Description

I am recommending a long position in Anheuser-Busch InBev ("ABI" or the "Company") at $51 per share.  InBev, a brewer based in Belgium, acquired Anheuser Busch ("AB") for $55 billion in November 2008, creating the largest beer company in the world with leading positions in 5 of the top 6 beer profit pools.  To consummate the AB acquisition, the Company levered up to 5x, and like any leveraged company during that period, the market assigned a near-distressed valuation for the company.  Since the acquisition, they have delivered on all their ambitious synergy and asset disposal commitments.  While the stock price has appreciated meaningfully since its fall 2009 lows, I believe significant upside remains.  Giving ABI credit for only cost synergies and no revenue synergies, I get to 2010 and 2011 EPS of $3.42 and $4.29, or 14.6x 2010 P/E and 11.9x 2011 P/E.  FCF for the company is higher than EPS (D&A and capex mismatch), so the FCF multiples are even more attractive - 13.1x 2010 P/FCF and 10.2x 2011 P/FCF.  For a leading, global FMCG company with 13 different brands generating over $1 billion in annual sales, I believe a conservative P/E multiple is 15x, which is $64 off of 2011 earnings, or 12.8x 2011 FCF.  Looking further out, I believe the company will get more and more credit as a leading FMCG company and less as a leveraged buyout.  The company's commitment is to rapidly delever to below 2x Net Debt/EBITDA.  My numbers get them to 2x by the end of 2011; in 2012, I believe they will restore the dividend policy to levels similar to where they were before the AB acquisition.  Using my estimate for 2012 EPS of $4.72 and assuming a 60% payout ratio gets you to a dividend of $2.83/share.  I don't think it's unreasonable for the stock to trade at $80/share off of these numbers 1.5 years from now:  3.5% dividend yield, 17x P/E, and 15x FCF.               

The Company has a global presence with balanced exposure in mature markets and faster growing emerging markets.  In its two largest markets, the U.S. and Brazil, the company enjoys market shares of 45% and 70%, respectively.  Both markets are largely consolidated and the pricing environment is favorable.  While the Company is not immune to prevailing economic pressures, the business is very resilient. In the U.S., volumes have clearly been affected by economic headwinds but appear to have stabilized at low single digit % declines.  Conversely, Brazil is benefiting from a robust economy and a rising working class and the company is enjoying volume growth in the high single digit % range.  The Company sees 2010 as another challenging year, particularly as the U.S. struggles with high unemployment, and has given guidance of volume growth in the 1% range.  In healthier times, prior to 2008, overall volume growth was in the 5% range.

I believe the AB acquisition will provide significant upside potential over the next several years.  In the short term, cost savings from the acquisition will more than offset current volume softness and provide solid earnings growth.  The company's guidance for cost synergies are $2.25 billion, of which $1.36 billion have been achieved through the end of 2009.  The remaining $900 million will be achieved over 2010 and 2011.  Unlike many other companies who boast about synergies captured but then claim the savings were "re-invested" back into the business, you actually see the AB synergies go through to the bottom-line.  Based on the management team's prior track record in extracting cost savings, I am highly confident they will deliver savings well in excess of $2.25 billion.  In their last earnings call, they suggested there will be further cost savings beyond the $2.25 billion but did not quantify the amount.  In the fall of 2009, ABI announced a joint purchasing agreement with Pepsi in the U.S., covering certain indirect expenses such as transportation, IT spend, etc.  Noting greater than expected success thus far, Pepsi and ABI have recently expanded the plan to include media buying.  Savings from this program are not included in the $2.25 billion synergy commitment.  While I don't see this particular venture to generate enormous savings, it is an example of management's out-of-the-box thinking and their relentless pursuit toward saving costs.  

Over the medium term to longer term, I believe there is a significant opportunity for ABI to capture a greater share of the margin pool in the U.S, as they have done in other markets.  This will be achieved through selective distributor consolidations (both by AB themselves as well as encouraging their largest and most efficient distributors to acquire their less efficient peers) and more sophisticated revenue management practices.  More on this below.  Note that the company's $2.25 billion synergy target includes no revenue synergies.       

Company Description

Prior to the AB acquisition, InBev was the product of the combination of the Latin American brewer, AmBev, and the Belgian brewer, Interbrew.  Although the company's headquarters remain in Belgium, ABInBev has the DNA of a Brazilian company as 9 of the top 13 executives are from AmBev.  The Brazilian management team, led by Carlos Brito, is extremely skilled at acquiring beer operations and extracting efficiencies.  Key acquisitions have included: Antarctica in Brazil, Quilmes in Argentina, Labatt in Canada and Interbrew in Belgium.  With the Interbrew merger, the Company was able to increase margins from 24.7% in 2004 (the first year of combined operations) to 32.7% in 2007 (the last full year before the AB acquisition).  The recipe has been the same in each of these cases:  a relentless focus on efficiencies led by their ZBB culture (zero-based budgeting) combined with remuneration tied to ambitious financial targets.  Under ZBB, instead of using the prior year's expenses as a baseline, every expense must be re-justified every year.  ZBB also includes an exhaustive benchmarking process where best practices are identified, and the division/group with the best practice is then charged to lead the other groups to close the performance gaps.  Management finds that in the first year of an acquisition, they are able to take out 8-10% of the fixed cost base from ZBB and an additional 5-10% in the second year.  The AB acquisition will prove to be no different, as it is hardly a secret that the old AB had somewhat of a bloated expense base (e.g. AB owned six planes and two helicopters, luxurious executive offices, every employee being given two free cases of beer per month). With the AB acquisition, the majority of the $2.25 billion in forecasted savings has/will come from ZBB; the other primary drivers being procurement savings from the much larger scale and manufacturing optimization savings.      

