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Booze. Burgers. Butts (cigarettes, people!). That’s how my summer sector allocation is shaping up. Oh, and Danish diabetes drug maker Novo Nordisk (NYSE:NVO) as a second derivative play on all of the above. Too cynical? To me it’s just human nature, all the more important in these uncertain times.

In this analysis, I’ll be taking a look at the fourth largest beer producer in the world, Ambev (ABV). Based in Brazil, Ambev produces, distributes and sells beer and Pepsi (NYSE:PEP) products all over Latin America. Let's take a deeper look to see whether or not Ambev’s business has the kind of durable competitive advantage that will make it profitable for years to come.

Brand Recognition

Ambev controls 70% of the beer market and around 40% of the total beverage market in Brazil. Its beer brands include market leader Skol, Anarctica, and Brahma. In the premium segment, Belgian import Stella Artois is on tap. As the largest Pepsi bottler outside the United States, its portfolio includes not only traditional Pepsi products like Pepsi-Cola and Gatrorade but the international soft drink brand, Guarana Anarctica, which is made from a native fruit of the Amazon forest and the best-selling soft drink in Brazil behind Coca-cola. The collective power of Ambev’s brand portfolio is undeniable.

Earnings Trend

A strong and rising earnings trend often indicates a business benefiting from a consumer monopoly and profit-minded management.

Ambev Earnings per Share (in Brazilian reals):

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

.34

.66

.76

.35

.47

.88

.92

1.54

1.94

2.44

After flattening briefly mid-decade, earnings per share at Ambev have remained in a clear uptrend since expanding into North America with its takeover of the world's third largest (then) brewer, Interbrew.

Debt

Great businesses typically generate strong cash flows and require little debt financing. Buffett believes the most effective way to evaluate a company’s financial position is not via the debt-to-equity ratio but by comparing earnings power to debt. Specifically, we like to see long-term debt less than three times current net earnings. With long-term debt of 4.2 billion and trailing 12-month net income of 8 billion, Ambev can easily cover its obligations.

Return on Equity

Companies that consistently deliver high returns on equity create the true wealth for shareholders. Average businesses typically offer a 12% return on equity while great businesses return over 15%.

Ambev Return on Equity:

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

24.31

40.41

33.39

10.91

8.38

14.34

15.36

26.80

27.97

32.61

Ambev’s 10-year average ROE is an impressive 23%.

Retained Earnings

Whether it’s via share buybacks or new investment in the core business, Buffett wants to own companies that are free to reinvest retained earnings at high rates of return. What he doesn’t want to see is high research and development costs or capital expenditures in the form of plant and equipment replacement. In Ambev’s case, while there are no R&D costs, ongoing investments in property, plant and equipment are required, some to new capacity, the rest to replacement. Current cap ex is 27% of operating cash flow and averages less than 20%. Year after year, free cash flow is positive.

The Verdict

Ambev’s strong fundamentals indicate a business with a durable competitive advantage. However, as evidenced by our analysis of Chipotle (NYSE:CMG), there is a difference between a great company and a great undervalued company. In part 2 of this analysis, we’ll look at Ambev’s valuation and decide on a desirable buy price.

Continue to Part 2 >>

Source: Ambev: Buy It Like Buffett Part 1