Return of the King!

If Anheuser-Busch (BUD), better known as Budweiser, is the King of Beers in the US, it may not be too long before the company grabs that title in China. BUD owns a 27 percent economic interest in Tsingtao Brewery Company, the largest brewer in China and producer of the Tsingtao brand. BUD's international growth options fit well with its more mature but dominant position in the US.

BUD's operations are comprised of four business segments: domestic beer, international beer, packaging and entertainment.

Domestic Beer is the company's main business, making up 75.8 percent of total sales in 2005. The domestic beer operation is basically a system of 12 strategically located breweries that serve BUD's immense distribution system. The company distributes its product range through more than 570 independent wholesalers.

BUD has formal, written distribution agreements with each of its wholesalers, covering such issues as where the wholesaler can sell, what brands can be sold and inventory protection and management. The company believes such agreements protect the quality and equity of the brand and therefore provide a key competitive advantage.

In 2005, BUD's domestic beer volume was 101.1 million barrels, down slightly from the 103 million barrels sold in 2004. Despite the small drop, BUD's 2005 sales exceeded those of its nearest competitor by 60 million barrels. The company remains the market leader in the US beer consumption with an impressive market share of around 50 percent.

The International Beer operations may be much smaller than the Domestic business however the growth trajectory is far more impressive. International beer sales for 2005 reached 20.8 million barrels, up 50 percent from 2004 levels. The main driver of the operations is BUD's ownership of brewing interests in both China and Mexico. With the economic focus switching from the developed to the developing world, we believe these operations will emerge as a significant growth driver for BUD in the decade ahead.

In China, the Company has a 97% equity interest in the Budweiser Wuhan International Brewing Company Limited, a joint venture that owns and operates a brewery in Wuhan. Wuhan is the capital of the Hubei province and is the most populous city in Central China.

In addition, BUD owns 100% of Harbin Brewery Group Limited, the fifth largest brewer in China. Harbin Brewery Group has thirteen breweries in northeast China.

Perhaps more significantly, BUD has a 27 percent economic stake in Tsingtao Brewery Company, the largest brewer in China. Originally established in 1903 by German settlers, Tsingtao has become China's number one beer.

While not yet a dominant player (as BUD is in the US) we expect strong growth from Tsingtao as China continues transitioning from an agricultural based economy. If beer is the drink of choice for the working class, then Tsingtao's future looks bright.

In Mexico, BUD owns a 35.12 percent stake in Modelo, Mexico's largest brewer and producer of the globally popular Corona brand.

BUD other divisions include Packaging and Entertainment. The Packaging division includes can, bottling, recycling and printing & packaging facilities. The Entertainment division, through the Busch Entertainment Corporation, owns nine theme parks, including the Busch Gardens and Sea World parks located throughout the US.

The sales and profit contributions of each of the divisions provides an insight into where potential value lies within the company. For 2005, divisional profit margins were as follows:

Domestic beer; 15 percent
International beer; 47 percent
Packaging; 3.6 percent
Entertainment; 11.7 percent

Accounting methods overstate International beer's margins however we believe the division is a more profitable operation than the domestic business. Hence, strong growth from this segment should have a material effect on the bottom line.

Packaging's margin of 3.6 percent reflects the highly competitive nature of the industry. Although not on the horizon, we believe BUD could add value and increase overall group margins by outsourcing the packaging function.

Increasing costs are a major challenge for BUD. In 2005, cost of sales increased by 6.6 percent and with raw material prices soaring, BUD will again feel cost pressures in 2006. We are reasonably comfortable with the rising cost environment because of BUD's dominant market position and ability to pass on most cost increases.

Furthermore, BUD sells to wholesalers who may in turn absorb some cost increases to maintain sales through the retail channel. In an emerging inflationary environment we believe it is important to invest in companies with pricing power. BUD is one such company, in our opinion.

The ability to pass on costs is an important consideration for investors. Stocks are likely to do well in times of high inflation if prices increase in line with costs. If companies do not have pricing power, margin pressures will result.

BUD derives the majority of sales and earnings in the US. Given our bearish long term view on the US economy, we would normally avoid such exposure. However, we believe the US operations provide a quality defensive exposure, while the international business provides attractive growth opportunities.

An investment in BUD provides an entry point into the lucrative Chinese beer market. We are encouraged that the predominant exposure is through a strategic investment in Tsingtao, rather than through an investment in building the brand from scratch. Such a strategy requires heavy investment while the returns are highly uncertain.

From a charting perspective, recent gains in BUD's stock price reflect a marked improvement in investor sentiment. After touching four year lows in October and retesting this low in February, we now believe that a substantial re-rating of the stock is underway.

As shown on the daily chart, BUD has broken clearly above trendline resistance. Prices have also broken above the important November high of $45.08. The November high was an important technical level, being the intervening high point between the "double bottom" lows of October and February, at $40.15 and $40.17 respectively. The break above $45.08 adds to the positive outlook for BUD.

Fundamentally, BUD offers reasonable value relative to the market. According to consensus earnings estimates, the company trades on a 2007 price to earnings multiple of around 17.5. Given the strong growth expected from the higher margin international business, we believe earnings growth forecasts might prove conservative.

BUD's dividend yield is around 2.34%. The company anticipates continuing to return excess funds to shareholders through both dividends and stock buybacks. A high return on equity of around 60 percent reflects the company's efficient capital structure.

BUD's relatively high debt levels help to boost the return on equity. Normally averse to high debt (BUD's gearing ratio - net debt to equity - is over 200 percent) we are comfortable with the balance sheet. In addition to having adequate interest cover, most of BUD's debt is fixed. 83 percent of the company's outstanding debt was fixed at 31 December 2005. BUD estimates that a 100 basis point increase in interest rates would only add $14 million to annual interest expense.

Given our views on inflation, high fixed debt provides another bonus. Inflation reduces the real value of debt, so when the bonds mature, BUD will be repaying in inflated dollars. In addition, BUD has borrowed US dollars to buy valuable offshore assets. These assets will increase in value (in dollar terms) if our outlook for a sharp devaluation comes to pass.

Given the recent positive price action, we believe downside risks are limited. On the charts, support between $44.40 and $44.15 should contain any near term weakness. With a new upward trend gaining strength, we believe BUD will witness further gains in the months ahead. Accordingly, we recommend buying BUD around $46.06.