#$sbmry

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Kris Rosemann contributed to this article.

Shares of newsletter portfolio holding Altria continue to rise on news of the mega deal between AB-InBev and SABMiller.

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On October 13, SABMiller and AB-InBev announced that they have agreed in principle on the key terms of a possible recommended offer to be made by AB-InBev. The deal consists of an all cash offer of £44 (~$67.90) per share for ~59% of all SABMiller shares, not owned by the company’s two largest shareholders, Altria and the Columbian Santo Domingo family via BevCo. This represents approximately a 50% premium to SABMiller’s closing price on September 14, the last day before speculation of a takeover reemerged. All calculations have been made using October 12 closing prices.

The remaining 41% of SABMiller shares, approximately 27% of which is owned by Altria with the balance being owned by the Columbian Santo Domingo family via BevCo, are subject to these two entity’s election of a partial share alternative (PSA). The PSA consists of .483969 unlisted shares of the newly-formed company, “NewCo,” and £3.788 (~$5.85) in cash per share, the equivalent of £39.03 (~$60.23) per share, or a 33% premium to SABMiller’s closing price on September 14. The premium allows these two shareholders to receive a higher stake in the combined AB-Inbev-SABMiller transaction than they otherwise would have in the event of a merger-of-equals where no premium was granted at all. 

As for why the offer for the PSA was not as large as that granted to the other SABMiller shareholders, we suspect Altria and the Columbian Santo Domingo family via BevCo waived part of the premium such that a sweeter offer could be given to the remaining SABMiller shareholders in order to iron out any dissenters to facilitate the transaction, while not requiring the higher offer to come directly from AB-InBev shareholders, which may not have happened. It stands to reason that Altria and the Columbian Santo Domingo family via BevCo believe that they will recoup the “missed” premium over the long haul, as competitive strengths and synergies resulting from the transaction offer a more enticing long-term picture than that of a standalone SABMiller, a view in which we agree.  

The structure of the PSA also speaks to a long-term focus by the two largest SABMiller shareholders. The shares distributed to Altria and the Columbian Santo Domingo family via BevCo will become restricted shares of the newly-formed company, “NewCo,” which is expected to be incorporated in Belgium. Unlike the shares of “NewCo” that will belong to former AB-InBev shareholders, converted on a one-to-one basis, the PSA shares will have the following characteristics: the PSA shares will be unlisted and not admitted to trading on any stock exchange; shares will be subject to a five-year lock-up after the deal closes; the shares will be convertible to ordinary shares of the newly formed company on a 1-for-1 basis at the end of the five-year lock-up; and the shares will have equivalent voting, dividend, and director nomination rights as ordinary shares.

In order for a formal transaction to be agreed upon, the board of SABMiller must unanimously recommend the all-cash offer, shareholders accept the deal, and SABMiller’s two major shareholders--Altria and BevCo--elect for the PSA. In the proposed transaction, AB-InBev has agreed to a reverse break fee of $3 billion payable to SABMiller, should the transaction fail to close as a result of the failure to clear regulations or not receiving approval from AB-InBev shareholders. In addition, the UK Takeover Panel has extended the relevant Takeover Code deadline to October 28 to enable both parties involved to continue to discuss the terms of the deal, as requested by SABMiller.

Altria has said that it is pleased with the development and looks to work constructively with both parties moving forward. We’re viewing it as a win for the Dividend Growth Newsletter portfolio and Best Ideas Newsletter portfolio holding. Altria not only is getting a heightened stake in “NewCo” thanks to the premium offered by AB-Inbev, but the stronger “NewCo” will be able to garner increased pricing power and operational synergies simply unavailable on a global stage by the standalone SABMiller. Altria will hold approximately 11% of “NewCo,” by our estimates, and while its stake will be tied up for at least 5 years, the company’s financial flexibility continues to be augmented by its holdings in the alcoholic beverages space. Altria remains one of our favorite dividend-paying corporates.

Beverages - Alcoholic: BF.B, BUD, SAM, BORN, CCU, STZ, DEO, FMX, TAP

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If you can't beat 'em…buy 'em out. That's the approach Big Beer is taking in combatting the rise of microbrewing. Anheuser-Busch InBev (BUD) announced last week it would be buying 10 Barrel Brewing Co., a microbrewery based in Bend, Oregon. This follows BUD's move earlier this year to buy Blue Point Brewing Co.

It's easy enough to see BUD's rationale. Americans are drinking less beer than they used to, though they're trading up in the craft beer they do buy. While total beer sales were down 2% last year, craft beer sales rose 17%.

Will this strategy work for Big Beer?

Let me answer that question with a question of my own. Do you remember Killian's Irish Red? I used to love that beer. It was a trendy craft brew about 20 years ago.

You never really see Killian's any more. When drinking independent craft brews became the defining image of hipsterism (well, that and growing a luxuriant beard), Killian's association with Molson Coors (TAP) made it distinctly unhip. The brand has slid into irrelevance.

And then there is my favorite go-to beer: the Spoetzl Brewery's Shiner Bock. In the late 1990s, no self-respecting college boy in Texas would be seen drinking Bud Light. It was Shiner Bock or nothing. 

The popularly of Shiner led to imitations—most notably BUD's Ziegenbock, marketed as “for Texans by Texans.”

Ziegenbock isn't a bad beer. But it's always been seen as a cheap imitation…and that is marketing death when selling an upscale product.

This brings me back to the problem facing Big Beer. Anheuser-Busch InBev, Molson Coors and SABMiller (SBMRY) can compete based on quality and variety. Hiring new brewmasters  and letting them experiment like mad scientists could easily create beers that rival Boston Beer (SAM), Spoetzl and the legions of brewpub startups across America.

The problem is one of marketing and—to a lesser extent—economies of scale. Craft beer has become a luxury good subject to the changing whims of fashion, and brand reputations are fragile. When your brand is associated with the regular working man, it loses its cachet and it's hard to convince the fashionable to pay up for them. And this doesn't just apply to blue-blooded patricians. The bearded hipster wearing “vintage” clothes from a thrift store can't be seen drinking a Bud Lite either. It violates their anti-establishment ethos.

Another issue is economies of scale. The beauty of Big Beer operations is their massive and efficient production and distribution. But this goes completely out the window when you buy a locally-produced microbrew. Mass producing it and selling it nationally—or globally—kills the “buy it local” vibe that made it popular to begin with. But keeping it local neutralizes Big Beer's marketing and distribution power.

Could BUD and the rest of Big Beer take a play out of Warren Buffett's book; buying a company outright but leaving its management in place and maintaining a low profile? Maybe. But it's hard to see regional microbrews having much of an impact on the bottom lines of companies with tens of billions in annual sales.

So, what are investors to do here? From the tone of this article, you might think I was a Big-Beer bear. Nothing could be further from the truth. I'm actually a major long-term bull in Big Beer because of its exposure to emerging markets. As I wrote in July, BUD gets about half its sales in Latin America, while SABMiller and Heineken (HEINY) get a disproportionate amount of their revenues from emerging Africa.

This year, exposure to emerging markets has been a major negative, particularly since the dollar began to aggressively rise late this past summer. But if you believe, as I do, that emerging markets represent the better long-term bet, then Big Beer remains one of best long-term investments to make on any significant pullbacks.

Disclosures: Long HEINY.

Charles Lewis Sizemore, CFA, is the chief investment officer of the investment firm Sizemore Capital Management. Click here to receive his FREE weekly e-letter covering top market insights, trends, and the best stocks and ETFs to profit from today's best global value plays.