Welcome to the Constellation Brands Q2 Fiscal Year 2021 Earnings Conference Call. [Operator Instructions]. I would now like to turn the call over to Patty Yahn-Urlaub, Senior Vice President of Investor Relations. Please go ahead.

Thanks, Jonathan. Good morning and welcome to Constellation's Second Quarter '21 Conference Call. I'm here this morning with Bill Newlands, our CEO; and Garth Hankinson, our CFO. As a reminder, reconciliations between the most directly comparable GAAP measure and any non-GAAP financial measures discussed on this call are included in our news release or otherwise available on the company's website at cbrands.com. Please refer to the news release and Constellation's SEC filings for risk factors, which may impact forward-looking statements we make on this call. Before turning the call over to Bill, similar to prior quarters, I would like to ask that we limit everyone to one question per person, which will help us to end our call on time. Thanks in advance, and now here's Bill.

Thank you, Patty. Good morning and welcome to our second quarter conference call. Before I begin with a discussion of our performance in the quarter, I'd be remiss if I didn't acknowledge the continued and unprecedented challenges of this year marked by the ongoing impacts of the COVID-19 pandemic, ongoing social unrest rooted in a long history of racial injustice in this country, and the most recent string of natural disasters, including wildfires across the western part of the United States. As it relates to the fires, fortunately, all Constellation employees are safe and accounted for, and there have been no direct impacts to any of our facilities. That said, our hearts go out to those who have been adversely affected by the fires, and we send our sincere thanks to the brave firefighters and other emergency personnel working tirelessly to battle the fires and keep people safe. I'd also like to thank the members of our Constellation team, who continued to pull together despite adverse circumstances to drive the success of our business, including excellent second quarter results. As Garth and I review these results, we'd like you to focus on 3 key takeaways. First, in what was expected to be our most challenging quarter of the year, our team overcame COVID-related headwinds to deliver solid business performance in Q2. This performance was led by our beer business, which grew depletions by almost 5% as we continue to see incredible consumer demand for our portfolio of brands. While the COVID-related slowdown of our beer production in Mexico earlier in the year impacted shipments and net sales in Q2 and created some temporary out of stocks at retail, we are quickly recovering and expect inventory to return to normal levels by the end of Q3, and we're beginning to see…

Thank you, Bill, and hello, everyone. Despite an uncertain economic environment and headwinds related to COVID-19, Constellation Brands continues to generate strong financial results. During our second quarter, we generated comparable basis EPS, excluding Canopy growth, of $2.91, continued to deliver strong margins in both our beer and wine and spirits segments and increased free cash flow by 10%, resulting in ongoing debt repayment and progress in achieving targeted leverage. Now let's review Q2 performance in more detail, where I'll generally focus on comparable basis financial results, starting with beer. Despite reduced shipment volume in Q2 related to COVID-19, net sales were flat to prior year. Excluding the impact of the Ballast Point divestiture, organic net sales increased 1% on organic shipment volume down 1%, which was partially offset by favorable pricing. Depletion volume growth for the quarter came in at nearly 5% driven by Modelo Especial and the successful launch of Corona Hard Seltzer as strong performance continued in the off-premise channel and more than offset the impact of the nearly 50% year-over-year reduction in the on-premise channel due to COVID-19. In Q2, we benefited from one extra sell day. When adjusted for the extra sell day impact, the beer business generated approximately 4% depletion volume growth. In Q3, depletion selling days are flat year-over-year. While depletion trends tempered in Q2 versus Q1 due to some out of stocks resulting from the slowdown in production earlier in the fiscal year, we remain confident in the strength of our business as underlying consumer demand remains quite robust. We are making good progress in rebuilding inventory supply across our network, both at our distribution centers and with distributors, following the production slowdown for roughly 2/3 of our Q1 and the beginning of Q2 that created out of stocks at retail and…

[Operator Instructions]. Our first question comes from the line of Bonnie Herzog from Goldman Sachs.

I wanted to ask a little bit about the spending that, Garth, you just kind of touched on. A key driver of your strong operating margins in the quarter really has been a result of lower marketing spend. And now you've talked about your outlook for spending for the full year being between 9% and 10% as a percentage of sales, which is about 50 bps lower than your previous guidance. So I kind of wanted to better understand that this is mainly a function of the ongoing pressures from COVID or do you see this maybe more as a realistic run rate going forward in terms of what you're seeing with your depletions and demand for your brands? I guess I'm trying to get a sense of how you guys are balancing things and really how important it is for you to drive continued margin expansion.

