Case Studies

Anheuser-Busch InBev

Anheuser-Busch InBev

Today, Anheuser-Busch InBev (ABI) is the largest and most profitable brewer in the world.  The ABI story began in Brazil in the 1980s with Jorge Paulo Lemann’s recognition that the richest man in each Latin American country was the brewer.  In Cristiane Correa’s book Dream Big, Lemann shares, “I was looking at Latin America and who was the richest guy in Venezuela? A brewer (the Mendoza family that owns Polar). The richest guy in Colombia? A brewer (the Santo Domingo group, the owner of Bavaria). The richest in Argentina? A brewer (the Bembergs, owners of Quilmes). These guys can’t all be geniuses… It’s the businesses that must be good.”  With that insight, Lemann and his partners went about trying to build a large-scale brewer, beginning with the acquisition of Brazilian-based Brahma in 1989.  In 1999, they merged Brahma with Antarctica Paulista to form AmBev, the dominant brewer in Brazil.  To this base in 2003, they added Quinsa, Argentina’s #1 brewer and owner of the Quilmes brand.  In 2004, the group ventured beyond South America with the acquisition of Interbrew, owner of Stella Artois in Belgium.  The expanded ownership group acquired a controlling stake in Anheuser-Busch (a former Cook & Bynum holding) in 2008, in the process becoming the largest brewer in the United States and the world.  In 2013, ABI purchased the largest brewer in Mexico, Grupo Modelo (also a former Cook & Bynum holding).  ABI then completed its purchase of SAB Miller in 2016, which materially expanded its global footprint, especially in emerging markets.  The integration of SAB Miller is ongoing with a number of cost synergies and cross-selling opportunities still contributing to earnings growth.

Lemann and his partners understood that breweries’ strong profitability and high returns on capital were generated by a virtuous cycle of dominant brands, distribution reach, and market share.  ABI benefits from all three of these advantages, which are further complemented by its production economies of scale.  The company has numerous strong, country-level brands in addition to three of the world’s biggest and most recognizable brands: Budweiser, Stella Artois, and Corona.  These national and global offerings cover various beer segments and allow the company to graduate consumers from value to mainstream to premium labels over time.  ABI’s revenue, margins, and profitability all grow from this “premiumization” effort.  Importantly, these brands also command pricing power, which helps grow revenues in line with or in excess of cost increases.

Beer distribution in the United States operates markedly different than it does elsewhere in the world.  Following the end of Prohibition in 1933, states passed laws that prevented alcohol producers from selling and distributing directly to retailers.  The resulting three-tiered distribution system gives small beer producers access to the scale advantages created by the category leaders, which is one of the key reasons craft brewers have made large in-roads in the U.S. relative to elsewhere in the world.  Outside of the U.S., no such legal framework exists, and large brewers do not share their scale distribution advantages with competitors big or small.  As a result, the craft competitive threat is much lower.

Chart 1. Route-to-Market Dominance Outside of the U.S.

Source: Cook & Bynum research

Additionally, in emerging markets, the retail marketplace is far more fragmented with formal channels representing a smaller portion of sales.  In the formal market, retailers typically operate their own distribution centers and allow small producers to access their stores simply by delivering to the distribution center.  To serve the informal market, on the other hand, a producer must send a truck to every point of sale.  This direct store delivery route-to-market is cost prohibitive for new entrants in emerging markets, making distribution a secondary moat for the leading consumer good in a category beyond the brand equity that is familiar to Western investors.  ABI further complements this distribution reach with manufacturing economies of scale that give it, alongside Carlsberg, the lowest unit production costs in the industry:

Chart 2. Total Cost per Liter

Source: ABI filings

In Chart 3 below, the horizontal axis shows the percentage of the company’s total operating profits — Earnings Before Interest and Taxes (EBIT), in this case — earned in each market, and the vertical axis shows the market share for each country.  Note the 50% or greater market share in many of the company’s countries, including 95%+ market share in Colombia and Peru:

Chart 3. Market Share in (Y-axis) & EBIT Share for (X-axis) Major Markets

Source: Company filings, Redburn 2017 estimates; Note: Top 10 markets labeled

These impressive market shares are not an accident but rather a natural result of ABI’s virtuous cycle in which market share, dominant brands, and distribution advantages reinforce one another.

