A Good Time for a Beer

Third-quarter organic revenue growth of 4.5% is above par for large-cap consumer staples companies in the current environment. Volume growth was soft, up just 30 basis points year over year; Brazil again underperformed, with beer volume down 3%. This, we believe, was mostly driven by macro pressures and a contraction in the market, but Heineken HEINY clearly took share in the quarter, and while we believe Brazil will remain a rational oligopoly in the medium to long term, competitive pressures may add to the volatility over the next year or two. We are sticking to our belief that 5% organic revenue growth is a reasonable assumption for Brazil in the medium term.

While the volume miss was disappointing, the price/mix growth driver of 4.2% was pleasing, given that strong pricing should shelter AB InBev from rising commodity inflation better than some other large-cap consumer staples businesses. Another positive was near 5% revenue growth in Europe, although we do not expect this to be sustainable.

The dividend cut announced Oct. 25 has looked increasingly likely over the past few weeks, and we think it will be to the benefit of the long-term investor. Having leveraged up to over 5 times net debt/EBITDA in order to acquire SABMiller in 2016, AB InBev was relying on EBITDA growth to lower its leverage ratios. From a free cash flow run rate of around $11 billion, the company paid over $9 billion in cash dividends last year, leaving only around $2 billion to repay debt. Our initial belief was that the dividend would be sustainable, but the headwinds to EBITDA growth have been relentless over the past few quarters. First, Brazil slowed under macro and political volatility, then other emerging markets followed, currencies devalued against the U.S. dollar, and in the last quarter, even South Africa volume declined. Under these circumstances and in the absence of a dividend cut, we had not expected AB InBev to get anywhere near its net debt/EBITDA target of 2 times within our five-year forecast period. In fact, we had previously modeled a leverage ratio of 3.6 times in 2022, a level that would have limited the firm’s M&A optionality and no doubt frustrated shareholders. Following the dividend cut, and with an extra $4 billion in free cash flow to put toward deleveraging the balance sheet, we believe AB InBev can get comfortably below 3 times net debt/EBITDA over five years, a much more comfortable financial position.

If the headwinds to EBITDA forced the dividend cut, the negative reaction of the share price facilitated it. AB InBev’s ADR market value had declined by one third year to date to the price in premarket trading and at the close of business Oct. 24 offered a dividend yield of 5%. By rebasing the dividend to 50% of its previous level, AB InBev now yields a shade under 2.5% at the premarket price, broadly in line with its peer group, and at a level high enough for some income investors to continue to hold the stock. We now model low-single-digit dividend growth through 2020, with growth accelerating to around 8% by the end of our forecast period, in line with our estimate of midcycle earnings growth.

Algorithms and forced selling will no doubt cause a bumpy ride for AB InBev shareholders over the coming days. However, we think that accelerated deleverage will probably come as a relief to many shareholders, as it will allow management to get back to its modus operandi of consolidation and cost-cutting. With the dividend cut in the rearview mirror, we hope that investors will now look more closely at the fundamentals of the core beer business. If they do, they will find a wide-moat business with powerful market shares in markets primed for long-term growth--some through growing consumption (Africa) and others through a multiyear premiumization tailwind (Latin America). They should also see a business with more than its fair share of tailwinds, but we think these are mostly cyclical in nature (apart from, arguably, its competitive positioning in the United States). With price/mix north of 4% even in this environment, AB InBev looks better positioned than most to ride out the macro volatility it faces in several markets. Despite all the hairs on the stock at present, with the shares trading at 16 times our below-consensus estimate of next year’s earnings, and with AB InBev’s above-sector profitable growth profile, we think there has rarely been a better time to build a position in this wide-moat name.