This Bud's for You

Both the American depositary receipts and the Belgium-traded ordinary shares of

We see three reasons for the relative underperformance of AB InBev: severe weakness in Brazil, a risk of a dividend cut, and a historically high multiple. All three are legitimate concerns, but we think all are overblown. Brazil is currently going through a turbulent economic period, and industry volume is pressured. However, AB InBev’s 68% volume share gives the firm a cost advantage and greater financial flexibility over competitors, which should position it well in this premiumizing market for the long term. Fears of a dividend cut are not without foundation, but we believe the dividend can be sustained and increased at a low-single-digit rate until the firm reaches its optimal leverage ratio of 2 times debt/EBITDA by 2020. The high level of acquisition debt not only provides a risk to the dividend, but also distorts the near-term earnings power of the business. When debt has been paid down, we expect the SABMiller acquisition to be accretive to earnings, and the stock trades at just 14.6 times our estimate for 2019 earnings per share.

Weakness in Brazil Brazil, the firm's second-largest market with around 14% of the volume of the now-combined business, is currently very weak. Organic volume fell 5% in the third quarter and are down more than 6% year to date, which implies some share loss from last year's 68% volume share. We attribute this in part to trading down, but we believe premiumization will resume in Brazil when the economy recovers. Volume weakness has come at the same time as a weakening of the Brazilian real (down 10% on a trailing 12-month basis) and some unfavorable currency hedges. In aggregate, we expect full-year EBITDA from Brazil to be $1.5 billion below last year's level, which equates to an EPS headwind of $0.60 this year and an impairment to our valuation of $12. Our fair value estimate assumes stabilization in Brazil next year. If that fails to materialize, and if Brazil revenue declines a further 10% next year, we would probably lower our fair value estimate, although by an immaterial amount.

While the near-term outlook remains weak, we believe AB InBev is well positioned for long-term growth in Brazil. We have identified Ambev, AB InBev’s Latin American business, as possessing the highest secular volume growth rate among its global peers as a result of its strong positioning in premium beer categories, through its Brahma and Skol brands. Although premiumization has clearly taken a pause during the current recession, we expect the Brazilian consumer to resume trading up when economic conditions improve. Furthermore, the expansion of returnable glass bottles is likely to be margin-accretive. We remain comfortable, therefore, with our medium-term forecasts of 6.5% average revenue growth and 7.5% average EBIT growth.

Risk to the Dividend Investors' concerns about the sustainability of AB InBev's dividend are not without foundation. The same management team slashed the dividend in 2008 to just 10% of the previous year's payout following InBev's acquisition of Anheuser-Busch as debt reduction became its number-one capital-allocation priority.

However, there are reasons to believe it is different this time, and we do not expect a dividend cut. First, the Anheuser-Busch acquisition was executed amid the worst financial recession in a generation. This time, although some markets such as Brazil are experiencing difficulty, market contraction is fairly isolated and the credit markets remain open. Second, at a weighted average coupon rate of just 3.7%, the interest rate on the debt is lower and manageable. Third, asset sales will help accelerate deleveraging in 2016 and 2017. Assuming $7 billion is raised from the sale of SAB’s Eastern European assets, we estimate that the incremental net debt from the deal will leave AB InBev at 4.7 times debt/EBITDA at the end of this year, roughly in line with its leverage following the Anheuser-Busch transaction. Finally, from free cash flow generation of $12 billion in 2017, we model $7 billion being paid out as dividends and the remainder being used to reduce debt. At an annual rate of $5 billion in debt reduction, we believe AB InBev can get close to its target level of leverage of 2 times debt/EBITDA by 2020.

Valuation After its pullback, AB InBev now trades at 18 times our 2017 EPS estimate. This is comfortably below the 22 times implied by our $126 valuation, which appears to be a rich multiple by historical standards. However, we estimate acquisition-related debt accounts for $1.4 billion in pretax incremental annual interest expense, or $0.53 in earnings per share. As we anticipate the bulk of this debt will be repaid by 2020, adjusting for it yields a 2017 earnings multiple of 16.5 times, a far more appealing multiple.