Delta bought $1Bn+ of their own shares in February 2019. In doing so, Delta accelerated management’s planned capital return to shareholders. My first thought was “Delta thinks its stock is cheap.” Today, I view the move as smart capital allocation with potential upside.
Delta funded the transaction with a seasonal working capital debt facility. Usually a company has to pay an upfront fee to obtain a new debt facility. Let’s assume the upfront fee was ~37.5bps given Delta’s credit profile and ongoing bank relationships. Like all debt facilities, there’s an associated interest expense with the facility. These facilities are usually priced in relation to LIBOR. For this discussion, I assumed Delta has to pay LIBOR + 150bps. That said, I suspect the cost is closer to LIBOR + 75bps or LIBOR + 100bps. Either way, the example yields the same conclusion.
Assuming Delta obtained the facility in January, the cost of the facility looks something like this:
As shown above, Delta incurred an incremental interest expense of roughly $13.8mm. What did Delta gain?
Delta’s dividend savings during the period almost exceeded the cost of the facility. On an annualized basis, the dividend savings exceed the assumed facility cost by 138%. Obviously, this math can get taken to an extreme because the company can retire more shares as it borrows more money. That said, this is a great example of how an investment grade balance sheet enables a company to play offense when opportunities present themselves.
Delta’s decision carries some risk. If the summer travel season is poor then Delta may not be able to pay the facility off as quickly as I assume. In that case, the facility costs will exceed my projections. Nevertheless, the company could manage an additional billion dollars of debt, if necessary (it had $1.9Bn of cash as of 3/31/19).
Importantly, despite any temptations, management didn’t get too carried away on the facility size. Accordingly, Delta made a low risk, potentially high reward bet. Those are exactly the kinds of bets I want my management teams making.
NOTE: Delta increased their dividend from $1.24/sh/yr to $1.40/sh/yr following the repurchase. This reduced the annualized savings from retiring the February shares from $24.3mm to $2.2mm. Personally, I would prefer for them to retire the shares and pay special dividends rather than raising the promised dividend. That said, I understand management’s decision and remain pleased with the corporate finance decisions.
Ryanair (“the Company” or “RYAAY”) is Europe’s largest low cost airline (“LCC”). The Company’s operations are extremely strong and it’s balance sheet is pristine. Historically, the Company consistently produced the best margins in the industry. RYAAY’s income statement is under pressure because Europe has way too much flying capacity and competitors are acting irrationally. Moreover, Brexit fears and a recently adopted union contract (Ryanair wasn’t “union” until last year) have investors very nervous about the future. So nervous that Ryanair’s ADRs are selling at $70.19/ADR (as of 5/22/2019) vs a high of ~$127.20/ADR (set 11/27/17).
Consequently, Ryan Air’s EV has meaningfully declined:
Note, the current EV is $13.3Bn (excluding leases, which account for 6% of the fleet) on a $12.8Bn market cap. The company thinks its stock is cheap and just announced a $700mm buyback. Therefore, roughly 5.5% of shares outstanding will be bought in at arguably attractive prices.
Importantly, Michael O’Leary, the CEO, is not known to overpay for anything. Further, he’s demonstrated particularly adept capital allocation. For instance, he made an incredible aircraft purchase following 9/11 and opts to pay a special dividend in order to maintain cash flow optionality. Given his record, it’s unlikely he is going to meaningfully overpay for stock. Further, he has 112 million reasons to double profits over the next 5 years. See https://skift.com/2019/02/11/ryanair-ceo-michael-oleary-could-get-a-giant-payday-despite-airlines-current-woes/. Thus, I don’t foresee him using cash for anything unproductive at this time. Accordingly, I give this share buyback more weight than others.
Nevertheless, it’s important to see whether anything fundamentally changed within the company to warrant the downward enterprise value rerating?
Going back to 2006, Ryanair’s operating performance has been fairly volatile. That said, the company’s trends are strong driven by increasingly efficient asset utilization. A chart may help show this:
As shown in the chart above, over time, Ryanair generates more sales per dollar of assets employed. This indicates the Company consistently improves it’s ROE potential. However, margins are volatile. Today, margins are within the “normal” historical range. That’s a pretty impressive feat considering the state of European air travel. Most importantly, RYAAY’s margins have a reasonably high probability of increasing as the competitive landscape rationalizes.
European air travel demand is remarkably resilient. Since 2005, passenger kilometers traveled have increased at 4.9% per annum (vs. 2.1% in the US). JP Morgan attributes that growth to (1) the stimulus of low fares (the low cost carrier (“LCC”) model is younger in Europe than the US); (2) Western European trips/capita well below the US; and (3) under penetrated growth opportunities in Eastern Europe. Moreover, LCCs grew their share of air travel from 17% in 2008 to 25% in 2018. This happened because LCCs (1) stimulated air travel with low fares (remember, trains are very viable competitors in Europe); (2) took market share from legacy airlines; and (3) opened new bases at secondary airports.
Here are a couple interesting charts illustrating potential European travel per capita and LCC market share:
Unfortunately, the European airline sector made a classic mistake. They expanded capacity way too quickly; growing capacity by 8-9% in calendar 4q18. Estimates suggest 1q19 capacity growth will also be close to 8-9%. Compare those rates to the 4.9% growth in passenger kilometers traveled and it’s easy to see why there are short term capacity problems. Michael O’Leary discussed Europe’s airline industry on Ryanair’s May 2019 conference call:
I’ll bet O’Leary’s comments prove reasonably accurate. Especially as they pertain to Ryanair’s ability to weather the storm. Yes, he is outspoken, brash, and sometimes contradicts himself, but his track record at Ryanair is impeccable. Further, his relentless focus on cost cutting is where I want to bet in a commodity game. That said, avoiding commodity games could be a smarter way to invest. Regardless, I have a sickness that pulls me toward my perception of value wherever I find it.
See below for some additional context on potential consolidation and the European airline industry’s recent economics:
Ryan Air Business Strategy
Ryanair is an amalgamation of Walmart, Amazon, and the airline industry. The company is hyper focused on efficiency. According to a friend (@Maluna_Cap on Twitter), Ryanair’s IR department said the entire airline has a call every morning. After the first wave of flights takes off, the head of each airport dials into a conference call. On the call they all give status updates. Managers are expected to explain the reasons behind any and all delays. Imagine the pressure of having to explain to ~80 peers why your airport performance was poor that day. Needless to say, that culture results in an efficient airline.
Ryanair’s strategy is to price seats extremely low in order to drive yield factors. Beginning in 2014, Ryanair adopted its own version of “scale benefits, shared.” The airline has consistently dropped price in order to drive yield. Since 2014, prices per passenger declined from €46/passenger to €39/passenger. On average, Ryanair’s fares are 15-20% lower than its nearest competitor (Wizz), 30-40% lower than EasyJet, and 70-80% less expensive than Lufthansa, IAG, and Air France/KLM. The result speaks for itself:
Ryanair’s low fares stimulate air travel. Many of RYAAY’s destination airports are secondary airports (think Midway in Chicago rather than O’Hare). Therefore, they are less expensive to fly into (Wizz benefits from using secondary airports as well). Moreover, they are looking to increase passenger traffic. This gives Ryanair negotiating leverage over the airports. Consequently, Ryanair’s network has structural cost benefits embedded in it; especially against anyone not named Wizz. Importantly, those cost advantages are hard to replicate because Ryanair’s scale results in increased discounts. See below for Ryanair’s scale advantage:
Next, Ryan Air sells consumers ancillary products. Similar to a grocery store’s use of milk, Ryanair prices seats at razor thin margins in order to sell additional upgrades (seat choices, preferred boarding, snacks, etc). Thus, high load factors help (1) improve (a) revenue (additional people to buy ancillary products), (b) margin (ancillary revenues are almost completely accretive to margins), and (2) reduce costs as Ryan Air can negotiate better rates with airports, as discussed above.
