Constellation Brands Inc (STZ) 2006 Q3 法說會逐字稿

Good morning, my name is Jackie and I will be your conference facilitator today.

At this time, I would like to welcome everyone to the Constellation Brands third quarter 2006 earnings conference call.

All lines have been placed on mute to prevent any background noise.

After the speakers' remarks, there will be a question-and-answer period. [OPERATOR INSTRUCTIONS] Thank you.

It is now my pleasure to turn the floor over to your host, Miss Lisa Schnorr, Vice President of Investor Relations.

Ma'am, you may begin your conference.

Thank you, Jackie, and good morning, everyone.

Welcome to Constellation's third quarter fiscal 2006 conference call.

Richard Sands, our Chairman and Chief Executive Officer and Tom Summer, our Executive Vice President and Chief Financial Officer are here with me in Rochester this morning.

By now, you should have had an opportunity to read our media release, which has also been furnished to the SEC.

This conference call is intended to complement the release.

During the call, we will discuss financial and statistical information on a GAAP basis, comparable basis and pro forma basis.

Reconciliations between GAAP and comparable basis and/or pro forma basis measures are available on the Company's Web site at www.cbrands.com under the "Investors" section.

These reconciliations include explanations as to why management uses comparable basis and pro forma measures and why management believes they're useful to investors.

Richard's and Tom's discussions will generally focus on comparable basis financial results, excluding acquisition-related costs, restructuring and related charges and unusual items.

They will also discuss certain pro forma net sales information after giving effect to Robert Mondavi brands, as if the brands had been in the Company portfolio in the same period a year ago.

As noted in our press release, on May 13, 2005, we effected 2 for 1 stock splits of Class A and Class B common stock distributed in the form of stock dividends.

All share and per share amounts referenced during this call will reflect the impact of the split.

Please also be aware that we may make forward-looking statements during this call.

While those statements represent our best estimates, actual results could differ materially from our estimates.

For a detailed list of the risk factors that may impact the Company's estimates, please refer to the media release and Constellation's SEC filings.

And finally, one additional housekeeping item before I turn the call over.

Currency exchange rate fluctuations negatively impacted our sales growth rates in all product categories in the third quarter.

Richard's and Tom's references to net sales growth rates will generally focus on constant currency sales growth rates, which excludes the impact of year-over-year currency exchange rate fluctuation.

The details of this are disclosed in our press release and I'd also like to point out that the constant currency growth rates calculated in our press release do not foot merely due to rounding.

If you have any follow-up questions after the call, please call Bob Dudak or me.

And now I'd like to turn the call over to Richard Sands.

Thank you, Lisa.

And good morning, everyone, and a Happy New Year.

We're delighted to kick off 2006 by announcing our strong third quarter results, results that clearly demonstrate true growth.

Growth that creates long-term shareholder value.

With an acceleration of revenue growth in our branded businesses and expanding margins, we generated $0.52 comparable earnings per share, outperforming our guidance range and street expectations.

I'll review our third quarter revenue performance and briefly touch on the business environment and then Tom Summer will review the financial details of the quarter.

We were pleased to report consolidated net sales growth of 19% on a constant currency basis for the third quarter.

Net sales included 129 million and $10.7 million of net sales for the Robert Mondavi and Ruffino brands respectively.

So excluding Robert Mondavi and Ruffino brands, net sales grew 6% on a constant currency basis, driven by our branded businesses across beer, wine and spirits.

And branded net sales, excluding Robert Mondavi and Ruffino brands, grew 9% on a constant currency basis, a very strong performance.

Equally as important, we almost doubled the margin expansion generating 200 basis points of operating margin expansion versus a year ago.

This dynamic, profitable, true growth crosses categories and geographies, despite some difficult trading additions in certain markets.

The strength of our brands is responsible for this growth.

The strongest growth in our base business came from Corona and our other imported beer brands with the beer business net sales growing 16% for the third quarter.

According to IRI data for the period ending November 27th, the U.S. beer market was essentially flat.

Within the beer category, consumers continued to trade up to imported beer brands and the Corona brand, with its strong brand equity and positioning with consumers continues, to lead this trading-up activity.

According to IRI data for the 13 weeks, Corona Extra has gained approximately a half of a share point of dollar sales since last year and the Modelo portfolio as a whole has gained nearly a full share point over the same time period.

Again, according to IRI data, the Modelo portfolio now accounts for more than 7% of the total dollars spent on beer in the United States.

While the Corona brand accounts for the majority of our beer volume and much of this year's case volume growth, the rest of our Mexican portfolio is also experiencing impressive growth.

Modelo Especial is the fastest growing brand in our portfolio.

This brand is positioned primarily with Hispanic consumers and is clearly benefiting from current demographic trends.

Now, I'd like to comment briefly on our year-to-date beer growth and our future growth expectations.

