Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Overview
The Company is a leading international producer and marketer of beverage alcohol brands with a broad portfolio across the wine, spirits and imported beer categories. The Company has the largest wine business in the world and is the largest multi-category supplier of beverage alcohol in the United States; a leading producer and exporter of wine from Australia and New Zealand; and both a major producer and independent drinks wholesaler in the United Kingdom.
The Company reports its operating results in three segments: Constellation Wines (branded wine, and U.K. wholesale and other), Constellation Beers and Spirits (imported beer and distilled spirits) and Corporate Operations and Other (primarily corporate related items and other). Amounts included in the Corporate Operations and Other segment consist of general corporate administration and finance expenses. These amounts include costs of executive management, corporate development, corporate finance, human resources, internal audit, investor relations, legal and public relations. Any costs incurred at the corporate office that are applicable to the segments are allocated to the appropriate segment. The amounts included in the Corporate Operations and Other segment are general costs that are applicable to the consolidated group and are therefore not allocated to the other reportable segments. All costs reported within the Corporate Operations and Other segment are not included in the chief operating decision maker’s evaluation of the operating income performance of the other operating segments. The business segments reflect how the Company’s operations are being managed, how operating performance within the Company is being evaluated by senior management and the structure of its internal financial reporting. In addition, the Company excludes restructuring and related charges and unusual costs that affect comparability from its definition of operating income for segment purposes.
The Company’s business strategy is to remain focused across the beverage alcohol industry by offering a broad range of products in each of the Company’s three major categories: wine, imported beer and spirits. The Company intends to keep its portfolio positioned for superior top-line growth while maximizing the profitability of its brands. In addition, the Company seeks to increase its relative importance to key customers in major markets by increasing its share of their overall purchasing, which is increasingly important in a consolidating industry. The Company’s strategy of breadth across categories and geographies is designed to deliver long-term profitable growth. This strategy allows the Company more investment choices, provides flexibility to ad dress changing market conditions and creates stronger routes-to-market.
Marketing, sales and distribution of the Company’s products, particularly the Constellation Wines segment’s products, are managed on a geographic basis in order to fully leverage leading market positions within each geographic market. Market dynamics and consumer trends vary significantly across the Company’s three core geographic markets - the U.S., Europe (primarily the U.K.) and Australasia (Australia/New Zealand). Within the U.S. market, the Company offers a wide range of beverage alcohol products across the Constellation Wines segment and the Constellation Beers and Spirits segment. In Europe, the Company leverages its position as the largest branded wine supplier in the U.K. In addition, the Company leverages its U.K. wholesale business as a str ategic route-to-market for its imported wine portfolio and as a key supplier of a full range of beverage alcohol products to large national accounts. Within Australasia, where consumer trends favor domestic wine products, the Company leverages its position as one of the largest wine producers in Australia.
The Company remains committed to its long-term financial model of growing sales (both organically and through acquisitions), expanding margins and increasing cash flow to achieve superior earnings per share growth and improve return on invested capital.
In Second Quarter 2005 (as defined below), the Company’s net sales increased 13.8% over Second Quarter 2004 (as defined below) primarily from increases in imported beer net sales, U.K. wholesale net sales, branded wine net sales and a favorable foreign currency impact. Operating income increased 62.4% over the comparable prior year period primarily due to a reduction in unusual costs (see below under Operating Income discussion). In addition, the net sales growth and related gross profit growth were partially offset by increased selling and advertising expenses, as the Company continues to invest behind the imported beer portfolio and certain wine brands to drive growth and broader distribution. Lastly, as a result of the above factors and lower interest expens e for Second Quarter 2005, net income increased 126.7% over the comparable prior year period.
In Six Months 2005 (as defined below), the Company’s net sales increased 16.7% over Six Months 2004 (as defined below) primarily from increases in imported beer net sales and U.K. wholesale net sales, the inclusion of an additional one month of net sales of products acquired in the Hardy Acquisition, and a favorable foreign currency impact. Operating income increased 36.6% over the comparable prior year period primarily due to a reduction in unusual costs (see below under Operating Income discussion). In addition, the net sales growth and related gross profit growth were partially offset by increased selling and advertising expenses, as the Company continues to invest behind the imported beer portfolio and certain wine brands to drive growth and broader distrib ution. Lastly, as a result of the above factors and lower interest expense for Six Months 2005, net income increased 76.5% over the comparable prior year period.
The following discussion and analysis summarizes the significant factors affecting (i) consolidated results of operations of the Company for the three months ended August 31, 2004 ("Second Quarter 2005"), compared to the three months ended August 31, 2003 ("Second Quarter 2004"), and for the six months ended August 31, 2004 ("Six Months 2005"), compared to the six months ended August 31, 2003 ("Six Months 2004"), and (ii) financial liquidity and capital resources for Six Months 2005. This discussion and analysis also identifies certain restructuring and related charges expected to affect consolidated results of operations of the Company for the year ending February 28, 2005 ("Fiscal 2005"). This discussion and analysis should be read in conjunction w ith the Company’s consolidated financial statements and notes thereto included herein and in the Company’s Current Report on Form 8-K dated August 19, 2004.
Acquisition in Fiscal 2004
Acquisition of Hardy
On March 27, 2003, the Company acquired control of BRL Hardy Limited, now known as Hardy Wine Company Limited ("Hardy"), and on April 9, 2003, the Company completed its acquisition of all of Hardy’s outstanding capital stock. As a result of the acquisition of Hardy, the Company also acquired the remaining 50% ownership of Pacific Wine Partners LLC ("PWP"), the joint venture the Company established with Hardy in July 2001. The acquisition of Hardy along with the remaining interest in PWP is referred to together as the "Hardy Acquisition." Through this acquisition, the Company acquired one of Australia’s largest wine producers with interests in wineries and vineyards in most of Australia’s major wine regions as well as New Zealand and the United States. Hardy has a comprehensive portfolio of wine products across all price points with a strong focus on premium wine production. Hardy’s wines are distributed worldwide through a network of marketing and sales operations, with the majority of sales generated in Australia, the United Kingdom and the United States.