Finally, Ryanair operates a very young fleet, which it owns. The young fleet requires less maintenance and downtime. Therefore, Ryanair’s maintenance costs are low and fleet utilization is high. Moreover, Ryanair carries very modest leverage so the entity avoids a lot of the fixed costs embedded in financing a capital heavy business.
Putting it all together, below is a chart that shows Ryanair’s costs (CASK), revenues (RASK), and operating profit (EBIT per ASK) vs. Easy Jet and Wizz (note: all units per kilometer, which is the appropriate metric to use; generally longer trips generate more profit):
Fundamentally, its hard to see why Ryanair’s enterprise multiple warrants a long term multiple contraction. Yes, there are short term issues. And yes, the decision to recognize unions could hurt the underlying economics of the business in the short term. However, based on Ryanair’s history, I suspect they will manage their unions as well as anyone. Moreover, there is room to raise ticket prices to cover additional costs and still offer incredible value to customers.
Brexit is a major short term concern. In the event of a hard Brexit, Ryanair is going to have to work with the EU to structure their shareholders in a way that 50% or more are EU domiciled (due to EU regulations). Further, there will likely be some travel disruptions as 23% of Ryanair’s sales come from the UK.
However, it’s hard to see Brexit being a permanent overhang on the LCC travel industry. Travel existed before Brexit. One would think rational minds can prevail in order to keep travel occurring after Brexit. That statement may be debatable. Regardless, it appears as though extremely poor short term industry dynamics and Brexit concerns resulted in a potential opportunity.
Ryanair’s relative valuation is pretty low compared to it’s history. While the growth potential may have slowed, it still exists. Slower growth, combined with potentially higher labor costs, would warrant some multiple compression. However, the current rerating seems overdone.
Moreover, the company is guiding to between €700-€950 of profit this fiscal year. That means the offered unlevered earnings yield on the enterprise is 6-8% on depressed earnings. Furthermore, an entering shareholder’s return will benefit from the 5% share buy back authorization.
As of today, I believe Ryanair is approximately 25%-30% undervalued. I’m basing that on a number of scenarios. The downside risk to my terminal value estimate is approximately 33%, my base case expects terminal value to increase by 58%, and my blue sky scenario expects terminal value to increase 86%. The investment’s realized return will depend on the accuracy of those estimates, the time it takes for the market to realize Ryanair’s value, and whatever cash flows Ryanair generates.
In short, I firmly believe the expected value of this bet is positive. My bet is Ryanair’s current valuation reflects short term (12-18 month) concerns rather than a permanent degradation in operating potential. Accordingly, Ryanair warrants consideration at these levels. Disclosure: Purchased a starter position on 5/21/2019 (yesterday); concerned about portfolio construction considering my Delta and Alaska investments.
Wizz is also interesting around these levels because almost all of the same analysis applies. Wizz, however, is smaller, younger (still non union), and leases its planes. Generally speaking, my view is the offered price on Wizz is much closer to intrinsic value. That said, Wizz will likely reward its shareholders through growth. In my view, Ryanair’s current EV and balance sheet provide a reasonable source of margin of safety. Therefore, I am more comfortable buying the proven asset at a discount to what I think it is currently worth. Moreover, Ryanair’s growth isn’t done even if it is going to be slower.
It doesn’t make any sense that Warren Buffett, arguably the greatest quality investor ever, retreated to his “value” roots to invest in airlines. This is the same guy that didn’t let Nike get through his investment filter. And now he invested in airlines? Airlines! The…worst…business…ever. Or is it?
Note: This is not investment advice! An airline investment is extremely risky and should only be undertaken after deep due diligence. If you believe what is written here and buy the shares of any company mentioned you should expect to lose your capital to someone more informed than you. Furthermore, the volatility in airline stocks is not for the faint of heart. Do not let yourself get interested in this idea if you consider Beta to be a meaningful metric.
Airlines: A Brief History
First, some facts must be stated:
Airlines will never be a capital light business. They require reinvestment to remain relevant. They may not need to purchase all new airplanes (ahem, American), but they do have to consistently reinvest in the cabin and airport experience.
No matter what, people will complain about flying. Very rarely do you hear someone say “Let me tell you how much I enjoy flying commercial airlines.” Usually people say they are being treated like cattle and getting gouged. The gouging claim is particularly interesting considering its never been less expensive to fly, but I digress. See https://www.travelandleisure.com/airlines-airports/history-of-flight-costs
The history of the airline industry is littered with wasted stakeholder capital. Note, I did not say shareholder. Everyone has had to compromise; shareholders, debt holders, employees, and sometimes customers. Here’s a quick look at a truly horrendous industry history:
Historically, financially weak competitors wreaked havoc on financially responsible airlines. Usually, the weak competitor had poor cost structures and too much leverage. Combine that with high exit barriers and high fixed costs and you have a recipe for disaster.
Why? Airline seats are commodities. Always have been and probably always will be. Thus, airlines can’t do much when competitors react to financial trouble by pricing seats to cover variable (rather than all in) costs. Once an airline prices seats in that manner, all competing airlines are faced with two bad choices:
Don’t match price, lose yield, and pray to cover costs.
Match price, lose margin, and pray to cover costs.
Neither of those choices are great. The problem gets exacerbated when the financially distressed competitor files for bankruptcy. Bankruptcy usually enables poorly run/capitalized airlines to restructure their liabilities (such as union contracts, debt arrangements, etc.). Following the bankruptcy proceedings, a new, lean airline emerges to compete against the well run and responsible airline. Thus, responsible airlines have had to compete with poorly run airlines while they were in decline followed by cost advantaged competitors post restructuring. That’s a tough equation.
If all that is true why did Buffett choose to invest in this space? Doesn’t he understand history? Doesn’t he understand that buying a one of a kind brand like Disney at a market multiple is a great bet? Isn’t he the one that said a capitalist should have shot the Wright brothers? Isn’t this the man that said:
“Businesses in industries with both substantial overcapacity and a ‘commodity’ product are prime candidates for profit troubles. Over-capacity may eventually self-correct, either as capacity shrinks or demand expands. Unfortunately for the participants, such corrections often are long delayed. When they finally occur, the rebound to prosperity frequently produces a pervasive enthusiasm for expansion that, within a few years, again creates over capacity and a new profitless environment.”
The Pari-Mutuel System
Buffett understands compounders, capital light compounders, pricing power, quality, and any other phrase you throw at him. But, what I believe he understands better than most is the odds at which each bet stacks up against each other. As Charlie put it:
“Any damn fool can see that a horse carrying a light weight with a wonderful win rate and a good post position etc., etc. is way more likely to win than a horse with a terrible record and extra weight and so on and so on. But if you look at the odds, the bad horse pays 100 to 1, whereas the good horse pays 3 to 2. Then it’s not clear which is statistically the best bet…The prices [are such]…that it’s very hard to beat the system.” – Charles T. Munger
While the odds offered are important, any damn fool can also tell you a three legged horse isn’t going to win the race. A lame horse is a lame horse. Good odds aren’t going to change that. So, what does Warren see that makes this horse worth betting on?
