The giant brewing company from Denmark has embarked upon a new chapter in it’s long history. The tough cost reduction has been implemented, but the cost discipline has been embraced by the company’s employees who will now need to focus on profitable organic growth, where there are many exciting opportunities in the beer industry’s new market segments.

Carlsberg Group is a story about expansion, where a brewer’s interest in and passion for beer launched a Danish export success. For breweries, it is primarily the largest breweries who are the most profitable – which Carlsberg is. With sales in Western Europe, Eastern Europe and Asia, the the brewer from Valby on the outskirts of Copenhagen is one of the world’s largest.

While previous management teams focused on on the size of revenues, the current management team of Carlsberg is more focused on optimising the value creation in the company. In 2018, the company raised expectations for the year’s profits twice – we don’t recall Carlsberg ever having done that before. The execution of the strategy has been impressive and profitability is increasing. This has released some financial resources that can now be used to turn the focus towards profitable sales growth.

Few would have expected it to come to this when the 24-year-old J.C. Jacobsen assumed control of his father’s brewery – and thus began building what would later become Carlsberg. The young brewer Jacobsen’s keen interest in research also led to the formation of the Carlsberg Foundation, which continues to own 75 percent of the voting rights and 30 percent of the capital in the company.

Carlsberg has been around for more than 170 years, and during this time it has grown through a combination of organic growth and acquisitions of other breweries. The discipline in which the company’s free cash flows are allocated have been tightened under the management of CEO Cees ‘t Hart, and CFO Heine Dalsgaard, and thus we expect the focus to be on creating organic growth. We find this to be an extremely positive approach towards creating real shareholder value in the brewery.

 Significant write-downs on goodwill on the balance sheet

Previous acquisitions have had differing degrees of success, and therefore Cees ‘t Hart has also written down the value of much of the goodwill resulting from some of these acquisitions. In total, the write-downs amount to a value of 14 billion Danish kroner, of which the most recent 4.8 billion was a write-down of the Baltika brand in Russia in 2017. With hindsight being 20/20, it is clear that the acquisitions were made at higher prices than the value of the underlying assets – however, it is worth noting that several of these assets currently hold significant market shares that Carlsberg can take advantage of in Eastern Europe, France and the western part of China.

Today, Carlsberg is the third-largest brewing company in the world. The European markets represent seven out of ten litres of beer sold and 70 percent of operating income, while Asia represents the remaining 30 percent. In Asia we also find Carlsberg’s largest single market, China, which consumes 16 out of every 100 litres of beer sold by Carlsberg around the world. Even so, the Chinese drink a mere 27 litres of beer per capita a year, which is less than half of what Danes consume. In 2018 Asia grew its operating income by an impressive 16 percent in local currencies despite significantly greater marketing investments.

Over the last three years, Carlsberg has been running a savings programme called “Funding the Journey”. Initially, Carlsberg stated that it would find savings of 1.5 to 2 billion kroner, which at the time amounted to three percent of revenue. This was later increased to 2.3 billion, but by the end of 2018, management reported that it had found savings worth three billion – the equivalent of four percent of revenue.

This is a testimony to strong strategic execution, and it has made us even more confident that management will succeed in cashing in on the potential for value creation that we see in the company. More than a billion Danish kroner of these savings have been used to invest in growth-promoting initiatives.

 The building up of a new and stronger corporate culture

As the cost programme’s name implies, funds needed to be found to finance the next steps of Carlsberg’s journey. Thus, 1 billion was re-invested into the company where Carlsberg, among other things, increased its marketing investments by 15 percent in 2018 – the equivalent of 700 million kroner or an increase of almost a whole percentage point from 7.8 percent of the revenue in 2017 to 8.6 percent. We like to see companies that are willing to invest in their business rather than focusing solely on the results in their financial statements, even if the economies of scale from the significant growth in revenue of more than six percent in 2018 were not fully reflected in earnings due to the increased investments – but we prefer to focus on long-term results and value.

While the Funding the Journey programme has concluded, we regard it as more of a first step towards a stronger corporate culture where the focus is on sales, profitability, returns on invested capital and free cash flows. These are precisely the areas that we believe all corporate cultures should be focused on.

In the context of growing free cash flows, Carlsberg has defined three areas that will drive the development – Carlsberg’s so-called ‘golden triangle’. Firstly, the company needs to sell larger volumes of beer. Secondly, Carlsberg needs to focus on increasing the proportion of each Danish krone from sales that Carlsberg can keep after deducting the production and logistics costs. Finally, Carlsberg needs to take advantage of its economies of scale to convert more of gross profits to operating income. The greater the efficiency, the more Carlsberg can invest in growing the business without the co-owners having to settle for lower operating margins. It sounds simple, as well as being very sensible.

