Heineken's (HEINY) deal with China Resources Beer is an interesting move. Despite working hard to build its own distribution and brewing capacity in China, the Dutch brewer has struggled to grow organically. The partnership with China's biggest brewer means they'll gain an insightful ally that knows the market. As a whole, Heineken has done well within the brewing industry in regards to maintaining earnings growth. Still, I worry that the rather slower macroeconomic state of the industry will have adverse effects on Heineken's long-term bottom line. Principally, big brewers are getting forced to market far more than they used to in order to derive growth. It's already beginning to show in operating income, as the company is getting pushed to increase its marketing initiatives to drive gains.
In many ways, the fight to gain supremacy in China is a fight to gain a foothold in one of the last big marketplaces for new beer sales. It's a fight that Heineken has struggled with on its own. Globally, they're one of the last big companies that seem capable of going head to head with Anheuser Busch-Inbev (BUD) . The two have been duking it out in South America, with Heineken making headwinds in Brazil. Ironically, BUD has suffered from the same trend that's eerily lurking in the minds of every big brewing establishment: people are shifting away from beer. But we'll get to that later.
To their credit, performance has been stronger than others
Some were critical of Heineken's recent earnings coming in below expectations. I say analysts expect too much. When you compare Heineken's financial performance to that of rivals like Molson Coors (TAP) , they're doing well. Molson's beer sales are such a problem that they're trying to save themselves with marijuana for crying out loud. Anheuser Busch, the big thorn in everyone's side, suffered revenue declines of more than 3% in the United States market. It's a problem facing almost every brewer these days. Heineken's overall strength is actually pretty good compared to many others like TAP.
Heineken's sales were up everywhere in the first half of the year; with the exception of a 0.1% decline in the European market. Annually, revenue growth has remained positive albeit a little sporadic year to year. The company has also been consistent in increasing gross operating incomes annually, with a 5.83% increase in fiscal 2017. Net income growth was sour in 2016, but other than that the 5 year trend has been overwhelmingly solid, with a 25.65% increase in 2017 to $1.94 billion. Even in the weaker years, Heineken returns healthy earnings per share.
While I can credit Heineken on doing well in a rather slower marketplace than years past, one must remain vigilant on the effects of the shifting consumer landscape. Heineken's operating income fell 2.9% in the first half of the year. The company made good on growing net profits by 3.8%, but there's clearly a squeeze happening.
China could open opportunities, but it's important that global growth not eat into operating income
Heineken is taking a 40% stake in China Resources Beer for $3.1 billion. The controlling company of CRB, China Resources Enterprise, is taking a 0.9% stake in Heineken for $537.5 million. Overall, this does lower Heineken's overall costs for the deal. It also helps lock Heineken in with a company that already has the distribution channels in China. This could, perhaps, help the company move its own brands to a bigger audience while also gaining them exposure to China's cheap beer brands. While I like all of this, we're still talking about an industry with changing preferences. Chinese beer consumption has declined since 2013. It seems to be a global trend as drinkers are opting for spirits and wine. Perhaps the collaboration of these enterprises can help to increase sales, but it's not a sure thing.
Take for instance Heineken's duel with Anheuser Busch in Brazil. The top 2 brewers are in an all out war; and it's eating into their margins. The company bought out the Japanese owned Kirin Holdings in Brazil which had been losing against BUD. They then pumped big time marketing into the area, and drastically grew sales. At the same time, the expenses of this expansion have eaten into their profitability.
It's a problem that brewers large and small are facing. I recently wrote a whole piece on Boston Beer Co's (SAM) woes over the costs being incurred to drive gains in sales. Who's to say that the same issues won't arise in China? Consumer preferences are clearly shifting as these big brewers struggle to constantly produce higher gains for shareholders; and it's apparently an international trend. Will Heineken's investment lead to an ever increasing marketing budget to attempt to drive Chinese consumption higher? As part of the deal, Heineken is selling its Chinese operations to China Resources Beer, while licensing its branding to them. This means Heineken is no longer responsible for its 3 breweries there, and will essentially be moving its labels through a third party. In a way, as much as the company is expanding, it's also throwing in the towel in order to lower its costs. This speaks volumes about what the potential in China has been like thus far. It makes me nervous.
On the plus side, you're going to see Heineken free up its operations in the country and license the branding to a company that is successfully selling within the country. On the negative, beer sales are still in decline; meaning they just spent billions on something that might not yield what they want. I can't justify this move as a reason to buy in. Some have already cited the fact that wealthier Chinese groups want craft beers and whiskey, not Heineken. Because of all the changing preferences, it's tough to get a clear picture of where things are heading in China.
Global operating income is still getting pressed, and that worries me. The company has already lowered its guidance for margins in 2018; indicating the effects of higher sales efforts globally. Even if the company hits forecasts of $2.47 per share, it gives the stock a forward P/E of around 21. I don't see enthusiastically paying that price premium for a stock in what is becoming a lower margin industry.