Total consideration paid in cash and Class A Common Stock to the Hardy shareholders was $1,137.4 million. Additionally, the Company recorded direct acquisition costs of $17.4 million. The acquisition date for accounting purposes is March 27, 2003. The Company has recorded a $1.6 million reduction in the purchase price to reflect imputed interest between the accounting acquisition date and the final payment of consideration. This charge is included as interest expense in the Consolidated Statement of Income for the six months ended August 31, 2003. The cash portion of the purchase price paid to the Hardy shareholders and optionholders ($1,060.2 million) was financed with $660.2 million of borrowings under the Company’s then existing credit agreement and $40 0.0 million of borrowings under the Company’s then existing bridge loan agreement. Additionally, the Company issued 3,288,913 shares of the Company’s Class A Common Stock, which were valued at $77.2 million based on the simple average of the closing market price of the Company’s Class A Common Stock beginning two days before and ending two days after April 4, 2003, the day the Hardy shareholders elected the form of consideration they wished to receive. The purchase price was based primarily on a discounted cash flow analysis that contemplated, among other things, the value of a broader geographic distribution in strategic international markets and a presence in the important Australian winemaking regions. The Company and Hardy have complementary businesses that share a common growth orientation and operating philosophy. The Hardy Acquisition supports the Company’s strategy of growth and breadth across categories and geographies, and strengthens its competitive position in its core markets . The purchase price and resulting goodwill were primarily based on the growth opportunities of the brand portfolio of Hardy. In particular, the Company believes there are growth opportunities for Australian wines in the United Kingdom, United States and other wine markets. This acquisition supports the Company’s strategy of driving long-term growth and positions the Company to capitalize on the growth opportunities in "new world" wine markets.
The results of operations of Hardy and PWP have been reported in the Company’s Constellation Wines segment since March 27, 2003. Accordingly, the Company’s results of operations for Six Months 2005 include the results of operations of Hardy and PWP for the entire period, whereas the results of operations for Six Months 2004 only include the results of operations of Hardy and PWP from March 27, 2003, to the end of Six Months 2004.
Results of Operations
Second Quarter 2005 Compared to Second Quarter 2004
Net Sales
The following table sets forth the net sales (in thousands of dollars) by operating segment of the Company for Second Quarter 2005 and Second Quarter 2004.
| | | Second Quarter 2005 Compared to Second Quarter 2004 | |
| | | Net Sales | |
| | | 2005 | | 2004 | | % Increase | |
| Constellation Wines: | | | | | | | |
Branded wine | | $ | 413,563 | | $ | 383,885 | | | 7.7 | % |
Wholesale and other | | | 258,161 | | | 207,261 | | | 24.6 | % |
| Constellation Wines net sales | | $ | 671,724 | | $ | 591,146 | | | 13.6 | % |
| Constellation Beers and Spirits: | | | | | | | | | | |
Imported beers | | $ | 289,137 | | $ | 247,414 | | | 16.9 | % |
Spirits | | | 76,080 | | | 72,504 | | | 4.9 | % |
| Constellation Beers and Spirits net sales | | $ | 365,217 | | $ | 319,918 | | | 14.2 | % |
| Corporate Operations and Other | | $ | - | | $ | - | | | N/A | |
| Consolidated Net Sales | | $ | 1,036,941 | | $ | 911,064 | | | 13.8 | % |
Net sales for Second Quarter 2005 increased to $1,036.9 million from $911.1 million for Second Quarter 2004, an increase of $125.9 million, or 13.8%. This increase resulted primarily from increases in imported beer net sales of $41.7 million, U.K. wholesale net sales of $22.6 million (on a local currency basis) and branded wine net sales of $12.8 million (on a local currency basis). In addition, net sales benefited from a favorable foreign currency impact of $44.0 million.
Constellation Wines
Net sales for Constellation Wines increased to $671.7 million for Second Quarter 2005 from $591.1 million in Second Quarter 2004, an increase of $80.6 million, or 13.6%. Branded wine net sales increased $29.7 million primarily from increased branded wine net sales in Europe and Australasia of $17.6 million (on a local currency basis) and a favorable foreign currency impact of $16.9 million, partially offset by decreased branded wine net sales in the U.S. of $4.8 million. The increases in branded wine net sales are primarily volume driven, as the Company continues to benefit from increased distribution, especially in the Australian wine category. The decrease in branded wine net sales in the U.S.is primarily due to substantially lower net sales of a product in the Second Quarter 2005 than in the same period a year ago. Second Quarter 2004 benefited from sales of this new product following its early fiscal 2004 introduction and national launch in the U.S. Partially offsetting this decrease was an increase in branded premium wines in the U.S. as the Company continues to benefit from increased distribution (as noted above) and greater consumer demand for premium wines. Wholesale and other net sales increased $50.9 million primarily due to growth in the U.K. wholesale business of $22.6 million (on a local currency basis) and a favorable foreign currency impact of $27.1 million. The net sales increase in the U.K. wholesale business on a local currency basis is primarily due to sales to new national accounts added in the first quarter of f iscal 2005 and increased sales in comparable existing accounts during Second Quarter 2005.
The global wine industry continues to be very competitive. The Company has taken a strategy of preserving the long-term brand equity of its wine portfolio and of making investments in the higher growth sectors of the wine business. In the U.S., the 2003 and 2004 California grape harvest were generally lighter than expected. The lighter than expected harvest should bring certain U.S. wine industry inventories closer into balance. At the same time, open market prices in the U.S. for many types of grapes and bulk wine have increased. These increases are expected to have minimal impact on the Company’s overall product cost.
