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Re: Bud's Looking Better

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By gdefelice
November 3, 2006

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I thought BUD's numbers looked good. I reviewed the Q and read the conf. call transcript.

Frankly, I'm surprised by the market's response to the new information, as I think the outlook for BUD is excellent.

Judging by some of the questions on the call, I think analysts are concerned that BUD's sales to retailers were poor in Q3 (and in particular Sept. was bad)....No one 'knows' why...

The Q and A sort of goes back and forth around these squiggles of percentages. Someone even asks if the Bud brands -- in the eyes of management -- are in decline.

There's a chance that BUD is on the cusp of what recently happened with Coke, where the market decides that carbonated soft drinks and, in this case, beer, ain't going the way of the dodo.

My take on BUD goes like this:

The company has enormous power in North America. Budweiser beer is the number 1 beer in Canada. We know BUD has about 50% market share in the United States (how high would they be allowed to go?) and makes prodigious amounts of free cash of the U.S. operations.

To round out the N. American dominance, Bud has a 50% stake in Grupo Modelo. Modelo controls about 60% of the Mexican market. Its flagship product is Corona, which they bill as the best selling Mexican beer in the world. Corona absolutely dominates Mexico. Crucially, too, it is the number 1 import in the United States (and it sells at premium prices). Corona dethroned Heineken in the late '90's as the number 1 import.

Modelo in fact sells four of the top 20 U.S. imports. It has done incredibly well and has recently signed a new deal with Const. Brands for them to handle distribution throughout the U.S. Based on comments in the call, this deal appears to improve the economics for Modelo. Modelo expanded margins this year. Modelo's exports recently surpassed 50% of its domestic sales but growth rates at home were still over 5% (and over 13% in exports).

The deal with Const. Brands suggests so me that Modelo has become increasingly powerful and you can see for yourself that it has become increasingly profitable. Modelo's portion of BUD's profits is growing ever larger.

Meanwhile, it is clear that the cross-ownership is increasing the stranglehold that BUD (with Modelo) has on the N. American market, as Tsingtao is distributed by Modelo in Mexico. As you know, BUD owns a big slug of Tsingtao. Meanwhile, Modelo distributes BUD's products in Mexico. And yes, distribution (together with advertising) is crucially important in the business....no one can match BUD's scale in N. America.

So, BUD owns an absurdly profitable cash cow in the U.S. and Canada and half of an obscenely profitable (check out the margins... www.gmodelo.com) and dominant cash cow in Mexico.

In the U.S., BUD was able to make price increases stick earlier this year and it will raise prices again early next year. This is an improving trend against the price wars a few years ago.

BUD won that battle and yet the analysts don't seem to see that. BUD has lower costs per barrel than its U.S. competitors (Miller, primarily) but it also sells its product for more....

Miller knows this but forgot for a bit. Since BUD has such a scale advantage already (and hence the lower costs), Miller can't lower enough to ever win...

Now, there's no question that a nasty battle with Miller would hurt BUD's profitability...but it wouldn't kill it. But, it would kill Miller. The fact that this recent battle didn't last long is a very good sign for BUD.

As the 'negative' trends in beer consumption revert to the mean growth rate, I think (paradoxically) Miller will feel less pressure to do stupid things like have a war they can't win.

In the meantime, BUD is so profitable (and has such enormous returns on tangible assets) that it is literally flooded with cash. It pays a big chunk out in dividends, it consistently buys back stock, it reduced debt $600 million. It used some of the excess to buy a nice position in China, with all of Harbin and over a third of Tsing-tao. Management has shown skill at not throwing away the profits. They have invested in selling Budweiser internationally and have had some success in the U.K. (though recent results were down with the end of the World Cup), Mexico and China. Again, it's all about distribution, as they use Tsing-Tao and Harbin to distribute Budweiser in China. In any case, they haven't made any massive bets but instead appear intent on the long-term and building the brand. I think they're doing this very well.

Bud also has a very profitable theme park business whose contribution to earnings is not immaterial. And, it has a packaging and recycling business which is profitable and is as much about expense control (in my opinion) as anything.

So, if Miller isn't intent on having a massive price war, then what are the threats to BUD. It seems the analysts feel it comes from the premium market and/or the "liquor" business (I don't concern myself about this second issue...except to think that when it becomes clear that beer isn't going away, it will improve the PE the market puts on BUD). So, what about the premium market?

Well, BUD already owns half the number 1 premium import. After the top few premium imports, things get pretty fragmented. BUD has introduced Budweiser Select and is putting a lot of money behind it. They've agreed to distribute Grolsch and Tiger and bought Rolling Rock and it looks like they're introducing a premium beer with the Harbin name on it...so, they're in the game in the premium/craft beer game.

It is very hard for me to see a competitive product will suddenly dislodge BUD...there are literally hundreds and hundreds of craft beers and imports and such and none of them can hope to generate both the scale and profitability of BUD...the long-term trend is still towards consolidation. But, again, BUD is so profitable and has such scale, that it will long be profitable to buy competitors even at apparently high prices, should that become necessary.

Unless BUD does something really dumb, they pretty much control N. America for the foreseeable future. In fact, while BUD has clearly not rested on its laurels in recent years, I'm glad they haven't tried to do too much.

If a few things go right, BUD could still be 30% higher in a year.

gdefelice

disclosure: long BUD (can change any time)


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