Shares of Danish brewer Carlsberg A/S (OTCPK:CABGY)(OTCPK:CABJF) have fallen sharply this year, losing more than 30% of their value following Russia’s invasion of Ukraine.
In the past, I’ve had somewhat mixed feelings about the company. With virtually no exposure to emerging markets in the Americas and Africa, it doesn’t have the kind of geographic footprint I’d like to see from an international brewer, and to see it trading at a premium valuation relative to to AB InBev (BUD) and Heineken (OTCQX:HEINY) didn’t really make sense to me. Yet, for good reason, management has done a very good job of improving the underlying story here over the past five to ten years, making the business more profitable while increasing profits and increasing returns on capital. for shareholders.
Going back for a moment to recent events, it is undeniable that the outlook has become much more complicated, at least in the short term. Carlsberg has significant exposure to the war in Ukraine – both direct and indirect – and was already struggling with uncertainty due to significant input cost inflation. Yet these stocks have now sold quite significantly and the investment case has become much more attractive for long-term investors.
Relatively low positioning
There are really only two ways for brewers to generate organic growth: they can increase volume by selling more beer and/or they can increase their unit prices. It’s obviously a bit more complex than that, and not all volume growth is equal: new products that might require different production processes might not generate the kind of leverage on fixed costs that the increasing existing production, for example. But overall, I think it pretty much sums it up.
With that, I was not thrilled with the company’s positioning against its listed peers mentioned above. On the one hand, Europe accounts for around 70% of the company’s volume and 60% of its operating profit. The region’s demographics aren’t great (to put it mildly), while competition is fierce and per capita consumption is already peaking in many of these markets.
Additionally, consumers in developed markets are increasingly turning to wines and spirits, putting further pressure on the already anemic growth outlook. With almost no exposure to attractive beer markets like Africa – where demographics and per capita consumption are tailwinds – I believe Carlsberg has one of the smallest geographic footprints among international brewers, with peers AB InBev and Heineken both dominating a huge leading market. stocks in many emerging markets.
At the same time, the company is also a bit light on its premium beer offering, which would help pricing, as noted above. However, it is more advanced in its “premiumization” efforts in Asia than in its home markets, and further work on this front presents at least a good long-term growth opportunity.
Credit where it’s due
Although the company appears to lack meaningful exposure to the industry’s long-term growth drivers, management deserves a lot of credit for improving the underlying situation here.
Cost initiatives and organic growth have led to a strong improvement in underlying profitability, with an operating margin up approximately 300 basis points over the past five years, placing it in the teen zone and online with Heineken. The history of capital returns has also improved, with management buying back shares and increasing the dividend payout ratio from less than 20% (2012) to its current level of 50%.
In terms of growth, there has been a good job of building up its exposure in Asia, with the company now having a leading position in Western China (#1 market share) as well as a decent business in Malaysia (#1 share). °2). Regional profit there has recorded a double-digit CAGR in recent years, helping to drive overall profit growth company-wide.
An uncertain short-term outlook
Recent events are adding uncertainty to the already increasingly hazy short-term outlook. Qualitatively, the company was guiding quite similarly to recently covered Heineken, seeking to offset significant input cost inflation with price increases – perhaps at the expense of volumes, which are still somewhat weak post COVID. (reported volume growth appears stronger due to acquisitions).
With operations in Ukraine and Russia, Carlsberg is directly exposed to war. In Ukraine, the beer market is probably not functioning at all for obvious reasons. In Russia, the company undoubtedly faces the same international pressure to exit as most Western companies operating there. It has already suspended exports and investment in the country, while also suspending advertising for the Carlsberg Group and majority-owned local brewery Baltika. The production and sale of the flagship and eponymous brand Carlsberg ceased, as Baltika was essentially run on a not-for-profit basis (the company pledged to donate all profits to humanitarian relief efforts).
At the same time, soaring energy and commodity prices will not solve the problem of cost inflation, while it may face local COVID lockdown issues in China.
It’s not all bad news, however. There is still latent recovery potential in Western Europe and Asia against the COVID-impacted FY2021, and this also applies to the non-Russian/Ukrainian part of its Central and Eastern Europe segment (which includes the Baltics , Italy and the Balkans, among others).
A long-term opportunity
Turning the above into concrete numerical forecasts is obviously a bit tricky, although the full Russian and Ukrainian business discount means a decline of around 9% in group-wide operating profit.
Previously, management had forecast annual organic operating profit growth of 0-7%, with the magnitude of that range indicating just how volatile the situation was. This guidance has now been canned in light of the war, but as an indication, I think we are looking at a low single digit decline in earnings this year.
While that means the near term is going to be a little disappointing, it’s not like these stocks have held steady. Indeed, Carlsberg stock is still down more than 20% from pre-invasion levels, and is currently trading at around 16 times FY21 EPS. The dividend yield is now above 3% based on the FY21 payout of DKK 24 per share, which I expect to be stable this year given the deteriorating outlook.
Longer term, management is aiming for 3-5% organic revenue growth, which I believe is achievable given historical performance. This, in turn, should be good for annualized free cash flow growth in at least the mid-digits, given the high leverage of fixed costs in the business. Combined with the dividend yield of over 3%, these are the most attractive stocks since the COVID sell-off in early 2020. Buy.