Changing corporate culture, however, takes more than just changing management or management outlining some new objectives. It is a long-term process, but fortunately Carlsberg seems to have gotten off on the right foot. One of the ways that we believe one can promote a new corporate culture is to provide the employees with the right incentives – as the Deputy Chairman of Berkshire Hathaway, Charlie Munger, once said: “If you show me the incentives, I will show you the results”.

Management’s long-term variable incentives are composed of targets with regards to organic revenue growth, operating income growth, higher returns on invested capital and, finally, the development in Carlsberg’s share price compared to similar companies. This is in line with what we believe drives long-term value creation. In the upcoming strategic period, there will be more focus on sales growth.

 An English workhorse

Carlsberg is more than just the beer of the same name. It also includes Tuborg, and some Danes have almost religious beliefs in terms of whether they prefer Tuborg over Carlsberg – though as co-owners of both, we have no horse in this race. Carlsberg also owns the brands 1664 Kronenbourg, Grimbergen, Jacobsen, Baltika and many others. Thus, there are plenty of opportunities to support our company on a warm summer day or a pleasant evening with friends. Increasingly, Carlsberg is also selling non-alcoholic beers so that the designated driver for the evening won’t have to feel too left out.

In terms of financial reporting, Carlsberg is divided into three regions: Western Europe, Asia and Eastern Europe, and last year these represented, respectively, 50, 29 and 21 of every 100 Danish kroner in operating income. Three out of every four Danish kroner in revenue at Carlsberg are from markets where Carlsberg is the largest or second-largest. In the brewing industry, there is a strong correlation between market size and the opportunities for optimising operating income.

Western Europe is Carlsberg’s largest geographical area when measured by both the amount of beer sold and operating income. While Western Europe, generally speaking, is struggling with flat to slightly decreasing volumes of beer consumption, 2018 showed a decent growth in the amount of beer sold. It increased by three percent to more than 46 million hectolitres. In addition to being driven by Carlsberg’s hard work, growth was also sped along by a warm summer and the Football World Cup.

Since Western Europe is a mature market where volumes of beer sold do not change much, Carlsberg is focused on upselling to the consumers – for example, getting them to buy craft beer – so that Carlsberg can generate more value per litre of beer sold. All other things being equal, this requires Carlsberg to invest in the marketing of these products and in strengthening its presence in bars and restaurants. As a result, there is a strong focus on minimising the amount of resources spent on activities that do not promote the business. The highly focused British workhorse, Chris Warmoth, was made responsible for this region in the autumn of 2017, and we strongly believe that he will continue to follow through effectively as the journey to increase income continues. Chris Warmoth has previously held top positions in international consumer companies such as Coca-Cola, Heinz and Procter & Gamble.

 Presence in over 20 cities with a million or more residents in China

Carlsberg aims to narrow the gap that Dutch Heineken has in profitability. Heineken has operating margins of about 17 percent on the European market. In comparison, in this region Carlsberg has managed to increase its operating margin to 15 percent in the last year, which is a pleasant narrowing of the difference. We expect Carlsberg will achieve operating margins of 17 percent before 2022, driven by a greater volume of beer sold at higher prices and an optimisation of the value chain. This will also have a positive impact on the return on invested capital.

China is currently Carlsberg’s largest market in terms of volume, and it is also Carlsberg’s most promising market – we believe it will be possible to achieve double-digit growth in revenue and improving profit margins without having to make significant capital investments. The amount of beer consumed in China is not growing that much, and it actually fell in 2018, but due to its international brand, Carlsberg is competing on the market for “premium” beer where growth is higher. Across Asia, Carlsberg sold nine percent more litres of beer in 2018 than the year before, resulting in total sales of more than 31 million hectolitres in Asia.

In China alone, Carlsberg’s beer revenue grew by 15 percent, of which around half was due to higher volumes of beer sold and the other half from higher average sales prices. Carlsberg’s operating income, as mentioned, grew by 16 percent in Asia despite significant investments in marketing, which grew by 300 million kroner and increased the presence in China. Asia has the highest potential for generating earnings among Carlsberg’s three regions, even if this potential is slightly hampered by significant investments.

The management team in China, headed by Executive Vice President – Asia, Graham Fewkes, is focusing on expanding beer sales to more cities, which have led to significant investments. Carlsberg’s premium beer is currently being sold in more than 20 cities with populations of more than a million, and seven to eight new cities are expected to be added to this list each year. Carlsberg’s efforts in these major cities are focused on being present in bars and restaurants where Carlsberg, with its premium imported beer, allows the bar and the guests to bask in luxury with the expensive beer brands.

China is also the largest market for 1664 Blanc, which until 2015 was only sold in France. Sales of 1664 Blanc in China in 2018 grew by a massive 51 percent
– and this for a craft beer that has a sales price that is five to six times higher than the price of an average beer in China.

