Description

Inbev NV (ticker: INB BB) (Euros 44.5).  (Market Cap: Euros 27.4bn)

I am recommending purchase of Inbev NV’s shares.  I am recommending sizing the position to leave room on weakness in the stock and a likely equity offering.

It would appear as if any moment, Inbev will announce the acquisition of Anheuser Busch.  This will create a world-wide dominant # 1 beer producer.  The industry still has unit growth (albeit slowing quite a bit in the US) and pricing power.  There are cost pressures and ever-growing competition in the US from craft beers.  Market shares in the business are very high, growing, and stable, because of marketing economies of scale and distribution economies of scale in route efficiencies and refrigeration.   

As it relates to the transaction, financing should be doable, more on this below.  It is possible that there could be anti-trust issues in the US.  Bud has about 50% market-share and Inbev adds roughly another 2% with Beck’s and Stella Artois.  However, Inbev operates in the premium segment which should reasonably be viewed as a separate segment.  So it is likely that the deal goes through.  If not, one risk is a subsequent bid for SAB Miller by Inbev and stock uncertainty.  Management has historically done an extremely good job of creating share-holder value.

While I think there is a reasonably attractive value proposition in Inbev, I cannot say it is as cheap as many other VIC ideas.  Indeed, the acquisition is very expensive and likely dilutive for at least a couple of years.  However, I believe that with this transaction, Inbev has transformed itself into a dominant worldwide consumer product company with geographic and brand diversification, one that has phenomenal market shares, a company that isn’t that vulnerable to competition and that has extraordinary franchise value.  This company cannot be recreated.

Pre the Bud deal, 60% or so of Inbev’s cash flow (after taking out the public’s minority interest) came from its holdings in Ambev, the dominant beer producer in Brazil.  Ambev is also the largest Pepsi distributor in Brazil.  Ambev’s revenue are 50% beer in Brazil, 11% soft-drinks in Brazil, 20% Labatt’s in North American (mostly Canada), and the balance beer in a number of other South America countries.  Inbev owns 73.5% of the Common shares and 54.1% of the Preferred shares.  Ambev is in and of itself an interesting investment.  One has to probably figure that the dividend here will be raised here to help pay off the debt incurred for the Budweiser acquisition or that there might even be a big one-time dividend.  

Here are the market shares in the 5 biggest markets from a company presentation:

                                Budweiser          Inbev             Combined 

US                            48.5%               < 2%               50.5%

Brazil                       < 1%                   68.6%           69%+

China:                        9.6%                 11.4%           21%

Germany                  <1%                    9.3%             About 10%

Russia:                       <1%                  19.3%            19-20%             

Budweiser also has a 55.5% market share in Mexico  through its holdings of Grupo Modelo.  Bud has the number one share in Canada with 10% for Bud and 5% for Bud Light through what is actually a joint effort between Bud and an Inbev partner, and Inbev brings Labatt’s to the mix.  Bud owns 27% of Tsingtao in China.  Budweiser itself is actually the #1 super-premium brand in China, and the combined companies have the largest share in China, the largest and fastest growing market.   The combined company will be #1 in North American and Latin America and #2 in Asia and Europe. 

As for growth, in 2007, Bud’s own brands grew number of barrels by 2.7%.  Equity partner (mostly Modelo and Tsingtao) barrel growth grew 4.9%.   In the US, the company had 6% sales growth, with roughly 2% volume, the balance price.  Overall, operating profit grew at about 5.5%.  First quarter operating profit grew 6%.  In the first quarter, volume grew less than 1%.  Equity partner volume growth was 9%.  Revenue per barrel was up 2.3% in the US due to price.  Bud’s market share continues to grow gradually, up .3% in Q1 year over year.

For Inbev, 2007 organic growth was 5.2% and revenue grew 7.2%.  Operating profit grew 20%.  Q1 of 2008 was tough.  Volume fell .4% off of weather and timing issues in the Brazilian beer market, although revenue grew 4.8%.  Operating income shrunk 1.1%.  In Brazil, for Ambev, beer market share grew 20 basis points to 67.8%.  The next closest share of beer in the market is about 12%.  Its carbonated soft-drink market share grew 40 basis points to 17.7%.  Coke dominates this market with a north of 50% market share.

