INDEPENDENT RESEARCH UPDATE 30th October 2017 by night Food & Beverages Fair Value DKK720 vs. DKK670 (price DKK730.50) SELL vs. NEUTRAL

Finalised on 27th October We are impressed with the company’s newly formulated strategy and Bloomberg CARLB DC Reuters CARCb.CO the effort to engage all employees into executing it. Although it will 12-month High / Low (DKK) 744.0 / 576.0 improve the company’s image, the business remains geared towards Market capitalisation (DKKm) 110,836 the low growth/declining markets of West and East Europe. Our Enterprise Value (BG estimates DKKm) 157,565 analysis of the Russian operations also highlights that it will not Avg. 6m daily volume ('000 shares) 257.1 Free Float 69.7% become a source of growth anytime soon. In our view the share price 3y EPS CAGR 17.0% has been running ahead of the pace of improvements and our Fair Gearing (12/16) 59% Value of DKK720 is below the current share price. We lower our Dividend yield (12/17e) 1.40% recommendation to Sell from Hold. YE December 12/16 12/17e 12/18e 12/19e  Carlsberg’s new management team has put together a coherent strategy of Revenue (DKKm) 62,614 63,591 65,430 67,446 efficiency improvements, re-investments behind core brands and growth EBIT (DKKm) 7,742 8,452 9,145 9,793 opportunities and improving returns. We believe the company is well on its way Basic EPS (DKK) 29.41 32.67 36.83 41.16 Diluted EPS (DKK) 25.44 32.39 36.48 40.74 to deliver DKK2.3m in efficiency improvements by 2018 which would trigger EV/Sales 2.50x 2.48x 2.34x 2.20x significant bonuses for the top 200 managers of the company. About DKK1bn EV/EBITDA 12.5x 11.9x 11.1x 10.3x is expected to be re-invested, but even then the company’s growth profile is not EV/EBIT 20.2x 18.6x 16.7x 15.2x going to change dramatically. We expect the company to achieve average organic P/E 28.7x 22.6x 20.0x 17.9x revenue growth of 3.3% over the 2017-2022 period compared with 2.6% over ROCE 5.3 6.1 6.8 7.4 2011-2016. After all, in 2016, 76% of revenues was from the stable European markets (60% West Europe and 16% from East Europe) and only 23% from the faster growing Asian markets.

733.3

683.3  is Carlsberg’s single largest market accounting for 15% of group EBIT. That is down sharply from 43% in 2009 as the Russian macro-economic 633.3 situation worsened, the government imposed measures to limit availability (e.g. kiosk ban) and affordability (e.g excise duty), and the key drinking 15-34 583.3 year olds group is declining. Furthermore, a lack of being in touch with market

533.3 developments and focus on short term profits rather than market position 26/04/16 26/07/16 26/10/16 26/01/17 26/04/17 26/07/17 26/10/17 CARLSBERG 'B' SXX EUROPE 600 lowered the group’s market share from 40% in 2009 to 35% in 2016. We believe that the market will not become easier. The government has still not reached its target of alcohol consumption at 7.5 litres pure alcohol per head (it is still 10.6l) so is likely, after the 2018 FIFA world cup, to increase again excise duties and further limit availability and restrict advertising. The macro-economic situation is improving but Russian consumers have been used to chasing price and the key beer drinking age group is expected to fall by 20% over the next 10 years. Furthermore, the recent proposed merger of the Russian and Ukrainian operations of Efes and AB InBev is likely to create a stronger number two who might have the ambition to challenge for a market leader position.

Analyst: Sector Analyst Team: Nikolaas Faes Clément Genelot 33(0) 6 11 12 44 44 Loïc Morvan [email protected] Antoine Parison Cédric Rossi Virginie Roumage, CFA

r r Carlsberg

Simplified Profit & Loss Account (DKKm) 2014 2015 2016 2017e 2018e 2019e Revenues 64,506 65,427 62,614 63,591 65,430 67,446 Change (%) 0.2% 1.4% -4.3% 1.6% 2.9% 3.1% EBITDA 12,561 12,614 12,484 13,194 13,814 14,429 EBIT 8,458 7,940 7,742 8,452 9,145 9,793 Change (%) -9.4% -6.1% -2.5% 9.2% 8.2% 7.1% Financial results (1,191) (1,531) (1,247) (1,073) (846) (681) Pre-Tax profits 7,267 6,409 6,495 7,380 8,299 9,112 Exceptionals (989) (8,506) 430 58.8 73.2 88.1 Tax (1,749) (849) (2,392) (2,157) (2,428) (2,565) Profits from associates 408 364 324 340 357 375 Minority interests (523) (344) (371) (639) (683) (731) Net profit 4,414 (2,926) 4,486 4,983 5,618 6,279 Restated net profit 5,496 4,557 3,881 4,941 5,565 6,215 Change (%) -4.8% -17.1% -14.8% 27.3% 12.6% 11.7% Cash flow Statement (DKKm) Operating cash flows 12,427 12,253 12,189 13,253 13,887 14,517 Change in working capital (799) 1,845 (5.0) 183 344 377 Capex, net (5,569) (2,735) (3,840) (3,815) (4,253) (4,384) Financial investments, net (1,746) 5.0 2,690 0.0 0.0 0.0 Dividends (1,897) (2,018) (2,453) (2,174) (2,783) (3,107) Other (3,412) (3,951) (2,688) (3,159) (3,200) (3,168) Net debt NM NM NM NM NM NM Free Cash flow 1,896 7,405 5,589 6,391 6,704 7,264 Balance Sheet (DKKm) Shareholders' funds 52,437 43,489 50,811 53,620 56,455 59,627 +Provisions NM NM NM NM NM NM +Net debt 37,039 32,516 26,592 22,035 17,757 13,225 =Invested Capital NM NM NM NM NM NM Company description Fixed assets 136,983 124,813 126,891 126,443 126,703 127,178 Carlsberg is the fourth largest brewer + Working Capital NM NM NM NM NM NM in the world, producing 116.9m hl of + Other 7,838 8,227 7,382 7,382 7,382 7,382 beer in 2016 and a further 21.9m hl of =Capital employed 117,312 103,137 97,195 97,656 96,722 96,027 soft drinks (mainly in the Nordic Total Balance sheet 136,983 124,813 126,891 126,443 126,703 127,178 countries). Carlsberg is focused on Financial Ratios Operating margin 13.11 12.14 12.36 13.29 13.98 14.52 Europe and Asia. In Europe the group Tax rate 27.86 28.00 33.00 29.00 28.00 27.00 is the largest brewer in Russia (15% of Net margin 8.52 6.97 6.20 7.77 8.51 9.21 EBIT), the (19%), ROE (after tax) 10.48 10.48 7.64 9.22 9.86 10.42 and . In Asia (28% ROCE (after tax) 5.20 5.54 5.34 6.15 6.81 7.44 of EBIT) the group holds a number Gearing 74.32 79.93 58.66 47.14 37.34 28.06 Pay out ratio 31.20 (46.92) 34.00 43.63 49.53 49.49 two position in Malaysia, is market Number of shares, diluted 153 153 153 153 153 153 leader in Western , and Data per Share (DKK) Cambodia and is the fourth largest EPS 28.85 (19.18) 29.41 32.67 36.83 41.16 brewer in . Restated EPS 35.92 29.87 25.44 32.39 36.48 40.74 Change(%) -4.7% -16.8% -14.8% 27.3% 12.6% 11.7% BV 344 285 333 352 370 391 Operating cash flows 81.22 80.33 79.91 86.88 91.04 95.16 FCF 12.39 48.54 36.64 41.89 43.95 47.62 Net dividend 6.48 6.48 7.20 10.26 13.13 14.67

Source: Company Data; Bryan, Garnier & Co ests.

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Carlsberg

Table of contents

1. Executive Summary – no quick ...... 4 1.1. Evaluating the corporate strategy ...... 4 1.2. And what about Russia? ...... 5 1.3. Key graphs executive summary...... 6 2. Investment considerations ...... 8 Key graphs investment case ...... 10 3. Valuation ...... 11 3.1. Peer comparison ...... 11 3.2. DCF valuation ...... 13 4. Business and operations ...... 14 4.1. Europe and Asia ...... 15 4.2. Key Countries: Nordics, Russia, VLC, China and Switzerland ...... 16 4.3. Scope to premiumise ...... 18 4.4. 5 brand market combinations is 30% of profits ...... 21 5. Sail’22 strategy plan ...... 22 5.1. Strengthening the core ...... 22 5.2. Revitalise the core beer business ...... 22 5.3. Transforming the Russian business...... 26 5.4. Excel in execution ...... 28 5.5. Funding the Journey efficiency programme ...... 28 5.6. Growth opportunities ...... 34 5.6.1. Improving share in premium products ...... 34 5.6.2. Big city approach ...... 39 5.6.3. Growing in Asia ...... 41 5.7. Creating the right corporate culture ...... 42 5.8. Financial targets - delivering value for shareholders ...... 42 6. Transforming the Russian business? ...... 45 6.1. How Carlsberg got so deeply involved with Russia ...... 45 6.2. The state of the market ...... 46 6.2.1. Numbers of the key beer drinking category is falling sharply ...... 46 6.2.2. Macro-economic conditions are improving ...... 47 6.2.3. Sobering up Russia ...... 49 6.2.4. Recent developments ...... 53 6.2.5. Carlsberg out of touch with market dynamics and nothing seems to change ...... 63 7. Results and profit forecasts ...... 65 7.1. West Europe back to growth ...... 66 7.2. East Europe struggling ...... 67 7.3. Asia pulling ahead ...... 68 7.4. Other financial items...... 69 Price Chart and Rating History ...... 71 Bryan Garnier stock rating system ...... 75

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Carlsberg

1. Executive Summary – no quick fix In this research, we are taking a deep dive into the company’s’ new formulated strategy and analyse the prospects of the Russia beer market which have been a drag on the company’s results since 2008. The conclusion is that much of the elements of the strategy are not new, except for the clear re- investment plan and the engagement of the organisation. On Russia we find that the market will remain tough and that new rules and duties are not excluded once the 2018 FIFA World Cup is finished.

1.1. Evaluating the corporate strategy Cees ’t Hart, who has been in charge of Carlsberg since June 2015, set out in March 2016, the Sail’22 strategy plan. Under the plan the company looks to revitalise its core beer brands, which are the key brands that the company has in the markets where it has a leading (#1 or #2) position. Indeed in every market a thigh set of brands produces the bulk of the profit and we calculate that the top 25 brand/market combinations contributes to 74% of beer profit. According to the CEO, 13 out of his top 20 brand/market combinations did not have the right marketing support.

Impressed with the We are particularly impressed with how there is now a clear sense of direction and prioritising, of strategy developing line extensions (craft, organic, alcohol free) to rejuvenate the local power brands. Through focussing on a limited set of brands in specific markets, streamlining the portfolio strategies at brand and SKU level, Carlsberg should be able to premiumise its portfolio and win share. The DraughtMaster could be a key enabler for that. It is a compact draught beer dispenser that allows the on-trade to offer a greater variety of (including premium variants) and locks the on-trade outlets in (only 5% annual turn compared to 30% normally). Luck has a lot to do with it. It is thanks to a stubborn country CEO in Italy (Alberto Frausin) who back in 2010 changed all steel kegs to the DraughtMaster and after years of decline, the Carlsberg’s Italian market share started growing again. Also the company’s two big international brands Tuborg and Carlsberg are getting extra support. For Tuborg that is probably obviously as the brand has been growing volumes by on average 14.3% p.a. over the past five years (driven by its “fun” premium positioning and exposure in China and India), but the Carlsberg brand has struggled for growth (0.7% annual volume growth over the past five years) as the brand could not find a coherent positioning. Also that seems to be solved through positioning the brand in a “knowing the best” category and a series of line extensions to support that are in preparation.

Seeking growth in Next to rejuvenating the local power brands Carlsberg looks for opportunities to grow its business in premium, Asia and major the premium segment where it is lagging its closest rival Heineken (only 22% of volumes are in cities premium compared to 33% for Heineken). The way the company wants to go about is to push into craft, specialities and also non-alcoholic beers, which all deliver better price points and margins. Two other areas in which the company seeks growth is its existing Asian business where it looks to reinforce itself in Vietnam (acquisition), India (expanding into new states) and China (in the premium category). New is also that the company is looking to expand into geographical areas where it has not been and it looks to do so through a “major city” approach in which dedicated teams will be established in strong growing, young and not too competitive cities, fully playing the urbanisation trend. Indeed, according to research from the UN, global population is expected to increase by 2.4bn to 9.7bn in 2050 from 7.3bn in 2015. At the same time, the population living in urban areas is projected to gain 2.5 billion, passing from 3.9bn in 2015 (54% of global population) to 6.4bn in 2050 (66%).

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Carlsberg

DKK2.3bn savings of All those projects for rejuvenating and strengthening its core brands and investments for future which DKK1bn will be growth do cost money. Hence the company is planning to re-invest half of the Funding the Journey reinvested 2016-2018 efficiency plan. That cost savings plan should yield DKK1bn to DKK2.3bn (we assume the top of the range) of which about DKK1bn is going to be reinvested and the remaining DKK flows to the bottom line. Reinvestments are slightly more for the growth initiatives (60%) than for strengthening the core (40%), but will be mostly in marketing and in Asia. What is more, is that the majority of the initiatives will continue in the years after and we understand that annual savings could well be DKK0.5 to DKK1bn p.a.

Strong financial incentive What we are most impressed about is that the new management team seems to succeed in pulling the to achieve cost savings entire company behind the plan. The top 60 managers were heavily involved in conceiving the new strategy, in applying and controlling it and in communicating it to the rest of the organisation. And the financial incentives are also not to neglect. If Carlsberg achieves the cost savings target of DKK2.0bn, the top 60 managers will receive an additional years’ salary and the next 140 is in for half a year salary. If DKK2.3bn is achieved, they will all get 120% of that bonus.

1.2. And what about Russia? Why don’t Carlsberg just Even though Russia now only accounts for 15% of group EBIT (down from an estimated 43% in sell Russia? There are no 2009), it remains Carlsberg’s single largest market and as such it has taken a special place in the Sail’22 synergies with any of its plan that aims to transform the Russian business. other businesses Market is not going to get From the moment (in 2008) Carlsberg gained full control over Baltika, the Russian government any easier extended its anti-alcohol policy from spirits to beer, whereas before it was encouraging beer consumption as a less damaging variant of alcohol. Government measures played on the affordability of beer (excise duty for beer was introduced in 2008 and set at RUB2.5/l and increased to RUB21 in 2017) and availability (e.g. kiosk ban). These measures came on top of a worsening macro-economic environment and demographic headwinds. As a result the business is much weaker than it used to be, following a deterioration of the macro-economic conditions but also efforts of the Russian government to reduce both affordability and availability of beer. However even today, Carlsberg’s Russian operations has lot of strong points: it is market leader, it is a profitable business, and it has a unique footprint, a second-to-none route to market and a distinctive portfolio of international, national and regional brands. Still the market is not getting easier. The macro-economic situation is improving, but consumers are hooked on their ways to chase value for money. Gaining and losing market share (brand and company) is very much a function of price. Furthermore the consumer group of 15-34 year olds that over-indexes on beer is about to fall 20% over the next ten years. And although the authorities seem less aggressive on taxing beer with no excise duty increase in sight, it is likely change after the FIFA world cup in 2018. After all, we calculate that in terms of pure alcohol consumptions, Russians (15y+) still drink on average 10.4l (down from 15.76l in 2010) which is still ahead of the Russian government’s target of 7.5l. On top of that the merger of the Russian and Ukrainian operations of AB InBev and Efes creates a strong number two (24.1%) market share (behind Carlsberg with 31.4% share), who might have the ambition to become market leader.

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Carlsberg

1.3. Key graphs executive summary Fig. 1: In every market a thigh set of brands Fig. 2: Top 25 brand/market combinations produces the bulk of the profit contributes 74% of beer profit

100% 0% 10% 20% 30% 40% 50% 60% 70% 80% - Tuborg 80% Laos - Cambodia - Angkor France -… 60% Switzerland -… - Superbock France - 1664 40% Russia - Baltika 7 China - Tuborg Russia - Baltika 3 20% Denmark - Carlsberg - Harnas China - Chong Qing 0% China - Shancheng Russia - Zatecky Gus - Lvivske Vietnam - Huda India - Tuborg Russia - Tuborg Norway - Poland - Kasztelan Finland - Karhu France - Grimbergen Poland - Okocim Brand 1 Brand 2 Brand 3 Other Russia - Carlsberg

Source: Bryan Garnier estimates

Fig. 3: Carlsberg Funding the Journey benefits Fig. 4: Investment priorities and re-investment

1200 Winning E Europe Capex 1000 Streng- Central SG&A 800 then the core 600 West Europe 400 Marke- ting Position 200 invest- for Asia ments 0 growth 2016 2018 2018

Efficiency improvement Re-investments By region By type By priority

Source: Carlsberg, Bryan Garnier estimates Source: Carlsberg

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Carlsberg

Fig. 5: Russian beer market volumes Fig. 6: Carlsberg Russian market share

120 45% 40% 100 35% 80 30% 25% 60 20% 40 15% 10% 20 5% 0 0%

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 Source: Baltika, BBH, Canadean, Bryan Garnier estimates Source: Baltika, BBH, Canadean, Bryan Garnier estimates Note: Merger in 2006 with Vena, Pikra and Yarpivo

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Carlsberg

2. Investment considerations Little growth in West West European recovery story (60% of revenues): 60% of Carlsberg revenues is in West Europe, Europe even if strategy is which is the highest from all major brewers (Heineken 35%, AB InBev 6%) and as such the company succesfull could be a main beneficiary of the improved macro-economic conditions in that zone. Indeed, EU unemployment has been falling in a straight line from 11% in 2013 to 7.6% in August 2017. That should create the conditions for modest volume growth and good price/mix, which in turn should be good for margins. Carlsberg has been lagging peer Heineken in offering a premium proposition (22% of volumes vs 33% for Heineken), but the premium priced line extensions that are being introduced seems to come to the market very timely. A great early adopter example is Feldschlossen that has seen the launch of Braufrish, craft extensions of Weizen, Hopfen and Dunkel and new packaging around its alcohol-free variant creating enough buzz around the brand that volumes have started growing. We are expecting that the launch of line-extensions and the investments behind the core brands will generate some volume growth in West Europe from next year on and we would expect the region to be a major part of the margin recovery story. We expect West European EBIT margins of 16.5% in 2022 compared to 14.3% in 2016.

