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STZ - Reaching for the Crown

Background

We believe that there is a consensus that STZ will continue to work once the Department of Justice approves the pending transactions.  To review, ABI (Anheuser-Busch InBev, ABI BB) is purchasing the 50% of Grupo Modelo that it doesn’t own while selling Modelo’s 50% stake in Crown Imports to Constellation Brands for $1.85 billion.  Crown Imports is the sole importer of Corona as well as other Modelo brands in the United States (Pacifico, Modelo Especial, among others).  Both STZ and ABI have guided expectations toward a Q1 2013 closing.  In late August, the Department of Justice made a second request for information on the pending transactions, a not at all uncommon occurrence.



Investor concerns appear to center around the fact that ABI will, after the proposed transactions, have direct and indirect control of over 53% of the US beer market – ABI’s existing share plus the Corona brand family’s share of market.  Our belief is that the indirect nature of the control over Crown is sufficient to satisfy the DOJ, as it was when InBev was forced to sell the rights to Labatt’s when the company acquired Anheuser-Busch (see below).  At worst, we expect that ABI’s perpetual call option on the Crown business will have to be foregone or some similarly benign accomodation to the DOJ.  From ABI’s perspective, we see this transaction as more about the global opportunity that the Modelo brand family represents, rather than the 5% share it currently enjoys in the U.S.  Further, ABI has identified $600 million in acquisition synergies that we think may be too low by as much as $400 million.



There is also some concern that there is significant variance by state in terms of ABI’s market share – ranging from the low-teens to low-70s.  Any increase in an already high existing state market share could throw up a red flag with the DOJ.  While the DOJ may be looking for a reason to block this transaction, we don’t see the facts of the matter supporting such an action.



Risk/Reward is unfavorable, but our view is that it is highly likely the DOJ gives consent

We accept that the risk/reward profile with respect to the event is asymmetric – STZ was a $21 stock prior to the announcement of this deal, and we expect that DOJ approval will move the stock closer to our fair value in the mid-$40’s given the company’s free cash flow profile and likely continued re-rating in the face of what we see as a transformative transaction.  At $37 per share, we recognize that there is a good bit of air underneath the name.  For clients so inclined, protection is available – assuming a closing date toward the end of Q1, there are options strategies that could mitigate the downside risk in the case of an issue with the DOJ approving the transaction.



Consolidation has not led to pricing power

From 1945 – 1980, the total number of brewers in the United States declined by 89%.  At the same time, beer production in the United States more than doubled.  Meanwhile, an increasingly consolidated industry found it difficult to take pricing ahead of the broader inflation measures.  Clearly, increased concentration has not led to increased market power, a fact that the DOJ must consider in its examination of ABI’s proposed acquisition of Modelo and STZ’s proposed acquisition of Crown.

 

STZ - Reaching for the Crown - Total Breweries

 

STZ - Reaching for the Crown - Beer CPI



Consolidation and concentration have been driven by economic factors as the industry has seen significant suboptimal brewing capacity removed over time.  In fact, we believe that a compelling argument exists that consolidation and concentration have worked for the betterment of the consumer, as less efficient capacity has exited the industry, allowing the remaining brewers to pass on the benefits of economies of scale to consumers in what remains a highly competitive industry.



Since the late 1980s/early 1990s, the industry has re-fragmented as there has been a proliferation of craft brewers.  In 2011, craft brewers represented 5.7% volume share and 9.1% dollar share of the industry.  Importantly, craft brewers continue to garner shelf space at the expense of traditional brewers.  With such a highly fragmented, aggressive segment of the market that is on trend with respect to consumers’ desire for choice and differentiation, it’s easy to see why the scale enjoyed by traditional brewers has not translated into the monopoly power that many people feared (including those that sent two beer mergers before the U.S. Supreme Court).



Importantly, craft beers make sense for wholesalers and retailers, so even if ABI wanted to, we think it unlikely that it could limit the growth of that segment of the market.  Further, retailers and wholesalers should be salivating at the prospect of a highly efficient ABI running the Modelo operation down in Mexico – the production issues and glass shortages and resulting out of stocks that crop up every summer would likely go away with a management team that has a global reputation for ruthless efficiency.