Today, 4 major airlines control 80+% of all US seats.
More importantly, at least 3 of the 4 are financially stable. The one that concerns me the most is American. Doug Parker, American’s CEO, would respond by saying the company’s loan to asset value (“LTV”) is reasonable. I don’t necessary disagree with that thought process. However, I worry about the interest expense (an added fixed cost in a downturn) causing irrational behavior. Given the industry’s history, I’d far prefer American to have a better balance sheet this late in a cycle.
Nevertheless, here is Scott Kirby, President of United, discussing what is “different this time:”
American remains my “canary in the coal mine.” That said, American is acting rational and the Big 4 have been rational since they consolidated. Whether they remain rational in a downturn remains TBD. But, as my friend Jake Taylor mentioned in his book The Rebel Allocator, industries can usually remain rational when they have under 5 major participants…
In the meantime, airlines benefit from:
structural tailwinds (people valuing travel and bragging via Instagram; the trend towards urbanization also helps because consumer spending on travel to see family has proven to be resilient),
technological advancements (far better scheduling and pricing ability),
more efficient, rolling hubs (3 large legacy carriers can run much more efficient hubs than 6 carriers could ever hope to),
decoupling of booking fees and ancillary revenues (ancillary revenues are harder to price shop and therefore more inelastic),
airport infrastructure that is difficult to expand (gates are somewhat constrained), and
the often overlooked credit card agreements.
A Quick Note on Game Theory
Airlines seem to face a prisoner’s dilemma with pricing decisions. A description of the prisoner’s dilemma can be found at https://en.wikipedia.org/wiki/Prisoner%27s_dilemma. There’s validity to the argument that in any given pricing situation Airline A is incentivized to “cheat” on price in order to gain market share. Since Airline B is afraid of that incentive, Airline B is incentivized to do the same. Thus, they will both end up cheating and aggregate returns will be suboptimal.
However, the prisoner’s dilemma applies to a game played only once. In the airline industry the game is played thousands of times every day. If Airline A cheats on one route, Airline B can respond on a different route. The 4 major participants signal to each other over and over again. They all also respond to these signals. When the game is repeated with such frequency it’s more likely to lead to prices that generate acceptable (though not great) returns.
SCG likes the competitive positions of the ultra low cost carriers (Allegiant, Spirit, Frontier), Delta (generates a revenue premium), and Alaska (benefits from a cost advantaged union contract that is unlikely to go away). As I see it, costs are the only way to win consistently in commodity industries. That said, Delta is an incredibly well run airline and has proven revenue premiums are sustainable in this industry. It’s only right to credit Phil Ordway of Anabatic Investment Partners as the original source for that line of thought. His thought process is compelling and I haven’t been able to debunk the reasoning. Disclaimer: Long Delta and Alaska.
Credit Card Agreements: The GemNo One Cares About
The industry’s credit card agreements are immensely profitable for the airlines. Further, the cash flows are growing at reasonable rates and generate free cash flow “float.” Alaska Air Group discussed their credit card agreement at a JP Morgan event. Here’s what they said:
It’s certainly interesting that Buffett, who’s core competence is financials, just happens to be interested in airline stocks at the same time the industry’s credit card economics improved. Maybe it’s a coincidence. Maybe not.
At a minimum these credit card agreements are a very efficient way to finance the business. A bull would argue this portion of the business is a high margin sales organization growing at ~14% per year. What’s that worth? Joe DiNardi, an analyst for Stifel, Nicohaus & Co is asking that same question:
Most importantly, why have the credit card economics changed so much and are these changes sustainable? That was a difficult question to answer. Scott Kirby believes it’s because of the airlines’ improved financial positions. See below:
Mr. Kirby’s explanation is rational. Distressed loans require banks to hold more capital against the loans. That additional capital requires a return. Therefore, the notion that banks historically hit their “hurdle rate” by keeping all the credit card economics makes sense. With the industry in better shape, banks now hold less capital against the loans and probably generate more cash management (and other ancillary) revenues. Thus, they are more willing to give up some of the credit card economics.
Importantly, Delta’s recent announcement seems to suggest the good times will continue for the airlines and credit card commissions. That’s good for all stakeholders.
Now that we’ve established that airlines might be reasonably healthy horses, it’s time to look at the odds offered on the bet. This post will analyze Delta because SCG believes it’s far and away the best run hub and spoke airline in the world. Further, Atlanta is a sustainable competitive advantage for Delta’s network. Atlanta is so valuable because it’s incredibly efficient. Some estimates say Atlanta is up to 200bps more profitable than other hubs. This advantage stems from Delta dominating the hub and Atlanta’s traffic volume.
Perhaps most importantly, Delta can survive turbulent periods. In the event of a downturn, Delta has $1.9Bn of cash, $3.0Bn of revolver availability, and generated free cash flow in 2009. Therefore, Delta can probably handle the left tail of potential outcomes. Delta has $1.7Bn of debt maturities coming due in 2020 and $1.4Bn due in 2022. It would be nice to see them refinance and meaningfully extend the term of that debt. Now is a good time to refinance because debt markets are seemingly starved for yield.
Delta’s Offered Odds
With that in mind, let’s take a look at Delta’s free cash flows available to equity since 2009. This analysis of free cash flow available to equity adds back a proformaadjustment assuming 40% of capex was financed with debt. As of today, Delta’s debt to Net PP&E totals 37%. Delta’s management is pleased with the balance sheet today. Thus, analyzing average free cash flows using a proforma adjustment assuming 40% of capex will be financed going forward is reasonable assumption.
Since 2013, Delta’s average pro forma free cash flow available to equity totaled $4.1Bn per year. As stated, this number rests on the proforma adjustment assuming that 40% of capex was/will be financed. Again, I am comfortable with that assumption because (a) it’s unreasonable to expect Delta to not finance any equipment purchases, (b) the balance sheet is in a reasonable financial position (debt and debt like obligations account for 41% of asset value; those obligations consist of $9.0Bn of pension obligations, $10.7Bn of debt, and $5.8Bn of operating leases), and (c) it’s more important to figure out how the business is going to look going forward rather than what it looked like in the past.
2013 is a valid starting point for the analysis because it is the year the DOJ approved the last of the Big 4 mergers. A reasonable argument can be made that requires the analysis to look back to 2009 (which is why I showed those years as well in the chart above). That said, I base this analysis on the competitive period that is most similar to today.
Going forward, Delta should return most of the free cash flow available to equity to shareholders. Let’s say they use 20% of cash flow to build cash reserves and 20% to voluntarily reduce pension obligations. That leaves about $2.5Bn for dividends and share repurchases. As of 3/31/2019 there were 655mm shares outstanding with a promised dividend of $1.40/share/year. Therefore, Delta will be paying roughly $920mm in dividends annually. Thus, approximately $1.5Bn, or 4% of the current market cap is available for share repurchases. Note, this assumption doesn’t take into account the impending growth in credit card cash flows.