Asia to continue to grow Asian growth engine (24% of revenues): No other major European brewer has the same exposure as Carlsberg to Asia. Asia is for Carlsberg 24% of revenues compared to 14% for Heineken and 13% for AB InBev. The region has been a strong contributor to organic growth, delivering over the past 5 years an annual organic revenue growth of 11.3% and organic operating profit growth of 12.1%. . In terms of volume outlook, Canadean is expecting the Asian markets to grow by 4.3% p.a. over the next five years, which is similar to the expected growth in Africa (4.4%) well outpacing growth in other regions. Carlsberg has a particular strong exposure to the growth markets of , Laos and Cambodia, as well as in the more mature markets of Malaysia, Singapore and . Moreover, the company plans to build its position further in the large beer markets of China (it has already a 50% share in West China (incl. ) and is likely to expand its premium offering in the big cities in the East, in India the company is likely to expand organic into more states (in 13 states it has already over 30% market share) and in Vietnam, the company hopes to be allowed to acquire Habeco (in which it has already a 17% share).

Wild card on Russia A wild card on Russia (16% of revenues) We do expect that once the FIFA world cup is over, the Russian government will again be tackling alcohol consumption. And although the problem is actually in the un-recorded alcohol consumption (30% of the market), measures seems to be targeting the reduction of all forms. If that were not the case, Russian beer consumption could stabilise and there might be some opportunities to premiumise. In the meantime, the market remains very much price driven and the merger between the Russian and Ukrainian operations of AB InBev and Efes is not likely to going diminish competition.

Companywide restructuring potential: During the October 2017 Capital Markets Day we hear that “Our profitability is far too low” according to Carlsberg’s CFO Heine Dalsgaard and according to CEO Cees ‘t Hart, the ambition is to bring Carlsberg margin (13.2%) closer to where Heineken’s is (17.0% in 2016). Whatever, if the company will be succeeding in this or not (Heineken might also want to move up), the ambition is set that even after the current Funding the Journey plan, the efforts to improve margin (through selling more premium products or through efficiency improvements) will not stop.

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Carlsberg

Potential for external growth: Most brewing M&A is value accretive (Carlsberg buying full control of Balticka was not) and Carlsberg has been standing on the side lines as it is implementing its organic growth agenda (Sail’22). But we understand that the company will be looking again to acquisitions to bolster its financial performance. With a net debt/EBITDA by the end of 2017 of 1.6x, it will have plenty of potential to do so (the target is to have a net debt/EBITDA of 1.5x-2.0 but the company is happy to go over that for a value accretive deal). The first such deal that could come up is Habeco, where we expect a price tag of EUR1.0bn. Habeco is one of the two Vietnamese brewers that is bing sold off and in which Carlsberg has already a 17% share and a right of first refusal.

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Carlsberg

Key graphs investment case Exposure to West Europe and Asia (% revenues) Breakdown of revenue by country (2016e)

The Baltics 3% Asia Ukraine Other Nordics 3% 24% West Europe India 8% 18% Portugal 3% 4% Russia Switzer- 12% 14% land 4% 60% China 11% 4% SE Europe 35% 4% VLC 13% UK 7% 6% 6% Poland France 7% Carlsberg Heineken AB InBev 7%

Source: Company data Bryan, Garnier & Co est. Source: Bryan, Garnier & Co est. Carlsberg – EBIT margin Carlsberg – organic revenue growth 30% 12% 10% 25% 2011-2016 8% 20% 2017-2022 6% 2010 15% 4% 2016 10% 2% 2022 5% 0% West East Asia Group 0% Europe Europe West East Asia Group Europe Europe

Source: Carlsberg, Bryan, Garnier & Co est. Source: Carlsberg, Bryan, Garnier & Co est. Global beer - outlook remains strong for Asia Carlsberg – re-investments of Funding the Journey 5% Africa Asia Winning E Europe Capex

2020 4% - Streng- Central SG&A 3% then the core EE W 2% Latam Europe Marke- 1% North ting America Position invest- 0% WE for Asia ments -1% growth

Beer volume growth 2015 growth volume Beer 0 20 40 60 80 Beer consumption per head 2015 (l) By region By type By priority

Source: Canadean Source: Carlsberg, Bryan, Garnier & Co est.

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Carlsberg

3. Valuation 3.1. Peer comparison Carlsberg shares are quite At the current share price of DKK730, Carlsberg is trading at a 2017 P/E of 22.5x, which is a 32% expensive premium to its average P/E of 17.0x over the past five years. Furthermore the stock average range over the past five years is 14.6x for the lows and 19.4x for the highs. At its peak level, the average P/E over the 2012-2015 period was 21.7x (we exclude here 2016 as the company’s adjusted EPS fell by 15% because of disposals of non-core businesses during the year (BGe of DKK360m), a one-off expense related to the final ruling in the tax dispute in Finland (BGe DKK250m), negative currency impact (BGe DKK120m).

Fig. 7: Stock market ratios

Stock market ratios Dec-12 Dec-13 Dec-14 Dec-15 Dec-16 Dec-17e Dec-18e Dec-19e Dec-20e Dec-21e Dec-22e AVG 12/16

P/E average (x) 13.5 14.7 14.7 18.6 23.5 22.5 20.0 17.9 16.1 14.7 13.5 17.0

P/E high (x) 15.8 16.1 16.7 21.7 26.8 19.4

P/E low (x) 11.3 13.4 12.6 15.6 20.3 14.6

P/CF (x) 7.8 8.8 8.4 9.2 10.6 11.5 10.9 10.3 9.7 9.1 8.6 9.0

FCF yield (%) 6.3% 3.4% 2.4% 8.7% 6.1% 5.7% 6.0% 6.5% 7.1% 7.6% 8.1% 5%

P/BV (x) 1.1 1.2 1.5 2.0 1.8 2.1 2.0 1.9 1.8 1.7 1.6 1.5

EV/adjusted EBIT (x) 13.3 15.0 16.1 16.8 17.7 18.7 16.8 15.2 13.7 12.4 11.1 15.8

EV/EBITDA (x) 9.3 10.6 10.5 10.4 10.8 11.7 10.8 10.1 9.3 8.5 7.8 10.3

Net dividend yield 0.9% 1.0% 1.2% 1.2% 1.2% 1.4% 1.8% 2.0% 2.2% 2.4% 2.7% 1%

Total shareholder return 6.9% 5.5% -3.5% -15.7% -13.6% 28.7% 14.4% 13.7% 13.6% 11.9% 11.9%

In terms of peer comparison, we believe that the profile of Carlsberg is closest to Heineken’s. both stocks are trading at similar levels on P/E or EV multiples (Carlsberg P/E 2017of 22.5x compares to 21.9x for Heineken). However, free cash flow yield at Carlsberg looks better with 5.7% for 2017 compares to 4.4% for Heineken. However, the driver for that is the capacity utilisation rate which we estimate for Carlsberg is only around 50% in both West and East Europe, compared to around 70% for Heineken in West Europe.

Fig. 8: Peer ratio comparison

EV/EBIT 5yr DA not Net Div EPS PEG P/E EV/EBIT adj. FCF yield debt/EBITDA Yield CAGR D

Market local Share Cap c'cy price (EURbn) 2017 2018 2019 2017 2018 2017 2017 2018 2017 2018 2016 2017

Brewers

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Carlsberg

AB InBev EUR 103.0 226.0 26.7 22.7 20.3 20.9 18.8 17.3 4.1% 4.7% 4.1 6.0 2.5% 2.4% 10% 2.19

Carlsberg DKK 730.0 14.9 22.5 20.0 17.9 18.7 16.8 11.7 5.7% 6.0% 1.6 1.3 1.2% 1.4% 11% 1.84

Heineken EUR 83.2 47.4 21.9 20.2 18.2 17.7 15.9 12.7 4.4% 4.8% 11.5 11.5 1.5% 1.4% 10% 2.01

Molson Coors USD 80.4 16.4 18.7 17.0 15.5 18.0 16.4 13.3 6.7% 7.2% 5.4 4.7 1.7% 2.2% 8% 1.77

Royal Unibrew DKK 290.4 2.1 22.3 20.9 19.6 18.2 17.1 14.3 4.8% 5.2% 0.8 0.9 1.8% 1.9% 7% 2.56

Source: Bryan Garnier

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Carlsberg

3.2. DCF valuation In developing our DCF valuation for Carlsberg we start with the Bryan Garnier assumptions of a risk free rate of 1.6% and a risk premium of 7%. We add to that an unleveraged beta of 1.0x (which becomes a leveraged beta of 1.1x given about 18% of the company’s market value of invested capital is targeted to be financed with debt – assuming a net debt/EBITDA target of 2.0) which ends up in a leverage cost of equity of 9.4%.

In terms of growth rate, we use a long term growth rate of 3.0%. We look for on average a ROE of just over 10% over the next five years of which most will be get paid out given the limited investment needs of the company (assuming no external growth). An assumed profit retention rate of 30% (which we also use for the other brewers), implies a growth rate of 3%, which we use for our long term assumption. In computing our DCF-based fair valuation of Carlsberg, we use for our long term assumption a necessary net capex figure of 0.3% of revenues which is significantly less than the 2% the company experienced in the past (and what also the level is for the other brewers). That has to do with the company’s significant over capacity in Europe and the limited expansion projects. The last assumption is what we believe would be the require working capital level at Carlsberg. That figure has come down to a negative working capital of 12% and the company’s CFO is budgeting that it will remain at that level, contributing to some free cash generation as revenues increase.

Fig. 9: DCF Valuation

Dec-16 Dec-17e Dec-18e Dec-19e Dec-20e Dec-21e Dec-22e Dec-23e Sales 62,614 63,591 65,430 67,446 69,580 71,842 74,241 76,487 EBIT 7,921 8,811 9,518 10,181 10,889 11,648 12,461 12,838

Taxes -2,614 -2,555 -2,665 -2,749 -2,940 -3,145 -3,365 -3,466

Operating profit after taxes 5,307 6,256 6,853 7,432 7,949 8,503 9,097 9,372

+ Depreciations 4,742 4,742 4,669 4,636 4,616 4,608 4,613

-Investments in fixed assets -3,840 -3,815 -4,253 -4,384 -4,523 -4,670 -4,826 0

Total net investments in fixed assets 902 927 416 252 93 -61 -212 -219

Net capex % revenue 1.4% 1.5% 0.6% 0.4% 0.1% -0.1% -0.3% -0.3%

-Investments in working capital -5 183 344 377 399 423 449 423

=Operating cash flow 6,204 7,365 7,613 8,061 8,442 8,865 9,333 9,576

Discount factor 1.00 0.92 0.85 0.79 0.73 0.67 0.62

Present value of free cash flow 7,365 7,038 6,889 6,668 6,472 6,297 5,972

Cumulative present value of free cash flow 46,699 Long term assumptions

+Present value of terminal value 116,684 Risk free 1.6%

=Enterprise value 163,384 Equity premium 7.0%

Adjusted net debt incl. Pension provisions (restated -31,470 Unleveraged Beta 1.00 cash) Other liabilities and commitments -13,091 Leveraged Beta 1.12

Revalued minority interests -13,672 Company debt spread 1.0%

(Assoc. + revalued investments) 4,701 RRE 9.4%

=Fair value 109,851 LT Growth 3.0%

Fair value fully diluted per share 720 Target Debt/IC 17%

LT WACC 8.3%

Source: Company Data; Bryan, Garnier & Co ests.

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Carlsberg

4. Business and operations World’s number 4 Carlsberg is the world’s fourth largest brewer in volume terms (6% global share), producing 116.9m hl of beer in 2016 and a further 21.9m hl of soft drinks (mainly in Nordic countries). Based in Denmark, Carlsberg was founded in 1847 in Copenhagen. In 1970 the group merged with its main Danish rival, Tuborg, while the merger with Orkla in 2001 brought leadership positions in and Norway and a 50% stake in BBH, the joint venture with Scottish & Newcastle. As a result of a joint take-over bid for Scottish & Newcastle by Carlsberg and Heineken in 2008, Carlsberg acquired the full 100% of BBH as well as the French Kronenbourg operations.

Controlled by a Carlsberg is controlled by the , which was founded in 1876 by J. C. Jacobsen, foundation which owns and its purpose, next to running Carlsberg A/S, is to run and fund , The only 30% of the company Museum of National History at Frederiksborg Castle, the (art museum), to but 75% of the votes fund scientific research, and to run and fund social works. Unlike most other ‘founder’ foundations, the Carlsberg Foundation is not diversified and only has dividend income from Carlsberg A/S, to fund its charitable works. However, there is nothing in the statutes that prevents the Carlsberg Foundation from selling off its beer business to a bigger, more diversified, higher dividend paying group, as long as the structure is in place that it keeps some control on the Carlsberg brand and keeps beer production in Denmark.

Currently the Carlsberg Foundation controls Carlsberg A/S through a 30% economic interest and 75% voting control. Its voting control is through its 98% interest in the A-shares, which have 20 votes compared with two votes for the B-shares. The foundation owns 33.0 million A-shares and 13.2million B-shares (and has been gradually switching more into A-shares). According to its revised statutes (2013) the Carlsberg Foundation has to own enough shares to control at least 51% of the votes in Carlsberg A/S (the previous requirement to own more than 25% of the share capital was dropped). Furthermore, the charter explicitly stipulates that the brewery business can be put into a subsidiary in which Carlsberg A/S (possibly through Carlsberg A/S as a holding company) keeps a significant influence necessary for the maintenance of “Carlsberg” as a widely-known and recognised beer brand and for the maintenance of continued beer production in Denmark.

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Fig. 10: Global market shares by volume, Fig. 11: Carlsberg volumes by country, 2016 2016pf incl. soft drinks

The Baltics Henan 2% Jinxing Cambodia Russia 1% Others 2% Laos Other 11% 18% Asahi 34% 2% Vietnam 1% 2% Portugal Kirin 3% China 2% Switzer- Yanjing land 17% 2% Germany AB InBev 3% 3% Tsingtao 27% 4% SE Europe Nordics 3% India 13% Molson 3% Coors UK Carlsberg 6% 4% 6% France CR Beer Heineken Ukraine Poland 5% 6% 11% 4% 5%

Source: Canadean, Bryan Garnier estimates Source: Canadean, Carlsberg, Bryan Garnier estimates

Source: Company Data; Bryan, Garnier & Co ests.

4.1. Europe and Asia Europe is 76% of Cees ‘t Hart, the company’s CEO since June 2015, made it clear that will continue with a business revenues and Asia 24% built around three regions and its existing markets, where it holds strong market positions and an interesting portfolio of local and international brands. About half of operating profits (54%) come from the mature West European markets, whereas the importance of East Europe has shrunk to 18% of operating profits (from 52% in 2009) and the weight of Asia has increased to 28% (from 6% in 2008 and 7% in 2009).

Fig. 12: West Europe remains the most Fig. 13: The growing importance of Asia and the important region, 2016 decline of East Europe – EBIT DKK bn

12 29% 23% 28% 10 16% 8 18% 25% 6 4 60% 47% 54% 2 0

Volume Revenue EBIT

West Europe East Europe Asia West Europe East Europe Asia

Source: Company data, Bryan Garnier estimates Source: Company data, Bryan Garnier estimates

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Carlsberg

4.2. Key Countries: Nordics, Russia, VLC, China and Switzerland

Patchy presence in Although Carlsberg is the world’s fourth largest brewer, it is only present in Europe and Asia. And Europe and Asia even in those regions it has a very patchy presence with a limited number of strongholds. is the company’s largest region (54% of operating profit) and only four countries Denmark, France, Switzerland and Poland is half of the profit. is 18% of operating profit and that profit is mainly from Russia. Asia is 28% of operating profit but only 4 countries China, Laos, Cambodia and Vietnam is nearly 80% of the regions profits).

Nordics, Russia, VLC, In our estimates the company’s top 6 markets (country or region) account for nearly 70% of group China, France and EBIT. And its five individual countries (Russia, Denmark, China, France and Laos) account for nearly Switzerland account for 50% of EBIT. Historically, the Nordic region was Carlsberg’s principal market and we estimate that nearly 70% of EBIT it is still the most important region accounting for 19% of 2016 group EBIT. In the Nordics, the company has leading market shares in Denmark (54%), Norway (55%) and Sweden (35%) and hold a strong second position in Finland (31%). The group’s second most important operations are in Russia, which we estimate accounted for 15% of group EBIT in 2016. The company is market leader in Russia with a 35% share of the market in 2016. Vietnam, Laos, Cambodia (VLC) is the third highest contributor with 13% (according to our estimates). The company holds market leading positions in Laos (96% share) and Cambodia (45%) and is the fourth largest brewer in Vietnam (10% share). The fourth contributor to profits (according to our estimates) is China accounting for 9% of group EBIT. In China the company has two operations. One is being a domestic oriented brewer in West China, where it holds a 58% share of the market and the other one is being an international premium brewer in East China (where Tuborg is now the second largest international brand behind Budweiser). In France (an estimated 8% of group EBIT) it holds the second place and in Switzerland (an estimated 5% of group EBIT) it is the largest brewer.

Fig. 14: Breakdown of revenue by country Fig. 15: Breakdown EBIT by country/region*

Ukraine The Baltics N Germany 3% 3% 2% UK India Other The India Nordics 2% 2% Other Nordics 3% 8% 18% Baltics 9% 19% 3% Portugal Ukraine 4% Russia 3% Russia 12% Switzer- 15% land Portugal 4% 3% Germany China SE Europe 4% 11% VLC SE Europe 4% Poland France 13% 4% VLC China 4% 8% UK 7% Switzer- 9% 6% Poland land France 7% 5% 7%

(*) Estimates before non-allocated costs and special items.