Sure, Bonnie. Let me take the first part of that, Garth. Our expected run rate is no different going forward than it's ever been. At the same point, because so much of our live events and sports were delayed in the year, I mean think about the NBA Finals, hockey, baseball playoffs, football, many of the things that we advertised on were pushed back later in the year, and therefore, into our third quarter. Some of our spend was also pushed back into those time frames as well. So our intention is to have a consistent run rate of spend in that 9% to 10% range as we always have, and you will expect to see a little bit more in the third quarter because many of those pre-bought scenarios will take place during that quarter rather than in the second quarter when we had originally anticipated they would occur.

Yes, and the only thing that I would add to that, Bonnie, is from a margin perspective, right, we continue to think that the right range to think about in terms of our beer margins are at 39% to 40%. Obviously, in any given year, we're going to face headwinds or tailwinds that are going to fluctuate a little bit. But those are best-in-class margins, and that's the right way to think about the business on a go-forward basis.

Our next question comes from the line of Nik Modi from RBC.

So Bill, I just wanted to have a chat on shelf space, right? So you guys have obviously been very active with the shopper first initiative, ran into a bit of a hiccup with supply/demand. So maybe you can just kind of give us a state of the union on are -- have you lost any spacing as a result of the out of stocks? Because that has happened in a few categories. So if you could just give us an update there. And number two, how do you think the retail psychology is evolving as the last six months has gone on? Clearly, Constellation has been under space for a very long time. So I'm just curious like where the retail universe is right now in terms of your actual slot in the core.

Sure. Certainly, the space issue has been somewhat challenging over the very most recent past, simply because of the reduction in production that we had around COVID-19. With that said, we have seen very little reduction of our overall space as we have spread out our product mix and our product offering into the existing space that we already had. We're also fortunate that many retailers have moved their resets and their timing back in the year for the same reason as because of the COVID-19 pandemic, which now matches up with the time when we're expecting to have our inventory levels back in a more normalized fashion during this quarter. So we don't see any long-term issue around that. We've been very straightforward with our retail partners about where we are. And as you well state, our business, if anything, demands more space given the great acceleration that our brands have in the marketplace. And we expect that over time, we will continue to gain in the distribution area much as we have over the last several years.

Our next question comes from the line of Kaumil Gajrawala from Credit Suisse.

As it relates to inventories, it looks like kind of year-to-date, you're running with shipments down about 4%, depletions up about 5%, and that's during a seasonal peak period. To get inventories back to where you want them by the end of Q3, what should we be thinking about in terms of the spread between shipments and depletions?

Yes. So Kaumil, thanks for the question. I'd say that the spread between depletions and shipments is going to be tough to gauge as we move through the quarter because it'll largely be dependent upon what depletions look like. And we've actually seen -- as Bill noted, we've actually seen very strong continued consumer takeaway in IRI, and depletion growth remains very robust. Suffice that to say, we do know that there will be a dislocation -- not really dislocation, but a difference in between shipments and depletions for the quarter. How much remains to be seen will be driven by consumer takeaway.

Let me just add to that. I'm sure that you have seen in the most recent four week share data that our brands are accelerating as we bring more and more of them back to the table. I think as Garth points out, that's going to be a big factor in terms of what the balance is of that. Depletions are certainly accelerating, we're very pleased with that, but it's very tough to give you an exact answer without knowing how that will land during the course of the quarter.

Our next question comes from the line of Vivien Azer from Cowen.

So I'm curious, Bill, it sounds like you're very constructive on the momentum that you've established early days on the Corona Hard Seltzer offering. Curious to hear how you're thinking about positioning a new hard seltzer offering and taking a portfolio approach to the category.

Well, we've shipped about 5.5 million cases year-to-date, which is ahead of what we had expected, and we're very excited about it. As I already said, our velocity against literally one SKU is second in the category. So everything that's occurring around Corona Hard Seltzer has been sort of positive to what our initial expectations are. As we already also stated, we're going to be in a position to put additional SKUs into the marketplace next year. We would -- we've already said also that our capacity would more than double next year. And keep in mind, we have a minority investment in PRESS, which we're very excited about. PRESS has performed exceedingly well. And as we've said in prior calls, we do expect some price stratification to occur over time in the seltzer category. So PRESS is very positive. We've also done some very limited regional things like Funky Buddha in Florida. In Florida, that particular brand is in the top 5 of all seltzers in the state of Florida. So we've got our toes in the water on a number of areas. Corona Hard Seltzer will continue to be our lead, but we certainly have other opportunities to continue to gain share in what is becoming a very important subsegment of the beer business.

