Item 7. 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, imported beer and spirits 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. 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 acquisition-related integration costs, restructuring and related charges and net 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 address 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 wine supplier in the U.K. In addition, the Company leverages its U.K. wholesale business as a strategic 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 through acquisitions and organically), expanding margins and increasing cash flow to achieve superior earnings per share growth and improve return on invested capital.
The environment for the Company’s products is fairly competitive in each of the Company’s key geographic markets, due, in part, to industry and retail consolidation. Competition in the U.S. beers and spirits markets is normally intense, with domestic beer producers increasing brand spending in an effort to gain market share.
Additionally, the supply of certain raw materials, particularly grapes, as well as consumer demand, can affect the overall competitive environment. Two years of lighter than expected California grape harvests, combined with a reduction in wine grape acreage in California, has brought the U.S. grape supply more into balance with demand. This has led to an overall firming of the pricing of wine grape varietals from California. In Australia, two years of record grape harvests have contributed to an oversupply of certain red grape varietals, which has led to an overall reduction in grape costs for these varietals and greater pricing competition in the domestic market.
In Fiscal 2005 (as defined below), the Company’s net sales increased 15.1% over Fiscal 2004 (as defined below) primarily from increases in branded wine net sales, the inclusion of $84.5 million of net sales of products acquired in the Robert Mondavi acquisition, increases in U.K. wholesale net sales and imported beer net sales, the inclusion of an additional one month of net sales of products acquired in the Hardy Acquisition (as defined below) and a favorable foreign currency impact. Operating income increased 16.5% over the comparable prior year period primarily due to a reduction in acquisition-related integration costs, restructuring and related charges and net unusual costs (see below under Fiscal 2005 compared to Fiscal 2004 Operating Income discussion), 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, and increased Corporate general and administrative expenses. Lastly, as a result of the above factors and lower interest expense for Fiscal 2005, net income increased 25.4% 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 year ended February 28, 2005 (“Fiscal 2005”), compared to the year ended February 29, 2004 (“Fiscal 2004”), and Fiscal 2004 compared to the year ended February 28, 2003 (“Fiscal 2003”), and (ii) financial liquidity and capital resources for Fiscal 2005. This discussion and analysis also identifies certain acquisition-related integration costs, restructuring and related charges and net unusual costs expected to affect consolidated results of operations of the Company for the year ending February 28, 2006 (“Fiscal 2006”). This discussion and analysis should be read in conjunction with the Company’s consolidated financial statements and notes thereto included herein.
Common Stock Splits
On April 7, 2005, the Board of Directors of the Company approved two-for-one stock splits of the Company’s Class A Common Stock and Class B Common Stock, which were distributed in the form of stock dividends on May 13, 2005, to stockholders of record on April 29, 2005. Share and per share amounts have been retroactively restated to give effect to these common stock splits.
Acquisitions in Fiscal 2005 and Fiscal 2004 and Equity Method Investment
Acquisition of Robert Mondavi
On December 22, 2004, the Company acquired all of the outstanding capital stock of The Robert Mondavi Corporation (“Robert Mondavi”), a leading premium wine producer based in Napa, California. In connection with the production of its products, Robert Mondavi owns, operates and has an interest in certain wineries and controls certain vineyards. Robert Mondavi produces, markets and sells premium, super premium and fine California winesunder the Woodbridge by Robert Mondavi, Robert Mondavi Private Selection and Robert Mondavi Winery brand names. Woodbridge and Robert Mondavi Private Selection are the leading premium and super-premium wine brands, respectively, in the United States.
The acquisition of Robert Mondavi supports the Company’s strategy of strengthening the breadth of its portfolio across price segments to capitalize on the overall growth in the premium, super-premium and fine wine categories. The Company believes that the acquired Robert Mondavi brand names have strong brand recognition globally. The vast majority of Robert Mondavi’s sales are generated in the United States. The Company intends to leverage the Robert Mondavi brands in the United States through its selling, marketing and distribution infrastructure. The Company also intends to further expand distribution for the Robert Mondavi brands in Europe through its Constellation Europe infrastructure beginning in the first half of fiscal 2006.
The Company and Robert Mondavi have complementary businesses that share a common growth orientation and operating philosophy. The Robert Mondavi acquisition provides the Company with a greater presence in the fine wine sector within the United States and the ability to capitalize on the broader geographic distribution in strategic international markets. The Robert Mondavi acquisition supports the Company’s strategy of growth and breadth across categories and geographies, and strengthens its competitive position in its core markets. In particular, the Company believes there are growth opportunities for premium, super-premium and fine wines in the United Kingdom, United States and other wine markets. Total consideration paid in cash to the Robert Mondavi shareholders was $1,030.7 million. Additionally, the Company expects to incur direct acquisition costs of $11.2 million. The purchase price was financed with borrowings under the Company’s 2004 Credit Agreement (as defined below). In accordance with the purchase method of accounting, the acquired net assets are recorded at fair value at the date of acquisition. The purchase price was based primarily on the estimated future operating results of Robert Mondavi, including the factors described above, as well as an estimated benefit from operating cost synergies.
The results of operations of the Robert Mondavi business are reported in the Constellation Wines segment and are included in the consolidated results of operations of the Company from the date of acquisition. The acquisition of Robert Mondavi is significant and the Company expects it to have a material impact on the Company’s future results of operations, financial position and cash flows. In particular, the Company expects its future results of operations to be significantly impacted by, among other things, the flow through of anticipated inventory step-up and adverse grape cost, acquisition-related integration costs, restructuring and related charges, and interest expense associated with the 2004 Credit Agreement (as defined below). Adverse grape cost represents the amount of historical inventory cost on Robert Mondavi’s balance sheet that exceeds the Company’s estimated ongoing grape cost and is primarily due to the purchase of grapes by Robert Mondavi prior to the acquisition date at above-market prices as required under the terms of their existing grape purchase contracts.
In connection with the Robert Mondavi acquisition and Robert Mondavi’s previously disclosed intention to sell certain of its winery properties and related assets, and other vineyard properties, the Company has classified certain assetsasheld for sale as of February 28, 2005. The Company expects to sell these assets inFiscal 2006 for net proceeds of approximately $150 million to $175 million. As of April 30, 2005, the Company has received net proceeds of $127.9 million. No gain or loss has been or is expected to be recognized upon the sale of these assets.
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 Fiscal 2004. 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 $400.0 million of borrowings under the Company’s then existing bridge loan agreement. Additionally, the Company issued 6,577,826 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 Fiscal 2005 include the results of operations of Hardy and PWP for the entire period, whereas the results of operations for Fiscal 2004 only include the results of operations of Hardy and PWP from March 27, 2003, to the end of Fiscal 2004.
Investment in Ruffino
On December 3, 2004, the Company purchased a 40 percent interest in Ruffino S.r.l. (“Ruffino”), the well-known Italian fine wine company, for a preliminary purchase price of $86.1 million. The purchase price is subject to final closing adjustments which the Company does not expect to be material. As of February 1, 2005, the Constellation Wines segment began distributing Ruffino’s products in the United States. The Company accounts for the investment under the equity method; accordingly, the results of operations of Ruffino from December 3, 2004, are included in the equity in earnings of equity method investees line in the Company’s Consolidated Statements of Income.
Results of Operations
Fiscal 2005 Compared to Fiscal 2004
Net Sales
The following table sets forth the net sales (in thousands of dollars) by operating segment of the Company for Fiscal 2005 and Fiscal 2004.
| | | Fiscal 2005 Compared to Fiscal 2004 | |
| | | Net Sales | |
| | | 2005 | | 2004 | | %Increase(Decrease) | |
| Constellation Wines: | | | | | | | |
Branded wine | | $ | 1,830,808 | | $ | 1,549,750 | | | 18.1 | % |
Wholesale and other | | | 1,020,600 | | | 846,306 | | | 20.6 | % |
| Constellation Wines net sales | | $ | 2,851,408 | | $ | 2,396,056 | | | 19.0 | % |
| Constellation Beers and Spirits: | | | | | | | | | | |
Imported beers | | $ | 922,947 | | $ | 862,637 | | | 7.0 | % |
Spirits | | | 313,283 | | | 284,551 | | | 10.1 | % |
| Constellation Beers and Spirits net sales | | $ | 1,236,230 | | $ | 1,147,188 | | | 7.8 | % |
| Corporate Operations and Other | | $ | - | | $ | - | | | N/A | |
| Unusual gain | | $ | - | | $ | 9,185 | | | (100.0 | )% |
| Consolidated Net Sales | | $ | 4,087,638 | | $ | 3,552,429 | | | 15.1 | % |
Net sales for Fiscal 2005 increased to $4,087.6 million from $3,552.4 million for Fiscal 2004, an increase of $535.2 million, or 15.1%. This increase resulted primarily from an increase in branded wine net sales of $217.8 million (on a constant currency basis), including $84.2 million of net sales of branded wines acquired in the Robert Mondavi acquisition and $45.7 million of net sales of branded wines acquired in the Hardy Acquisition; an increase in U.K. wholesale net sales of $84.1 million (on a constant currency basis); and an increase in imported beer net sales of $60.3 million. In addition, net sales benefited from a favorable foreign currency impact of $155.5 million.
