Author's Note: All graphs, tables and the calculations contained within them were created by the author. All data (unless otherwise noted) was collected from publicly-accessible company filings and reports.
There is little doubt that alcohol companies are highly attractive investments. With strong stable earnings and incredible cash flow generation characteristics, they represent compelling long-term investments. Most have substantial economic moats courtesy of incredible brand power. Although I generally prefer spirits companies with their additional barriers to entry created by often long maturing times, increasingly beer companies have caught my eye. Previously, this amounted to a closer look at Dutch-brewer Heineken (OTCQX:HEINY). This time, however, my eye has turned to Brazilian brewer Ambev (NYSE:ABEV).
Sentiment towards Ambev has suffered due to its connection with Brazil ( a theme also covered in my coverage of Experian (OTCQX:EXPGY)). The Latin American country, as a member of the fast-growing BRIC group, had been seen as a land of great growth opportunities for many companies and individuals until recently. Yet as the Brazilian economy has fallen into recession as well as political turmoil in recent months and years interest has been diminished and confidence in its prospects have plummeted.
Ambev has suffered not only by being a Brazil-listed business but also for its heavy reliance on the Brazil market for its top and bottom line performance.
I argue, however, that this is unfair. For Ambev, its Brazilian exposure remains a massive asset rather than liability. Also, for international investors, Brazil's current woes suggest that right now may well be an attractive point to open up a position in this mega brewer, especially through its ADRs.
What is undoubtedly true is the importance of Brazil to Ambev. As well as being its home, it represents the lion's share of its revenue. Over 54% of its top line comes from this one country (Data source: Ambev Q1 2016 results):
This is little wonder, of course, seeing as Brazil is by far their biggest Ambev market from a population perspective (Data source: Various sources via Wikipedia):
Indeed, Brazil's population is bigger than Ambev's next four largest operating countries combined (Colombia, Argentina, Canada and Peru) by population.
It is not just its historic links and big demographics which have rendered Brazil a core revenue component for the company. In fact, Ambev's market share in Brazil leaves it by and far the dominant player with 67% of the beer market of this Latin American giant (Data source: Nielsen):
As impressive as this market share is today, it has in fact been shrinking in recent years. Head back to 2009 and Ambev held 70% of the market:
Although in many ways unwelcome, this decline is more a reflection of the attractiveness of the market than anything else. More international players are being pulled into Brazil attracted by its appealing demographics. Heineken, in particular, has grown its market share significantly in recent years. Despite this erosion of market share, however, it remains clear that Ambev remains the market leader and will remain so for some time to come.
Improving Brazil Situation?
Before we look at Ambev further, let's return to Brazil itself. Brazil has clearly been struggling in recent years. Yet there is evidence that it may be starting to stabilize. Politically, this has been most pronounced. Interim President Michel Temer, who in May (at present temporarily) replaced impeached former President Dilma Rousseff, has so far encouraged a less tumultuous political feeling to emerge. Despite having an approval rating of just 31%, a recent Datafolha poll taken between July 14 and July 15 suggested that over 50% of the population were keen for him to stay in place as President until the next planned election in 2018.
Encouragingly, the same Datafolha poll suggested that confidence in the Brazilian economy received a healthy boost. The "Index of Confidence" hit 98 points, 11 points higher than in the last poll in February and the highest since the end of 2014.
Part of this may have been fed by the recent election of Rodrigo Maia to replace the antagonistic and scandal-ridden speaker, Eduardo Cunha. Maia was Temer's personal choice and has been recognized as a pragmatic centre-right politician who has proven adept at reaching out to leftist colleagues in the past.
His election - which makes him essentially the second most powerful political figure in Brazil after the President - is encouraging for Temer and his push to get reforms (especially related to austerity measures) through the lower house. The effect is that sentiment appears to have improved in Brazil as can be seen in the Brazilian real (that is, BRL) to USD currency rates over the last year:
After plummeting late last year, the BRL has strengthened against the USD back to similar levels one year ago. Despite this, it remains noticeably weaker than its historic rate over a long time period:
This is not to assume that as GDP growth returns, its strength against the USD will also return to historic levels. Yet it is quite likely. Brazil remains a country with huge growth potential, what is more the USD has seen its relative strength against a wide range of currencies exaggerated as it stands almost alone in raising rather than reducing interest rates.
How much the real may strengthen in the short term, however, is unclear. Some Brazilian politicians remain reluctant to let the BRL appreciate too much whilst the economy continues to struggle. Jose Serra, currently Brazil's foreign minister and a former (and likely future) Presidential candidate, stated on 14 July that:
I believe [the BRL] will stay around where it is. It would be very bad for the real to appreciate excessively because the current level only compensates for the overappreciation that we saw in a relatively recent period.
