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Morningstar | In Line 4Q for ABI Amid Slow Progress to Deleveraging

AB InBev reported fourth-quarter and full-year results that were very close to our forecasts, closing the book on a difficult year with a relatively stable quarter. With organic growth above most of the broader consumer staples sector, and because 2019 guidance is also close to our forecasts, we are maintaining our $118 fair value estimate for the ADRs. Despite the rally in the stock year-to-date, we still believe there is material upside to AB InBev, although we recognize that the upside is dependent upon margin improvement in Brazil and balance sheet deleverage, neither of which are likely to occur overnight.

Fourth-quarter organic revenue growth of 5.3%, and 4.8% for the full year, was decent, and driven by premiumization in developing markets, key to our investment thesis. This is below the 6% achieved by other large brewers Heineken and Carlsberg, both of which had strong volume drivers in certain markets. It is comfortably ahead of the broader consumer packaged goods sector, however, reflecting the secular price/mix opportunity, particularly in Latin America.

Margin development is crucial to the investment case, and the consolidated EBIT margin expanded by 50 basis points (and the EBITDA margin by 118 basis points). Management expects to achieve the final $250 million in cost synergies from the SABMiller acquisition this year. Beyond this year, however, we believe the margin expansion opportunity lies in growing scale in Africa and in premiumization in Latin America, and we think a mid-30% EBIT margin is achievable in the medium term.

Reported net debt/EBITDA decreased to 4.6 times from 4.8 times a year ago. With cost inflationary pressures likely to limit EBITDA growth again this year, it could be another slow year of deleveraging, although there could be upside to management’s guidance of a net debt ratio below 4 times by the end of 2020, which does not appear to imply debt repayments from the proceeds of an IPO of the Asia business.

It is inevitable that investors will assume some read-across from the recent financial meltdown of Kraft Heinz, and wonder about the sustainability of AB InBev's strategy. Besides the 3G connection, there are similarities between the two companies. Both have led industry consolidation, leveraging up to well over 4 times net debt/EBITDA, both follow stringent cost control strategies, including zero-based budgeting, and both have cut their dividend in recent weeks. There are, however, important differences in the categories and secular trends of the two companies, favourable to AB InBev, that mean the brewer is not solely dependent upon cost reduction to drive EBITDA growth:

1) Despite its exposure to the U.S., AB InBev has a presence in growing markets. In spite of cyclical headwinds in 2018, Africa should drive mid-single-digit volume growth in the medium term, while premiumization should provide a reasonably strong price/mix driver in Latin America in the medium term. The ability to grow EBITDA in the medium term alleviates some of the financial risk of the high leverage, roll-up strategy.

2) The secular growth opportunities mean that a strategy to grow cash flows through cutting costs is not appropriate. Although AB InBev has been aggressive in cutting costs, it has also maintained its brand investments. Sales and marketing expenses as a percentage of net revenues was down only 55 basis points in 2018 versus 2014, before the SABMiller acquisition, while both R&D expense and capital expenditures were flat over the same period. Notably, the FIFA World Cup was held in both of these years, an event at which AB InBev remains a leading sponsor. The deal for SAB itself was a pivot from cost reduction to optimizing its growth footprint, giving AB InBev access to markets in Africa that are likely to grow at an above-industry-average rate for the foreseeable future, while disposing of some slow-growth markets in Europe. The further disposal of less attractive assets is also likely to occur this year with the IPO of the company's Asia business.

3) Beer is a more scalable business than food, especially at the regional level, so investing for growth makes more sense. There is more inherent operating leverage in a growing business in which the product portfolio is made from similar raw materials, than there is in a business producing products from coffee to mac & cheese to hot dogs.

While we are not disputing that leverage of around 5 times net debt/EBITDA is risky, and may limit opportunities for value creation in the short to medium term, we believe AB InBev's category dynamics and emerging markets footprint should allow it to reduce leverage quicker, while the strategy to scale the business is likely to be value-creative in itself. Despite all the hairs on the stock at present, with the stock trading at 17 times 2019 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.