Our beer net sales grew 11% year-to-date and we expect a similar growth rate in the fourth quarter.

However, we expect mid-single digit growth rates next year.

Keep in mind that volume trends for late fiscal 2004 and early fiscal 2005 were impacted by the price increase on our Mexican portfolio two years ago.

When you normalize the growth over the past two years, volumes grew mid-single digits, which we believe is more indicative of the underlying growth rate for our beer business longer term.

Now moving on to our spirits business.

As background, Discus and IRI data both show volume growth of about 3% for the latest 12 weeks, with the value segment declining at approximately 2% and premium spirits growing approximately 4%.

In the third quarter, our spirits business grew 1%, significantly better than the value category in which we have the highest proportion of our branded spirits sales.

I'd like to take a moment to discuss our overall spirits strategy.

First, we continue to build our premium portfolio by growing our existing premium brands, introducing new premium products and entering into import and distribution agreements for premium products, like the one we have with Inverhouse for their single malt brands, Old Pulteney, Balblair and Speyburn and acquiring smaller, up and coming brands like Cocktails by Jenn.

This appears to be a slow-building process yet it is a process that will result in long-term brand development and growth.

We will continue to pursue larger premium spirits opportunities as we build our portfolio and I believe five years from now, we will be a significant force in the premium spirits category.

Our spirits business today is much like our wines business was in the mid-'90s before we made our first major fine wine acquisition.

And look, today, we're the fine wine category leader in the U.S.

So, speaking of our wine business, I'd like to move to branded wines.

Net sales grew 32%, due in large part to the addition of Robert Mondavi and Ruffino.

When we exclude Robert Mondavi and Ruffino brands, net sales for branded wines grew 6% on a constant currency basis.

This is a great growth rate, especially given the apparent concern over trading conditions in the U.K. and Australia.

So, let's look at these geographies.

Branded wine net sales in Europe grew 10% on a constant currency basis, driven primarily by volume growth in the U.K. and mainland Europe.

I'd like to provide some insight on long-term trends in the U.K. wine market, which, from our perspective, appear to be improving.

The U.K. wine market continues to experience a venue shift from on-premise to off-premise.

We believe as this shift occurs, consumers will have more money to spend on higher quality branded products.

In fact, recent A.C.

Nielsen data shows value growth outpacing volume growth both on and off-premise.

This is clearly evident in California wines, where volume growth is in the high teens and value growth well exceeds 20%.

And I should mention also that the average price points for California wines are slightly higher than the market as a whole.

Finally, with the continued growth of branded new world wines, branded products are becoming an increasingly larger percentage of the market.

All of this suggests that the U.K. consumer is increasingly willing to pay more for quality branded products they know and want, just like wine consumers in other branded wine markets.

Consumer purchasing habits don't change overnight.

But the signs are there of a very significant potential shift to more branded products at higher price points and in our opinion, this signals the start of a positive long-term trend that bodes especially well for Constellation because we are the clear market leader in the U.K. branded wine business.

Net sales in Australasia grew 9% on a constant currency basis.

In Australia, we have been able to leverage our portfolio and relationships with retailers to maintain our leadership position despite recent challenging market conditions.

Now, let's move to the U.S. where our net sales of branded wines grew 50%, including sales of Robert Mondavi and Ruffino brands.

Excluding the acquired brands, our business showed healthy growth in line with all category levels, and for the first time ever in a 52-week reporting period, Constellation surpassed Gallo as the market leader in terms of total dollar table wine sales according to IRI data.

The U.S. wine market is experiencing healthy growth both in terms of volume and value.

According to IRI, for the last 52 weeks, table wine grew 3%, that's in volume, while value grew 10%.

The value growth is due to a combination of factors: Positive mix shift due to trading up and increases in retail pricing year-over-year, which have benefited from the firming of the California grape supply which was a direct result of the 2004 light harvest.

The Robert Mondavi brands continue to perform very much in line with our growth expectation.

Looking at Woodbridge and Private Selection for the first nine months of fiscal 2002, net sales of these brands are up approximately 4%.

Depletion trends for these brands are positive and have generally tracked with shipment trends for third quarter and year-to-date periods.

Finally, I'd like to comment briefly on the 2005 California harvest, which has been a newsworthy topic recently.

We've been in the business a long time and we understand the grape cycles perhaps better than anyone out there.

So, I'd like to offer some insights that should ease concerns about the size of the latest harvest.

While data is still coming in, it looks like the harvest will be 15 to 20% higher than last year with the increases varying by varietal and region.

The higher yield resulted from optimal growing conditions at the end of the season, and indications are that the quality of the grapes is outstanding.

But what's most important is this bountiful harvest is helping to keep the grape supply in relative balance after two years of lighter harvests and actually kept this year's grape prices from increasing as they would have otherwise.

