During the 2016 U.S. presidential campaign, then-candidate Donald Trump made controversial proposals about his desire to institute tariffs and renegotiate longstanding trade deals. Today, President Trump's threats of tariffs have become reality, with the president recently initiating tariffs on imported steel and aluminum.
Initially, Trump exempted Mexico, Canada, and the European Union as they are often reliable trading partners, but he has since reversed the exemptions. As the currency of the U.S.' most dependent trading partner, Mexico's peso tumbled to a one-year low versus the U.S. dollar. Yet oddly enough, Constellation Brands (STZ -0.37%) and its host of Mexican beers stand to benefit directly from Trump's tariffs.
Image Source: Getty Images.
Foreign exchange 101
Most companies source some, or all, of their products or labor from foreign markets to sell in their home market and around the world. For U.S. companies, the most optimal situation is when the U.S. dollar strengthens versus the local currency of sourcing countries, making the cost of goods sold (COGS) cheaper.
In a perverse way, Trump's tariffs benefit nontargeted industries and companies that rely on imported goods from those countries as a part of their cost of goods sold, provided steel and aluminum isn't a significant component of COGS. That's because the dollar should now buy more Mexican labor and raw materials. As the chart shows, the peso has significantly weakened in the last year,. pushing past the 20 peso level, a level rarely attained in the last decade.
US Dollar to Mexican Peso Exchange Rate data by YCharts. Note: Conventional presentation is Mexican pesos per $1, so higher figures mean peso devaluation.
Constellation Brands is well situated
With that in mind, perhaps there's no company better positioned for a decrease in the Mexican peso than Constellation Brands. First, the clear majority of its brewing operations and brands -- Modelo, Corona Extra, and Corona Light -- are from our neighbors to the south, and most of its sales are in the United States. For example, Corona Extra is the best-selling imported beer in the United States, and 97% of Constellation's total sales were in the United States last year.
Therefore, a weaker peso affords Constellation options to better compete against its U.S-brewed peers. The company can leave its pricing unchanged and experience margin expansion and possible higher equity prices. It can lower prices in order to grow market share, spend on other nondirect expenses (like marketing) to increase brand awareness, or a combination of all of the above.
There's already evidence this is occurring: In its fiscal 2018 earnings report, Constellation noted its beer operating margin increased by more than 3 percentage points to 39.5%, citing "foreign currency favorability" as a reason for the increase. Although Constellation is partially hedged for currency changes from both a balance sheet and transactional basis, a cheaper peso will allow the company to lock in more favorable hedges for longer.
A lower peso can have longer-lasting effects as well
A lower peso is more important than current transactions, however. Constellation continues to spend heavily to build out operations south of the border, having already spent $2.9 billion to increase its Mexican capacity to 31.5 million hectoliters, including a new glass production plant that should lower the production cost of glass over and above the currency savings. The current container mix for U.S. beverages are 70% glass and 27% aluminum, although it's likely now glass will take a larger role due to tariff avoidance and cheaper sourcing via the new glass plant.
Additional plans are to further increase production by an additional 12.5 million hectoliters in the next five years. Not only is this becoming cheaper in U.S. dollars due to FX effects, but the new tax law makes a significant portion of capex immediately expensible, which lowers cost as well. Prudent corporate finance calls for Constellation to expedite its planned capital expenditures to take advantage of the dollar's strength.
Trade wars on deck?
Constellation Brands is in a delicate situation; although the company benefits from targeted tariffs and the threat of trade issues, like most companies it has a vested interest in targeted tariffs not devolving into full-fledged trade wars and embargoes. Most likely, share prices across the board will be heavily affected, however, not just for companies that source in Mexico.
It's likely that the worst-case scenario for trade will not occur. However, in the interim, look for Constellation to take advantage of a cheaper peso to grow operating margins and profit in the short term while investing in the country via new plants and equipment to grow operating margins over the long term.
