Description

INVESTMENT THESIS

At its current market price I believe Anheuser-Busch (“A-B”) represents an attractive opportunity to earn outsized returns (15-20%/year over the next three to four years - higher if the price/value gap closes sooner) with the downside likely limited to earning a market return.  This assessment is predicated on the following:

·        I believe the company’s U.S. operations have an intrinsic value that is approximately equal to today’s share price, with the investor in essence getting A-B’s 50% interest in Grupo Modelo (Mexico’s largest brewer) and 27% stake in Tsingtao (China’s largest brewer) for free.

·        From a fundamental value standpoint, I estimate the sum of the parts intrinsic value of the equity at $60-65/share, with that intrinsic value likely to compound at a market rate going forward – possibly higher. 

·        The market is pricing the business as if the margin compression and stunted top-line growth that occurred in the domestic business in FY2005 (as a result of spikes in commodity prices and price discounting) are permanent.  The reality is that even if commodity prices remain at current levels (and run-rate margins are permanently compressed), the company’s operating/financial leverage and exceptional ROIC should enable it to grow domestic free cash flow at 4-5%/year with minor annual price/volume increases.  Any expansion of margins as a result of declines in commodity prices would be additive to the valuation assumptions inherent in this analysis.  Further, to the extent that domestic beer industry conditions remain difficult than A-B’s key competitive advantages place the company at an interesting inflection point where it could significantly benefit from further industry consolidation.

BACKGROUND

From 1994-2004, A-B (the U.S.’s dominant beer producer with almost 50% market share and more than twice that of its nearest competitor) was the model of operating consistency.  Reported operating income, net income, and earnings per share grew at compounded annual rates of 6%, 8%, and 11% respectively while only suffering one down year - 1995.  Additionally, the company’s operating results improved in the last five years – those growth rates increased to 8%, 10% and 13% respectively between 1999-2004. 

Then in 2005 operating results declined precipitously.  Revenues were flat and reported operating income, earnings and earnings per share dropped by 22%, 18%, and 15% respectively.  Correspondingly, the company’s market value has dropped in response – enterprise value is down approximately 20% from the levels that the business traded at in the 2002-2004 period, in spite of its recent rebound and the fact that A-B is on pace to earn the same in FY2006 as it averaged during the 2002-2004 time frame.

The driver of A-B’s success during the 1994-2004 period was not robust growth in domestic beer consumption – the compounded annual growth rate of aggregate beer consumption during this period was only 0.8%.  Rather, it was a combination of the following:

·        Market share gains - in a textbook example of how a scale advantage in a moderately commoditized industry leads to the “rich getting richer” over time, A-B was the primary beneficiary of the consolidation that occurred among the large brewers between the late 80s and the end of the 90s.  From 1988 through 2000, A-B’s market share grew from 40% to 49%.  The decline of G. Heileman and Stroh Brewing Company were the primary sources of A-B’s improved market share and resulting volume gains.  In 1988 A-B’s domestic volume was 78.5 million barrels and Heileman and Stroh were selling a combined 35 million barrels.  Over the next twelve years, A-B picked up 20 million barrels, primarily from Heileman and Stroh.  During this period the second largest producer, Miller, slightly lost market share (from 21% to 18%), and the third largest player, Coors, was essentially flat (10-11%).

·        More aggressive price increases – historically the company’s pricing objective has been to increase prices at an average rate that is less than the rate of inflation while maintaining relative pricing with respect to competing brands.  However, following the period of consolidation (and reduced industry brewing capacity), A-B began to raise prices more aggressively.  Between 1999-2004, the company raised prices 20% faster than the rate of inflation.  This period of accelerated price increases coincided with a combination of relatively static raw material costs and expanded investment in productivity improvements, all of which resulted in enhanced profitability per barrel (a 200+ basis point improvement between 1999-2004).

