We  are  still  UNDERWEIGHT  on  the  brewery  sector.  In  this  report,  we cite five reasons why 2014 beer volume is likely to experience a sharper than  expected  slowdown.  We  reiterate our SELL  recommendations on Guinness  and  Carlsberg,  with  new  FVs  of  MYR13.49  and    MYR11.01 respectively. Our divestment case is primarily premised on their stocks’ rich valuations and waning yield appeal.

• Five reasons why  2014 beer volume  may  fall  further.  i)  Recent rate hikes  and  Government  subsidy  rationalisation  measures  may  dampen discretionary consumer spending  this year,  ii)  easy access to illicit and counterfeit beers in the off-trade segment, iii) cannibalisation by premium and  super  premium  beers  as  “smart  drinkers”  choose  “quality”  over “quantity”,  iv)  FIFA World Cup 2014 is unlikely to boost on-trade sales given its odd kick-off hours, and v)  no major spillover effects  from Visit Malaysia 2014.
• Expecting 5% drop in beer sales.  We think beer consumption  in 2014 may  experience  a  sharp  slowdown  instead  of  growing  1%  as  we  had projected earlier. Hence, we cut our MLM volume growth estimates to  -5% but retain our FY15 forecast of +1% growth. We think consumers will grow  accustomed  to  the  higher  cost  of  living  by next  year  and  start to spend again on discretionary items.
• Trimming  estimates.  On  cutting  our  MLM  volume  assumptions  while keeping:  i)  the market share ratio between  Guinness  and  Carlsberg  at 60%:40%, and ii)  our annual ASP growth assumption of +2%, we revise down Guinness and Carlsberg’s 2-year prospective earnings by 3-8%.
• Preview  of  results.  Guinness  and  Carlsberg  are  slated  to  announce their 4QCY13 results on 20 and 21 Feb respectively.  For Guinness, we expect  a  weaker  y-o-y performance due to softening  beer demand,  but there should be  a  q-o-q  improvement  on account of seasonality during the  Oct-Dec  period.  Similarly,  we  see  stronger  q-o-q  numbers  from Carlsberg. However, unlike Guinness, its y-o-y figures  should be better in comparison with its weak performance in 4QCY12.
• Valuation & recommendation.  Following  the downward revision in  our earnings  forecasts, we reiterate our SELL call on Guinness,  with a new FV of  MYR13.49 (from MYR15.19)  on incorporating  a higher WACC of 8.5% (from 7.8%), with our terminal growth (TG)  estimate kept at +2.5%. Likewise,  post-earnings revision,  Carlsberg  remains  a SELL,  with a new FV  of  MYR11.01  (vs  MYR11.31)  and  our  WACC  and  TG  assumptions remaining  at  8.1%  and  2.5%  respectively.  Our  recommendations  are primarily premised on the stocks’ rich valuations and fading yield appeal. We think  there is still some downside risk even though the share prices of both stocks have fallen sharply from last year’s peaks (down 30-45%). Hence, we retain our UNDERWEIGHT stance on the sector.
• The slight uptick  in MLM volume  in 2007  was primarily due to the zero excise duty hike that year, which spurred the demand for beer
• We  expect  MLM  volume  to  contract  5%  in FY14, followed by a 1% increase in FY15
• Improvement in profit margins
• Revise  down  Guinness  and  Carlsberg’s  2-year prospective earnings by 3-8%
• Maintain  UNDERWEIGHT  on  the  sector premised  on  rich  valuations and  fading  yield appeal

Why is beer volume likely to depress further?
Reason #1.  Following  the recent  rate  hikes and subsidy rationalisation efforts by the Government,  we  think  that  these  measures  may  negatively  dampen  discretionary consumer spending  in 2014, especially  for  the middle to low  income  group.  In fact, 
this  trend  began  to  emerge  in  the  malt  liquor  market  (MLM)  since  3QCY13  as  we observed  sliding  beer  demand  –  revenue  decreased  by  double  digits  y-o-y, suggesting that volume had declined by a similar quantum (see Figure 1 & 2).

Reason  #2.  Easy  access  to  illicit  and  counterfeit  beers  in  the  off-trade  segment(supermarts, sundry shops etc)  may  fuel the decline in legal  beer  volume  –  a can of legal  beer  could  cost  up  to  50-70%  more  than  illegal  ones.  Our  recent  channel checks suggest that this phenomenon is growing in prevalence in West Malaysia and is giving rise to  concerns. Demand for mainstream beers (Tiger and Carlsberg Green Label) may slow down as price sensitive drinkers switch to illegal beers.

Reason #3.  Cannibalisation of mainstream beers could occur if  the drinkers become more  discerning,  causing  overall  MLM  volume  to  contract.  We  think  that  “smart drinkers”  will  help  fuel  the  growth  of  premium  and  super  premium  beers  (eg Heineken,  Asahi,  Kronenbourg)  as  they  choose  “quality”  over  “quantity”.  Also,  this segment should continue to thrive as drinkers  in this segment  are typically from the high income bracket  and  who are less  price sensitive. Premium and super premium brands – which can cost up to 20-40% more than mainstream brands - now make up ~20% of total sales volume vs ~5% in 2007.

Reason  #4.  Normally,  during  a  major  football  event  (FIFA  World  Cup  and  UEFA European Championship),  on-trade beer  sales  (pubs, bar, coffee shops etc)  tend to spike  up  on the back of  additional promotion  campaigns  by  brewers.  These will get supporters  to  flock  to  neighbouring  pubs  and  coffee  shops  to  watch  their  favourite teams  in action. Typically,  beer sales  increase by 20-30%  vs average monthly sales during this period.  However, this  may not be the case  for  FIFA World Cup  2014,  as the event this time will be held  in Brazil and  the  live matches  will be  televised  here between  11pm  and  10am  , which are hours  that  coincide  with  Malaysians’  working hours. This may douse Malaysian supporters’ fervour in watching the matches.

