Quilmes Industrial: Imminent Buyout Makes It A Sell

Quilmes Industrial, S.A. (LQU) is a beverage company providing beer, soda, and water in Argentina, Bolivia, Paraguay, Uruguay, and Chile. The company is widely known as Quinsa, a Luxembourg-based holding company that has the majority stake (93%) in Quilmes International (Bermuda), Ltd. [QIB]. Quinsa also owns two PepsiCo bottlers: Baesa and EDISA (99% controlling interest), and a 49% minority interest in the mineral water company, Eco de los Andes.

65.2% of Quinsa's 2006 revenues were generated from Argentine beer, soft drinks, and other beverages, with Bolivia, Paraguay, Uruguay, and Chile contributing 13.4%, 12.2%, 5.3%, and 3.9%, respectively. Argentina generated 56.9% of the operating profits [EBITDA] in 2006, Bolivia 20.8%, Paraguay 18.1%, Uruguay 4.5%, and Chile 0.0%. Argentina Bolivia Chile Paraguay Uruguay Through an 87.6% ownership in Quilmes International, Quinsa has strong market leadership positions in the beer markets of Argentina (78.7% market share in 2006), Bolivia, Paraguay, and Uruguay, along with a presence in Chile (12.7%).

The company's beer brands include: Quilmes Cristal (the flagship brand), Andes, Imperial, Liberty, Quilmes Bock, Palermo Quilmes Light, and Bieckert in Argentina; Pacena Pilsener, Tropical Extra, and Centenario in Bolivia; Pilsen and Dorada in Paraguay; and Doble Uruguaya and Zillertal in Uruguay.

Baesa is the largest PepsiCo bottler in Argentina and the sole PepsiCo bottler in Uruguay while EDISA is the second largest PepsiCo bottler in Argentina. The companies produce 84% of PepsiCo's soft drinks in Argentina and 100% in Uruguay. PepsiCo's soft drink products include Pepsi Cola, Pepsi Cola Light, Pepsi Twist, Pepsi Max, Seven-Up, Seven-Up Light, Mirinda, Paso de los Toros, Kasfruit Juice, Kas, Tropicana, and Gatorade.

Quinsa's Class A and Class B shares are listed on the Luxembourg Stock Exchange. Quinsa's American Depository Receipts [ADRs] represent non-voting Class B shares and trade on the NYSE with the symbol LQU. However, the company reports ADR results in U.S. dollars, translating the financial statements from the local currencies of the countries in which it operates.

AmBev Alliance
Quinsa enjoys an increased competitive advantage following an agreement with AmBev. Quinsa's beverage businesses are benefiting substantially from the implementation of a distribution alliance with AmBev (one of the formidable competitors in the past). In return for AmBev being able to produce and distribute Quinsa's brands in Brazil, Quinsa will manufacture and sell AmBev's beer brands in the Southern Cone markets, thereby, strengthening the competitive positions in Argentina, Bolivia, Chile, Paraguay and Uruguay.

Since the agreement, beer and soft drinks volumes have been strong in both Argentina and Bolivia, and there have been recoveries in Paraguay and Uruguay. In addition to increasing market share, the alliance decreased operating unit costs through cost synergies. As a result, the company was able to increase prices by more than 20% in real terms. Higher average prices for beer in Argentina and Paraguay and for soft drinks in Argentina contributed meaningfully to the increased revenues.

An additional benefit of the alliance was that it provided the opportunity for Quinsa to consolidate the beer and soft drinks operations. Prior to the relationship with AmBev, soft drink and beer operations had not been fully merged. Subsequent to the agreement, the divisions share the same warehousing and distribution facilities. The efforts have led to lower costs and improved profitability.

In addition to streamlining distribution networks, the company continues to roll out direct sales operations in key markets. Continuing with the momentum observed in 2005, Quinsa reported robust results in 2006, and the trend is expected to continue.

Beer Market
Argentina, Bolivia, Paraguay, Uruguay, and Chile all witnessed strong volume growth. In 2006 beer volumes increased 9.1% year-over-year with all operating markets contributing. Soft drink volumes were also strong, increasing 25.4%, reflecting accelerating growth in Argentina and regained momentum in Uruguay. Starting in 2004, Quinsa bolstered its position in the Argentinean premium beer market with the flagship brand, Quilmes Cristal, and the re-launch of the Iguana brand.

