Does SABMiller Taste Great, Or Is The Valuation Too Filling?

Dec.11.12 | About: SABMiller plc (SBMRY)

This has been a good year to own companies in the adult beverage trade, as stocks like Anheuser-Busch InBev (NYSE:BUD), Diageo (NYSE:DEO), Pernod-Ricard (OTCPK:PDRDY), and Heineken (HINKY.PK) have all outperformed the S&P 500 by a significant margin. The world's second-largest brewer, SABMiller (OTCPK:SBMRY) belongs on that list of outperformers as well, as investors have bid up the shares on improving volume growth and margins. Looking out into 2013, though, the question is whether SABMiller is still poised to be an outperformer.

Solidly In Place Where The Growth Is

SABMiller is the second-largest brewer in the world with about 14% global share, trailing BUD's 18% share. That's only part of the story, though, as SABMiller is much more strongly leveraged to the fast-growing emerging markets of the world.

SABMiller gets about a third of its EBITDA from Latin America, and slightly more from Africa (both South Africa and "rest of Africa" combined), with about 6% coming from Asia as well. The company holds 50% or greater share in most of Africa, the #2 slot in Russia, and sizable 20%+ shares in both India and China, where its joint venture with China Resource Enterprises makes and markets Snow, the best-selling beer brand in the world.

Perhaps not surprisingly, this has positioned SABMiller with some of the best organic volume growth among the world's top brewers. This growth has come at a cost, though, as the company has invested extensively in breweries and distribution operations. This also leads to a key part of the bull thesis on SABMiller - after years of above-average capex investment, the company should be in a position to start better leveraging those assets and posting higher free cash flows. At the same time, those substantial investments have widened the company's moat in many key markets.

Opportunities Remain, But It's Getting Harder

Like BUD and Heineken, SABMiller has not been shy about growing through acquisition. Even still, the company isn't equally strong in all markets. The company's lower relative market share in Canada and Western Europe likely shouldn't trouble investors much given the relative growth prospects there, but the same can't be said for the emerging markets.

While SABMiller is quite strong in Colombia and Peru, the company has far less of a presence in Mexico and Brazil, where BUD and Heineken moved aggressively to build share. Unfortunately, there are not many local breweries left to buy that would significantly move share. So, too, in much of Eastern Europe and Asia - while a few properties like Boon Rawd and Hite might be "gettable," the name of the game is increasingly about marketing and distribution.

That's not to say that there couldn't be further acquisitions in the space. Rumors pop up now and then about a combination of BUD and SABMiller, though I believe the antitrust issues would be a real problem. More likely, though, could be deals for companies like Heineken or Molson Coors (NYSE:TAP).

SABMiller already has a relationship with Molson Coors (MillerCoors) in the U.S., and an outright purchase would give SABMiller more exposure to Canada and Brazil, as well as more margin leverage possibilities in North America. Heineken would likewise be a mixed blessing - while SABMiller would likely be in no great hurry to gain more exposure to Europe (about two-thirds of Heineken's sales), the growth opportunities in Mexico, Brazil, Africa, and Asia could be too much to pass up for the right price.

A Long-Term Margin Story

As I alluded to earlier, I think there's considerable potential for margin and free cash flow leverage at SABMiller in the coming years. The last decade has seen a large amount of money invested in production and distribution infrastructure and while that infrastructure needs to be maintained, I believe the company is past the point of maximum investments.

Likewise, I believe there are incremental improvement opportunities elsewhere in the business. The company's acquisition of Foster's was definitely a "scratch and dent" type of purchase, but I believe that SABMiller can go a long way toward stabilizing Foster's market share, not to mention driving better leverage of Foster's infrastructure through expanded distribution both in Australia (selling a wider range of SABMiller's products through existing Foster's customers) and elsewhere (selling Foster's more effectively on a global basis).

SABMiller's soft drinks business could also be an under-appreciated asset. With over 40 bottling plants around the world, SABMiller is one of the largest Coca-Cola (NYSE:KO) bottlers in the world, with a very strong presence in Africa. Along those lines, Turkish partner Anadolu Efes could be a future target as well; the companies already operate a joint venture in beer (which has the #2 share in Russia) and Anadolu is not only a major presence in beer in Europe, the Mideast, and former Russian states, but also in Coca-Cola.

While SABMiller's operating margin was consistently in the mid-teens for most of the past decade, I believe management's plans to better leverage existing assets and brands should drive those higher. More specifically, I believe margins in the 20%'s are possible over the next three years, with the high 20%'s or low 30%'s possibly attainable over the long term.

Hardly An Unknown Name

As the second-largest brewer in the world, SABMiller is not exactly an obscure or under-followed name. That's not to say that it can't be a value, though, as analysts are often slow to accept the potential for companies to change (either for the better or worse).

Right now I believe that SABMiller can grow revenue at a long-term rate of just over 5%. For the recently-completed first half of fiscal 2013, the company reported 8% organic growth with 4% organic volume growth - the best results among the big brewers. Keep in mind, too, that the industry is still suffering from the impact of customers moving down-market to save money (suggesting that 5%+ growth will come from a relatively lower bar).

With the aforementioned improvements in operating margin (into the mid-20%s and then into the high 20%'s/low 30%'s) and incrementally less capex spending as a percentage of revenue, I believe that SABMiller can significantly improve its free cash flow production - so much so that I believe low-teens free cash flow growth over the next five to 10 years is plausible.

When those numbers are fed through a discounted cash flow model, they imply a fair value in the mid-to-high $40's. Against a current price of around $45 and a dividend yield of around 2%, that's not the most breath-taking appreciation potential in the market. That said, quality spirits and beverage companies like Coca-Cola, Diageo, and SABMiller are not exactly famous for trading at substantial discounts to fair value. Consequently, I believe SABMiller can still be a solid performer and a good stock to own from here, though I completely understand if new investors want to wait in the hopes of a 10% or so pullback in the shares.

Disclosure: I am long OTCPK:SBMRY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.