Constellation Wines
Net sales for Constellation Wines increased to $2,851.4 million for Fiscal 2005 from $2,396.1 million in Fiscal 2004, an increase of $455.4 million, or 19.0%. Branded wine net sales increased $281.1 million. This increase resulted from increased branded wine net sales in the U.S., Europe and Australasia of $217.8 million (on a constant currency basis), including $84.2 million of net sales of branded wines acquired in the Robert Mondavi acquisition and 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 $63.3 million. The increases in branded wine net sales in the U.S., Europe and Australasia are primarily due to volume growth as the Company continues to benefit from increased distribution and greater consumer demand for premium wines. Wholesale and other net sales increased $174.3 million primarily due to growth in the U.K. wholesale business of $84.1 million (on a constant currency basis) and a favorable foreign currency impact of $92.2 million. The net sales increase in the U.K. wholesale business on a local currency basis is primarily due to the addition of new national accounts in the first quarter of fiscal 2005 and increased sales in existing accounts during Fiscal 2005.
Constellation Beers and Spirits
Net sales for Constellation Beers and Spirits increased to $1,236.2 million for Fiscal 2005 from $1,147.2 million for Fiscal 2004, an increase of $89.0 million, or 7.8%. This increase resulted from a $60.3 million increase in imported beer net sales and an increase in spirits net sales of $28.7 million. The growth in imported beer sales is primarily due to a price increase on the Company’s Mexican beer portfolio, which was introduced in January 2004. The growth in spirits net sales is attributable to increases in both the Company’s contract production net sales as well as volume growth in branded net sales.
Gross Profit
The Company’s gross profit increased to $1,140.6 million for Fiscal 2005 from $975.8 million for Fiscal 2004, an increase of $164.8 million, or 16.9%. The Constellation Wines segment’s gross profit increased $122.6 million primarily due to the additional two months of sales of products acquired in the Robert Mondavi acquisition, volume growth in the U.S. branded wine net sales and a favorable foreign currency impact. The Constellation Beers and Spirits segment’s gross profit increased $30.6 million primarily due to the increase in imported beer net sales and volume growth in the segment’s spirits portfolio. In addition, net 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 $11.6 million in Fiscal 2005 versus Fiscal 2004. This decrease resulted from a $16.8 million write-down of commodity concentrate inventory in Fiscal 2004 in connection with the Company’s decision to exit the commodity concentrate product line in the U.S. (see additional discussion under “Restructuring and Related Charges” below) and reduced flow through of inventory step-up associated with the Hardy and Robert Mondavi acquisitions of $16.0 million, partially offset by the relief from certain excise tax, duty and other costs incurred in prior years of $11.5 million, which was recognized in the fourth quarter of fiscal 2004, and the flow through of adverse grape cost associated with the Robert Mondavi acquisition of $9.8 million in Fiscal 2005. Gross profit as a percent of net sales increased to 27.9% for Fiscal 2005 from 27.5% for Fiscal 2004 primarily due to the lower net unusual costs.
Selling, General and Administrative Expenses
Selling, general and administrative expenses increased to $555.7 million for Fiscal 2005 from $457.3 million for Fiscal 2004, an increase of $98.4 million, or 21.5%. The Constellation Wines segment’s selling, general and administrative expenses increased $64.7 million primarily due to increased selling and advertising expenses as the Company continues to invest behind specific wine brands to drive broader distribution and additional selling, general and administrative expenses from the addition of the Robert Mondavi business. The Constellation Beers and Spirits segment’s selling, general and administrative expenses increased $7.1 million primarily due to increased imported beer and spirits selling expenses to support the growth across this segment’s businesses. The Corporate Operations and Other segment’s selling, general and administrative expenses increased $13.7 million primarily due to increased general and administrative expenses to support the Company’s growth and costs associated with higher professional services fees, including costs incurred in connection with compliance activities associated with the Sarbanes-Oxley Act of 2002. Lastly, there was an increase of $12.9 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 includes $31.7 million of financing costs recorded in Fiscal 2005 related to (i) the Company’s redemption of its Senior Subordinated Notes (as defined below) and (ii) the Company’s new senior credit facility entered into in connection with the Robert Mondavi acquisition as compared to $11.6 million of financing costs recorded in Fiscal 2004 in connection with the Hardy Acquisition. Partially offsetting the $20.1 million increase in financing costs were net gains recorded in Fiscal 2005 on the sales of non-strategic assets and the receipt of a payment associated with the termination of a previously announced potential fine wine joint venture. Selling, general and administrative expenses as a percent of net sales increased to 13.6% for Fiscal 2005 as compared to 12.9% for Fiscal 2004 primarily due to the growth in the Corporate Operations and Other segment’s general and administrative expenses and the increased net unusual costs described above.
Restructuring and Related Charges
The Company recorded $7.6 million of restructuring and related charges for Fiscal 2005 associated with the restructuring plans of the Constellation Wines segment. Restructuring and related charges resulted from (i) the further realignment of business operations as previously announced in Fiscal 2004, (ii) the Company’s decision in Fiscal 2004 to exit the commodity concentrate product line in the U.S. (collectively, the “Fiscal 2004 Plan”), and (iii) the Company’s decision to restructure and integrate the operations of Robert Mondavi (the “Robert Mondavi Plan”). The Company is in the process of refining the Robert Mondavi Plan which will be finalized during Fiscal 2006. Restructuring and related charges included $3.8 million of employee termination benefit costs (net of reversal of prior accruals of $0.2 million), $1.5 million of contract termination costs, $1.0 million of facility consolidation and relocation costs, and other related charges of $1.3 million. The Company recorded $31.2 million of restructuring and related charges for Fiscal 2004 associated with the Fiscal 2004 Plan. In total, the Company recorded $48.0 million of costs for Fiscal 2004 allocated between cost of product sold and restructuring and related charges associated with the Fiscal 2004 Plan.
For Fiscal 2006, the Company expects to incur total restructuring and related charges of $4.9 million associated with the restructuring plans of the Constellation Wines segment. These charges are expected to consist of $1.7 million related to the further realignment of business operations in the Constellation Wines segment and $3.2 million related to the Robert Mondavi Plan.
Acquisition-Related Integration Costs
The Company recorded $9.4 million of acquisition-related integration costs for Fiscal 2005 associated with the Robert Mondavi Plan. Acquisition-related integration costs included $4.9 million of employee related costs and $4.5 million of facilities and other one-time costs. The Company expects to incur $14 million of acquisition-related integration costs for Fiscal 2006. These charges are expected to consist of $5 million of employee related costs and $9 million of facilities and other one-time costs.
Operating Income
The following table sets forth the operating income (loss) (in thousands of dollars) by operating segment of the Company for Fiscal 2005 and Fiscal 2004.
| | | Fiscal 2005 Compared to Fiscal 2004 | |
| | | Operating Income (Loss) | |
| | | 2005 | | 2004 | | % Increase/ (Decrease) | |
| Constellation Wines | | $ | 406,562 | | $ | 348,132 | | | 16.8 | % |
| Constellation Beers and Spirits | | | 276,109 | | | 252,533 | | | 9.3 | % |
| Corporate Operations and Other | | | (55,980 | ) | | (41,717 | ) | | 34.2 | % |
Total Reportable Segments | | | 626,691 | | | 558,948 | | | 12.1 | % |
Acquisition-Related Integration Costs, Restructuring and Related Charges and Net Unusual Costs | | | (58,795 | ) | | (71,591 | ) | | (17.9 | )% |
| Consolidated Operating Income | | $ | 567,896 | | $ | 487,357 | | | 16.5 | % |
As a result of the factors discussed above, consolidated operating income increased to $567.9 million for Fiscal 2005 from $487.4 million for Fiscal 2004, an increase of $80.5 million, or 16.5%. Acquisition-related integration costs, restructuring and related charges and net unusual costs of $58.8 million for Fiscal 2005 consist of certain costs that are excluded by management in their evaluation of the results of each operating segment. These costs represent financing costs associated with the redemption of the Company’s Senior Subordinated Notes and the Company’s new senior credit facility entered into in connection with the Robert Mondavi acquisition of $31.7 million, adverse grape cost and acquisition-related integration costs associated with the Company’s acquisition of Robert Mondavi of $9.8 million and $9.4 million, respectively, restructuring and related charges of $7.6 million in the wine segment associated with the Company’s realignment of its business operations and the Robert Mondavi acquisition, and the flow through of inventory step-up associated with the Hardy and Robert Mondavi acquisitions of $6.4 million, partially offset by a net gain on the sale of non-strategic assets of $3.1 million and a gain related to the receipt of a payment associated with the termination of a previously announced potential fine wine joint venture of $3.0 million. Acquisition-related integration costs, restructuring and related charges and net unusual costs of $71.6 million for Fiscal 2004 represent the flow through of inventory step-up and the amortization of deferred financing costs associated with the Hardy Acquisition of $22.5 million and $11.6 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 $31.1 million, partially offset by the relief from certain excise taxes, duty and other costs incurred in prior years of $10.4 million.