Constellation Beers and Spirits
Net sales for Constellation Beers and Spirits increased to $365.2 million for Second Quarter 2005 from $319.9 million for Second Quarter 2004, an increase of $45.3 million, or 14.2%. This increase resulted from both volume and pricing gains on the Company’s imported beer portfolio, which increased $41.7 million, as well as an increase in spirits net sales of $3.6 million. The Company believes the volume gains on its imported beer portfolio for Second Quarter 2005 were attributable to several factors, including increased advertising and selling expenses behind the Company’s Mexican beer portfolio and favorable depletion results following the price increase on the Mexican beer portfolio. The pricing gains are due to the price increase that was introduced in January 2004 on the Company’s Mexican beer portfolio. The growth in spirits net sales is attributable to increases in both the Company’s contract production net sales as well as branded net sales.
The Company expects net sales growth for imported beer for Fiscal 2005 to be in the mid to high single digits despite difficult volume comparisons for the third and fourth quarters of Fiscal 2005. The difficult volume comparisons are primarily due to the timing of the price increase which resulted in strong wholesaler and retailer demand in the third and fourth quarters of Fiscal 2004.
Gross Profit
The Company’s gross profit increased to $289.7 million for Second Quarter 2005 from $240.5 million for Second Quarter 2004, an increase of $49.2 million, or 20.4%. The Constellation Wines segment’s gross profit increased $10.5 million primarily due to volume growth in the segment’s wholesale business plus a favorable foreign currency impact. The Constellation Beers and Spirits segment’s gross profit increased $13.8 million primarily due to the volume growth and price increase in the segment’s imported beer portfolio. In addition, unusual costs, which consist of certain costs that are excluded by management in their evaluation of the results of each operating segment, were lower by $24.9 million in Second Quarter 2005 versus Second Quarter 20 04. This decrease resulted from a $16.8 million write-down of commodity concentrate inventory in Second Quarter 2004 in connection with the Company’s decision to exit the commodity concentrate product line (see additional discussion under "Restructuring and Related Charges" below) and reduced flow through of inventory step-up associated with the Hardy Acquisition. Gross profit as a percent of net sales increased to 27.9% for Second Quarter 2005 from 26.4% for Second Quarter 2004 primarily due to the lower unusual costs, partially offset by reduced gross margins in the Constellation Wines segment, driven primarily by increased sales of lower margin U.K. wholesale products and branded wine products.
Selling, General and Administrative Expenses
Selling, general and administrative expenses increased to $132.4 million for Second Quarter 2005 from $127.3 million for Second Quarter 2004, an increase of $5.1 million, or 4.0%. The Constellation Wines segment’s selling, general and administrative expenses increased $7.1 million primarily due to increased selling and advertising expenses as the Company continues to invest behind specific wine brands to drive broader distribution. The Constellation Beers and Spirits segment’s selling, general and administrative expenses were relatively flat as increased selling expenses were offset by decreased general and administrative expenses. The Corporate Operations and Other segment’s selling, general and administrative expenses increased $3.0 million primaril y due to increased general and administrative expenses to support the Company’s growth. Lastly, there was a decrease of $5.2 million of net unusual costs which consist of certain items that are excluded by management in their evaluation of the results of each operating segment. The Second Quarter 2004 costs consisted of financing costs recorded in connection with the Hardy Acquisition. There were no unusual costs in Second Quarter 2005. Selling, general and administrative expenses as a percent of net sales decreased to 12.8% for Second Quarter 2005 as compared to 14.0% for Second Quarter 2004 primarily due to (i) lower unusual costs, (ii) the percent increase in Constellation Wines segment’s general and administrative expenses growing at a slower rate than the percent increase in the Constellation Wines segment’s net sales, and (iii) the percent increase in the Constellation Beers and Spirits segment’s selling, general and administrative costs growing at a slower rate than the percent inc rease in the Constellation Beers and Spirits segment’s net sales.
Restructuring and Related Charges
The Company recorded $1.2 million of restructuring and related charges for Second Quarter 2005 associated with the restructuring plan of the Constellation Wines segment. Restructuring and related charges resulted from the further realignment of business operations as previously announced in Fiscal 2004, and included $0.2 million of employee termination benefit costs (net of reversal of prior accruals of $0.2 million), $0.3 million of facility consolidation and relocation costs, and other related charges of $0.7 million. The Company recorded $17.1 million of restructuring and related charges for Second Quarter 2004 associated with (i) the Company’s decision to exit the commodity concentrate product line and sell its winery located in Escalon, California, and (ii ) the realignment of business operations in the Constellation Wines segment. In total, the Company recorded $33.9 million of costs in Second Quarter 2004 allocated between cost of product sold and restructuring and related charges associated with these actions.
For Fiscal 2005, the Company expects to incur total restructuring and related charges of $7.2 million associated with the restructuring plan of the Constellation Wines segment. These charges are expected to consist of $6.9 million related to the further realignment of business operations in the Constellation Wines segment and $0.3million related to renegotiating existing grape contracts as a result of exiting the commodity concentrate product line.
Operating Income
The following table sets forth the operating income (loss) (in thousands of dollars) by operating segment of the Company for Second Quarter 2005 and Second Quarter 2004.
