though it is the No. 3 producer, Spain has more acreage “under vine” than any other country in the world. It appears France and Italy enjoy higher yields on their grape vines.)

Writing for Reuters, Felix Salmon takes issue with some of Morgan Stanley’s numbers and notes that strong production in 2013 has alleviated any immediate risk of a shortage. Based on my own anecdotal observations about the retail price of wine (I’ve been known to buy the occasional bottle), I’m inclined to agree with Mr. Salmon.

But whether or not we see a shortage in the years ahead, I do expect demand to be stronger than ever for one major reason: growth in Chinese wine consumption.

Chinese consumption has doubled twice in the past five years. By 2016, China is expected to be the biggest consumer of wine in the world, out-drinking even the United States and France.

So as investors, how can we profit from this trend?

Wine Stocks Few and Far Between

Sadly … outside of opening a vineyard in China, your options are fairly limited.

Publicly traded vineyards are rare and tend to be low-margin businesses. And outside of the ultra-high-end vineyards such as Chateau Lafite Rothschild (which is wildly popular as a status symbol among China’s elite), most wines lack the brand recognition of beer and spirit brands.

I wrote about this earlier this year. Discussing the struggles of Constellation Brands (STZ), the largest publicly traded winery, I said:

“Outside of, say, Coca-Cola (KO), beer and spirits are probably the most recognizable and valuable brand names in existence. Not surprisingly, premium beer and spirits businesses tend to enjoy high margins and high returns on equity relative to their peers.

Wine is a different story. The attractiveness of a given vineyard varies from year to year, and few have national or international brand awareness. Wine connoisseurs know their favorite vintages, but there is little brand loyalty at the mass-market level. For a company of Constellation’s size, wine is a much harder business to operate.”

Think about it. Off the top of your head, how many beer brands can you name? A dozen or more without even having to strain? Now … how many wine labels can you name?

In the Morgan Stanley report that Salmon picks apart, the authors recommend Treasury Wine Estates (TSRYY), an Australian winery. The shares are a little rich for my liking, trading hands at 70 times trailing earnings and 18 times expected 2014 earnings, though they do yield a respectable 3% in dividends.

Me? I prefer to avoid wine stocks altogether and focus instead on spirits.

Go With Booze Instead, Buy Diageo

I’ve recommended Diageo (DEO) off and on for years, and I still consider it one of my favorite long-term holdings.

Diageo is the world’s largest purveyor of spirits, and its brands include Johnnie Walker, Crown Royal, Smirnoff and scores more.

Diageo’s branding helps it to generate returns on capital that are consistently three times as high as those of Constellation Brands (see chart). Diageo also has grown its top-line sales by nearly half since 2008 — and the past five years have been rather challenging for most consumer-related businesses.

Diageo DEO STZ

Much of this growth has been due to high demand from emerging markets, which already constitute 42% of Diageo’s sales and continue to take a bigger slice every year.

As incomes continue to rise in China, India, Latin America and other brand-conscious emerging markets, so do standards of taste. Ordering a premium spirit or offering a bottle as a gift is a sign that you have “made it” in life. This is a long-term macro theme with decades left to run.

I also should add that Diageo is an International Dividend Achiever, meaning the company has raised its dividend for a minimum of five consecutive years. I expect Diageo to continue raising its dividend at a nice clip in the years ahead. DEO currently yields 2.7%.

I won’t say this about too many companies, but Diageo stock is something you can buy and forget. I recommend the stock for your core, long-term portfolio — and I also recommend you take the time to enjoy a bottle of Black Label, preferable with full-bodied cigar.

And if Diageo performs as I expect, use your dividend proceeds to upgrade to a bottle of Blue Label.

This article first appeared on InvestorPlace.

Charles Lewis Sizemore, CFA, is the chief investment officer of the investment firm Sizemore Capital Management. As of this writing, he was long DEO. Click here to receive his FREE 8-part investing series that will not only show you which sectors will soar, but also which stocks will deliver the highest returns. This series starts Nov. 5 and includes a FREE copy of his 2014 Macro Trend Profit Report.

