ARGUS Independent Equity Research Since 1934 MARKET UPDATE 2016 - DJIA: 19,762.60 1934 - DJIA: 104.04 THURSDAY, APRIL 6, 2017 Good Afternoon. This is the Market Update for Thursday, April 6, 2017 with analysis of the financial markets and comments on American International Group Inc. and Constellation Brands Inc. IN THIS ISSUE: Growth Stock: American International Group Inc.: Reiterating BUY but lowering target to $70 (Jacob Kilstein) Growth Stock: Constellation Brands Inc.: Strong quarter; maintaining BUY and $194 target (John Staszak) DAILY INSIGHT APPLE INC. (NGS: AAPL)... BUY Apple has released its new ipad with no fanfare and with no name beyond ipad. The product is priced at $329 for a standard model with impressive features. We believe that Apple now regards tablets for the consumer market as almost a commodity product. The motivation for this lowkey approach, in our view, is to further differentiate the ipad Pro as a high-end business tool. Fiscal 1Q17 results and 2Q17 guidance demonstrate that iphone unit sales are growing larger as well as steadier, with less seasonality. Despite a strong run this year, the shares currently trade at a discount to their historical relative P/E. We are reiterating our BUY rating to a 12-month target price of $160. MARKET REVIEW: Stocks rose modestly on Thursday morning following Wednesday s late afternoon selloff, which was prompted by the Fed s announcement that it would begin to reduce its bond holdings later this year. On the employment front, the Labor Department said that first-time jobless claims fell by 25,000 to 234,000 for the week ended April 1. The Bloomberg consensus forecast had called for a smaller decline to 250,000. The Dow, the S&P, and the Nasdaq were all up about 0.3%. Crude oil rose 1% to about $51.50 per barrel, while gold rose $6 to trade near $1251 per ounce. A R G U S R E S E A R C H C O M P A N Y 6 1 B R O A D W - A 1 Y - N E W Y O R K, N. Y. 1 0 0 0 6 ( 2 1 2 ) 4 2 5-7 5 0 0 LONDON SALES & MARKETING OFFICE TEL 011-44-207-256-8383 / FAX 011-44-207-256-8363
AMERICAN INTERNATIONAL GROUP INC. (NYSE: AIG, $62.05)... BUY AIG: Reiterating BUY but lowering target to $70 We have lowered our earnings estimates for AIG for the next two years amid reserve charges and poor underwriting. However, we like the company s leading positions in global P&C and U.S. life insurance, geographic diversification, ongoing divestitures of noncore assets, strong liquidity, and aggressive share buybacks. On March 9, AIG announced that CEO Peter Hancock had resigned but would stay on until the company named a successor. The resignation does not appear to have been voluntary. Carl Icahn, a board member with a 5% ownership stake in AIG, had publicly called for Mr. Hancock s ouster last year. AIG shares look cheap relative to peers. The price/book ratio is 0.8, versus an industry median of 1.4. The forward P/E ratio is 12.6 versus a peer median of 16.8. Our revised target price of $70 implies modest expansion of the price/book multiple to above 0.9, still well below the industry median. ANALYSIS INVESTMENT THESIS We are reiterating our BUY rating on American International Group Inc. (NYSE: AIG) but are lowering our target price to $70 from $75. We have lowered our earnings expectations for the next two years amid reserve charges and poor underwriting. However, we like the company s leading position in global P&C and U.S. life insurance, geographic diversification, efforts to cut costs and sell noncore assets, strong liquidity, and aggressive share buybacks. The company plans to spin off its mortgage insurance business, boost dividends and stock buybacks, and raise ROE to 9.5%. It also appears well positioned to improve returns on its $242 billion bond portfolio as interest rates move higher. We also expect earnings growth and share price gains to be driven by reduced financial regulation, lower taxes, and the possible removal of the company s SIFI designation. Although AIG shares are trading near a 52-week high, they look cheap relative to peers. The price/book ratio is 0.8, versus an industry average of 1.4. The forward P/E ratio is 12.6 versus a peer median of 16.8. The ROE is below the five-year average and the peer average of 10%. As the profitability gap with peers closes, the price/book gap should close as well. Our revised target price of $70 implies modest expansion of the