Interest Expense, Net
Interest expense, net of interest income of $2.3 million and $3.6 million for Fiscal 2005 and Fiscal 2004, respectively, decreased to $137.7 million for Fiscal 2005 from $144.7 million for Fiscal 2004, a decrease of $7.0 million, or (4.8%). The decrease resulted from lower average borrowing rates in Fiscal 2005 as well as lower average borrowings. 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 rate revolver debt. The reduction in average borrowings 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, partially offset by additional borrowings in the fourth quarter of fiscal 2005 to finance the Robert Mondavi acquisition.
Provision for Income Taxes
The Company’s effective tax rate remained the same at 36.0% for Fiscal 2005 and Fiscal 2004.
Net Income
As a result of the above factors, net income increased to $276.5 million for Fiscal 2005 from $220.4 million for Fiscal 2004, an increase of $56.1 million, or 25.4%.
Fiscal 2004 Compared to Fiscal 2003
Net Sales
The following table sets forth the net sales (in thousands of dollars) by operating segment of the Company for Fiscal 2004 and Fiscal 2003.
| | | Fiscal 2004 Compared to Fiscal 2003 | |
| | | Net Sales | |
| | | 2004 | | 2003 | | % Increase | |
| Constellation Wines: | | | | | | | | | | |
Branded wines | | $ | 1,549,750 | | $ | 983,505 | | | 57.6 | % |
Wholesale and other | | | 846,306 | | | 689,794 | | | 22.7 | % |
| Constellation Wines net sales | | $ | 2,396,056 | | $ | 1,673,299 | | | 43.2 | % |
| Constellation Beers and Spirits: | | | | | | | | | | |
Imported beers | | $ | 862,637 | | $ | 776,006 | | | 11.2 | % |
Spirits | | | 284,551 | | | 282,307 | | | 0.8 | % |
| Constellation Beers and Spirits net sales | | $ | 1,147,188 | | $ | 1,058,313 | | | 8.4 | % |
| Corporate Operations and Other | | $ | - | | $ | - | | | N/A | |
| Unusual gain | | $ | 9,185 | | $ | - | | | N/A | |
| Consolidated Net Sales | | $ | 3,552,429 | | $ | 2,731,612 | | | 30.0 | % |
Net sales for Fiscal 2004 increased to $3,552.4 million from $2,731.6 million for Fiscal 2003, an increase of $820.8 million, or 30.0%.This increase resulted primarily from the inclusion of $571.4 million of net sales of products acquired in the Hardy Acquisition as well as increases in imported beer sales of $86.6 million and U.K. wholesale sales of $61.1 million (on a constant currency basis). In addition, net sales benefited from a favorable foreign currency impact of $74.6 million.
Constellation Wines
Net sales for the Constellation Wines segment for Fiscal 2004 increased to $2,396.1million from $1,673.3 million for Fiscal 2003, an increase of $722.8million, or 43.2%.Branded wine net sales increased $566.2 million, primarily due to the addition of $548.4 million of net sales of branded wine acquired in the Hardy Acquisition. Wholesale and other net sales increased $156.5 million primarily due to a favorable foreign currency impact of $63.1 million, growth in the U.K. wholesale business of $61.1 million (on a constant currency basis), and the addition of $23.0 million of net sales of bulk wine acquired in the Hardy Acquisition. The net sales increase in the U.K. Wholesale business on a local currency basis is primarily due to the addition of new accounts and increased average delivery sizes as the Company’s national accounts business continues to grow.
Constellation Beers and Spirits
Net sales for the Constellation Beers and Spirits segment for Fiscal 2004 increased to $1,147.2 million from $1,058.3 million for Fiscal 2003, an increase of $88.9 million, or 8.4%. This increase resulted primarily from volume gains on the Company’s imported beer portfolio, which increased $86.6 million. Spirits net sales remained relatively flat as increased branded spirits sales were offset by lower bulk whisky and contract production sales.
The Company’s gross profit increased to $975.8 million for Fiscal 2004 from $760.7 million for Fiscal 2003, an increase of $215.1 million, or 28.3%. The Constellation Wines segment’s gross profit increased $200.4 million primarily due to gross profit on the sales of branded wine acquired in the Hardy Acquisition. The Constellation Beers and Spirits segment’s gross profit increased $42.5 million primarily due to the volume growth in the segment’s imported beer portfolio. These increases were partially offset by $27.8 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. These net costs represent the flow through of inventory step-up associated with the Hardy Acquisition of $22.5 million and the write-down of concentrate inventory recorded in connection with the Company’s decision to exit the commodity concentrate product line of $16.8 million (see additional discussion under “Restructuring and Related Charges” below), partially offset by the relief from certain excise tax, duty and other costs incurred in prior years of $11.5 million, which was recognized in the fourth quarter of fiscal 2004. Gross profit as a percent of net sales decreased slightly to 27.5% for Fiscal 2004 from 27.8% for Fiscal 2003 as an increase in gross profit margin from sales of higher margin wine brands acquired in the Hardy Acquisition was more than offset by the net unusual costs discussed above and a decrease in gross profit margin on the Constellation Wines’ U.K. wholesale business.
Selling, General and Administrative Expenses
Selling, general and administrative expenses increased to $457.3 million for Fiscal 2004 from $351.0 million for Fiscal 2003, an increase of $106.3 million, or 30.3%. The Constellation Wines segment’s selling, general and administrative expenses increased $76.8 million primarily due to $67.7 million of selling, general and administrative expenses from the addition of the Hardy and PWP businesses. The Constellation Beers and Spirits segment’s selling, general and administrative expenses increased $7.9 million due to increased imported beer and spirits advertising and selling expenses to support the growth across this segment’s businesses, partially offset by foreign currency gains. The Corporate Operations and Other segment’s general and administrative expenses increased $8.9 million primarily due to additional deferred financing costs associated with the Company’s new bank credit facility and increased general and administrative expenses to support the Company’s growth. In addition, there was a $12.7 million increase in selling, general and administrative expenses related to net unusual costs which consist of certain items that are excluded by management in their evaluation of the results of each operating segment. These costs consist primarily of the additional amortized deferred financing costs associated with the bridge financing in connection with the Hardy Acquisition of $11.6 million. Selling, general and administrative expenses as a percent of net sales increased slightly to 12.9% for Fiscal 2004 as compared to 12.8% for Fiscal 2003 due primarily to the net unusual costs and the increased general and administrative expenses within the Corporate Operations and Other segment as discussed above.
Restructuring and Related Charges
The Company recorded $31.2 million of restructuring and related charges for Fiscal 2004 associated with the restructuring plan of the Constellation Wines segment. Restructuring and related charges resulted from (i) $10.0 million related to the realignment of business operations and (ii) $21.2 million related to exiting the commodity concentrate product line in the U.S. and selling its winery located in Escalon, California. In total, the Company recorded $38.0 million of costs associated with exiting the commodity concentrate product line and selling its Escalon facility allocated between cost of product sold ($16.8 million) and restructuring and related charges ($21.2 million).
The Company recorded $4.8 million of restructuring and related charges for Fiscal 2003 associated with an asset impairment charge in connection with two of Constellation Wines segment’s production facilities.
Operating Income
The following table sets forth the operating income (loss) (in thousands of dollars) by operating segment of the Company for Fiscal 2004 and Fiscal 2003.
| | | Fiscal 2004 Compared to Fiscal 2003 | |
| | | Operating Income (Loss) | |
| | | 2004 | | 2003 | | % Increase | |
| Constellation Wines | | $ | 348,132 | | $ | 224,556 | | | 55.0 | % |
| Constellation Beers and Spirits | | | 252,533 | | | 217,963 | | | 15.9 | % |
| Corporate Operations and Other | | | (41,717 | ) | | (32,797 | ) | | 27.2 | % |
Total Reportable Segments | | | 558,948 | | | 409,722 | | | 36.4 | % |
Acquisition-Related Integration Costs Restructuring and Related Charges and Net Unusual Costs | | | (71,591 | ) | | (4,764 | ) | | 1402.7 | % |
| Consolidated Operating Income | | $ | 487,357 | | $ | 404,958 | | | 20.3 | % |
As a result of the factors discussed above, consolidated operating income increased to$487.4 million for Fiscal 2004 from $405.0 million for Fiscal 2003, an increase of $82.4 million, or 20.3%. Acquisition-related integration costs, restructuring and related charges and net unusual costs of $71.6 million and $4.8 million for Fiscal 2004 and Fiscal 2003, respectively, consist of certain costs that are excluded by management in their evaluation of the results of each operating segment. Fiscal 2004 costs represent the flow through of inventory step-up and the amortization of deferred financing costs associated with the Hardy Acquisition of $22.5 million and $11.6 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 concentrate inventory of $16.8 million and restructuring and related charges of $31.2 million, partially offset by the relief from certain excise taxes, duty and other costs incurred in prior years of $10.4 million. Fiscal 2003 costs represent restructuring and related charges associated with the Company’s realignment of its business operations in the wine segment.