While I'm on the topic of the California wine supply, I should comment about the flooding in Northern California, which has received a lot of news coverage in the past several days.

Everybody needs to realize the vines are dormant this time of the year and so flooding itself generally does not cause damage to the vines.

To the extent there is soil erosion, which can occur close to the riverbeds, there can be damage to the vineyards.

In general, there has been extremely little damage, little soil erosion and we don't expect that what damage there is will have a material effect on the upcoming crop.

As it relates to our own vineyards, our reports are very positive from our West Coast operations people indicating, again, very little damage.

I've covered a lot of ground this morning and I'd now like to provide a wrap-up.

All three of our branded businesses performed extremely well during the third quarter.

Even in markets where trading conditions are somewhat difficult, we are growing our brands.

The Robert Mondavi acquisition is meeting our expectation and is contributing to growth and solid margin expansion.

All in all, we had a great quarter of true growth and we are very pleased with our performance.

Now I'd like to turn the call over to Tom Summer for our financial review.

Thanks, Richard.

Good morning.

I'm going to go through cash flow first, then go through the P&L and get to guidance last.

Starting with free cash flow, which we define as net cash provided by operating activities minus Cap Ex, free cash flow totaled 191 million for the first nine months of 2006.

And for the full year of fiscal 2006, we expect free cash flow to be in the range of 240 to $260 million in line with the projection we provided at the beginning of the year.

Additionally, we continue to expect Cap Ex of approximately 140 million for the year.

Now, as we always say, exclusive of acquisitions, our priority for free cash flow is always to pay down debt.

Now, during the quarter, we received $7 million of additional proceeds attributed to Mondavi vineyard assets and for the first nine months of the fiscal year, we've generated 171 million from Mondavi asset sales.

These disposition efforts are essentially complete and came in at the high end of our expectations effectively reducing our original investment in Robert Mondavi.

Our free cash flow generation combined with proceeds from asset sales have contributed to our debt paydown during the year.

We finished the third quarter with approximately $2.95 billion of debt, which is down $350 million from the $3.3 billion balance at the end of fiscal 2005.

And we expect to exit the year again with approximately 2.9 billion of debt.

At the end of the third quarter our debt to trailing 12-month adjusted EBITDA was 3.3 times compared with 4.5 times at the end of fiscal 2005.

This is a great improvement in this ratio and projected debt paydown reflects the benefits of our growth and demonstrates our ability to deleverage after we complete acquisitions.

Now let me turn to the income statement and as has already been noted, my comments will focus on comparable basis financial results and I wanted to start by just briefly reiterating a few key sales metrics.

Our consolidated net sales grew 19% on a constant currency basis for the quarter and our base net sales grew 6% on a constant currency basis.

Branded wine net sales led the way increasing 32% with our base up 6% on a constant currency basis.

And our imported beers were up a strong 16%.

So, the thing that I'm really trying to get to and highlight here is that the net sales of our higher margin base-branded businesses, taking beer, wine and spirits in totality, increased an impressive 9% on a constant currency basis.

That's a great quarter.

And I think if you move the margins, we also had a very impressive quarter when it comes to margins.

In the third quarter our gross margin was 31.5%, up 240 basis points from the prior year.

This increase reflects improved sales mix due in part to the addition of Mondavi premium products to our portfolio, faster growth for our brand of businesses, as well as improved pricing in our U.S. popular wine portfolio.

SG&A on a percentage basis for the quarter was 12.4% of net sales compared with 12% a year ago.

This increase, again, was expected because of the addition of Mondavi.

As you'll recall, Mondavi's historical SG&A run rate was much higher than Constellation's, yet the synergies we've achieved allowed us to bring that SG&A rate much closer in line with our historical run rate.

For the quarter, corporate and other expenses increased $1.5 million to $15.3 million, reflecting increases incurred to support the Company's growth.

We're targeting corporate expenses to be in the range of 59 to $61 million for fiscal 2006.

This range is higher than our previous guidance only because it includes approximately $4 million of expenses associated with the Vincor tender offer that will be recognized during our fourth quarter.

Our operating income increased 31% for the quarter and operating margin -- this is another impressive number for the quarter -- was 19.1%, an increase of 200 basis points from the prior year, primarily due to the favorable product mix effects that have already been discussed on this call.

Interest expense for the quarter, $48 million, up 17 million over last year.

Borrowings related to Mondavi and Ruffino.

At the end of November we had just under $2 billion of debt outstanding under our bank credit facility. 1.2 billion of which is fixed with swaps that begin in March 1st of 2006.

In addition, we have just under a billion dollars of fixed term and other debt and our average interest rate for the quarter on all of our debt was about 6.5%.

Earnings in equity method investments increased $9 million from last year and that increase relates almost entirely to equity earnings in Opus 1.

Opus 1's revenue and profits are very seasonal with the bulk of their annual revenue recognized upon the release of the latest year's vintage.