For a detailed description of the Company's business, I refer you to their 20-F that they filed in conjunction with their ADR listing in the fall of 2009.  Here are some basic facts of the pro forma business:

• 13 beer brands with over $1 billion of annual global sales, including Budweiser, Bud Light, Skol, Stella Artois, Brahma, Busch, Beck's, Michelob, Antarctica, Natural Light, Sedrin, Quilmes and Jupiler
• $33.9 billion of revenue and $12.1 billion of EBITDA in 2009
• % of sales and EBITDA by region:

• Other assets:  50% non-controlling economic interest in Grupo Modelo, the dominant Mexican brewer with 58% domestic market share - ABI's share is reflected in a single line item as Share of Result of Associates.
• Minority Interest:  ABI owns 62% of AmBev, which operates the Latin America North, Latin America South and Canadian businesses.  The remaining 38% of AmBev is publicly traded on the Bovespa.  ABI consolidates these operations in its financials with a corresponding Minority Interest line item.
      

Investment Rationale

Significant cost savings combined with rapid deleveraging.  The company has committed to an additional $900 million of cost synergies over 2010 and 2011 ($1.36 billion being achieved thus far).  Given management's history in attaining prior cost synergy targets, I am very confident that actual synergies will be above the stated goal.  In fact, management has already suggested that there will be more synergies beyond the original $2.25 billion but has not yet quantified the amount.  In addition to the synergies, the company has been extremely disciplined with working capital and capital expenditures, all of which contributes to very robust FCF generation.  Management extracted $787 million from working capital in 2009 and believes that working capital will continue to be a source of funds in 2010.  Management believes that capital expenditures are sustainable in the medium term at $1.7 billion, compared to D&A of $2.5 billion.  I see them paying down over $13 billion of debt over 2010 and 2011, getting them to a Net Debt/EBITDA level of 2x by the end of 2011.  The rapid deleveraging leads to rapid E.P.S. growth of 56% and 25% in 2010 and 2011, respectively.   

Strong pricing power, lack of private label threat .  In its two largest markets, the U.S. and Brazil, the company enjoys market shares of 45% and 70%, respectively.  Both markets are largely consolidated, allowing for favorable pricing environments.  The U.S. is essentially a duopoly where ABI and MillerCoors together account for 80% of volume.  Unlike most other food categories in the U.S., beer pricing has remained robust, increasing 2.5% in 2009.  Even though volumes have been under pressure and are currently down low single digit %s, the industry has maintained pricing discipline.  There is always the risk that pricing discipline gets relaxed should volume weakness persist.  There was indeed a beer price war in 2005 when there were three players in the market (before MillerCoors joint venture).  However, management at both ABI and MillerCoors constantly refer to the painful lessons learned from that experience and refer to the fact that prices have yet to recover from the pre-2005 inflation-adjusted levels.  The greater consolidation of the industry should also help with overall pricing discipline.  In Brazil, pricing runs at or slightly north of inflation (~5%).  Strong pricing in Brazil has been supported by recent minimum wage increases.  The Company also attributes the strong pricing environment to the government's clampdown on tax evasion by ABI's smaller competitors, putting more pressure on these companies to follow through on price increases.  The other favorable attribute of beer, unlike most other food categories, is that there is practically no private label presence.     

Longer-term top-line optimization of US business through revenue management, sharing of best practices with wholesalers and distributor consolidation.  Another significant opportunity the Company sees in the U.S. market is the potential for revenue synergies. I see the potential for revenue synergies in the following forms: (i) further penetrating the premium end of the U.S. market, most notably through Stella Artois; (ii) sharing of best selling and operating practices with wholesalers; and (iii) taking a larger share of the value pool by sharing in distributor efficiencies and through increased direct distribution. 

One of the more immediate top-line opportunities is further penetrating the premium market within the U.S. with the Company's Stella Artois brand.  Stella Artois has tremendous brand value in the U.S., positioned in the premium sector of the market.  Stella Artois has been widely available in the U.S., especially since early 2007 when old AB struck a distribution agreement with Inbev (owner of Stella Artois) to distribute Stella Artois through its wholesalers.  However, under that distribution agreement, profits had to be split between 3 parties:  the wholesalers, AB and Inbev.  Now that Stella is under one umbrella, profits only have to split between the wholesalers and ABI.  Stella is priced at a ~90% premium to Bud/Bud Light and is considerably more profitable for both ABI and wholesalers, and therefore wholesalers now have much more incentive to market Stella Artois to its end customers.   