Use InBev’s Acquisition of Anheuser-Busch as a template for examining the Crown deal

Anheuser-Busch held an approximate 48.5% share of market at the time it was acquired by InBev.  As part of the judgment of the Department of Justice consenting to the transaction, InBev was required to divest the Labatt’s business in the United States – the business was part of Labatt Brewing Co. Ltd., which was a partially owned subsidiary of InBev based in Toronto.  While Labatt’s held a less than one percent share of the total market (0.8%) in the United States, more than half its sales were in upstate New York, where the DOJ was concerned that, when combined with Anheuser-Busch’s share of market in that region, the new entity would enjoy a market share over 75%.



The solution was the mirror image of the proposed Crown transaction – InBev was required to grant an exclusive license to brew, market, sell and distribute the brands in the United States.  Labatt’s Canada agreed to brew the brand during an interim period (three years).   The rights in the United States were eventually sold to North American Breweries.



In the case of Constellation Brands and Crown, STZ will be purchasing the same rights (distribution, marketing, promotion, and, importantly, pricing) as those acquired by North American Breweries with two key differences.  The first difference is that ABI will remain responsible for continuity of supply (brewing) as well as brand innovation.  The second difference is that ABI has the right to exercise a call option on Crown and purchase the business at 13x EBIT every ten years.  We suspect that the later could be a remedy if the DOJ seeks an injunction, but that it wouldn’t represent a negative for STZ.



There are other remedies that the DOJ might seek – for example, limiting the ability of ABI to introduce other imports into the U.S. for a period of time.  A small brand divestiture (Michelob?) might be in play as well.  At the end of the day, we think ABI would be anxious to agree to reasonable changes to the current deal structure as the global opportunity represented by the Modelo brand family is substantial.



Is “Beer” the relevant market for the DOJ to be examining?

Increasingly, we are seeing wine and spirits manufacturers talking about targeting “beer occasions” with various ready to drink (RTD) offerings.  Admittedly, RTD beverages have been around for a long time, with a mixed (pun intended) history – some way too sweet and way too fruity drinks that likely skewed way too young (read - below legal drinking age) in terms of the consumer.

We look back at some comments made by Molson Coors vice chairman, Pete Coors at the time of the SABMiller and Molson Coors merger (October, 2007):



“This transaction is driven by the profound changes in the U.S. alcohol beverage industry that are confronting both of our companies with new challenges.  Consumers are broadening their tastes and are increasingly looking for greater choice and differentiation; wine and spirits companies are encroaching on traditional beer occasions and global beer importers and craft brewers are both taking a larger share of volume and profit growth.”



What was true in ’07 is true today – perhaps even more so as the uncertain economic environment drove weakness in alcohol consumption on premise (in bars).  For budget conscious consumers looking to imitate the cocktail taste profile of on-premise consumption, RTD offerings seemed to make perfect sense.  With this as a tailwind, we have seen increased product innovation from the spirits and wine companies that likely make the growth in the segment sustainable.  If frugality is the new normal, and we continue to see new product innovation and news coming from the spirits and wine companies, we think it is safe to think of beer and spirits/wine as substitute goods for at least a segment of the consuming public.



In summary, we see an opportunity for STZ to continue higher once the DOJ gives its consent for the proposed transactions to move forward, an outcome that we see as highly likely given the factors that we laid out above.

 

Robert  Campagnino

Managing Director

HEDGEYE RISK MANAGEMENT, LLC

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BULLISH FORMATION: S&P 500 LEVELS, REFRESHED

Takeaway: Kicking the can down the cliff is good – for now.