Opus 1's 2002 vintage was just released for retail distribution in November and Constellation's share of the profits were recognized in the third quarter.

Our effective tax rate came in at 39.3% for the quarter.

As we've stated throughout the year, due to facts and circumstances which are specific to each quarter, our effective tax rate has been and will continue to be somewhat variable on a quarter-to-quarter basis.

We anticipate the tax rate for the full-year to approximate 36% on a comparable basis.

And based on our projections could potentially be 20, maybe 30 basis points higher than last year's rate of 36%.

What this implies is a lower tax rate in the fourth quarter of fiscal 2006 compared to the actual tax rate year-to-date of 37.1%.

As a result of all the factors that I've already talked about on the P&L, our net income increased 25% for the quarter and our weighted average diluted shares were 239 million compared with 233 million a year ago.

Our diluted EPS grew 24% to $0.52 for the quarter and was slightly ahead of our guidance range that we provided at the end of last quarter.

We're reiterating our full-year guidance, except that we're raising the bottom of the range to reflect the fact that we're three quarters through the year.

And we're now projecting comparable basis diluted EPS in the range of 157 to 160 and that's consistent with where we said we would be all year long.

That translates into a fourth quarter range of $0.34 to $0.37 for comparable basis diluted EPS, which again, includes about 4 million of expenses associated with the Vincor tender offer that I discussed earlier.

The comparable basis EPS guidance excludes acquisition-related integration costs, restructuring and related charges and unusual items which are detailed in the press release.

The full-year guidance does assume consolidated net sales growth in the mid-teens, including the benefit of 10 additional months of Robert Mondavi.

When looking at base business revenue by category, actual growth rates for the first nine months should provide a fairly good directional indication of full-year growth rates.

Operating margin expansion should come primarily from our wine segment due to mix and cost savings, while operating margin in our beers and spirits segment are expected to decline slightly, primarily due to mix and higher transportation costs.

Interest expense should be in the range of 190 to $195 million and as I mentioned earlier, we expect our effective tax rate for the full-year to approximate -- be a little bit on the high side -- of 36% on a comparable basis.

And we are assuming weighted average diluted shares to approximate $240 million.

Our guidance for 2006 excludes the impact of FAS 123R, which the Company will adopt at the beginning of fiscal 2007.

Some analysts have already begun to estimate the impact of FAS 123R so that they can evaluate all companies on a consistent basis, including the impact of stock-based compensation, so I wanted to provide a little bit of data to help with this analysis.

Our pro forma footnote disclosures are a good indication of what our actual stock option expense would have been in each of the past several years.

As reported in our fiscal 2005 Form 10-K, the estimated stock-based compensation on a pro forma basis was $0.08 per diluted share for fiscal 2003, $0.08 for fiscal 2004 and $0.15 for fiscal 2005.

The pro forma expense for the first nine months of fiscal 2006 is expected to be approximately $0.04 per share.

These fluctuations are related primarily to the performance-based acceleration feature in Constellation's stock option plan.

The vesting period for most of our recent option grants is four years.

However, vesting can be accelerated if certain performance criteria related to our stock price are attained.

In fiscal 2005, the Company stock appreciation resulted in accelerated vesting for many stock options granted in 2004 and prior.

This resulted in significantly higher pro forma stock-based compensation expense for fiscal 2005 versus fiscal 2004 and fiscal 2003 and lower pro forma stock-based compensation expense for fiscal 2006.

So, all of that was to explain the variability in these pro forma numbers.

So, as you model stock-based compensation expense, you should take these fluctuations into account.

We do expect to provide a range of the estimated impact of actual stock-based compensation expense on fiscal year 2007 earnings as part of our fourth quarter press release conference call in April.

As it relates to full year fiscal 2007 guidance, we are well into our planning process and expect to be in a position to provide fiscal year 2007 guidance sometime closer to our fiscal year-end.

Now, getting back to the third quarter and to briefly summarize, we delivered strong top and bottom line performance, reflecting strong growth of our branded business and excellent margin expansion.

These results demonstrate the underlying strength of our diversified portfolio and our operational scale and we've got a strong balance sheet that positions us with plenty of flexibility to grow and further strengthen our portfolio.

Overall, we're very pleased with our third quarter and year-to-date results and we continue to be very optimistic as we look forward.

That concludes my remarks and now we'll be happy to open the call to questions.

Thank you, Jackie, and will you please open the floor for questions now?

[OPERATOR INSTRUCTIONS] Your first question is from Tim Ramey of D.A. Davidson.

Congratulations, good morning.

The question I had was relating to the performance of the Australian business.

I know what you said about the sales in Australasia, but could you give us some sense about how the business performed overall in its export markets to the U.S. and the U.K.?

Yes.

Our export business to the U.K. is increasing very much in line with the Australian category and to the United States.