I’d be remiss not to mention that Delta’s market cap includes $2.0Bn of equity investments in other airlines, a refinery that does about $4.0Bn of sales every year (total assets were $1.5Bn at 3/31/19), and a maintenance repair organization (“MRO”). The MRO has run rate revenues of ~$800mm annually with “mid teens” margins. Further, Delta expects the MRO to achieve $2Bn of revenues over the next 5 years. All together lets say the assets mentioned in this paragraph are worth $4.0Bn.
Accepting the assumptions above, Delta currently trades at an 11+% free cash flow available to equity yield. Moreover, they have the opportunity to “buy in” 4% of their shares every year. IF the competition remains rational shareholders have a reasonable chance to earn 13-15% on their capital in the foreseeable future. Those kinds of returns will generate a lot of wealth when rates are below 3%.
Returning to Munger for a moment…the airline “horse” may not be the best. But the odds offered are intriguing. Importantly, the horse is reasonably healthy. One question remains: is the future actually different this time? Who knows? Buffett put his chips in. I did too. But, I may be some schmuck that convinced himself an elegant theory was correct because I wanted to believe it so badly. Time will tell. I’ll still be in the position when the story is told.
The beauty of this game is Buffett’s “fat pitch” doesn’t have to be anyone else’s. Regardless of people’s conclusions, it’s important to look at why the greats do what they do. The thesis above isn’t dispositive, but it does hit many of the key points. See also https://twitter.com/BillBrewsterSCG/status/1010219620131893250 for a bit more industry information.
As always, please feel free to contact me with any questions and/or corrections.
PS. I asked Charlie about the airline investment. He said this:
PPS. If you liked any of the above commentary look into subscribing to Airline Weekly. Also, follow Phil Ordway @pcordway on Twitter. Phil is the Portfolio Manager at Anabatic Investment Partners LLC. He gave a fantastic presentation to Manual of Ideas that started my research journey. Finally, try to participate in any Manual of Ideas events you can. John Mihaljevic puts on great events and strikes me as a person doing it for the right reasons.
The world can change. Fast. Or at least perception can.
At hand is a confession. Or rather, a reflection.
The game of investing is hard. Very hard. A mere 18 months ago I was fairly convinced LaCroix was a true brand. The kind that could stand the test of time. The kind that a young Buffett and Munger would dream of. At the time I saw (and to some extent still see) a low wallet share, frequently purchased, habit forming product that didn’t suffer from taste attrition. The taste attrition attribute was absolutely key to my thesis because it’s the quality that makes Coke so desirable. And, more importantly, keeps customers returning. See the clip below (starting at ~44:28 for why I thought that was so key).
Below are screenshots of when I made my meaningful purchase and sell decisions on National Beverage Corporation (“National Beverage” or “FIZZ”), the owner of LaCroix. I am sharing because I think it’s important to be transparent. In that same spirit I have to admit I bet too little at the time. I wasn’t fully comfortable running a portfolio back then so my strategy was to bet small and ensure survival.
Below is a chart of what happened during my “investment.” I put investment in quotes because it is never my intention to hold a position for under a year. In my view, holding a security under a year is closer to speculation than investing.
Ultimately, I got nervous about how quickly the position increased. I just couldn’t get myself to hold on to an entity priced at ~2.5% current cash flow yield (~$100mm of trailing 12 month free cash flow and a $4.0Bn enterprise value at time of sale). So I sold. The hardest part of selling is I was certain the business would continue to grow. So, I felt pretty horrible as I watched the stock increase another 20% within 10 weeks.
Fast forward to today…I tweeted at @alderlaneeggs (hereafter “Mr. Cohodes”) asking why he was short the company. I was poking around because the stock has fallen substantially since I exited.
Mr. Cohodes is known for shorting frauds. It was odd to see him short this company because, while I agree there are substantial corporate governance issues, I don’t believe fraud is a major risk. While he didn’t give me a direct answer, he did mention competition and his Twitter feed has pictures showing Costco discounting LaCroix Curate (an extension of the LaCroix brand). Therefore, I believe Mr. Cohodes is short because of capital cycle theory (more assets/competition chasing the market) resulting in LaCroix discounting to drive sales. Discounting is not only a sign of organic demand declining, but also results in lower margins.
I didn’t realize I’d find out whether he was right so quickly. Tonight FIZZ released its 10-Q. It contained the following:
Alternatively, it is possible the lawsuit against LaCroix really has hurt volumes and customers are waiting for the outcome. I suspect the headline of the lawsuit reads worse than the facts ultimately prove. If that is truly the case, I’d bet LaCroix will recover (see Chipotle for an example of a food company rebounding from negative health publicity).
Nevertheless, look at the reaction to the 10-Q:
Which brings me to my takeaways from this post:
Beware that facts can change pretty quickly- Just last quarter FIZZ disclosed 16% growth in the Power+ (mostly LaCroix) brands. What a difference a quarter makes.
Don’t be afraid to sell when you think you are getting above fair value- I exited when the cash flow yield felt egregious. The short term pain of exiting and watching the stock run up is worth not being in the stock today.
Be mindful that things you know may not be so- I was certain LaCroix would grow and grow. This is now two consecutive quarters of free cash flow erosion. Pay attention to facts as they develop and don’t get anchored to an opinion/conclusion.
Seek out smart people with divergent opinions- I wasn’t prepared to purchase the stock today. I didn’t have enough data. But, tweeting at Mr. Cohodes (and his response) reframed how I view the situation.
The only thing worse than a value trap is a busted growth story.
The book Capital Returns is too good to summarize. The book itself is a summary of Marathon Asset Management’s investor letters from 2002-2015. The intellectual flexibility that firm demonstrates is inspiring.
One key takeaway is analyzing industries through a capital cycle theory lens. The capital cycle can be described as follows:
High returns on capital lead to competition entering an industry.
The new competition increases the amount of assets chasing the same dollars of profit.
More assets fighting over the same profit dollars reduces margins.
Reduced margins decentivize entrants, drive out competition, and enable the surviving companies to begin increasing margins.
Accordingly, firms and sectors with the lowest asset growth tend to outperform. The phenomenon is called the asset-growth anomaly. See https://www.aqr.com/Insights/Research/Journal-Article/Investing-in-the-Asset-Growth-Anomaly-Across-the-Globe for a solid paper on the topic. That theory is a major reason I like the beer industry so much despite the rise of craft entrants. Globally, I still perceive the industry to be very rational and I view brewpubs more as restaurant competition rather than brewer competition. That said, it’s impossible to view more assets chasing beer sales dollars as bullish for Big Beer. But I digress…
Moreover, consumers are willing to trust brands quickly. Therefore, the brand equity that used to serve as a consumer short cut has eroded. That said, social media influencers and internet marketing are not very discerning. Time will tell whether brand equity makes a comeback. Watch the documentaries on the Fyre Festival on Netflix or Hulu to determine whether you think its plausible that consumers begin to crave the certainty of Big Brands again.
Regardless, barriers to entry are clearly lower than they used to be. The perception of viability attracts assets to the industry. When new assets chase returns faster than industry profit pools grow, total profit declines. Importantly, Mr. Market knows that. So it’s worth looking to see how entities are priced given the facts. Kraft Heinz is a traditional CPG company impacted by these trends; though mostly because of consumer’s willingness to trust private label brands. Its valuation relative to history looks like:
I’m not extremely excited about those multiples because a 16x EV/EBIT equates to less than a 5% unlevered (EV/NOPAT assuming no interest expense) cash flow yield on a firm that isn’t growing. Moreover, competition remains strong and private label attacking market share is likely to continue. Personally, I’d like to see Kraft Heinz offer a return on equity north of 12% (PE of ~8.3x) before I got excited given the facts as I understand them.