This note was originally published January 02, 2013 at 12:03 in Macro

As quickly as the quantitative RISK MANAGEMENT signals told us to get defensive last Thursday, they were telling us to get offensive as of this Monday. Back in a Bullish Formation, the US equity market (SPX), likes what it sees with regards to this latest #KeynesianCliff compromise. Highlights include:

 

  • The marginal tax rates for the wealthiest ~2% of Americans (i.e. individuals making more than $400k per year and households making more than $450k per year) have reverted back to the Clinton-era peak of 39.6%;
  • These income thresholds will also be applied to an increase of the capital gains and dividend tax rates to 20% from 15%;
  • The estate tax rate will rise +500bps to 40% while maintaining the existing threshold of $5 million;
  • The AMT will be permanently fixed;
  • Unemployment benefits will be extended by one full year; and
  • The $110 billion sequester of spending cuts will be delayed for two months – just in time to be used as political leverage during pending debt ceiling “negotiations”.

 

Regarding the aforementioned “negotiations”, President Obama has repeatedly stated that he refuses to negotiate with Congressional Republicans on meaningful entitlement reform amid debt ceiling talks. Moreover, he continues to stress that further deficit reduction must come via his politically-compromised definition of a “balanced” approach. Having caved to some degree already, we highly doubt the GOP brass sees eye-to-eye with Obama on either stance.

 

As a result, you are officially invited to look forward to more political theater in t-minus ~8 weeks (on the off chance you didn’t get your fill this past holiday season). Only this time, the stakes are much, much higher – an unlikely, but potential US sovereign default.

 

Looking deeper into the latest fundamental RESEARCH signals, this deal to avert the full plunge of the Fiscal Cliff is positive for the US and global economy on an immediate-term TRADE and intermediate-term TREND basis – particularly relative to the now-moot fiscal doomsday scenario. This morning's sequential acceleration in the ISM Manufacturing PMI to 50.7 in DEC (from 49.5 prior) is also positive and supportive of our directionally-positive views on global growth.

 

On a long-term TAIL basis, however, this deal is likely to be viewed by many as explicitly bearish for the US dollar – particularly relative to expectations of meaningful fiscal reform. By some estimates, this latest deal is good for only $600 billion of deficit reduction over the next 10 years – a sharp decline from previous negotiations in the area code of $4 trillion.

 

As we have said time and time again, what’s bad for the US dollar is also bad for sustainable economic development, as well as the long-term prosperity of the US economy. Two critical factors that continue to register near-perfect inverse correlations to USD debauchery in our model are current POLICY volatility and uncertainty regarding future POLICY. The confluence of those factors tends to get manifested in two very distinct ways:

 

  1. Shortened economic cycles; and
  2. Amplified financial market volatility.

 

Prepare your proverbial “anchor” for both in about a couple of months. For now, enjoy the melt-up as we kick off what is sure to be an eventful 2013. Best of luck out there!

 

Darius Dale

Senior Analyst

 

BULLISH FORMATION: S&P 500 LEVELS, REFRESHED - SPX


FISCAL CLIFF: What Lies Ahead

Now that Congress has come to an agreement on how to solve the crisis surrounding the fiscal cliff, let’s look at what the bill means for the American taxpayer. 

 

First, the good: 99% of Americans will not experience the bulk of the tax increases scheduled for 2013. The Bush Tax Cuts are here to stay save for individuals and families making 400k and 450k, respectively. There is also a delay for scheduled cuts in Medicare payments to doctors. Additionally, unemployment benefits have been extended for two years.

 

Now, the bad: Capital gains and dividend taxes will increase from 15% to 20% on the top 1% of Americans. A temporary 2% cut in payroll taxes was not renewed, meaning there will be a nominal increase in taxes for many Americans. 

 

There’s also the two-month delay on sequestration and raising the debt ceiling. This time of uncertainty will put pressure on corporations trying to factor it into earnings. Overall, the bill isn’t the best outcome but it’s far from lousy. The extension of Bush Tax Cuts will bring a sigh of relief to many.


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PODCAST: New Year, New Risk

 

On this morning’s investment call held for Hedgeye subscribers, Hedgeye CEO KEith McCullough discuss how we’ll be managing risk in 2013. One of the moves we've made thus far is taking our asset allocation in fixed-income down to 0% and shorting commodities as growth stabilizes.