| | | Second Quarter 2005 Compared to Second Quarter 2004 | |
| | | Operating Income (Loss) | |
| | | 2005 | | 2004 | | % Increase/ (Decrease) | |
| Constellation Wines | | $ | 87,745 | | $ | 84,413 | | | 3.9 | % |
| Constellation Beers and Spirits | | | 83,811 | | | 70,117 | | | 19.5 | % |
| Corporate Operations and Other | | | (13,256 | ) | | (10,238 | ) | | 29.5 | % |
Total Reportable Segments | | | 158,300 | | | 144,292 | | | 9.7 | % |
| Restructuring and Related Charges and Unusual Costs | | | (2,141 | ) | | (48,136 | ) | | (95.6 | )% |
| Consolidated Operating Income | | $ | 156,159 | | $ | 96,156 | | | 62.4 | % |
Restructuring and related charges and unusual costs of $2.1 million for Second Quarter 2005 consist of certain costs that are excluded by management in their evaluation of the results of each operating segment. These costs represent the flow through of inventory step-up associated with the Hardy Acquisition of $0.9 million and restructuring and related charges associated with the Company’s realignment of its business operations in the wine segment of $1.2 million. Restructuring and related charges and unusual costs of $48.1 million for Second Quarter 2004 representthe flow through of inventory step-up and the amortization of deferred financing costs assoc iated with the Hardy Acquisition of $9.0 million and $5.2 million, respectively, and costs associated with exiting the commodity concentrate product line and the Company’s realignment of its business operations in the wine segment, including the write-down of commodity concentrate inventory of $16.8 million and restructuring and related charges of $17.1 million. As a result of these costs and the factors discussed above, consolidated operating income increased to $156.2 million for Second Quarter 2005 from $96.2 million for Second Quarter 2004, an increase of $60.0 million, or 62.4%.
Interest Expense, Net
Interest expense, net of interest income of $0.3 million and $0.9 million for Second Quarter 2005 and Second Quarter 2004, respectively, decreased to $30.4 million for Second Quarter 2005 from $41.1 million for Second Quarter 2004, a decrease of $10.7 million, or (26.0%). The decrease resulted from lower average borrowings in Second Quarter 2005 as well as slightly lower average borrowing rates. The reduction in debt resulted from the use of proceeds from the Company's equity offerings in July 2003 to pay down debt incurred to partially finance the Hardy Acquisition combined with on-going principal payments on long-term debt. The reduction in average borrowing rates was attributed in part to the replacement of $200.0 million of higher fixed rate subordinated no te debt with lower variable rate revolver debt.
Provision for Income Taxes
The Company’s effective tax rate remained the same at 36.0% for Second Quarter 2005 and Second Quarter 2004.
Net Income
As a result of the above factors, net income increased to $80.6 million for Second Quarter 2005 from $35.6 million for Second Quarter 2004, an increase of $45.1 million, or 126.7%.
Six Months 2005 Compared to Six Months 2004
Net Sales
The following table sets forth the net sales (in thousands of dollars) by operating segment of the Company for Six Months 2005 and Six Months 2004.
| | | Six Months 2005 Compared to Six Months 2004 | |
| | | Net Sales | |
| | | 2005 | | 2004 | | % Increase | |
| Constellation Wines: | | | | | | | |
Branded wine | | $ | 777,446 | | $ | 694,365 | | | 12.0 | % |
Wholesale and other | | | 505,396 | | | 392,114 | | | 28.9 | % |
| Constellation Wines net sales | | $ | 1,282,842 | | $ | 1,086,479 | | | 18.1 | % |
| Constellation Beers and Spirits: | | | | | | | | | | |
Imported beers | | $ | 526,033 | | $ | 454,678 | | | 15.7 | % |
Spirits | | | 155,371 | | | 142,709 | | | 8.9 | % |
| Constellation Beers and Spirits net sales | | $ | 681,404 | | $ | 597,387 | | | 14.1 | % |
| Corporate Operations and Other | | $ | - | | $ | - | | | N/A | |
| Consolidated Net Sales | | $ | 1,964,246 | | $ | 1,683,866 | | | 16.7 | % |
Net sales for Six Months 2005 increased to $1,964.2 million from $1,683.9 million for Six Months 2004, an increase of $280.4 million, or 16.7%. This increase resulted primarily from increases in imported beer net sales of $71.4 million, increases in U.K. wholesale net sales of $48.9 million (on a local currency basis), and the inclusion of $48.9 million of net sales of products acquired in the Hardy Acquisition. In addition, net sales benefited from a favorable foreign currency impact of $81.5 million.
Constellation Wines
Net sales for Constellation Wines increased to $1,282.8 million for Six Months 2005 from $1,086.5 million in Six Months 2004, an increase of $196.4 million, or 18.1%. Branded wine net sales increased $83.1 million. This increase resulted primarily from an additional one month of net sales of $45.7 million of branded wines acquired in the Hardy Acquisition, completed in March 2003, and a favorable foreign currency impact of $27.1 million. Wholesale and other net sales increased $113.3 million primarily due to growth in the U.K. wholesale business of $48.9 million (on a local currency basis) and a favorable foreign currency impact of $54.4 million. The net sales increase in the U.K. wholesale business on a local currency basis is primarily due to the addition of new n ational accounts in the first quarter of fiscal 2005 and increased sales in existing accounts during Six Months 2005.
The global wine industry continues to be very competitive. The Company has taken a strategy of preserving the long-term brand equity of its wine portfolio and of making investments in the higher growth sectors of the wine business. In the U.S., the 2003 and 2004 California grape harvests were generally lighter than expected. The lighter than expected harvests should bring certain U.S. wine industry inventories closer into balance. At the same time, open market prices in the U.S. for many types of grapes and bulk wine have increased. These increases are expected to have minimal impact on the Company’s overall product cost.
Constellation Beers and Spirits
Net sales for Constellation Beers and Spirits increased to $681.4 million for Six Months 2005 from $597.4 million for Six Months 2004, an increase of $84.0 million, or 14.1%. This increase resulted from both volume and pricing gains on the Company’s imported beer portfolio, which increased $71.4 million, as well as an increase in spirits net sales of $12.7 million. The Company believes the volume gains on its imported beer portfolio for Six Months 2005 were attributable to several factors, including increased advertising and selling expenses behind the Company’s Mexican beer portfolio and favorable depletion results following the price increase on the Mexican beer portfolio. The Company believes the favorable depletion results were due in part to the inclu sion of Corona in special product promotions by certain grocery stores in California, the purpose of which were to attract customers back to those stores following the end of strikes. The pricing gains are due to the price increase that was introduced in January 2004 on the Company’s Mexican beer portfolio. The growth in spirits net sales is attributable to increases in both the Company’s contract production net sales as well as branded net sales.
