We upgrade both Carlsberg and Heineken from Sell to HOLD with unchanged TPs of RM19.70 and RM18.70, respectively based on a DCF valuation methodology (WACC: 8.5%, TG: 2.5%). By studying the recovery of beer sales in Thailand, we reckon that a similar pattern could happen in Malaysia. We also reckon that chances of an excise duty hike during Budget 2021 to be low. However should this happen, brewers can mitigate the earnings impact by “watering down” their beer. Still, there are some concerns from the recent apparent tougher stance by the government on alcohol related matters.

3Q20 inevitable recovery to mirror Thailand? We expect both brewers’ sales to rebound strongly in 3Q20 due to easing of MCO rules. While Malaysian monthly beer sales volume data is unavailable, we believe volume recovery should mirror or even exceed recovery in neighbouring country Thailand. Note that Thailand beer sales volume grew 27% YoY in July due easing of lockdown restrictions in-spite of the lack of tourist (Figure #1). Using Thailand as a benchmark, we expect beer sales volumes in 3Q20 to be stronger YoY as we understand a larger portion of beer consumption in Malaysia (50%) is consumed out-of-home (vs. Thailand’s 27%), which translates to stronger recovery as consumers are permitted to return to drinking outlets post-MCO (Figure #2). Particularly, we expect Heineken to return to profitability in 3Q20 (vs. 2Q20 net loss of -RM18m) as we understand May and June were already profitable months after losses peaked in March (-RM43m net loss).

Excise duty hike risk and illicit trade. We do not expect the government to hike alcohol excise duty as Malaysia’s alcohol excise duty is already the 2nd highest in the world. Additionally, we reckon the government will not risk increasing alcohol excise duty which could in turn fuel illicit market activity and result in lower tax collection. Note that in the tobacco industry, after tobacco excise duties were increased in 2015, legal volumes shrank drastically at the expense of illicit options as consumers began seeking cheaper alternatives (Figure #3-4). This resulted in the government collecting less tobacco excise duty revenue despite raising the excise duty structure. For this reason, we believe the current government will not risk the same happening in the alcohol sector. Heineken recently shared that they estimate illicit trade to account for ~28% of the total market.

Hike in excise duty less of a risk to earnings than investors believe. While we don’t expect the government to raise alcohol excise duty, in the event that it does occur, we reckon the impact can be mitigated. To recap, Malaysia’s alcohol excise duty is based on alcohol content (RM175 per litre of pure alcohol). Should the alcohol excise duty be increased, we reckon brewers will be able to “water down” their products in order to mitigate the increased excise duty cost, and therefore keep selling prices unchanged. We reckon both brewers are more than able to do this as many of their locally brewed brands currently have higher alcohol by volume (ABV) vs. their European and Japanese counterparts (Figure #5).

Recent anti-drinking headwinds. Despite sales recovery going into 2H20, we note there have been a number of worrying structural issues recently: (1) while other F&B companies were permitted to operate throughout the MCO period, both Carlsberg and Heineken were forced to close their breweries for approximately 6 weeks; (2) recently approved harsher penalties for drunk driving (RM100k fine and up to 15 years imprisonment for first time offenders); (3) drinking outlets continue to operate with shortened hours while certain other entertainment venues and nightclubs remain closed altogether. These operations remain one of the last few sectors of the economy that has not been permitted from operating. Overall, these seem to point towards a tougher stance by the current administration on alcohol related matters.

Upgrade to NEUTRAL. We anticipate strong sales volume recovery as MCO rules are gradually relaxed. As such, we upgrade both Carlsberg and Heineken a HOLD (from SELL) with unchanged TPs of RM19.70 and RM18.70, respectively based on a DCF valuation methodology (WACC: 8.5%, TG: 2.5%). Note that since our downgrades earlier this year, Carlsberg and Heineken’s share prices have fallen - 28.5% and -6.1%, respectively.

Source: Hong Leong Investment Bank Research - 28 Sept 2020