Up more than a third over the past year (and around 30% over the past two years), Kirin (OTCPK:KNBWY) has outperformed peers like Asahi (OTCPK:ASBRY), Sapporo (OTC:SOOBF), and Suntory (OTCPK:STBFY) as management has made several moves to improve several underperforming segments of the business, including the sale of the long-struggling Brazilian operation to Heineken (OTCQX:HEINY). Now the question is what Kirin management can do to stimulate growth when its core market(s) offer minimal underlying growth at best and acquisition prices are steep.
Kirin shares deserved their run, but management needs to prove that it can deliver more than low single-digit FCF growth in the future. Although the underlying growth assumptions are not very high here, and the shares are undervalued on the basis of established industry M&A premiums, Kirin's best growth opportunities hinge upon the company executing well in precisely those places where it has struggled, and that's a little too aggressive for my comfort today.
A Strong Domestic Player With A Questionable Overseas History
Kirin squeaks in as a top 10 global beer company in overall volume and revenue market share with a global volume and revenue market share around 2%. Kirin is the #2 beer company in Japan (a few points behind Asahi), where it has long enjoyed a strong product development track record but has been compromised by weakness in its go-to-market efforts. Kirin's non-alcoholic Japanese beverage is credible in terms of overall market share - #4 with 13% share, well behind Coca-Cola (NYSE:KO) and Suntory, but competitive with Asahi and Ito En (OTCPK:ITOEF) - but poor operational performance has led to very weak margins.
The last two decades have seen the company use the cash flow generated by the Japanese operations to expand internationally, and the track record has been mixed. The acquisition of nearly half of San Miguel's (OTCPK:SMGBY) San Miguel Brewery business has gone pretty well, as has the acquisition of the quite profitable Australian Lion Nathan business. Expansion into Brazil went badly wrong, though, as the company's product mix, expense structure, and marketing strategy were wrong, and the company recently sold its operations to Heineken for less than half of what it paid in 2011.
Most recently, the company acquired controlling stakes in Myanmar Brewery and Mandalay Brewery, giving Kirin around 85% to 90% share of Myanmar's small but growing beer market (with Heineken and Carlsberg (OTCPK:CABGY) also figuring in as competitors).
The San Miguel and Lion deals have both worked out relatively well, though Kirin's stake in San Miguel is not controlling. In both cases, Kirin bought into businesses that enjoyed strong share in the local market, and it has managed not to screw that up. In fact, the Australian beer operations are quite profitable. That's encouraging with respect to the recent acquisitions in Myanmar.
On the other hand, Kirin could never do much of anything with the Brazilian beer business (Schincariol) that it acquired. Despite low-to-mid teens market share at the time of the acquisition, Kirin saw the business fall from second to fourth place (and roughly 8% share) with a product line-up that wasn't good enough to compete with premium offerings from the likes of Heineken or affordable enough to compete with mass market offerings from AB InBev (NYSE:BUD) or Petropolis. Worse still, the company's expense structure was out of whack, and the distribution operations were not good.
How To Grow In Low-Growth (Or No-Growth) Markets?
One of the biggest challenges that I believe Kirin has to deal with is the fact that its core market, the Japanese beer market, has been declining around 1% to 2% a year for several years and seems likely to continue to do so. Japan's population is aging and its younger generations haven't been as reliable when it comes to consuming beer (with sales of wine, spirits, and other beverages outpacing beer).
On the plus side for Kirin, the company has a good track record of developing new products and Japan's peculiar tax policies incentivize new product development. Unfortunately, Kirin's go-to-market strategy has been on the wrong foot for quite some time and the company has struggled to translate its new product development acumen into actual sales and market share. Making matters worse, marketing has gotten more and more competitive in Japan with Asahi, Suntory, and Sapporo all fighting hard in an effort to grab share.
Encouragingly, Kirin's multiyear market share declines seem to have stopped (and the company only lost about five or six points at worst). Also encouraging is an apparent trend among the domestic players to cool it with the aggressive promotional and marketing spending and instead refocus around driving better margins instead of market share. If Kirin can make improvements in its marketing/promotion efforts (which is an area of focus for management), the benefits could be pretty significant from a margin standpoint.