The Company’s imported beer volume was better than expected for Six Months 2005. The Company expects net sales growth for imported beer for Fiscal 2005 to be in the mid to high single digits despite difficult volume comparisons for the third and fourth quarters of Fiscal 2005. The difficult volume comparisons are primarily due to the timing of the price increase which resulted in strong wholesaler and retailer demand in the third and fourth quarters of Fiscal 2004.
Gross Profit
The Company’s gross profit increased to $540.1 million for Six Months 2005 from $449.6 million for Six Months 2004, an increase of $90.5 million, or 20.1%. The Constellation Wines segment’s gross profit increased $34.5 million primarily due to the additional one month of sales of branded wines acquired in the Hardy Acquisition plus a favorable foreign currency impact. The Constellation Beers and Spirits segment’s gross profit increased $26.9 million primarily due to the volume growth and price increase in the segment’s imported beer portfolio. In addition, unusual costs, which consist of certain costs that are excluded by management in their evaluation of the results of each operating segment, were lower by $29.1 million in Six Months 2005 versus Six Months 2004. This decrease resulted from a $16.8 million write-down of commodity concentrate inventory in Second Quarter 2004 in connection with the Company’s decision to exit the commodity concentrate product line (see additional discussion under "Restructuring and Related Charges" below) and reduced flow through of inventory step-up associated with the Hardy Acquisition. Gross profit as a percent of net sales increased to 27.5% for Six Months 2005 from 26.7% for Six Months 2004 primarily due to the lower unusual costs, partially offset by reduced gross margins in the Constellation Wines segment, driven primarily by increased sales of lower margin U.K. wholesale products and branded wine products.
Selling, General and Administrative Expenses
Selling, general and administrative expenses increased to $270.8 million for Six Months 2005 from $235.1 million for Six Months 2004, an increase of $35.7 million, or 15.2%. The Constellation Wines segment’s selling, general and administrative expenses increased $24.6 million primarily due to the increased selling and advertising expenses as the Company continues to invest behind specific wine brands to drive broader distribution. The Constellation Beers and Spirits segment’s selling, general and administrative expenses increased $5.2 million due to increased advertising and selling behind its Mexican beer portfolio and increased general and administrative expenses to support the growth across this segment’s businesses. The Corporate Operations and Ot her segment’s selling, general and administrative expenses increased $4.8 million primarily due to increased general and administrative expenses to support the Company’s growth. Lastly, there was an increase of $1.1 million of net unusual costs which consist of certain items that are excluded by management in their evaluation of the results of each operating segment. This increase consists of $10.3 million of financing costs recorded in Six Months 2005 related to the Company’s redemption of its Senior Subordinated Notes (as defined below) as compared to $9.2 million of financing costs recorded in Six Months 2004 in connection with the Hardy Acquisition. Selling, general and administrative expenses as a percent of net sales decreased to 13.8% for Six Months 2005 as compared to 14.0% for Six Months 2004 primarily due to (i) the percent increase in Constellation Wines segment’s general and administrative expenses growing at a slower rate than the percent increase in the Constellation Wines s egment’s net sales, and (ii) the percent increase in the Constellation Beers and Spirits segment’s selling, general and administrative costs growing at a slower rate than the percent increase in the Constellation Beers and Spirits segment’s net sales, both of which were partially offset by the growth in the Corporate Operations and Other segment’s general and administrative expenses.
Restructuring and Related Charges
The Company recorded $2.8 million of restructuring and related charges for Six Months 2005 associated with the restructuring plan of the Constellation Wines segment. Restructuring and related charges resulted from the further realignment of business operations as previously announced in Fiscal 2004, and included $1.4 million of employee termination benefit costs (net of reversal of prior accruals of $0.2 million), $0.6 million of facility consolidation and relocation costs, and other related charges of $0.8 million. The Company recorded $19.4 million of restructuring and related charges for Six Months 2004 associated with (i) the Company’s decision to exit the commodity concentrate product line and sell its winery located in Escalon, California, and (ii) the re alignment of business operations in the Constellation Wines segment. In total, the Company recorded $33.9 million of costs in Second Quarter 2004 allocated between cost of product sold and restructuring and related charges associated with these actions.
For Fiscal 2005, the Company expects to incur total restructuring and related charges of $7.2 million associated with the restructuring plan of the Constellation Wines segment. These charges are expected to consist of $6.9 million related to the further realignment of business operations in the Constellation Wines segment and $0.3million related to renegotiating existing grape contracts as a result of exiting the commodity concentrate product line.
Operating Income
The following table sets forth the operating income (loss) (in thousands of dollars) by operating segment of the Company for Six Months 2005 and Six Months 2004.
| | | Six Months 2005 Compared to Six Months 2004 | |
| | | Operating Income (Loss) | |
| | | 2005 | | 2004 | | % Increase/ (Decrease) | |
| Constellation Wines | | $ | 155,404 | | $ | 145,436 | | | 6.9 | % |
| Constellation Beers and Spirits | | | 151,663 | | | 130,000 | | | 16.7 | % |
| Corporate Operations and Other | | | (25,125 | ) | | (20,309 | ) | | 23.7 | % |
Total Reportable Segments | | | 281,942 | | | 255,127 | | | 10.5 | % |
| Restructuring and Related Charges and Unusual Costs | | | (15,362 | ) | | (60,004 | ) | | (74.4 | )% |
| Consolidated Operating Income | | $ | 266,580 | | $ | 195,123 | | | 36.6 | % |
Restructuring and related charges and unusual costs of $15.4 million for Six Months 2005 consist of certain costs that are excluded by management in their evaluation of the results of each operating segment. These costs represent the flow through of inventory step-up associated with the Hardy Acquisition of $2.3 million, financing costs associated with the redemption of the Company’s Senior Subordinated Notes of $10.3 million, and restructuring and related charges associated with the Company’s realignment of its business operations in the wine segment of $2.8 million. Restructuring and related charges and unusual costs of $60.0 million for Six Months 2004 represent the flow through of inventory step-up and the amortization of deferred financing costs associated with the Hardy Acquisition of $14.5 million and $9.2 million, respectively, and costs associated with exiting the commodity concentrate product line and the Company’s realignment of its business operations in the wine segment, including the write-down of commodity concentrate inventory of $16.8 million and restructuring and related charges of $19.5 million. As a result of these costs and the factors discussed above, consolidated operating income increased to $266.6 million for Six Months 2005 from $195.1 million for Six Months 2004, an increase of $71.5 million, or 36.6%.