Reinvestment Opportunities & ABI Geographic Footprint

Another important takeaway from Chart 4 above is that while ABI is based in Leuven, Belgium and the U.S. is its largest market, the company is really an emerging markets business.  In 2017, 63% of the company’s EBIT came from its operations in developing economies.  By 2027, we expect that figure to rise to 77% as faster growth continues in Latin America, China, and Africa.  The rising middle class in these markets will be a tailwind for both volume and price growth for at least the next two decades.  ABI management understands these dynamics well, and the team is responding with smart capital allocation decisions.  The company is harvesting profits from the United States, which are likely to shrink in the next decade (more on this below), and reinvesting them in faster-growing, less mature foreign markets.  Additionally, the projects in which the company is investing are “easy decisions” that will dig the company’s competitive moat deeper and enhance long-term profitability.  Examples include investments in (1) marketing initiatives that promote the cross-selling of higher-margin premium brands, (2) coolers for mom-and-pop stores that improve revenue at the point of sale, and (3) manufacturing plants that better meet demand in emerging markets and lower production costs.

Understanding these investment decisions and, more broadly, what is happening at the local level in each ABI important market is a critical piece of our research.  Key takeaways for top ten ABI markets follow:

United States & Canada

ABI currently earns 28% of its operating profits in the United States, which is a market where consumers’ evolving tastes and preferences are working against the business.  First, beer as a category has been declining slowly for decades versus wine and spirits.  Second, over the last decade, craft beer and imports (principally Mexican brands owned by ABI outside of the U.S.[1]) have taken significant share from the two largest ABI U.S. brands, Bud Light and Budweiser.  The combined volume share of Bud Light and Budweiser has declined from around 28% to 24% since 2010.  Against this backdrop, however, we have some optimism for ABI in the U.S.

While Mexican imports continue to gain share, Michelob Ultra has been a terrific success with its low carb/low calorie lager, which is well-positioned for current health and wellness consumer trends.  Michelob Ultra sales grew 17% in 2018, and the label is on track to pass Budweiser as ABI #2 brand in the U.S. in the next couple of years, mitigating Bud Light and Budweiser revenue declines.  Even better, Michelob Ultra is sold at a premium price to Bud Light but is cheaper to produce.  As a result, superior economics of Michelob Ultra are moderating negative impact of Bud Light and Budweiser on margins and profitability.

Importantly for all large brewers, the most recent Nielsen data show year-over-year craft sales slowing from 15%+ growth in 2015 to slight declines by year-end 2018.  The deceleration coincides with rising fragmentation in the craft market.  Craft drinkers are fickle and frequently try a different beer every time they consume.  This transient consumer makes building a branded, scale brewer challenging, as does this consumer’s tendency to prefer a “local” beer.  The desire for local reduces the possibility that a craft brewer might become the next Sam Adams or New Belgium, both of which were initially regional players that built national footprints.  We do not think we will see another such breakout winner anytime soon.  Interestingly, both Sam Adams and New Belgium are struggling in this new buy local paradigm, as they both experienced double-digit volume declines in the first nine months in 2018.

Canada, 10th largest ABI market by profits, has a market share profile and competitive dynamics similar to the U.S.  The country has demographic headwinds and its per capita beer consumption will likely shrink over the next decade partially due to competition from wine, spirits, and (maybe) cannabis, which is now legal in the country.  Canada craft segment has reached 6% market share and although regulation varies by province, the route-to-market is often owned, controlled, or supervised by the government, which makes it difficult to exclude subscale players. Despite this, ABI successfully grew the volumes of its own craft brands by double digits during 2018.  The company’s premiumization strategy is also working, as Corona and Stella Artois enjoyed market share gains during the year.  Moreover, ABI is successfully cross-selling its U.S. labels, as Bud Light and Michelob Ultra are among the fastest-growing brands in Canada.  We anticipate a decline in per capita consumption of beer, but we expect the up-selling of premium labels and the cross-selling of core ABI brands will keep earnings stable over the next decade.

