This Beverage Stock Is at Least 50% Undervalued

This article is part of our Rising Star Portfolios series.

Paul Chi and I co-manage The Motley Fool's Street Fighter portfolio, looking for cheap, unloved stocks with home run potential. We recently added a compelling oil and gas stock to the portfolio. Today, we're seeing value in another form of liquid gold: beer!

One name in particular caught our eye: Heineken (OTC: HINKY). The Dutch beer giant famous for its ubiquitous green-bottled namesake brand, has the right brew of strong brands, above-average growth, and cheap stock price. In fact, we think Heineken has at least 50% upside from today's price.

The cheapest in Spudland
Heineken operates a global network of 140 breweries in more than 70 countries. Its 200-plus brand portfolio includes popular labels such as Amstel, Dos Equis, Kingfisher, Newcastle, and Sol. Trailing-12-month revenue of $24.6 billion put it in the ranks of the biggest players, like Anheuser-Busch Inbev (NYSE: BUD  ) , in terms of annual sales.

Here's how Heineken stacks up against its big beer competitors:

Company	Anheuser-Busch Inbev	SAB Miller (OTC: SBMRY)	Heineken	Grupo Modelo (OTC: GPMCY)	Molson-Coors (NYSE: TAP  )
?	?	?	?	?	?
Major brands	Budweiser, Stella Artois, Beck's Michelob, Hoegaarden	Miller, Peroni, Pilsn! er Urque ll, Grolsch	Heineken, Amstel, Dos Equis, Newcastle	Corona, Modelo, Victoria, Leon, Montejo	Coors, Molson, Canadian, Rickard's Red
?	?	?	?	?	?
Enterprise value	$125,109	$63,106	$37,170	$18,851	$8,560
TTM revenue	$37,751	$15,145	$24,640	$7,560	$3,334
TTM free cash flow	$7,561	$1,854	$3,039	$1,400	$427
P/S ratio	2.2	3.6	1.0	2.5	2.3
EV/FCF	16.5	34.0	12.2	13.5	20.1

Source: S&P Capital IQ. In millions of U.S. dollars, except for ratios.

What should jump out at you immediately from this table is just how cheap Heineken is. Heineken's multiples to sales and free cash flow are the cheapest of the bunch. In fact, Heineken's enterprise value is 42% lower than competitor SAB Miller, despite generating 50% more in sales and free cash flow over the past 12 months!

There are a few reasons for this disparity. The 2008 acquisition of Scottish & Newcastle, a major U.K. brewing giant, saddled Heineken with lots of debt just as the credit crisis and global recession were taking hold. Heineken also has outsized exposure to Europe -- 68% of revenue in 2010 -- where economic conditions are particularly dire at the moment.

A stock with hops
But I see clearer skies ahead. Heineken has made d! ebt redu ction a top priority and has already paid down a significant amount since 2008. In spite of higher commodity costs, management's cost-cutting efforts helped Heineken grow its organic profit by nearly 20% in 2010, despite slightly lower volumes in its legacy brands. And the European economic situation will eventually improve.

Also, Heineken's 2010 acquisition of Mexican conglomerate Fomento Economico Mexicano S.A.'s (NYSE: FMX  ) beer operations in Mexico and Brazil has the company poised for substantial growth in the years to come. The $7.8 billion deal added the popular Dos Equis and Sol brands to Heineken's portfolio and gave the company a larger footprint in Latin America to compete with Corona brewer and region dominator Grupo Modelo.

At the current price of around $23, Heineken is priced as if its free cash flow is in a permanent, steady decline. That makes no sense. Even if you remove roughly $500 million -- my estimate of what Heineken generated in revenue from the newly acquired FEMSA operations last year -- Heineken's free cash hit $2.2 billion last year. That represents 13% compound annual growth per year since 2005.

I think modest top-line growth, thanks to Heineken's growing presence in emerging markets, combined with the company's ongoing cost-cutting efforts will help the company achieve at least 6.5% average annual growth in free cash flow over the next 10 years. Note that's only half the rate Heineken was able to grow free cash flow over the past five years. Under that assumption, my discounted cash flow model, using an 11% discount rate, suggests that Heineken's shares are worth at least $35 -- giving investors more than 50% upside from the current price.

The Foolish bottom line
With some of the most widely recognized brands in the business and a new foothold in Latin America, Heineken is in position to capture a huge piece of the developing world's growing thirst for beer. Yet H! eineken trades at an enormous discount to its peers. Like a full glass of cold beer on a hot summer day, that's a situation that just won't last very long.

We aren't the only ones banking on the massive potential for consumer goods in emerging markets. Some of The Motley Fool's analysts have dug up a potential gold mine banking on Latin American consumer goods growth. Their report is titled The Hottest IPO of 2011, and you can access it for free! Just click here. Fool on!

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