But, I will continue to watch “melting ice cubes” because when facts and/or results change they can offer very attractive risk/rewards. More importantly, no one else likes to own them. Historically speaking, out of favor companies outperform the most loved companies. Though this last “bull run” makes me wonder whether that rule changed. Time will tell.
SCG recently acquired a minority interest in AB InBev and presented the idea to MOI Global, a group of investment managers. In the future, I will share the presentation in order to show the investment thought process. In the meantime, below is a summary of my thoughts. NOTE – This is not investment advice, all information should be confirmed, much of this is opinion, and AB InBev carries substantial risk.
Volume and Price Trends
Large beer companies’ biggest brands in developed markets are losing volume. Therefore, they’ve driven growth (if any) by increasing prices. In the U.S., growth in the beer category is attributable to craft and imports. While AB InBev has an impressive import portfolio, it needs a brand that resonates with Hispanic consumers (the company owns the rights to Corona and Modelo globally but had to sell the U.S. brand rights because of antitrust concerns).
People often say 3G doesn’t know how to drive organic growth. Is that true?
Yes, that data is stale. But, that chart doesn’t suggest 3G can’t grow organically. Instead, it says the biggest brands within AB InBev’s U.S. portfolio are losing share. But so are the categories those brands compete in. Stella, Michelob, and Rolling Rock are all growing nicely. Moreover, Corona and Modelo, which benefit from 3G’s international marketing are also growing nicely. I’d argue the trends against AB InBev’s larger brands are so strong that volume losses aren’t really management’s fault.
The beer industry responded to the volume trends above by increasing prices:
AB InBev primarily competes in consolidated end markets. Moreover, the company has dominant market share in many end markets:
“Market share is often conflated with a competitive advantage, which it’s not…Generally speaking you will have much better economics when you have a relative scale advantage.” Pat Dorsey to Patrick O‘Shaughnessyon the Invest Like the Best podcast, 2/20/2018 @ 30:25-31:34. The chart above is strong evidence of AB InBev’s relative scale advantage. That scale advantage, combined with consolidated end markets is highly desirable and results in eye popping gross and EBIT margins.
The biggest risk in this investment is the leverage. While the headline leverage number is very high, it’s important to note that the leverage was incurred to make transformative acquisitions. It’s reasonable to criticize 3G for paying too much for SAB Miller. That said, the acquisition combined the number 1 and 2 players in the market, solidified AB InBev’s relative scale advantage, and gave AB Inbev exposure to growing end markets. Carlos Brito, AB InBev’s CEO, discussed the strategic importance of SAB Miller’s India assets saying:
The Groupo Modelo transaction was also strategically important. Groupo Modelo’s strategy involved gaining market share by keeping price constant. That strategy hurt Big Beer’s ability to raise prices without losing volume. When AB InBev acquired Groupo Modelo the U.S. beer market became more rational and the company acquired fantastic global beer brands. See https://www.justice.gov/atr/case/us-v-anheuser-busch-inbev-sanv-and-grupo-modelo-sab-de-cv for details.
There’s a lot of risk in this investment. People have said there’s no Alpha and AB InBev just offers Beta risk. That is a reasonable argument. But, it’s reasonable Beta risk to take because the company has such a strong competitive position and frequently sells a drug to a diversified consumer base.
The market doesn’t like management right now. But, the market is fickle. At these equity prices the investment can work without heroic assumptions. Below is a back of the envelope model.
In my view, the projected return is reasonable and the model is conservative. While I’d prefer returns far higher than 9%, this entity is an extremely strong competitor with a great management team competing in a consolidated, rational industry. Morever, the entity isn’t likely subject to technological disruption. 9% is reasonable given those facts.
First and foremost, SCG is not an investment advisor and does not recommend buying shares in AB InBev. The investment discussed below has substantial risk and should only be considered after lengthy due diligence. That said, I recently purchased shares of AB InBev @ $68.37/sh. Therefore, readers should presume I am promoting my own position when I am talking about AB InBev going forward.
I recently presented an investment in AB InBev to a group I belong to, The Manual of Ideas, as my “Best Idea of 2019.” That was my first presentation to the group. Thus, I took career/reputation risk discussing this investment. Moreover, it’s an investment with a credible bear thesis so I have a reasonably high chance of looking “obviously foolish.” As if that weren’t emotionally taxing enough, yesterday I saw some numbers released that created some “fast thinking” panic. Bud and Bud Light both apparently saw U.S. volume declines in excess of 6%. See https://adage.com/article/special-report-super-bowl/ab-inbev-reveals-super-bowl-ad-plans/316173/?mod=djemCMOToday.
My first reaction to the story was “Great, it took exactly one day for my ‘Best Idea of 2019’ to blow up.” Then I started to do some math and write.
To begin, I have a high degree of confidence the cited numbers relate to AB InBev’s U.S. business. The U.S. market accounts for ~31% of sales attributable to AB InBev (AB InBev only owns ~62% of AmBev but consolidates 100% of the entity’s sales). In 2016 Bud and Bud Light accounted for ~60% of AB InBev’s U.S. volumes. Presumably this percentage declined as brands like Stella and Michelob grew their percentage share in AB InBev’s portfolio. But, let’s assume 60% is the correct number and volume production equates to sales.
If 60% of 31% of sales are fading at 6.6% the result is a 1.2% decline in total sales. That sales decline doesn’t account for the offset in growing brands such as Stella Artois and Michelob Ultra. That’s actually not that bad. My projected returns rely on U.S. sales declining at 2% per year. See below.
Do I wish Bud and Bud Light were growing in the U.S.? Yes. But I knew they weren’t. The 6.6% number scared me emotionally. But once I got rational and “thought slow” I realized I had accounted for that possibility via a conservative underwriting. That said, rapid volume declines could put my margin assumptions under pressure but as of now I think those margin assumptions are reasonable. Time will tell.
writing I probably couldn’t be so rational about the results because of how
badly I want this idea to work. The
presentation induced emotion that otherwise might not have been there. Thankfully, writing has me thinking slow. This investment may not work. But at least the investment’s success or
failure won’t be caused by my emotional reaction.
What Should AB InBev Do About Bud and Bud Light?
The investment thesis in AB InBev is not a U.S. focused thesis. That said, the U.S. business is important for AB InBev’s debt repayment. Therefore, data points such as Bud and Bud Light falling 6+% y-o-y are concerning.
I’d like to see more resources diverted towards the craft beer portfolio, Stella Artois, and Michelob Ultra. Those brands are growing nicely. See https://www.bizjournals.com/birmingham/news/2018/10/01/here-are-the-top-20-best-selling-beer-brands-in.html. The recent repackaging in the “Taste of Belgium” 12 pack (Stella, Leffe, and Hoegarden in one 12 pack) is a good packaging innovation. While Bud Light remains important, I don’t believe marketing will solve the consumption trends in that brand; it’s more about milking the cow rather than driving growth.
Longer term, I’d like to see the company figure out how to activate the craft beer portfolio they’ve acquired. Perhaps they should borrow a page from Starbucks and create the beer equivalent of Starbucks Roasteries. A group of really awesome beer shrines in urban environments could be a decent way to remain corporate but also authentic to beer lovers.