Source: Company data, Canadean, Bryan Garnier estimates

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Carlsberg

The limited number of profit generators at the company also hints from where future profit growth could come, which are the pools the company need to protect and where the challenges lie. The Nordics is the most important region in revenue and operating profits but we estimate that beer is only 40% of revenues and 60% is soft drinks. In Denmark and Finland it is bottler for The Coca- Cola company and in Sweden and Norway it handles PepsiCo products. In the company’s most important West European profit generator, i.e. Denmark, the company is selling nearly three times more Coca-Cola than Tuborg. These botling operatings are lower margin (operating margins around the 10% level) and the fact that in most of these countries there has not been a single price increase over the past five years is not helping (a first price increase is being tested in Denmark this year). So any premiumisation in beer will help margins but it will be diluted if soft drinks prices are not improved. In Russia the environment remains volatile and competition from regional brewers harsh. In VLC most profit comes from Laos and Cambodia and their profit generation might come under pressure from cheap beer producers in Thailand (all members of the Asean Free Trade Zone). In China, Tuborg’s premium position is hitting a sweetspot in consumer demand. In France, the company used to be the leading brewer, but Heineken’s more premium offering (matchin consumer trends) has made it suffer and in Switzerland, the market seemed less dynaimc (Carlsberg is making big improvements in 2017 with new product launches and extensions of Feldschlossen).

Fig. 16: Market share and position Fig. 17: Market share and margin

50% N1 35% N1 N1 N1-2 VLC 40% N1 30% N2 N2 25% 30% N1-4 Switzerl. N3 20% FranceRussia 20% N2-3 N3N1 UkraineThe Baltics N4 15% SE Europe Nordics China Portugal

N5 margin EBIT 10% 10% Poland India N Germany 0% 5% UK UK

VLC 0% India China Russia France Poland 0% 20% 40% 60% Nordics Ukraine Portugal SE Europe SE

The Baltics Market share N Germany Switzer-land Source: Company, Canadean, Bryan Garnier estimates Source: Company, Canadean, Bryan Garnier estimates

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Carlsberg

4.3. Scope to premiumise Tuborg, Carlsberg, Baltika The Carlsberg and Tuborg, brands are widely recognised. In 2014, Tuborg became the largest brand and Shancheng are the of the , as success in India and China, allowed it to surpass the Carlsberg brand that main brands suffered from its Russian and UK exposure. According to the latest Canadean figures, Tuborg accounted in 2016 for 14.2m hl compared to Carlsberg for 11.9m hl, which is respectively 12% and 10% of all its beer volumes, which already indicates that company is mainly geared towards local brands. Furthermore, the top 10 beers account for an estimated 48% of the company’s sales volumes. Furthermore, three of the group’s top 10 brands are Chinese.

Fig. 18: Carlsberg – 10 largest brands by sales volumes, 2016 Brand Main market m hl Tuborg Global 14.3 Carlsberg Global 11.9

Baltika Russia 8.6

Shancheng China 5.4

Chong Qing China 5.1

1664 France, UK 3.8

Tianmuhu China 3.6

Beerlao Laos 3.3

Lvivske Poland 3.2

Kronenbourg France 2.9 Source: Company Data; Bryan, Garnier & Co ests.Source: Canadean, Bryan Garnier estimates The premiumisation of Carlsberg is roughly in line with the one of other major brewers except for Heineken, that standout with 1/3th of its portfolio in premium beers compared to 22% for Carlsberg (and 20% for AB InBev), indicating also the upside that the latter two have. Carlsberg scores low on Brand wise, 78% of the Heineken brand is in the premium segment compared to 48% for Tuborg and premiumisation 37% for Carlsberg. Both Carlsberg and Tuborg used to be roughly 50% in premium, but the lowering of the price of Carlsberg in Russia brought that brand there (at least temporary) in the mainstream category, which means that for Carlsberg in 2016 only 37% of the brand volumes were in premium and 48% for Tuborg. Carlsberg is mainly premium in China, Germany and some volumes in the UK and India. Tuborg is mainly premium in China, Russia, Italy and Romania.

Fig. 19: Brand portfolio according to price Fig. 20: Part of the brand in the international segment premium segment

100% 78% 80% 59% 60% 51% 48% 45% 37% 40%

20%

0% Heineken Carlsberg AB InBev

Discount Mainstream Premium Superpremium

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Carlsberg

Source: Canadean, Bryan Garnier estimates Source: Canadean, Bryan Garnier estimates

Tuborg has overtaken With a more premium image but also because of its consistent positioning as “fun”, the Tuborg brand Carlsberg has grown faster (14.3% p.a. over the past five years) than the Carlsberg brand (0.7% p.a.) and the global high-end beer category (4.2%)

Fig. 21: Tuborg positioning has been much Fig. 22: Tuborg’s growth has been outstripping stronger than Carlsberg’s (m hl) global high-end growth rates (2011- 2016)

16 14.3% 14 12

10 4.2% 8 0.3% 0.7% 6 Carlsberg -0.3% 4 -1.9% 2 Tuborg 0

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Source: Canadean Source: Canadean

Only 20% of beer In beer only, the Carlsberg company has 20% of volumes in premium (22% including Somersby volumes in premium cider), which is a significant decline that has happened over the past 4 years, whereas global premium volume share has been growing. The latest downward repositioning was in Russia, where the Carlsberg brand was lowered to the mainstream level of Baltika 3. That did boost Carlsberg volumes in Russia, but it did take some share from Tuborg in Russia. After all both are Danish beers in a green bottle and distancing them from each other has not always been so easy.

Fig. 23: Carlsberg and Tuborg are Danish beer Fig. 24: Share of premium in beer only in a green bottle (Carlsberg group vs the world)

35% 30% 25% 20% 15% 10% Carlsberg 5% World 0%

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Source: Bryan Garnier Source: Canadean, Bryan Garnier estimates

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Carlsberg

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Carlsberg

4.4. 5 brand market combinations is 30% of profits Tuborg in Denmark, Another angle to analyse, the Carlsberg group is looking at its top brand/market combinations. Beerlao in Laos, Angkor According to our calculations, the company’s top 20 brand/market combinations accounted in 2016 in Cambodia, for 67% of the group’s beer profit (which is pretty close to the company’s CEO statement that they Kronenbourg in France represent 70% of profits). According to our own calculations 30% of the company’s profits are from and Feldschlossen in 5 brand/market combinations: Tuborg in Denmark, Beerlao in Laos, Angkor in Cambodia, Switzerland Kronenbourg in France and Feldschlossen in Switzerland. An interesting comment from the CEO on its top 20 brand/markets is that only 7 were properly supported and that 13 were under invested, which does hint towards a potential significant boosts that these brands can experience now that under the SAIL’22 strategy they will get appropriate levels of investments.

Fig. 25: Top 25 brand-market combinations is 74% of operating profits 0% 10% 20% 30% 40% 50% 60% 70% 80% Denmark - Tuborg Laos - Beerlao Cambodia - Angkor France -… Switzerland -… Portugal -… France - 1664 Russia - Baltika 7 China - Tuborg Russia - Baltika 3 Denmark - Carlsberg Poland - Harnas China - Chong Qing China - Shancheng Russia - Zatecky Gus Ukraine - Lvivske Vietnam - Huda India - Tuborg Russia - Tuborg Norway - Ringnes Poland - Kasztelan Finland - Karhu France - Grimbergen Poland - Okocim Russia - Carlsberg

Source: Canadean, Bryan Garnier estimates

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Carlsberg

5. Sail’22 strategy plan The goal that he set for Cees ’t Hart, the former head of the Dutch dairy company RoyalFrieslandCampina, has been in the company is to become charge of Carlsberg since June 2015. After studying the company and reflecting with the top 60 a successful, professional leadership team, he redefined in March 2016 what the goals and ambitions are for Carlsberg and what and attractive brewer the plan of action is to reach those goals – the Sail’22 strategy plan (’22 because it is the strategy for the company up until 2022). The goal that he set for the company is to become a successful, professional and attractive brewer:

• Successful: Drive top- and bottom-line growth by finding the optimal balance between beer volume market shares, gross profit after logistics margin and operating profit.

• Professional: Better service clients thought strengthening capabilities within consumer insights, customer management, category management and execution and innovation in the logistics area.

• Attractive: Creating value for shareholders by delivering consistent earnings growth and improving return on invested capital, for employees by creating a great working environment and actively encouraging a high-performance culture and for society, by operating a responsible and sustainable business.

The game plan to achieve that ambition is to strengthen its position in core beer, position the company for growth and create a team-based, winning culture. In the words of Cees ‘t Hart: “Priorities of strengthening the core and positioning for growth represent the sail of the boat and as a sail, they will attractively leverage the winds around us to propel us forward. The winning culture is the crew sailing the ship, making sure that we move in the right direction, fast but securely. The sail and the crew will bring us successfully towards our 2022 destination and as we do so, we create value for our shareholders.”

5.1. Strengthening the core Under the plan of strengthen the core, Carlsberg puts three different priorities: leveraging its strongholds, excel in execution and Funding the Journey. Leveraging its strongholds includes two important actions:

5.2. Revitalise the core beer business 82% of revenues is beer The (core) beer brands account for 82% of group net revenue. Through revitalising the portfolio the company looks for growth in top-line, market share and profits. But because there was no coherent system to tackle the very diverse portfolio of brands at Carlsberg (more global brands in the Asian region, more regional/local brands in East Europe and national brands in West Europe), Jessica Spence, the new Carlsberg Chief Commercial Officer (since 2015), first developed a frame of consumer needs in which beer fits and that enables the company to better place its local and global brands and develop a scalable model to rejuvenate and premiumise its brands.

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Carlsberg

Fig. 26: Carlsberg portfolio structure varies Fig. 27: The Demand Spaces provide a frame substantially by region for the portfolio – both global and local brands

53% 73% 85%

47% 27% 15%

West Europe East Europe Asia

Local brands Global brands

Source: Carlsberg Source: Carlsberg

What we are particularly impressed with is how the company has started filling in the different demand spaces. The demand space “part of the group” has always been a quintessential motivation for beer consumption, but advertising has mostly been about guys watching football and that is changing. “Part of the group” can be filled in differently; it can be about national identity. For example the company’s rejuvenated packaging for the Serbian beer Lav features a prouder lion. It also enables to develop certain themes across the portfolio. “Part of the group” is also about fresh and unprocessed beer (eg. Felschlossen Braufrish, Karhu Raaka, Ruborg Ra), it is about craft beer, it is about non-alcoholic beer (1/3 of all “part of the group” serves are alcohol free). In that alcohol free space, the company did set priorities for 2017 to launch alcohol-free line extensions of the local power brands.

Fig. 28: Lav old and new packaging Fig. 29: Fresh and Unprocessed

Source: Carlsberg

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Carlsberg

Fig. 30: Crafty line expansions versus core lager Fig. 31: Alcohol delivers attractive variant revenue and GPaL growth

179 170 135 131 123 115

Norway Switzerland Finland

Price index GPaL index

Source: Carlsberg, GPaL: gross profit after logistic costs Source: Carlsberg

Local power brands is We are particular impressed with is how there is now a clear sense of direction and prioritising, of 45% of revenues developing line extensions (craft, organic, alcohol free), of rejuvenating the local power brands, which after all do account for about 45% of the company’s beer net revenue. Through focussing on a limited set of brands in specific markets, streamlining the portfolio strategies at brand and SKU level should ensure that Carlsberg has a strong and efficient presence in key market segments and enable them to win share. Investments is being redirected and refocused behind those key brands which deliver the bulk of the company’s profit and also have margin growth potential. Earlier, we have already highlighted how according to our calculation 20 brand/market combinations (out of 140) deliver 67% of group beer operating profit and how according to the company’s CEO 13 out of these 20 did not had the right marketing support. As funds come available (from the Funding the Journey) and investments behind the local power brands are upped, it could have a significant impact on the groups top line growth from 2018 onwards.

Fig. 32: In every market a thigh set of brands Fig. 33: Top 25 brand/market combinations produces the bulk of the profit contributes 74% of beer profit

100% 0% 10% 20% 30% 40% 50% 60% 70% 80% Denmark - Tuborg 80% Laos - Beerlao Cambodia - Angkor France -… 60% Switzerland -… Portugal - Superbock France - 1664 40% Russia - Baltika 7 China - Tuborg Russia - Baltika 3 20% Denmark - Carlsberg Poland - Harnas China - Chong Qing 0% China - Shancheng Russia - Zatecky Gus Ukraine - Lvivske Vietnam - Huda India - Tuborg Russia - Tuborg Norway - Ringnes Poland - Kasztelan Finland - Karhu France - Grimbergen Poland - Okocim Brand 1 Brand 2 Brand 3 Other Russia - Carlsberg

Source: Bryan Garnier estimates

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Carlsberg

Felschlossen brand has A great early adopter example is Feldschlossen, which we believe is good for 65% of the profit that been an early adopter the company makes in Switzerland. In our calculation the Switzerland/Feldschlossen combination even accounts for 4% of group operating profit. Feldschlossen was a very typical local power brand in the Carlsberg stable with volumes and market share declining slightly year after year as tastes and preferences are changing. That also brought not much incentive to invest behind the brand. But that has been changing and the launch of Braufrish in 2015, the 140 year festivities in 2016, the launch of the craft extensions of Weizen, Hopfen and Dunkel in 2017, the new packaging for the alcohol-free variant, all is creating enough buzz around the brand that volumes start growing again and the brand is regaining share.

Fig. 34: Feldschlossen volumes and Swiss market share Fig. 35: Feldschlossen new product line up

1.12 24.5% 1.10 24.0% 23.5% 1.08 23.0% 1.06 22.5% 1.04 22.0%

1.02 21.5% million hl 1.00 21.0% 20.5% share Market 0.98 20.0% 0.96 19.5% 0.94 19.0%

Source: Canadean, Bryan Garnier estimates Source: Bryan Garnier

Equally important is how the new demand spaces approach is going to be used to better define the Carlsberg brand. Tuborg has never really had a problem as it has been about fun for a long time and that resonates in many different markets. But the position of Carlsberg has been more problematic and all over the place. The result is that in West Europe, the Carlsberg brand volumes are in decline with volumes down 28% over the past five years and Carlsberg as a percentage of Carlsberg West European beer volumes is down to 19.9% from 25.2% in 2011.

Repositioning of the However, the Carlsberg brand is being re-established in “Knowing the best”. And to re-assert that Carlsberg brand there is a pipeline of innovations being lined up. The first such innovation is Carlsberg 1883 (launched 2017), using living yeast cells extracted from a bottle of beer in the brewer’s Copenhagen cellars dating to 1883. Based on that success, the Carlsberg Laboratory will play a key role in driving the brand perception going forward and we would expect other line extensions to come to the market.

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Carlsberg

Fig. 36: Carlsberg brand volumes in Western Europe Fig. 37: New in 2017: Carlsberg 1883 and share of the portfolio

9.0 30% 8.0 25% 7.0 6.0 20% 5.0 15% 4.0 million hl 3.0 10% 2.0 5% 1.0 0.0 0%

2008 2009 2010 2011 2012 2013 2014 2015 2016

Source: Carlsberg

5.3. Transforming the Russian business The second action under leveraging strongholds is transforming the company’s business in Russia. Even though Russia now only accounts for 15% of group EBIT (down from an estimated 43% in 2009), it remains Carlsberg’s single largest market. The business is much weaker than it used to be, following a deterioration of the macro-economic conditions but also efforts of the Russian government to reduce both affordability and availability of beer. However even today, Carlsberg’s Russian operations has lot of strong points: it is market leader, it is a profitable business, and it has a unique brewery footprint, a second-to-none route to market and a distinctive portfolio of international, national and regional brands.

Fig. 38: The Russian business’ declining profit Fig. 39: Carlsberg Russian operating margin contribution

5.0 45% 35% 4.5 40% 30% 4.0 35% 25% 3.5 30% 3.0 25% 20% 2.5 20% 15% 2.0 1.5 15% 10% 1.0 10%

Operating profit DKK bn DKK profit Operating 5% 0.5 5%

0.0 0% profit operating of group Share 0%

2009 2010 2011 2012 2013 2014 2015 2016 Source: Carlsberg, Bryan Garnier estimates Source: Carlsberg, Bryan Garnier estimates

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Carlsberg

Although the macro-economic situation is improving a new consumer reality which includes down trading and shopping around, is settling in. The actions that Carlsberg is taking in Russia includes:

1. Protecting the core: 11 brands have revenues of more than RUB1bn and are 70% of the profits. Those brands which include the core Balitka 3, Baltika 7, Zatecky Gus, Carlsberg and Tuborg are being repositioned or re-launched (eg. Carlsberg is getting upped again in price). 2. Developing alcohol free beer: Baltika 0 has a leadership position (57% share) and the current window of the World Cup Football in 2018 is allowing advertising for beer and its alchol free variants. 3. Build a strong regional portfolio: Carlsberg has 5 out of the top 15 regional brands like Arsenalnoe, Don, Gor’kovskoe, Yarpivo, Chelyabinskoe. The company is in the process of refreshing the portfolio. 4. Winning with winning modern trade customers: by providing best brands and SKUs in channel-relevant demand spaces and by driving category value / size with key customers including X5, Magnit and Dixie. 5. Gaining fair share in DIOT channel: the company has long neglected that channel that has a share of 9% of the market according to Nielsen, but Carlsberg is now estimating that the channel is now even 15% of the market. From a neglected position, the company is looking to achieve a share of 30/34% in the channel.

Fig. 40: Carlsberg owns five out of top-15 regional brands

Source: Carlsberg, Nielsen retail audit, June 2017

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Carlsberg

In a separate section we will be analysing the prospects of this Russian business but we do believe there are opportunities to optimising the range of national and regional brands, more fully leveraging its’ supply chain and production network and improving the in-store visibility to enhance its position in the growing modern trade, and reducing costs in all areas. But given the competitive nature of the industry and the emergence of a new strong number two (AB InBev/Efes) which might have the ambition to become the market leader, the best that the company can aim for in Russia is to have flat volumes and a flat price/mix.

5.4. Excel in execution To ensure that the company is delivering on leveraging strongholds (core brands and Russia), the aim is to excel in execution. The critical areas have been defined as excelling in 1) managing the brand portfolios which have to be more consumer-occasion and benefit driven; 2) managing complexity (eliminate unnecessary complexity, leaving room only for smart complexity); 3) execution at the point of purchase (eg the FIT programm – Focus Implement & Track); 4) step-changing the digital agenda to connect with consumers and customers more efficiently; 5) master value management and 6) consumer-driven R&D with focus on strategic priorities and a faster, simpler and more impactful process.

