ABI and SABMiller: They Have An Agreement, At least in Principle

FILED OCTOBER 13, 2015

Dear Client:

Just when I wrote that the dance between ABI and SABMiller was not to be consummated into a full marriage -- and told everybody at the Constellation Beers party at NBWA that it wouldn't get done by Wednesday -- we have this news breaking late tonight. Yes, SABMiller and AB Inbev have an "agreement in principle and extension of PUSU deadline."

That means they have come under the deadline of the UK authorities, and have agreed to continue formal negotiations to extend the deadline, but it doesn't necessarily mean they have a final deal. Here's the deal: The Altria guys, as they smoke their cigarettes in their boardrooms and run the numbers, as the largest shareholder, hell yes they want a deal and let's get it done yesterday, because we're not getting any younger. Maybe the Santo Domingo family does too but they've been less vocal. Meanwhile, the rest of the owners -- institutional investors and individuals and, yes, executives who own stock options -- want to hold out for more money. That's where we stand.

This is not surprising. If SABMiller had let the UK securities authorities kibosh negotiations, it would put them at a 3 month standstill at a minimum, infuriating Altria and possibly leading to a board upheaval and shareholder lawsuits. But by agreeing to continue to "negotiate", they keep everybody at the table, even if they still are billions of dollars apart.

Please stay tuned, because we will be watching this stuff.

DOJ LOOKING INTO A-B DISTRIBUTION INFLUENCE

Yesterday afternoon, Reuters reported that the U.S. Justice Department has started to investigate allegations that Anheuser-Busch is trying to reduce competition by buying distributors and impeding other brewers' route to market. We've been hearing about this for weeks. Several craft brewers in California have been jointly contacted by the DOJ and the California AG's office regarding vertical integration by A-B. One source told BBD, "The [California] AG is a little clueless about how the beer industry works" but the DOJ "seems to be much more informed." Will one or the other agencies intervene? These things take time. But the time the government makes that decision, these pending A-B branch deals will likely be long done.

In the past few months, A-B has made deals for five distributors in three different states. In California, recall, they entered into deals with Horizon Beverage Company in Oakland and ME Fox and Company in San Jose. For Colorado, they bought American Eagle Distributing in Loveland and traded their Kentucky operations for Standard Sales Company. And in New York, A-B acquired R. Ippolito Distributing in Staten Island.

Once a distributorship falls in A-B's hands, craft brewers allege, "they can't distribute their beer as easily and sales growth stalls."

After two of his distributor partners were snatched up by A-B in 2011 and 2012, Ninkasi Brewing CEO Nikos Ridge said he saw their "healthy sales growth quickly stall" and continue to decelerate until they found another set of wholesale partners.

"Our feeling was that we weren't getting the same level of representation," said Nikos with typical understatement. "We saw our trends drop and we have seen improvements since we've switched."

A-B's wholesaler purchases aren't the only thing antitrust regulators are looking into. An early investigation is being held over another set of claims from craft brewers that "A-B pushes some independent distributors to only carry the company's products," thus separating themselves from the craft industry. This is indeed shocking news.

An anonymous craft brewer executive said after A-B bought one of its distributors it "slowly but surely" began to shed any non-A-B products. "We're one of the last ones," the executive said. "We're at the mercy of a lot of big players." Reuters claimed they had similar conversations "with at least four other craft brewers."

A-B confirmed to Reuters that they are indeed talking to regulators. "Anheuser-Busch has been in communication with the Department of Justice and California attorney general's office about the transactions. We are working cooperatively to address any questions they have," a spokesperson said in an email.

Antitrust experts like Jonathan Lewis feel the craft brewers might have a case, but as Ringo Starr would say, "you know it don't come easy." Indeed. A-B typically prevails just by waiting them out.

Jonathan, an attorney at Hostetler LLP, estimates it will take A-B owning 50% of distributors in a given area for authorities to bring down the hammer.

