There’s very little to nitpick in beer giant Constellation Brands’ solid quarter and guidance

Club holding Constellation Brands (STZ) reported solid fiscal second-quarter earnings before the opening bell Thursday. The beer, wine and liquor company reported net sales of $2.66 billion, up 12% year over year and ahead of Wall Street expectations of $2.52 billion. On the bottom line, the company said it had adjusted earnings of $3.17 per share, an increase of 33% over the prior year and a beat versus the $2.85 consensus. Excluding equity losses from Constellation’s stake in cannabis firm Canopy Growth , adjusted EPS came in at $3.33 per share. In addition to the headline numbers, adjusted operating income of $883 million was up 21% year over year and well above the $788 million consensus. Operating cash flow came in at $1.7 billion, significantly more than the $878 million estimate. Free cash flow of $1.2 billion was also well ahead of the $677 million the Street was looking for. Bottom line These were very good results in a very difficult operating environment. In addition to the better-than expected headline numbers, cash flow performance was stronger than anticipated and management positively revised their full fiscal year sales and earnings guidance. If there was anything to nitpick it would be in the Wine and Spirits segment, which is why we were pleased to see management announce their intention to divest the lesser performing wine brands and focus on the higher-end of the portfolio. With the transaction expected to close later Thursday, we think Constellation Brands is an even stronger company going forward than the one that put out these solid results and is well positioned to deliver on the revised guidance. The reaction we are seeing in the stock — roughly a 1.3% decline Thursday — is not unlike what we saw on the prior quarterly release — and similar to then, may be due to management’s choice not to pass through the full magnitude of the quarterly beat into forward guidance. However, as we thought last time, we believe this to be a buying opportunity as investors will come in to take advantage of shortsighted traders who are selling a market share leader that continues to gain share. We spoke to this view and more on Thursday’s “Morning Meeting” and look forward to learning more when CEO Bill Newlands speaks with Jim Cramer on Thursday’s edition of “Mad Money” at 6 p.m. ET. We have a 1-rating on STZ, meaning we see current levels a buy. In fact, we bought for the Club portfolio last month. Share reclassification As noted in Wednesday’s commentary ahead of Constellation’s earnings, we said we would like to see the company’s reclassification proposal to eliminate Class B shares get resolved. A day after, on the earnings call, Newlands said, “We have called a special meeting of shareholders to vote on the reclassification next month on November 9.” He later said the move is expected to result in a $1.5 billion cash payment. The reclassification would strip the founding Sands family of outsized voting rights. In the case of STZ, the Class B-removal is a good thing because the Sands family has made questionable capital allocation decisions in the past. Wine portfolio sales Before digging into the quarter, we want to call out that in addition to the reported results, management announced that they had reached an agreement with The Wine Group “to divest a portion of its mainstream and premium wine portfolio, including Cooper & Thief, Crafters Union, The Dreaming Tree, Monkey Bay, 7 Moons, and Charles Smith Wines.” The deal is expected to close later Thursday. On the call, management said, “When it closes, we believe this transaction will further enable us to focus our portfolio and efforts to deliver the industry-leading growth end margins that we continue to work toward.” We are fans of the move as it will serve streamline the company’s portfolio with an increased focus on the higher-end brands, which as we note below have seen better depletion rates than those brands being sold. Depletions measure U.S. domestic distributor shipments of Constellation’s branded products to retail customers based on third-party data. Company results Beer sales of $2.14 billion, up 15% year over year, were better than expectations of $1.98 billion. Operating income on beer rose 25% to $865.6 million, outpacing the $766 million consensus. Aiding the outperformance, operating margin in the segment increased 330 basis point versus the year ago period, climbing to 40.5%, well ahead of the 38.7% consensus estimate. The company cited “favorable pricing, lower obsolescence charges, fixed cost absorption from strong volume growth, and lower marketing spend driven by timing more than offset expected higher raw material costs.” Additionally, shipments to distributors were up 12.1% annually while depletions increased 8.9% versus the year ago period. On the call, management called out depletion growth of over 37% for Pacifico, adding it was a top-ten share gaining brand in tracked channels. Meanwhile, Modelo Chelada drinks saw depletion growth of