5.5. Funding the Journey efficiency programme Probably DKK2.3m In November 2015, Carlsberg announced its programme to improve efficiency and provide funding savings for its strategy, Funding the Journey. The expected net benefits of the plan are DKK1.5bn to DKK2bn (with a hint towards DKK2.3bn) and the expectation is that about 50% will be invested in Sail’22 and the other 50% will improve the profits. This means that by 2018, the company expects to improve by DKK0.75bn to DKK1.0bn on its 2015 operating profit (corrected for currencies). In terms of when the benefits fall, the company has guided that about 25% of the savings would fall in 2016 (DKK0.5bn was delivered), 50% in 2017 and the remaining 25% in 2018.

DKK1bn reinvestment The reinvestment of about DKK1bn is mostly expected to be in marketing but there is also some additional overhead costs and incremental depreciation. For example the BrewMaster roll-out costs investments (DKK100,000 per unit) that need depreciating. Most of the investments are expected to be in Asia followed by West Europe. More than half of the investments are behind the position for growth (craft, specialities, non-alcoholic, big cities, Asia) while still another 40% is expected to be behind strengthen the core.

In terms of timing, there were not much cost-out opportunities in 2016 (DKK150m), but that should increase in 2017 and 2018 as the Sail’22 programme is gaining momentum. We estimate that in 2017 DKK400m will be reinvested and a further DKK450m in 2018. This leaves the net benefit for operating profit improvement (and assume a DKK2.3bn saving) at DKK350m in 2016, DKK600m in 2017 and DKK350m in 2018.

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Carlsberg

Fig. 41: Carlsberg Funding the Journey benefits Fig. 42: Investment priorities and re-investment

1200 Winning E Europe Capex 1000 Streng- Central SG&A 800 then the core 600 West Europe 400 Marke- ting Position 200 invest- for Asia ments 0 growth 2016 2018 2018

Efficiency improvement Re-investments By region By type By priority

Source: Carlsberg, Bryan Garnier estimates Source: Carlsberg

While the Funding the Journey is a program that will terminate by the end of 2017, the principles, standards and processes (such as value management, supply chain efficiency and operating cost management) are expected to remain a vital part of how to do business in Carlsberg in the future.

The Funding the Journey programme is centred on four elements:

 Value management: This is about optimising the balance between market share, volume growth and profit. The focus of value management will be on creating and capturing profitable business across the different core channels and customer segments. Initiatives will examine promotional strategies, pack-price architecture and assortment to ensure a high-value, competitive offering in the market place. Additionally, value management work will also look to fully embed sales and pricing tools in the markets, align sales and marketing incentives with corporate objectives, and set up rigorous performance management processes resulting in a more profitable mix of brands, channels and promotional activities.

 Supply chain efficiency: Efficiency improvements within all areas of the supply chain – procurement, production, warehousing and logistics. Procurement will focus on best-in-class sourcing practices. In production, focus will be on brewery efficiency gains and continuing a positive trajectory of reducing waste and utility consumption. Warehousing and logistics will focus on optimizing warehouse operations, productivity of the distribution network, centralizing transport operations, and sourcing practices. BSP1 will be an important tool in realising these efficiency improvements by facilitating one integrated supply chain supported by a uniform system and set of processes. Finally, supply chain efficiency will also include a complexity reduction initiative to simplify the portfolio with the aim to deliver more value to shoppers. By the end of 2016, the total number of SKUs, net, had been reduced by approximately 1,200.

 Operating expense efficiency: Improve organisational efficiencies by simplifying, streamlining and removing duplication in processes. By the end of 2016, Carlsberg had reduced white-collar headcount by 2,280 employees. Other initiatives include the implementation of Operating Cost

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Carlsberg

Management (ZBB), a framework for budgeting, tracking and monitoring costs. OCM is going through all cost items which includes initiatives on travel, print (no more colour printing), company cars, etc. According to the company, OCM already delivered in 2016 in Asia and East Europe and in 2017 will start delivering in West Europe. Operating expense efficiency also is about further outsourcing of selected shared services.

 As part of the outsourcing of shared services, Carlsberg concluded in 2016, the transfer of approximately 300 roles involved in transactions to its external service provider located in India. Part of the shared services remains at Carlsberg in Poland in China, but part is now outsourced to Genpackt in India.

 Right-sizing of businesses: Closing , selling businesses, reducing capacity. Below we have summarised, under a separate point, the different actions the company has been taking over the past 18 to 24 months.

There is actually not much new in the Funding the Journey programme as it pulls together cost savings programmes that already existed and were initiated by the company’s previous management:

 BSP1: Launched in 2014, Business Standardisation Process 1 who’s aim was to improve performance by introducing uniform processes and centralised, standardised functions that can be adapted to local needs.

 ZBB Carlsberg style: On the back of the standardisation set out by BSP1, the plan was in 2015 to prepare Zero Based Budgeting programme and in 2016 to implement the new implement the new way of budgeting, monitoring and tracking costs.

 SKU rationalisation: There was already a plan active to reduce the number of different bottle and crate types, necessary for cross border sourcing.

 From 2007 onwards, different functions from the Western European operations, were gradually transferred to the Carlsberg shared service centre in Poznan and since 2012 all procurement of addressable spend was centralised in Switzerland.

Nothing new under the Previously we had already expected savings from BSP1, ZBB and product standardisation to add up sun to DKK1.4bn by 2017. Next to that the company was establishing a series of regional and local projects to complement the group programmes which included the continuing benchmarking across all breweries on specific topics, the reorganisation of the sales structure in Norway from a regional to a national structure, a change in sales and administration organisation in Finland, closing Leeds and capturing the needs by expanding the Northampton brewery and using the Obernai brewery in France. These types of local programmes should have yielded another DKK0.4bn, which puts the savings target from the old management at DKK1.8bn, exactly in the middle of the DKK1.5- DKK2.0bn from the new management.

Although Carlsberg’s new management team does pretend that OCM is their new efficiency initiative, we argue that is not the case and that BSP1 was always going to be followed by a ZBB type of programme. On the existing initiatives, new management has been communicating that their implantation was taking too long and there was no rigorous follow-up on process improvements.

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Right sizing of the business In addition, to the efficiency improvement programmes, Carlsberg announced in November 2015, that it decided to right-size parts of the business. This has been reflects both an updated assessment of the anticipated future earnings projections of individual businesses and brands (impairments!) and an assessment of its supply base relative to expected volumes (brewery closures, capacity reduction and selling off businesses). Those plans, already in 2015, resulted in asset impairment and restructuring costs of DKK 8.5bn in 2015 and an additional DKK0.5bn in 2016. The majority of the 2015 impairments relate to the Russian brands, mainly the Baltika brand (DKK 4.1bn), and impairment of the Eastern Assets in China and CBC local brands (DKK 3.2bn). So far, the actions that have been taken over the past 24 months are:

• Following on from the continued decline in the Russian beer market (and the expectation that the market will continue to decline for a few more years), Carlsberg decided to restructure its production capacity and impair some of its brands. The total impairment charge and restructuring costs that were taken in 2015 added to DKK5.0bn. Already based on previous decisions, at the start of 2015, Carlsberg closed two of its Russian breweries (in Chelyabinsk and Krasnoyarsk), reducing capacity by 15% (and 5,000-6,000 workers). Further in 2015 and 2016, the company continued to close bottling lines in its remaining breweries.

• In China, the turn-around of the Eastern Assets did not delivered according to expectations as its efficiency improvements were offset by the beer market decline and intensified competition. Carlsberg made an impairment of tangible assets and of brands as well as restructuring costs in total of DKK4bn. following on from 1) an assessment of those Eastern Assets operations; 2) also a review of the brewery footprint in China with the aim to improve the supply chain network efficiency; and 3) CBC local brands did not delivered the expected growth due to higher than expected growth on the Tuborg brand. In total Carlsberg closed or sold 18 sites (16 breweries and 2 malting units).

• In the UK, the company made impairment and restructuring costs in total of DKK 600m. Indeed during the recent years, the financial performance of the UK business has been deteriorating (from already a poor profitability) as a result of the market challenges. The delisting at Tesco in 2015 further added to the challenges and led to under-absorption of costs in the operations. Consequently, Carlsberg intended to refocus and restructure the business with the aim to reduce capacity and costs. It exited the on-trade distribution business for third parties and is in the process of outsourcing its distribution business to DHL Tradeteam (to be finished in autumn 2018). Already in 2015, Carlsberg sold the land of the former Tetley brewery in Leeds and now still has only one brewery in Northampton.

• Finally, Carlsberg has been assessing a plan to provide better alignment of its production and logistics capacity with market requirements across various markets. The plan was to enhance the future profitability of the business and entailed reducing capacity within breweries as well as brewery closures. That happed in Russia in 2015 and in China in 2016. In addition, as part of the focus on maximizing return on invested capital, Carlsberg announced that when appropriate, release capital employed from the often small, less core assets.

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Additional structural changes in 2016 and at the beginning of 2017 were 2016

• The remaining land at the Tuborg site

• Disposal of 100% shareholding in Danish Malting Group.

• Asset swap in China of the 30% ownership in the holding company Hops for full ownership of Xinjiang Wusu Group.

• Disposal of Vung Tau, its wholly owned brewery in Southern Vietnam.

• Disposal of the 59% shareholding in Carlsberg Malawi.

• Disposal of the 25% shareholding in the plant-breeding company Sejet.

2017

• Disposal of 100% shareholding in Carlsberg .

• Disposal of 23% shareholding in United Romanian Breweries.

• Disposal of 30% shareholding in Russian malt producer MSSP.

• Disposal of 100% of the German wholesale business Nordic Getränke.

In total the asset disposals yielded DKK3.2bn so far of which Carlsberg Malawi and the Danish Malting Group were attracted the highest prices.

Engaging the organisation Whereas we believe there is not much new in the efficiency improvement plans, we do give new management the credit of pulling the organisation behind the plan. The involvement is based on a clear and structured communication approach.

There are three different level of plans: a strategic overview with a time span of 3 to 5 years which outlines the overall approach and direction; an operational plan with a time span of 2 to 3 years and which provides to the organisation a clear understanding of timing of critical milestones and a one- year 9-grid plan which secures sequencing and focus among priorities. The structure of communication is that the company’s top 60 managers are continuously involved in the plan with monthly calls and meetings three times a year. A further 200 managers are kept in the loop with regular mailings and through the local and entity leadership teams. The rest of the organisation is kept informed thought different media with town hall meetings, videos, activation tool kits, internet, and articles. That internal communication strategy is then measured once every year and compared with scores of other fast moving consumer goods companies. At the capital markets day in Copenhagen on 12 October 2017, some of the numbers of the annual IBM study were presented. The company boasted in 2017 an 82% employee engagement of 82% (+4% vs 2016 and +10% vs FMCG norm).

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Also in terms of pay, the performance bonus of the top 200 managers is linked with achieving the DKK2.0bn of Funding the Journey benefits. The top 60 is going to be paid an extra year’s salary and the next 140 is going to be paid an additional half. If the company achieves DKK1.5bn, they get 50% of the bonus; if they achieve DKK2.0bn they get 100% of the bonus but if they achieve DKK2.3bn, they will get 120% of the bonus. All bonuses are to be paid at the start of 2018 on the back of the realised savings in 2016 and 2017 and the budget for 2018 (with clawback if budget will not be reached). The total potential payment of DKK200m is already provided for.

Also CEO Cees ‘t Hart and CFO Heine Dalsgaard ‘s salaries are linked with Sail’22 and Funding the Great salary benefits for Journey through share incentives options that can be exercised in 2019. Their total pay in 2016 top 200 if targets are met including the performance and FtJ options was DKK36.1m and DKK25.5m.

Fig. 43: Top 200 bonus linked to realising Funding the Journey benefits

2.5 120% pay-out 2 100% pay-out

1.5 50% pay-out

1 0% pay-out 0.5

0

Source: Carlsberg

Although there is a certain focus of the Funding the Journey plan to save DKK1.5-DKK2.0bn of costs in the 2016-2018 period, it is becoming a new way to live for Carlsberg and there is a certain expectation that cost savings will continue to be achieved and partially being ploughed back in the business.

Fig. 44: Funding the Journey from a project to a way of living…

Value management Supply chain efficiencies Operating costs efficiencies Right-sizing Ambition • Optimise price, volume and mix • Deliver efficiency improvements • Reduce sales and admin costs • Ensure an efficient Group to drive GPaL across the supply chain, structure reducing material and non- material cost per hl Activities • Build culture of consistent focus • Establish global, integrated • Drive OCM further • Continuously streamline and on value across all commercial end-to-end supply chain optimise structures and planning and execution businesses • Roll out Group-wide value • Improve end-to-end efficiency • Embed routines for key cost • Perform annual review of management practices through in production and procurement drivers (e.g. FTEs) portfolio of businesses standardised tools and processes • Track rigorously • Reduce complexity • Further harmonisation of business processes • Manage network • Further outsourcing of shared service processes • Track rigorously • Track rigorously

Source: Company Data; Bryan, Garnier & Co ests.Source: Carlsberg

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5.6. Growth opportunities While ‘strengthening the core’ is focussed on extracting more value from existing brands and businesses, Carlsberg sees interesting opportunities to generate additional top-line growth. This is reflected in the monies allocated from the Funding the Journey, which allocates more than half of the DKK1.0bn investments into growth initiatives (as opposed to an estimated 40% in Strengthening the Core). The three areas in which the company sees growth opportunities are moving into new categories and occasions, growth opportunities coming from the increasing global urbanisation trend and from its Asian region. A fundamental change compared to the past is that it is establishing dedicated teams with sufficient resources to drive efforts in these areas (which is part of the SG&A investment)

5.6.1. Improving share in premium products With Carlsberg’s portfolio very much geared to mainstream beer. We have highlighted before that according to the latest Canadean figures only 22% of Carlsberg volumes is in premium or above compared to 33% at Heineken (it is 20% at AB InBev) and less than half of its international beers does its volumes in the international premium segment. As a result there are plenty of opportunities for Carlsberg to up its presence in the more premium offerings. In concreto, this means that it is looking to up pricing of its mainstream beer, increase craft & speciality beer, alcohol-free and increase its exposure to the on-trade.

Fig. 45: Premiumisation is pivotal for all strategic initiatives in Western Europe

Source: Carlsberg

DraughtMaster key enabler to regain on-trade momentum Part of the premiumisation effort is also to increase its share in the on-trade and for that the company is now pushing through its DraugthMaster product. The DraughtMaster is a compact draught beer dispenser that uses smaller 20 litre PET kegs instead of steel kegs. The self-cleaning system requires only water, a power supply, drainage and space for installation, with CO2 replaced with an in-built air compressor. Because nothing touches the beer from when it leaves the brewery until it goes in the glass, the DraughtMaster will keep beer fresh for 31 days compared to only around a week for a steel keg that needs CO2 to pressure it. It is also lighter (20l compared to 50l) which enables all the staff to

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change it. Although there is an initial investment for Carlsberg at DKK100,000 per unit, we see three key positive business advantages:

 Because beer can be kept longer, the company will be able to present a bigger assortment including more premium and craft beers which offer opportunities for consumers to uptrade

 As a starter, the beer that the converted outlets buy is already a little more expensive, but because the on-trade is “locked-in”, there is more opportunity to increase prices afterwards.

 The better quality coming from the fresher beer and the self-cleaning, means that customers will have a better experience and could increase consumption.

Fig. 46: DraughtMaster key enabler to regain Fig. 47: DraughtMaster in on-trade momentum

Source: Carlsberg Source: Carlsberg

Thank you Alberto Although the DraughtMaster already existed since 2010, only the Italian business was fully utilising its potential and in Italy all draught beer from the group is in PET. In Italy it did increased customer loyalty to 95% (previously it was 70%, which means that 30% of customers turned the company each year), it has proved for a 10% revenue uplift (6% in volume and 4% in mix) and after years of decline, the Carlsberg’s Italian market share started growing again to 7.3% in 2016 from 5.7% in 2010. Following on from that success the system got also implemented in Greece and Portugal, where now already 95% of all draught sales volumes go through the DraughtMaster. And with the arrival of the new Carlsberg CEO Cees ‘t Hart the system is going to be rolled out further. The first target is Denmark and the idea is to achieve full conversion from steel in 2 to 2.5 years and achieve uplift in brand mix with premium priced brands. At the recent capital markets day, the example was given that in the Danish Scandic hotel chain premium beer increased to 37% of volumes compared to 12% previously. And indeed, in his homemarket, the company has been under attack from different players including , who also distributes the Heineken product range.

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Fig. 48: Carlsberg – market share in Italy Fig. 49: Carlsberg – market share in Denmark

9.5% 65.0% 9.0% 8.5% 60.0% 8.0% 55.0% 7.5% 7.0% 50.0% 6.5% 6.0% 45.0% 5.5% 5.0% 40.0%

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Source: Canadean Source: Canadean

Craft and speciality beers Craft has only taken off The craft and speciality category is particularly interesting in mature markets; and according to the recently company, it is expected to grow 15% per annum, globally, in volume terms. Indeed, according to our own research high-end beer is growing stronger than other segments and that is true across all regions. Over the past decade, globally, premium beer has grown by 3.8% p.a. and superpremium beer by 4.8% p.a. compared to 2.5% growth in mainstream beer. Within the high-end category, craft beers are growing faster. There is not much West European data available as craft beer has only take off recently. However in the USA and Canada where craft beer has been around longer, the growth has been respectively 17% and 12% p.a. over the past ten years. Craft penetration has now reached 13% in the USA and 6% in Canada.

Fig. 50: Global growth for the different price Fig. 51: Craft beer as percent of USA beer segments consumption

7% 14% cagr 10y 6% 12% 5% cagr 5y 10% 4% 3% 8% 2% 6% 1% 4% 0% 2% -1% 0%

Source: Canadean, Bryan Garnier est. Source : Canadean, Bryan Garnier est.

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By contrast, penetration of craft beer in Europe is only 2%, but it has found already some following in Sweden (7%), UK (5%, Denmark (4%) and France (4%). And growth has been rapid. In Sweden, the craft beer market has been growing by 32% p.a. over the past five years, in the UK by 13%, in Denmark by 26% and in France by 15%.

