Description

A number of good VIC ideas this year have come from south of the border. Grupo Modelo, while not a quintessential value play (16X 04 earnings) is an extremely well-positioned company with a huge moat. Modelo has an unassailable market position, very high margins, strong unit growth, pricing flexibility, a superb balance sheet, and, last but not least, free cash flow that should grow dramatically over the next several years. Furthermore, several catalysts spotlighting Modelo should develop over the next few months. Longer-term, I think it is very likely that Anheuser Busch, which currently owns 50% of the economics of Modelo through a series of transactions from 1993-1998, buys the entire company.


Business: Grupo Modelo is the dominant brewer in Mexico with a 57% domestic market share. Like BUD in the US, Modelo has continually gained share, from 42% in 1982 and 51% in 1992 to current levels. Mexico is a very attractive market, with the second largest beer profit pool in the world. Just under half of the population is under 18, so the number of beer drinkers is assured to grow at a meaningful pace. Modelo is expecially dominant--77% market share--in the central region (around Mexico City), which also augurs well for the future as per capita consumption is lower here than in the north of the country.

Modelo has been hugely successful in the US market. Over the last 10 years, exports have grown over 20%/annum, from a minor business to almost 30% of corporate revenues. Corona, Modelo's dominant brand, represents almost 30% of the US import business; in total, Modelo brands have just under a 36 share. Corona Light and Modelo Especial (now the #10 import) are both growing almost 20%/year. Corona is the 4th largest beer brand in the world.

Current Results: Through nine months domestic volume is up 3.6% and export volume up 2.7%. In constant pesos, sales climbed 3.6% and operating income 6.9%. Gross margins were 70 basis points higher year over year, reaching 55.7% and operating margins climbed 90 basis points to 27.6%. In general, Modelo's margins have moved gradually upwards; I see no reason why this shouldn't continue.

An Inflection Point in Corporate Strategy? Modelo is currently nearing the end of a major capital expansion and plant modernization program. In recent years, capital spending has been about twice depreciation levels. By 2005, when Modelo will reach its goal of 60MM hectoliters of capacity (30% more than 2002 levels), capital spending will decline significantly from current levels. While CapX should still exceed depreciation, the margin will narrow and free cash generation will accelerate upwards.

I like to look at free cash flow yields as a measure of value, particularly in the case of stable branded goods companies. By my calculations, Modelo's free cash flow yield (adding back dividends) is now 5.2%--interesting but far from compelling. But this should rise to 6.5% in 2004 and a very enticing 9.3% in 2005. Note that this measure actually understates the true cash generation prowess of the company: Modelo has no debt and over $1 billion in cash.

There may be even more significant ramifications of the end of the capital expansion initiative. I think there is a good chance that Modelo will follow in the footsteps of BUD in the late 1990s. Upon completion of its major capital upgrade program, Anheuser Busch shifted from an all-out push for market share and began to take more pricing initiative in the marketplace. (Interestingly, the company has continued to gain share.) Earnings growth has subsequently accelerated and, perhaps even more importantly, ROIC has expanded rapidly. The stock has been an excellent performer in both relative and absolute terms. Reading the last several Modelo annual reports bears testimony to how much this company is modelling itself after its largest investor.

Interestingly, Modelo recently announced a price increase in the US of roughly 10% (at the wholesale level--pricing will probably rise 6-8% to consumers) effective January 1. Note that Corona is priced at a discount to Heineken in most US markets, the Dutch company will probably welcome the opportunity to raise its prices given the fall of the dollar in the last year, and imports actually need to maintain a meaningful price premium to domestic brands (it has come down somewhat in recent years) to retain their cache. While Q4 volumes will be artificially inflated (and Q1 depressed) as distributors buy ahead of the price hike, this is a very important step fro Modelo. The potential for a reduction in the VAT for beer in Mexico from 15% to 10% (proposed by the Fox administration but an uncertain outcome) would allow Modelo to maintain flat consumer pricing next year but effectively garner a 5% price increase.

Risks:

1. Further peso weakness. Hard to call.

2. Management does something stupid with their large and growing cash hoard. I think this is very unlikely given the corporate history.

3. Anheuser buys the whole company at an inadequate premium.

Catalyst

1. ADR listing in Q1.

2. Price increases in the US and Mexico drive accelerated earnings growth next year.

3. When the US sneezes Mexico catches a cold. The reverse is true as well, which should accelerate domestic consumption.

4. Declining capital program drives free cash generation and ROIC higher.

5, Anheuser Busch buys the company.