Interest Expense, Net
Interest expense, net of interest income of $0.8 million and $2.0 million for Six Months 2005 and Six Months 2004, respectively, decreased to $60.7 million for Six Months 2005 from $80.3 million for Six Months 2004, a decrease of $19.7 million, or (24.5%). The decrease resulted from lower average borrowings in Six Months 2005 as well as lower average borrowing rates. The reduction in debt resulted from the use of proceeds from the Company's equity offerings in July 2003 to pay down debt incurred to partially finance the Hardy Acquisition combined with on-going principal payments on long-term debt. The reduction in average borrowing rates was attributed in part to the replacement of $200.0 million of higher fixed rate subordinated note debt with lower variable r ate revolver debt.
Provision for Income Taxes
The Company’s effective tax rate remained the same at 36.0% for Six Months 2005 and Six Months 2004.
Net Income
As a result of the above factors, net income increased to $131.9 million for Six Months 2005 from $74.8 million for Six Months 2004, an increase of $57.2 million, or 76.5%.
Financial Liquidity and Capital Resources
General
The Company’s principal use of cash in its operating activities is for purchasing and carrying inventories and carrying seasonal accounts receivable. The Company’s primary source of liquidity has historically been cash flow from operations, except during annual grape harvests when the Company has relied on short-term borrowings. In the United States, the annual grape crush normally begins in August and runs through October. In Australia, the annual grape crush normally begins in February and runs through May. The Company generally begins taking delivery of grapes at the beginning of the crush season with payments for such grapes beginning to come due one month later. The Company’s short-term borrowings to support such purchases generally reach their h ighest levels one to two months after the crush season has ended. Historically, the Company has used cash flow from operating activities to repay its short-term borrowings and fund capital expenditures. The Company will continue to use its short-term borrowings to support its working capital requirements. The Company believes that cash provided by operating activities and its financing activities, primarily short-term borrowings, will provide adequate resources to satisfy its working capital, scheduled principal and interest payments on debt, preferred dividend payment requirements, and anticipated capital expenditure requirements for both its short-term and long-term capital needs. The Company also has in place an effective shelf registration statement covering the potential sale of up to $750.0 million of debt securities, preferred stock, Class A Common Stock or any combination thereof. As of October 12, 2004, the entire $750.0 million of capacity was available under the shelf registration stat ement.
Six Months 2005 Cash Flows
Operating Activities
Net cash provided by operating activities for Second Quarter 2005 was $54.2 million, which resulted from $131.9 million of net income, plus $68.4 million of net noncash items charged to the Consolidated Statement of Income, less $146.2 million representing the net change in the Company’s operating assets and liabilities. The net noncash items consisted primarily of depreciation of property, plant and equipment and deferred tax provision. The net change in operating assets and liabilities resulted primarily from seasonal increases in accounts receivable and inventories, partially offset by a seasonal increase in accounts payable.
Investing Activities
Net cash used in investing activities for Second Quarter 2005 was $51.2 million, which resulted primarily from $50.9 million of capital expenditures.
Financing Activities
Net cash used in financing activities for Second Quarter 2005 was $28.2 million resulting primarily from principal payments of long-term debt of $234.7 million partially offset by net proceeds of $192.5 million from notes payable.
During June 1998, the Company’s Board of Directors authorized the repurchase of up to $100.0 million of its Class A Common Stock and Class B Common Stock. The repurchase of shares of common stock will be accomplished, from time to time, in management’s discretion and depending upon market conditions, through open market or privately negotiated transactions. The Company may finance such repurchases through cash generated from operations or through the senior credit facility. The repurchased shares will become treasury shares. As of October 12, 2004, under the share repurchase program, the Company had purchased 4,075,344 shares of Class A Common Stock at an aggregate cost of $44.9 million, or at an average cost of $11.01 per share. No shares were repurchased during Six Months 2005 under the Company’s share repurchase program.
Debt
Total debt outstanding as of August 31, 2004, amounted to $1,993.5 million, a decrease of $54.4 million from February 29, 2004. The ratio of total debt to total capitalization decreased to 45.6% as of August 31, 2004, from 46.3% as of February 29, 2004.
Senior Credit Facility
In connection with the Hardy Acquisition, on January 16, 2003, the Company, certain subsidiaries of the Company, JPMorgan Chase Bank, as a lender and administrative agent, and certain other agents, lenders, and financial institutions entered into a new credit agreement, which since has been amended (or amended and restated) in March 2003, October 2003, February 2004 and August 2004 (as amended and restated in August 2004, the "Credit Agreement"). The Credit Agreement provides for aggregate credit facilities of $1.2 billion consisting of a $345.0 million Tranche A Term Loan facility due in February 2008, a $500.0 million Tranche B Term Loan facility due in November 2008 and a $400.0 million Revolving Credit facility (including an Australian Dollar revo lving sub-facility of up to A$10.0 million and a sub-facility for letters of credit of up to $40.0 million) which expires on February 29, 2008. The Company uses the Revolving Credit facility under the Credit Agreement to fund its working capital needs on an on-going basis. In August 2004 the then outstanding principal balance under both the Tranche A and Tranche B Term Loan facilities was refinanced on essentially the same terms as the credit agreement in effect prior to August 2004 but at a lower Applicable Rate (as such term is defined in the Credit Agreement) and the remaining payment schedule of the Tranche B Term Loan facility was modified.