price/book multiple to above 0.9, still well below the industry average of 1.4. RECENT DEVELOPMENTS AIG shares have underperformed over the past three months, declining 8% compared to a gain of 4% for the S&P. They have performed in line with the market over the past year, however, with both AIG and the S&P 500 rising 14%. The beta on AIG shares is 1.18, compared to 0.88 for peers. On March 9, AIG announced that CEO Peter Hancock had resigned but would stay on until the company named a successor. AIG Chairman Douglas Steenland highlighted Mr. Hancock s accomplishments, including leading a company turnaround, repaying TARP loans to the U.S. Treasury, and developing a two-year strategic plan laid out in January 2016. AIG shares rose 2.5% following the resignation announcement, suggesting that investors were pleased with the change. The resignation does not appear to have been voluntary. Carl Icahn, a board member with a 5% ownership stake in AIG, had publicly called for Mr. Hancock s ouster last year. Mr. Icahn wanted someone who knew the P&C business better and who would, in his view, be more open to change. In particular, Mr. Icahn called for a CEO who would make the company smaller and more focused, and help it to remove the SIFI label, which places restrictions on its use of capital. On February 14, AIG reported 4Q16 results that missed consensus expectations. The aftertax operating loss came to $2.8 billion or $2.72 per share, compared to a loss of $1.3 billion or $1.07 per share a year earlier. The consensus forecast had called for operating income of $0.42 per share. The shortfall reflected higher-thanexpected claim costs of $5.6 billion; the consensus was $3.5 billion. P&C net premiums earned fell 14% to $4.2 billion, and net premiums written fell 20% to $3.7 billion. Revenue rose 6% to $13.0 billion, above the consensus of $12.9 billion. - 2 -
After-tax operating ROE came to 4.8% in 4Q16, down from 6.6% a year earlier and below management s long-term target of 10%. The year-over-year decline was due in part to losses in Commercial Insurance. For all of 2016, ROE was 7.5%, below the low end of management s guidance range. As recently as the 3Q earnings call, Mr. Hancock had said that the company expected to at least achieve the low end of its target range of 8.4%-8.9%. Book value at the end of the quarter was $76.66 per share, up from $75.10 at the end of 2015. The company s two main segments reported mixed operating results Commercial Insurance posted a loss of $5.0 billion, compared to a loss of $2.6 billion a year earlier, while Consumer Insurance earnings grew 55% to $969 million. The combined ratio in Commercial deteriorated to a very high 241.6 from 163.3 a year earlier; however, in Consumer Insurance, it improved to 96.9 from 103.1. For all of 2016, after-tax operating income fell 86% to $406 million and EPS fell 83% to $0.36. Revenue fell 10% to $52.4 billion. The adjusted accident year combined ratio in Commercial Insurance improved 500 basis points to 95.8%. The combined ratio for Consumer Insurance improved to 96.4 from 101.1 in 2015. The 2016 normalized ROE of negative 0.2% was below the positive 1.9% recorded in 2015, reflecting price erosion, losses in Europe, and poor operating performance. On the positive side, expenses fell 10%. Management has lowered its 2017 ROE target to 9.5% from 10.0%, reflecting lost investment income associated with the 4Q16 reserve charge. However, Mr. Hancock said that the company would improve ROE in 2017 through better risk selection, the sale of underperforming businesses, and reduced catastrophe risk. Paulson & Co., a hedge fund run by AIG board member John Paulson lowered its stake in the company to 5 million shares as of December 31. Mr. Paulson owned 9 million shares in September and 11 million in March 2016. The earnings miss, lower ROE target, and news of the Paulson stock sale caused shares to drop 9% on February 14, the largest one-day decline since 2011. On March 23, management reiterated the 2017 financial targets that AIG announced at its Investor Day in November, including a 9.5% ROE target. The company is three quarters into an eight-quarter plan to reduce expenses, narrow revenue sources, and return capital to shareholders. AIG expects to return $29 billion to investors in 2016-2017, above its initial target of $25 billion. CFO Sid Sankaran has said that