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Morningstar | We Are Not Throwing in the Towel on AB InBev; 2Q Mixed but Long-Term Story Intact

We are not throwing in the towel on AB InBev following a second-quarter report that contained mixed news on the underlying performance of the business. We have modestly lowered some of our near-term assumptions, but this has little impact on our $126 fair value estimate, and we believe there is now material upside to the ADRs. The market may be concerned about several issues, most of which we think will blow over. AB InBev has a wide economic moat that should help it to sustain its competitiveness in most markets in the long term, and with material upside to our fair value estimate, we think the weakness presents a buying opportunity.

The first issue concerning the market is the apparent deterioration in trends in the U.S. Reported U.S. volumes fell 5.1%, a disastrous number, but one distorted by channel inventory corrections. ABI's retail sales fell by 3.1% in the quarter, with around 1.3 percentage points of the decline due to timing issues, meaning the underlying trend is unchanged from the first quarter. The boost to volumes from Budweiser's sponsorship of the FIFA World Cup would have been very limited in the U.S., whose national team did not take part in the tournament.

The second issue is a new headwind in the shape of weakness in South Africa, where revenue declined in the midsingle digits. Although ABI was cycling a tough comparable, it seems likely that a VAT increase at the beginning of the quarter, along with the higher oil price, is taking its toll on the South African consumer, and a 10% price increase has clearly disrupted price elasticity. This could continue for several more quarters, and we have slightly lowered our volume estimates for the Europe, Middle East, and Africa region for the rest of the year. However, we think ABI owns a strong franchise in South Africa, and while the market may be volatile, the firm's cost advantage should ensure that it reaps the rewards of the attractive long-term volume growth and premiumisation trends there.

Another potential source of the drop in AB InBev's market value is the company's announcement that it is to restructure its geographic zones. We do not regard this, in itself, as being particularly significant, but the devil is in the details, and ABI said that the new Zone Presidents "will own the commercial and external affairs agendas for their businesses." We interpret this to mean that the company is taking a more decentralized approach, with more responsibility for merchandise and profitability being pushed to the regions. Across consumer staples, small and emerging brands have been taking share from big brands in many markets, and this has manifested in beer in the form of craft. We view decentralized capital allocation as a sensible strategy to ensure that regional and niche innovation is not drowned out by the need to invest in large brands, and it is a strategy we have advocated for both Nestle and Unilever, who both now operate in a similar fashion. In the case of AB InBev, however, global brands are the company's growth engine; the driver of the premium portfolio, and higher-margin than its local brands, so management must now walk the line between optimizing the global brands and ensuring regional portfolios are appropriate for local conditions. One market in which this strategy may help is the U.S., where we feel that AB InBev is not well positioned for the long term, and we would not be surprised to see a greater portfolio skew to craft beer in the future.

There were some positive developments in the second quarter, not least of which was a welcome return to volume growth in Brazil, ABI's second-largest market with 16% of its total volume. Volume growth of 1.5% contributed to 9.4% revenue growth, although this will slow again in the remainder of the year as the firm cycles a price increase and the World Cup will no longer provide a benefit in the fourth quarter. On the other hand, this growth was achieved in spite of the truckers' strike this quarter.

Our valuation of AB InBev relies on profitability improvement, and the firm executed well again on this metric, with underlying EBIT margin expansion of 85 basis points despite the incremental investment around World Cup marketing activations. The company remains on track with the SABMiller integration, with synergies so far this year of $358 million. We still regard 37% as an achievable steady-state margin for AB InBev, driven by continued cost management, operating leverage, and premiumisation of the portfolio.