Most importantly, AB InBev should focus on emerging markets. The relative scale advantages AB InBev enjoys matter immensely in those economies. Expanding the beer category and offering consumers a reasonably cheap alcoholic beverage solution offers true growth potential in EM. Furthermore, any and all potential distribution advantages should be solidified over the next 3-5 years. Those investments would generate solid ROIC for years to come.
After paying down debt and widening the emerging market moat AB InBev should probably diversify further away from beer. This would be natural as the company already bottles and distributes Pepsi and Gatorade in LatAm. Whether the diversification efforts lead to non drug related beverages or marijuana related beverages remains to be seen. For the near future, let’s work with the portfolio we have and pay down debt. Acquisitions can wait.
Stalking The King continues. The topic at hand is AB InBev’s craft beer strategy. Throughout this post I will reference information found in the book Barrel Aged Stout and Selling Out by Josh Noel; beer writer for the Chicago Tribune. It’s a great business book and a must read for beer enthusiasts. Josh Noel, if you read this, thank you for writing the book.
AB InBev’s Regional Approach To Quality Acquisitions
AB InBev probably should have entered the craft beer market earlier. However, management suffered from a classic Innovator’s Dilemma because their core brands were so much bigger than any up and coming segment. Further, they were focused on debt repayment rather than product innovation. Consequently, they’ve pivoted to an acquisition based craft beer strategy. Below is a timeline of key acquisitions:
As I said in my previous post, I believe craft beer is a regional game. The map below shows how AB InBev’s strategy is consistent with my interpretation of the marketplace.
The result is a regional portfolio of quality brands, almost all of which are located near a major city. AB InBev created a formidable beast. “With eight or ten or twelve of the kinds of breweries it could never create itself, Anheuser-Busch [can] scale up beers from them all—just as it [has] done with Goose Island—and shoot them into national distribution at affordable Big Beer prices. Its distributors [can] walk into any bar, chain restaurant, supermarket, or convenience store as a one-stop shop: A low-alcohol IPA from Los Angeles! A robust IPA from Seattle! A vanilla porter from Colorado! A stout aged in bourbon barrels from Chicago! An easy-drinking lager from Virginia!…No one ever had to [know] that much of the beer was brewed in the same tanks.” Barrel Aged Stout and Selling Out at 307.
Strategically, this makes sense. AB InBev was never going to be able to out innovate the small craft breweries. The institutional imperative precludes such thinking. Therefore, it makes more sense for an incumbent like AB InBev to acquire talent. Furthermore, its distributors, and their customers, can offer a “diverse” beer selection even though many of the beers trace back to common tanks (which results in efficiencies of scale).
Why Would Craft Brewers Choose To Partner with AB InBev?
There are basically three choices craft breweries have: (1) remain independent, (2) sell to private equity, or (3) sell to Big Beer (AB InBev, MillerCoors, Heineken, etc). Remaining independent, while noble, basically relegates companies to a small geography. Scaling requires a fair amount of capital investment and large scale distribution relationships are very hard to develop. AB InBev, for example, has restricted (and may still restrict) the product portfolio its distributors are allowed to carry (distributors can only carry small craft breweries’ products). Few distributors will choose to upset Big Beer in favor of smaller craft breweries. Thus, local craft breweries are somewhat limited to local bar and liquor store distribution.
Selling to private equity is a decent option if a brewery owner wants to get paid. But, private equity isn’t buying for the long haul. By definition there are fund lives and decisions are made with an exit plan in mind. Furthermore, private equity, while well capitalized, can’t compete with Big Beer on product procurement, cost, or production quality/consistency. Therefore, if a brewery owner (a) wants to scale his/her brand and (b) cares about the long term vision of his/her company, private equity probably isn’t the best exit plan.
Big Beer, as odd as it may sound, actually provides a fairly good long term exit plan. Why? Because a growing brewery must invest in beers that appeal to the masses. Those products require reliable access to quality hops (raw material), additional capital investment (brewing equipment), and allocation of resources towards the growing products (as opposed to projects of love). Big Beer offers a solution to these problems as well as distribution relationships to ignite growth. Therefore, Big Beer can offer premium exit multiples while still creating a win-win.
Yes, there are downsides to selling a local brewery to Big Beer. People will threaten to boycott the brand. Some employees will leave. Some local craft bar owners will drop the beer from their taps. But it seems as though the benefits outweigh the costs. Especially since now AB InBev understands that supporting the “craft” part of the craft beer industry is extremely important.
Goose Island’s Decision to Sell to AB InBev
Goose Island’s owner, John Hall, was a business man. He wanted to make money. But he also loved creating craft beer. In order to get his brewery to the next level he was going to have to invest substantial time and resources to scale a new beer’s production. That beer was 312 (the area code for Chicago).
The 312 ramp up required new equipment, space, inventory investment, hiring resources, etc. Moreover, every square foot Goose Island dedicated to 312 production took Goose Island’s brewers away from the premium beers they made (like Bourbon County Brand Stout, Sofie, Matilda, Lolita, etc). John found himself tight on capital, time, and making less of what he loved.
AB InBev provided the solution when it offered to offload the: (a) burden of figuring out how to scale production, (b) investment requirements needed to scale production, (c) HR headaches of hiring people, (d) establishment of safety measures required for mass production, and (e) top notch raw material procurement. AB InBev was able to offer this because it already had the processes, procurement strategies, and facilities to brew beer in massive quantities.
As part of the deal, 312 production was diverted AB InBev’s existing facilities. Moreover, AB InBev took a fairly “hands-off” approach to Goose Island’s local operations. They did institute some rules and invest capital, but they allowed Goose Island to operate as its own entity. To John Hall, and the other breweries that ultimately sold to AB InBev, that value proposition was a win-win.
AB InBev is Committed to Making Quality Product
It’s very important for AB InBev (or any acquirer) to maintain a brand’s reputation after closing an acquisition. As stated above, an important part of AB InBev’s pitch to craft brewers is the acquisition enables the brewery to focus on craft items and get rid of the headache of mass production. But can AB InBev ramp production without sacrificing quality? 312’s production increase provides a good case study.
312 was AB InBev’s first attempt at mass craft beer production. Predictably, ramping up production of 312 and satisfying Goose Island’s brewers was not easy. But AB InBev committed to getting the formula right:
“‘[AB InBev] ended up dumping more beer than every frat house in America could have drunk in a single year when we started making 312…We dumped batch after batch after batch after batch after batch.’…Finally, St. Louis became worried. Where was this headed? They had dumped three thousand barrels of 312 Urban Wheat Ale—more beer than most US breweries made in a year.” Id. at 202; Emphasis added; Quotes attributed to Brett Porter.
Eventually Goose Island and AB InBev got the formula correct. 312 was complete only after the Goose Island team approved the beer’s taste, texture, and appearance. In my view, this is a crucial example of AB InBev deferring to Goose Island and following through on a commitment to maintain the brand. AB InBev easily could have settled on a formula that was “close enough.” Instead they took a long term outlook and developed the right product to maintain brand integrity and fulfill their commitment to John Hall.
But Does AB InBev Know How to Sell Craft Beer?