·        Success of international equity investments – from 1995-2004, equity income grew from non-existent to 20% of total earnings.  The primary source of these earnings was the Company’s stake in Grupo Modelo.  This investment continues to perform and A-B’s share now has a market value of over $8 billion (the Company’s cost basis in this investment is $1.6 billion).

ANALYSIS OF 2005 RESULTS (U.S. BEER OPERATIONS)

A-B’s 2005’s poor performance was the result of two primary issues.  The first related to the exceptional results that the company experienced in the immediate prior periods (2002-2004).  These were overstated as a result of A-B over-shipping wholesalers ahead of retail demand and the aforementioned aggressive pricing – conditions which were largely corrected in 2005. Had shipping to wholesalers tracked retail demand on a consistent basis, A-B’s volume would have been lower in the prior years and would have been 102.5 million barrels in 2005 (1.4 million barrels more than was actually shipped).  Further, following price discounting during 2005, A-B’s prices are back below the long-term inflation factor (the company’s products are again cheaper on a real basis than they were five years ago), and the company has resumed selective price increases in 2006.

The second involved the spike in energy and raw material costs.  From 2000-2004 A-B’s cost of goods per barrel increased by a relatively modest 1.9% per year.  In 2005, these spiked by 7.0%.  As a result, operating margins for the U.S. beer division dropped from over 25% in 2004 to 20% in 2005. 

While these factors provide a relatively benign explanation for the downturn, it does not eliminate the possibility that the company’s fundamental economics have permanently deteriorated as a result of more serious structural changes.  The major concerns to consider are:

·        Aggregate demand in the U.S. beer industry peaking  – while many analysts have sounded the alarm bells over the flat domestic beer consumption in 2005 (especially with wine and spirits consumption experiencing a growth spurt), this occurrence has happened before in the not so distant past.  U.S. aggregate beer consumption was flat in 1995, but it quickly resumed its moderate annual growth.  In fact, while per capita beer consumption in the U.S. has been on the decline over the last 25 years (0.5% per year), it actually increased for several years after the 1995 slump.  It seems the safest bet is that with the population growing at approximately 1% per year, and the long-term trend of per capita beer consumption declining by 0.5% per year, that aggregate U.S. beer consumption will still be higher 3, 5, and 10 years from now.

·        Change in consumer preferences within the U.S. beer industry -of greater concern would seem to be the trends in consumer preferences towards the import and craft beer categories.  The import category accounts for approximately 12% of total U.S. beer consumption and has been growing at mid-single digit rates over the last five years.  The craft beer segment is much smaller (3% market share) and has grown at high single-digit rates over the last two years. 

However, in addition to benefiting via its 50% ownership stake in the leading importer of beer to the U.S. (Grupo Modelo), the company is leveraging its unrivaled distribution platform to exploit this trend, signing numerous deals with recognized import brands over the last year (InBev’s Stella Artois and Beck’s, Grolsch, Tiger, etc.).         

·        Change in competitive landscape among major domestic brewers – again, at first glance there appears to be some merit to this concern.  The easy market share gains that came during the 90s are gone as a result of a less fragmented industry.  Additionally, since taking over Miller in 2002, SAB appears more committed to revitalizing the brand than prior owner, Phillip Morris.  Further, following its 2004 merger with Molson, Coors is slightly better positioned financially to challenge for share. 

However, scale is critical in the beer industry and A-B possesses a significant scale advantage over its domestic competitors.  Many of the major beer markets around the world are characterized by duopolistic competitive structures, and the returns on invested capital experienced by the market leaders (A-B in the U.S., Grupo Modelo in Mexico, Inbev in Brazil, etc.) are typically far superior to those of smaller competitors.  This advantage should be largely immune to the most recent merger activity in the domestic beer business due to geographic limitations.  For example, while SAB brings greater focus to Miller, it is difficult to leverage their operations in other markets to improve the long-term fundamental economics of Miller (i.e. by reducing Miller’s capital requirements or production, marketing and distribution costs per unit).  While they might be willing and able to invest to try to gain market share, it should prove difficult to do so at the expense of A-B, whose management has a demonstrated commitment to preserving the company’s primary competitive advantage, even at the expense of short-term profits.