the company had reduced operating expenses by $800 million as of the end of 4Q16, representing 57% of its two-year target. AIG shares have risen 8% since the November 9 election, likely reflecting expectations that reduced financial regulation under the new administration, as well as higher interest rates, would boost earnings for financial companies. CFO Sankaran also noted that a reduction in the statutory tax rate to 25% (from about 35%), would boost ROE by 90 basis points. However, we believe that tax benefits are more likely in 2018 than in 2017. EARNINGS & GROWTH ANALYSIS AIG s recent financial performance has been poor, and we feel that management s new strategic plan could be more aggressive. In particular, boosting the ROE to 9.5% in 2017 appears to be an inadequate target given that MetLife and Prudential regularly have ROEs of almost 10%. However, we believe that AIG can change direction. We like the company s leading positions in global P&C and U.S. life insurance, geographic diversification, ongoing divestitures of noncore assets, strong liquidity, and aggressive share buybacks. We also see margins improving due to reduced operating expenses. Despite these positives, we are lowering our 2017 EPS estimate to $4.90 from $5.48 as AIG struggles with reserve losses, divests some business segments, and works to find its strategic footing. We are also lowering our 2018 estimate to $5.88 from $6.09. FINANCIAL STRENGTH & DIVIDEND Our financial strength rating on AIG is Medium-Low. The total debt-to-capital ratio was 28% during the fourth quarter, while the peer median was 19%. EBIT for the trailing 12 months ending December 31, 2016 covered interest expense by a factor of 1.8, below the peer median of 5.7. As AIG s after-tax operating loss for the fourth quarter was $2.8 billion, its adjusted net profit margin was negative, compared to a median net profit margin of 7.1% for peers. - 3 -
On January 31, S&P lowered its rating on AIG s senior debt to BBB+ from A- in anticipation of its 4Q reserve charge, which caused the company to fall short of required fixed coverage ratio thresholds. The company has a Baa1 rating with a stable outlook from Moody s. AIG pays a quarterly dividend of $0.32 per share, or $1.28 annually, for a yield of about 2.0%. Our dividend estimates are $1.28 for 2017 and $1.36 for 2018. Along with the earnings report, AIG s board authorized $3.5 billion in additional share repurchases, which increased its remaining authorization to $4.7 billion. It bought back $3.0 billion of its stock in 4Q and another $1.2 billion after the end of the quarter. In 2016, AIG repurchased $11.5 billion of its stock. AIG has been particularly aggressive with share buybacks, which have had a greater impact on EPS growth than the company s operating results. MANAGEMENT & RISKS On March 9, AIG announced that CEO Peter Hancock had resigned but would stay on until the company named a successor. The resignation does not appear to have been voluntary. Carl Icahn, a board member with a 5% ownership stake in AIG, had publicly called for Mr. Hancock s ouster last year. Risks for AIG include larger-than-expected catastrophe losses, pricing pressure, lower investment income, and continued low interest rates. COMPANY DESCRIPTION AIG is a leading provider of insurance products. It is organized into three segments: property casualty insurance, life insurance and retirement services, and mortgage guaranty. AIG is based in New York and has operations in more than 130 countries. VALUATION We think that AIG shares are attractively valued at current prices near $62. Over the past year, the share price has ranged between $48 and $67. More recently, shares have fluctuated between $60 and $67. AIG shares look cheap relative to peers. The price/book ratio is 0.8, versus an industry median of 1.4. The forward P/E ratio is 12.6 versus a peer median of 16.8. We note that forecast ROE of 9.5% is below the long-term industry average of 10%. In our view, that s the opportunity for AIG investors. As the company responds to pressure from activist shareholders, we expect earnings and ROE to improve. And as the profitability gap with peers closes, the price/book gap should close as well. Our revised target price of $70 implies modest expansion of the price/book multiple to above 0.9, still well below the industry median of 1.4. On April 6 at midday, BUY-rated AIG traded at $62.05, up $0.43. (Jacob Kilstein, CFA, 4/6/17) - 4 -