Again, we're seeing significant increases in our exports and really to all places around the world, we're seeing significant increases in exports.

So, the export portion of the Australian business is very strong and I really should mention that you've got to also think about New Zealand because that is one of the strongest parts our worldwide export business.

Our New Zealand brands, whether it's Nobilo or a brand like Monkey Bay, our new sauvignon blanc is really on fire around the world as is New Zealand in general, but we're definitely leading the trend.

Okay.

And just, appreciate some of the incremental financial details in the press release, but one thing that you've provided in the past and would be nice to know if you could, some of the specific sales performance of some of the wine brands other than just the top one or two Mondavi and Private Selection that you did give?

You know, I would suggest talking to Lisa.

I think you're really referring to last year where we had certain key focus brands that we were driving distribution on and as a result, we reported on those distribution gains and volume gains.

This year's a little bit different and that's why we're not reporting.

We don't quite have the same focus -- set of focus brands and it's much more of a portfolio effect that we're looking at and obviously tracking the Robert Mondavi integration.

Thanks, Richard.

Thank you.

Your next question is from Bryan Spillane of Banc of America Securities.

Hey, good morning.

Richard, just two questions on the beer business if you could.

One, we've heard a bit that you're potentially thinking about price increases.

Maybe selectively, can you talk a little bit about that?

Sure.

I think what you're referring to, Bryan, is that we are taking a very different approach to price increases with regards to the Modelo portfolio.

We're working collaboratively with our partner to assess opportunities based on the competitive dynamics of each market and each brand and actually each SKU in each brand and market.

So, we are implementing and intend to continue to implement price increases on an ongoing basis where appropriate, rather than what's happened in the past, which has been an across the board increase as a function of when Modelo needs to or wants to raise their price to us.

So, we consider this to be very positive in that we've always believed, no matter what category, pricing should be market driven and very specific to market-by-market, brand-by-brand SKU conditions.

So, this is, we think, very good in evidence of our strong relationship with Modelo to make this dramatic fee shift, really, in how we're pricing.

And just so I'm clear, you've implemented some increases already, is that right?

Yes, they are in the process of being implemented so they didn't affect the P&L or the shipments in the third quarter.

They will have a slight effect on the fourth quarter.

And then if you could, Richard, just looking at the relationship with Modelo and the beer business in total I'm assuming at some point the next, you know, few months, we will probably hear something about the Gambrinus and Modelo arbitration and it just raises the question about your relationship with Modelo and, you know, how your relationship will sort of exist going forward.

Can you just, to the extent that you can comment about that, and how that decision does or doesn't impact, you know, your relationship with Modelo?

Yeah, first of all, let me start by saying you are correct.

It is our understanding that the arbitration decision should be handed down fairly soon.

I also have to say as I always say, we are not involved in any way in the arbitration.

This is something between Modelo and Gambrinus and it really is none of our business and we are staying out of it.

Our relationship with Modelo and our contract is very different than the Gambrinus/Modelo situation that is being arbitrated.

We have a very good relationship, we're very focused on building the business in a cooperative fashion and as you know, we have an automatically renewable contract if we meet certain conditions which we have met and are easy to meet and we're going to meet and so on and so forth.

So, our focus has been on our territory and the business that we have with our partner.

And our relationship is very good.

So I don't see any spillover effect.

Obviously, there's a lot of speculation about what will happen if Modelo wins the arbitration, what will they do with the Eastern portion of the business?

And, you know, the answer is, we don't know anymore than you know, but we have been quite specific that no one should imagine, speculate, that there is a scenario where Constellation will get a windfall profit if Modelo were to choose to do something with Constellation on a unified basis, i.e. give us, in some way, the Eastern portion of the U.S.

So, to me, that's the most important point.

If it makes sense to Modelo, which we'll find out in due course, and it's strategically the right thing to do, you know, Modelo's not going to just hand Constellation a pot of gold.

So, we have done the best we can to take any speculative wind out of those sales.

Right.

But the reality is we have no idea what's going to happen.

Okay.

Thank you.

Thank you.

Your next question is from Mark Swartzberg of Stifel.

Thanks, Operator.

Good morning, guys, good morning, Lisa.

Richard, a question for you on your acquisition priorities.

It sounds like spirits remains your number one priority of the three you have.

Can you comment a little bit more on your view of the opportunities set, particularly in the United States, the ability to actually undertake acquisitions which, in aggregate, amount to you becoming substantially larger over the next five years, as you mentioned?

And one of the reasons I ask that is that when you look at the difference between spirits versus wine, or one of the differences, is you don't seem to have the level of economic triggers, if you will, on the spirits side, that you often have in wine, where you see folks who make some bad decisions in one phase of the grape cycle coming, you know, coming back and creating an opportunity for an acquirer like you.