Subsequently, Stella Artois (locally brewed) was introduced in November 2004, which continues to add to volume growth. Argentina is witnessing improved volumes for soft drinks and other beverages behind product innovations including H2Oh! (a less carbonated calorie-free drink), which has already gained a 15.4% market share. In addition, the management is in the process of doubling the capacity at the Tres Arroyos malting plant, which will not only aid Quinsa in meeting its malting requirements but also will produce excess malt for export to Brazil.

Management is increasing distribution capacity by investing in two additional bottling lines in Mendoza and Buenos Aires. The Bolivian beer market is benefiting from the introduction of several limited edition bottles in the company s principal brands. The capacity in both Santa Cruz and La Paz facilities was increased to meet the rising demand. Operations in Chile are improving with strong beer volume growth in the company's well known brands and the new launch of Brahma brand. According to the data provided by A.C. Neilson, the company's market share in Chile has increased to 12.7% (which represents a gain of full point since the last year), principally due to the launch of Brahma brand.

The beverage market in Paraguay continues to recover and an average of 23% price increase was implemented during the year. The company has also completed building a 100-ton/day glass bottle production facility, which is expected to meet 25% of Quinsa's regional needs. In Uruguay, the company's conservative pricing policy, a positive mix shift, and a series of marketing campaigns accelerated top-line growth.

Overall, net sales grew 22.2% in 2006, reflecting the higher average beer prices and improved beer volumes. Although overall net revenues increased in Uruguay during 2006, sales were adversely impacted during the last three months of the year by the disruptive measures taken by the trade unions representing transportation workers and chamber of freight companies. The delivery of the company's products was severely hampered, which resulted in lower sales and loss of market share, especially in the soft drink business. Management estimates that Quinsa lost six market share points in soft drinks from September to November. The company reached a new agreement with the trade unions, which includes new social service contributions to be borne by the company beginning in 2007.

Investment Concerns
Long-term concerns about the volatile South American economies and higher transportation costs are the negatives associated with Quinsa. The company operates predominantly in South America, which has very volatile political and economic climates, marked by histories of hyperinflation and currency devaluation. In particular, Argentina was in recession for several years, and while the short-term outlook appears favorable, the country has had problems with debt repayments and issues with the IMF; therefore, the long-term situation remains unclear.

Transportation expenses are increasing as a result of the extension of direct sales force and higher fuel costs. The rise in transportation expenses will pressure profit margins in the coming quarters. Upon the sale of Quinsa s entire stake held by Beverage Associates Corporation's [BAC] to Companhia de Bebidas das Americas (AmBev) for $1.25 billion in cash, AmBev became the sole controller of Quinsa with 97.16% voting interest and approximately 91% economic interest. While the market for ADS (Class B shares) would not be directly impacted, investor confidence is limited due to the lack of visibility on corporate oversight. However, the offer to buy existing shareholders out at a premium price mitigates this risk.

INDUSTRY OUTLOOK - POSITIVE
The outlook for the beverage industry in the southern cone of Latin America is positive. The beer segment is driven by increasing per capita consumption and the demographic profile of a region. The per capita consumption in Quinsa's major markets of Argentina, Chile, Paraguay, Uruguay and Bolivia are 32, 26, 35, 21, and 19 liters, respectively. Compared to 84 liters in the U.S., 68 in Canada and 81 in Venezuela, Quinsa's markets have significant growth potential. Beer volume is affected by the key 21- to 28-year-old age group, the youth drinker demographic segment.

In the U.S., the group comprises 13% of the population yet traditionally accounts for more than 27% of total beer consumption. The demographics in Quinsa s countries of operation exhibit a relatively faster growth in the drinking age population than Western Europe and North America. In the short-term, adverse weather conditions can adversely affect consumer demand. Consolidation is another trend governing the beer industry, with the need for scale and cost efficiencies being the driving factors. Rationalization of production (through the agreement with AmBev) should allow for an environment of positive pricing.

The soft drink segment includes bottlers of carbonated and non-carbonated drinks and non-alcoholic beverages. Sales growth has averaged in the mid-single digits historically and this trend seems likely to continue well into the future. Inclement climatic conditions can also temporarily reduce soft drink sales. There is additional growth potential for non-carbonated drinks such as bottled water, fruit juices, sport drinks, vitamin water and ready-to-drink flavored tea. The demand for these products has been increasing as consumers seek healthier alternatives. Product line extensions from soft drink producers should continue to spur the interest of consumers and help keep the industry moving forward.

