DOJ Vs. AB InBev

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After working for over a year for AB InBev (NYSE: BUD) I realized not only how good the company was for making acquisitions and cutting costs but also how smart it was at using its high share of the market to increase prices. The company's results speak for itself, its EBITDA margin is 39%. Such great profitability is achieved through dominant market position in many of the markets where the company operates (such as Brazil or Argentina). In those markets, the company can achieve better pricing and lower fixed costs per hectoliter than its competitors. If AB InBev had the same market dominance in the US as in Brazil or Argentina, then the company would be one of the most efficient cash machines in corporate history.

Thinking of all the above, I do realize that the Department of Justice (DOJ) had a point when it launched a legal challenge to BUD's proposed acquisition of Grupo Modelo (NASDAQOTH: GPMCY), owner of Corona and other brands. Clearly, the challenge is largely based on beer prices. The DOJ says Modelo, by refusing to follow BUD's lead in pushing up US prices, has helped keep the market competitive. Raising beer prices is great for the industry and bad for consumers but competitors are also worried. In their case the cause for concern is related to the increased distribution difficulties that they may suffer if AB InBev would dominate the market; after all, beer is mainly a distribution business and the company has a history of blocking competitors around the globe.

When DOJ's allegations were filtered to the press, share prices fell for everyone involved in the deal. AB InBev and Modelo dropped 8% and Constellation Brands (NYSE: STZ) (which would have gained full control of the joint venture that distributes Modelo’s brands in the US, had the deal gone through) lost more than 17%.

AB Inbev has three options.

(1) It could take on the mighty DOJ. They had hoped to persuade the authorities that Constellation, as the sole distributor of Modelo’s beer, would have control over pricing. The DOJ disagreed but the judges might not. An army of lawyers will no doubt earn a large fee for trying to persuade them.

(2) The company could change the deal to smooth the DOJ’s concerns. This is possible, but it will not come without economic and strategic consequences. For example, BUD could potentially offer to sell production facilities in Mexico and the distribution venture in the US. That said, the US accounts for about a quarter of Modelo’s revenues, so getting rid of the entire US business would become seemingly expensive at the deal's current valuation.

(3) More radically, AB Inbev could drop the deal at once. It would be losing $600 million in potential synergies, but at least, by dropping the offer, the company would dissipate all uncertainties surrounding the matter. After all, BUD is well known to close a deal only if it is a great deal. Nevertheless, walking away would leave the question of what AB InBev is to do with the 50 percent of Modelo it already owns.

My educated guess is the following: BUD will go for a mix between (1) and (2). I don't think dropping the deal is in the cards for AB InBev's ambitious management and controlling group. I am sure the company will arrive to get to close a deal with the DOJ where they will make some core concessions in exchange for the deal to be completed more or less as planned. I would go long on BUD and I would also go long on US beer prices.


Fool blogger Federico Zaldua does not own shares in any of the companies mentioned in this entry. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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