And while SABMiller has the financial wherewithal to absorb a less profitable environment over a period of time, Molson Coors would be more challenged.  For example, in 2005 A-B increased its marketing spending by over $100 million.  This represents approximately 50% of Molson Coors’ 2005 U.S. operating profit.  As sales in the beer industry are largely driven by marketing, promotion, and pricing, Molson Coors would likely find their U.S. operations marginally profitable at best if a depressed pricing environment or extended fight for market share ensued.

In the unlikely event that the problems are systemic in nature, than A-B’s important scale advantage should allow it to gain incremental market share as the same forces of consolidation that the Company exploited during the early 90s intensify – this is the potential inflection point referenced above.       

 VALUATION

In considering what the investor is getting for their $49/share investment, I distinguish A-B’s U.S. operations and interest in Grupo Modelo, each of which offers a degree of certainty of value, from the company’s interest in Tsingtao which is tantamount to a penny warrant at this stage. 

1.      A-B’s U.S. operations – I include the Company’s packaging, entertainment and wholly-owned international divisions for simplicity as they account for 10%-15% of earnings.  I estimate run-rate EBIT and distributable cash flow (owner earnings) to be around $3.0 billion and $1.6 billion respectively (this is still below 2004’s results which were $3.3 billion and $1.8 billion respectively).  Over the last 9 years, the company has grown unlevered owner earnings at an average annual rate of 4.5% while investing less than $1 billion in estimated growth expenditures.  This translates into an unlevered, after-tax return on invested capital of near 50%.

Annual free cash flow growth from minimal price and volume gains should range from 3-5% going forward.  Assuming 4% provides an inherent equity value of $38 billion ($49/share).

2.      50% stake in Grupo Modelo - Modelo has proven to be an outstanding investment for A-B.  A few of the key financial highlights:

·        Revenues, operating income, and earnings were $4.7 billion, $1.3 billion, and $0.9 billion in 2005.  Over the last 7 years each has grown at average annual rates of 8.5%, 8.4%, and 9.9%% respectively.

·        The company has a sterling balance sheet with no debt and US$1.7 in cash.  Its operations include a retail presence of 1,100 convenience stores which hurts the company’s ROIC, but un-levered, after-tax ROIC remains in the mid-teens.

·         Modelo has a 60% market share of the Mexican beer market (FEMSA has the other 40%) which is the second most lucrative in the world and is growing aggregate consumption at five times the expected long-term rate of that in the U.S.  Modelo, with its flagship Corona brand, is also the leading beer importer to the U.S. (imports currently account for 12% of the U.S. beer market).

Modelo currently has a market value of $17B ($10.75 per A-B share), however this also appears undervalued as it is trading at <14x FY2007 estimated earnings.
 

3.      27% stake in Tsingtao – Tsingtao is China’s largest brewer with over US$1 billion in revenues and 14% market share.  China’s beer industry is the world’s largest by volume and fastest growing, but is currently highly fragmented and marginally profitable (Tsingtao is profitable and revenues and earnings have recently been growing at double-digit rates).  Following the success of A-B’s Modelo investment, the Company has recognized the value creation opportunities afforded by providing capital and expertise to an already established market leader – Tsingtao being the latest investment in this strategy.  

KEY RISKS

• Risk that management invests the large amounts of cash flow that the business throws off unwisely.
  
• Risk of deterioration in the profitability of Modelo due to:
• Increased competition in the U.S. import market.  Inbev and Heineken specifically are upping their efforts to gain share. 
• Potential price pressure in Mexico from start-up generic brands.  Mexico is the seventh largest beer market in the world by volume, but the second most lucrative.  This may indicate greater susceptibility to cheaper generics.
• Increased competitive pressure from FEMSA which is a very formidable number two player (40% market share and a 4:1 advantage in controlled points of purchase through its owned retail network).

Catalyst