Gain on Change in Fair Value of Derivative Instruments
The Company entered into a foreign currency collar contract in February 2003 in connection with the Hardy Acquisition to lock in a range for the cost of the acquisition in U.S. dollars. As of February 28, 2003, this derivative instrument had a fair value of $23.1 million. Under SFAS No. 133, a transaction that involves a business combination is not eligible for hedge accounting treatment. As such, the derivative was recorded on the balance sheet at its fair value with the change in the fair value recognized separately on the Company’s Consolidated Statements of Income. During the first quarter of fiscal 2004, the gain on change in fair value of the derivative instrument of $1.2 million was recognized separately on the Company’s Consolidated Statement of Income.
Equity in Earnings of Equity Method Investees
The Company’s equity in earnings of equity method investees decreased to $0.5 million in Fiscal 2004 from $12.2 million in Fiscal 2003 due to the acquisition of the remaining 50% ownership of PWP in March 2003 resulting in consolidation of PWP’s results of operations since the date of acquisition.
Interest Expense, Net
Interest expense, net of interest income of $3.6 million and $0.8 million for Fiscal 2004 and Fiscal 2003, respectively, increased to $144.7 million for Fiscal 2004 from $105.4 million for Fiscal 2003, an increase of $39.3 million, or 37.3%.The increase resulted from higher average borrowings due to the financing of the Hardy Acquisition, partially offset by a lower average borrowing rate, and $1.7 million of imputed interest expense related to the Hardy Acquisition.
Provision for Income Taxes
The Company’s effective tax rate for Fiscal 2004 declined to 36.0% from 39.3% for Fiscal 2003 as a result of the Hardy Acquisition, which significantly increased the allocation of income to jurisdictions with lower income tax rates.
Net Income
As a result of the above factors, net income increased to $220.4 million for Fiscal 2004 from $203.3 million for Fiscal 2003, an increase of $17.1 million, or 8.4%.
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 highest 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 stock 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 May 16, 2005, the entire $750.0 million of capacity was available under the shelf registration statement.
Fiscal 2005 Cash Flows
Operating Activities
Net cash provided by operating activities for Fiscal 2005 was $320.7 million, which resulted from $276.5 million of net income, plus $176.0 million of net noncash items charged to the Consolidated Statement of Income, less $131.7 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, deferred tax provision and the noncash portion of loss on extinguishment of debt. The net change in operating assets and liabilities resulted primarily from increases in accounts receivable and inventories. The increases in accounts receivable and inventories are primarily as a result of the Company’s growth in Fiscal 2005.
Investing Activities
Net cash used in investing activities for Fiscal 2005 was $1,222.9 million, which resulted primarily from net cash paid of $1,052.5 million for purchases of businesses and $119.7 million of capital expenditures.
Financing Activities
Net cash provided by financing activities for Fiscal 2005 was $884.2 million resulting primarily from proceeds from issuance of long-term debt of $2,400.0 million, partially offset by principal payments of long-term debt of $1,488.7 million.
Fiscal 2004 Cash Flows
Operating Activities
Net cash provided by operating activities for Fiscal 2004 was $340.3 million, which resulted from $220.4 million of net income, plus $137.9 million of net noncash items charged to the Consolidated Statement of Income, less $18.0 million representing the net change in the Company’s operating assets and liabilities. The net non-cash items consisted primarily of depreciation of property, plant and equipment, deferred tax provision and amortization of intangible and other assets. The net change in operating assets and liabilities resulted primarily from an increase in accounts receivable and a decrease in accounts payable, partially offset by a decrease in inventories and an increase in accrued advertising and promotion.
Investing Activities
Net cash used in investing activities for Fiscal 2004 was $1,158.5 million, which resulted primarily from net cash paid of $1,069.5 million for the purchases of businesses and $105.1 million of capital expenditures.
Financing Activities
Net cash provided by financing activities for Fiscal 2004 was $745.2 million resulting primarily from proceeds of $1,600.0 million from issuance of long-term debt, including $1,060.2 million of long-term debt incurred to acquire Hardy, plus net proceeds from the 2003 Equity Offerings (as defined below) of $426.1 million. This amount was partially offset by principal payments of long-term debt of $1,282.3 million.
During June 1998, the Company’s Board of Directors authorized the repurchaseof 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 May 16, 2005, the Company had purchased a total of 8,150,688 shares of Class A Common Stock at an aggregate cost of $44.9 million, or at an average cost of $5.51 per share. Of this total amount, no shares were repurchased during Fiscal 2005, Fiscal 2004 or Fiscal 2003.
Debt
Total debt outstanding as of February 28, 2005, amounted to $3,289.3 million, an increase of $1,241.4million from February 29, 2004. The ratio of total debt to total capitalization increased to54.2% as of February 28, 2005, from 46.3% as of February 29, 2004, primarily as a result of the additional borrowings in the fourth quarter of fiscal 2005 to finance the acquisition of Robert Mondavi.
Senior Credit Facility
2004 Credit Agreement
In connection with the acquisition of Robert Mondavi, on December 22, 2004, the Company and its U.S. subsidiaries (excluding certain inactive subsidiaries), together with certain of its subsidiaries organized in foreign jurisdictions, JPMorgan Chase Bank, N.A. as a lender and administrative agent, and certain other agents, lenders, and financial institutions entered into a new credit agreement (the “2004 Credit Agreement”). The 2004 Credit Agreement provides for aggregate credit facilities of $2.9 billion, consisting of a $600.0 million tranche A term loan facility due in November 2010, a $1.8 billion tranche B term loan facility due in November 2011, and a $500.0 million revolving credit facility (including a sub-facility for letters of credit of up to $60.0 million) which terminates in December 2010. Proceeds of the 2004 Credit Agreement were used to pay off the Company’s obligations under its prior senior credit facility, to fund the cash consideration payable in connection with its acquisition of Robert Mondavi, and to pay certain obligations of Robert Mondavi, including indebtedness outstanding under its bank facility and unsecured notes of $355.4 million. The Company uses the remaining availability under the 2004 Credit Agreement to fund its working capital needs on an as needed basis. In connection with entering into the 2004 Credit Agreement, the Company recorded a charge of $21.4 million in selling, general and administrative expenses for the write-off of bank fees related to the repayment of the Company’s prior senior credit facility in the fourth quarter of fiscal 2005.
The tranche A term loan facility and the tranche B term loan facility were fully drawn on December 22, 2004. As of February 28, 2005, 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) | | | | | | | |
| 2006 | | $ | 60,000 | | $ | - | | $ | 60,000 | |
| 2007 | | | 67,500 | | | 17,168 | | | 84,668 | |
| 2008 | | | 97,500 | | | 17,168 | | | 114,668 | |
| 2009 | | | 120,000 | | | 17,168 | | | 137,168 | |
| 2010 | | | 127,500 | | | 17,168 | | | 144,668 | |
| Thereafter | | | 112,500 | | | 1,626,828 | | | 1,739,328 | |
| | | $ | 585,000 | | $ | 1,695,500 | | $ | 2,280,500 | |
The rate of interest payable, at the Company’s option, is a function of 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 2004 Credit Agreement) and, with respect to LIBOR borrowings, ranges between 1.00% and 1.75%. As of February 28, 2005, the LIBOR margin for the revolving credit facility and the tranche A term loan facility is 1.50%, while the LIBOR margin on the tranche B term loan facility is 1.75%.
The Company’s obligations are guaranteed by its U.S. subsidiaries (excluding certain inactive subsidiaries) and by certain of its foreign subsidiaries. These obligations are also secured by a pledge of (i) 100% of the ownership interests in most of the Company’s U.S. subsidiaries and (ii) 65% of the voting capital stock of certain of the Company’s foreign subsidiaries.
The Company and its subsidiaries are also 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, the disposition and acquisition of property and the making of certain investments, in each case subject to numerous baskets, exceptions and thresholds. The financial covenants are limited to maximum total debt and senior debt coverage ratios and minimum fixed charges and interest coverage ratios. As of February 28, 2005, the Company is in compliance with all of its covenants under its 2004 Credit Agreement.
As of February 28, 2005, under the 2004 Credit Agreement, the Company had outstanding tranche A term loans of $585.0 million bearing a weighted average interest rate of 4.3%, tranche B term loans of $1,695.5 billion bearing a weighted average interest rate of 4.4%, revolving loans of $14.0 million bearing a weighted average interest rate of 3.8%, undrawn revolving letters of credit of $36.7 million, and $449.3 million in revolving loans available to be drawn.