Brazil

ABI dominates the Brazil beer market with 64% market share and the country’s three largest beer brands: Skol, Brahma, and Antarctica.  A well-developed ABI distribution network in Brazil meets the needs of a fragmented market that has a high portion of on-premise, immediate consumption in restaurants, bars, and bodegas.  We visited the country twice in 2018 and were impressed with the company’s execution and reach at points of sale.  The result is a market with 35% operating margins and returns on invested capital above 35%.  While in Brazil, we met with the ABI team, formal channel retailers, and two Coke bottlers (more in a minute on why the latter is important to our analysis).

While ABI overall positioning in Brazil is excellent, we are closely following the country’s evolving market structure and macroeconomic health.  In 2017, Heineken bought Kirin to form the #2 brewer in Brazil with a combined market share of 26%.  The flagship Heineken brand in the premium segment has a little over 1% share, with the balance of the brands in both Heineken and Kirin portfolios selling mostly in the lower-priced and lower-margin value segment.  This merger has created a good deal of uncertainty in the market.

Heineken is a strong premium brand in Brazil that has been built over the last decade with distribution from the Coke bottling system.  This arrangement is a legacy of Heineken’s 2010 purchase of FEMSA Cerveza, which was the beer division of FEMSA (a former holding of Cook & Bynum based in Monterrey, Mexico).  In addition to its former ownership of FEMSA Cerveza, FEMSA owns a controlling stake in the largest Coke bottler in the world and the outstanding Mexican convenience store operator, Oxxo.  Kirin brands are distributed through its captive distribution network, and Heineken wants to start using this network to distribute its portfolio as well.  Accordingly, Heineken has given notice to remove its distribution from the Coke system before the March 2022 contract expiration.  The matter is currently in arbitration with a legal resolution expected in the first half of this year.

The Coke system does not want to lose Heineken from its distribution network as it represents 7% of its total volume.  It is possible that Heineken will remain in the Coke distribution system until 2022, which would be a worse outcome than an earlier termination of the agreement for both Heineken and ABI.  The Coke system offers Heineken 400,000 points of sale in Brazil and helps it move volume.  However, according to a series of conversations we had while in Brazil, the structure of the distribution deal gives practically all of the resulting profits from Heineken sales to the Coke system.  Heineken would likely be better off if it sold less volume but self-distributed and held on to enough margin to make Brazil a profitable market.  The resulting decline in Heineken volume would also be a positive for ABI as most of the volume surrendered would accrue to ABI.  We suspect that current volume growth of Heinekin in Brazil is artificially enhanced by promotions implemented by the Coke system to improve its bargaining position in the current arbitration.  When the Coke system does lose Heineken, we expect the system to look to partner with either a small domestic brewer or an international brewer such as Carlsberg or Diageo and try to repeat the Heineken experience by growing a beer brand on the strength of the Coke distribution system.  Long-term this will likely be effective, but it will take at least a decade for it to be important in the market.

The one exception would be if the Coke system agreed to distribute Petropolis, the #3 brewer in Brazil with 16% share, because of its recognized brands and existing production capacity in the country.  However, Petropolis is currently under investigation for a bribery scandal in the state of Rio de Janeiro, which likely disqualifies the brewer from a partnership with the Coke system.  Petropolis is losing market share, and we expect its business to continue to face headwinds and surrender market share to both ABI and Heineken.

Ultimately, economic growth of Brazil is more important to ABI profits than the changes in the beer industry’s competitive landscape.  Brazil is emerging from a three-year recession that severely impacted consumer spending and decreased beer consumption:

Chart 4. Annual Brazilian Beer Consumption

                Source: Euromonitor

The country has been dealing with the hangover from two decades of corrupt socialism under the da Silva and Rousseff administrations, which robbed the country of much of its economic potential.  Happily, during Richard’s December visit, people were invariably optimistic that the economy was going to improve in 2019 under the new presidency of Jair Bolsonaro.  The exposure of wide-spread corruption thanks to Operation Car Wash has had a profound and positive impact on the country’s politics.  The country’s newspapers are filled with the latest news about the scandal and the jail time imposed on those caught.  Consumer confidence is on the rise, and we are cautiously optimistic that there will be an improvement in economic conditions that will increase per capita consumption of beer back to and beyond pre-recession levels.