Fig. 52: Craft beer penetration in Fig. 53: Growth in craft beer penetration in and West Europe selected West European markets

14% 8% 12% 6% 10% 8% 4% 6% 2% 4% 2% 0% 0% UK ROI USA Italy Spain Malta France Cyprus Austria Greece Iceland Finland Canada Sweden UK Norway Sweden Portugal Denmark Germany

Switzerland Denmark France Netherlands Luxembourg Source : Canadean Source : Canadean

Profitability of high end On top, profitability of high end beer (including craft) significantly exceeds that of mainstream beer. beers exceed that of There are higher costs associated with producing, selling and distributing high-end beers, but their mainstream beers pricing more than offset this. As a result, premium beers are about 50% more profitable than mainstream beers and superpremium beers (most craft beers) are nearly 4 times more profitable. In terms of margin the uplift for superpremium beers is around 10% and it is 5% for premium beers (but of course on higher selling prices).

Fig. 54: Profitability model for high end beers

Discount Mainstream Premium Superpremium

Selling price 80 100 130 180

Cost of sales/production -45 -50 -58 -67

Gross profit 35 50 72 113

Gross margin 44% 50% 55% 63%

Distribution -12 -12 -15 -22

Sales and marketing -10 -17 -25 -40

% revenue 13% 17% 19% 22%

Administrative -7 -7 -7 -7

Operating profit 6 14 25 44

Operating margin 7.5% 14.0% 19.2% 24.4%

Source: Bryan Garnier est. To take advantage of this craft, speciality opportunity, Carlsberg plans to use its existing portfolio which includes international crafty/speciality brands like Grimbergen and 1664 Blanc, crafty line extensions of local power brands (e.g. Koff APA, Eriksberg Karakter) , authentic craft brands.

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Amongst those authentic craft brands the company finds Brooklyn but also local champions like the Nya Carnegie Bryggeriet, E.C.Dahls, Jacobsen or the recently acquired London Fields Brewery. There are no plans to acquire aggressively into craft brewing.

Carlsberg is mainly Carlsberg is mainly looking to deliver craft quality at scale, manage COGS and increase category looking to deliver craft profitability and will significantly increase its marketing support behind craft and speciality. It has quality at scale already a number of proven successes in Scandinavia. For example in Sweden, it has started the Nya Carnegie Bryggeriet which is a joint venture with the Brooklyn Brewery and it has developed Eriksberg Karakter. Internationally, its speciality beers 1664 Blanc and Grimbergen are realising significant growth. In the first half of the 2017, 1664 Blanc did grow revenues by 53% and Grimbergen by 23%.

In 2016, craft, specialities and alcohol-free beer accounted for 5% of group rvolumes and 10% of net revenues.

Non-alcoholic beers Alcohol free benefiting Another category where Carlsberg sees attractive growth opportunities is non-alcoholic beer, which from global health and are also benefiting from the growing global health and wellness trends. According to Carlsberg, non- wellness trends alcoholic beer is growing three-times faster than the overall beer market and offers some excellent margin opportunities as the beer tend to be sold at the same price (or higher) and does not carry excise duty (the cost of extracting the alcohol is additional).

Carlsberg is well on its way to market a full portfolio of both line extensions and specialised own brands and to do this in both existing (e.g. France) and new markets where the company does not sell yet alcohol-free beer (e.g. the Asian markets). The company has already a number of successful non- alcoholic products, such as Tourtel in France and Nordic in Denmark. Tourtel sold already 149,000 hl of beer in 2016 and the aim is to double the size in three years’ time. In Denmark, Carlsberg Nordic has a value market share in the alcohol-free category of 54% and is the 7th best-selling 6-pack across the total beer category. Furthermore the priority for 2017 was to launch alcohol-free line extensions with clear naming and differentiation vs the core brand.

Fig. 55: Tourtel in France Fig. 56: Nordic in Denmark

Source: Carlsberg Source: Carlsberg

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5.6.2. Big city approach Tapping the urbanisation The second key initiative for driving growth is a targeted approach towards big cities. This taps into potential the global urbanisation trend and Carlsberg expects that it will not only deliver volume growth, but more importantly, be an attractive driver for value growth, due to the premiumisation in urban centres. The aim is to build profitable businesses in big cities and countries where the company is not yet active with full-fledged operations (but often is active with an export and licencing business).

For capturing these opportunities, Carlsberg will use an asset-light model, building on the learning from its export and license division. In that division, it already has proven successes, for instance in Toronto where, with a local sales force, Carlsberg has built an interesting position in imported premium beer and cider. In Toronto the company works with a local distributor but has their own contacts with the state-organised retail network.

Carlsberg has not communicated yet in which cities it is likely to roll out, but it has established a team in 2 big cities with another 4 to enrol next year, which could be accelerated or delayed depending on the learnings from the first two. In total the company is targeting about 40 big cities.

According to our analysis there are plenty of city opportunities in areas where Carlsberg is not yet (Africa, Latin America, some parts of Asia, North America), given the strong trend to urbanisation across the different continents. In terms of criteria, the company is looking for big cities, with young population, available distribution networks and limited competition (hence excluding an entry in the USA).

Riding the global urbanisation trend Indeed, urban areas are expected to absorb all population growth expected over the next decades while at the same time drawing in some of the rural population. According to research from the UN, global population is expected to increase by 2.4bn to 9.7bn in 2050 from 7.3bn in 2015. At the same time, the population living in urban areas is projected to gain 2.5 billion, passing from 3.9bn in 2015 (54% of global population) to 6.4bn in 2050 (66%). Most of the population growth expected in urban areas will be concentrated in the cities and towns of the less developed regions. Asia, in particular, is projected to see its urban population increase by 1.4bn, Africa by 0.9 bn, and Latin America and the Caribbean by 0.2 bn.

Fig. 57: Urban population by region

3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0

2015 2050

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Source: United Nations

Between 2015 and 2030, the percentage of people living in urban areas will increase strongly in countries like Morocco, from 57 to 73 per cent; Indonesia, from 54 to 69 per cent; Nigeria, from 50 to 66 per cent; Bosnia, from 49 to 62 per cent; China, from 45 to 60 per cent; Sierra Leone, from 38 to 60 per cent; Pakistan from 37 to 50 per cent; Vietnam, from 29 to 42 per cent; Bangladesh, from 28 to 40 per cent and India, from 30 to 41 per cent.

China, India and Nigeria Taken together, China, India and Nigeria are projected to account for 37 per cent of the increase of contributing 37% of nearly 2.5 billion people in the urban population by 2050. India will contribute most adding 404m world population growth followed by China with 292m and Nigeria adding 212m. Seven other countries - the Democratic by 2050 Republic of the Congo, Ethiopia, the United Republic of Tanzania, Bangladesh, Indonesia, Pakistan, and the of America - are projected to contribute more than 50 million each to the urban increase between 2015 and 2050 and will constitute together another 20 per cent of the total increase in urban population.

Fig. 58: Cities with the biggest increase in population and GDP by 2030

Population Change 2013-2030 GDP Change 2013-2030 Rank City Country Millions Rank City Country USD bn 1 Lagos Nigeria 13.0 1 New York US 874 2 Dhaka Bangladesh 8.4 2 China 734 3 Karachi Pakistan 7.5 3 Tianjin China 625 4 Kinshasa Congo 7.2 4 Beijing China 594 5 Beijing China 7.2 5 Los Angles US 522 6 Tianjin China 6.7 6 Guangzhou China 510 7 Jakarta Indonesia 6.2 7 Shenzhen China 508 8 Delhi India 5.9 8 London UK 476 9 Mumbai India 5.1 9 Chongqing China 432 10 Dar Es Salaam Tanzania 4.9 10 Suzhou China 394 11 Shanghai China 4.8 11 Tokyo 372 12 Bangalore India 4.5 12 Jakarta Indonesia 354 13 Kaunda Angola 4.2 13 Sao Paolo Brazil 335 14 Lahore Pakistan 4.2 14 Foshan China 302 15 Baghdad Iraq 4.1 15 Wuhan China 301 16 Abuja Nigeria 3.7 16 Chengdu China 300 17 Chennai India 3.7 17 Washington US 288 18 Hyderabad India 3.6 18 Istanbul Turkey 282 19 Riyadh Soudi Arabia 3.5 19 Chicago US 280 20 Ahmadabad India 3.4 20 Houston US 280

Source: Company Data; Bryan, Garnier & Co ests.Source: Oxford economics

Focus on Johannesburg Although maybe not immediately a most obvious choice given Carlsberg withdrawal from Africa selling its only African brewing operations in Malawi to Castel (August 2016), there are some arguments that could make Johannesburg an interesting choice, ticking all the boxes (young and growing population, beer culture, distribution available, benign pricing environment). We don’t have a particular insight that Johannesburg is on the list but would like to highlight that there are plenty of opportunities for Carlsberg with the big city approach. Indeed, Johannesburg is the largest city in South Africa, and the capital of Gauteng, the wealthiest province in the country. Johannesburg urban agglomeration accounts for 9.2m people and that is expect to grow to 11.6m by 2030. Like in the rest

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of Africa, population is still young: 23% is below 15 years, 8% is between 15 and 19 years old and 34% between 20 and 34. The 2015 YouthfulCities Index named Johannesburg as the “most popular African city” overall for young people aged 15-29. Johannesburg outclassed its continental counterparts – Lagos, Casablanca and Nairobi.

Johannesburg is the richest city in Africa with a total GDP of USD96bn in 2013. And the increase in GDP by 2030 is expected to be USD100bn, which is the largest increase in absolute terms for any African city.

There is a strong beer culture, having been developed by SABMiller and Heineken, and there also craft brewers emerging (SNACK!, Airport Craft Brewers) and there is a plenty of distributors available and senior AB InBev (SABMiller) executives who might want to try their luck in a smaller set-up.

Fig. 59: Africa – Median ages Fig. 60: Age profile Johannesburg

65+ 4%

0-14 23% 34-64 31% 15-19 8%

20-34 34%

Source: CIA Factbook Source: SHSUP

5.6.3. Growing in Asia The last growth initiative which already has been a key growth driver for the company is Asia. Carlsberg aims to increase its focus on its premium portfolio and further strengthening the number one and two positions in the growth markets of Nepal, Laos and Cambodia, as well as in the more mature markets of Malaysia, Singapore and Hong Kong. Moreover, the company plans to build its position further in the large beer markets of China, India and Vietnam, through product launches, geographical expansion and management of a portfolio of brands, designed to meet a broad range of consumer benefits and price needs. In these very large markets, Carlsberg is likely to focus on leadership in certain regions and cities. In China the company will be looking to increase its presence in the premium segment, in India, the company has more states to enter and in Vietnam it is awaiting developments on the Habeco acquisition.

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In China, the company has a strong presence in West China (incl. Chongqing) with approx. a 50% market share. But it finds that even in the provinces where the company is there are still parts of the provinces where it could increase its presence. This is for example the case in the province in China where the Carlsberg boast strong positions in Kunming, Dali and Baoshan, but is weak in some of the other ones that still have several 100,000 inhabitants like Xuanwei (0.6m). But also in other Chinese cities on the East Coast, the company is still underrepresented and is looking to bulk itself up. At the brand level, Carlsberg has been successful with the Tuborg brand which is still in roll-out mode and there are parts of its existing geographies where Tuborg is only just getting started. But these types of city extensions belong to the Asian/Chinese teams and not to the big cities team in Copenhagen.

5.7. Creating the right corporate culture In order to achieve the priorities on strengthening the core and positioning for growth, Carlsberg wants to change its corporate culture to a strong, team-based, high-performance and winning culture. Its new values and the new performance management system is based on the triple ‘A’s.

• Alignment on its objectives

• Accountability for the actions;

• Action: decisions are implemented with speed and rigour.

As part of this, Carlsberg will track progress against agreed targets for both Funding the Journey and SAIL’22. Furthermore, Carlsberg is creating a stronger sense of ownership and accountability for delivering results by encouraging and incentivising higher-performance behaviour. This also means having a tight alignment between management incentive plans and financial objectives. For example, long-term incentive schemes for the leadership are now directly linked to delivery of Funding the Journey benefits and short-term incentive schemes are linked to metrics such as market share, GPaL (gross profit after logistics) margin, absolute EBIT, solid cash flow and improved ROIC. Typically a managing director of a country will have his performance evaluated for 50% on his country, 30% on the region to which he belongs and 20% on the group. Also about 80% of annual KPIs are linked to financial objectives and the remaining 20% will be personal KPIs. Clearly the further down somebody works in a country, the more the performance will be judged on the country and the reverse for group functions.

5.8. Financial targets - delivering value for shareholders The ultimate goal of the strategy is to develop a sustainable business model that delivers value for shareholders. For tracking the value creation, the company will focus on three key metrics:

• organic operating profit growth: reflecting both top line growth and ability to reduce costs

• return on invested capital: ROIC improvement will be driven by the operating profit improvement and by optimising the capital base. The idea is to sweat fixed assets through improved utilisation and a strict financial discipline when making investment decisions. The company believes that it can keep capital expenditure below depreciation for a while (although the company may divert slightly from this level when needing to invest behind

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some of the growth initiatives). In addition, the company has been looking critically at those businesses that do not deliver satisfactory returns and evaluating how that can be changed. Furthermore the company will continue to focus on improving trade working capital. As a result, the company believes it will be able to deliver high cash conversion in the coming years.

• Capital allocation: For the company, the first priority is to invest behind the plans critical to deliver sustainable long-term growth. The second priority is to reduce financial leverage to a net debt/EBITDA below 2x. Once that is achieved, the company plans to increase the dividend pay-out ratio to 50% from 30%. When both targets are achieved, management plans to return excess cash to shareholders, either as buybacks or extraordinary dividend. Because Sail’22 is about strengthening the company’s business organically, acquisitions have low priority. However, if there are some that allows strengthening the business, they will be pursuit (and the company is willing to deviate temporarily from the leverage and pay-out targets). On divestitures, the company is willing to dispose of businesses or brands, which may be of higher value to others. Earlier in the note we have highlighted the different assets that the company sold over the past 2.5 years and which yielded a net proceed of DKK3.2bn.

Fig. 61: Organic operating profit growth Fig. 62: Return on Capital Employed

10% 14% 8% 12% 6% 10% 4% 2% 8% 0% 6% -2% 4% -4% -6% 2% -8% 0%

2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 Source: Carlsberg, Bryan Garnier estimates Source: Carlsberg, Bryan Garnier estimates

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Fig. 63: Pay-out ratio Fig. 64: Net debt/EBITDA 60% 3.5 3.0 50% 2.5 40% 2.0 30% 1.5 1.0 20% 0.5 10% 0.0 0% -0.5

2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 Source: Carlsberg, Bryan Garnier estimates Source: Carlsberg, Bryan Garnier estimates

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6. Transforming the Russian business? Profits from Russia have Profits from Russia have fallen over the years to an estimated DKK1.5bn in 2016 from DKK4.4bn in fallen over the years to an 2009. Nevertheless it still accounts for 15% of EBIT in 2016 (compared to 43% in 2009). In this estimated DKK1.5bn in section, we investigate if there is a chance that profits from Russia are going to rebound strongly. 2016 from DKK4.4bn in Unfortunately that does not seem to be likely. The Russian government has not yet reached its target 2009 to halve alcohol consumption to 7.5l (pure alcohol) from 15.76 in 2010 (according to our calculations it was 10.4l in 2016). For the moment there is not much new regulations/excise duties as Russia prepares for the FIFA world cup 2018 (with its beer sponsorships), but once they are behind, we do expect further regulation to decrease affordability and availability. In the meantime the Russian consumers got used to chase value for money what probably means that Russia will remain a price competitive market, which something the bigger brewers (including Carlsberg) do not seem to grasp. But indeed, gaining and losing market share always seems to be the resultant of price action. Furthermore the planned merger of the Russian and Ukrainian operations of AB InBev and Efes could create a strong number two who’s ambition it might be to become market leader. The combined group would hold a 24.1% compared to Carlsberg’s 31.4%, but Carlsberg seems to be well on its way to lose an additional 2% in 2017.

6.1. How Carlsberg got so deeply involved with Russia Russia has been quite an Baltika was set up 1990 and Carlsberg bought itself into Baltika in 1992, through a joint venture set up adventure for Carlsberg. with Scottish&Newcastle. The investment was a big success as in the company grew its market share in an ever expanding market driven by the favourable macro-economic environment (rising oil price) and the availability of good quality beer. Furthermore, market growth was undoubtedly helped through regulation favouring beer over vodka as regulators wanted to crack down on excessive Russian vodka consumption (including a total TV advertising ban). Beer consumption rose rapidly especially amongst younger drinkers and grew from 32m hl in 2001 to 101m hl in 2006, when it moved ahead of Germany (91m hl) to become the fourth-largest beer market in the world, representing 6% of global beer consumption. Growth continued into 2007 to 116m hl from when on the market started to shrink to 84m hl in 2016. But before that happened, Carlsberg acquired in 2008 the 50% in BBH that it did not own (through a joint Carlsberg/Heineken bid on Scottish&Newcastle) and as a result Carlsberg was owning for 88.86%. DKK43bn out of the DKK57bn acquisition price was allocated to BBH (the French business was another DKK12bn). In 2012, it bought the minorities out and gained the full 100% control (for an additional DKK6.7bn, USD1.15bn). The 2008 and 2012 combined, Carlsberg spend nearly DKK50bn to buy out a 56% share in Baltika that it did not own, valuing the company at DKK89bn.

Carlsberg doubled its Coincidence or not, from the moment Carlsberg gained control of Baltika in 2008, the Russian Russian exposure right at government started to limit availability of beer (e.g. kiosk ban) and affordability (excise duty for beer the moment that both the was introduced in 2008 and set at RUB2.5/l and increased to RUB21 in 2017). Indeed, it looks very market and its market much that the vodka producers (Rosspiritprom, the state-owned alcohol producer that owns share were peaking. controlling stakes in 18 distilleries and nearly a dozen of the country’s alcohol companies) dramatically increased their lobbying power once the main Russian shareholders of Baltika sold out. Together with the worsening macro-economic environment and the changed demographic profile of the population, beer consumption declined.