Our next question comes from the line of Bryan Spillane from Bank of America.

Garth, I just wanted to follow up on the incremental costs in the wine segment. So I guess two questions related to it. First are the costs that you highlighted, are they relevant to the -- or related to the ongoing business, so separate from the piece that's going off in the divestiture to Gallo? And then second, I guess trying to understand if this at all impacts kind of the timing or the cadence of supply chain for the wine business going into next year. And I guess what I'm trying -- I'm thinking of it is, are you -- is there a delay in terms of pressing grapes and putting juice in the tanks? Is there a delay in pulling product out of the tank and bottling? I'm just really just trying to understand if there's going to be any kind of disruption in the flow of the supply chain in wine that might lead into next year.

Yes. Bryan, thanks for the question. So the costs, as I outlined them, are for the remaining business, for the business that we are retaining, not for what we're divesting to Gallo. And as it relates to the question on supply chain, we don't expect there to be any material impact on our ability to meet consumer demand as we go forward. We have lots of flexibility in how we source grapes and fruit, whether that's through the bulk line market, the bulk line that we have on hand, our own vineyards, relationships we have with other growers. We don't see any impact on our ability to meet consumer takeaway.

Our next question comes from the line of Dara Mohsenian from Morgan Stanley.

So Bill, you mentioned your aspiration to be a top 3 player in the seltzer category -- hard seltzer category longer term. Obviously, you just touched on some of the new SKUs that you have planned. But can you also give us a sense for how important new platforms will be in that aspiration long term in terms of becoming a top 3 player? And is that more of a longer-term focus? Or could we see a big push behind new entries of brands in the hard seltzer more near term?

Well, certainly, Corona Hard Seltzer will be our primary approach to this category. As we stated, given our roughly $10 million capability for this year, we've relied on one -- literally one SKU. So as we go forward and we expand and finish the Obregon expansion that I discussed earlier, that gives us the opportunity to extend our reach within the Corona Hard Seltzer franchise. We're a big believer that Corona is the perfect brand to maintain our lead focus for seltzer because it meets up exactly with the whole brand essence of refreshment, relaxation and finding your beach. So it -- that will continue to be the lead play for us, but we're always exploring what consumers are interested in going forward. And yes, we do have some additional things that we'll be talking to you about in future conference calls as to what we expect to do during the next fiscal year.

Our next question comes from the line of Sean King from UBS.

Yes, I wanted to dig a little bit more into what you're seeing in the month of September. I know you mentioned like based on the IRI data that we're seeing a gradual acceleration as you're getting more on the shelves, but in terms of the on-premise that you're seeing there would be helpful. And what I've been hearing is that there's fewer taps at most of the outlets that are open, if that's a potential headwind or a benefit for your portfolio.

Sure. As you know, we are somewhat less susceptible to the on-premise versus much of the competition with our brands. With that said, there's -- we had 50% closure in the second quarter. We had 75% in the first, and it's looking more and more like that will also reduce another 15% to 20% during the third quarter if things continue as they're going. With that said, admittedly, the quarter -- I mean, excuse me, the month literally ended yesterday, so we're still adding it up. But it certainly looks like we're going to have a significantly better depletion month in September than we have year-to-date. In fact, it could quite well be our best month of the year so far. That matches up entirely with the acceleration that you've seen in IRI data over the last 4 weeks, which has been accelerating and returned us to a gaining share position, which is something we've normally seen in our business over the course of time.

Our next question comes from the line of Kevin Grundy from Jefferies.

Great. This is building on Nik's question earlier. This is for you, Bill. Just the outlook for the Modelo brand looking out over the next few years and kind of pass some of the near-term volatility related to COVID comes up frequently with investors, understandably given the importance of the brands to your outlook. So could you comment on your ability to grow volumes in that business double digits over the next few years? As we look at the Nielsen channels, ACV is less of an opportunity. But as was pointed out, shelf space is an opportunity. So maybe comment on that a bit, talk a little bit about the interplay and your ability to drive that kind of growth, the interplay between Modelo with the Corona brand. And then just lastly, perhaps touch on, is it in the consideration sector that you would extend the Modelo brand into seltzers as well?