So, could you talk a little bit more about your view of the opportunities set particularly in the United States spirits market?

Yeah.

Actually the analogy that I used, that our wine -- our spirits position today is much like our wine position was in the '90s, I think very much addresses your questions because if you look at how we built and what opportunities existed to build the fine wine business in the mid-'90s, you will see that it had little to do with the standard economic drivers of grape cycles so on and so forth.

And what it had to do with is something that is actually going on in the spirits business today that, in many regards, went on in the wine business, the fine wine business in the mid-'90s.

There's this tendency to believe that, you know, premium spirits have been the growth category for years and years and years and years and that really isn't the situation.

It's really very recently that we're seeing premium spirits have significantly higher growth rates than value spirits or value spirits start to go into a state of decline.

Now, what is driving this?

Well, what's driving this is, yes, the consumer is gravitating towards premium spirits, but also, they're moving toward new and innovative brands in the premium spirits categories.

So, much like we saw in the fine wine business in the mid-'90s, there's a whole set of new brand in the category that are emerging and becoming of material size.

So, you go back to the late '80s, a company like Franciscan wasn't even of size to buy.

So, by 1998, they had developed a business over that five, six-year period through some dynamic growth of some new brands and some old brands that made them of size enough for us to buy, to start building a foundation in the fine wine business.

We're seeing the same thing in the spirits business.

Lots of new brands, some of them getting very meaningful traction and those brands, you know, some will desire to go to be the next big premium spirits brands and the owners will want to take it all the way.

Others, the owners will only want to take to, I'm going to call it a medium point of penetration, and want to cash out and turn it over to people like ourselves with the scale, the roots to market that we can really dynamically take what they've started on an embryonic basis and grow.

So, the premium spirits business is changing in ways that aren't really obvious to people outside the industry, which we believe is creating dynamic opportunities for us over the next five years to build, what I'm going to call is more of a new age premium spirits portfolio versus some of the old standbys, which may actually be fading.

That's great.

Very helpful.

Thanks, Richard.

Thank you.

Your next question is from Bonnie Herzog of Citigroup.

Good morning.

How are you?

Good, Bonnie, how are you?

Oh, fine, thanks.

I just had a question about the wine industry and the growth that you've experienced and your position in the industry.

Just trying to think about future innovation and maybe what you can do to make the products more acceptable for the younger, legal-age consumers, and I guess I'm thinking about it in terms of your industry, doing things like making it attractive by creating smaller bottles, the screw tops, you know, are there other things that you're working on?

And I guess I'm asking this because you are a leader and I do think there's a tremendous amount of opportunity to make wine less intimidating for many consumers and innovation could play a great role.

And what is your company doing here?

And how can you leverage this?

Can you talk a little bit about that, please?

Sure.

First of all, you are correct.

We are the leader in the wine industry on a worldwide basis and in the United States and being the leader, it is incumbent upon us to expand our markets and we're in a very enviable position because the reality is no matter what age group and almost no what sociodemographic group you're talking about, wine is the category people are moving to.

Right.

Okay?

And it is wonderful to be the leader in a category where people are moving to instead of moving away from.

And it's our job to make sure that we capture the vast majority of those people moving to the category and not only continue and support that trend but accelerate it, so, your question is right on.

So, what do we do?

Well, first of all, your comment about approachability and closures is very important and many of our new products and even old, old products, we are moving to screw caps and the new brands that we come out with are clearly not oriented towards the wine aficionado, the wine expert, but they're oriented towards making the brand and the product in the bottle very approachable, very understandable and consistent with the younger lifestyle.

Example, you know, 3 Blind Moose, Twin Fin, Monkey Bay, The Jibe, Kelly's Revenge, Foolish Oak, Smashed Grapes.

These are not names that you would expect to see on a first growth Bordeaux or an unapproachable $100 bottle of wine.

These are very trendy, lifestyle names.

You know, half the products I just named have screw caps and if you look at how they're marketed, they're marketed directly to the consumer, to this new consumer group that's moving to wine, that wants wine to be approachable.

And basically how have we come to this?

Very easily.

We have ongoing consumer research, in fact, some of the biggest, broadest and best research that's been done by our operating companies recently we've reported on, to make sure that our new products are consumer-driven.

So, we are definitely the leader in innovation.

We have the most new products and our new products have a much higher success rate and faster growth track than any of our competitors because we're doing exactly what you suggested.

And also just to push, I would hope that there's also a packaging component.

Is that fair to say?

Well, yeah, you can look at, we're moving to more splits, you know, 375s and 187s.

Different packaging components look at our premium bag in the box lines like Hardy's Stamp or Black Box.

These are three-liter premium varietal wines.

You take them out of glass, they're much more approachable, much more usable across occasions.

So, we're definitely talking the same language.

Okay.

