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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