As of February 28, 2005, the Company had outstanding five year interest rate swap agreements to minimize interest rate volatility. The swap agreements fix LIBOR interest rates on $1,200.0 million of the Company’s floating LIBOR rate debt at an average rate of 4.1% over the five-year term. Subsequent to February 28, 2005, the Company monetized the value of the interest rate swaps by replacing them with new swaps which extended the hedged period through fiscal 2010. The Company received $30.3 million in proceeds from the unwinding of the original swaps. This amount will be reclassified from Accumulated Other Comprehensive Income ratably into earnings in the same period in which the original hedged item is recorded in the Consolidated Statement of Income. The effective interest rate remains the same under the new swap structure at 4.1%.
Foreign Subsidiary Facilities
The Company has additional credit arrangements available totaling $176.0 million as of February 28, 2005. These arrangements support the financing 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 February 28, 2005, amounts outstanding under the subsidiary credit arrangements were $34.0 million.
Senior Notes
As of February 28, 2005, 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 February 28, 2005, the Company had outstanding £1.0 million ($1.9 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 February 28, 2005, the Company had outstanding £154.0 million ($295.4 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 February 28, 2005, 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. On March 11, 2004, the Senior Subordinated Notes were redeemed with proceeds from the revolving credit facility under the Company’s then existing senior credit facility at 104.25% of par plus accrued interest. During Fiscal 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 associated with the original issuance of the Senior Subordinated Notes.
As of February 28, 2005, 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.
Contractual Obligations and Commitments
The following table sets forth information about the Company’s long-term contractual obligations outstanding at February 28, 2005. It brings together data for easy reference from the consolidated balance sheet and from individual notes to the Company’s consolidated financial statements. See Notes 9, 11, 12, 13 and 14 to the Company’s consolidated financial statements located in Item 8 of this Annual Report on Form 10-K for detailed discussion of items noted in the following table.
| | | PAYMENTS DUE BY PERIOD | |
| | | Total | | Less than 1 year | | 1-3 years | | 3-5 years | | After 5 years | |
(in thousands) | | | | | | | | | | | |
Contractual obligations | | | | | | | | | | | |
| Notes payable to banks | | $ | 16,475 | | $ | 16,475 | | $ | - | | $ | - | | $ | - | |
Long-term debt (excluding unamortized discount) | | | 3,273,258 | | | 68,094 | | | 619,746 | | | 594,249 | | | 1,991,169 | |
| Operating leases | | | 408,221 | | | 52,952 | | | 91,094 | | | 63,060 | | | 201,115 | |
| Other long term liabilities | | | 358,316 | | | 88,410 | | | 111,926 | | | 59,367 | | | 98,613 | |
Unconditional purchase obligations(1) | | | 2,755,098 | | | 470,788 | | | 731,604 | | | 501,588 | | | 1,051,118 | |
Total contractual obligations | | $ | 6,811,368 | | $ | 696,719 | | $ | 1,554,370 | | $ | 1,218,264 | | $ | 3,342,015 | |
(1) | Total unconditional purchase obligations consist of $27.2 million for contracts to purchase various spirits over the next eight fiscal years, $2,499.7 million for contracts to purchase grapes over the next ten fiscal years, $132.1 million for contracts to purchase bulk wine over the next seven fiscal years, $80.0 million for processing contracts over the next ten fiscal years, and $16.0 million for sweetener purchase contracts over the next two fiscal years. See Note 14 to the Company’s consolidated financial statements located in Item 8 of this Annual Report on Form 10-K for a detailed discussion of these items. |
Equity Offerings
During July 2003, the Company completed a public offering of 19,600,000 shares of its Class A Common Stock resulting in net proceeds to the Company, after deducting underwriting discounts and expenses, of $261.2 million. In addition, the Company also completed a public offering of 170,500 shares of its 5.75% Series A Mandatory Convertible Preferred Stock (“Preferred Stock”) resulting in net proceeds to the Company, after deducting underwriting discounts and expenses, of $164.9 million. The Class A Common Stock offering and the Preferred Stock offering are referred to together as the “2003 Equity Offerings.” The majority of the net proceeds from the 2003 Equity Offerings were used to repay the Company’s then existing bridge loans that were incurred to partially finance the Hardy Acquisition. The remaining proceeds were used to repay term loan borrowings under the Company’s then existing senior credit facility.
Capital Expenditures
During Fiscal 2005, the Company incurred $119.7 million for capital expenditures. The Company plans to spend approximately $140 million for capital expenditures in Fiscal 2006. In addition, the Company continues to consider the purchase, lease and development of vineyards and may incur additional expenditures for vineyards if opportunities become available. See “Business - Sources and Availability of Raw Materials” under Item 1 of this Annual Report on Form 10-K. Management reviews the capital expenditure program periodically and modifies it as required to meet current business needs.
Effects of Inflation and Changing Prices
The Company’s results of operations and financial condition have not been significantly affected by inflation and changing prices. The Company has been able, subject to normal competitive conditions, to pass along rising costs through increased selling prices. There can be no assurances, however, that the Company will continue to be able to pass along rising costs through increased selling prices.
Critical Accounting Policies
The Company’s significant accounting policies are more fully described in Note 1 to the Company’s consolidated financial statements located in Item 8 of this Annual Report on Form 10-K. However, certain of the Company’s accounting policies are particularly important to the portrayal of the Company’s financial position and results of operations and require the application of significant judgment by the Company’s management; as a result they are subject to an inherent degree of uncertainty. In applying those policies, the Company’s management uses its judgment to determine the appropriate assumptions to be used in the determination of certain estimates. Those estimates are based on the Company’s historical experience, the Company’s observance of trends in the industry, information provided by the Company’s customers and information available from other outside sources, as appropriate. On an ongoing basis, the Company reviews its estimates to ensure that they appropriately reflect changes in the Company’s business. The Company’s critical accounting policies include:
| · | Accounting for promotional activities.Sales reflect reductions attributable to consideration given to customers in various customer incentive programs, including pricing discounts on single transactions, volume discounts, promotional and advertising allowances, coupons, and rebates. Certain customer incentive programs require management to estimate the cost of those programs. The accrued liability for these programs is determined through analysis of programs offered, historical trends, expectations regarding customer and consumer participation, sales and payment trends, and experience with payment patterns associated with similar programs that had been previously offered. If assumptions included in the Company’s estimates were to change or market conditions were to change, then material incremental reductions to revenue could be required, which would have a material adverse impact on the Company’s financial statements. Promotional costs were $390.9 million, $336.4 million and $231.6 million for Fiscal 2005, Fiscal 2004 and Fiscal 2003, respectively. |
| · | Inventory valuation. Inventories are stated at the lower of cost or market, cost being determined on the first-in, first-out method. The Company assesses the valuation of its inventories and reduces the carrying value of those inventories that are obsolete or in excess of the Company’s forecasted usage to their estimated net realizable value. The Company estimates the net realizable value of such inventories based on analyses and assumptions including, but not limited to, historical usage, future demand and market requirements. Reductions to the carrying value of inventories are recorded in cost of goods sold. If the future demand for the Company’s products is less favorable than the Company’s forecasts, then the value of the inventories may be required to be reduced, which could result in material additional expense to the Company and have a material adverse impact on the Company’s financial statements. |
| · | Accounting for business combinations. The acquisition of businesses is an important element of the Company’s strategy. Under the purchase method, the Company is required to record the net assets acquired at the estimated fair value at the date of acquisition. The determination of the fair value of the assets acquired and liabilities assumed requires the Company to make estimates and assumptions that affect the Company’s financial statements. For example, the Company’s acquisitions typically result in goodwill and other intangible assets; the value and estimated life of those assets may affect the amount of future period amortization expense for intangible assets with finite lives as well as possible impairment charges that may be incurred. |
| · | Impairment of goodwill and intangible assets with indefinite lives. Intangible assets with indefinite lives consist primarily of trademarks as well as agency relationships. The Company is required to analyze its goodwill and other intangible assets with indefinite lives for impairment on an annual basis as well as when events and circumstances indicate that an impairment may have occurred. Certain factors that may occur and indicate that an impairment exists include, but are not limited to, operating results that are lower than expected and adverse industry or market economic trends. The impairment testing requires management to estimate the fair value of the assets or reporting unit and record an impairment loss for the excess of the carrying value over the fair value. The estimate of fair value of the assets is generally determined on the basis of discounted future cash flows. The estimate of fair value of the reporting unit is generally determined on the basis of discounted future cash flows supplemented by the market approach. In estimating the fair value, management must make assumptions and projections regarding such items as future cash flows, future revenues, future earnings and other factors. The assumptions used in the estimate of fair value are generally consistent with the past performance of each reporting unit and other intangible assets and are also consistent with the projections and assumptions that are used in current operating plans. Such assumptions are subject to change as a result of changing economic and competitive conditions. If these estimates or their related assumptions change in the future, the Company may be required to record an impairment loss for these assets. The recording of any resulting impairment loss could have a material adverse impact on the Company’s financial statements. |
Accounting Pronouncements Not Yet Adopted
In November 2004, the FASB issued Statement of Financial Accounting Standards No. 151 (“SFAS No. 151”), “Inventory Costs - an amendment of ARB No. 43, Chapter 4.” SFAS No. 151 amends the guidance in Accounting Research Bulletin No. 43 (“ARB No. 43”), “Restatement and Revision of Accounting Research Bulletins,” Chapter 4, “Inventory Pricing,” to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage). SFAS No. 151 requires that those items be recognized as current period charges. In addition, SFAS No. 151 requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. The Company is required to adopt SFAS No. 151 for fiscal years beginning March 1, 2006. The Company is currently assessing the financial impact of SFAS No. 151 on its consolidated financial statements.