over 60% in the quarter, with management adding “it remains the Number 1 brand in the space and owns nearly 60% market share of the Chelada segment nationwide.” Constellation said it was the top share gainer in the U.S. beer industry, with four of the top 15 growing high-end brands, noting that Modelo Especial remains both the No. 1 brand in high-end and the leading share gainer. Modelo Especial achieved over 10% depletion growth in the quarter. Wine and Spirits net sales came in at $515.8 million, an increase of 1% year over year and ahead of the $503 million expected on Wall Street. On the other hand, operating income of $99.4 million was a bit short versus the $109 million expected as segment operating margin contracted 40 basis points to 19.3%, below the 21.67% the Street was looking for. Driving the operating margin contraction was an increase in the cost of goods sold (COGS) and higher selling, general, and administrative (SG & A) costs that were partially offset by higher spirits sales, lower marketing as a percent of net sales, and favorable pricing. On the call, management said, “The increase in COGS was mainly a result of higher supply chain cost, particularly container surcharges and warehousing and higher material costs including grapes and glass partially offset by favorable fixed cost absorption as a result of the lapping of the New Zealand frost and the wildfires in the U.S. The increase in general and administrative expense was driven by compensation and benefits primarily to improve marketing effectiveness. Marketing was favorable due to the timing of spend.” Shipments were up 7.4% annually while depletions declined 2.2% versus the year ago period. Importantly, on the release, management said, “Constellation’s largest premium wine, fine wine, and craft spirits brands — Meiomi, Kim Crawford, Ruffino, Robert Mondavi Private Selection, The Prisoner Wine Company, High West Whiskey, Casa Noble Tequila, and Mi Campo Tequila — all delivered positive depletion growth.” The divergence in depletions between the segment total and those called out above — many of which were included in the list of what management is holding onto — speaks to why we like management’s aforementioned decision to divest the lower-end of the portfolio as we believe the move stands to support growth. Guidance Looking ahead, management upwardly revised fiscal year 2023 segment sales and earnings guidance. Excluding Canopy, management now anticipates consolidated earnings of $11.20 to $11.60 — up slightly from the $11.20 to $11.50 per share range previously provided — and well ahead of the expectations of $11.01 per share coming into the print. Assumed in this guidance are more robust beer sales and operating income growth of 8% to 10% and 3% to 5%, respectively. Behind the segment higher topline guidance is an anticipated 2% to 3% price increase due to ongoing supply chain headwinds. That’s up from the 1% to 2% management was previously factoring into their outlook. Wine and spirits sales are expected to be flat to down 2% versus the down 1% to down 3% previously provided. That will be offset by operating income growth of 3% to 5% — down from the 4% to 6% range previously provided. On the cost side, management commented on the call that they expect to continue to see margin pressure resulting from elevated corn prices as well as higher costs for cans, cartons and glass. Though the team does have a hedging policy that should blunt the blow to some extent, they will likely be less effective in the second half compared to the first half of the year due to timing. “While we’re nicely hedged, they just won’t be at the favorable rates if you will as we were in the first half,” they explained. Another factor that will pressure margins is investments being made in advance of additional capacity coming online. As members know, when we see a company that is a market leader and taking share, we take no issue with management pressing their advantage and investing in future growth. Finally, on cash flow, management reiterated their operating cash flow forecast of $2.6 billion to $2.8 billion a tad short versus the $2.82 billion expected. Taking out capital expenditures of $1.3 billion to $1.4 billion (also unchanged) and we got a reiterated free cash flow forecast of $1.3 billion to $1.4 billion, which at the midpoint is also slightly below the $1.41 billion expected. (Jim Cramer’s Charitable Trust is long STZ. See here for a full list of the stocks.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. Jim waits 45 minutes after sending a trade alert before buying or selling a stock in his charitable trust’s portfolio. If Jim has talked about a stock on CNBC TV, he waits 72 hours after issuing the trade alert before executing the trade. THE ABOVE INVESTING CLUB INFORMATION IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY , TOGETHER WITH OUR DISCLAIMER . NO FIDUCIARY OBLIGATION OR DUTY EXISTS, OR IS CREATED, BY VIRTUE OF YOUR RECEIPT OF ANY INFORMATION PROVIDED IN CONNECTION WITH THE INVESTING CLUB. NO SPECIFIC OUTCOME OR PROFIT IS GUARANTEED.