Takeover fever in the brewing industry may help explain why Tsingtao Brewing (0168.HK) shares currently command a premium price, but shrinking margins and high capital spending levels suggest that the company’s earnings might not be sustainable.
Tsingtao beer may not have quite the same level of name recognition as Budweiser or Heineken, but nevertheless it has become one of China’s best-known consumer products, quaffed from Australia to Finland. But the outlook for the Tsingtao Brewery Co.’s (0168.HK) earnings may not be as upbeat as are the consumer reviews of the beer it brews. What’s amiss? In contrast to Jiangsu Yanghe Brewers (002304.SZ), a company to whose upbeat outlook we drew attention on AlphaNow early this year.
Tsingtao’s operating margins have been declining steadily, from 10.3% in the six months ended June 30, 2011, to 9.1% in the most recent six-month period, ended December 31, 2011. (The company is expected to report earnings for the just-completed semiannual period on August 13, 2012.) Whereas Jiangsu Yianghe sells not only beer but also other spirits – which command higher prices and margins – Tsingtao’s fortunes are tied to the beer market. That means that there is little to offset the impact on its margins of the soaring cost of barley, which broke above the psychologically-important $5 per bushel level last year and which shows no signs of retreating any time soon.
When margins fall, the only way to boost profits is to increase the volume of products sold. Logically, therefore, Tsingtao has responded to the jump in its raw materials costs by investing in new production facilities, and specifically by acquiring Shandong Xin Immense Brewery and Hangzhou Zijintan Wine Co. early in 2011. But highly motivated buyers, like Tsingtao, risk overpaying when they make acquisitions, and given the $2 billion spike in goodwill on Tsingtao’s balance sheet last year, there’s a chance that that is what the company has done in this case. Moreover, new production facilities tend to mean higher capital spending – and that, too, is just what has been seen at Tsingtao, which has increased its capital expenditures in each of the last four semiannual periods. Indeed, in two of the last three six-month periods, capital spending has exceeded cash flow from operations, a classic warning sign that a company’s earnings might not be sustainable at their current levels. In the most recently-reported six month period, when the company had a net cash outflow from operations of 255 million Chinese yuan (CNY), it still devoted CNY1.3 billion to capital spending.
Until recently, at least, Tsingtao’s stock had been relatively resilient, and even after a large decline, was still up 3.8% for the year at the end of the second quarter. That is when the company’s chairman, Jin Zhiguo, stepped down from his post to become honorary chairman. The company attributed his departure to health reasons, and named Sun Mingbo as his successor. That wasn’t the only major piece of news involving Tsingtao last month: the company’s third largest shareholder, Chen Fa Shu, sold part of his stake in the company at what Reuters news calculated was a discount to its market value. (For more on these developments, please see this Reuters news story.)
Tsingtao’s shares currently trade on the Hong Kong Stock Exchange for about $45.75 Hong Kong dollars, a significant premium to what StarMine models calculate to be its intrinsic value. To justify its current share price, Tsingtao would need to have a market-implied forward earnings growth rate of 13% annually for the forthcoming 10 year period. That kind of growth, if Tsingtao was able to achieve it, would put it in the 90th percentile in its sector. Accomplishing that feat might be a bit of a stretch, given that the company is a mature business (founded more than a century ago) operating in a low-margin part of the industry and facing higher raw material costs. Indeed, StarMine calculates Tsingtao’s SmartGrowth rate as closer to 10% annually (by intelligently adjusting for inherent analyst biases) over the coming decade, implying that a stock price of HK$35.50 may be closer to fair market value. This explains why the stock has such a poor StarMine Intrinsic Value (IV) model score of 4.
The premium at which Tsingtao appears to trade today may be due, at least in part, to the amount of consolidation underway in the brewing industry at present. Only today, for instance, Heineken (HEIN.AS) announced an offer to acquire Asia Pacific Breweries (APBRF.PK) for 50 Singaporean dollars per share, or S$5.1 billion. That ignites a bidding war for ownership of the Southeast Asian entity that will pit Thai and Japanese bidders against Heineken. Clearly, companies in the region are viewed as attractive acquisitions, and given that Tsingtao has 6 billion Chinese yuan on its balance sheet, this may be contributing to the company’s premium valuation. (While foreign bidders couldn’t acquire Tsingtao outright, they might still be interested to pay a premium for a stake in the company.)
When judged solely on its own merits, however, Tsingtao is on shaker ground, given the relatively lackluster earnings quality (the company has a low StarMine Earnings Quality (EQ) score of 20), declining margins and its hefty capital spending levels.
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