Description

SUMMARY

With the merger of Coors with Molson, which closed in February 2005, Molson Coors Brewing Company is now the fifth largest brewer by volume in the world. The Company operates in very competitive markets including Brazil, UK, Canada and the US. Over 40 brands are marketed by the Company including Carling, Grolsch, Coors Light, Kaiser, Blue Moon, Killian’s Red, Keystone, Molson, Aspen Edge, and Zima, among others.

Despite the challenges in the current environment related to intense competition and continued industry pressure in mature markets including the US, Canada, and UK, the Company has significant opportunities to grow free cash flow by 1) attaining operational efficiencies related to logistics at Coors Brewing in the US; 2) closing/selling or stabilizing Brazilian operations; 3) achieving $175MM of identified merger related synergies; 4) stabilizing its leading share position in Canada by better managing the value segment; and 5) the return of the hockey season next year.

With successful execution by the Company’s management team, free cash flow could grow from current normalized levels of around $400MM to $650MM by 2008. We believe the market cap should double within the next 3-5 years if the Company execute on the cost and merger savings initiatives assuming the base businesses are able to stabilize and grow with GDP.

INVESTMENT THESIS

The market has been overly bearish on TAP and we believe that as the Company executes on its plan, the shares should trade significantly higher as the realization of synergies and cost savings increase annualized cash flows to the $600MM level. Should the challenges persist, we believe that there lies a significant margin of safety in a consolidating industry as the private market value suggests a valuation at least 50% higher from current levels.

INVESTMENT HIGHLIGHTS

Strong Management team:
Leo Kiely III has been CEO of Coors Brewing since May 2000 and prior to that he was COO since March 1993. He shifted the Company’s focus from technology to building an efficient operation growing ebit margins from 4.9% in 1993 to 7.8% in 2004. He was the first outsider to take the helm from a business that was family owned and managed since its inception. Post merger, he recently hired Frits van Paasschen to take over his former role and run the US Coors Brewing business. Frits comes from Nike and was general manager for Europe, the Middle East and Africa. His strengths are in marketing and focusing on the consumer. We have heard from several sources that he has already made an extremely positive impression on the distribution network and within the Company. Coming from Nike (one of the best managed brands in the world), we expect Frits to better manage Coors brands in the US from the front end while the team in place should continue to attain $1/barrel/year in cost savings from operational improvements.

Post merger with Molson, 12 Coors executives took packages from the change of control clauses and left the Company. They were either replaced by outsiders and other internal Molson/Coors executives.

Brazil Goes Away:
Management has announced that it is not investing any incremental dollars in Brazil and is actively seeking strategic options for the business. Should the business operate at cash flow breakeven or even if the Company closes or sells the operation, this would add an estimated $40MM of free cash flow from current levels.

By way of background, Molson acquired Bavaria in December 2000 and Kaiser (then the #2 player in the market) in March 2002, which brought Molson’s market share in Brazil up to 18%. Molson paid $1.14BN for Kaiser and then subsequently sold 20% of the Brazilian operations to Heineken for $334MM. Market share decreased from 17% in fiscal 2002 to 12.4% in FY2004, 15% annual declines; and now market share is closer to 8%. Volumes decreased 17.5% in FY04 as competitors have been aggressively attacking the market. The Brazil segment generated EBIT of $37MM in ’03, EBITDA of $57MM decreasing to negative $22MM and negative $3MM, respectively in 2004. In Q1 of ’05, Brazil had a pretax loss of $18MM (excluding special items) compared to a loss of $16MM the previous year while volume decreased 7.1% versus the previous year. In Q2 of ’05, volumes declined 11.7% versus the previous year, but the team managed to reduce operating losses ($19.6MM) by approximately half from the second quarter of 2004. Management’s near-term goal is to operate the business on a break-even basis from operating cash flow perspective.

Brazil is the #4 beer market in the world amounting to approximately 88mm hectoliters, 4.5x the Canadian market, which was estimated to be 21.5MM hectoliters in 2004. By 2010, Brazil is expected to takeover Germany as the #3 beer market given the demographics of its population – 35% of the population is under 18. Ambev is the dominant player in Brazil with 68% market share and an unparalleled distribution system with 1MM points of sales reached. EBITDA margins are 37% and it is the lowest cost producer in Brazil. The Company is a fierce competitor. Approximately 70% of beer by volume is sold on-trade (e.g. at bars, restaurants, etc.) and therefore having the distribution network is key. Among other tactics, the Company offers freezers and other items to bars in exchange for exclusivity at the bars.