ALL ABOUT ALIGNMENT, FROM THE LAWYERS AND ADVISORS BEHIND THE LINES

Ippolito Christon and Co's Monday morning session on deal-related alignment issues offered some interesting insights and caveats on the subject.

"Does alignment create or destroy value?" Ippolito's Andy Christon posited. The answer is - "it depends," for both suppliers and distributors.

He quoted Tony Magee's idea that "distributor alignment is an obsolete idea." Andy believes rather that it's "an evolving idea," and one that's "been around a long time." At least since his beginning in the business in the '80s, "suppliers have been promoting the concept of aligning distributors with their own purposes."

But alignment and its implications have gotten complicated by the groundswell of craft brands.

THE "WAVE" OF DISTRIBUTOR AGREEMENTS. A "wave" of distrib deals was kicked off this spring with two major terminations: First, Monster Energy Co. distributor rights were reassigned to the Coke network (some 200 A-B wholesalers had half of U.S. Monster volumes) for about 1 times gross profits.

Ther other major realignment around springtime was Constellation's termination of roughly six A-B branches. "I think the trade press reported that A-B received like $200 million for the terminated brand rights, which could about six times gross profit," said Andy. "Expressed in terms of a multiple like that, that's not a bad price but I'd be willing to bet … if you did the economic analysis, it was worth more than that to the party terminated, and to the parties who got the brand. That's the other side of the coin."

Ippolito's Karen Kovtun tallied the recent distributor deals per public sources: In 2014, distributor deals tallied some 38 million cases. The (MillerCoors distributor) Reyes deal in Cali alone was about 12 million cases; other than that it was fairly evenly weighted between A-B and other systems.

But 2015 wholesaler deals have dwarfed the prior year's: Phoenix/Beehive merger alone was 45 million cases, not to mention Reyes's 27 million case deal in Florida (Gold Coast), and the Coke-Reyes deal for 42 million cases.

But as for trends: The "big story here is the A-B branches: the swapping of and A-B buying more branches," said Karen. There's also a theme of jumping across state lines, distributors buying in other territories. She also mentioned the A-B Lakeshore Beverage deal in Chicago, which involved A-B-affiliated Hand family's purchase of non A-B brands, including Pabst, craft and NAB. In Arizona, Hensley, an A-B distributor, also picked up other brands.

CRAFT CONSOLIDATION: "THIS IS WHAT BEER DISTRIBUTORS WERE DOING 25 YEARS AGO." But of course we can't tally big deals without touching the craft brewer component. Andy says the deals over the last year or so represent a "significant percentage of craft." But because high growth in the manufacturing business requires significant capital to expand, and the family-owned nature of many brewers, these deals will accelerate. "This is what beer distributors were doing 25 years ago," he said (which is why Andy and co. got into this business).

BUT WHAT HAPPENS WHEN YOU HAVE TO DIVEST OF A POWER BRAND? It's no surprise that distributors hurt when they lose a power brand (Yuengling, Corona, Boston, etc.). Here's exactly why: "You're not able to shed costs as quickly as you lose volume [on a power brand], or the converse," said Andy.

They offered a hypothetical - but fairly typical - scenario: A 10 million case distributor at roughly 40 share in a good size urban market. Said distributor might have $51 million gross profit and EBITA of $16 million, which results in profit margin of 7.8% and EBITA per case of $1.60. But when you go to divest of a "power brand" from an operation this size, where power brand volume was 15% of distribs' total volume, gross profits dropped by 19%.

"In this instance when you lose a power brand, in year one, my prediction is that a 10 million case operation will lose 1/3 of its bottom line profit as result of not being able to shed costs to same extent, to make up for loss in gross profit," said Andy. (Moreover, some end up overpaying to replace these lost brands.)

