Carlsberg Undervalued And Executing Well

The market being what it is today, when I find a quality name that looks cheap, I get suspicious as to what I may be missing. In the case of Danish brewer Carlsberg (OTCPK:CABGY), I do see risks from the company’s overreliance on mature Western European markets, iffy innovation history, and its lack of exposure to markets in Latin America and Africa. On the flip side, the company has done well in China, has chosen to prioritize value over market share in Russia, and has good leverage to growth in multiple Asian markets outside of China. In addition to that, management has built credibility where margin performance is concerned, with about two points of EBITDA margin improvement over the last five years.

Carlsberg’s footprint isn’t likely to offer the same growth as Heineken‘s (OTCQX:HEINY), and I likewise don’t see the same degree of positive growth drivers as I do for Constellation Brands (STZ), but I do think mid-single-digit revenue growth is achievable, with improved scale and margin leverage opportunities driving FCF margins into the mid-teens and pushing mid-to-high single-digit free cash flow growth. With that, I believe Carlsberg could reasonably be expected to generate high single-digit annualized returns for shareholders from these levels.

Good Guidance As On-Premise Comes Back

Carlsberg management only grudging provided guidance after first half earnings in August (Danish regulators have been pushing companies to restore guidance as quickly as possible), but the initial outlook for a 10%-15% profit decline in the second half has been lifted to a “high single-digit decline”, as the company has benefited from warm weather and on-premise recoveries in many markets.

On-premise (basically, alcoholic drinks served in restaurants, bars, and so on) is a significant part of the market in Western Europe (often around 30% to 40%, sometimes as high as 50% in some markets) and a significant part of Carlsberg’s Chinese business as well, and the relaxation of COVID-19 lockdowns is helping drive a recovery.

At the same time, I don’t think investors should ignore the risk in a recovery coming from this channel. With COVID-19 cases rebounding across Europe, many countries (Spain, Poland, Finland, and the Czech Republic) have recently enacted new restrictions and reportedly other countries are considering new rules as well. Carlsberg isn’t as vulnerable to on-premise as some of its peers, but it’s still a driver that needs to be monitored.

Solid Outperformance During This Downturn

I’ve been impressed with Carlsberg’s performance during this downturn, particularly in its growth markets and where cost efficiency is concerned.

Second quarter volume declined a little more than 7% in Asia (beer volumes), or half the decline of Heineken, and China has held up quite well for the company, with evidence of ongoing share gains in the Western provinces where it is strong. Volume in Eastern Europe was actually up 5%, and while Carlsberg has surrendered the #1 spot in Russia to Anheuser-Busch InBev (BUD), it looks like this business has at least stabilized, if not started to improve. In Western Europe volume was down 9%, which was again better than its peers, due in part to its market exposures and more consistent consumer behavior for its brands.

Since then, data have been somewhat mixed. The most recent Nielsen data for Europe showed more growth for ABI and Heineken (both up around 14% versus around 8% for Carlsberg), but then Carlsberg didn’t see the same level of declines in the first half.

I’ve been even more impressed by the cost/margin performance. Carlsberg’s SAIL2022 plan was put in place to drive margin-efficient growth in its core territories, and the plan seems to be working, combined with the prior “Funding the Journey” cost savings program. Despite meaningful volume reductions, gross margin fell less than a point, and operating income declined only 9% in organic terms (margin actually rose 30bp), with 1% organic operating income declines in the Asia and Eastern Europe operating regions.

So … Now What?

Carlsberg has some challenges it must manage well in the coming years. A little over half of the company’s profits still come from Western Europe, and while this region hasn’t seen quite the same volume declines for beer as North America (an insignificant market for Carlsberg), it’s still not a growth market.

To me, that means that management must be ferocious in driving premiumization and operating efficiency. Carlsberg’s premium/super-premium positioning is okay, but not great – better than ABI, but not as strong as Heineken, with top brands including Tuborg, Carlsberg, Baltika, Kronenbourg, and Chongqing. Product innovation hasn’t been all that exciting, so I’d like to see more done on the operating front. I believe the proposed joint venture with Marston‘s (currently under evaluation by U.K. antitrust regulators) is a sign of things to come, with sub-scale brewers (Carlsberg is a distant #4 in the U.K.) needing to band together to optimize distribution.

The same can be said for Russia. Carlsberg has seen a painful combination of share loss and market shrinkage here, as the Russian government has been aggressive in steps to reduce alcohol consumption and as the market, unlike most around the world, has generally moved away from premium products (trading down to cheaper products, I believe, in response to government measures that have made drinking more expensive). I don’t blame Carlsberg for ceding the market share lead to ABI, but the company still has to deal with capacity utilization that is only around 50% now. I would expect Carlsberg to look to close/consolidate more facilities over time.

The situation in Asia is very, very different. Markets like China, Vietnam, Cambodia, India, Myanmar, and Laos remain growth markets for Carlsberg, and China is Carlsberg’s largest market for volume, sales, and profits. The company has managed to build mid-teens share nationwide in the premium sector despite a very limited presence in Eastern provinces, and the company has done a good job of mitigating the challenges in the Western provinces (lower incomes, less population density, et al).

With China, I still see opportunities for consumption growth over time, and I believe Carlsberg will take a “slow and steady” approach to trying to grow share in Eastern markets. With Vietnam, it looks like after many years of rumors and discussions, the company may be allowed to increase its stake in HABECO, the market share leader in North Vietnam to over 50%; while HABECO still has respectable share, I believe the business could be better managed and would be with Carlsberg having majority control.

The Outlook

Because of the significant exposure to Europe and the lack of exposure to Latin America, I expect core underlying market growth for Carlsberg to be a little less than half that for Heineken. On the other hand, while markets like Latin America and Africa offer a lot of growth, it can be tough to harvest that growth in a cost-effective manner – Heineken and ABI have had their challenges with distribution in those regions. All told, I do expect Carlsberg to grow a little more slowly than Heineken, but still more than brewers lacking strong growth market exposure, with a long-term revenue growth rate likely around 3% to 4%.

I do also expect management to drive more costs out of its mature operations and optimize its manufacturing and distribution infrastructure. Coupled with increasing scale in profitable markets in Asia, I expect that to push FCF margins into the mid-teens, driving mid-to-high single-digit FCF growth.

The Bottom Line

With the cash flows I expect, I believe Carlsberg is priced for a high single-digit annualized total return (an EV/EBITDA approach suggests roughly 10% undervaluation). I normally like to target double-digit return opportunities (on DCF), but that’s harder to do in this market, and I think Carlsberg’s quality offers a decent compromise. While I would probably lean a bit more towards Heineken on a quality/drivers analysis, Carlsberg’s valuation is more compelling, and I think either of these names can do reasonably well for investors from here in a market that still has me a little nervous.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.