CONSTELLATION BRANDS INC. (NYSE: STZ, $171.86)... BUY STZ: Strong quarter; maintaining BUY and $194 target We have a positive view of the recent additions to Constellation s brand portfolio and increased share of the U.S. beer market, as well as of its above-average margins. Constellation reported strong fiscal 4Q17 results on April 6. Comparable sales rose 5% to $1.63 billion, above the consensus estimate of $1.59 billion. EPS rose to $1.48 from $1.19 a year earlier and topped the consensus forecast of $1.36. We are raising our FY18 EPS estimate from $7.50 to $7.90 and setting an FY19 estimate of $8.50. STZ stock appears attractively valued relative to peers and based on our discounted cash flow analysis. ANALYSIS INVESTMENT THESIS We are maintaining our BUY rating and $194 price target on Constellation Brands Inc. (NYSE: STZ). Constellation is a global producer and marketer of wine, spirits, and beer with a wide range of brands, including Clos du Bois, Ruffino, Robert Mondavi, and SVEDKA vodka. The company also owns the rights to brew and market Modelo Mexican beers (including Corona) in the United States. In addition, Constellation acquired a whiskey distillery in 3Q17. With more than 12% of the U.S. market and nearly 2% of the global market, STZ is the world s largest wine producer and should continue to benefit from economies of scale. We have a positive view of the recent additions to Constellation s brand portfolio and increased share of the U.S. beer market, as well as of its above-average margins. The stock also appears attractively valued based on peer comparisons and our discounted cash flow analysis. RECENT DEVELOPMENTS Constellation reported strong fiscal 4Q17 results on April 6. STZ shares have been strong performers since we initiated coverage in mid-january 2015, with a gain of approximately 62%, including dividends. The beta on STZ shares is 1.0. For the fiscal fourth quarter (ended February 28, 2017), comparable sales rose 5% to $1.63 billion, above the consensus estimate of $1.59 billion. The adjusted gross margin was 48.3%, up 190 basis points from the prior year, and 40 basis points above the consensus estimate. The adjusted operating margin increased 220 basis points to 30.4%, above the consensus estimate of 29.3% and our forecast of 29.8%. The better-than-expected operating margin was driven by strong volume and a more favorable product mix. Operating income rose 14% and EPS came to $1.48, up from $1.19 a year earlier. EPS also topped the consensus forecast of $1.36 and our estimate of $1.43, reflecting the strong gross margins and management s solid execution. For all of FY17, comparable sales grew 12% to $7.3 billion, while adjusted EPS rose from $5.43 to $6.76. The full-year adjusted operating margin increased 140 basis points to 29.9%. Along with the 4Q17 results, management issued adjusted FY18 EPS guidance of $7.70-$8.00. In the wine and spirits segment, management expects sales to decrease 4%-6% and looks for flat operating earnings. These estimates reflect the December 2016 divestiture of the company s Canadian wine business, as well as recent acquisitions. In the beer segment, it projects a 9%-11% increase in sales and an 11%-13% gain in operating earnings. The company projects free cash flow of $725-$825 million. In our opinion, management s FY18 guidance is conservative and suggests that positive earnings surprises are likely to continue. As discussed in a previous note, during the third quarter, Constellation Brands completed the acquisition of High West Distillery for $160 million. High West s brand portfolio includes American straight whiskeys and other spirits. The High West Distillery, which has reported double-digit volume growth over the past three years, will enable Constellation to enter the lucrative market for premium craft whiskey. In April 2016, Constellation completed the $285 million acquisition of Prisoner Wine Company brands, a seller of premium wines. Prisoner Wine s volume has grown 30% over the last three years. We believe that the acquisition will accelerate revenue growth and significantly expand margins. - 5 -