INDUSTRY POSITION
Quinsa is the largest beer producer in Argentina and the combined southern cone markets. For full-year 2006, the company held approximately 78.7% of the Argentine beer market. On January 31, 2003, Quinsa completed a strategic relationship with AmBev, the largest brewer in Brazil and in South America, which led to the subsequent integration of their respective operations in the southern cone markets. Pursuant to this alliance, Quinsa has begun to manufacture, market, and distribute the AmBev beer brands in the southern cone markets under a royalty-free exclusive license, and AmBev was able to distribute some of Quinsa's beer brands in Brazil, which provides Quinsa with strategic access to AmBev's extensive distribution network.

Including the relationship with AmBev, Quinsa has almost 80% of the Argentine beer market. In Argentine, Quinsa competes with the large German brewer, Warsteiner, and the Chilean brewer, Compañía Cervecerías Unidas [CCU]. The company also faces increased competition from a joint venture between CCU and Anheuser-Busch. In Bolivia, Quinsa with 97.7% market share only faces competition from imported beer and small local brewers. In Chile, Quinsa's biggest rival is CCU, the largest competitor in that country.

Quinsa is a relatively new entrant and faces a competitive disadvantage since the company no longer has the licensing rights of Heineken in Chile after AmBev essentially took control of Heineken s stake in Quinsa. As a result, Heineken's licensing rights were transferred to CCU. The Heineken brand was the major driver of Quinsa s growth in the Chilean market. The company s soft drink business in Argentina and Uruguay began in December 1999 with the acquisition of Baesa, the largest PepsiCo bottler in Argentina and the sole PepsiCo bottler in Uruguay. The company subsequently acquired a 99.2% interest in EDISA, the second largest PepsiCo producer and bottler in Argentina. Quinsa now has control of 100% of the production and sale of PepsiCo carbonated soft drinks in both Argentina and Uruguay. Local Coca-Cola® bottlers and second-tier brands that compete exclusively on a price basis are the company s most significant competitors.

RECENT NEWS
On March 5, 2007, Quinsa's Board of Directors announced that the offer by Beverage Associates Holding Ltd to purchase Quinsa's ADSs at $67.07 per ADS has been extended to March 16, 2007 (5:00 PM New York City Time). On March 1, 2007, Quilmes Industrial reported resulted for the 24-week1 and full-year ending December 31, 2006. The company posted earnings of $0.814 per share (or $1.628 per ADR) in the second half of the year, up 12.6% year-over-year from $0.723 per share (or $1.446 per ADR) recorded in the prior-year period. Net sales grew by an impressive 22.2% to $645.8 million, largely driven by the strong growth for both beer and soft drinks.

Beer volume increased 11.8% to 9.706 million hectoliters, driven by the strength across all the operating markets, especially Bolivia, Paraguay, and Argentina. Volume for soft drink and water also increased during the period by a healthy 20.5% to 5.738 million hectoliters, fueled by solid growth in both Argentina and Uruguay. Also, higher average beer prices in Paraguay, stronger performance of the Pepsi brand in Argentina, and introduction of new products such as Brahma brand in Chile and Stella Artois in Uruguay contributed to the top-line growth. The company invested in two additional bottling lines which contributed to the increase in volume. However, top-line gains were partially offset by the disruptions caused by the trade unions representing transportation workers and chamber of freight companies in Uruguay.

Despite escalating input costs, the gross margin expanded 202 bps to 60.3% from 58.3% in the comparable prior-year period, attributable to improved volumes and pricing, coupled with cost cutting and higher efficiency levels. Although selling & marketing expenses and transportation costs were higher year-over-year, the operating margin expanded 355 bps to 33.9% versus 30.4% in the prior-year period. Total capital expenditures amounted to $94.3 million in the second half of the year, mostly attributable to the acquisition of bottles, crates, and coolers, along with capacity expansion of soft drinks business in Argentina and glass bottle facility in Paraguay.