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Investing in All Things Naughty

It’s so good to be bad—at least when it comes to investing.

Vice stocks are a corner of the market where many investors—and particularly professionals—are afraid to venture.  But this reluctance by many investors to embrace vice stocks is precisely what makes them such profitable investments (seeThe Price of Sin).  Because professional investors like to avoid being associated with merchants of death and peddlers of peccadillo, these companies tend to trade at discounts to the broader market and often pay substantial dividends.

Some areas of the vice world—in particular tobacco and firearms—have moats around their businesses that mafia dons or drug lords would envy.  Government regulation and a hostile legal regime make it almost impossible for new company to set up shop in these businesses.  The compliance costs would prevent them from ever getting off the ground…and the first lawsuit would bury them.

Today, we’re going to take a look at five high-profile vice stocks and evaluate their investment merits.

We’ll start with Diageo ($DEO), the London-based premium spirits giant.   Diageo just reported earnings growth of 28% year over year, helped along by rising U.S. booze consumption.

Most of the chatter today revolves around improving U.S. sales, but the real story is in emerging markets, where Diageo already gets 40% of its revenues and soon expects to get more than half.  Diageo sees “soft spots” in some of its key emerging markets, most notably in Brazil and China, but this is a short-term, cyclical cooling.  Diageo’s future lies in the developing world, and the long-term secular trend towards rising consumer incomes is here to stay.

Diageo is also a serial dividend raiser, boosting its dividend every year since 1999 (Note: dividends are paid in British pounds, and the gains can be masked when translated into dollars.)  Diageo raised its dividend by 9% this quarter and currently yields 2.6%.

Diageo’s core scotch whisky business has some of the best competitive moats I’ve seen.  Scotch isn’t even technically “scotch” until it been aged by 3 years, and you can’t command premium pricing until it has been aged by at least 12 years…if not 25.  Few would-be competitors have the patience or the bankroll to sink large sums of money today into a project that won’t be profitable for a decade or more. (SeeDiageo: The Ultimate 12- to 18-Year Investment”)

Diageo currently trades for 18 times earnings, making it a little on the pricey side.  This is a stock that should trade at a premium to the broader market and one that I expect to outperform the market over time.  But you might want drip into this one slowly or, better, wait for a pullback before making any large new purchases.

Next on the list is one of my very favorite long-term holdings, Dutch megabrewer Heineken ($HEINY).  Heineken, along with Anheuser-Busch InBev ($BUD) and SABMiller ($SBMRY), is a global enterprise with a portfolio of beer brands that covers every inhabited continent.

You might be surprised to see me this bullish on Big Beer.  After all, beer is a mature industry in the United States and Europe and growth—where there is growth at all—tends to be centered on smaller “micro brew” brands, not the big names you see advertised at the Super Bowl.

This is where Heineken’s geographic reach comes into play.  Heineken already gets about a quarter of its profits from Africa.  Think about this for a moment.  Africa is the least developed region of the world, and the last real “frontier” market of any size.  It also happens to be a rare pocket of growth in an otherwise moribund global economy and a region where incomes are still rising.

Topping it off, a disproportionate amount of alcohol consumed in Africa is of the homemade moonshine variety; in some countries the number is more than half.  As incomes rise, these drinkers will trade up to branded beer and spirits.

As Africa moves up the income ladder, the 25% of profits that Heineken already earns there will explode.  Consider Heineken a long-term investment in the rise of the African consumer.

Heineken is considerably cheaper than its Big Beer peers, trading for just 10 times trailing earnings and 1.7 times sales.  As a point of comparison, AB InBev trades for 20 times trailing earnings and at 3.6 times sales…and also lacks Heineken’s exposure to Africa.

