If you've read the news recently, you'll know that scientists can trace the gene that allows us to digest alcohol back thousands of years to when the first primates came down from the trees and developed a genetic mutation to help them eat fermenting fruit found on the ground. Today, we humans enjoy this evolutionary phenomenon by consuming vast amounts of alcohol. Much of that industry is controlled by global brewers and distillers who have, this past year, enjoyed a fairly good, if volatile, run. The MSCI World Beverage Index (which also includes non-alcoholic producers) has climbed 11 per cent thus far, outpacing a 4.7 per cent increase in the Global Index. Brewers had the biggest gains, up 21 per cent, while distillers grew 7 per cent. That's a trend reflected in the share prices of the UK's two beasts of the booze world: SABMiller (SAB) and Diageo (DGE). The former has enjoyed an 11 per cent share price gain, while Diageo's growth was limited to 2 per cent.
These were robust performances given the challenging backdrop over the past 12 months. As well as stalled growth in maturing Western markets, SABMiller, Diageo and many of their global peers, such as Heineken (NL:HEIA), Anheuser-Busch InBev (BE:ABI) and Remy Cointreau (FR:RCO), were dealt a double whammy as their profits were eroded by currency depreciation and widespread economic slowdown in emerging markets. These faster-growing economies are areas in which brewers and distillers have built up their businesses to offset muted trading closer to home. The Ebola outbreak in West Africa was also a major headache for some beverage makers. Heineken cut brewery operations and halted expansion in Sierra Leone, while Remy Cointreau cancelled some of its Nigerian operations on the back of weakened demand.
Yet, the buoyant share prices and toppy average rating among beverage makers - a forward price to earnings multiple of roughly 20, equating to a 31 per cent premium to the wider global index and 15 per cent higher than the three-year average - reflects three things: the defensive nature of these stocks, cost cutting and crucially, real potential for further mergers and acquisitions.
Distilling down profits
Current data from Euromonitor suggests global beer sales may rise 2.6 per cent a year to $740bn in 2018. That outstrips the 1.3 per cent annual sales growth generated by the industry since 2004. Some of that growth will be down to an improving economic outlook, but more efficient operations and a focus on acquisition-led growth will be key. Across the board, all beverage makers are trimming down while investing in efficiency and snapping up smaller producers. North American beverage makers have invested in their businesses and expanded breweries - capital spending as a proportion of sales reached 4.4 per cent in the third quarter, from 3.8 per cent last year. Cost savings will continue, helped in part by economies of scale, while raw material costs have stabilised and in some cases fallen. AB InBev said in November that it was cutting its US workforce amid slow beer sales in the region, while SABMiller is in the middle of a $500m savings plan. Diageo announced in January a £200m a year cost savings target by 2017. And, as these companies become leaner and operate in an increasingly slow-growth environment, they'll look at ways to expand, and the obvious route is through M&A.
M&A saves the day
Beverage makers will continue to grow by expanding in Asia and other developing markets to offset slow growth in the US and Western Europe and to consolidate their market share. Diageo, for its part, has been busy on that front. It has made good progress in Asia Pacific and India and recently acquired the remaining 50 per cent stake in Tequila Don Julio. C&C Group (GCC), a cider maker, has been eying up Spirit Pub Company (SPRT), although the chances of that deal going through are looking slim. It has also diversified by tapping into the craft beer revolution in the US, a a big, and growing, sub-sector.
But the most compelling possibility for M&A in 2015 lies with SABMiller, whose boss Alan Clark said in October that acquisitions and partnerships were his company's "priorities for driving top line growth". That was recently evidenced by news last month that SABMiller had sealed a deal with Coca-Cola, making it the soft drink giang's biggest bottler in Africa. Soft drinks are an important element of SAB's growth strategy - in the first half of this year total volumes were up 1 per cent, lager was down, but soft drinks jumped 9 per cent. The deal increases SAB's total exposure to the African beverage market, which boasts a fast-growing population and rising per capita consumption. It also cements SAB's relationship with Coca-Cola, making it a more favourable bid target.
On that note, the first hint at serious consolidation at the top came in September when Heineken rejected a proposed buyout from SAB. The bid was never likely to be accepted, but it was significant because it was widely interpreted as a defensive move intended to strengthen SAB against a potential bid from the even mightier AB InBev. AB InBev could really bolster its defences against a declining Western market through SAB, which derives 26 per cent of its sales in Africa and Asia. The total African alcoholic drink market was worth $54bn in 2013, according to Euromonitor.
Given the scale of the potential deal, it would need approval from the US Department of Justice. The $92bn US beer industry is one of the most concentrated of all large consumer product categories. The top three brewers, AB InBev, SAB and MillerCoors, control 77 per cent of beer sales. To get around the hurdle, SAB could divest its 58 per cent stake in MillerCoors, a joint venture with MolsonCoors.
IC VIEW:
Sentiment in this sector has really improved since the start of the year, a fact reflected in the premium ratings enjoyed by many beverage stocks. The expectation is that slowing economic growth in developing markets will prompt further cost cutting on the one-hand and on the other, keep the possibility of M&A alive and kicking. Some analysts also believe that 2015 may bring with it dividend boost by up to 9 per cent on average. The reason being that stable input costs, lower overheads and efficiency savings from recent industry acquisitions will support healthy cashflow. Weakening macroeconomic conditions in emerging markets might actually limit further capital spending, too. Admittedly, short-term catalysts are difficult to spot, but over the long-term, demographic trends favour the beverage sector.
The companies:
SABMiller
SAB's frothy rating - 20 times forward earnings - is a premium to its peers, despite having reported a lacklustre set of interim results last month. But its strong exposure to emerging markets and M&A potential in a low-growth world will keep the shares relatively buoyant.
C&C Group
Shares in C&C have fallen by a third since June and trade at just 12 times forward earnings. But that might be for good reason: the brewer had a soggy set of half-year results and bid interest in Spirit Pub Company looks increasingly unrealistic. However, it generates a lot of cash and has a decent balance sheet. The struggling US business is operationally geared, so should trading improve - and management is working hard at this - gearing will kick in to the upside. Meanwhile, the Scottish and Irish businesses are benefiting from recent acquisitions.
Diageo
Diageo relies on rich Chinese consumers for sales of its premium scotch Johnnie Walker, so a government crackdown on lavish gift giving has really put the kibosh on sales. Overall, revenue in Greater China, and other parts of Asia, bar India, have been falling, hit by pricing pressure and weakening currencies. By contrast, developed markets are putting in a better showing and finance director Deirdre Mahlan expects North America and Europe to continue to improve this financial year, while emerging markets should tick up, but won't return to the frenzied days of double-digit growth any time soon. There are few catalysts for growth, but cost cutting and brand investment are increasing market share.
