Even Kings Can Be Cheap

The current research project is Anheuser-Busch InBev (“AB InBev”).  I mentioned (on Twitter) that it seemed cheap the other day.  The response was lukewarm.  That’s exciting.  Real deals don’t usually occur when everyone thinks a deal exists.

The most common complaint about AB InBev is it isn’t growing and it is still trading at 22.7x trailing earnings.  An earnings yield of 4.4% with no growth is understandably not exciting.  Especially in an industry that is fighting structural headwinds in the form of craft beer, wine, and sprits, which are  taking market share from AB InBev’s portfolio brands.  

That said, these are not new trends and AB InBev’s equity was priced 34% higher at the start of the year.  Has something fundamentally changed or has Mr. Market presented an opportunity?  Potentially neither.  It’s possible Mr. Market was irrationally excited before and the equity is still over valued! Citing the equity price decline as a basis for interest potentially induces confirmation and anchoring biases.  

Thus far I’ve only spent three full days researching this idea.  The market is in a relatively volatile period (compared to recent history, though historically speaking I’d argue this is a non event) and many “more attractive” names appear reasonably priced.  So why waste time on a no growth heavily indebted company?

Question 1: Do I Understand this Opportunity Enough to Develop and Informed Opinion About AB InBev’s Value?

In my younger and dumber years I waited in line for beer releases.  Therefore, I can appreciate craft beer’s threat to AB InBev.  This perspective also enables me to understand that the available variety of craft beer has become overwhelming.  I could buy a different IPA every week for a year and still not try them all.  It’s my view that craft will probably continue to take market share in the US, but it’s also plausible that the market has reached the shakeout phase.

Regardless of whether the craft market is currently saturated, I suspect regional winners will emerge (or already have emerged).  Some craft brews travel well, but the craft beer market is still a regional market (in my opinion). Over time AB InBev may be able to acquire some regional winners to enhance growth.  The risks to growth through rolling up regional craft beer producers are:

  • The regional winners may not want to sell to AB InBev.  That risk is somewhat mitigated by people’s desire for money.  AB InBev successfully purchased Goose Island, a strong Chicago brand at the time of acquisition.  I recently attended an event where Goose Island spoke highly of AB InBev’s hands off approach to Goose Island’s side projects.  That said, some craft beer producers are artists and  simply don’t want to sell to a large corporation.  If money were the primary driver for all industry participants 3 Floyd’s, The Alchemist, and Russian River would all be much bigger companies.  
  • Valuations could get so stretched that AB InBev won’t be able to make a reasonable return on investment.  This risk is mitigated by 3G’s success creating AB InBev.  This management team has been in the beer industry for a very long time.  They understand (a) rational acquisition multiples and (b) how to create long term value for equity in this industry.
  • Brands lose their craft image when AB InBev purchases them.  This is a serious risk.  Anecdotally, it seems as if fewer Chicagoans purchase Goose Island at bars these days.  But that may also be attributed to the explosion of craft beer options since AB InBev purchased Goose Island.  At a minimum, Chicago men are still excited for Goose Island’s BCBS lineup of beers.  See https://wgntv.com/2018/11/23/long-lines-in-lincoln-park-for-release-of-goose-island-signature-beer/.  Therefore, Ab InBev’s ownership hasn’t totally killed the brand image.
  • The AB InBev portfolio is so large that tuck in acquisitions won’t move the needle.  This is the most valid criticism of AB InBev’s US business’ growth prospects.  But I don’t view AB InBev as a US growth story.   Going forward I expect growth from emerging markets.  Importantly, I view management as capable and rational capital allocators.  Therefore I trust them to reinvest in organic emerging market growth. If the US market fades at less than 2% per annum, this investment can work. 

Question 2:  Are these people I want to align myself with?

3G has a number of portfolio companies.  Of the most prominent, Kraft Heinz draws limited investor excitement, Jim Grant hates Restaurant Brands International, and AB InBev is a “no growth” story.  So, why should I even be interested?  Isn’t this a management team that’s lost touch with where the world is going?  Don’t they cut costs too aggressively and forego the future for the present? 

Generally, I like to look for ideas (a) in places that are glaringly obvious and (b) places where things don’t make any sense (thank you Adam Robinson for this advice; see Tim Ferris’ podcast interview with Adam Robinson).  In my opinion, it makes no sense that 3G is held in such high regard by Buffett and Munger but the market narrative seems so negative.  A cynic would argue Buffett and Munger only care about profit and don’t care how 3G does what they do.  But the way Charlie talked about 3G is too powerful for me to ignore.  Further, Charlie and Warren aren’t short term thinkers.  So they must think 3G is a reasonably competent long term manager and not just cost cutters. 

One of the first things AB Inbev highlights in its corporate filing is: “we are building a company to last, brewing beer and building brands that will continue to bring people together for the next 100 years and beyond.”  It’s not too often you see long term discussions from public management teams.  Too often the focus is on next quarter and guidance.  But, talk is cheap!  So I started to dig into the SEC filings of AB InBev’s subsidiary, AmBev.  This filing (https://www.sec.gov/Archives/edgar/data/1565025/000129281418003434/ambevsa20181030_6k.htm)  is a great clue showing why Buffett and Munger like 3G so much.

The filing is well written, easy to read, addresses stakeholders in the business (rather than just shareholders), separates the CEO and Chairman of the Board roles, and consistently discusses long term compensation and orientation.  That clue, combined with the Berkshire stamp of approval, and my general knoweldge of 3G, makes me believe AB InBev’s stewardship is exemplary (Morningstar agrees, for whatever that is worth).  