Despite correctly developing 312, AB InBev made a big mistake marketing Goose Island. Goose Island’s team told AB InBev to build the Goose Island brand deliberately. They argued that distributors needed to understand the merits of Goose Island’s beers and brand in order to successfully position the brand against Sierra Nevada and other craft beers. AB InBev thought that idea was quaint and figured they could push Goose Island’s beer through their distribution machine. The 2014 national roll-out of Goose Island was a massive failure.
To its credit, AB InBev learned from that mistake. They acknowledged the initial rollout was mishandled and pivoted when they released Goose Island “4 Star Pils.” AB InBev marketed 4 Star Pils by taking a local approach to distribution. 4 star Pils, intially Blue Line, was available in Chicago, only on draft, during the spring of 2015. National production scaled only after Chicago embraced the beer and the product had momentum. Id. at 328.
In its most impressive sign of adaptation, AB InBev released 4 Star Pils even though it directly competed with Budweiser. The old Anheuser-Busch would never release a beer that directly competed with Budweiser. Id. at 328. But, 3G learns and adapts to the market. That adaptability resulted in Goose Island growing sales as follows:
Important things to note about the chart above include:
AB InBev grew Goose Island at a ~28% CAGR since it acquired a 100% ownership interest in Goose Island.
Goose Island’s sales don’t even amount to a rounding error compared to AB InBev’s $15.6Bn of 2017 North American sales. Therefore, Goose Island isn’t going to offset material erosion in AB Inbev’s core portfolio.
Growth slowed in 2017. Craft beer sales are based on “pull through” demand. They aren’t easily pushed onto consumers. Therefore, it’s plausible that Goose Island will grow at a much slower rate going forward.
Goose Island is only one of AB InBev’s craft beer portfolio companies. Assuming all 10 achieve similar results they still won’t be material to AB InBev as it exists today. But, they could be material to AB InBev’s future strategy and market position.
Distribution Matters A Lot. And AB InBev has it in Spades.
Through a series of smart strategic regional acquisitions, AB InBev has accumulated a product portfolio that is both geographically relevant and diverse. “The big thing to me is, the craft beer industry was built on individuals and their stories…We’re not corporate. We are entrepreneurial and individual…It’s going to be harder and harder to get our voices heard at the wholesale level…It’s hard enough for craft beer in general to get meetings with big chain buyers. Now, AB can go in and pitch [their portfolio].” Id. at 281; Quoting Breckenridge Brewery’s founder, Todd Ursy. Breckenridge later sold to AB InBev.
Furthermore, AB InBev’s scale enables it to offer kegs at prices no other brewer could reasonably offer. For instance, when the company wanted to expand its Goose Island IPA product it was able to cut the price to $110/keg. This compares to a standard-priced keg of Budweiser costing $106. Therefore, AB InBev can offer bars a premium product at average prices. That becomes an easy decision for the bar owner.
AB InBev’s distributional and cost advantage enabled Goose Island IPA to to grow like this:
Importantly, AB InBev can offer a portfolio of craft beer styles and geographies. While it may take time to establish different brands, the power of AB InBev’s competitive position is undeniable.
Ab InBev has a reasonable strategy that should enable the company to successfully navigate the craft beer trend in the United States. This is evidenced by (a) the company’s regional acquisition strategy and (b) management’s willingness to learn from failure and pivot marketing strategies. Furthermore, AB InBev increasingly relies on its acquired craft breweries to perform research and development. This should enable AB InBev to leverage core competencies and benefit from the talent it acquired.
I still have a lot to learn about AB InBev’s international markets. Reading Barrel Aged Stout and Selling Out made me realize how ignorant I was about some of AB InBev’s strategy. There’s still a lot of work to do.
Remaining Concerns About The Investment Thesis:
The biggest risk to this investment thesis is AB InBev’s leverage. I don’t believe there is a material chance of bankruptcy, but dilution is a real possibility. My “model” shows AB InBev generating sufficient cash to meet its debt obligations. However, that “model” is dependent on emerging market growth. Emerging market fundamentals negatively impacted AB InBev’s results through this year. Some emerging market risk can be mitigated via foreign exchange derivatives, but emerging market economic risks are an inherent part of this investment thesis.
Thus far the debt market seems confident in AB InBev’s ability to satisfy its obligations. That said, the cost of insuring debt repayment rose over the past year. My general bias is to look to the credit markets for warning signs. Thus, the cost of debt insurance increasing is a concern.
Concerns About Putting Too Much Emphasis on One Book:
Question 1: Which biases might I suffer from while reading this book?
Goose Island was the first local beer I drank when I arrived in Chicago. 312 was my go to choice. I left the brand when Goose Island sold to AB InBev and haven’t considered their products other than Bourbon Country Brand Stout and Matilda since. So I had some biases about the brand and its development when I started reading the book.
I find it difficult not to like the companies I am researching. Endowment bias creeps in after devoting hours to an idea. Further, the sunken cost fallacy compounds the irrational devotion to an idea as time invested increases. It’s important to remember that one book is not the end all cure for due diligence. That said, this book was incredibly good at answering key questions about AB InBev’s craft beer strategy.
Which brings up the final biases I am concerned with. Availability, authority, and confirmation biases. How did this book fall into my lap the week I began to research AB InBev? How did it answer some of my major concerns about AB InBev’s strategy and management team? Am I seeing something that doesn’t exist because my brain wants to? I think I am being rational but I am not certain I’m not answering questions I’ve already predetermined the answers to. Further, an industry expert wrote the words. He can’t be wrong, right? Right?! (Sarcasm font)
Question 2: Which biases might the author suffer from?
Josh Noel is a well known beer writer. Could he write a hypercritical book about a local beer company and the biggest beer company in the world AND maintain his industry contacts? I’m not sure.
I’ve read some of his blog posts to get a sense his biases. Generally, I think Josh Noel has more incentive to “call it like he sees it” rather than become an AB InBev shill. After all, he has a pretty awesome job that depends on people trusting his beer knowledge.
That said, he interviewed a lot of people from AB InBev. Those people are incredible sales people. Otherwise AB InBev probably wouldn’t have them in jobs where Josh could interview them. On the other hand, Josh went out of his way throughout the book to present the other side of almost every argument. So, I suspect he consciously avoided taking one side or the other. Again, I believe his incentive is to speak his version of truth.
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.
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.
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:
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.
The business of attention capture and resale can be traced back many years. According to Tim Wu’s The Attention Merchants, Benjamin Day began the business model of reselling attention when he started The New York Sun. The New York Sun was the first newspaper to sell for below its cost to produce and rely on advertisers to create profitable revenue streams. Hence, the beginning of the business model depending on selling user’s eyeballs.
Once other newspapers caught onto the idea they specialized in certain niches and adopted the business model. According to Wu:
“We’ve already seen the attention merchant’s basic modus operandi: draw attention with apparently free stuff and then resell it. A consequence of that model is a total dependence on gaining and holding attention. This means that under competition,the race will naturally run to the bottom…[to] whatever stimulus…engage[s] what cognitive scientists call our ‘automatic’ attention as opposed to our ‘controlled’ attention…[This]…poses a fundamental, continual dilemma for the attention merchant – just how far will he go to [harvest attention.]” The Attention Merchants by Tim Wu @ 16.
The more things change, the more they stay the same. The obvious difference today is the scale at which the attention capture and advertising distribution changed. In the past there were regional barriers to distribution. Today, the only barrier to distribution is a company’s ability to capture the incremental user.