Others in the government have suggested that the currency should be allowed to travel as it wishes. As such, with sentiment improving, the BRL could strengthen further.
Whatever the case, the strengthening real has been helpful in what appears to be a slight reduction in the high inflation which has been hitting the country. Analysts are of the mind that July should see prices lift 8.84% rather than the 8.94% in June. Indeed, the drop was anticipated to be lower had not poor weather hit agricultural output in the country. Although still well above the targeted range of 2.5% to 6.5% inflation, it is down nicely from the 10%+ rates seen during late 2015 and early 2016.
All told, it is little surprise that investment interest in Brazil appears also to be improving. In the last few months, the country has seen net inflows of investment capital (Data source: Banco Central do Brasil via TradingEconomics):
None of this suggests that currency rates will necessarily strengthen further for the real in the short term. Yet I find it hard not to see this as the likely outcome over the long term. Growth will return with most agreeing - at the latest - by 2018 if not earlier. Patience will clearly, therefore, be required but I suspect will be rewarded.
Let's not overstate the case, however. Brazil is still faced with significant headwinds.
Take the debt issue, for instance. Brazil's government debt levels as a percentage of GDP are relatively modest compared to some other countries:
However, where it differs badly is the matter of interest rates. Whereas Japan's 10-year bonds rarely went above 1.5% over the last decade, Brazil's has rarely sat below 10%. Its Latin American peer, Mexico, has also rarely seen interest rates north of 10% with them sitting around 6% at present. This means Brazil's interest repayment costs are pretty massive. Needless to say, after attaining investment grade credit ratings in 2008 to 2009, it crashed back out of it again in 2015 as the economy continued to struggle.
Unemployment has also grown significantly. After hitting an all-time low in 2013 of just 6.2%, it has lifted over 11%. Clearly, for a company like Ambev which relies upon the financial firepower of the consumer, finding that more of those consumers are out of work is not a healthy looking trend.
Brazil may well see itself remain in recession in 2016 and 2017 (a view currently held by the OECD). This does seem likely as they set about reformulating the economy of the country and the political details which underpin it. Yet the upside potential seems strong especially with the political backdrop showing signs of improvement. As the OECD reported:
As the political panorama has a major impact on economic performance, it presents both upside and downside risks for the projections. If uncertainty about future policies is resolved more rapidly than assumed and a consensus for reforms is achieved, confidence could improve rapidly and growth could even be positive in 2017.
This is no insignificant comment. As I highlighted above, people are growing more certain about the political environment. Despite there still being pressure for Rousseff to be reinstated, many Brazilians now accept that the recent turn to Temer is worth running with at present. With Maia in place in the lower house, the potential for reforms to be proposed and passed seems to have better odds of success than previously. It is still an uphill fight, yet the gradient has shallowed a little. Growth in 2017 is not impossible in light of this. Yet there remains a long way to go.
Ambev's Brazilian Hangover
So how has Ambev fared in all of this? Well, if we take a snapshot of Q1 2016 things did not look all that encouraging with volume, profit and revenue all down in the Brazilian beer segment (Data source: Ambev Q1 2016 results):
It would seem, therefore, that Ambev is not immune from the hangover left in the Brazilian economy. Yet when we look at the reason for this poorer performance in Q1, this conclusion is complicated somewhat. As Ambev explained, this weak performance was:
mainly driven by the adverse macroeconomic environment and a tough comparable base due to the early Carnival and price increases to mitigate taxes.
Needless to say, Ambev felt the need to highlight the impact that the economic situation in Brazil was having on performance. Yet you can't overlook the other reasons. The Carnival is a mammoth event with regards to beer consumption followed by a sizeable slowdown. As Ambev's CEO, Bernardo Paiva explained at the Q1 2016 earnings call:
The sooner the Carnival, the sooner the summer ends in Brazil, historically we had a weaker first quarter whenever we face an early Carnival.
With Carnival falling in early February in 2016, as opposed to late February in 2015, this was no small effect on volumes. Combine this with price hikes (again leading to volumes declines) to offset tax raises, and you can understand the weaker Q1.
Operating profit fell further than revenue chiefly because of a mixture of growth in Selling, General & Administrative (SG&A) expenses and a decline in other operating income due to differences in the geographic production mix. Without this, gross profit declined in line with revenue.
Net revenue per liter was up 6% which was highly encouraging. Of course, price hikes played a key part of this. Yet, as Ambev explained, this was also due to in part to the "benefit of premium mix." This is significant as they continue to look to shift the Brazilian beer market towards premium products. Clearly, this would have positive effects on margins.