Management believes there is considerable opportunity to improve wholesaler sales and operations by sharing best practices and modifying the standards by which their wholesalers are measured.  When the current management team was part of AmBev ten to fifteen years ago, they would frequently visit AB and other breweries to exchange best practices.  One of the more impressive takeaways from their AB meetings was a comprehensive manual that AB put together for their wholesalers regarding sales and operational procedures.  The Ambev management team started employing many of those same practices in Brazil, and over the years, they refined them dramatically as the industry evolved and as they found better ways of doing things.  After the AB acquisition closed, one of the first things they asked for was the current version of that manual -they found that it was essentially the same as it was a decade ago.  In general, management has found that AB required their wholesalers to certain rigorous standards (temperature of the warehouses, keep trucks freshly painted and shiny, etc.) that consumed significant time and resources but ultimately did not affect the amount of beer sold.  In an effort to free up more time and money for wholesalers to sell beer, management has already changed and simplified the KPIs for their wholesalers and is currently rolling out best practices and benchmarks.      

As a corollary to the two points above, I believe there is an opportunity for ABI to gradually capture a larger share of the U.S. beer value pool - value pool being defined as the distribution of the retail value of beer split between the brewer, distributor, retailer and taxes.  Redburn Securities has done some good analysis on this and below outlines their analysis on how the value pool is split in ABI's key markets.

Value Share as % of Gross Retail Price:

In Brazil, management has been able to raise their share of the value pool from 26% to 38% over the past 8 years.  This was done through revenue management (increasing prices to the retail/3rd party distribution channel at a faster rate than the retail price to the consumer) and by consolidating distributors (increasing the % of volume that went through directly-owned distribution, thereby recapturing margin that way).  Between the years 2000 and 2005, the % of volume in Brazil that went through direct distribution went from 27% to 50%.  In the U.S., there are strict laws governing the 3-tier distribution system, and in many states, the direct ownership of distribution is prohibited by law.  Theoretically, AB could own up to 50% of their volume through direct distribution (they currently directly distribute 7% of their volume).  I do not think they will ever own up to 50% of US distribution, but I do believe that they will make selective acquisitions of distributors in key metro regions, and more importantly, I believe they will strongly encourage the continued consolidation of distributors.  This will allow the distributors to achieve greater efficiencies, allowing AB the greater ability to pass through price increases at a faster rate than what is ultimately passed on to the consumer. 

Recapturing share of the margin pool will be a multi-year process, but if the Company is successful, it could have powerful impacts on the P&L.  If you take the average retail price of $3.50 per liter across all channels, then ABI's share of that would be $1.02 (29% of $3.50).  Every 1% of the retail value would equate to 3% on ABI's net price, or $3/HL (HL = 100 liters).  If we assume ABI is able to capture 3% of the value pool over time, that would equate to $1.1 billion of added revenue, all of which could flow through to the bottom-line.  Such an amount would equate to an additional $0.51/share of E.P.S. (~15% accretive to my 2010 E.P.S.)       

Financials (note that my estimates do not reflect any of the revenues synergies discussed above):

Risks to Thesis

• Exposure to Brazil, currency risk
• Unemployment worsens in the US, causing further pressure on volumes and pricing discipline 
• Increase in excise taxes - governments can look to raise taxes on beer which could temporarily suppress volumes 

Catalyst

• Rapid deleveraging leading to robust earnings growth
• Re-institution of dividend and share repurchases after deleveraging is complete
• Further awareness by U.S. investors with recent ADR listing - The main listing for the stock is on the Brussels exchange (ticker: ABI) and is well covered by European beverage analysts.  However, the BUD ADR listing was launched in September of last year, and my sense is that the story is not well known among U.S. investors.  I only know of two U.S. based research firms (Merrill Lynch and Stifel Nicolas) that have picked up coverage since the ADR launch.  As the U.S. drives roughly 50% of overall EBITDA, I see U.S. investors becoming much more aware of this story over time.
• Possible acquisition of Grupo Modelo - Many have speculated that ABI is in the driver's seat to acquire the remaining 50% interest in Grupo Modelo.  Modelo and ABI are actually in arbitration right now over Modelo's contention that AB had no right to sell its shares in Modelo without Modelo's controlling shareholders' consent.  ABI believes that Modelo's claims are without merit in that the investment agreement (between AB and Modelo controlling shareholders) does not contain any provision precluding a change of control of AB.  For what it's worth, the former CFO of Modelo has also publicly stated that Modelo has no basis to win the arbitration.  In addition, many believe that Heineken's acquisition of the other Mexican brewer, Femsa, will force Modelo to sell to ABI.  Assuming a rational price paid, I'd welcome the opportunity for ABI to acquire Modelo.  Mexico represents another large, growing, consolidated market (duopoly) and offers another huge opportunity for ABI to create a step-change in profitability.