That led to another caveat from the Ippolito team. Often presenters urged distributors to opt for fair market value in their dealings with small suppliers. Ippolito's Susan Massey said that even in the case of a startup, if the contract says they only have to pay 3 times gross profit to terminate, "even if it's a small brand, say 1% or less of your volume - take a look at that gross profit number ... look at the multiples. Let's say they're going to get 3 times gross - which sounds OK on its face. But look at the EBITA, they're going to lose their gross profit of $10 million in just two years; so 3 times gross is actually terrible in this situation because of the profit you're going to lose … it's fine to throw that in the contract in the beginning, but know that it may not be at all fair." Fair market value may be substantially higher than that.

(And to that point, Keith Hochheiser of Ettelman & Hochheiser later said: "The way I look at it with smaller suppliers, [if you say] you want to leave, fine, but pay fair market value - it's a disincentive to termination," because of layers and litigation to determine that value. "Smaller guys can't afford that battle, most of you guys can.")

SELLER CAVEATS: ON REPLACING GOLDEN CASES TO MAXIMISING PRICE. The E&H guys took the stage toward the end to offer some caveats to sellers. They've worked on the Monster termination with A-B distributors, The A-B/Blue Point deal, and more. They spoke on seller caveats and maximizing price and sales.

GETTING FAIR MARKET VALUE FOR NONALIGNED BRANDS. The first scenario they contemplated: "How does one sell nonaligned brands and still receive fair market value?" That has to start with "an analysis of distribution agreements and your local laws. … from the A-B agreement to MillerCoors agreement… there's so many times you can inadvertently trigger adverse consequences," said Gary. With the MillerCoors agreement, for example, "you just think of selling, you gotta give them notice." Local statutes demand the same level of attention.


Keith also cautioned against "compelled sales" in a realignment situation. "If you cement your transaction as wholesaler with a supplier and the word gets out, it's going to be hard to sell non-aligned brands for fair market value because everyone knows you're compelled to sell. So before you start trying to sell nonaligned brands, cement your deal with the supplier; but it's critical that that stays confidential."

REPLACING GOLDEN CASES. Another issue they touched: Sellers must replace profit from the loss of golden cases, right? Wine and spirits or nonalc could fit that bill, but "absent any level of protection, it's not unusual to see 1 times" [upon termination, as seen with Monster]. "But there are strategies where you can have close to franchise protection in NAs."

WINNING FORMULAS FOR BEST PRICE. As for a "winning formula to maximize price?" Start with the right price offering. For that, you "need not just a typical valuation," but also "understanding the value of your business to the buyer. It's more of an economist valuation than typical. And sophisticated buyers know about that modeling. You need the right valuation guy." On the other hand, "any sophisticated buyer has methodologies of eroding that price."

DO DUE DILIGENCE "CLEANSINGS." Part of protecting against that price erosion is identifying potential issues and being proactive. That's what Gary Ettelman calls "due diligence cleansing," and he gave the example of the A-B Blue Point deal, where a municipal issue arose. They learned about it early enough to deal with the municipality and get it resolved so that when A-B came in, it was good. But if they had to do that in the middle of the transaction, the deal might not have closed, or for a substantially lower price.

And finally, re: brand sales: don't ever assign your distribution agreements. "Assign your distribution rights, but not agreements," Gary said. Under law, when you assign agreements, you're not released of obligations; you're becoming a guarantor for new distributor.

AND OF COURSE, AN SAB/ABI WEIGH IN: We haven't been in a session yet that didn't mention MegaBrew, this one non-exempt. Andy offered a caveat to the potential ABI/SAB deal: "Will any of the domestic brands perceived to be part of MillerCoors be exempted from a [likely] DOJ restriction on ABI buying the MillerCoors business in this country? Nobody doubts that would be prohibited." But he points out that "MillerCoors also controls a lot of 'non-mainstream brands' that would be of great interest to A-B and their distributors, including Leinenkugel's [and other] Tenth and Blake brands." And "I don't know that it's clear that those would be restricted in terms of a U.S. acquisition by A-B," he said.

Until tomorrow, Harry

"A hero is no braver than an ordinary man, but he is braver five minutes longer." - Ralph Waldo Emerson

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