Overview:

We believe Carlsberg A/S represents an attractive long investment over a 24 month period with meaningful upside catalysts and limited downside at current prices.

Carlsberg is one of the largest global beer businesses in the world (4^th largest brewer globally behind ABI, Heineken and SAB Miller). The company is based in Denmark and listed in Copenhagen under the ticker CARLB DC. Liquidity is not an issue with 3 month average dollar volume traded of USD ~$35M per day.

We believe Carlsberg is overlooked by investors due to: (i) its listing in Copenhagen, (ii) lack of meaningful market share in North America and (iii) their poorly timed and ultimately “bad” acquisition of their Russian beer business, Baltic Beverage Holdings (acquired from Scottish & Newcastle in 2008).

However, global beer businesses are high quality consumer staple businesses with strong brand equity that operate in a largely consolidated industry with only a handful of scale players. These businesses have very high staying power, extremely high barriers to entry and scarcity value (Suntory probably viewed BEAM as having similar scarcity value in an adjacent global branded business).

We believe that Carlsberg is finally lapping the headwinds to the Russian beer business which will face easing comps in 2014 and is taking the right steps to rationalize their under-earning W. Europe beer business.

Finally, Carlsberg A/S holds a crown jewel asset in their Asian beer business that would likely command a very high multiple in the private market, making the implied valuation of the stub beer business even more attractive.

Business Overview:

Carlsberg today has three operating segments W. Europe (58% of revs / 47% of profits), E. Europe / Russia (27% of revs / 37% of profits) and Asia (15% of revs / 16% of profits).

Carlsberg brews their flagship Carlsberg beer and nearly 350 other brands or variations tailored to local markets in places like France, Croatia, China, Ukraine, etc.

Carlsberg brands: http://www.carlsberggroup.com/BRANDS/Pages/default.aspx

The Opportunity:

W. European Margins:

Carlsberg’s W. European operating margins are currently ~13.5% vs. peers at 16-22%. The company is embarking on a multi-year program to improve operating margins by at least 250 bps. Incredibly, Carlsberg has never integrated their breweries and supply chains. Management has outlined three priorities to boost margins: (i) one integrated supply chain, (ii) one common business process model (new SAP system enabling this), and (iii) one common IT platform. This supply chain presentation from December 2013 spells out the transformations the company is making.

http://www.carlsberggroup.com/investor/downloadcentre/Documents/Other%20Presentations/Supply%20Chain%20and%20BSP1%20day_03122013_FINAL.pdf

We believe these changes are straight forward blocking and tackling that other global beer companies have completed years ago. This gives us confidence that 250 bps of margin improvement is not only achievable but could be conservative given the margin profile in W. Europe of peers.

250bps of W. European margin improvement would reduce the ~14x 2014 P/E multiple to ~12.4x making the investment even more attractive relative to HEIA NA (near 52 week lows) at ~15.7x and ABI at 19x forward earnings.

Stabilization and Growth of E. Europe / Russian Beer Business:

The Russian beer business accounts for about 40% of Carlsberg’s profits and has been a fairly terrible business for the past three years. The global recession coupled with regulations meant to curb alcoholism have eroded the profit pool. The good news is that Carlsberg (with a stable ~40% market share) is the healthiest of the Russian players and regulations are largely behind us setting up favorable comps for 2014 and beyond.  Carlsberg has faced the following regulatory challenges: (i) 200% increase in excise tax in 2010, (ii) advertising ban in July 2012 and (iii) ban of beer sold through kiosks (beer vending machines) in January 2013.

The Russian government has not announced any material restrictions for the past 2.5 years and the beer kiosk ban looks to be the “last shoe to drop” on the Russian beer market. The Russian government has indicated that they do not feel further regulatory changes are needed for the beer market.

Here is an article from 2013 that discusses the kiosk ban from 2013, the last meaningful regulation holding back this business which negatively impacted Russian volumes in 2013: http://online.wsj.com/news/articles/SB10001424127887323446404579010562098511876

2014 should be a year of favorable comparisons and a return to modest growth for the E. European beer business that has held Carlsberg back for three years.

The Asian Crown Jewel:

Carlsberg owns a collection of fast growing beer assets in Asia (China, Malaysia, Vietnam, Laos, Cambodia, etc.) that account for ~16% of profits today. These businesses are growing organically by low teens year-on-year and sport healthy and stable EBIT margins in the 18-19% range.

The beer business is North America, Europe and Latin America has largely consolidated while Asia has not. Given the fragmented nature of the market and high growth potential, we have seen many recent examples of M&A deals at high valuations for Asian beer assets.

Heineken purchased a controlling stake in Asia Pacific Breweries (maker of Tiger beer) for 16.8x EBITDA in 2012: http://online.wsj.com/news/articles/SB10001424127887324178904578339561232034242

KKR purchased Oriental Breweries for 11x EBITDA in 2011 from ABI in a favorable deal for KKR that included seller financing and a put option to sell the business back to ABI. ABI was motivated to do the deal to raise capital to pay down debt from their acquisition of Anheuser-Busch. There is recenty speculation that KKR would look to sell Oriental Breweries for a teens EBITDA multiple.

Allocating corporate overhead and D&A to Carlsberg’s Asian segment EBIT and applying 11-15x TEV / EBITDA multiple implies that you are paying just 7-8x 2014 EBITDA for the stub beer business vs. 9.4x forward EBITDA for Heineken (near 52 week lows) and 11.2x for ABI. While this exercise is theoretical, we think it is important to frame how cheaply you can currently buy the stub beer business in advance of any “self-help” restructuring efforts.

The continued growth of the Asian beer business should boost total EBIT by nearly 10% over the next 3 years based on our estimates even though it is a small portion of total EBIT today.

Valuation / Price Target

Carlsberg is currently trading for approximately 14x consensus EPS estimates for 2014. This compares to ABI BB at 18.9x, SAB LN at 18.0x, HEIA NA at 15.7x and TAP at 13.7x forward EPS.

Based on a return to low single digit revenue growth in the Russian beer business, low hanging fruit cost savings in the W. European beer business and continued strong low double digit growth in Asia, we expect Carlsberg to grow EBIT by ~10-11% over the next 3 years and EPS by ~15% over the same time frame as they use cash flow to delever the balance sheet. This compares favorably to ABI which is expected to grow EPS at a 12.5% CAGR over the coming three years according to consensus estimates, yet trades for nearly 19x forward EPS.

As Carlsberg executes on their turnaround and Russian headwinds abate, we could see the multiple re-rate to reflect the high quality nature of a global beer business. 15-17x 2016 EPS of DKK 57 would lead to a 50-70% return over the next 2 years or a 22-30% compounded return from today’s price.

Upside could exist in the W. European and Russian beer business if we see a moderate pick up the macro economic conditions there.

We see limited downside given the relatively cheap valuation on 2014 consensus EPS which does not give them full credit for the cost cutting opportunity or credit for the highly valuable Asian asset. If the stock traded down to 12x 2014 consensus EPS of DKK 42 we would see 13% downside. 12x is several turns lower than a market multiple today and represents an particularly low valuation for a consumer staple beer business. 12x is also a >10% discount to the current multiple afforded to TAP, the lowest multiple among the peer group.

We view 50-70% upside over 2 years and 13% downside as a very attractive risk / reward in this environment.

Management delivering on W. Europe cost savings over the next 24 months

Return to growth in the Russian beer business in 2014

EPS compounding at 15% leading to multiple re-rating

Modest recovery in European and Russian economy