No list of prominent vice stocks would be complete without mention of cigarettes.  Big Tobacco is a true pariah industry and the quintessential vice investment.  Unless prohibited for religious reasons—as is common with Islamic investment funds—many socially-responsible investors will give alcohol a free pass.  Not so with tobacco.

This is precisely why Big Tobacco has been such a profitable investment over the decades.  Because they have limited potential for growth and are largely forbidden to advertise, tobacco companies have huge piles of cash to distribute as dividends.  And because many investors shun the sector, the cheap valuations push the yield higher.  With dividends reinvested and compounded, Altria ($MO) is the most profitable company of the past half century, as Jeremy Siegel laid out in The Future for Investors.

Unfortunately, investors seem to have caught on, and much of what made Altria such a fantastic investment in years past no longer holds true.

At current prices, Altria yields 4.9% in dividends, which still makes it one of the biggest payers among large-cap American stocks.  But this is significantly cheaper than its five-year average of 6.5%, and it no longer trades at a discount to the broader market.  In fact, most Big Tobacco stocks trade at a slight premium to the market.

Tobacco stocks were fantastic investments for virtually the entire investing lifetime of anyone trading today.  But they were great investments precisely because they weren’t popular…and today, they are.

As compelling as the vice story is, Big Tobacco is best avoided at this time.

Next on the list is…ahem…”gentlemen’s club” operator Rick’s Cabaret International ($RICK).   The adult sphere is an interesting subset of the vice universe in that the economics are very different from the rest.  As I wrote earlier this year, adult media businesses like Playboy Enterprises have had a hard time competing with free and abundant competition on the internet and have had to change their business models.  Playboy is no longer a “publisher” but a brand management firm focused on selling its image and its bunny logo.  The jury is still out as to whether this transformation will be a monetary success.

Rick’s is a different animal altogether in that—as an operator of strip clubs—its economics are closer to those of nightclubs, bars, and restaurants.  Unlike booze and cigarette sales—which tend to hold up well during economic downturns—strip clubs are more sensitive to the health of the economy and to the permissiveness of corporate expense accounts.  That said, Rick’s revenues held up remarkably well throughout the lean years of 2008 and 2009 and have been growing steadily for the past several years.

Rick’s is also reasonably cheap at 10 times earnings and 0.8 times sales.  And the company is reportedly considering spinning off its clubs into a REIT, which, if successful, could give a nice jolt to the stock price.

Alas, Rick’s is not going to be investable for most people reading this.  Rick’s has a market cap of just $84 million and average trading volume of just 33,000 shares per day.  This is a tiny small-cap stock that few investors are going to be comfortable owning.  That said, the company does have some big-name institutional buyers, including CALPERS (California-Public Employees Retirement System) and Dimensional Fund Advisors.

And finally, we come to “merchant of death” Northrop Grumman ($NOC), a defense firm perhaps best known for its unmanned drones.

Of course, Northrop Grumman does more than just drones.  The company builds an array of defense systems and even offers logistical support and “cyber defense” systems.

I come across Northrop Grumman regularly, as it has popped up on the Magic Formula screen off and on for the past several years.  For those unfamiliar with it, the Magic Formula was a screen devised by hedge fund legend Joel Greenblatt to find highly-profitable companies trading at temporarily low valuations.  I’ve used the screen as a “fishing pond” for years and have found some real gems.

Northrop Grumman’s dependence on government contracts at a time when the government is broke and looking to downsize has dampened investor enthusiasm for the stock.  It trades for just 11 times earnings and 0.8 times sales.

Yet the company has managed to navigate a difficult political environment deftly and has kept its net income stable even while revenues have been slightly down.

Northrop Grumman recently hiked its dividend by 11% and has raised its dividend for 10 consecutive years.  The company also has ambitious plans to buy back about 25% of its outstanding shares by 2015, making Northrop Grumman a model of shareholder friendliness.  At current prices, the stock yields an attractive 2.7%.

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