Australia, too, is a challenging market. Consumption volume has been weakening and AB InBev's acquisition of SABMiller could shake up what had been a relatively stable and profitable competitive arrangement. Product development has proven tricky in the Australian market (with consumers more likely to switch to cider or other beverages than try a new beer), and I don't have solid ideas on how to make this more than a cash cow type of business.
Kirin also has work to do in fixing its non-alcoholic beverage businesses. In Japan, management is attempting to reduce costs and change up its product/packaging mix in an effort to improve margins from the very low single-digits. With a relatively limited product line (strong in fruit juices and mineral waters, but weaker in teas and coffees), this may be a tough turnaround unless the company can find some inspiration on the product development side. What the company has done in Australia may offer a roadmap - although the Australian beverage business is mostly built around milk-based products, management has seen some success in the last couple of years by doubling down on stronger brands, streamlining marketing and distribution, and cutting marginal SKUs.
High Growth Can Mean Higher Risks
I'm not sure what to make of Kirin's forays into Myanmar. The premiums paid haven't been bad (10x EBITDA for the original Myanmar Brewery business, versus 12x for Lion Nathan and 14x for Brazil), the business is quite profitable, and Kirin seems to do better when it buys business with significant market share advantages. What's more, Myanmar's beer market is still relatively small and the country under-consumes significantly in comparison to the likes of Vietnam or Thailand. Still, it's a small market that won't likely move the needle in a big way for some time to come, as the sales contribution will be only a low single-digit percentage of the total.
Myanmar may not be Kirin's only deal. While Kirin basically stood pat while AB InBev/SABMiller sold off assets to get its deal done, there have been rumors of Kirin looking to acquire Vietnamese government-owned market-leader SABECO. SABECO holds around 40% of Vietnam's market, the third-largest Asian beer market, but you can bet that Heineken, Carlsberg, and others would/will be interested in the asset as well, making a potential deal quite likely to be expensive. Given the likelihood of more competition in this fast-growing market, I would be worried about a repeat of the Brazil experience (acknowledging, though, that SABECO is in a much, much stronger starting position).
What About The Drug Business?
Kirin also owns just over 50% of Kyowa Hakko Kirin, a pharmaceutical and biochemical business that contributed around 16% of FY 2016 revenue and 25% of operating profit. Kyowa Hakko Kirin has a credible pipeline, and seems to be establishing itself as a potentially more significant player in rare diseases, with drugs for X-linked hypophosphatemia and adult T-cell leukemia under development. While Kirin could sell its stake if it needed to (or conceivably increase its stake), I believe standing pat is the more likely scenario.
Kirin management has done a lot to address weaknesses in the business. Realizing that there was really no viable path to prosperity in Brazil with such low market share, management chose to sell the business at a decent multiple (10x EBITDA) rather than perpetuate a turnaround strategy that was likely only going to produce limited benefits or risk even more capital by trying to acquire Petropolis or Heineken's operations (neither of which were likely to sell, and certainly not sell cheaply). In addition, management has done a good job with the Australian non-alcoholic beverage business and seems to have reasonable plans underway for the Japanese alcoholic and non-alcoholic operations.
The problem is the "... and then what?" question. The Myanmar operations are too small to change much, and entering Vietnam would/will be risky. Moreover, even if there are improvements to be had in Japan and Australia, those beer markets still aren't growing much. Accordingly, it's hard for me to see how Kirin drives more than low single-digit revenue growth. I do believe that its restructuring and self-improvement efforts can drive better margins, allowing for FCF margins to grow into the high-single digits, but the resulting mid-single-digit FCF growth still isn't enough to drive an attractive fair value.
The Bottom Line
Kirin does not look undervalued on cash flow, though it does trade at a forward EV/EBITDA ratio that is below the recent norms for buyouts in the beer space. Given the low-growth nature of the Japanese and Australian markets, though, I don't think the shareholders of a company like Heineken or Carlsberg would be all that excited about such a transaction. While domestic consolidation is a possibility and Kirin could elect to sell its pharmaceutical operations and return the cash to shareholders (or use it for more acquisitions in faster-growing beer markets), it's hard for me to find a compelling argument to buy Kirin given that the market has already recognized a lot of the improvements made in the past year or so.
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