While it has reported strong third-quarter results and made bullish forecasts, analysts have reservations about the coming year for Constellation Brands, as the US and UK markets for Australian wines face toughening conditions. Olly Wehring takes a look at the new giant on the block and examines the challenges it is facing.

Last week, Constellation Brands announced record sales for the third quarter to the end of November 2003. The bulk of this growth came from the company's US$1.8 billion acquisition of BRL Hardy a year ago. But while the group painted a very rosy picture when announcing its results, analysts are reluctant to give Constellation a big thumbs-up. Indeed, some believe the company is going to have a tough time going forward.

The figures themselves are impressive. Net sales for the quarter hit a record US$987m, a rise of 34%, with net income excluding restructuring and other exceptional charges up 42% at US$91m, also a record. Wine sales surged by 47% to US$681m, thanks mainly to BRL Hardy's contribution.

"Constellation's strengths - our broad portfolio crossing three major beverage alcohol categories, our vast geographical reach across North America, Europe and Australia, and our scale which provides strong routes-to-market - together enabled us to grow at the high end of our expectations," said the group's chairman and CEO, Richard Sands.

However, in spite of the optimism radiating from the US last week, analysts remained circumspect, predicting tough times around the corner. "It's a wait and see," one analyst said. "The whole company is a wait and see." Another warned: "Year Two (of Constellation's ownership of BRL Hardy, beginning in April) is the big issue for the stock. People are going to be very interested to see how that moves forward."

Mark Swartzberg analyst at New York stockbrokers, Legg Mason, believes the company will find it difficult to sustain the recent levels of earnings growth. "(The) next 12 months' earnings levels are likely to be uninspiring compared to the earnings upgrade delivered over the last 12 months, in our view," he said.

Nevertheless, Constellation feels that it has the scale, structure and the brands which set it apart from its competitors. "None of our competitors have the routes-to-market that we have," said Rob Sands, president and chief operating officer of Constellation Brands.

The company prides itself on being the world's biggest wine producer, following its acquisition of Hardy. Annually, the group sells around 72m cases. Before the merger, Hardy was performing very well. Operating profit grew from A$8.8m in 1992 to A$84.3m in 2002. The acquisition was a clear example of Constellation's general strategy - to have a portfolio that covers every single base.

And heading into 2004, Constellation appears keen to keep ahead of its competitors by staying the biggest. "We expect to continue making acquisitions where there is a good strategic fit," said Stephen Millar, CEO of the company's wine division, Constellation Wines. The areas Constellation feels are going to provide it with growth opportunities in wine are the US and the UK.

Constellation says that one of the keys to its success is that it has comprehensive sales, marketing and distribution networks around the world. "We believe that our wine portfolio, coupled with our size and routes-to market, gives us a competitive advantage in global wine markets," says Millar. In particular, with sales of Australian wine growing by over 50% per annum in the US, Millar has high hopes for the company's US operations. "We would be disappointed if we could not achieve at least a 15% market share by 2008, with a longer-term target of 25%."

In order to shore up its US activities, Constellation announced last week that it is to make strategic changes to its Canandaigua Wine Company, Pacific Wine Partners and Batavia Wine Cellars organisations in an effort to seek continued growth. A new umbrella group, Constellation Wines - US, to be headed up by Jose Fernandez, will provide services such as channel management, finance, operations, human resources and legal services to the three companies, which, it is hoped, will allow the group to leverage the combined scale of the businesses. However, each will continue to be responsible for managing its own separate sales and distribution networks and retain their own identities and business strategies.

One major concern looms in the US however. Reports last week suggested that Australian wines' decade-long love affair with the US may come to an end this year as the Australian dollar surges and the US dollar slides. As the US dollar weakens against the Australian currency, winemakers in Australia face a critical decision. Either they trim margins to maintain volumes and market share, or risk both by pushing through price increases in the US to maintain profitability. Neither option would be particularly palatable for Australian wine exporters.

But typifying the confident outlook which Constellation has projected since the BRL Hardy takeover, Millar said the company welcomed such challenges. "Challenges are opportunities," Millar says. "The growth opportunity for Hardy wine, in my view, has never been stronger."

And Constellation is also bullish about its prospects in the UK. "The UK market is a wonderful market for New World wines," says Millar. And Constellation has had it good as Australian wines have soared in popularity. The company boasts a 10% market share of the total wine market in the UK, and 25% of the market for Australian wine. "We expect Australian wine will achieve at least a 30% share (of the UK wine market) and Constellation is targeting 30% of that share."

But again, Constellation also faces a potential banana-skin in Australian wine's largest export market. In November last year, a report by KPMG Australia highlighted the competitive, cut-throat nature of the UK's off trade market. In 1992, the four big supermarket chains, Sainsbury, Tesco, Safeway and Asda had less than a 20% share of the UK wine market. Today that figure is closer to 60%. As these big players get bigger, so price point becomes the main differentiation between them. As in the US, the pitfall that awaits New World wine manufacturers threatens to push margins ever lower.

One danger that applies to both these markets is the ongoing debate over the potential for a wine oversupply. In Australia, the area covered by grape-bearing vines has doubled in the last five years to 143,000 hectares, according to statistics released by the Australian Bureau of Agricultural and Resource Economics. The big question remains whether demand will actually match supply. If it doesn't, there will certainly be downward pressure on prices. Again, this is not going to help margins and, as the Southcorp debacle revealed, could have long-term negative ramifications.

Short- to medium-term, Constellation will have all these factors to struggle with. While the company is well placed for the long-term, by dint primarily of its reach, breadth of coverage and scale, these external conditions are going to provide quite a challenge in the next 12 months.