As of August 31, 2004, the required principal repayments of the Tranche A Term Loan and the Tranche B Term Loan are as follows:
| | | Tranche A Term Loan | | Tranche B Term Loan | | Total | |
(in thousands) | | | | | | | |
| 2005 | | $ | 30,000 | | $ | - | | $ | 30,000 | |
| 2006 | | | 80,000 | | | 5,000 | | | 85,000 | |
| 2007 | | | 100,000 | | | 5,000 | | | 105,000 | |
| 2008 | | | 120,000 | | | 125,313 | | | 245,313 | |
| 2009 | | | - | | | 364,687 | | | 364,687 | |
| | | $ | 330,000 | | $ | 500,000 | | $ | 830,000 | |
The rate of interest payable, at the Company’s option, is LIBOR plus a margin, the federal funds rate plus a margin, or the prime rate plus a margin. The margin is adjustable based upon the Company’s Debt Ratio (as defined in the Credit Agreement) and, with respect to LIBOR borrowings, ranges between 1.00% and 2.50%. As of August 31, 2004, the LIBOR margin for the Revolving Credit facility is 1.75%, the LIBOR margin for the Tranche A Term Loan facility is 1.25%, and the LIBOR margin on the Tranche B Term Loan facility is 1.50%.
The Company’s obligations are guaranteed by certain subsidiaries of the Company ("Guarantors") and the Company is obligated to pledge collateral of (i) 100% of the capital stock of all of the Company’s U.S. subsidiaries and certain foreign subsidiaries and (ii) 65% of the voting capital stock of certain other foreign subsidiaries of the Company.
The Company and its subsidiaries are subject to customary lending covenants including those restricting additional liens, the incurrence of additional indebtedness (including guarantees of indebtedness), the sale of assets, the payment of dividends, transactions with affiliates and the making of certain investments, in each case subject to baskets, exceptions and/or thresholds. The primary financial covenants require the maintenance of a debt coverage ratio, a senior debt coverage ratio, a fixed charge ratio and an interest coverage ratio. As of August 31, 2004, the Company is in compliance with all of its covenants under its Credit Agreement.
As of August 31, 2004, under the Credit Agreement, the Company had outstanding Tranche A Term Loans of $330.0 million bearing a weighted average interest rate of 3.2%, Tranche B Term Loans of $500.0 million bearing a weighted average interest rate of 3.5%, $139.0 million of revolving loans bearing a weighted average interest rate of 3.2%, undrawn revolving letters of credit of $26.9 million, and $234.1 million in revolving loans available to be drawn.
Subsidiary Facilities
The Company has additional line of credit facilities totaling $155.7 million as of August 31, 2004. These lines support the borrowing needs of certain of the Company’s foreign subsidiary operations. Interest rates and other terms of these borrowings vary from country to country, depending on local market conditions. As of August 31, 2004, amounts outstanding under the subsidiary revolving credit facilities were $54.6 million.
Senior Notes
As of August 31, 2004, the Company had outstanding $200.0 million aggregate principal amount of 8 5/8% Senior Notes due August 2006 (the "Senior Notes"). The Senior Notes are currently redeemable, in whole or in part, at the option of the Company.
As of August 31, 2004, the Company had outstanding £1.0 million ($1.8 million) aggregate principal amount of 8 1/2% Series B Senior Notes due November 2009 (the "Sterling Series B Senior Notes"). In addition, as of August 31, 2004, the Company had outstanding £154.0 million ($277.1 million, net of $0.5 million unamortized discount) aggregate principal amount of 8 1/2% Series C Senior Notes due November 2009 (the "Sterling Series C Senior Notes"). The Sterling Series B Senior Notes and Sterling Series C Senior Notes are currently redeemable, in whole or in part, at the option of the Company.
Also, as of August 31, 2004, the Company had outstanding $200.0 million aggregate principal amount of 8% Senior Notes due February 2008 (the "February 2001 Senior Notes"). The February 2001 Senior Notes are currently redeemable, in whole or in part, at the option of the Company.
Senior Subordinated Notes
On March 4, 1999, the Company issued $200.0 million aggregate principal amount of 8 1/2% Senior Subordinated Notes due March 2009 ("Senior Subordinated Notes"). The Senior Subordinated Notes were redeemable at the option of the Company, in whole or in part, at any time on or after March 1, 2004. On February 10, 2004, the Company issued a Notice of Redemption for its Senior Subordinated Notes. The Senior Subordinated Notes were redeemed with proceeds from the Revolving Credit facility on March 11, 2004, at 104.25% of par plus accrued interest. During Six Months 2005, in connection with this redemption, the Company recorded a charge of $10.3 million in selling, general and administrative expenses for the call premium and the remaining unamortized financing fees associ ated with the original issuance of the Senior Subordinated Notes.
As of August 31, 2004, the Company had outstanding $250.0 million aggregate principal amount of 8 1/8% Senior Subordinated Notes due January 2012 (the "January 2002 Senior Subordinated Notes"). The January 2002 Senior Subordinated Notes are redeemable at the option of the Company, in whole or in part, at any time on or after January 15, 2007. The Company may also redeem up to 35% of the January 2002 Senior Subordinated Notes using the proceeds of certain equity offerings completed before January 15, 2005.
Guarantees
A foreign subsidiary of the Company has guaranteed debt of a joint venture in the maximum amount of $3.8 million as of August 31, 2004. The liability for this guarantee is not material and the Company does not have any collateral from this entity.