The Brazilian market does appear open to this sort of shift. Since 2010 the premium segment (judged as anything above 115 in the beer price index) has grown from 5% to 9% of the beer market. Yet it still remains behind many other peers as well as the Latin American average (Data source: Heineken investor presentation):
As such, plenty more opportunity for extending premium brands is latent within the Brazilian market. Clearly, in the immediate term, the economic landscape will constrain many consumers from bumping their drinking habits up the scale into the premium segment. Yet many are, and there is a great deal of potential for rapid growth once the economic situation improves for the Brazilian consumer.
This should help Ambev return to improving its already impressive margins. At company level, Ambev has experienced significant margin expansion since the turn of the millennium. However, understandably, with Brazil and its populace finding their financial positions tested in the last couple of years margins at company-level have shrunk a little (Data source: company reports):
This trend of shrinking margin growth has continued in recent quarters with Q1 2016, suggesting that margins in 2016 may be (for the first time since 2008) below 40% (Data source: company reports):
Clearly, this does not make particularly attractive reading at the moment. Yet I doubt that Ambev will find itself stuck in this downward margin trend for too long. Already its "premiumization" drive is generating results, and as the Brazilian economy begins to pulls itself out of recession, inflation slows and confidence return this should begin once again to pull higher.
In the meantime, Ambev's margins at the higher end of 30% remain compelling by any measure, sitting well ahead of its major international peers:
Ambev continues to be, therefore, a compellingly high-quality performer in an industry marked by generally incredible margins.
Strong Demographic Options
Brazil presents even more opportunities for Ambev over the longer term too. Although Brazil is cited as having fairly high per capita beer consumption levels (largely in line with its Western European peers), as Ambev points out it disguises huge disparities within the population based upon income (Source: Ambev investor presentation):
Consequently, Brazil still carries a huge amount of volume growth opportunity beneath the surface which Ambev - being the market leader - is well placed to take advantage of.
Carrying on Regardless?
Clearly, the slow down in Brazil is not welcome and the "adverse macroeconomic environment" remains a strong headwind to its operations in the immediate term. In such an environment, it will prove more challenging for the 1/3 of the Brazilian population to lift their personal income levels. Consequently, the anticipated growth in beer consumption that is anticipated to emerge alongside rising personal incomes in this large section of the population will likely be delayed. Yet that latent potential remains clear to be seen.
Yet Ambev has managed to not only survive but thrive during both weaker and stronger economic conditions in the country. Indeed, Ambev has consistently managed to generate earnings growth despite the economic backdrop (Data source: World Bank and company reports):
Indeed, over the last decade, operating profit has grown at a CAGR of over 10% despite a far more erratic GDP performance. Even with Brazilian GDP looking set to decline further in 2016, it looks very much like Ambev will continue to power through this with growth in its all-important Brazilian business.
As such, if you're after exposure to Brazil's attractive long-term growth story without having to yield to short-term earnings weakness, Ambev looks a solid and dependable option.
Cash Flow King
Ambev has also consistently generated copious amounts of cash flow. Free cash flow has generally grown and, most importantly, the amount of its revenue converted to FCF has been following a growing trend (Data source: company reports):
Consequently, it has been able to distribute large amounts of cash to its investors. Ambev has generally done this through two means: dividends and interest on capital (that is, IoC). Both in essence operate as dividends, but for foreign investors, dividends attract no withholding tax whereas IoCs have a 15% tax attached. They are rather lumpy in terms of when and how they are delivered and so looking at them from a calendar year perspective is quite useful (Data source: Ambev):
Distributions have, therefore, been very attractive in recent years. This largesse also extends to share buybacks which have slowed in recent years as dividends and IoCs have grown. With cash flow set to continue to impress, I have little doubt that Ambev will continue with this generosity.
Healthy Balance Sheet
In a country in which discussions on the sustainability of the debt situation in the light of moderately high debt levels combined with hefty interest rates has come to dominate concerns both at the government and corporate level, Ambev's position is reassuringly strong. Indeed, unusually for a consumer defensive company, its debt to equity levels are very low and have shrunk significantly in recent years (Data source: Company reports):
Indeed, since 2011, the company has run a sizeable net cash position:
The strength of Ambev's balance sheet is encouraging with the credit agencies offering Ambev strong A-grade ratings which compare well to its peers* (read here to find out how I normalize credit ratings):
Not only should it mean that it has the flexibility to be able to bear any further blows in its largest market, but it also provides it will a lot of potential firepower to take advantage of any opportunities that come its way whether in the Brazilian or any of its other current or potential markets.