In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123 (revised 2004) (“SFAS No. 123(R)”), “Share-Based Payment.” SFAS No. 123(R) replaces Statement of Financial Accounting Standards No. 123 (“SFAS No. 123”), “Accounting for Stock-Based Compensation,” and supersedes Accounting Principles Board Opinion No. 25 (“APB Opinion No. 25”), “Accounting for Stock Issued to Employees.” SFAS No. 123(R) requires the cost resulting from all share-based payment transactions be recognized in the financial statements. In addition, SFAS No. 123(R) establishes fair value as the measurement objective in accounting for share-based payment arrangements and requires all entities to apply a grant date fair-value-based measurement method in accounting for share-based payment transactions. SFAS No. 123(R) also amends Statement of Financial Accounting Standards No. 95 (“SFAS No. 95”), “Statement of Cash Flows,” to require that excess tax benefits be reported as a financing cash inflow rather than as a reduction of taxes paid. SFAS No. 123(R) applies to all awards granted, modified, repurchased, or cancelled after the required effective date (see below). In addition, SFAS No. 123(R) requires entities that used the fair-value-based method for either recognition or disclosure under SFAS No. 123 to apply SFAS No. 123(R) using a modified version of prospective application. This application requires compensation cost to be recognized on or after the required effective date for the portion of outstanding awards for which the requisite service has not yet been rendered based on the grant date fair value of those awards as calculated under SFAS No. 123 for either recognition or pro forma disclosures. For periods before the required effective date, those entities may elect to apply a modified version of retrospective application under which financial statements for prior periods are adjusted on a basis consistent with the pro forma disclosures required for those periods by SFAS No. 123. In March 2005, the SEC staff issued Staff Accounting Bulletin No. 107 ("SAB No. 107"), "Share Based Payment", to express the views of the staff regarding the interaction between SFAS No. 123(R) and certain SEC rules and regulations and to provide the staff's views regarding he valuation of share-based payment arrangements for public companies. The Company is required to adopt SFAS No. 123(R) for interim periods beginning March 1, 2006. The Company is currently assessing the financial impact of SFAS No. 123(R) on its consolidated financial statements and will take into consideration the additional guidance provided by SAB No. 107 in connection with the Company's adoption of SFAS No. 123(R).
In December 2004, the FASB issued Statement of Financial Accounting Standards No. 153 (“SFAS No. 153”), “Exchanges of Nonmonetary Assets - an amendment of APB Opinion No. 29.” SFAS No. 153 amends Accounting Principles Board Opinion No. 29 (“APB No. 29”), “Accounting for Nonmonetary Transactions,” to eliminate the exception from fair value measurement for nonmonetary exchanges of similar productive assets and replace it with a general exception from fair value measurement for exchanges that do not have commercial substance. SFAS No. 153 specifies that a nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. The Company is required to adopt SFAS No. 153 for fiscal years beginning March 1, 2006. The Company is currently assessing the financial impact of SFAS No. 153 on its consolidated financial statements.
On October 22, 2004, the American Jobs Creation Act (“AJCA”) was signed into law. The AJCA includes a special one-time 85 percent dividends received deduction for certain foreign earnings that are repatriated. In December 2004, the FASB issued FASB Staff Position No. FAS 109-2 (“FSP FAS 109-2”), “Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004.” FSP FAS 109-2 provides accounting and disclosure guidance for this repatriation provision.Although FSP FAS 109-2 is effective immediately, the Company is currently assessing the impact of guidance issued by the Treasury Department and the Internal Revenue Service on May 10, 2005, as well as the relevance of additional guidance expected to be issued. The Company expects to complete its evaluation of the effects of the repatriation provision within a reasonable period of time following the publication of the additional guidance.
In March 2005, the FASB issued FASB Interpretation No. 47 (“FIN No. 47”), “Accounting for Conditional Asset Retirement Obligations - an interpretation of FASB Statement No. 143.” FIN No. 47 clarifies the term conditional asset retirement obligation as used in FASB Statement No. 143, “Accounting for Asset Retirement Obligations.” A conditional asset retirement obligation is an unconditional legal obligation to perform an asset retirement activity in which the timing and/or method of settlement are conditional on a future event that may or may not be within the control of the entity. Therefore, an entity is required to recognize a liability for the fair value of a conditional asset retirement obligation if the fair value of the liability can be reasonably estimated. FIN No. 47 is effective for the Company no later than the end of the year ending February 28, 2006. The Company is currently assessing the financial impact of FIN No. 47 on its consolidated financial statements.
CAUTIONARY INFORMATION REGARDING FORWARD-LOOKING STATEMENTS
This Annual Report on Form 10-K 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 Annual Report on Form 10-K, including the statements under Item 1 “Business” and Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding the Company’s business strategy, future financial position, prospects, plans and objectives of management, as well as information concerning expected actions of third parties are forward-looking statements. When used in this Annual Report on Form 10-K, the words “anticipate,” “intend,” “expect,” and similar expressions are intended to identify forward-looking statements, although not all forward-looking statements contain such identifying words. All forward-looking statements speak only as of the date of this Annual Report on Form 10-K. The Company undertakes no obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. Although the Company believes that the expectations reflected in the forward-looking statements are reasonable, it can give no assurance that such expectations will prove to be correct. In addition to the risks and uncertainties of ordinary business operations, important factors that could cause actual results to differ materially from those set forth in, or implied, by the Company’s forward-looking statements contained in this Annual Report on Form 10-K are as follows:
The Company’s indebtedness could have a material adverse effect on its financial health.
The Company has incurred substantial indebtedness to finance its acquisitions and may incur substantial additional indebtedness in the future to finance further acquisitions or for other purposes. The Company’s ability to satisfy its debt obligations outstanding from time to time will depend upon the Company’s future operating performance, which is subject to prevailing economic conditions, levels of interest rates and financial, business and other factors, many of which are beyond the Company’s control. Therefore, there can be no assurance that the Company’s cash flow from operations will be sufficient to meet all of its debt service requirements and to fund its capital expenditure requirements.
The Company’s current and future debt service obligations and covenants could have important consequences. These consequences include, or may include, the following:
| § | the Company’s ability to obtain financing for future working capital needs or acquisitions or other purposes may be limited; |
| § | a significant portion of the Company’s cash flow from operations will be dedicated to the payment of principal and interest on its indebtedness and dividends on its Series A mandatory convertible preferred stock, thereby reducing funds available for operations, expansion or distributions; |
| § | the Company’s ability to conduct its business could be limited by restrictive covenants; and |
| § | the Company may be more vulnerable to adverse economic conditions than less leveraged competitors and, thus, may be limited in its ability to withstand competitive pressures. |
The restrictive covenants and provisions in the Company’s senior credit facility and its indentures under which its debt securities have been issued include, among others, those restricting additional liens, additional borrowing, the sale of assets, changes of control, the payment of dividends, transactions with affiliates, the making of investments and certain other fundamental changes. The senior credit facility also contains restrictions on acquisitions and certain financial ratio tests including a debt coverage ratio, a senior debt coverage ratio, a fixed charges ratio and an interest coverage ratio. These restrictions could limit the Company’s ability to conduct business. A failure to comply with the obligations contained in the senior credit facility, its existing indentures or other loan agreements, or indentures or loan agreements entered into in the future could result in an event of default under such agreements, which could require the Company to immediately repay the related debt and also debt under other agreements that may contain cross-acceleration or cross-default provisions.
The Company’s acquisition and joint venture strategies may not be successful.