 

Keep in mind that growth helps drive gold and bonds down. As far as equities go, it’s a bullish market and a good time to take off shorts. You can listen to the full call above.


BULLISH FORMATION: SP500 LEVELS, REFRESHED

Takeaway: Kicking the can down the cliff is good – for now.

As quickly as the quantitative RISK MANAGEMENT signals told us to get defensive last Thursday, they were telling us to get offensive as of this Monday. Back in a Bullish Formation, the US equity market (SPX), likes what it sees with regards to this latest #KeynesianCliff compromise. Highlights include:

 

  • The marginal tax rates for the wealthiest ~2% of Americans (i.e. individuals making more than $400k per year and households making more than $450k per year) have reverted back to the Clinton-era peak of 39.6%;
  • These income thresholds will also be applied to an increase of the capital gains and dividend tax rates to 20% from 15%;
  • The estate tax rate will rise +500bps to 40% while maintaining the existing threshold of $5 million;
  • The AMT will be permanently fixed;
  • Unemployment benefits will be extended by one full year; and
  • The $110 billion sequester of spending cuts will be delayed for two months – just in time to be used as political leverage during pending debt ceiling “negotiations”.

 

Regarding the aforementioned “negotiations”, President Obama has repeatedly stated that he refuses to negotiate with Congressional Republicans on meaningful entitlement reform amid debt ceiling talks. Moreover, he continues to stress that further deficit reduction must come via his politically-compromised definition of a “balanced” approach. Having caved to some degree already, we highly doubt the GOP brass sees eye-to-eye with Obama on either stance.

 

As a result, you are officially invited to look forward to more political theater in t-minus ~8 weeks (on the off chance you didn’t get your fill this past holiday season). Only this time, the stakes are much, much higher – an unlikely, but potential US sovereign default.

 

Looking deeper into the latest fundamental RESEARCH signals, this deal to avert the full plunge of the Fiscal Cliff is positive for the US and global economy on an immediate-term TRADE and intermediate-term TREND basis – particularly relative to the now-moot fiscal doomsday scenario. This morning's sequential acceleration in the ISM Manufacturing PMI to 50.7 in DEC (from 49.5 prior) is also positive and supportive of our directionally-positive views on global growth.

 

On a long-term TAIL basis, however, this deal is likely to be viewed by many as explicitly bearish for the US dollar – particularly relative to expectations of meaningful fiscal reform. By some estimates, this latest deal is good for only $600 billion of deficit reduction over the next 10 years – a sharp decline from previous negotiations in the area code of $4 trillion.

 

As we have said time and time again, what’s bad for the US dollar is also bad for sustainable economic development, as well as the long-term prosperity of the US economy. Two critical factors that continue to register near-perfect inverse correlations to USD debauchery in our model are current POLICY volatility and uncertainty regarding future POLICY. The confluence of those factors tends to get manifested in two very distinct ways:

 

  1. Shortened economic cycles; and
  2. Amplified financial market volatility.

 

Prepare your proverbial “anchor” for both in about a couple of months. For now, enjoy the melt-up as we kick off what is sure to be an eventful 2013. Best of luck out there!

 

Darius Dale

Senior Analyst

 

BULLISH FORMATION: SP500 LEVELS, REFRESHED - SPX


GOLD: Pressure On Pawns

As commodity prices continue to deflate as growth stabilizes, we think that gold is likely to continue to fall in price and that will act as a headwind for pawn operators like EZ CORP (EZPW) and Cash America (CSH). It’s not just falling gold prices that will create problems for pawns going forward; gold volume also plays a significant role in the equation. Consider the “Cash 4 Gold” craze thats occurred over the past few years. With fewer customers coming in to sell gold, pawns that rely on gold and jewelry as a substantial part of their revenue will feel the pressure immediately. It’s important to keep an eye on the first quarter of 2013 as companies like CSH and EZPW are likely to feel the pain.

 

GOLD: Pressure On Pawns - image001


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