Question 3: Why Does This Potential Opportunity Exist

At the present time, a back of the envelope model generates an IRR of ~10%.  I’d argue a 10% IRR on a conservative model with a ~16.7x exit multiple warrants some attention.  So why does this “opportunity” present itself?  

To begin, the US brand portfolio is losing (or has lost) its cache as beer drinkers migrate to craft beer.  According to Statista, craft beer has increased its share of beer production from 7.8% in 2013 to 12.7% in 2017.  The combined effect of consumers drinking more craft beer, craft beer adding assets to the industry (which all else equal will depress profits), and a shrinking beer market (per capita consumption down from 1.23 gallons/capita in 2000 to 1.08 gallons/capita in 2016) depresses the outlook for major US beer makers.  While this concern is real, I believe the risk is somewhat mitigated by AB InBev’s (1) slightly positive U.S. volume growth last year and (2) sales mix (US sales accounted for 27% of AB Inbev’s TTM 6/30/18 sales mix). 

The second criticism is AB InBev is not growing.  I’m not sure I agree with that assessment over the long term

  1. 70% of Ab InBev’s consolidated revenues come from emerging markets.  A little more than half of the company’s Latin America (“Lat Am”) exposure is via AmBev, of which AB InBev owns ~62%.  That entity will probably grow at GDP-like rates (which are volatile in emerging markets). EBIT margins should improve at slightly higher than GDP as the company executes it’s long term value creation plan of raising prices in line with inflation while keeping cost growth below inflation.
  2. AB InBev’s acquisition of SABMiller gave the company a strong presence in Africa.  Again, I suspect this market should grow at approximately GDP with EBIT outpacing GDP for similar reasons to the LatAm region. Any premiumization of the beer category would be accretive to profits.

Both regions above should continue to grow at GDP rates due to historical (and current) birthrates.  Moreover, AB InBev should keep meaningful market share as the competitive landscape in emerging markets appears to be a distribution and cost advantage game.  AB InBev is almost 2.5x larger than its largest global competitor; Heineken (measured by volume).  That scale, combined with regional focus, should enable AB InBev to acquire emerging market customers because AB InBev should have a cost advantage.  Emerging markets consumers are very price sensitive.  To put price importance in perspective, see the graphic below:

Source: Golman Sachs, July 2018 Report

The final reason I believe people don’t like AB InBev right now is a confluence of problems with the equity performance.  AB InBev issued equity to complete the SABMiller deal, and recently (October 2018) cut its dividend in half.  That leads people to wonder whether future cash flows are now looking materially worse than when the acquisition occurred.  Moreover, shares were already underperforming the S&P before the dividend cut.  I suspect equity holders are ready to throw in the towel.

The chart below shows how many dollars of assets (less goodwill) AB InBev has historically needed to generate a dollar of operating income (“EBIT”) since 2008:

I view this measure as a reasonable way to look at the underlying franchise power of the business.  Generally speaking, AB InBev appears to be heading towards its historical franchise earnings power.  I need to dig in deeper to understand commodity pressures, LatAm concerns (which impacted American Airlines this year as well), etc.  But, the trend towards “normal” is encouraging.  (Note the spike in 2016 is a function of the SAB Miller acquisition.  The operating income benefits hadn’t gone through the income statement until 2017.)  That said, the deterioration in franchise earnings power since 2014 is concerning and warrants more attention. 

Conclusion: This Idea Warrants a Deeper Dive

The past is not the future.  My thesis as of today is that management will likely invest heavily in emerging markets, use excess cash flow to reduce leverage, and focus on organic growth.  I don’t expect share repurchases or a large acquisition any time soon.  Nevertheless, I suspect AB InBev’s ROE will improve as emerging market earnings grow. 

In summary, my back of the envelope exit multiple is 16.7x earnings; compared to 20x+ since 3G purchased the company.  The IRR in that scenario still exceeds 10%.  Most importantly, I believe AB InBev’s long term competitive advantage remains in tact, despite difficult US trends.  Thus, I view the distribution of potential returns as fairly tight and my downside as limited.  Therefore, I believe this idea warrants further consideration.

Disclosure:  No position     

4 thoughts on “Even Kings Can Be Cheap

  1. Great post, any concerns about the balance sheet regarding how much debt they’ve incurred since the acquisition?

    1. Yes.

      This is where I am with this idea: I’m not sure this is an “under/mispriced” situation. I think it’s much closer to a situation where the equity is currently a “deal” because it’s being offered at the lower part of a J curve. The enterprise value of the business isn’t “cheap.” But, the market cap seems to offer a reasonable return here IF you believe the business can delever.

      I’m working through volume numbers now. Fundamentally, a business that sells a product hundreds of millions of times per year among a diverse population should be able to carry reasonably hefty leverage. Moreover, the reason the leverage is elevated makes sense to me. It’s not as if management levered up to do a buyback or something like that.

      The offered return probably is “efficient” given the leverage and emerging markets exposure. That said, I believe outperformance over time can result from taking smarter “efficient” risks than the overall market. I believe this may fall into that bucket.

      Thank you for reading and commenting.

      1. I would mostly agree with this. I’m also curious what you think about a possible FIZZ acquisition. Is it something you think BUD would/could do?

  2. I have no idea about FIZZ and BUD as a match. I suspect there will be a number of suitors for FIZZ once the founder passes away. Seems like KO, PEP, or KDP are more logical fits. That said, they do bottle PEP products in LatAm so it’s not totally outside their circle of competence. It’s not an outcome I’d count on though.

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