The risk to attention exploitation is customer revolt. Historically people have lobbied government to step in. Again, to quote Wu, “when audiences begin to believe that they are being ill-used – whether overloaded, fooled, tricked, or purposefully manipulated – the reaction can be severe and long-lasting enough to have serious commercial consequences and require a significant reinvention of approach.” Id. @ 21. Without users there is no attention to merchandize. As of November 2018 that risk feels particularly heightened with Facebook.
If this risk materializes and customers revolt the business erodes and dies; like My Space and AOL. If the users leave then other users have less incentive to stay because the network shrinks. In that scenario Facebook’s inventory becomes less valuable to advertisers. Therefore, the value of Facebook’s platform depends on the user base connecting with each other.
The most important investment question: Will People Leave?
The key investment question is whether Facebook’s current negative publicity cycle results in users disengaging from the platform. A recent Pew Research study suggested people were deleting the Facebook App en masse. Subsequent company released user metrics put that report in doubt. It’s possible for both things to be true. Facebook doesn’t report engagement through its app. Rather, the company reports daily and monthly active users (DAU and MAU, respectively). Thus, it is possible for someone to continue accessing Facebook, Instagram, or WhatsApp but not do so through the app. But I disgress…
To begin to answer the sustainability question its important to understand users access Facebook only when they are infront of a screen. Facebook is an immense beneficiary from smart phones making screens accessible all day. Moreover, data plans have enabled consumption on the go. Today, the average person looks at their phone 39 times per day. Irresistible by Adam Alter @ 14. People’s screen time addiction is so powerful that the mere presence of a smart phone is disruptive to people’s ability to concentrate. Id @ 16.
How sustainable is this trend? 46% of people say they couldn’t bear to live without their smartphones. Id. @ 27. 80% of teens check their phone every hour (Snapchat tends to dominate this cohort’s social media usage). Id at 28, parenthesis added. Only 24% of people spend less than two hours in front of their smartphones every day. Id @ 15. It seems as though screen usage isn’t going away anytime fast. That said, a transition to another media consumption medium would be a direct threat to Facebook’s business.
Why Do People Choose Facebook, Instagram and WhatsApp?
The next issue is to identify what factors enable Facebook to capture people’s attention when they look at their phone.
Facebook gives people a platform where they can feel heard and be a part of a group. Therefore, it can be a good tool to satisfy people’s fundamental needs of friendship, intimacy, family, and sense of connection. An even more utopian view of the Facebook platform could surmise that those feelings lead to fulfilling higher human needs of increased self-esteem, recognition, and status. A dystopian view is the platform enables spreading hate speech, entering filter bubbles, and elevating trolling. Regardless of the view point, a key psychological insight driving Facebook’s success is tribalism.
When Facebook began it was only available at select colleges. If you’ve ever been to a nightclub (or just thought about your high school days) you may remember not being part of the “cool” kids. There is an intense desire to be a part of the cool crowd. Please see the movie Mean Girls for an entertaining analysis of this desire. The exclusivity created a buzz around the product that made it different from a site like My Space. So as it rolled out around the country students signed up in droves. Finally, college kids everywhere could be in the cool crowd. Merely being in Facebook was joining a tribe and it signaled that you were part of the “in crowd.”
As time passed further subtribes emerged as people became “Friends” and joined groups. The creation of tribal identity is very powerful, especially when combined with Facebook’s like and comment features. Why? Because people within a tribe are more likely to “like” each other’s posts (social proof and reciprocation tendencies drive this behavior). And likes are the secret sauce.
As Rameet Chawla said, “[They are] our generation’s crack cocaine. People are addicted. We experience withdrawls. We are so driven to get this drug, getting just one hit elicits truly peculiar reactions. I’m talking about likes.” – Rameet Chawla, founder of Lovematically, as quoted in Irrestistible @ 128.
Every time someone logs onto Facebook and sees a red icon indicating that they got likes/comments on their posts their brain releases dopamine. The dopamine released causes the brain to want, desire, seek out, and search. It reinforces the impulse to visit Facebook’s properties. But why do so many people seek the dopamine hit on a daily basis?
In Irresistible, cited throughout this post, Adam Alter set out to determine that answer. He found the answer in an odd place. In 1971, Michael Zeriler, a psychologist, set up an experiment to see how pigeons respond to stimulus. The experiment required pigeons to press a button in order to receive food. During his experiment Zeriler altered the amount of times a pigeon had to press a button before receiving food. Zeriler found that pigeons feverishly pecked the “feed” button when they received a relatively consistent but not guaranteed reward (50-70% of the time). They were less interested in the button when the reward was guaranteed. See Irresistible from 126-127.
And herein lies the genius of the like button, comments, and notifications. No one knows whether and how much feedback they are getting on any given Facebook post, Instagram upload, or WhatsApp message string. The feedback loop is uncertain and has the potential to release dopamine and satisfy base human desires. Facebook’s properties capture people’s screen time as they feverishly check to see whether people “like” us and whether the world is passing us by.
A Nod To Charlie Munger
One of the best speeches I’ve ever read is Charlie Munger’s Psychology of Human Misjudgment. In it he outlines what he believes are the reasons people make poor/irrational decisions. These are what I believe are the pertinent psychological forces further driving Facebook usage:
Liking/Loving Tendency – Humans care what people think about them and a desire to get more people to like them. People go to Facebook and Instagram and share their life. Voila. Likes galore. Or they head over to WhatsApp and feel connected to their text chains. These platforms enable engagement with otherwise tenuous relationships. Much of the time that affirmation feels great, even if it comes from a tenuous relationship.
Disliking/Hating Tendency – The opposite of the liking tendency is the tendency to seek conflict. Look at the human races’ history of war. A more common illustration of the disliking/hating tendency takes place seemingly everyday as politics is difficult to escape. The need to feel heard in a cultural war drives traffic to Facebook, in my opinion.
Envy/Jealousy Tendency – Humans seem unable to avoid situations that leave them envious. Instagram and Facebook are fantastic places to feel envious.
Excessive Self Regard Tendency – Most people suffer from overconfidence. They assess their ability and prospects too highly. Facebook and Instagram are the best platforms to showcase how fantastic a person’s life is.
Lollapalooza Tendency – The tendencies above, when together, can create exponential effects. I’d go add that the issues identified in Irresistible compound the effects even further. Facebook understands these principles and created its algorithm to exploit them.
The current narrative is Facebook’s properties are harmful to its users, disintegrate public discourse, and people don’t trust the company. I have no idea whether the sentiment accusations are accurate (what people say is different from what they do). Even if they are true, history can offer some clues about how this all may play out. Did people trust cigarette companies after the 1980s? Are Coke and Pepsi “good” for you? No and no. Yet, the companies continued to perform well.
Habit and addiction are very hard to break. I believe many people are addicted to Facebook and its properties. Which is why I don’t think Facebook was lying when it reported the following stats:
Those stats might be somewhat inflated because of fake accounts. That said, I believe they are on a like for like basis. Which is to say I suspect the number of fake accounts randomly fluctuates and the reported numbers convey an accurate trend. Some people, myself included, were surprised about Facebook’s lack of customer attrition given the negative news cycle. For the reasons cited above, combined with data that disproved my original thesis, I now suspect Facebook’s customer usage trends continue.
Which brings me to my final investing point. Change your mind when the facts change. And remain open to changing your mind again.