Sure. As we've said, Modelo is one of the chief growth drivers of our beer business. Modelo Especial has become the number three beer brand in the U.S. market, and it continues to accelerate, part of -- it does that for a number of reasons. One is it continues to have a disproportionate SKU in the Hispanic community, which is a growing demographic in the United States, but we've also radically extended that into the non-Hispanic community. Jim Sabia has been advertising to the non-Hispanic community only for the last few years. So this is relatively new that we've been expanding the reach, particularly in Modelo Especial. As you know, our Chelada introductions have gone extremely well, one after the next. And certainly, it's continued to see growth in Negra as well. So the overall family is very healthy. As I said in my prepared remarks, we're looking at the 35th consecutive year of growth for that brand. And quite honestly, I don't know how high is up. I think there's -- there remains tremendous opportunity to extend that franchise, both with its core Hispanic community as well as the non-Hispanic marketplace into which we've started to advertise. I highly doubt that we will do a seltzer under that brand. We believe that the core essence of that brand focuses much more on full flavored beer. And any innovation that we might approach on that particular brand will follow more of the brand essence of the Modelo brand rather than what we have done with Corona, where we feel the whole refreshment platform matches up perfectly with the hard seltzer subsegment.

Our next question comes from the line of Andrea Teixeira from JPMorgan.

So I wanted to go back to the depletions commentary. I understand there are obviously a lot of puts and takes, but you sounded optimistic. So Bill, are you running in the mid-single digits as you alluded to before or even at the high single digits for beer depletions in September?

Well, as I said earlier, and I'll maintain that thought given we have not even gotten all the numbers in yet, and therefore, Garth has not added them all up. But it appears that September will be significantly better than what our year-to-date has been. And as I said, it very likely will be our single best month of the year. So we continue to be optimistic that what we've seen on takeout and IRI trends that have occurred over the last four weeks is currently being reflected in our increased depletion trend that we're seeing in September, which again matches up with our expectation given we have been back operating at normal levels within the plant now for a significant period of time. So again, it's a little difficult to put an exact number on it right at this point, but it certainly looks like September was a very, very positive month.

And if I can squeeze -- that's helpful, Bill. If I can squeeze just a margin question. I know it's like you just quoted some of the expenses that are -- I mean, obviously, the COVID expenses. Other than those, like which may or may not recur as we lap next year, are we looking at obviously a better outlook now that production is when -- it's where it should be and you're reaching back to the production and you're getting obviously economies of scale and you're getting your seltzer volumes like as you quoted better than anticipated? Should we see a progression in like long-term outlook for margins to continue to build or you're going to have to invest more into the pricing? The pricing commentary obviously is going to last, but you're going to increase the pricing through the beginning of fiscal -- we could go into fiscal, but I'm just thinking of the puts and takes of FX and volumes coming back, how we should be thinking about margins going forward.

Yes. So margins for our beer business going forward, as we said earlier, the right range to think about them is, as we said previously, which is that 39% to 40% range, right, again, best-in-class margins. In any given year, we're going to have puts and takes as it relates to margins. We're going to get the benefits of our pricing, but we're also going to face headwinds around things like incremental depreciation that flows through cost of goods as well as we build and add capacity, we'll have periods where we have lower utilization rates, which can -- which will have a drag. And so as we say, there's always going to be these puts and takes in any given year, but 39% to 40% is the right way to think about our margin profile over the medium term. And on the seltzer point that you raised, seltzer currently is a drag given the additional flavors and some of the co-packing that needs to be done there. As we progress and as we get to be -- have more scale in seltzer, there'll definitely be margin improvement there, and we'll start to get closer in line with Corona Extra glass. But again, even as margins improve on seltzer, that there will be other puts and takes. So 39% to 40% is the right way to think about it.

Our next question comes from the line of Robert Ottenstein from Evercore.

Bill, I just want to kind of step back and ask you a big picture question that you're probably in a better position to answer than anybody else. And that is at least based on the data we get, and for spirits, it's not that good, but even with the tremendous boost that the beer industry has gotten from hard seltzers, it looks like spirits are gaining share of throat and that maybe even have accelerated this year. And based on what you see, is that, in fact, true? And what do you account for that? Is it the out of stocks for beer? Or is there something -- due to the COVID environment that favors spirits? And if these trends look like they're going to continue, are you thinking just in terms of your long-term capital allocation to pivot more towards spirits? I know you just made a spirits acquisition. But just how are you thinking about that dynamic?

