BUD/ABV Stub - ($22.65)

I recommend creating a stub consisting of Anheuser-Busch InBev's non-South American operations by going long BUD and shorting BUD's proportionate stake in its 61%-owned South American subsidiary, AmBev (ABV).   Doing so takes advantage of the market's over-enthusiasm for emerging markets, and under-enthusiasm for consumer staples companies in developed markets.   The resulting stub consists predominantly of BUD's US and Mexico assets and trades at 8.3 2011 EBITDA and 9.3x 2011 adjusted EPS, far below its brewing and CPG peers, which trade at 9x-11x 2011 EBITDA and 12-18x 2011 EPS.     I believe this represents a compelling value considering BUD's solid earnings growth outlook and their world-class management team. 

In addition, I believe there is significant future earnings growth potential in the stub assets from:

• additional cost-saving measures in the US
• synergies from consolidating their stake in Grupo Modelo
• growth in Russia and China
• an improving macro environment in the US

Based on a DCF valuation and the trading multiples of comparable companies, I estimate fair value for the stub is at least $35 per share (10.7x EBITDA and 14.8x EPS).

ABV share price                                                             $29.99

ABV shares / BUD share                                             1.1325

Value of ABV shares short                                             $33.96

Value of BUD stub                                                         $22.65

Valuation:

Value of BUD stub                                                         $22.65

BUD diluted shares outstanding (mil)                             1,591

Equity Value of BUD stub                                            $36,034

Consolidated BUD net debt (YE 2010E)                      $37,791

Less: ABV net debt (YE 2010E)                                   ($1,000)

Less: BUD share of Modelo net cash (YE 2010E)        ($1,000)

Enterprise Value of BUD stub                                      $71,825

                                                                                        Value               Multiple

2010E EBITDA                                                               $7,920                    9.1x

2010E EBITDA - Capex                                                  $6,736                  10.7x

2010E Adj. Net Income                                                 $3,281                  11.0x

2011E EBITDA                                                                $8,696                  8.3x

2011E EBITDA - Capex                                                   $7,481                  9.6x

2011E Adj. Net Income                                                  $3,861                  9.3x

I believe (EBITDA - Capex) is an appropriate proxy for sustainable EBIT.  InBev achieved meaningful capex synergies as a result of its merger with A-B, and management has indicated that current levels of capex are sustainable for the forseeable future.  Over time, D&A will decline to match up with capex as older assets come off the books.  I derive adjusted net income by starting from (EBITDA - Capex), subtracting interest, and taxing the remainder. 

The main source of growth for 2011 in my model is the remaining $500 million or so in synergies from the $2.25 billion originally promised in the A-B merger.  I project volumes will be relatively flat, and pricing will continue to keep pace with inflation, so any upside from sources such as a stronger than expected economic recovery is not included.

Profitability of stub assets by region (2011E):

                                                            Volume (000s hl)               2011 EBITDA                      2011 EBITDA - Capex

US                                                       119,367                             $6,221                                $5,810

Western Europe                                  32,155                               $1,062                                $805

Mexico (look-through)                         27,069                                $912                                   $787*

Russia / Ukraine                                  27,085                                $323                                   $155

China                                                  53,186                                $288                                   $81

Corporate & Other                              6,661                                 ($110)                                ($171)

Total                                                   292,377                              $8,696                                $7,481

Most of the earnings in the stub comes from the US, while most of the remainder comes from Western Europe and Mexico.  Note that although BUD owns 50.2% of Grupo Modelo, its Mexican asset, it is not consolidated in its financial statements, so I present BUD's pro rata share of their financials on a "look-through" basis.  (*I use EBIT instead of EBITDA - Capex for Modelo since there is no merger-related mismatch like there is at BUD.)

BUD sells a significant volume of beer in Russia and China, but because those markets are more fragmented and less wealthy, they account for a minimal proportion of profit.  I believe there is potential for those markets to be a much bigger contributor to the bottom line in several years, as they mature.

Summary 2011 Income Statement

EBITDA - Capex                                                                                                                         $7,481

Interest Expense                                                                                                                     ($1,910)

PBT                                                                                                                                            $5,571

Tax (30%)                                                                                                                                ($1,709)

Adj. Net Income                                                                                                                        $3,861

Dil. Shares Outstanding                                                                                                              1,591

Adj. EPS                                                                                                                                      $2.43

The interest expense shown above is significantly different from the finance charge shown in the financials.  When InBev acquired A-B, they took on a significant amount of bank debt, and entered into swaps that fixed LIBOR at a much higher rate than it is at today.  They then issued bonds to refinance most of the bank debt, but the liability with the swaps remained outstanding and had to be charged to interest expense.  The interest expense shown above is simply the cash interest expense associated with outstanding bonds and bank debt (excluding AmBev's portion); I include the liability associated with the swaps in net debt.  Note also that the tax rate for the stub is above the overall corporate rate of 25%-27% because of the lower rate for AmBev.

The Economics of Beer

There seems to be a perception that owning a major beer company in a developed market like the US is an inherently unattractive proposition because of the dim prospects for volume growth.  While I would agree that the prospects for volume growth are indeed relatively dim, for the reasons usually offered (aging demographics, competition from wine and spirits, increased focus on health), I would argue that even with flat volume, the economics of the brewing industry make BUD an interesting investment.