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Fig. 65: Russian beer market volumes Fig. 66: Carlsberg Russian market share

120 45% 40% 100 35% 80 30% 25% 60 20% 40 15% 10% 20 5% 0 0%

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 Source: Baltika, BBH, Canadean, Bryan Garnier estimates Source: Baltika, BBH, Canadean, Bryan Garnier estimates Note: Merger in 2006 with Vena, Pikra and Yarpivo

6.2. The state of the market Below we analyse that volume and real price/mix growth in the market is very unlikely as the Russian government will probably continue to limit affordability and availability of beer and as the key beer drinking population of 15 to 34 year olds is falling sharply. A better macro-economic situation and an absence of excise duty increase in 2018 and 2019 might give some temporary relief. But figures on 2016 does show again that brand success and failure in Russia is mostly a function of price.

6.2.1. Numbers of the key beer drinking category is falling sharply Key drinking category The demographics of Russia are challenging. The Russian population has started to decline since 1995 numbers are falling and is expected to continue to slide to 130m by 2050 from 142m in 2015. But what is more worrying for the brewers is that in the next ten years the 15-34 year olds, who over index in beer consumption, will tumble by 20% (2.4% p.a.) after it already fell by 10% over the past five years.

Fig. 67: Russia – total population in m Fig. 68: Russia - key beer drinking category 15- 34 year olds in m 160 50 45 -30% 150 40 140 35 30 130 25 20 120 15 110 10 5 100 0

1950 1960 1970 1980 1990 2000 2010 2020 2030 2040 2050 1990 1995 2000 2005 2010 2015 2020 2025 2030 2035 2040 2045 2050 Source: U.S. Census Bureau Source: U.S. Census Bureau

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6.2.2. Macro-economic conditions are improving Affordability is a key We have analysed before in 110 countries the relationship between beer consumption per capita and metric the cost of a beer, as measured by average minutes worked in order to pay for a pint of beer. On the back of those data we can concluded that Russia is a strong beer market as consumption per head in 2016 was still 60 litres although it takes 27 minutes to earn a pint of beer. By comparison, in France it takes nine minutes and consumption per capita is 28 litres, in the UK it takes nine minutes and consumption per capita is 71 litres, and in the US six minutes for 73 litres per head. Furthermore, in Russia, there is a strong correlation between affordability and beer consumption per head. Over the past five years, beer has become 20% less affordable (Increase of time to earn a pint of beer by 25%) and beer consumption per head has gone down by 22%. From that we could concluded that if excise duties remain the same (see next point on regulation), beer consumption per had should start increasing if GDP and disposable income are picking up again.

Fig. 69: Overall distribution of countries (2013) Fig. 70: Russia – affordability of beer (2000 - 2016)

160 90 140 80 120 70 60 100 50 80 40 60 30 40 20 20 10

0 (l) head per consumption Beer 0 Beer consumption per (l) per head consumption Beer 0 50 100 150 200 0 20 40 60 Minutes worked to earn a pint Minutes worked to earn a pint

Source: Canadean, Ilostat, Bryan Garnier estimates Source: WorldBank, Canadean, Bryan Garnier estimates

Indeed, after three years of decline, Russian GDP is expected to grow by 1.5% this year, supported by higher oil prices (following on from the agreed production cuts by Opec and non-Opec members at the end of 2016) and despite the ongoing sanctions against Russia. Indeed, in the first 6 months of 2017 Urals oil price has averaged USD50.4/barrel. According to the latest estimates of the US Energy Information Administration, the World Bank and the International Monetary Fund, the predictions for crude oil in 2017 is a range of USD52 to USD53 per barrel and for 2018, USD52 to USD56. That would imply an increase in the oil price of around 25% on 2014.

Oil prices are important to the Russian economy because oil and gas products accounted for more than half of the value of all exports (2015) and the driver behind the country’s positive trade balance. Furthermore, the oil and gas industry contributed about 50% of the Russian Federal budget revenues in 2011-2014, but in 2015-2016 due to deterioration of the oil market prices their share has substantially decreased to 36% in 2016 which was countered by the Russian government to slash its budget (mainly healthcare and national economy).

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Fig. 71: Russia – GDP in USD trl Fig. 72: Average annual OPEC crude oil price (USD per barrel)

2.5 120

2 100 80 1.5 60 1 40

0.5 20

0 0

Source: Worldbank Source: Statistica

On top of that, starting 2014, the government had to deal with the sanctions from US, Canada, Europe, Japan, Australia and New Zealand following the invasion of the Crimea. Nevertheless, the Russian economy is climbing out of a two-year recession delivering GDP growth in the first half of the year of 1.5% (0.5% in Q1 and 2.5% in Q2), in part of a resurgent oil prices. Most forecasters expect a similar growth rate for the second half and next year if the oil price remains around USD50 a barrel. Modest recoveries in private domestic demand and exports should fuel gradual growth. However, growth would continue to depend on the oil price and sanctions.

Fig. 73: Russian GDP growth Fig. 74: Urals and Brent oil price

3% 98.9 2% 97.6 Urals Brent 1% 0%

-1% 54.5 53.2 52.5 52.39 51.6 51.2 51.2 50.4 43.73 -2% 41.8 -3% -4% -5%

2020 2014 2015 2016 H1 2017 2018

Q3 2014 Q4 2014 Q1 2015 Q2 2015 Q3 2015 Q4 2015 Q1 2016 Q2 2016 Q3 2016 Q4 2016 Q1 2017 Q2 2017 Q3 2017 Q4 2017 Q1 2018 Q2 2018 2017

Source: Rosstat Source: IMF, World Bank, US EIA, 2017 and 2018 forecast based on average from estimates by those three agencies

Furthermore consumer confidence in Russia increased to -11 in the third quarter of 2017 from -14 in the previous period. It was the highest reading since the third quarter of 2014, as households were less pessimistic about the country's economic situation over the next 12 months (-3 from -4 in Q1); personal financial situation (-4 form -6) and conditions for major purchases (-29 from -30). Consumer

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Confidence in Russia averaged -14.92 from 1998 until 2016, reaching an all-time high of 1 in the third quarter of 2008 and a record low of -59 in the fourth quarter of 1998.

Fig. 75: Inflation Fig. 76: Consumer confidence

15.5%

-7 -11 -15 -14 7.8% 6.8% 7.1% -18 -19 -18 5.1% -23 -24 4.5% 4.2% 4.0% 4.0% -26 -26 -30 -32

2012 2013 2014 2015 2016 2017 2018 2019 2020 Q3 2014 Q4 2014 Q1 2015 Q2 2015 Q3 2015 Q4 2015 Q1 2016 Q2 2016 Q3 2016 Q4 2016 Q1 2017 Q2 2017 Q3 2017 Source: Rosstat Source: Rosstat

6.2.3. Sobering up Russia Alcohol consumption in Next to the downward trend in the population category for which beer over indexes and the Russia is still way too high disappointing macro-environment, regulations has been targeting both availability (kiosk ban, advertising ban) and affordability (increases in excise duty) as the Russian government made efforts to lower alcohol consumption. Excise duty has increased to RUB21 per litres from RUB2.5 in 2008, but event with the VAT of 18%, that is only 29% of the retail price, which is about the average in West Europe, the same as in Denmark, far less than in the UK (42%) but more than in France (19%).

Fig. 77: Pure alcohol consumption in selected Fig. 78: Retail price per litre compared (EUR) markets, 2010

16 6 14 12 5 10 4 8 6 3 4 2 2 0 1 0 UK France Denmark Russia

Beer Spirits Wine FAB Un-recorded Price ex taxes Excise VAT

Source: WHO, Bryan Garnier estimates Source: Canadean, European Commission, Bryan Garnier estimates

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Timeline Russian beer market regulations After some initial excise duties for beer set in 2008 and 2009, the Russian government properly started to tighten beer market regulations in 2010 by tripling excise taxes, followed by restrictions on sales, advertising and consumption. It did change the landscape for beer consumption:

2010 • Russia hikes beer taxes by 200 percent.

2011 • Russian President Dmitry Medvedev signs a bill that classifies beer as an alcoholic drink. Most provisions of the law will come into effect in 2012 and 2013, extending to beer regulations that had already been applied to stronger spirits. • Excise taxes rise by 11 percent.

2012 • Russia bans beer drinking in public places and TV, Internet, and outdoor advertising of beer. • Excise taxes rise by 20 percent.

2013 • Russia bans beer sales in kiosks and other non-stationary places and bans beer sales elsewhere from 11 p.m. to 8 a.m., excluding bars, cafes and nightclubs. Regional authorities may set their own time limits and in some regions beer sales are now banned between 9 p.m. and 11 a.m. • Beer advertising ban is extended to printed media. • Excise taxes rise by 25 percent. • Russian deputies call for an increase in the legal drinking age to 21 from 18. A bill is submitted to the State Duma lower house of parliament. • Russian brewers agree to voluntarily stop selling beer in plastic bottles of more than 2.5 litres, or 2 litres for beer with alcohol content above 6 percent, from 2014, amid calls from some parliamentarians to ban beer in plastic bottles completely.

2014 • Excise taxes rise by a further 20 percent. • The lower house of parliament takes the first step towards limiting the size of plastic beer bottles. • Rules for beer advertising were relaxed until the 1st of January 2019 (i.e. after the FIFA World Cup in 2018). It is possible to advertise beer in Russia but with the following restrictions: in the print publishes and magazines, excluding covers, the first and the last pages; on the sport TV channels and radio stations; on the live broadcasts or sport competitions records, excluding children (youth) competitions; in the sport buildings and on a distance of 100 meters during the official sport events.

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2015 • On 1 October 2015, the law to connect to the Unified Federal Automated Information System (UFAIS/EGAIS- in Russian) all breweries with an annual production volume over 300 deciliters (roughly 95% of the market) came into force. This UFAIS system is used to control production and distribution of alcohol drinks in order to fight black market and fraudulent products. The requirement to record information in UFAIS applies to companies dealing with procurement, storage, supplies and retail trade in wines and spirits and alcohol- containing products. An exception is made only for sales of beer, wines and spirits in public catering establishments and rural settlements with the population below 3,000 (and lack of internet). The plan is to gradually connect all players in the alcohol market to UFAIS: production of alcohol, including beer was connected on October 1, 2015, distributors/wholesalers and logistics companies of all alcohol – on January 1, 2016, retailers in urban Russia – will be connected on July 1, 2016 and then retailers in rural areas from July 1, 2017. Therefore market experts anticipate a decline of production volume and increases in unit prices once all members are linked into the new system. • Increase in excise duty by 11%

2016 • The Ministry of Finance becomes in charge of formulating and implementing State policies and legal regulations in the sphere of production and circulation of ethyl alcohol, alcohol and alcohol-containing products. The aim is to improve the efficiency of the duty collection. • Retailers in urban Russia will be connected to UFAIS starting July 1, 2016

2017 • On January 1, 2017, the law restricting sales of alcoholic drinks in PET (plastic) bottles cames into effect. It bans production and sales of alcoholic products in in PET (plastic) bottles having more than 1.5 liter in capacity. Retail sales of alcoholic drinks in PET bottles will be banned starting July 1, 2017. • Excise duty is increased by 5% to 21 rouble from 20 rouble. • As of January 1, 2017, manufacturers of pharmaceutical substances are required to keep records of alcohol in Unified State Automated Information System (USAIS). This measure will allow the authorities to control volumes of manufactured pharmaceutical substance which is often involved in production of counterfeit alcohol. • Retailers in rural areas will be connected to UFAIS on July 1, 2017

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Fig. 79: Beer: excise duty Fig. 80: Vodka: minimum price and excise duty

25 600 5% 0% 5% 25% 0% 0% 20%11% 500 33% 20 25% 400 18% 9%

300 10% 16% 8% 20% 10% 16% 52% 15 3% -

11% 200 28% 10% 200% 0% 10 100 0 5 20%

0 Excise duty vodka (per liter of pure alcohol) minimum vodka price 0.5l

Source: Bryan, Garnier & Co. est. Source: Bryan, Garnier & Co. est.

More alcohol restrictions For the moment no further legislation to restrict the availability or excise duty increases are planned, likely as level of but alcohol consumption still remains a problem in Russia. After a decade of limiting availability and consumption is too high decreasing affordability, alcohol consumption in Russia is an estimated 10.4 litres of pure alcohol (per 15+). That is down by 34% from the 15.76 litres it was in 2010, but still ahead of the maximum 8 litres that the WTO believe is a safer level of alcohol consumption for adults (and that was also the goal of the Russian leadership, including Prime Minister Vladimir Putin and President Dmitry Medvedev to reach by 2020). The global average is 6.2 litres. All the measures that have been put in place have been equally hitting recorded and unrecorded consumption (both down by about 1/3th). Estimating the unrecorded consumption is difficult but the Russia's Federal Alcohol Regulator estimates itself that Russians consume between 170 and 250 million litres in the vodka equivalent (containing 40 percent ethyl alcohol). However, other estimates go up to as much as 800 million litres (Moscow Times), which is the figure that we withheld. This fits in well with the estimates from the state consumer watchdog Rospotrebnadzor, that the average Russian consumed just over 10 liters of alcohol in 2016, compared to 15 liters in 2009.

Efforts to deter alcohol abuse have inspired equally undesirable consequences, though, with cost increases prompting drinkers to settle for cheaper — and more dangerous — alcohol alternatives. Indeed as unrecorded consumption has been very much a function of affordability (both taxes and macro-economic conditions). As a result we look for a situation that in the best case, recorded consumption stays flat (and all volume declines come at the expense of unrecorded consumption). There are three groups of unrecorded alcohol: samogon (home-produced spirits); medicinal compounds; and other spirits (mainly sold as aftershaves).

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Fig. 81: Structure of the alcohol market in Fig. 82: Structure of the alcohol market in pure volume terms – 93.5 litres 2016e alcohol terms – 10.4 litres per capita, 2016e

Un- Wine recorded 4% 8% Spirits 8% Un- recorded Beer FAB 28% 36% 2%

Wine Beer 4% 78% Spirits 31% FAB 1%

Source: Canadean, Bryan Garnier estimates Source: Canadean, Bryan Garnier estimates

The tendency towards perfume and cosmetic alcohol recently sparked controversy, when businessmen in the Russian cities of Kaluga, Saratov, Chita, and Novouralsk set up vending machines to sell the Boyarka brand of alcohol-based cosmetic rub, which contains 75 percent ethyl alcohol. Officially the product is cosmetic, yet even the advertisement for the vending machine claimed that demand for Boyarka was growing every day due to "hard times."

Fig. 83: Boyarka cosmetic alcohol out of Fig. 84: Homemade Samogon vending machine

6.2.4. Recent developments Following a series of events, the market looks to become even more difficult. These include the ban of large PET packs, the continued growth of the modern trade and DIOT channels, the good 2016 summer and the merger of the Russian and Ukrainian operations of AB InBev and Efes.

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The ban of large PET packs

In 2017, the ban on beer production (1/1/2017) and retail sales (1/7/2017) in PET packages that are larger than 1.5 litres came into force, aimed at encouraging reduced consumption of economy beer in the country. Indeed, the large PET bottles were mainly aimed at those consumers looking for a value proposition. In 2016, the average price for a 2.5l PET bottle was 30% lower than the same beer packed in a glass bottle of 0.5l and there was approximately a 12% difference compared to beer in a PET package of 1-1.5 litres. Although these price differentials are for both mainstream and economy beer, more than 80% of PET beer volumes are in the economy segment where prices range from 60 to 80 RUB for a liter. Brands that are in this category are Zhigulevskoe (Carlsberg version), Belly Medved, Tolstyak, Tri Medvedya, Arsenalnoe, Bolshaya Krzshka, private label and most regional brands.

Binning large PET bottles Furthermore, the category of large PET bottles accounts for 23% of total beer volumes. Because the which account for 23% of large bottles are mainly used in the economy segment of the market, the risk was mainly for a volume total beer volumes drop is in that segment and Carlsberg estimates that the total loss for the market would be 5%. What happened was that those brewers that had most to loose from the ban, started lowering the prices for the 1.4 litre PET (which before was trading at a 12% price premium).

Among the bigger brewers Efes was going to suffer the most, as it is the market leader in low mainstream segment and an estimated 30% of its volumes are in PET. Furthermore, volumes of Bolshaya Kruzhka (Carlsberg) as well as beer Tri Medvedya (Heineken) could well be under pressure. Already at the start of 2016, AB InBev started to move its bigger sizes for Tolstyak into 1.4 litre Tolstyak Zhivoe much to the advantage of Ochakovo. However, coming into 2017, Ochakovo and the regional brewers came under pressure, which prompted further discounting of the smaller sizes. Both Efes and Heineken joined in discounting those packs.

Fig. 85: Average pricing for different pack sizes Fig. 86: Beer market segment by packaging and type - 2016, RUB/l

90 87 82 80 76 36.3% 34.0% 68 PET 21.7% 21.4% Glass Can 19.5% 19.6% Keg

22.5% 25.0% Bottle Can 0.5l PET 1l Can 1l PET 1l- PET 2.5l 0.5l 1.5l 2015 2016

Source: Bryan, Garnier & Co. est. Source: Bryan, Garnier & Co. est.

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Fig. 87: Beer market segmentation by price, %

Segment Brands 2015 2016 Superpremium >125 RUB/l Heineken, Miller, Stella Artois, craft beer, import 6.5% 6.4% Premium 101-125 RUB/l Baltika 7, Naltika 9, Baltika 0, Zhiguli, Bud, Velkopopovicky 26.2% 25.4% Kozel, Bavaria, Krusovice Mainstream 81-100 RUB/l Zatecky Gus, Klinskoe, Baltika 3, Baltika Kuler, Okhota, 37.2% 37.0% Carlsberg, Stariy Melnik, Zolotaya Bochjka, Goesser, Obolon

Economy <60 RUB/l Zhigulevskoe (Carlsberg), Belly Medved, Tolstyak, Tri 30.0% 31.2% Medvedya, Arsenalnoe, Bolshaya Krzshka, private label, most regional brands

Source: Company Data; Bryan, Garnier & Co ests.

While Efes and Heineken and some regional brewers were cutting their prices, Baltika increased its PET shelf price by 6% compared to 2016 driven by a price increase and a PET mix move to 1.42l packaging. Although that was very good for margins it resulted in a loss in market share in the PET segment of approx. 5%. The value-approach impacted its brands in the lower mainstream segments and it were brands such as Bolshaya Kruzhka and Zhigulevskoe that lost share. (according to Nielsen, some of Carlsberg’s 1.42-liter products now sell at a premium of up to 30% to 40%).