A Beer Bargain?
Ambev has also had a robust share price performance in recent years. Of course, if you had bought into Ambev's ADR back in January 2012, each $100 invested would be worth about $99.60. Not exactly a star investment, perhaps. Yet in BRL R$100 invested in the underlying Sao Paolo-listed shares have lifted to over R$183:
Ambev has done what consumer defensive companies do best: provide stability in otherwise unstable conditions. Yet for ADR investors, this underlying stability has been undermined by the instability of the BRL. Ambev's share price has been hit by collateral damage from the Brazilian economy, yet Ambev the company itself has continued to perform impressively. The fact you can pick up Ambev's ADRs for a similar USD price as in January 2012 is very attractive indeed. The company is stronger and more profitable now than in 2012 which is not, to my mind, reflected in its current price.
Its mixture of consumer defensive stability and long-term growth potential means I'd struggle to argue against a P/E valuation of 22 as a fair value for Ambev in the current market. This is especially true in light of the elevated valuation of some of its major peers (Data source: company filings):
Assuming this is the case and EPS continues to grow at ~8% per year for the next two years, a underlying fair value price in BRL of R$22 seems fair. Whilst the underlying shares remain below this price, and unless the BRL appreciates very sharply anytime soon, picking up the ADRs today and over the coming months looks like a good time to pick up a bargain. I would argue that should the BRL appreciate to 2.5 per 1 USD, it would be time to reassess the situation, as it might imply that the BRL has appreciated significantly.
Ambev, as I argue, is a highly attractive business to hold for the long term. Yet it also comes with a generous kicker. Ambev's controlling shareholder is beer giant Anheuser-Busch InBev (NYSE:BUD) with 61.9% of the company's shares (Data source: Ambev Q1 2016 earnings report):
With Ambev's positioning within high-growth markets - including Brazil - there is little doubt that eventually AB InBev will want to take full control of Ambev. To date, it has been hamstrung in doing so, however.
The next largest single shareholder is FAHZ (Fundação Antonio e Helena Zerrener Instituição Nacional de Beneficência) which was the former controlling shareholder of Antarctica which was one of the original brewers along with Brahma to merge to form Ambev in the first place. FAHZ, despite it much smaller shareholding, controls powerful veto rights until 2019 which were arranged under an earlier Shareholders' Agreement. Dividends, acquisitions, investments and the issuance of new debts all fall under its veto control until then.
Consequently, until this veto power lapses, it seems unlikely AB InBev will make any moves to acquire the rest of Ambev. However, after that point, it seems likely AB InBev will be keen to do so. Ambev, therefore, has a surprisingly obvious buy-out story to back up its long-term growth story.
Brazil is still faced by a challenging set of headwinds both in the political and economic realms. Yet once they have managed to make progress in rectifying some underlying structural problems, their economy will no doubt return to sustainable and potentially rapid GDP growth.
Sentiment towards Brazil has improved markedly of late. Politically, a degree of admittedly delicate stability has arrived as well as both what appears to be a willingness and potential ability to push through necessary reforms. Like so many emerging markets, Brazil is experiencing the growing pains which mark their economic progress. It may not be pretty for investors, but it is necessary. Although in reverse right now, Brazil will once again reposition itself ready to clunk up the gears of economic growth once again.
Whatever the case, however, Ambev looks a good bet due to rather than despite its hefty Brazilian exposure. Its relatively diverse revenue stream, although heavily reliant on Brazil, soften some of its effects. What is more, the Brazilian segment of the business appears more than capable to continue to drive profit growth despite what is certainly challenging conditions.
Corporate debt and defaults may fix upon many people's minds in Brazil. Yet Ambev remains in a very healthy position with limited debt and massive cash flow generation.
Right now I would happily start building up a holding in Ambev, taking advantage of what is undoubtedly a favorable currency exchange rate. This may be one for the patient, yet if you want any sort of exposure to the Brazilian economy and its future growth potential, Ambev appears a compelling story today which can only grow more compelling in the future.
What is clear is that this is a fantastic company. Its heavy exposure to the Brazilian beverage market remains an attractive long-term asset and, in the immediate term, is set to continue to produce results which seem to defy the economic and political backdrop. In time, investors may profit from it being fully consumed by AB InBev, in the meantime, however, investors can profit from the admirably consistent growth Ambev has managed in the past and looks likely to continue into the future.
* These ratings are for debt denominated in BRL. Ambev's credit ratings for USD-denominated debt are lower due to unfavourable currency trends. Even here, Ambev's attracts securely investment grade credit ratings.
Disclosure: I am/we are long ABEV.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.