Reason #5.  In conjunction  with  Visit  Malaysia  2014,  we  can  expect  greater tourist arrivals this year.  However,  we do not think that there will be  a major spillover effect on the beer industry. As observed during Visit Malaysia 2007, the 20% spike in tourist arrivals did not translate  into  a  stronger  MLM volume  growth  (+4%  vs  the  average “normal” growth of +1%  from 2000  to 2006). The  slight uptick  came primarily  from  a period  of  zero  excise  duty  hike  (see  Figure  3).  Hence,  we  are  of  the  view  that Malaysia is not a  popular  destination for beer tourism,  given that most of the beer offerings here are mainstream international brands.

What to expect?  Currently, our economist is projecting  private  consumer spending to  grow  at  a  more  moderate  +5.6%  pace  in  2014  vs  +7.6%  in  2013.  This  will  be supported  mainly  by  spending on  non-discretionary items  (for full report, click here: 
Economic Highlights  -  Real GDP Improved In The 4Q, Growth To Be On A Firmer Footing In 2014). Observing a parallel correlation between the growth of MLM volume vs private consumer spending (see Figure 4), we think 2014’s beer consumption may also  experience a sharper  than expected  slowdown instead  of the +1% growth  we projected  earlier.  Hence,  we  cut  our  MLM  volume  growth  estimate  to  -5%,  but  we retain  our  FY15  forecast  of  +1%  growth. We  think  consumers  will  eventually  grow accustomed  to  the  higher  cost  of  living  by  next  year  and  start  to  spend  again  on discretionary items,  unless the Government decides to increase the excise duty on beer in the Budget 2015, which may then cause demand to shrink.

The only bright spot
Although  there are some  setbacks  to beer demand  over  the short term, we expect the  brewers’  profit  margins  to  improve  in  2014  (50-100bpts  from  2013).  This  is premised on: i)  lower  raw material cost, ii) growing premium brand  sales,  and iii)  the typical 2-3% annual increase in average selling prices (ASP). Raw materials make up 3-6%  of  total  cost,  and  we  observe  that  the  prices  of  wheat  and  malt  barley  have declined by  23%  and 20%  respectively  since Jan 2013  (see Figures  5 & 6).  Hence, this  should  benefit  Guinness  and  Carlsberg,  although  not  substantially,  as  raw material is not a major  cost  component  (beer taxes  make up  50-60% of total cost).Also,  the  growing  trend of consuming  premium and super premium  beers  plus  thetypical  2-3%  pa  rise  in  ASP  may  help  to  mitigate  the  overall  deterioration  in  MLM volume this year. 

Forecasts & risks
After  cutting  our  2014 MLM volume  assumption to -5% (from +1%),  while keeping: i) the  market  share  ratio  between  Guinness  and  Carlsberg  at  60%:40%,  and  ii)  our annual ASP growth assumption of +2%, we revise down Guinness and Carlsberg’s 2-year prospective earnings by 3-8% (see Figure 7).The  key  risks  to  our  forecasts  include: i)  stronger  sales  volume,  and  ii)  lower -than expected opex.

Results preview
Guinness  and  Carlsberg  are  due  to  announce  their  4QCY13  results  on  20 and  21 Feb respectively.  For Guinness, we expect weak y-o-y performance (Rev: -10%, NP: -9%)  on  the back  of  softer  beer  demand,  but  there should  be  improvements q-o-q (Rev: +19%, NP: +22%) given that: i) this year’s Chinese New Year (CNY) fell earlier ,in  Jan  vs  Feb  in  2013,  which  would  drive  festive  beer  sales  and  ii)  sales  w ill experience a seasonal rise during the Oct-Dec period. For Carlsberg, we also expect stronger  q-o-q performance  (Rev: +20%, NP: +22%), but unlike Guinness, its y-o-y figures  (Rev:  +26%,  NP:  +16%)  should  be  better  in  comparison  with  its  weakperformance in 4QCY12.

Valuation & recommendation
Following  the  downward  revisions  in  earnings,  we  reiterate  our  SELL  call  on Guinness,  with a new  FCFF-based  FV of MYR13.49  (from  MYR15.19). This  implies FY14/FY15 P/Es  of 19.4x/18.0x  respectively,  after  incorporating  a higher WACC of 8.5%  (from  7.8%)  as  we  adjust  our  capital  structure  assumption  to  an  equity:debt ratio  of  80:20  (from  70:30).  This  is  because  Guinness  has  been  paring  down  its borrowings  and  there  are  no  indications  of  any  potential  capital  management initiatives. Our terminal growth (TG) assumption for Guinness remains at +2.5%.Post-earnings  revision,  Carlsberg  remains  a  SELL,  with  a  new  FCFF-based  FV  of MYR11.01 (from MYR11.31), which implies FY14/FY15 P/Es of 19.7x/18.3x,  with our WACC and TG assumptions unchanged at 8.1% and 2.5% respectively.

Our divestment case is primarily premised on their stocks’ rich valuations and waning yield appeal. The dividend return spread between Guinness and Carlsberg vs the 10-year  MGS yield has narrowed to only 30-40bpts vs the  historical  10-year average of 280-290bpts (see Figure 8 & 9). We opine that there is still some downside  risk even though the share prices of both stocks are down significantly  from last year’s  peaks  (-30-45%).  Hence, we retain our UNDERWEIGHT recommendation on the sector.

Source: RHB