For full year, earnings increased 26.2% to $1.529 per share (or $3.058 per ADR) versus $1.212 per share (or $2.424 per ADR) recorded in the prior-year period. Net sales grew by an impressive 22.2% year-over-year to $1.166 billion, principally due to an improvement in both beer and soft drink businesses. Beer volumes increased 9.1% to 17.956 billion hectoliters led by strong performance in all the operating markets Argentina (+6.5%), Bolivia (+18.8%), Chile (+25.8%), Uruguay (+8.8%), and Paraguay (+8.0%). Soft drinks volume grew by an impressive 25.4% to 10.698 billion, driven by the strength in both Argentina and Uruguay. In addition, price increases in both Argentina and Paraguay spurred top-line growth. The gross margin improved 183 bps to 59.5% while operating margin increased 243 bps to 32.4%, mostly due to lower depreciation expense and other factors similar to the second half of 2006. Net debt position was $38.4 million, significantly down from $187.2 million in the year-earlier period as the company generated strong cash flow and did not repurchase shares during 2006.

On February 9, 2007, Punch Card Capital released the text of a letter to Quinsa's Board, in which the firm criticizes the Board for not appointing an independent committee of Directors to evaluate and negotiate the offer and for not obtaining an independent opinion on the offer other than from Citigroup Global Market, which is one of AmBev's regular financial advisors and has provided AmBev with investment banking services on at least six different occasions.

On November 14, 2006, Quinsa's Board of Directors announced that the offer by Beverage Associates Holding Ltd to purchase Quinsa s ADSs at $67.07 per ADS is fair from a financial point of view to Quinsa's shareholders. The offer represents a 15.6% premium to the closing price of the ADSs on November 7, 2006, the last trading day prior to the announcement of the offer. On November 9, 2006, Quinsa received a voluntary tender offer to purchase any and all Class A and Class B shares (including Class B shares held as American Depositary Shares) that are not owned by AmBev or its subsidiaries. The offer will be made by Beverage Associates Holding Ltd (a Bahamian corporation and a wholly-owned subsidiary of AmBev). The offer price is $67.07 per ADS. On August 8, 2006, the company announced the sale of the shares held by Beverage Associates Corporation [BAC], one of the largest shareholders in the company, to Companhia de Bebidas das Americas (AmBev) for $1.25 billion in cash. AmBev now holds 91.18% economic interest and 97.16% voting interest in Quinsa. When originally announced on July 4, 2006, the stock rallied $6.45 or 17.1% on the news.

VALUATION
The $69.50 target is based on the buyout offering price by Beverage Associates Holding Ltd to purchase Quinsa s ADSs at $67.07 per ADS plus $2.43 for the resolution of Punch Card Capital s call for the appointment of an independent committee of Directors and a subsequent higher independent opinion on the offer by Beverage Associates.

RISKS
A higher buyout offer by Beverage Associates could be offered under pressure by shareholder Punch Card Capital.

INSIDER TRADING AND OWNERSHIP
Institutions hold approximately 0.5% of Quinsa's total shares outstanding at the quarter December 31, 2006. The top holders at the end of the period were Arnhold & S Bleichroeder Advisors (0.191%), Duma Capital Partners (0.167%), Morgan Stanley Capital Services (0.070%), Strome Investment Management (0.048%), and Renaissance Technologies (0.028%) All the top institutional holders added to their positions in the latest reported quarter except for Morgan Stanley Capital Services, which maintained its position during the period. Punch Card Capital owns Ordinary Class B Shares of Quilmes Industrial and not Quinsa ADSs, which this report addresses in terms of institutional ownership.

KEY POINTS

Quinsa has received a buyout offer of $67.07 per ADS from a subsidiary of AmBev. Since Quinsa s Board has stated publicly that the offer is fair, little stock appreciation is expected from the stock going forward.

The company's business in Uruguay is facing difficulties due to the disruptive measures taken by trade unions.

SUMMARY
Quilmes Industrial (Quinsa), S.A. is a beneficiary of the recovering economies in Latin America. In addition, the synergies from the alliance of operations with AmBev have become apparent from the company's latest financial reports. AmBev increased its economic ownership of Quinsa to 91% and voting interest to 97%, effectively controlling the company. In November, the company received a buyout offer of $67.07 per ADS from a subsidiary of AmBev, which Quinsa's Board has agreed is fair. The subsequent pressure by Punch Card Capital to obtain an independent opinion should result in a modest increase in the offer. The Sell rating is retained.

1 Quilmes Industrial (Quinsa) reports earnings semi-annually, usually in August (first half results) and March (second half and full year results). However, the company reports volumes quarterly.

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