Elsewhere in Latin America

We believe ABI operations in Latin America are the crown jewels of its portfolio.  Beyond Brazil, the balance of Latin America represents more than 25% of ABI combined operating earnings, with Mexico, Colombia, Argentina, and Peru all in ABI top ten markets by earnings.  Mexico is the largest of these, which ABI entered in 2013 with its acquisition of Grupo Modelo.  The country operates in a stable duopoly with Heineken, who acquired FEMSA beer operations in 2010.  Heineken local brands are stronger in Northern Mexico (Tecate, Sol) while ABI brands are stronger in Mexico City and the South (Corona, Modelo).  ABI 2018 volumes and revenues grew in the high single and double digits, respectively, and we expect industry-wide growth through both volume expansion and premiumization to benefit both players.

ABI Colombian operation is a legacy SAB Miller business. Decades of consolidation, outstanding execution, and the competitive virtues of the beer business have produced 95%+ market share, some of the highest beer margins in the world, and incredible returns on capital. With insights from developed markets, ABI is getting ahead of potential competitive threats posed by small brewers offering new or local tastes.  A robust ABI portfolio of local, import, premium, and mainstream brands in these markets leaves little room for competition to gain a foothold without incurring massive losses. For example, ABI owns Bogotá Beer Company, the leading craft brewery in the country.  Of course, ABI profits in Colombia are not without risk.  Chile CCU (part-owned by Heineken) began operating a new three- million-hectoliter brewery with a goal of capturing 10% of the Colombian market.  We will be watching closely to assess the progress of the endeavor.

Argentina is also a wonderful market for ABI, which it entered through the acquisition of Quinsa in 2002.  ABI has higher market share, around 75%, than it does in Brazil thanks to the Argentine national brand Quilmes, local brand Patagonia, Brazilian brand Brahma, and premium imports.  The country’s recent macroeconomic troubles, highlighted by the ongoing currency instability that forced ABI to apply hyperinflation accounting during the second half of 2018, and its wine-drinking culture are constraints on growth.  Longer term, however, pricing power, premiumization, and the company’s dominant  market position give us optimism about the durability and growth of ABI’s earnings over the coming decades.

In Peru, ABI operates through its Backus y Johnston subsidiary (“Backus”), which it acquired as part of its SAB Miller purchase.  ABI owns about 97% of the company’s equity, with around 3% still free-floating.  Beyond its ABI ownership, the Fund is a direct owner of Backus shares.  Accordingly, our summary of this market and our investment in this business are included in its own section.

Australia

Australia is the fifth largest ABI market by EBIT, and the company accounts for nearly half of all beer sales in the country with Japanese Kirin as a strong #2.  Australia is a mature, developed market that experienced limited volume growth in 2018; we expect volume growth to remain subdued going forward.  Fortunately, ABI premiumization strategy grew revenues in the low single digits in 2018 and will continue to grow them in the future (alongside price increases/pricing power).  Both ABI local brands, notably Great Northern, and its global brands, particularly Stella Artois and Corona, are growing quickly, with Corona reaching almost 6% market share.

China

ABI is the third largest brewer in China, but by far the leader in profits as more than half of its volume is premium, high-margin product. The two largest brewers, Tsingtao and China Resources Beer, have mainstream portfolios and lower profitability. The Chinese premium segment and ABI franchise is growing much faster than the rest of the beer industry, which has slowed after decades of rapid growth but still has plenty of room for per capita consumption to converge with wealthier Asian countries.

A big factor in this growth is how ABI global premium brands resonate with the Chinese consumer.  For example, Budweiser is extremely popular, and Chinese sales of Bud surpassed U.S. sales of Bud last year.  One competitive concern worth noting: Heineken recently completed a tie-up to allow China Resources Beer to sell for the multinational in the country.  We will watch the developments of this arrangement with interest, but the large and growing pie provides opportunities for multiple competitors to succeed.