From the year, the calendar year of 2006, we'll hear more news about this and in terms of the costs perspective, is this somewhat minimal like what we're discussing right now, you know, the up-front costs invested behind this?

Yeah, you know, you move to calendar 2006, what I'm trying to tell you is there's been a tremendous activity in calendar 2005 and calendar 2004.

So this is an ongoing cost that we, as a company, have born and will continue to bear, but it bears fruit very rapidly and we're seeing very positive results.

Great.

Thank you so much.

Thank you.

Your next question is from Jonathan Feeney of Wachovia.

Good morning, congratulations.

Richard, you know, you drew a comparison between your success in building a fine wine business and your future plans in spirits and, you know, in response to [inaudible] kind of followed up on some of the nichier, maybe more consumer aligned newer spirits brands that are out there, you know, as a growth strategy.

But it occurs to me you essentially stepped into a vacuum in term of leadership in the wine business.

I think you were very smart to do that and been very clear about that whereas there is some leadership right now in the spirits business.

So, could you, just as a follow-up, do you think it's the case that the big kind of established deeply, heavily-funded spirits companies are kind of missing niches of the spirits industry now or is it just a case that, you know, you're going to be able to go and do a lot of the same things better than these big companies as you grow your spirits portfolio in North America?

Yeah.

I think that given our decentralized structure and our ability, therefore, to move against market opportunities, we are a bit faster afoot and closer to these trends, which allows us to take advantage of them versus some of the spirit companies that are in leadership positions.

I don't want what I have said to really mean that this has to take place just in the United States.

There are many other spirits markets and that this means that we're going to be number one.

That is not our goal, to be number one in the premium spirits business.

But we can be, by focusing on these niches and emerging trends, we can be a powerful force in the premium spirits business, which will build upon our powerful position in value spirits and in wine, both value and premium wine and in imported beer in the United States.

So, taken alone, we will be viewed certainly as a powerful premium spirits player five years from today, not necessarily the leader, but then taking our total alcoholic beverage business, we will emerge as a total beverage alcohol leader crossing all categories and all geographies even more than we do today.

So, you can't take it sort of by itself, as the fine wine example may have suggested.

You have to take it in the context of our total business.

Okay, thanks.

That's very helpful.

And just a couple of follow-ups for Tom, if you wouldn't mind.

You mentioned transportation with respect to beer margins.

Is it possible that you could quantify transportation costs a little bit more granular way across the entire company and also, you know, $140 million, is this a good level for capital expenditures as a percent of sales or should we expect sales to outpace Cap Ex for the next few years?

Yeah, I think on the first question, I don't want to get that granular on this call and I would suggest that you follow-up with Lisa or Bob and they can give you some color.

Relative to Cap Ex, you know, we haven't completed our plans for next year.

We will be guiding to Cap Ex but I think as a general guideline, we are seeing a lot of good growth investment opportunities as we're going through the plans and I would probably be thinking that next year will be, you know, around the same level as this year at this point in time.

Okay.

Thank you very much.

Thank you.

Your next question is from Christine Farkas of Merrill Lynch.

Thank you very much.

Good morning, Richard.

I have a quick question regarding your branded wine business in the U.S.

Specifically, can you comment on the organic wine growth?

If I look at your reported underlying currency neutral growth in Europe and you're up 10% in Australia about 9, that suggests the U.S. was flat to maybe down a little bit.

Can you take us through the popular and the premium wine segments and how you think, perhaps, you can manage the mix even better than you are?

Yeah, in the U.S., our base business, excluding Mondavi and Ruffino, is not flat.

It is up in the low mid-single digits and basically the categories that you talked about, which I would say, you know, are value wines, premium wines, super premium wines, luxury wines, I'm citing varietals in there, really are performing.

The higher the price, the better the performance of the category and our business, category-by-category, is either in line with the category or as you move up the price points, we're actually performing better than the price category.

On the surface it looks like our value business and our popular price business is losing share.

That is an anomaly that we've talked about created by the fact that we eliminated white zinfandel SKUs because of a shortage and high prices of zinfandels, and actually, that situation coming off the harvest of 2005 will be rectified as there was plenty of white zinfandel, prices were reasonable, so, we're refilling all of those SKUs that were low-priced and basically will have the positive side of the comparisons versus the negative side that we saw all year as we eliminated those SKUs.

So, when you take that out, our value wines are holding share, albeit declining because value wines in general are declining, but our premium-priced wines are growing faster than their respective price categories.

That's why we have such a fantastic mix effect.

If you were to refill these low-end SKUs then essentially that would actually hurt your mix giving you're growing the low-end wines.

Can you give us a relative margin comparison between your low-end and high-end wines?

Is there a way to do that?

Well, you are correct, you know, on the margin in what you said but, you know, it's going to result in reducing the positive mix effect, is the way I would put it, because the market is, let me give you an example.