Significant Merger Synergies will be realized:
The Company should be able to realize $175 minimum synergies by 2007 from its merger with Molson. $60MM is related to brewery and logistics synergies from the closure of the Memphis brewery which will eliminate excess capacity and reduce freight costs. The Company plans to shut down its Memphis brewery by the middle of 2006 and bring capacity to its Virginia Shenandoah Valley facility, which is currently only a packaging facility. They believe Shenandoah will come online early in 2007. Another $60MM is expected to come from procurement savings through contract pricing and supplier rationalization through increased throughput. Another $25MM in savings is expected to come from G&A and overhead synergies through the elimination of Coors Canada and Molson USA and corporate staff reductions. Finally, the Company expects $25MM from information technology synergies from the consolidation of hardware, software and outsourced agreements. By the end of 2005, 2006, and 2007, the Company expects $50, $40 and $85MM of annual cost savings, respectively.

Other Cost Savings Initiatives Above the Synergy:
Two pre-existing programs existed at both Molson and Coors separately to improve efficiencies and include the P125 program in Canada and a directive to improve $5-6/barrel or $1/barrel/year for Coors in the US. We expect the Company can generate after-taxes approximately $120MM annually from savings from these pre-existing programs assuming a 30% tax rate (note that the company has guided that its long-term tax rate to be in the 25-30% range).

In Canada, Molson established multi-year cost-savings programs. Management implemented the Project 100 program, designed to cut CN$100MM in costs over three years. Soon, Project 100 became Project 150, and after three years (by the end of FY03), the program achieved CN$152MM in savings. Equipment was modernized, organizational savings were achieved- sourcing and distribution contributed to the savings, as did sales and marketing. In the late 1990s, Molson had a mid-teens EBITDA margin. Upon completion of Project 150, Molson had a 23% EBITDA margin.

Project 150 worked so well, management instituted a sequel to the cost-cutting program in '02 designed to achieve CN$100MM in savings during the '04-'06 timeframe. Management subsequently increased this Project 100 to Project 125. The P125 program seeks further cost efficiencies in distribution, capacity utilization and procurement. The project is 2/3 complete with the end expected in March 2006. This would imply US$30-$40MM in incremental savings over the next 12 months.

In the US, Coors has an $8-$10/barrel unfavorable cost differential compared to Budweiser. The Company believes that half of the difference cannot be made up due to Budweiser’s scale. However, $4-$5 barrels can be achieved through freights savings and other operating efficiencies. On average there are 1000 miles between Coors and its distributors whereas the difference is 300 miles for Budweiser (note: Budweiser has 12 brewing stations around the country while Coors has 1 in Golden and 1 in Memphis, which will be closed, and 1 in Shenandoah by early 2007). The Company already ships via intermodal (combination of train and truck) but plans to ship more via intermodal to decrease its freight costs and make up approximately $2.5/barrel/year of the $5-$6/barrel/year goal.

Return of Hockey Next Year:
Beer volume in Canada has been hurt from the cancelled hockey season this past year which runs from September through May but it is difficult to quantify the exact effect. However, as the hockey season is expected to return next year, we do expect volumes should increase – analyst estimates in the range of 3-5% in terms of volumes.

Private market value suggests much higher valuation:
Takeout EBITDA multiples have ranged from 9.5-12x. Combined 2004 EBITDA is about $1BN reaching $1.2-$1.3BN in 2 years. Using $1.2BN EBITDA and applying the range, this would imply a private enterprise value of $11.4-$14.4BN less $2.7BN in debt implies a market value of $8.7-$11.7BN. The current market capitalization is $5.5bn. As the industry is consolidating, we believe this provides a significant margin of safety should the Company not be able to execute on its plan. SAB Miller or Heineken would be perfect matches for the company.

Also note, the AmBev/Interbrew deal provides us with an acquisition multiple for Labatt Canada (#2 in Canada), which is a part of the combination. AmBev acquisition of Labatt Canada v implies a 13x '03 FV/EBITDA and 11x '04E FV/EBITDA. So applying the 11x EBITDA multiple to an assumed $635MM in future EBITDA, Molson alone would have an enterprise value of $7BN.

Compelling Valuation –
This is a merger/turnaround story for a Company that should be able to increase its operating margins from 11.1% in 2004 to the low teens of 14-16%. If this happens with GDP type of growth, the Company should generate at least $900MM in operating income and about $1.2bn in EBITDA by the end of 2008. During that time, we expect the Company to use its excess cash to buy back shares and pay down debt. The 2008 FCF multiple would then be trading from something less than 7x.