In December 2015, Constellation completed the acquisition of Ballast Point Brewing & Spirits for $1 billion. The acquisition was financed with cash and debt. In January 2016, Constellation announced plans to build a new brewery in Mexicali, Mexico for approximately $1.5 billion. The project is expected to be completed in calendar 2019. EARNINGS & GROWTH ANALYSIS Constellation s results over the past decade reflect several key industry trends, including faster U.S. sales growth for premium beer (imported and craft ) than domestic beer; an increase in global wine consumption, which has favored the sale of more expensive wines; strong sales of premium spirits; and the consolidation of suppliers, wholesalers and retailers. Constellation has a record of growth. Over the past six years, the company has posted compound annual revenue growth of 7.4%, operating income growth of 25%, and EPS growth of 19.8%. This growth has been driven by the launch of new brands as well as by changes in the business portfolio. For example, in 2011, Constellation purchased the 50.1% of Italian winemaker Ruffino that it did not already own; that year, it also divested its Australian and U.K. businesses and launched four new brands. In 2012, it acquired the Mark West premium wine brand. And in 2013, it completed the $4.75 billion acquisition of Grupo Modelo s U.S. beer business from Anheuser-Busch InBev. In the fourth quarter, sales in the beer segment rose 11% from the prior year, primarily reflecting volume growth and higher prices. Wine and spirits sales were flat, due primarily to the sale of the Canadian wine business, offset by the acquisitions of Prisoner Wine and High West. The 4Q operating margin rose 220 basis points to 30.4%, above the consensus estimate of 29.3%. Margins rose 160 basis points to 26.6% in the wine and spirits segment, and 320 basis points to 38.0% in the beer segment. Looking ahead, we expect sales and earnings growth at Constellation to be driven by new products, new packaging, and line extensions. For FY18, we now estimate revenue of $7.8 billion, up from a prior estimate of $7.7 billion. Based on our expectations for greater-than-expected cost synergies from the Ballast Point acquisition and management s guidance, we are raising our FY18 EPS estimate from $7.50 to $7.90. For FY19, we are establishing an estimate of $8.50. FINANCIAL STRENGTH & DIVIDEND We rate the financial strength of Constellation as Medium, the midpoint on our five-point scale. The company scores average on key tests such as debt levels, fixed-cost coverage, and profitability. At the end of 4Q17, cash and cash equivalents totaled $177 million, up from $83 million at the end of FY16. At the end of 4Q17, long-term debt was $7.7 billion and the long-term debt/capital ratio was 52.7%. The company has also issued debt in the past to fund share buybacks. Operating income covered interest expense by a factor of 9.1 in 4Q17. In its 4Q17 earnings release, Constellation announced an increase in the dividend on its Class A shares, from $0.40 to $0.52. The new dividend will be paid on May 24, 2017 to shareholders of record as of May 10. Management expects to maintain a 25%-30% payout ratio over the next several years. Our dividend estimates $2.08 for FY18 and $2.20 for FY19. MANAGEMENT & RISKS The CEO of Constellation is Robert S. Sands II. He has been with the company since 1986 and has served as CEO since 2008. His brother, Richard Sands, is the former CEO and current chairman. The Sands family effectively controls the company through the voting power of its Class B common stock 10 votes per share versus just one vote for Class A common stock. Investors in STZ shares face numerous risks, ranging from the concentrated ownership of the Sands family to the company s relatively high debt levels. In addition, the company faces fierce competition and, like other producers of alcoholic beverages, is subject to significant regulation. The spirits business is also seasonal, and depends heavily on sales in the second half of the calendar year. Sales of premium wine and beer may also decline during economic downturns. Even the weather is a risk factor, as Constellation is a major purchaser of agricultural commodities. - 6 -