Overall in the first half, Carlsberg’s Russian market share was down to 32.2% (-2.3% vs 2016) as it lost 15% in volumes compared to a market decline of 5% (gained share in DIOT channel – see later – could not compensate for the lost share in PET). That loss of share is very similar to 2015 when market share was down 3% also on the back of pricing ahead of the market. The problem is that even if pricing comes more in line with the market (what happened in 2016) that lost share is not regained.

Fig. 88: Shelf price dynamics of pet packaging Fig. 89: Carlsberg Russian market share per litre (RUB)

85 +5.4% 38.6% 80 +0.9% 37.8% +4.4% 75 70 34.8% +2.9% 34.5% 65 60 32.2% 55 50 2014 2015 2016 H1 2017

Market Baltika 2013 2014 2015 2016 H1 2017

Source: Carlsberg Source: Carlsberg

The growth of the modern trade and the DIOT channel

In general there are three distinct beer sales channels in Russia: 1) food retail shops that include the traditional stores, minimarkets and the modern retail (super-and hyper markets); 2) on-trade channel that includes hotels, traditional beer restaurants, bars and craft gastropubs, 3) a retail channel (DIOT

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– draught in off trade) that holds the middle between off-trade and on-trade and that includes the former kiosks but also the specialised retail channel (Keg-to-PET shops with limited beer range and beer shops with a wide variety of beer offerings).

Within the Russian beer market there has been very strong and abrupt evolutions (often driven by legislation). The two recent trends have been the strong growth of the modern trade and the development of the DIOT channel. Both of them are the result of consumers looking for a better, fresher product at a cheaper price.

Strong growth of the Today the modern retail trade (super- and hypermarkets) is the biggest distribution channel for beer, modern retail trade accounting for 25% of beer sales compared to 21% for the traditional retail. That is a big change that happened over the past five years when modern retail represented only 15% of beer sales compared to 38% for the traditional retail. However, in absolute terms there has not been much growth in that channel neither but it has been stable in a declining market as consumers looked for super-and hypermarkets to deliver better pricing.

The bigger brewers including Carlsberg have been surprised by the speed of the development which left them with too much stock at the distributor level, for the traditional retail. Meanwhile all the large brewers have been looking to best position themselves into the modern retail. And indeed, it is one of Carlsberg’s main targets to win with winning modern retail clients. Off’course being focussing on the modern trade, the larger brewers (Carlsberg, Efes, Heineken, AB InBev) has been actively cutting their presence in the traditional channels. The never seems to be able to get the balance right. The regional brewers took their place in the traditional channel and on top of that pressed for additional sales (in large PET bottles) of regional brands in the modern trade.

Fig. 90: Structure of beer retail landscape - Fig. 91: Evolution of beer sales channels - Russia, 2016 Russia

Kiosks 100% Modern On-trade 5% 90% retail 11% 80% Minimarkets Modern Keg to 70% retail Traditional PET, 60% 25% 50% stores beer (Keg to PET, shop 40% beer shops 13% Mini- 30% On-trade markets 20% 25% Traditio- 10% Kiosks nal 0% stores

21% 2010 2011 2012 2013 2014 2015 2016

Source: Pivnoe-delo Source: Pivnoe-delo

The growth of the DIOT The first one was the legislation that banned kiosks causing that channel to shrink from doing 20% of channel is on the back of beer sales in 2010 to 5% in 2016. Those lost volumes got partially picked up by the minimarkets the kiosk ban and ban of (some kiosks transferred into minimarket) and by the DIOT channel. The DIOT channel or Keg-to- selling beer in large PET PET is a relatively new channel where consumers buy an empty plastic bottle (including more than 1.5l), which they then fill up and take home or consume at the premise. This newish channel partially

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circumvents the legislation that prohibits the sale of beer in PET containers of more than 1.5l, but it also replaced some kiosks (located in the apartment buildings). The advantage of the channel is that it is very convenient located, and has on site a variety of usually fresher, tastier beer on offer than the PET offering in the modern trade. As a result also some supermarkets are now offering draught beer.

Fig. 92: Keg-to-PET outlet in an apartment Fig. 93: Draught beer outlet in the Pyaterochka block (part of X5) store St. Petersburg

Source: Carlsberg Source: Bryan Garnier

DIOT channel is already Trade data indicate that the keg-to-PET and beer shops together accounted for 13% in 2016, up from 13% of volumes 5% in 2010. There is an argument that the convenient location and the wide availability of fresh beer could potentially boost the channels share further. However, the challenge that the channel represent is that by April 2017, all beer sellers need to install modern point-of-sale terminals and that some regional authorities are looking to introduce limitations for selling draught beer on the ground floors of apartment blocks. After having ignored the channel for a long time (and hence losing out of 13% of the market) Carlsberg finally got into making an effort to take a 30-34% market share in this channel. And indeed in the first half of 2017, Carlsberg grew its volumes by around 50% in this channel.

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Fig. 94: Baltika market share in DIOT channel Fig. 95: Carlsberg owns six out of top-15 national brands

70% Zatecky Guss Baltika #7 60% Baltika #3 Okhota 50% Bely Medved Klinskoe 40% Velkopopovicky Kozel Carlsberg 30% Other Baltika Zhigulevskoe… 20% Bud Zhiguli Barnoe 10% Baltika #9 15.2% 17.1% Tuborg 9.3% 8.0% Tolstyak 0% Tri Medvedya H2 2014 2015 2016 H1 2017 Stary Melnik Bolshaya… Baltika 0% 1% 2% 3% 4% 5%

Source: Carlsberg Source: Carlsberg

High comps for Q3 – was it really hot last year?

Looking at weather patterns in Russia, the summer of 2016 was in general rather warm but the zones of high temperatures were shifting. In June 2016, it was particularly hot in the territories with low level of beer consumption (the northern part of Siberia). And in July, the weather was hot in the north of the European part of Russia in western Siberia. Instead, August 2016 was rather warm nearly all over Russia — from Central region to Ural inclusive. But the weather in the populated area of Volga region and South Ural was particularly hot. As nearly 40% of the beer sales in Ural accrue to Baltika, Carlsberg was the main beneficiary of better weather. This is especially so as he bulk of beer is not manufactured at the local market but delivered from neighbouring regions. Furthermore as July and August was warmer in some areas it resulted in the brewers getting carried away and also delivered more for September, which then disappointed in terms of weather.

Fig. 96: Average temperatures for Q3 in key Fig. 97: Average temperatures for Q3 in key West Russian cities Central and East Russian cities 28 28 26 26 24 24 22 22 20 20 18 18 16 16 14 14 12 12 10 10 2014 2015 2016 2017 2014 2015 2016 2017 2014 2015 2016 2017 2014 2015 2016 2017 2014 2015 2016 2017 2014 2015 2016 2017 2014 2015 2016 2017 2014 2015 2016 2017 St Moscow Kazan Rostov-on- Yekaterin- Novo- Irkutsk Vladi- Petersburg City Don burg sibirsk vostok

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Merger Efes and AB InBev – consolidation good for margins?

Rostat market share Fig. 98: Evolution market share Russia figures are well lower for Carlsberg than Nielsen 100%

80% 15.9% 15.6% 15.4% 13.9% 13.1% 12.5% 11.9% 12.3% 11.4% 60% 10.2% 10.9% 12.2% 12.6% 12.6% 14.5% 12.1% 10.8% 16.8% 16.1% 14.7% 13.0% 13.2% 40% 12.7% 13.3%

20% 40.5% 35.3% 34.3% 34.2% 34.1% 34.0% 31.1% 31.4%

0% 2009 2010 2011 2012 2013 2014 2015 2016 Carlsberg Efes Heineken AB InBev MBC Ochakovo Tomsk Beer Small breweries Others domestic Private label Import (excl. top 5)

Source: Rostat

Efes/AB InBev would On 9 August 2017, Anadolu Efes and AB InBev announced that they intend to merge their existing become a clear #2 with Russian and Ukrainian businesses on a 50/50 basis. This follows on from AB InBev’s acquisition of a market leader ambitions 24% stake in Anadolu Efes as part of its combination with SABMiller, which completed in October 2016. The merger remains conditional on the completion of satisfactory due diligence and is subject to regulatory approvals in Russia and Ukraine. Nevertheless, it is anticipated that the transaction could

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complete by the end of H1 2018. Until completion of the transaction, both Anadolu Efes and AB InBev’ businesses in Russia and Ukraine remain separate and continue business as usual.

If the merger would go ahead that would create a strong number two that on 2016 figures would hold 24.1% compared to Carlsberg’s 31.4%. Although consolidation normally is good for the margins in the market, the competitive nature of the Russian beer market, makes it unlikely that this would be the case. With Carlsberg having lost more market share in H1 2017 and probably reaching a 29% share (on the back of Rostat figures), the new combination could have the aspiration to become market leader in Russia (and Ukraine). That prospect should put some pressure on Carlsberg and we would expect the company to become more price-aggressive in the market.

Fig. 99: Market share Russia – pf 2016 Fig. 100: Big brewers loose market share

90% Top 4 Import (excl. top 80% Carlsberg Rest 5) 31% 70% Private 1% label 60% 1% Efes 50% Others 13% domestic 40% 18% Small 30% AB InBev AB InBev breweries 12% - Efes 20% 3% 25% Tomsk 10% Beer 2% 0% Ochakovo MBC Heineken 5% 2009 2010 2011 2012 2013 2014 2015 2016 3% 11% Source: Rostat, Bryan Garnier estimates

The next new thing: craft and alcohol free beer

In 2016 craft beer represented 3% of the total Russian beer market, which was flat compared to 2015 but well ahead of the 1.3% five years earlier (2011). In Moscow and the craft beer segment with specialized distributors and sales channels is developing the most rapidly. But in the regions, most of the craft brewers continue operating in traditional beer formats and compete with medium-sized breweries supplying their products to draught beer shops. For the moment, those craft brewers mainly produce beer in kegs that they sell to the on-trade or the keg-to-PET shops (including the ones in the supermarkets). Hardly any can afford a bottling line which excludes them from the shelves of the modern and traditional grocery stores, who all want large volumes of stable taste and long shelf life. However, one company stands out and that is the Moscow Brewing Company which has become the craft market leader, despite the scale of its operation. Next to producing its own craft beers, the MBC has started importing different craft beers from the USA, Netherlands and Denmark (and is producing under licence some of the Royal Unibrew brands like Faxe and Lapin Kulta).

The non-alcoholic beer market in Russia is 1.0% of the total market and grew in 2016 by 12%. Its’ growing popularity has to do with that the generation born in the 80’s is, according to RLMS HSE, already the largest beer consumer group (37% of volumes) and that generation born in the 90’s represent another 9%. Both generations have a healthier life style and are less alcohol dependant for their social interaction. Baltika #0 is by far the market leader with a 60% share in the segment and in

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March 2017 the company launched a new production line for non-alcoholic beer at their Samara brewery. Other popular brands that were launched Bud Alcohol Free (summer 2015) and Zhiguli Barnoe Alcohol Free (spring 2016, MBC). The new launches (and the category growth) are supported by a very active promotion which complied with the law. The majority of brands advertized on TV in 2016 were alcohol free which allowed them to avoid advertisement limitations.

Fig. 101: Craft beer penetration, 2016 Fig. 102: Alcohol free beer penetration, 2016

14% 5% 12% 4% 10% 8% 3% 6% 2% 4% 1% 2% 0% 0% UK ROI USA Italy Italy Spain Russia Russia France France Poland Poland Austria Greece Croatia Iceland Finland Canada Canada Norway Norway Ukraine Sweden Slovenia Slovenia Hungary Portugal Romania Denmark Denmark Germany Switzerland Netherlands Czech Republic Czech Republic Slovak Republic Slovak Republic Source: Canadean, Bryan Garnier estimates Source: Canadean, Bryan Garnier estimates

2016 market dynamics – increase price, lose volumes; lower price, boost volumes

In 2016, the Russian beer consumption continued its decline by 2%, which was a little less than the annual 5% decline in the previous 5 years. The market was supported by a stable excise duty and also the further rise of affordable beer, allowing for beer price inflation in line with food inflation.

Fig. 103: Beer price RUB/l Fig. 104: Inflation Beer v Food

110 14% 2.5% Beer price inflation (MoM) 12% 2.0% 105 Food inflation (MoM) 10% 1.5% 100 8% 1.0% 95 6% 0.5% 90 Beer price RUB/l (rhs) 4% 0.0% 85 2% -0.5% Beer price inflation (YoY, lhs) 80 0% -1.0% déc-15 déc-16 déc-15 déc-16 juin-15 juin-16 juin-15 juin-16 sept-15 sept-16 sept-15 sept-16 mars-15 mars-16 mars-17 mars-15 mars-16 mars-17 Source: Rostat Source: Rostat

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In the run up of the FIFA world cup in 2018, beer advertising was again allowed during sports events and broadcasting. A heatwave in parts of Russia, also helped with beer volumes. However, the

Carlsberg recovered market share in 2016 (to 31.4% from 31.1%) due to aggressive discounting that closed the price gap with the market (which led to a sharp 3% share loss in 2015). There was also a strong push for the Baltika 0%. And the company did made a strong effort (also price effort) in the DIOT channel with its Zhigulevskoe brand.

In 2016 there was fast growth of the Carlsberg brand that was lowered to the Baltika 3 price level (and eat into the Baltika 3 market share but also in Tuborg and Holsten’s share). In the mainstream brands Zatecky Gus continue to grow sales, supported by strong advertising and execution (and the brand continued to grow in 2017). Zatecky Gus is now the biggest brand in Russia with a Czech proposition (launched only 7 years ago) and is the largest single brand in the market (4% share). Carlsberg also benefited more than others from the good weather in the Ural, Volga, and Southern regions, where it won share from AB InBev and Heineken.

Efes increased its overall market share in 2016 as it grew its presence in the modern trade and hardly increased prices. As a result it grew its share in the premium segment (Miller, Velkopopovicky Kozel, and Stary Melnik) which compensated for its decline in PET. In PET, Efes had about 1/3 of the market in package volumes exceeding 2l, which could not be downsized as is the case with 1.5l bottles. As a result instead of one of the largest players in PET it became one of the smaller players.

Heineken had been increasing its prices since the Q3 2015 and that continued in 2016. By Q3 2016 it became the more expensive brewer where two years earlier, it was still the cheaper bigger brewer. The price increase for its economy brands (eg Tri Medvedya and regional brands Shikhan and Okskoe) also caused their volume to decline (next to halting production of Petra and PIT). On the other hand, the company performed well with its Okhota brand in the mainstream segment and with Goesser that like Carlsberg was repositioned from premium to mainstream.

AB InBev lost more market share in 2016 as it was improving prices for its value brands Tolstyak and Klinskoe which immediately resulted in volume decline. The brand that did well was Sibirskaya Korona that was supported by advertisement, shelf space expansion and price reduction (to the lower end of premium).

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Fig. 105: Average retail price for the top 4 brewers (RUB/l)

Source:

6.2.5. Carlsberg out of touch with market dynamics and nothing seems to change Faced with the multitude of challenges in the Russian beer market, Carlsberg did present at its capital markets day in October 2017, a strategy that should enable the company to improve revenue per hl and operating margins. The key points of that we have highlighted before. However, much of the elements of that strategy have been in place since a long time. Below we put face-to-face the Russian strategy as presented at the capital markets day in Copenhagen in October 2017 with the one in Copenhagen in September 2010. Instead of “Grow the bucket of billion-rouble-brands “ it was “Drive Power brands and balance the portfolio”;” instead of build strong regional portfolio” it was “drive further portfolio customisation” which was centred around the regional portfolios. Instead of “Win with winning modern trade customers” it was “Win in-store/channels” and “Gaining fair share in DIOT” was “Address new growth platforms”.

Fig. 106: Russia strategy CMD September Fig. 107: Russia strategy CMD October 2010 2017

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Source: Carlsberg Source: Carlsberg

And seven years later, the company’s share fell to 32.2% in the first half of 2017 (Baltika estimate) from 40% in 2009 (Canadean), it missed the development of the DIOT channel, forgot about its regional brands, withdraw too quickly from the traditional retail and has still not made the full commitment of a price fighter brand. It’s eagerness to improve margins rather than to hold share, allowed completion to eat into its market share while economy beer and the DIOT channel have been taking significant shares as consumers have been looking for new more price aggressive alternatives. That continued under the new management and got for worse in the first half of 2017, when Carlsberg Russian volumes fell by 15% compared to a market decline of 5%, impacted by the downsizing of PET bottles, continued challenging consumer environment and cold weather in parts of the country.

In its recent presentation it does like to highlight that although volumes are down 40% over the past 5 years it managed to increase revenue per hl by 35%. Off’course with inflation in that period cumulating to nearly 50% (49.6% to be exact), revenue per hl in real terms went down. So in the past five years both volumes and price/mix in real terms have been declining.

Going forward volumes Going forward we are expecting that in the best case volumes and price/mix are flat. On volumes to be flat at best there is still the target of the Russian government to decrease alcohol consumption by 1/3th. And even if that happens fully on the back of the un-recorded alcohol consumption (best case scenario) than it only means flat volumes for the recorded alcohol consumption including beer.

Volumes for Carlsberg will probably also at best be flat. On the one hand the company has all these wonderful plans to build a strong regional portfolio, increase its share in the modern trade and gaining share in the DIOT channel. On the other hand, the combination AB InBev/Efes will probably look to get to a market leading position. At the same moment, the local brewers who have proven to be close to the market are very unlikely to let Carlsberg retake some of their lost market share. Again in the first half of this year, Carlsberg lost more share following a mispricing of its high volume 1.42l pack. The company is hoping to regain share that it lost in H1, but unfortunately that is not going to happen (it didn’t happen neither in 2016 following on from a similar pricing mistake at the end of 2015). And all that was already under the current new management.

Do they ever learn? Given the absence of any further excise duty increases in 2018 and 2019 there might be some pricing opportunities. But if there are any, they are likely to be cancelled by the company’s plans to build a strong regional portfolio, increase its share in the modern trade and gaining share in the DIOT channel, next to regain the lost share in the larger PET formats. The company must have learned by now that the Russian consumer is keen to get a good deal and there are plenty of market participants that are willing to offer that. Furthermore, over the medium term there will be more opportunities for the Ministry of Finance to further increase beer taxes (excise of VAT) which together account for 29% of the average selling price. That is in line with the average for the Western world, but Russia has a far bigger alcohol problem, so there should be further increases. After a grace period, which probably will last until after the FIFA world cup in 2018, we would expect that further excise duty increases will be announced.

