THE SECRET PM: BUY HEINEKEN

Beer requires no introduction. Across countries three factors overwhelmingly determine the size of the beer profit pool: population size, GDP per capita, and market structure. North America and Western Europe serve as an example of market structure. Market size (300 million hectolitres) and wealth ($40,000 GDP per cap) are roughly equivalent, yet operating margins are 15% in Europe but 25% in North America. The difference? North America is made up of oligopolies: ABInbev and MillerCoors are 80% of volumes sold in the US. That contrasts with Europe, where the big markets of Germany and the UK have no dominant players.

With this simple framework in mind it is not hard to understand the meteoric rise of Ambev: from a split-adjusted 40c a share in 2000 to over $8 a share in 2013.

Ambev’s main market is Brazil, which has a large population. 170 million in 2000 and 200 million today. From 2000 Brazil’s GDP per capita grew from about $3,000 to $10,000, levels which show a very strong positive correlation with beer consumption (above $15,000 beer consumption typically plateau’s at 70 litres per person). So Ambev was operating in a huge market, which was experiencing rapid growth in beer consumption. Between 2004 and 2014 Ambev grew Brazilian volumes from 83mln hectolitres to 117mln hectolitres : 2% pa from population growth and another 2% pa from growing disposable income.

Key to Ambev’s success is the fact that it dominates the market, with 65% share. Without strong competition Ambev charges high prices – $110 per hectolitre, roughly equivalent to prices in the US – and enjoys tremendous economies of scale, sufficient to record operating margins above 40% (while its competitors earn less than 10%). Ambev has thus been able to turn 4% pa volume growth into 14% pa EBITDA growth. In 2014 Ambev reported Brazilian EBITDA of around $6bn and is valued at $100bn.

With Ambev’s success story in mind consider Heineken. Heineken operates in Nigeria through recently merged majority-owned subsidiaries Nigerian Breweries and Consolidated Breweries. Heineken controls 70% of the market’s volume. Nigeria historically operated as a duopoly with Guinness. This market structure coupled with very low consumer incomes (GDP per capita of $250) led to limited brewery investment and very high prices: at $140 per hectolitre prices are higher than those in the US. High prices and very low incomes held back beer consumption to just 10 litres per capita in 2011. Less than 10% of Nigerians can comfortably afford beer, cheap alternatives make up 90% of alcohol consumption.

Today Nigeria has a population of 170 million and is expected by the UN to grow to over 400 million by 2050. At today’s 12 litres per capita total beer volumes in Nigeria today are around 25 mln hectolitres. Even considering religious constraints (half the population is Muslim) growing consumer wealth should lead to growing beer consumption. At 35 litres per capita – half the level in the mature markets and similar to China’s level today – by 2050 Nigerian beer volumes would top 140mln hectolitres, a level bigger than the Brazilian market. Today GDP per capita in Nigeria is at $3,000, growing in excess of 10% pa, and right at the point where broad beer consumption begins.

The excellent prospects for the Nigerian market coupled with excessive incumbent pricing served as an incentive for SABMiller to enter the market in 2009. SAB launched the Hero Lager brand at $1 for 500ml, a 25% discount to Heineken’s mainstream brand, Star. This strategy enabled SAB to grow its share from 3% to 10% in 5 years (at the expense of high-priced Guinness). But more importantly it served to spur beer growth in a market dominated by cheaper alternatives, from 15 mln hectolitres sold in 2009 to 20mln. Lower price points in a market of rising incomes is clearly stimulating volume growth. Indeed, neighbouring Cameroon serves as an interesting test case since Cameroon also has a large Muslim population. Cameroon beer prices are 30% below those in Nigeria while beer consumption in Cameroon is 3x greater, at about 40 litres per capita. With the right pricing and brand investment beer consumption per capita in Nigeria can seemingly growth 4x.

SAB’s commercial strategy is invigorating the Nigerian market, and Heineken has responded, upping African capex from a stable Eur 300 mln per year in 2008/9/10 to over Eur 500 mln in 2013. With control of 60% of Nigeria’s brewing capacity and a broad mix of value and mainstream brands Heineken is positioned to benefit as the Nigerian beer market grows towards its potential. With little scope for new entrants owing to import bans and limited infrastructure, and SAB deliberately avoiding head to head competition in cities like Lagos, Heineken’s dominant share allows it to benefit from economies of scale as volumes pick up – much like Ambev did in Brazil. Already in 2013 Heineken earned operating margins around 25%.

The building blocks are in place for the beer profit pool in Nigeria 15 years hence to resemble the profit pool we see today in Brazil: $6bn. Heineken consolidates about half its Nigerian profits, so if Ambev is valued at $100bn it is not unreasonable to expect Heineken’s African business is be worth, in time, $50bn. Today all of Heineken is valued at $43bn.

Of course in addition to Brazil Ambev benefits from strong market positions in Canada and Argentina. Heineken too however has dominant positions in the DRC and Ethiopia, which are forecast to see their combined populations double to nearly 400 million by 2050, and both are starting from very low levels of income ( less than $500 GDP per capita) and consequently little mainstream beer consumption.

Heineken has a unique and protected growth runway in Africa to double group profits in 10 years. In an industry where the big volume markets like the US and Brazil are at mature levels of consumption (70 litres per capita) and not delivering much organic volume growth Heineken is the only significant beer company that “owns” the next decade’s growth. This is of huge strategic value to SAB and especially ABInbev, which is generating $10bn a year in free cash flow with precious little place to invest. Valued at 20x profits (ex amortisation) Heineken is still cheaper than both SAB and ABInbev, that is not going to last. SAB’s takeover approach in 2014 show’s they know this too. The share price pullbacks are likely to be rare and shallow, use the opportunity.