The Company has made a number of acquisitions, including the recent acquisitions of Robert Mondavi and Hardy, and anticipates that it may, from time to time, acquire additional businesses, assets or securities of companies that the Company believes would provide a strategic fit with its business. In addition, the Company has entered into joint ventures and may enter into additional joint ventures. Acquired businesses will need to be integrated with the Company’s existing operations. There can be no assurance that the Company will effectively assimilate the business or product offerings of acquired companies into its business or product offerings. Acquisitions are also accompanied by risks such as potential exposure to unknown liabilities of acquired companies and the possible loss of key employees and customers of the acquired business. Acquisitions are subject to risks associated with the difficulty and expense of integrating the operations and personnel of the acquired companies, the potential disruption to the Company’s business and the diversion of management time and attention. The Company shares control of its joint ventures and, therefore, there is the risk that the Company’s joint venture partners may at any time have economic, business or legal interests or goals that are inconsistent with those of the Company or the joint venture. There is also risk that the Company’s joint venture partners may be unable to meet their economic or other obligations and that the Company may be required to fulfill those obligations alone. The Company’s failure or the failure of an entity in which the Company has a joint venture interest to adequately manage the risks associated with any acquisitions or joint ventures could have a material adverse effect on the Company’s financial condition or results of operations. There can be no assurance that any of the Company’s acquisitions or joint ventures will be profitable.
Competition could have a material adverse effect on the Company’s business.
The Company is in a highly competitive industry and the dollar amount and unit volume of its sales could be negatively affected by its inability to maintain or increase prices, changes in geographic or product mix, a general decline in beverage alcohol consumption or the decision of the Company’s wholesale customers, retailers or consumers to purchase competitive products instead of the Company’s products. Wholesaler, retailer and consumer purchasing decisions are influenced by, among other things, the perceived absolute or relative overall value of the Company’s products, including their quality or pricing, compared to competitive products. Unit volume and dollar sales could also be affected by pricing, purchasing, financing, operational, advertising or promotional decisions made by wholesalers, state and provincial agencies, and retailers which could affect their supply of, or consumer demand for, the Company’s products. The Company could also experience higher than expected selling, general and administrative expenses if the Company finds it necessary to increase the number of its personnel or its advertising or promotional expenditures to maintain its competitive position or for other reasons.
An increase in excise taxes or government regulations could have a material adverse effect on the Company’s business.
In the United States, the United Kingdom, Australia and other countries in which the Company operates, the Company is subject to imposition of excise and other taxes on beverage alcohol products in varying amounts which have been subject to change. Significant increases in excise or other taxes on beverage alcohol products could materially and adversely affect the Company’s financial condition or results of operations. Recently, many states have considered proposals to increase, and some of these states have increased, state alcohol excise taxes. In addition, the beverage alcohol products industry is subject to extensive regulation by federal, state, local and foreign governmental agencies concerning such matters as licensing, trade and pricing practices, permitted and required labeling, advertising and relations with wholesalers and retailers. Certain federal and state regulations also require warning labels and signage. New or revised regulations or increased licensing fees, requirements or taxes could also have a material adverse effect on the Company’s financial condition or results of operations.
The Company relies on the performance of wholesale distributors, major retailers and chains for the success of its business.
In the United States, the Company sells its products principally to wholesalers for resale to retail outlets including grocery stores, package liquor stores, club and discount stores and restaurants. In the United Kingdom and Australia, the Company sells its products principally to wholesalers and directly to major retailers and chains. The replacement or poor performance of the Company’s major wholesalers, retailers or chains, or the Company’s inability to collect accounts receivable from the Company’s major wholesalers, retailers or chains could materially and adversely affect the Company’s results of operations and financial condition. Distribution channels for beverage alcohol products have been consolidating in recent years. In addition, wholesalers and retailers of the Company’s products offer products which compete directly with the Company’s products for retail shelf space and consumer purchases. Accordingly, there is a risk that wholesalers or retailers may give higher priority to products of the Company’s competitors. In the future, the Company’s wholesalers and retailers may not continue to purchase the Company’s products or provide the Company’s products with adequate levels of promotional support.
The Company’s business could be adversely affected by a decline in the consumption of products the Company sells.
Although since 1995 there have been modest increases in consumption of beverage alcohol in most of the Company’s product categories, there have been periods in the past in which there were substantial declines in the overall per capita consumption of beverage alcohol products in the United States and other markets in which the Company participates. A limited or general decline in consumption in one or more of the Company’s product categories could occur in the future due to a variety of factors, including:
| § | a general decline in economic conditions; |
| § | increased concern about the health consequences of consuming beverage alcohol products and about drinking and driving; |
| § | a trend toward a healthier diet including lighter, lower calorie beverages such as diet soft drinks, juices and water products; |
| § | the increased activity of anti-alcohol consumer groups; and |
| § | increased federal, state or foreign excise or other taxes on beverage alcohol products. |
The Company generally purchases raw materials under short-term supply contracts, and the Company is subject to substantial price fluctuations for grapes and grape-related materials, and the Company has a limited group of suppliers of glass bottles.
The Company’s business is heavily dependent upon raw materials, such as grapes, grape juice concentrate, grains, alcohol and packaging materials from third-party suppliers. The Company could experience raw material supply, production or shipment difficulties that could adversely affect the Company’s ability to supply goods to its customers. The Company is also directly affected by increases in the costs of raw materials. In the past, the Company has experienced dramatic increases in the cost of grapes. Although the Company believes it has adequate sources of grape supplies, in the event demand for certain wine products exceed expectations, the Company could experience shortages.
The wine industry swings between cycles of grape oversupply and undersupply. In a severe oversupply environment, the ability of wine producers, including the Company, to raise prices is limited, and, in certain situations, the competitive enviroment may put pressure on producers to lower prices. Further, although there may be enhanced opportunities to purchae grapes at lower costs, a producer’s selling and promotional expenses associated with the sale of its wine products can rise in such an environment.
One of the Company’s largest components of cost of goods sold is that of glass bottles, which, in the United States and Australia, have only a small number of producers. Currently, substantially all of the Company’s glass container requirements for its United States operations are supplied by one producer and most of the Company’s glass container requirements for its Australian operations are supplied by another producer. The inability of any of the Company’s glass bottle suppliers to satisfy its requirements could adversely affect the Company’s business.
The Company’s operations subject it to risks relating to currency rate fluctuations, interest rate fluctuations and geopolitical uncertainty which could have a material adverse effect on the Company’s business.
The Company has operations in different countries throughout the world and, therefore, is subject to risks associated with currency fluctuations. Subsequent to the Hardy Acquisition, the Company’s exposure to foreign currency risk increased significantly as a result of having additional international operations in Australia, New Zealand and the United Kingdom. The Company is also exposed to risks associated with interest rate fluctuations. The Company manages its exposure to foreign currency and interest rate risks utilizing derivative instruments and other means to reduce those risks. The Company, however, could experience changes in its ability to hedge against or manage fluctuations in foreign currency exchange rates or interest rates and, accordingly, there can be no assurance that the Company will be successful in reducing those risks. The Company could also be affected by nationalizations or unstable governments or legal systems or intergovernmental disputes. These currency, economic and political uncertainties may have a material adverse effect on the Company’s results of operations, especially to the extent these matters, or the decisions, policies or economic strength of the Company’s suppliers, affect the Company’s global operations.
The Company has a material amount of goodwill, and if the Company is required to write-down goodwill, it would reduce the Company’s net income, which in turn could have a material adverse effect on the Company’s results of operations.
As of February 28, 2005, goodwill represented $2,182.7 million, or 28.0% of the Company’s total assets. Goodwill is the amount by which the costs of an acquisition accounted for using the purchase method exceeds the fair value of the net assets acquired. The Company adopted the Financial Accounting Standards Board issued Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets,” in its entirety, on March 1, 2002. Under SFAS No. 142, goodwill is no longer amortized, but instead is subject to a periodic impairment evaluation based on the fair value of the reporting unit. Reductions in the Company’s net income caused by the write-down of goodwill could materially and adversely affect the Company’s results of operations.
The termination or non-renewal of the Company’s imported beer distribution agreements could have a material adverse effect on the Company’s business.
All of the Company’s imported beer products are marketed and sold pursuant to exclusive distribution agreements with the suppliers of these products and are subject to renewal from time to time. The Company’s agreement to distribute Corona Extra and its other Mexican beer brands in 25 primarily western U.S. states expires in December 2006 and, subject to compliance with certain performance criteria, continued retention of certain personnel and other terms of the agreement, will be automatically renewed for additional terms of five years. Changes in control of the Company or its subsidiaries involved in importing the Mexican beer brands, or changes in the chief executive officer of such subsidiaries, may be a basis for the supplier, unless it consents to such changes, to terminate the agreement. The supplier’s consent to such changes may not be unreasonably withheld. Prior to their expiration, all of the Company’s imported beer distribution agreements may be terminated if the Company fails to meet certain performance criteria. The Company believes that it is currently in compliance with all of its material imported beer distribution agreements. From time to time the Company has failed, and may in the future fail, to satisfy certain performance criteria in the Company’s distribution agreements. It is possible that the Company’s beer distribution agreements may not be renewed or may be terminated prior to expiration.
Class action or other litigation relating to alcohol abuse or the misuse of alcohol could adversely affect the Company’s business.