COMPANY DESCRIPTION Constellation is a global manufacturer and marketer of wine, spirits, and beer with a wide range of brands, including Clos du Bois, Ruffino, Robert Mondavi, and SVEDKA vodka. The company also owns the rights to brew and market Modelo Mexican beers (including Corona) in the United States. VALUATION Reflecting earnings that topped the consensus estimate by a wide margin, STZ shares rose 7% intraday on April 6. We believe that the shares are attractively valued at current prices near $173, near the top of the 52-week range of $115-$175. The shares also appear attractive relative to peers and based on our discounted cash flow model. Our DCF calculation, using an initial growth rate of 10%, a terminal growth rate of 2%, and a WACC of 7.7%, points to a value of $198 per share. Our updated peer comparison, which considers the company s above-average earnings growth, prospects for higher returns on invested capital, and improved margins, points to a value of $190 per share. Based on our blended analysis, we are maintaining our target price of $194. On April 6 at midday, BUY-rated STZ traded at $171.86, up $10.46. (John Staszak, CFA, 4/6/17) Argus Research Co. (ARC) is an independent investment research provider whose parent company, Argus Investors Counsel, Inc. (AIC), is registered with the U.S. Securities and Exchange Commission. Argus Investors Counsel is a subsidiary of The Argus Research Group, Inc. Neither The Argus Research Group nor any affiliate is a member of the FINRA or the SIPC. Argus Research is not a registered broker dealer and does not have investment banking operations. The Argus trademark, service mark and logo are the intellectual property of The Argus Research Group, Inc. The information contained in this research report is produced and copyrighted by Argus Research Co., and any unauthorized use, duplication, redistribution or disclosure is prohibited by law and can result in prosecution. The content of this report may be derived from Argus research reports, notes, or analyses. The opinions and information contained herein have been obtained or derived from sources believed to be reliable, but Argus makes no representation as to their timeliness, accuracy or completeness or for their fitness for any particular purpose. This report is not an offer to sell or a solicitation of an offer to buy any security. The information and material presented in this report are for general information only and do not specifically address individual investment objectives, financial situations or the particular needs of any specific person who may receive this report. Investing in any security or investment strategies discussed may not be suitable for you and it is recommended that you consult an independent investment advisor. Nothing in this report constitutes individual investment, legal or tax advice. Argus may issue or may have issued other reports that are inconsistent with or may reach different conclusions than those represented in this report, and all opinions are reflective of judgments made on the original date of publication. Argus is under no obligation to ensure that other reports are brought to the attention of any recipient of this report. Argus shall accept no liability for any loss arising from the use of this report, nor shall Argus treat all recipients of this report as customers simply by virtue of their receipt of this material. Investments involve risk and an investor may incur either profits or losses. Past performance should not be taken as an indication or guarantee of future performance. Argus has provided independent research since 1934. Argus officers, employees, agents and/or affiliates may have positions in stocks discussed in this report. No Argus officers, employees, agents and/or affiliates may serve as officers or directors of covered companies, or may own more than one percent of a covered company s stock. Argus Investors Counsel (AIC), a portfolio management business based in Stamford, Connecticut, is a customer of Argus Research Co. (ARC), based in New York. Argus Investors Counsel pays Argus Research Co. for research used in the management of the AIC core equity strategy and model portfolio and UIT products, and has the same access to Argus Research Co. reports as other customers. However, clients and prospective clients should note that Argus Investors Counsel and Argus Research Co., as units of The Argus Research Group, have certain employees in common, including those with both research and portfolio management responsibilities, and that Argus Research Co. employees participate in the management and marketing of the AIC core equity strategy and UIT and model portfolio products. - 7 -