Africa

ABI has the largest market share in many African countries, including South Africa, Tanzania, Uganda, Mozambique, and Ghana.  In aggregate, these markets represent over 220 million consumers.  Consistent with the levels of per capita income in Africa, 80% of alcohol consumption is still informal including spirits distilled at home or beer brewed in small batches that only has a three-day shelf life.  The opportunities for these African consumers to move to ready-to-drink value beer are enormous for brewers that have the brands and distribution network to reach them.  That transition will happen over the next twenty years in Africa, and ABI is well-positioned to benefit thanks to its SAB Miller acquisition, which gave the company a strong portfolio of offerings across segments and superior distribution reach on the continent.  Additionally, Africa will have significant population growth over the next thirty years — current estimates are for an additional 1.3 billion people on the continent by 2050 — that will serve as a strong tailwind to growth.

Chart 5. Global Beer Consumption by Region

Source: Kepler Cheuvreux, Canadean

Our Investment

Our core investment criteria have been the same since our founding — circle of competence, business, people, and price.  Since 2001, we have invested extensively in the beverage industry both in developed and developing markets.  Three of these previous investments were in brewers, which are businesses we have long admired because of the predictability and durability of their cash flows thanks to the competitive dynamics we outlined above — dominant brands, superior distribution reach, and large market shares.

ABI controlling shareholders include the Belgian families of Interbrew, the Colombian Santo Domingo family, and the Brazilian partners of 3G Capital — Jorge Paulo Lemann, Marcel Herrmann Telles, and Carlos Alberto Sicupira.  3G partners have a track record of long-term wealth creation with a number of successes in Brazil along with Burger King and Kraft Heinz (in partnership with Berkshire Hathaway).  The firm is particularly known for its zero-based budgeting approach to cost-cutting and judicious capital allocation.  This approach has successfully increased margins and cash flow across its platform companies, although 3G has been criticized for going too far with its cuts, particularly at the expense of brand building.  ABI marketing spend, however, has increased as a percentage of revenue in recent years, and it remains in line with its competitors’ spending.

ABI carries more leverage than we typically like in an investment; as of the end of last year, ABI ratio of net debt-to-EBIT was 5.7x.  We are comfortable in this case for a couple of reasons.  First, the non-cyclical, resilient nature of the beer business and the resulting long-term stability of the company’s operating earnings should yield sufficient cash flows to service current debt levels, even in an economic downturn.  Second, more than 80% of the company’s debt matures after 2023, and 95% of its debt has a fixed coupon relieving any sensitivity to rising interest rates.  Lastly, management has demonstrated a commitment to dealing with the debt intelligently.  At the end of the third quarter of 2018, ABI announced a 50% dividend cut so that the company could divert cash into reinvestment opportunities and faster debt retirement.  While we applauded the move, the market disagreed with this decision, which sacrificed short-term return of capital for what we expect to be increased long-term earnings.  In fact, one of our biggest concerns with existing debt levels is how they restrict ABI financial flexibility and strategic options.  Paying down the debt faster will improve both weaknesses while also de-risking the business.  We would have supported discontinuing the dividend altogether for a few years.

As of year-end 2018, we estimate that ABI offered a 7% owner earnings yield after the stock fell nearly 40% during the year (making it, by far, the largest detractor from the Fund performance in 2018).  We expect these owner earnings to grow in the mid-single digits annually over the next decade thanks to secular volume expansion (led by emerging markets), pricing power, cost rationalization, and investments in projects that promise returns on invested capital of nearly 20%.  In total, we believe the Fund investment in ABI should compound at an attractive rate from here — safely in excess of 10% annually.  The potential for accretive acquisitions and/or share buybacks down the road provides further upside.  Most importantly, we believe there is minimal risk of any permanent impairment of capital at today’s stock prices.

We believe the 2018 stock price drop created a buying opportunity, and ABI insiders seem to agree.  The people who should know the business the best bought more than US$700 million of the stock in the open market:

Chart 6. Selected 2018 ABI Insider Share Purchases (in Euros)

Source: FSMA, Cook & Bynum research

While insufficient evidence on their own, insider purchases frequently signal an undervalued business.  This indication is particularly strong in ABI given the sophistication of buyers, their track record of intelligent capital allocation, and sheer size of their recent purchases.  We are excited to partner with this group in the interest of long-term wealth creation.

[1] In order to get regulatory approval for its Grupo Modelo acquisition, ABI sold the U.S. rights to manufacture and distribute Corona and other Modelo brands to Constellation Brands.  ABI retains these rights outside of the U.S.