There are no indications that growth rates or earnings growth will mature in the near future. We therefore believe that there are significant opportunities for Carlsberg to maintain a minimum of ten percent growth in the Chinese market over the next five years. Within the first two or three years of being present in a major Chinese city, Carlsberg can achieve operating margins of an impressive 20 percent – and this is even including higher marketing costs than expected to remain high in the long term. When Carlsberg increased its marketing investments by 700 million kroner in 2018, 40 percent were earmarked for the Chinese market. In general, we believe that the investors and analysts are is underestimating Carlsberg’s long-term attractive opportunities on the Chinese market.

 Consolidation benefits Carlsberg

Eastern Europe, including Russia, is no longer the core part of Carlsberg that it used to be. However, in 2018, the market grew by three percent in terms of volumes of beer sold – the first time it has grown since 2007. Growth was boosted by the Football World Cup and warm summer weather. Carlsberg is still the market leader in Eastern Europe, where a consolidation recently took place when AB InBev acquired Efes. This means that the number of major players on the market has now been reduced to three. AB InBev is known for pursuing value growth by focusing on premium beer, and this is expected to have a positive impact on the total earnings that can be generated in Russia, where Carlsberg currently sits on the market’s entire profit pool.

The daily management team consists of the abovementioned Cees ‘t Hart as CEO and Heine Dalsgaard as CFO. Cees ‘t Hart joined Carlsberg in 2015 with significant experience within consumer goods – he has worked for consumer companies his entire career, including a long stint with Unilever in both Europe and Asia. Heine Dalsgaard was CFO at ISS, a Danish company, for three years before he joined Carlsberg in 2016.

We appreciate management’s increased focus on value creation. In 2018, Carlsberg managed to increase the return on invested capital (excluding goodwill) by more than five percentage points to almost 21 percent. In 2018, operating income grew by an impressive 11 percent in local currencies despite the previously mentioned 15 percent increase in marketing costs and other growth-promoting initiatives. Operating margins thus reached 15 percent, which was a bit higher than in 2017.

As part of the Sail’22 strategy plan that Carlsberg launched in 2016 (which included the Funding the Journey strategy), there was also an increased focus on profitability and being disciplined about how to allocate capital. The first step was to reduce the levels of debt, which at the time amounted to more than two years of EBITDA. Once the debt had been brought down, management intended to increase the distributions of capital to the shareholders once cash flows were set aside to finance the expansion of the business. Management’s target is for the debt to amount to somewhere between one and a half and two years of EBITDA.

With its 2018 annual report, Carlsberg announced a share buyback programme of 4.5 billion kroner, as debt had reached a level of under 1.3 times EBITDA. This is something that we appreciate, and we see it is a strong signal that the company is being more disciplined in how it allocates its free cash flows. On top of this, there was a dividend payment of 18 kroner per share, which is a direct dividend yield of almost six percent. The dividend buys you around three cans of beer, which is a significant increase in just a few years. In 2016, the dividend wouldn’t even buy you two.

New hirings needs to be approved by the executive board

The lower debt levels and annual free cash flows of more than six billion kroner provide Carlsberg with significant financial resources. We would prefer that these resources not be spent on major acquisitions. If acquisitions are made, we would prefer that Carlsberg buy breweries where it already has an ownership stake, just as it did in 2018. In 2018, Carlsberg increased its ownership stake in several breweries in Cambodia, Greece, Belarus and Portugal. There is less risk involved in buying more shares of an asset that you are already familiar with.

The financial resources can also be used to invest in Carlsberg’s growing focus on craft beer and non-alcoholic beers in addition to the draft beer system called “Draughtmaster”. There was impressive growth in craft beer in 2018 – an entire 26 percent – while non-alcoholic beer sales grew by 33 percent. Carlsberg has higher profit margins on these products, which for craft beer is due to higher sales prices, where non-alcoholic beers have the advantage of no alcohol taxes. Therefore, for every additional Danish krone in sales in these categories, Carlsberg gets a higher proportion of income.

While the cost-cutting programme Funding the Journey has been concluded, this is not the end of Carlsberg’s focus on optimising costs. We believe that the transformation of the corporate culture has taken root in the organisation, and if not, at least it reflects strong discipline that new hiring and capital investments must be approved by the management team.

For 2019, we expect operating income to grow at just under ten percent. This is not the same pace as in 2018, but it is however an indication that Carlsberg is expecting to pursue earnings growth despite an expected pressure on prices for raw materials amounting to two to three percent per litre brewed. Carlsberg is expected to pass on these additional costs to their customers.

We strongly believe that the strengthened strategic platform in Carlsberg is a great launching point for the journey ahead. With an increasing focus on generating higher returns on the invested capital and stable and growing free cash flows, it should be possible to continue to distribute cash flows to shareholders as Carlsberg sells more and more beer in Europe and Asia – whether they be with or without alcohol.