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7. Results and profit forecasts Over the past couple of years, the revenue profile of the company was of declining volumes in East Europe, flat volumes in West Europe and growth in Asia. Going forward we are expecting that the company’s plan to reinvest some of the efficiency improvement savings into rejuvenating the core brands does pay off and we are expecting modest growth in West Europe while growth continues in Asia. Even for East Europe we are assuming some kind of improvement to flat volumes but are aware that more restrictions on alcohol consumption in Russia are very likely as the country battles to reach less damaging levels of consumption. As a result we are expecting, Carlsberg to grow revenues organic by 1.6% in 2017, 3.3% in 2018 and look for a five year average of 3.2% which sits in the middle of the target of 2% to 4% that Carlsberg’s CEO Cees’t Hart unveiled during its capital market day in October 2017.

As not all efficiency improvements are being reinvested (half is flowing through the bottom line), we look organic EBIT growth of 8.5% in 2017 (target is 4 to 7%) and 7.5% in 2018. On average we compute 7.2% EBIT growth for the next five years.

With deleveraging, refinancing at cheaper rates and a decline in tax rate (from 33% to 30% in 2017 and 26/27% target for the medium term), we are expecting an adjusted EPS jump by 27% to DKK32.4 and by another 13% to DKK36.5 in 2018. Starting in 2017, we are expecting an average EPS growth of 10.8%.

Fig. 108: Income statement

DKK m Dec-15 Dec-16 Dec-17e Dec-18e Dec-19e Dec-20e CAGR CAGR 11/16 17/22 Net Revenue 65,427 62,614 63,591 65,430 67,446 69,580 (0%) 3.1% reported growth 1.4% (4.3%) 1.6% 2.9% 3.1% 3.2% organic growth 1.7% 2.0% 1.6% 3.3% 3.6% 3.7% 3.2% EBITDA 12,849 12,682 13,553 14,187 14,817 15,505 (1%) 5% A&P % revenues 10% 10% 10% 10% 10% 10% EBIT 8,093 7,921 8,811 9,518 10,181 10,889 (4%) 7% reported growth (8.3%) (2.1%) 11.2% 8.0% 7.0% 7.0% EBIT adjusted 7,940 7,742 8,452 9,145 9,793 10,486 (4%) 7% adjusted growth (6.1%) (2.5%) 9.2% 8.2% 7.1% 7.1% organic growth (7.0%) 5.0% 8.5% 7.5% 6.7% 6.7% 7.2% Special items, net (8,659) 251 (300) (300) (300) (300) Net financial income (expenses) (1,531) (1,247) (1,073) (846) (681) (506) (9%) (35%) Interest charge -4.4% -4.2% -4.0% -3.8% -3.8% -3.8% Affiliates 364 324 340 357 375 394 Tax (849) (2,392) (2,157) (2,428) (2,565) (2,700) Minorities (344) (371) (639) (683) (731) (782) (7%) 7% Net profit (2,926) 4,486 4,983 5,618 6,279 6,995 reported growth (166.3%) (253.3%) 11.1% 12.7% 11.8% 11.4% Net profit adjusted 4,557 3,881 4,941 5,565 6,215 6,919 (6%) 11% adjusted growth (17.1%) (14.8%) 27.3% 12.6% 11.7% 11.3%

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Fig. 109: Per share data

DKK Dec-15 Dec-16 Dec-17e Dec-18e Dec-19e Dec-20e CAGR CAGR 11/16 17/22 No of shares, year end (m) 153 153 153 153 153 153 0% 0% Average no of shares, diluted (m) 153 153 153 153 153 153 (0%) 0% EPS -19.18 29.41 32.67 36.83 41.16 45.86 (3%) 11% EPS adjusted 29.87 25.44 32.39 36.48 40.74 45.36 (6%) 10.8% adjusted EPS growth (16.8%) (14.8%) 27.3% 12.6% 11.7% 11.3% Free cash flow 48.5 36.6 41.9 43.9 47.6 51.6 6% 7% Book value 285.1 333.1 351.5 370.1 390.9 414.1 (5%) 6% Net dividend 6.48 7.20 10.26 13.13 14.67 16.33 13% 14%

Given the past performance of the company, our assumptions for growth in topline and margin are pretty bullish. We are expecting organic revenue growth of 3.2% for the next three years, compared to 2.6% in the past five years. Published net revenue growth should come in at 3% compared to no growth in the past five years. Furthermore we look for an EBIT margin in 2022 of 16.2% which is a 380bp improvement on 2016 and would bring the company back to the level where it was in 2010, i.e. 16.4%.

Fig. 110: Carlsberg – EBIT margin Fig. 111: Carlsberg – organic revenue growth

30% 12% 10% 25% 2011-2016 8% 20% 2017-2022 6% 2010 15% 4% 2016 10% 2% 2022 5% 0% West East Asia Group 0% Europe Europe West East Asia Group Europe Europe

Source: Carlsberg, Bryan Garnier estimates Source: Carlsberg, Bryan Garnier estimates

7.1. West Europe back to growth The West European market is generally perceived as a mature and hence ex-growth market. Indeed over the past 10 years and 5 years the decline has been respectively with 0.7% and 0.1%. However, in the past three years, there has been some growth mainly driven by France, Italy and Portugal, where beer consumption is still relatively low as it are mainly wine consuming countries. Indeed in France beer consumption per head is 28 litres, in Italy it is 27 and in Portugal 46 litres, which compares with a European average of 71 litres (USA is 73). Although growth in the high end category has been better over the past 10 years, the main pocket of growth over the past five years has been mainstream, maybe because high end is already 34% of the West European market and by definition some of the high end propositions (brands with price index 115 +) will start falling into the mainstream categories (brands with price index 91-114).

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There are different elements that convince us that Carlsberg will be able to do slightly better than the underlying markets: it still has a lower share of high-end beers, it has a clear proposition and plan to rejuvenate its core beer proposition, it is planning to put money behind it and the DraughtMaster (which had such good success in Italy of regaining market share and premiumising) is being rolled out in the other markets, starting with its key Nordic markets. In our modelling that translate in a more bullish outlook for Carlsberg to achieve 0.5% volume growth and 1% price/mix over the coming five years, before volume growth trends again to 0%. Given the volume growth and the price/mix improvement which largely should cover cost increases and the ongoing efficiency programmes, we are equally bullish on operating margins in West Europe and look for the company to reach an operating margin of 16.3% in 2022 compared to 14.3% in 2016.

Fig. 112: West European beer markets Fig. 113: West European beer market growth by price segment

3% 1.7% West Europe 10 yr 2% Carlsberg markets 5 yr 1% 0% -1% -0.1% -0.1% -2% -0.4% -0.7% -3% -1.0% -1.3% -4% -1.5% Discount Mainstream High end Market

Source: Canadean Source: Canadean

7.2. East Europe struggling On the East European business we are assuming a longer term trend of flattish volumes. On the one hand the macro-economic environment is improving and there is no planned excise duty increase in Russia in 2018 and 2019, but on the other hand the key beer consuming population is declining and we find it likely that the Russian government will impose further restrictions on availability and affordability (excise duty) of beer. Although the company might have the aspiration to improve its share in the market, its track record under both previous and current management is not encouraging. 2017 is already off to a bad start with both a market volume decline (high comps and the impact of large PET packs) and a mess-up in terms of pricing of the next level of large PET packs (1.42l). Margins will probably expand in 2017 on the back of the good pricing and the Sail’22 efficiency improvements. Going into 2018, we are expecting Carlsberg to correct its PET pricing, which will drag down pricing but we expect that the company will benefit from some volume growth (a little because of the lower PET pricing, but more because of gaining share in the DIOT channel and the FIFA world cup). However, we expect flattish margins given the low profitability of the economy segment and the lower PET pricing. For the medium term we are assuming no volume growth, a little real pricing and margin expansion. By 2022 we assume an operating margin of 20.6% vs 17.8% in 2016 and 20.1% in 2017.

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7.3. Asia pulling ahead Asia has been the most important growth driver for Carlsberg over the past five years, delivering organic revenue growth of on average 10.6%. This is likely to remain. Not only are the Asian beer markets delivering stronger volume growth, but also there are still significant opportunities for uptrading. Indeed, about 45% of the re-investments of the Funding the Journey plan are expected to go to the Asian regions, where the company has been looking to put more money behind its premium Tuborg and Carlsberg brands. Next to strong top line growth of on average 8% p.a. over the next five years, we do expect continued margin expansion despite that the company will be looking to reinvest in additional marketing the expected improvements in gross margin. We look for a 2022 operating margin of 23.9% compared to 19.1% in 2016.

Fig. 114: Carlsberg organic revenue Fig. 115: Plan for the Russian business growth by region (2012-2016)

10.6%

1.9% 0.4% 0.8%

West East Europe Asia Group Europe

Source: Carlsberg, Bryan Garnier estimates Source: Carlsberg

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Fig. 116: Divisional breakdown forecast

Dec-15 Dec-16 Dec-17e Dec-18e Dec-19e Dec-20e Western Europe Beer sales (m hl) 50.2 48.4 47.9 48.2 48.4 48.6 organic growth 0% -4% 0% 0.5% 0.5% 0.5% Net sales 38,811 37,597 37,221 37,923 38,640 39,372 organic growth 0.0% -1.1% 1.0% 1.9% 1.9% 1.9% reported growth 2.8% -3.1% -1.00% 1.9% 1.9% 1.9% Net sales/hl 585 581 577 582 588 594 Operating profit 5,325 5,358 5,219 5,583 5,843 6,111 organic growth -3.0% 2.6% 7.3% 7.0% 4.7% 4.6% reported growth -2.7% 0.6% -2.6% 7.0% 4.7% 4.6% Operating margin 13.7% 14.3% 14.0% 14.7% 15.1% 15.5%

Eastern Europe Beer sales (m hl) 32.3 32.4 30.1 30.4 30.4 30.4 organic growth -14% 0% -7% 1% 0% 0% Net sales 10,963 10,305 11,321 11,256 11,256 11,256 organic growth 2.0% 8.0% -1.0% 2.0% 3.0% 3.0% reported growth -22.0% -6.0% 9.9% -0.6% 0.0% 0.0% Net sales/hl 322 300 352 347 346 346 Operating profit 1,908 1,832 2,146 2,159 2,196 2,232 organic growth -19% 12% 6% 3% 5% 5% reported growth -36% -4% 17% 1% 2% 2% Operating margin 17.4% 17.8% 20.0% 20.0% 20.2% 20.3%

Asia Beer sales (m hl) 37.8 36.1 36.1 37.2 38.3 39.4 organic growth 2.0% -3.0% 0.0% 3.0% 3.0% 3.0% Net sales 15,339 14,666 14,999 16,199 17,495 18,895 organic growth 5.0% 4.0% 5.0% 8.0% 8.0% 8.0% reported growth 22.8% -4.0% 2.3% 8.0% 8.0% 8.0% Net sales/hl 371 369 376 394 413 433 Operating profit 2,799 2,802 3,136 3,484 3,867 4,290 organic growth 13.5% 6.0% 11.9% 11.1% 11.0% 10.9% reported growth 27.5% 0.1% 11.9% 11.1% 11.0% 10.9% Operating margin 18.2% 19.1% 20.9% 21.5% 22.1% 22.7%

Source: Company Data; Bryan, Garnier & Co ests. 7.4. Other financial items Based on the spot rates on August 14, the company is guiding for a positive translation impact on operating profit of around DKK50m for the full year compared to its earlier guidance in May of DKK300m. That lower guidance is mainly due to the weakening of the Russian rouble during the summer.

Special items were a positive DKK38m in the first half, but give the ongoing restructuring programmes, we expect it to be slightly negative for the full year.

The company has guided that for another 2 year, capex levels will be below depreciation but that afterwards it expect them to come back up to depreciation. We assume that the company will invest

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between 6% and 7% of net revenue. On net working capital which stood at -12.9% after the first half 2017, the company expects that to remain so in the years ahead.

We are expecting slightly higher minorities than the DKK600m-DKK650m 2016 figure adjusted for the Chongqing impairment and restructuring.

Company guidance for the full year is to reach mid-single digit, i.e. 4% to 7%, of organic operating profit growth. Given that the company already did 15% organic operating profit growth in the first half, this figure might look conservative. However 1) the heatwave in Eastern Europe in Q3 last year makes tough comps; 2) weather in West Europe has been not so good this year in Q3; 3) there is a different phasing of marketing costs in 2017 compared to 2016, when more marketing costs were taken in anticipation of the UEFA Euro 2016 and 4) investments for Sail’22 are being accelerated in the second half of the year.

On tax, the company is guiding for a 2017 tax rate below 30 percent which should come down over time to 26/27% as the company optimises its legal structures especially in Asia and, following on from BSP1 model in West Europe.

On financial expenses the company is guiding for 2017 to DKK1bn excluding currency losses/gains and fair value adjustments. For 2018, the company will benefit from its lower debt levels (expected to be DKK22.0bn by the end of the year compared to DKK26.6bn at the end of 2016) and would also benefit from the cheaper re-financing in October of a EUR500m debt at 0.5% saving DKK100m of financial costs in 2018.

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Price Chart and Rating History

Carlsberg

765.0

715.0

665.0

615.0

565.0

515.0 26/04/16 26/07/16 26/10/16 26/01/17 26/04/17 26/07/17 26/10/17

CARLSBERG 'B' Fair Value Achat Neutre Vente

Ratings

Date Ratings Price 08/02/17 NEUTRAL DKK630.5

04/01/17 SELL DKK612.5

25/11/16 NEUTRAL DKK587

18/08/16 SELL DKK679

11/05/16 NEUTRAL DKK638

11/01/16 SELL DKK588

Target Price

Date Target price 05/04/17 DKK670

21/03/17 DKK645 01/12/16 DKK599

11/05/16 DKK600

07/04/16 DKK500 26/02/16 DKK520

11/01/16 DKK485

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Bryan Garnier stock rating system For the purposes of this Report, the Bryan Garnier stock rating system is defined as follows: Stock rating Positive opinion for a stock where we expect a favourable performance in absolute terms over a period of 6 months from the publication of a BUY recommendation. This opinion is based not only on the FV (the potential upside based on valuation), but also takes into account a number of elements that could include a SWOT analysis, momentum, technical aspects or the sector backdrop. Every subsequent published update on the stock will feature an introduction outlining the key reasons behind the opinion. Opinion recommending not to trade in a stock short-term, neither as a BUYER or a SELLER, due to a specific set of factors. This view is intended to NEUTRAL be temporary. It may reflect different situations, but in particular those where a fair value shows no significant potential or where an upcoming binary event constitutes a high-risk that is difficult to quantify. Every subsequent published update on the stock will feature an introduction outlining the key reasons behind the opinion. Negative opinion for a stock where we expect an unfavourable performance in absolute terms over a period of 6 months from the publication of a SELL recommendation. This opinion is based not only on the FV (the potential downside based on valuation), but also takes into account a number of elements that could include a SWOT analysis, momentum, technical aspects or the sector backdrop. Every subsequent published update on the stock will feature an introduction outlining the key reasons behind the opinion. Distribution of stock ratings

BUY ratings 52.6% NEUTRAL ratings 33.1% SELL ratings 14.3%

Research Disclosure Legend 1 Bryan Garnier shareholding Bryan Garnier & Co Limited or another company in its group (together, the “Bryan Garnier Group”) has a No in Issuer shareholding that, individually or combined, exceeds 5% of the paid up and issued share capital of a company that is the subject of this Report (the “Issuer”). 2 Issuer shareholding in Bryan The Issuer has a shareholding that exceeds 5% of the paid up and issued share capital of one or more members No Garnier of the Bryan Garnier Group. 3 Financial interest A member of the Bryan Garnier Group holds one or more financial interests in relation to the Issuer which are No significant in relation to this report 4 Market maker or liquidity A member of the Bryan Garnier Group is a market maker or liquidity provider in the securities of the Issuer or No provider in any related derivatives. 5 Lead/co-lead manager In the past twelve months, a member of the Bryan Garnier Group has been lead manager or co-lead manager No of one or more publicly disclosed offers of securities of the Issuer or in any related derivatives. 6 Investment banking A member of the Bryan Garnier Group is or has in the past twelve months been party to an agreement with the No agreement Issuer relating to the provision of investment banking services, or has in that period received payment or been promised payment in respect of such services. 7 Research agreement A member of the Bryan Garnier Group is party to an agreement with the Issuer relating to the production of No this Report. 8 Analyst receipt or purchase The investment analyst or another person involved in the preparation of this Report has received or purchased No of shares in Issuer shares of the Issuer prior to a public offering of those shares. 9 Remuneration of analyst The remuneration of the investment analyst or other persons involved in the preparation of this Report is tied No to investment banking transactions performed by the Bryan Garnier Group. 10 Corporate finance client In the past twelve months a member of the Bryan Garnier Group has been remunerated for providing No corporate finance services to the issuer or may expect to receive or intend to seek remuneration for corporate finance services from the Issuer in the next six months. 11 Analyst has short position The investment analyst or another person involved in the preparation of this Report has a short position in the No securities or derivatives of the Issuer. 12 Analyst has long position The investment analyst or another person involved in the preparation of this Report has a long position in the No securities or derivatives of the Issuer. 13 Bryan Garnier executive is A partner, director, officer, employee or agent of the Bryan Garnier Group, or a member of such person’s No an officer household, is a partner, director, officer or an employee of, or adviser to, the Issuer or one of its parents or subsidiaries. The name of such person or persons is disclosed above. 14 Analyst disclosure The analyst hereby certifies that neither the views expressed in the research, nor the timing of the publication of Yes the research has been influenced by any knowledge of clients positions and that the views expressed in the report accurately reflect his/her personal views about the investment and issuer to which the report relates and that no part of his/her remuneration was, is or will be, directly or indirectly, related to the specific recommendations or views expressed in the report. 15 Other disclosures Other specific disclosures: Report sent to Issuer to verify factual accuracy (with the recommendation/rating, No price target/spread and summary of conclusions removed). Summary of Investment Research Conflict Management Policy is available www.bryangarnier.com

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