I will now turn to the numbers.  Backing out 1x items, Inbev’s trailing earnings were about Euro 3.10.  Earnings were down in q1 on the timing and weather issues in Brazil and cost pressures.  Analysts have earnings going to about Euro 3.25 in 2008 and Euro 3.58 in ’09 on a stand-alone basis.  At $65 a share, Inbev had said that the deal would be accretive the second year, 2010.  Were the company to hit 3.58, it is trading 12.5x earnings.  Bud has never traded this cheap.  Ambev is trading at 14x next year’s earnings and Bud has routinely traded at 16x earnings.  Even at 15x earnings of trailing 3.10 for Inbev, the stock belongs a couple of Euros higher, at which price level  I feel the stock  represents great long-term value.   Still, as noted in the beginning of the write-up, I think one needs to leave room as I question how easily the earnings will be reached. 

As a result of Inbev’s bid, Bud announced major cost-cutting initiatives, saying it would cut $1bn pre-tax or $.90+/share after tax.  This would take operating margins to about 22.5%.  Ambev’s are overall north of 25%, and Inbev’s are overall north of 22%, so Bud’s targets are likely doable.  Bud is forecasting earnings of $3.90 in 2009, growing at double digits thereafter.   Bud has 713mm shares outstanding (pre options).  At $3.90 a share, that is $2.78bn of net income.  Subtracting $650mm of equity earnings is $2.13bn.  Divided by a .61% after-tax rate is $3.491bn of operating income.   Bud has about $9bn of debt.  However, it also has 100mn options exercisable at $47.50 a share.  (Yikes).  So adding another 100mm shares at $70, less $4.7bn of cash makes the deal’s overall enterprise value $61bn, with the equity value about $52bn.  So operating income of $3.49bn + $650mm of equity earnings = $4.14bn divided by $61bn is 6.8%.  This is not a cheap acquisition; I expect it will be dilutive for a second year as well.  However, there will never be another Budweiser, and these numbers take no cost or other efficiencies into account or Inbev’s belief that it can move more of each company’s products through the other’s distribution networks in areas where there is no overlap (and I suspect t even areas where there is). 

Still, the financing is going to be extraordinarily tight.  For Bud, D&A adds an extra $1bn of year, and capital expenditures have historically been a couple hundred million less for Bud.  But there has been no excess of D&A over cap x for Inbev.

Compounding the difficulty in covering the financing is that a key piece of Bud’s earnings are equity in natur, and, for Inbev, there is a big minority interest piece in Ambev.  As such for the combined companies, a big piece of the earnings are not 100% owned, complicating financing. 

To fund the acquisition, Inbev plans to use substantial amounts of debt, divestiture of non-core assets (which I doubt will raise that much), and equity offerings.   Ignoring income from Ambev and Bud’s equity interests, Bud projects $3.5bn of operating income.  On a trailing basis, again not counting Ambev, Inbev had about $1.8bn.  Combined, this is $5.3bn.  Not counting Ambev, Inbev has about $4.3bn of debt, Bud currently $9bn, and roughly $50bn more is needed.  This combines to total debt of $63.3bn.  The $5.3bn of operating income over 63.3bn is about 8.4%.  Given the stability of the business and all the assets, particularly with an equity offering, I think the deal is financeable. 

Still, I think it highly questionable whether it can be done at the 6.8% needed to make it non-dilutive without synergies (and including Bud’s cost cutting effort).  So I do think there is a real risk that there will have to be an equity financing, thereby eating up a couple of years of growth.  As such, for Inbev, earnings could easily dip below the Euro $3.10, and take a couple of years to get back to this level.  As such, I think there is a genuine risk that the stock could be dead money for a while.

But given what the company is in the totality, a wonderful consumer franchise where private label isn’t a concern, where there is pricing power, unit growth, a developing country story, currency diversification, plus major, stable, and growing market shares due to marketing and distribution economies of scale, I have felt compelled to own Inbev, and I recommend it. 

However, as noted, I recommend a partial position.  There are risks.  There are deal risks due to regulatory and financing risks.  There has to be execution risks.  There will likely be equity offerings.  Rights offerings are common in Europe, and one could take place here.  There are cost pressures.  If the deal does not happen, either tomorrow or before consummation, there is uncertainty as to what comes next.  Finally, there is earnings risk. 

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