COMPETITION

The markets where the Company competes, including Canada, UK, Brazil and the US, are extremely competitive. In the US, the top three brewers own 81% market share with Bud owning approximately half, SAB Miller at about 18.5% and Coors at 11.5% share (Note: Imports are 11% and growing). US total beer volume grew less than 1% in 2004 and its share of the beverage market has declined for the fourth time in five years in 2004. Budweiser historically has been priced at a premium to Miller and Coors and has recently narrowed the price gap. Last year at Q2, Bud Light was 0.48 cents higher than Miller Light and Q2 this year it is 0.27. Bud is clearly concerned about maintaining its market share and has announced that it will delay its yearly second price increase scheduled for the fall until February next year. We expect Coors brand will remain competitive and maintain its market share in the US. Should industry volumes continue to decline, we believe that the Company will be able to manage its operating profit from managing its freight costs through intermodal transportation and the closure of its Memphis brewery.

In Canada, the Company operates in a duopolistic environment with Molson (43%) and Labatts (42%) controlling 85% of the market. The value segment has been growing share due to the government giving local breweries tax breaks and thus enabling them to maintain a $9-$10/24 pack price differential between themselves and the premium brands. Historically, this gap was as low at $4-5/24 pack. The tax break sets annual volume limits and total volume limits over a five year period. For some regional breweries, e.g. Lakeport, the tax break is going away in 2006 because they were able to grow volume by underpricing competition. Labatts and Molson have responded by increasing prices of the value brands that they manage. Molson has offered promotions of their premium brands during the holiday season and special occasions. We believe that Molson and Labatts will be able to manage the value brands and will at least have a positive catalyst next year with the return of the hockey season.

In Brazil, the market is owned by Ambev with 68% share. Skinchariol is a private Company with 13% ownership and Molson Coors Kaiser and Bavaria brands own 8%. Skinchariol’s executives are under investigation by the government for tax evasion and some analyst believe that the Kaiser and Ambev brands should benefit from this. Ambev’s has a major competitive advantage in that over 50% of its volume are sold through their own proprietary distribution network and the rest is sold by exclusive 3rd parties with exclusive territories. Kaiser brands are exclusively sold through coke bottlers who do not have a strong incentive to promote or push the brand. In 2002, Molson bought the brand from the bottlers and since then the Kaiser brand has seen market share declines. The salesmen make little money on Kaiser and have no interest in promoting it as they no longer have any equity interest. We believe that it will be extremely difficult for Kaiser to turnaround the situation as they do not own their distribution network. Either the Company sells the business or focuses on certain regions where brand loyalty is high.

The UK is a mature market with four national brewers including Scottish/Newcastle with a market share of 24-25%, CBL (Coors/Molson) with 21%, Interbrew with 19% and Carlsberg with 14%. One major trend in the UK is the move toward lager beers away from Ales, which historically was the larger part of the market, now making 25% of the volume. In the US, as a reference point, Ales market share is under 3%. Should this trend continue, CBL, with the largest mainstream lager (Carling) brand representing 75% of CBL’s total volume will benefit disproportionately relative to its competitors. Another major trend is the move from on-trade (i.e. pubs) to off-trade (e.g. at home) consumption. On premise consumption used to be as high as 90% historically and now represents 2/3 of volume. As the strongest on-trade brand, CBL’s Carling brand should do well in off-trade consumption. Based on these trends, we believe CBL is well positioned in the marketplace.


RISKS
• Brazil continues to impact operating results and Company may not be able to either sell or operate as breakeven
• Continued declining growth – as trends in the US and Canada continue to move to spirits
• Pricing pressures continue in the US because of deep discounting by Bud and Miller
• Large pricing gap continues in Canada degrading market share
• Macro-economic conditions curb consumer spending/playing – although, historically, in an economic downturn, beer companies have traditionally done well and have been able to weather the storm
• Promised merger synergies not achieved
• Continued sustained high oil prices could materially impact shipping and energy costs

Catalyst

• Brazil gets sold or operates at cash flow breakeven
• Beer consolidation continues – somebody acquires them
• Industry/pricing environment improves in US
• Price gap returns to historical levels in Canada
• Hockey season returns increasing volumes in Canada
• Cost savings from P125 in Canada and $4-$5/ barrel/year are achieved increasing operating margins
• Synergies achieved in a timely manner