You look at wines above $10, 10 to 15, they're growing at 15%, okay?

Wines below $3 are declining at 2%.

The difference in those growth rates combined with the margin difference is very significant.

The wines at 10 to $15 will have double the margin of the wines below $3.

So the fact that we fill up SKUs, refill up SKUs and change our growth rate from minus 3% to minus 1% isn't going to have a lot of impact as long as our 10 to $15 grow at 15, 16%.

Great.

And just a final question.

Clearly there's a lot of talk about new world wines.

There looks like there's a resurgence of Italian wines or imports.

Are you seeing anything change dramatically from the old world wines coming into the U.S.?

Well, yeah, I would agree with you that Italian wines of all the old world wines seem to have been most responsive to the implied consumer taste preferences that are driving new world wine growth and you see a lot more fruit forward, big Italian wines, which are best characterized by your super Tuscan wines, otherwise known as your IGT wines.

And you see a lot more of those.

Our Ruffino business is growing very nicely as a result of that trend.

And the composition of our Ruffino business is moving towards, these are typically called blending wines versus appellated wines, so Italy definitely is the most responsible world country.

France is having troubles, responding in part because of some of their regulatory and appellation control "A" restrictions and Spain actually has some really great wines but doesn't have, especially in the United States, the historic reputation.

So, there's a lot of changes taking place.

All right, that's helpful.

Thanks, Richard.

Thank you.

Your next question is from Robert van Brugge of Sanford Bernstein.

Yes, good morning.

I was wondering if you could comment on the beer and spirits margins?

I realize that there's a mix shift from spirits to beer, which will lower the margin somewhat and that the transportation costs are negative, but is there anything else that resulted in the big difference between revenue growth and operating profit growth in the segment?

Not really, Robert.

Those are the main things and that's why we noted them.

There's a few small things here and there, but nothing worth noting.

Okay.

And then if I may, one question on Mondavi.

The sales performance has been up slightly this year and you said that it's in line with the expectations for the first year.

Going forward, do you expect this growth rate to pick up or is this more of a longer-term trend that you're looking at?

I guess my first comment would be is it's up a little bit more than slightly, but, you know, it's been healthy growth, we're very happy with the performance.

I would say we have very high expectations for the brand.

Obviously as it flattens out a little bit in the domestic market, there's a lot of opportunities in other markets.

There's just a lot of opportunities for the brands.

So, you know, I think, I don't think we would expect anything tremendously different, you know, in the near-term.

Okay.

Thanks.

We're running over a bit so I think we're just going to take one more question.

Your final question from Caroline Levy of UBS.

Hi, it's Nancy for Caroline.

Richard, I was wondering if you could talk a little more about the U.K. market?

With the strong growth that you saw in the past quarter than with the overall industry?

Leanne, I'm sorry, you cut out there for a minute.

Could you repeat your question?

I'm sorry, can you hear me now?

That's much better, thank you.

I was wondering if you could talk a little more about the U.K. market and whether the 10% growth you saw last quarter was consistent with the overall industry?

And whether you think the worst is over?

Well, you know, the worst is over.

First of all, I think that the problems in the U.K. market have been severely overplayed and that they're not so bad.

As we indicated, we had lower growth rates, particularly in the second quarter in the U.K. than the market itself, as we were changing some of our pricing and promotion approaches.

So, with those adjustments in place, we're very happy with our growth rates.

We don't view it as an indication that the markets changed dramatically.

The other thing that I think's very important and that we've tried to emphasize is that, if you look at the profits generated by our total portfolio and I don't just mean trading profits, I mean, you know, including brand-owner profits, we're running a very, very large and growing, profitable business.

And you'd never think that if you listened to what everybody says about the U.K.

So, we're happy with our growth, we're happy with our profitability.

Yes, things can improve.

There could be a little less pressure and, you know, a little more consumer activity towards trading up.

We think all of that will happen in due course but our real point is very simple.

While everybody talks about how bad the U.K. is, you know, we've got a great business.

It's growing, it's profitable and it's not bad.

It's good.

Okay.

And as a follow-up, can you talk about your pricing strategy for the U.S. this year?

I think you took a pricing on some of the popular wines recently and, you know, given the increase in harvests, what is your pricing strategy going forward?

Yes, yeah, the increase in the harvest, basically resulted in stable prices year-over-year.

It did not result in a decrease in prices, especially on value wine, other than there is higher availability of white zinfandel.

So, our costs on our popular priced wines didn't go down and, therefore, the price increases that we took, which reflected the higher prices of the 2004 harvest, will stay in place and the profitability will remain about the same but we have more availability of white zinfandel.

That's about the only difference.

Okay.

Great.

Thank you.

Okay, I think that wraps up our call.

Jackie, would you like to say some closing remarks please?

Thank you.

This does conclude today's teleconference.

You may now disconnect your lines and have a wonderful day.