Bud's Lost Fizz Offers Opportunity

After a significant pullback in the past four months,

AB InBev posted a solid fourth quarter, with revenue just shy of our estimate but above consensus and EBIT ahead of both, thanks to the speed of its cost savings. We are reiterating our $126 fair value estimate for the ADRs, as a slightly less aggressive medium-term EBIT margin assumption offsets the impact of the time value of money. We have lowered our valuation of the Belgium-traded shares to EUR 103 from EUR 105 to account for the strength of the euro against the U.S. dollar.

With the exception of the Europe, Middle East, and Africa region, where South African volume was a little soft, all geographies showed solid performance, with revenue generally in line with our forecasts. Fourth-quarter organic revenue growth of 8.2% was impressive, on top of 4% growth in the year-ago period, and helped AB InBev recover from a subpar year to finish 2017 with 5.1% organic growth. For all investors’ concerns about AB InBev’s ability to grow, this puts the company at the top end of its global consumer staples peer group in terms of organic growth last year.

AB InBev appears to be realizing the synergies from the SABMiller integration slightly quicker than we had expected, and its fourth-quarter adjusted EBIT margin of 34.7% was around 30 basis points above our forecast. Although input cost inflation returned in the fourth quarter after falling in the third, the margin was supported by AB InBev’s ability to pass through price increases (price/mix was up 6.6% in the quarter) that exceed the rate of commodity inflation (up 2.6%), which we believe is indicative of the company’s strong market positions and brand equity.

We have noted three primary concerns from investors as the stock price declined over the past few months. The first is that Brazil, a market that represented 14% of revenue and 18% of EBIT for AB InBev last year, has been in a downturn. This is certainly true, and the country is likely to remain economically and geopolitically volatile. However, Brazil is a premiumizing market, and Ambev ABEV, AB InBev’s Latin American business, possesses a brand portfolio that includes premium lager brands such as Brahma, which should retain or even increase share over time, notwithstanding Heineken’s HEINY ability to expand the footprint of its recently acquired Kirin assets. In a 2014 report, we identified Ambev as possessing the highest secular volume growth rate among its global peers as a result of its strong positioning in premium beer categories. Brazil returned to margin growth in the fourth quarter, up 540 basis points over the year-ago quarter, which we believe supports our thesis that AB InBev’s headwinds in Brazil have been cyclical, rather than secular, in nature.

The second concern is the U.S. business, which provided 24% of revenue and 28% of EBIT for the company in 2017. There is no denying that AB InBev is on the wrong side of the trend in this market. Volume has declined for several years, with mainstream brands losing share to craft beer, and increasing share in the fragmented craft segment would require a huge brand-building investment or a potentially expensive acquisition. Nevertheless, we think there is a natural ceiling to craft beer’s market share because its higher price point will constrain its appeal to medium- to high-income brackets, and because there will be a limit to its ability to win shelf space. Some data already suggests that craft has reached saturation, with the Brewers Association indicating that U.S. volume share ticked up just 10 basis points last year to 12.3%. As craft volume growth slows, this should ease the pressure on mainstream brand volume. The 1.4% decline in industry sales to retailers in the fourth quarter is almost exactly in line with our medium-term forecast of a 1.5% volume decline in North America. Continued contraction in the U.S. beer market is a reasonable assumption based on a consumer migration to other categories, such as spirits, but this looks more than priced into AB InBev’s market value.

The third bone of contention is the highly leveraged balance sheet and AB InBev’s ability to pay its dividend in the near term. These concerns are not without foundation, as the company ended 2017 at net debt/EBITDA of 5 times, and the same management team slashed the dividend in 2008 to 10% of the previous year’s payout following InBev’s acquisition of Anheuser-Busch in order to make debt reduction 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 and the United States 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, from a free cash flow to the firm run rate of $15 billion in 2017, we model just over $10 billion being paid out annually as dividends and the remainder being used to pay back borrowings. At an annual rate of $5 billion in debt reduction, AB InBev can reduce the leverage on its balance sheet to just over 3 times net debt/EBITDA by 2022 without any risk to its dividend, in our opinion.

After its pullback, AB InBev trades around 22 times our 2018 earnings per share estimate, in line with to slightly above peers and below the 25 times implied by our $126 valuation. However, with another $1.1 billion in pretax savings from the SABMiller acquisition to go, we estimate that normalized earnings per share would be around 7% higher. At 19 times our estimate of 2019 earnings, with best-in-class margins, best-in-class management, and an underappreciated growth rate, AB InBev offers relatively appealing value, in our opinion.