Sure, Rob. It's very difficult in a COVID year to make lots of predictions about what will be sustainable and what will maintain itself once we come out of the COVID scenario and what won't. I do think it's very fair to say there will be some fundamental change. Some of that fundamental change will be about 3 tier e-commerce and direct-to-consumer, things that we're investing a lot of our energy and focus on going forward. So I wouldn't make a lot of prediction as to what the adjustments that could occur between spirits or beer or wine. What I would say is we have worked aggressively, as you've seen, to make sure that our portfolio is positioned for where the consumer is going, not where the consumer has been. We've invested in craft spirits, which we think has tremendous upside. Our beer business plays in the high end, which is where the growth in the category is. We're extending our capabilities in seltzer to more than double what we have done in this fiscal year going forward. And our wine business is tremendously positioned to continue to leverage the premiumization trend that's going on. In addition to that, we're doing the kinds of innovations that the consumer is looking for in things like betterment and convenience. You're seeing that in some of the new products that we've talked about this year. That's where our focus really lies, and I think there's tremendous opportunity within our portfolio no matter how it shakes out post-COVID. As I said, I do think there will be some fundamental change about how the consumer buys. And to some degree, there almost has to be because there has been a significant shift from the on-premise to the off-premise. And I think that the long-term trend of that, I still think, is too early to predict.

Our next question comes from the line of Bill Chappell from Truist Securities.

This is Grant on for Bill. Just had one on the wine and spirits power brand's depletion growth this quarter. I was just hoping, Garth, you give a bridge on some of those impacts you walked through the inventory changes at the distributor level and the promotional changes. Just trying to get an underlying growth number for that business.

Yes. I think the question is that you want to understand sort of like why the power brand growth wasn't higher than you were expecting, and that really is because we did do -- we didn't repeat some non-return generating promotional activity or take some non-enhancing -- non-value-enhancing pricing actions. And we also cleaned up or reduced the number of days outstanding with some key retailers. So the underlying brands are strong as you see in the IRI takeaway, and the reduction or a slowdown in depletions really is just -- is doing a little bit of house cleaning, so to speak.

Yes. Keep in mind, Bill, if I could add -- just to add to Garth's comment, our high-end over $11 power brands continue to outpace their competition, and that's led by Meiomi and the Prisoner family, Kim Crawford. These brands are accelerating in the minds of consumer. Keep in mind, going back to sort of Robert's question from a minute ago, one of the things that we continue to see is people are attracted to try and true brands. And we are very fortunate when you talk about our beer business or our wine business or our spirit business to have a lot of those brands that are inherently trusted, and that has been extremely helpful for us during the pandemic.

Our next question comes from the line of Laurent Grandet from Guggenheim.

Another question on seltzer. With the launch of Topo Chico seltzer next year, there will be more competition to attract Hispanic consumers into the seltzer category potentially from beer. So first, I mean do you see Topo Chico seltzer as a risk for your core Mexican beer business? And second, what are your plan with Corona seltzer to increase Hispanic penetration that seems to be low by your account?

Well, as I said earlier, we have been very pleased by the development of our Corona Hard Seltzer business with the Hispanic community. It's indexing somewhere between 5 and 10 points greater than the overall category, and we think that speaks very well to broadening the reach of the seltzer subsegment with consumers. So we're very positive about that. As I'm sure you've seen, there's been a lot of introductions in the seltzer category, but consumers have a tendency to go with tried and true, trusted brands. And there is really no stronger brand that's trusted in the minds of consumers than Corona. And certainly, Corona Hard Seltzer will fall into that ZIP code as well. So we always wish well for our competition, but we'll be quite happy to do our bit, and we'll see how it all falls out.

Thank you. And this does conclude the question-and-answer session of today's program. I'd like to hand the program back to Bill Newlands for any further remarks.

Thanks, Jonathan. So thank you, everyone, for joining our call today. Despite the continued and unprecedented challenges that have occurred since the beginning of our fiscal year, our team continues to remain agile and have overcome massive headwinds to deliver strong business performance in the first half of our fiscal year. We remain confident in the resiliency of our business. Our beer business, as we've discussed today, continues to be a top growth driver within the industry, while our wine and spirit premiumization strategy continues to gain momentum, especially as we enter the final stages of completing our transaction with Gallo. We remain bullish on the future performance of our powerful collection of consumer connected brands, and we are well positioned to deliver a solid year of organic growth in fiscal '21. Our next quarterly call is scheduled for early January. So I'm wishing everyone at this point a safe and happy holiday season, and I'm also reminding you to enjoy some of our great products during your socially-distant celebrations with your family and friends. So thanks again for joining the call today, and have a great day.

Thank you, ladies and gentlemen, for your participation in today's conference. This does conclude the program. You may now disconnect. Good day.