There has been increased public attention directed at the beverage alcohol industry, which the Company believes is due to concern over problems related to alcohol abuse, including drinking and driving, underage drinking and health consequences from the misuse of alcohol. Several beverage alcohol producers have been sued in several courts regarding alleged advertising practices relating to underage consumers. If there are adverse developments in these or similar lawsuits or there is a significant decline in the social acceptability of beverage alcohol products that results from these lawsuits, the Company’s business could be materially adversely affected.
The Company depends upon its trademarks and proprietary rights, and any failure to protect its intellectual property rights or any claims that the Company is infringing upon the rights of others may adversely affect the Company's competitive position.
The Company’s ability to protect its current and future brands and products and to defend its intellectual property rights is essential to the Company’s future success. The Company has been granted numerous trademark registrations covering its brands and products and has filed, and expects to continue to file, trademark applications seeking to protect newly-developed brands and products. The Company cannot be sure that trademark registrations will be issued with respect to any of its trademark applications. There is also a risk that trademark registrations may not be timely renewed or that the Company's competitors will challenge, invalidate or circumvent any existing or future trademarks issued to, or licensed by, the Company.
Contamination or other circumstances could harm the integrity or customer support for the Company’s brands and adversely affect the sales of those products.
The success of the Company’s brands depends upon the positive image that consumers have of those brands, and contamination, whether arising accidentally, or through deliberate third-party action, or other events that harm the integrity or consumer support for those brands, could adversely affect their sales. Contaminants in raw materials purchased from third parties and used in the production of the Company’s wine and spirits products or defects in the distillation or fermentation process could lead to low beverage quality as well as illness among, or injury to, consumers of the Company’s products and may result in reduced sales of the affected brand or all of the Company’s brands. Also, to the extent that third parties sell products which are either counterfeit versions of the Company’s brands or brands that look like the Company’s brands, consumers of the Company’s brands could confuse the Company’s products with products that they consider inferior. This could cause them to refrain from purchasing the Company’s brands in the future and in turn could impair brand equity and adversely affect the Company’s sales and operations.
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Item 7A. 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 foreign currency exchange rates and interest rates. To manage the volatility relating to these risks, the Company periodically purchases and/or sells derivative instruments 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 February 28, 2005, 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 February 28, 2005, and February 29, 2004, the Company had outstanding foreign exchange derivative instruments with a notional value of $601.6 million and $735.8 million, respectively. Approximately 63% of the Company’s total exposures were hedged as of February 28, 2005. Using a sensitivity analysis based on estimated fair value of open contracts using forward rates, if thecontract base currencyhad been 10% weaker as of February 28, 2005, and February 29, 2004, the fair value of open foreign exchange contracts would have beendecreased by $65.2 million and $72.4 million, respectively. Losses or gains from the revaluation or settlement of the related underlying positions would substantially offset such gains or losses on the derivative instruments.
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 $1,088.1 million and $1,321.8 million as of February 28, 2005, and February 29, 2004, respectively. A hypothetical 1% increase from prevailing interest rates as of February 28, 2005, and February 29, 2004, would have resulted in a decrease in fair value of fixed interest rate long-term debt by$37.0 million and$52.9 million, respectively.
As of February 28, 2005, the Company had outstanding five-year interest rate swap agreements to minimize interest rate volatility. The swap agreements fix LIBOR interest rates on $1,200.0 million of the Company’s floating LIBOR rate debt at an average rate of 4.1% over the five-year term. A hypothetical 1% increase from prevailing interest rates as of February 28, 2005 would have increased the fair value of the interest rate swaps by $53.1 million. As of February 29, 2004,the Company had no interest rate swap agreements outstanding.
In addition to the $1,088.1 million and $1,321.8 million estimated fair value of fixed rate debt outstanding as of February 28, 2005, and February 29, 2004, respectively, the Company also had variable rate debt outstanding (primarily LIBOR based) as of February 28, 2005, and February 29, 2004, of $2,302.7 million and $861.8 million, respectively. Using a sensitivity analysis based on a hypothetical 1% increase in prevailing interest rates over a 12-month period, the approximate increase in cash required for interest as of February 28, 2005 and February 29, 2004 is $23.0 million and $7.4 million, respectively.
Item 8. Financial Statements and Supplementary Data
CONSTELLATION BRANDS, INC. AND SUBSIDIARIES
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
FEBRUARY 28, 2005
The following information is presented in this Annual Report on Form 10-K:
Page
Report of Independent Registered Public Accounting Firm - KPMG LLP.................... 45
Report of Independent Registered Public Accounting Firm - KPMG LLP.................... 46
Management’s Annual Report on Internal Control Over Financial Reporting................. 48
Consolidated Balance Sheets - February 28, 2005, and February 29, 2004................. 49
Consolidated Statements of Income for the years ended February 28, 2005,
February 29, 2004, and February 28, 2003.................................................... 50
Consolidated Statements of Changes in Stockholders’ Equity for the years ended
February 28, 2005, February 29, 2004, and February 28, 2003..................... 51
Consolidated Statements of Cash Flows for the years ended February 28, 2005,
February 29, 2004, and February 28, 2003.................................................... 52
Notes to Consolidated Financial Statements................................................................ 53
Selected Quarterly Financial Information (unaudited)................................................... 99
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
Constellation Brands, Inc.:
We have audited the accompanying consolidated balance sheets of Constellation Brands, Inc. and subsidiaries as of February 28, 2005 and February 29, 2004, and the related consolidated statements of income, changes in stockholders’ equity, and cash flows for each of the years in the three-year period ended February 28, 2005. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Constellation Brands, Inc. and subsidiaries as of February 28, 2005 and February 29, 2004, and the results of their operations and their cash flows for each of the years in the three-year period ended February 28, 2005, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Constellation Brands, Inc.’s internal control over financial reporting as of February 28, 2005, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated May 16, 2005 expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.
/s/ KPMG LLP
Rochester, New York
May 16, 2005
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
Constellation Brands, Inc.:
We have audited management’s assessment, included in the accompanying Management’s Annual Report on Internal Control Over Financial Reporting, that Constellation Brands, Inc. maintained effective internal control over financial reporting as of February 28, 2005, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Constellation Brands, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management’s assessment that Constellation Brands, Inc. maintained effective internal control over financial reporting as of February 28, 2005, is fairly stated, in all material respects, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, Constellation Brands, Inc. maintained, in all material respects, effective internal control over financial reporting as of February 28, 2005, based oncriteria established in Internal Control—Integrated Framework issued by the Committeeof Sponsoring Organizations of the Treadway Commission (COSO).
Constellation Brands, Inc. acquired The Robert Mondavi Corporation on December 22, 2004, and management excluded from its assessment of the effectiveness of Constellation Brands, Inc.’s internal control over financial reporting as of February 28, 2005, The Robert Mondavi Corporation’s internal control over financial reporting associated with assets, net sales and income before income taxes
comprising 23.6%, 2.1% and 0.6% of the consolidated total assets, net sales and income before income taxes of the Company as of and for the year ended February 28, 2005. Our audit of internal control over financial reporting of Constellation Brands, Inc. also excluded an evaluation of the internal control over financial reporting of The Robert Mondavi Corporation.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Constellation Brands, Inc. and subsidiaries as of February 28, 2005 and February 29, 2004, and the related consolidated statements of income, changes in stockholders’ equity, and cash flows for each of the years in the three-year period ended February 28, 2005, and our report dated May 16, 2005 expressed an unqualified opinion on those consolidated financial statements.
/s/ KPMG LLP
Rochester, New York
May 16, 2005
Management’s Annual Report on Internal Control Over Financial Reporting
Management is responsible for establishing and maintaining an adequate system of internal control over financial reporting of the Company. This system is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America.
The Company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, a system of internal control over financial reporting can provide only reasonable assurance and may not prevent or detect misstatements. Further, because of changes in conditions, effectiveness of internal controls over financial reporting may vary over time. Our system contains self-monitoring mechanisms, and actions are taken to correct deficiencies as they are identified.
Management conducted an evaluation of the effectiveness of the system of internal control over financial reporting based on the framework inInternal Control - Integrated Frameworkissued by the Committee of Sponsoring Organizations (COSO) of the Treadway Commission. Based on this evaluation, management concluded that the Company’s system of internal control over financial reporting was effective as of February 28, 2005. This evaluation excluded the internal control over financial reporting of The Robert Mondavi Corporation (“Robert Mondavi”), which the Company acquired on December 22, 2004. Management did not have adequate time to gather sufficient evidence about the design and operating effectiveness of internal control over financial reporting for Robert Mondavi from the date of acquisition through February 28, 2005; therefore, Management was not able to perform an evaluation with respect to the effectiveness of internal control over financial reporting for Robert Mondavi. As of February 28, 2005, the assets, net sales, and income before income taxes of Robert Mondavi comprised 23.6%, 2.1%, and 0.6% of the consolidated total assets, net sales, and income before income taxes of the Company.
Management’s assessment of the effectiveness of the Company’s internal control over financial reporting has been audited by KPMG LLP, an independent registered public accounting firm, as stated in their report which is included herein.