Accounting Pronouncements Not Yet Adopted
In December 2003, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 132 (revised 2003) ("SFAS No. 132(R)"), "Employers’ Disclosures about Pensions and Other Postretirement Benefits—an amendment of FASB Statements No. 87, 88, and 106." SFAS No. 132(R) supersedes Statement of Financial Accounting Standards No. 132 ("SFAS No. 132"), by revising employers’ disclosures about pension plans and other postretirement benefit plans. SFAS No. 132(R) requires additional disclosures to those in SFAS No. 132 regarding the assets, obligations, cash flows, and net periodic benefit cost of defined benefit pension plans and other defined benefit postretirement plans. SFAS No. 132(R) also amends Accounting Principles Board O pinion No. 28 ("APB Opinion No. 28"), "Interim Financial Reporting," to require additional disclosures for interim periods. The Company has adopted certain of the annual disclosure provisions of SFAS No. 132(R), primarily those related to its U.S. postretirement plan, for the fiscal year ended February 29, 2004. In addition, the Company has adopted the interim disclosure provisions of SFAS No. 132(R) for the three months ended August 31, 2004. The Company is required to adopt the remaining annual disclosure provisions, primarily those related to its foreign plans, for the fiscal year ending February 28, 2005.
In March 2004, the Financial Accounting Standards Board issued a proposed statement, "Share-Based Payment, an amendment of FASB Statements No. 123 and 95." The objective of the proposed statement is to require recognition in an entity’s financial statements of the cost of employee services received in exchange for equity instruments issued, and liabilities incurred, to employees in share-based payment (or compensation) transactions based on the fair value of the instruments at the grant date. The proposed statement would eliminate the alternative of continuing to account for share-based payment arrangements with employees under APB No. 25 and require that the compensation cost resulting from all share-based payment transactions be recognized in an entity’s financial statements. If adopted in its current form, the proposed statement would be effective for awards that are granted, modified, or settled in fiscal years beginning after December 15, 2004. Also, if adopted in its current form, the proposed statement could result in a significant charge to the Company’s Consolidated Statement of Income for the fiscal year ending February 28, 2006.
Information Regarding Forward-Looking Statements
This Quarterly Report on Form 10-Q contains "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These forward-looking statements are subject to a number of risks and uncertainties, many of which are beyond the Company’s control, that could cause actual results to differ materially from those set forth in, or implied by, such forward-looking statements. All statements other than statements of historical facts included in this Quarterly Report on Form 10-Q, including statements regarding the Company’s future financial position and prospects, are forward-looking statements. All forward-looking statements speak only as of the date of this Quarterly Report on Form 1 0-Q. The Company undertakes no obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. In addition to the risks and uncertainties of ordinary business operations, the forward-looking statements of the Company contained in this Form 10-Q are also subject to the following risks and uncertainties: the Company achieving certain sales projections and meeting certain cost targets; wholesalers and retailers may give higher priority to products of the Company’s competitors; raw material supply, production or shipment difficulties could adversely affect the Company’s ability to supply its customers; increased competitive activities in the form of pricing, advertising and promotions could adversely impact consumer demand for the Company’s products and/or result in higher than expected selling, general and administrative expenses; a general decline in alcohol consumption; increases in excise and other taxes on beverage alcohol pro ducts; and changes in foreign currency exchange rates. For additional information about risks and uncertainties that could adversely affect the Company’s forward-looking statements, please refer to the Company’s Annual Report on Form 10-K for the fiscal year ended February 29, 2004.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
The Company, as a result of its global operating and financing activities, is exposed to market risk associated with changes in interest rates and foreign currency exchange rates. To manage the volatility relating to these risks, the Company periodically enters into derivative transactions including foreign currency exchange contracts and interest rate swap agreements. The Company uses derivative instruments solely to reduce the financial impact of these risks and does not use derivative instruments for trading purposes.
Foreign currency forward contracts and foreign currency options are used to hedge existing foreign currency denominated assets and liabilities, forecasted foreign currency denominated sales both to third parties as well as intercompany sales, and intercompany principal and interest payments. As of August 31, 2004, the Company had exposures to foreign currency risk primarily related to the Australian dollar, euro, New Zealand dollar, British pound sterling, Canadian dollar and Mexican peso.
As of August 31, 2004, and August 31, 2003, the Company had outstanding derivative contracts with a notional value of $694.6 million and $561.5 million, respectively. Using a sensitivity analysis based on estimated fair value of open contracts using forward rates, if the U.S. dollar had been 10% weaker as of August 31, 2004, and August 31, 2003, the fair value of open foreign exchange contracts would have been increased by $68.8 million and $56.4 million, respectively. Losses or gains from the revaluation or settlement of the related underlying positions would su bstantially offset such gains or losses.
The fair value of fixed rate debt is subject to interest rate risk, credit risk and foreign currency risk. The estimated fair value of the Company’s total fixed rate debt, including current maturities, was $1,062.1 million and $1,025.6 million as of August 31, 2004, and August 31, 2003, respectively. A hypothetical 1% increase from prevailing interest rates as of August 31, 2004, and August 31, 2003, would have resulted in a decrease in fair value of fixed interest rate long-term debt by $39.2 million and $45.6 million, respectively.
In addition to the $1,062.1 million and $1,025.6 million estimated fair value of fixed rate debt outstanding as of August 31, 2004, and August 31, 2003, respectively, the Company also had variable rate debt outstanding (primarily LIBOR based) as of August 31, 2004, and August 31, 2003, of $1,023.6 million and $1,118.5 million, respectively. Using a sensitivity analysis based on a hypothetical 1% increase in prevailing interest rates at August 31, 2004, and August 31, 2003, would result in an approximate increase in cash required for interest of $9.0 million and $9.3 million, respectively.
The Company has on occasion entered into interest rate swap agreements to reduce its exposure to interest rate changes relative to its variable rate debt. As of August 31, 2004, and August 31, 2003, the Company had no interest rate swap agreements outstanding.