With most CPG manufacturers, high returns on equity come mostly from the value of the brand, and the price premium it commands over private label.  In the brewing industry, private label typically doesn't even exist, because of the significant cost advantages to brewing on a large scale.  BUD makes all of its beer in the US at just 12 breweries, despite the high cost (relative to value) of shipping beer.  By contrast, in just the US, Pepsi and Coke have something like 100 bottling plants each.  As a result, much of the profitability of major brewers comes from their lower cost structure versus their competition.  To illustrate, here are the financials for the last twelve months for the two major brewers in the US, BUD and MillerCoors, and the financials of the largest craft brewer, Boston Beer Co (Samuel Adams):

                                          BUD[1]               MillerCoors                        Samuel Adams

Volume (000 hl)                 118,481                 79,249                                 2,626

Revenue / hl                       $100                     $95                                      $173

COGS / hl                            $46                       $59                                      $80

MG&A / hl                            $18                       $23                                      $65

EBIT / hl                              $37                       $13                                      $29

The contrast is fairly stark.  Despite charging 75% more, the craft brewer is less profitable per unit of volume than BUD, because of the much higher cost structure it faces.  Even the gap between BUD and MillerCoors is fairly significant; some of it can be attributed to better management at BUD, but some of it is down to advantages of scale that cannot be bridged.  For example, being able to have more breweries cuts the average distance a barrel of beer has to be shipped, only having to advertise one brand is cheaper than having to advertise two, and size provides advantages in procurement.

I see pricing growth at inflation or inflation plus as a fairly realistic target for BUD in the US in the medium term.  Since the beer market in the US is now a duopoly, and there is no private label threat, there should be fairly good pricing discipline.  Furthermore, I see profit growth in the mid-single digits, as pricing discipline would mean that further cost efficiencies will likely be additive to the bottom line, instead of being competed away as is often seen in other industries.

Other Geographies

It follows from the above discussion that geographies where the market is more fragmented are generally less attractive economically.  Western Europe is has more fragmented competition, and there has recently been pressure on volume (between higher taxes, a weak economy, and bans on smoking in bars). Margins in Western Europe have long been lower for ABInBev than in their other markets (25% vs. 40%-50% in the Americas).  However, some of their important premium export brands (Stella and Beck's) are based there.  Russia and China are growing, but right now also suffer from competition and relatively low wealth.

Mexico, like the US, is a duopoly.  ABInBev owns 50.2% of Grupo Modelo, the leading producer there, which it inherited from A-B.  Because of the way the deal was structured, they do not control it, despite their majority ownership.  Most observers believe that they will eventually strike a deal to acquire the remainder, and drive down the cost structure like they did at A-B.  Currently, Grupo Modelo has an EBITDA margin of about 30% (vs. mid 40s for ABInBev elsewhere in the Americas), and there is additional opportunity to be had by terminating their US distribution JV with Constellation Brands.  All in, I think a deal could provide a boost of over $300 million just to BUD's share of Grupo Modelo EBITDA.  I would not expect a deal to be considered until ABInBev hits their deleverage target, which should be in one or two years.

The US Macro Environment

Beer consumption in the US has been negatively affected by the economic environment, and in particular by declining employment, which the decline in beer consumption has tracked with a bit of a lag (see below).  As payrolls begin to perk up from depressed levels, I would expect that we see at least a flattening of volume trends, if not outright volume growth.  If we get a stronger than expected recovery, we should get stronger volumes, which would be very positive for earnings because of the operating leverage in the business model.

AmBev

It seems appropriate here to discuss why AmBev seems overvalued.  By way of background, AmBev derives about two-thirds of their earnings from their Brazilian beer operations, a market in which they have about 70% market share.  The remainder of their earnings is about evenly split between their other South American beer operations, their Canadian beer operations, and their Brazilian non-alcoholic drinks operations (they are the bottler for Pepsi).  On the surface, their valuation of 12.5x 2011 EBITDA / 19x 2011 earnings hardly seems too demanding, considering volumes grew at a double-digit pace in the last year, pricing is strong, and the future for Brazil seems bright.  However, consider that:

• The Brazilian real is, by wide consensus, highly overvalued. In the last two years, it has appreciated from 2.4 to 1.7 versus the dollar, and according to the Big Mac index, it is currently overvalued against the dollar by 35%. This is the result of rising commodity prices (Brazil is a major exporter) as well as very high local interest rates (currently 10.75%, with the expectation they will soon rise to over 12%; inflation is currently running at only 5%). Eventually, the economy will cool, interest rates will fall, and so will the real. (If you believe otherwise, the carry trade is your best bet, anyway). Since ABV derives most of its revenue in the real, and some of its costs are in dollars, it would be hit hard by a depreciation.
• The recent strong growth in beer volumes is due in no small part to the strong Brazilian economy - unemployment is at an all time low, and the strong real reduces the cost of imports and puts more money in the pockets of consumers. As bright as the long-term outlook might be for Brazil, it's probably safe to say that the Brazilian economy is running a bit above trend, and there are some near-term downside risks.
• Surprisingly, per capita beer consumption in Brazil is not that far below levels in developed nations. It is currently running near levels seen in Europe, and 25% below the US level.

Combined, all of these facts suggest to me that ABV is not a particularly attractive investment at this point in time, and should probably be avoided until the market cools down a bit in Brazil.

[1] BUD earns a small, undisclosed amount of revenue from non-beer sources such as agricultural operations and freight, which I estimated and adjusted for.