Asymmetric Allocation: Top 5 Reasons Why A Market Neutral Trade With Ambev SA ADR And Craft Brew Alliance Inc. Is A Potential Money Maker

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Includes: ABEV, BREW
by: Nelson Nguyen, CFA

Summary

Market Neutral Trade: Longing Ambev SA ADR (ABEV) and shorting Craft Brew Alliance Inc. (BREW).

Long: The average fair value estimate for ABEV is $21.20 with a current price of $5.11.

Short: BREW appears to be overvalued with an average fair value estimate of $7.02 with a current price of $17.25.

What is a market neutral trade?

Market neutral investing is an investment strategy or portfolio that seeks to avoid some form of market risk entirely, typically by hedging.

Ever had a good idea to invest in but little money to invest? Or have you ever found a good Long or Short but you were killed when the whole market moved in the wrong direction? There is a solution called Market neutral trading.

This strategy is used by big hedge funds, but I am offering this "secret" for a cost of a click and a few minutes of your time. What Market neutral trading involves longing (buying) a position and shorting (selling) another position for stocks in the same industry/sector. If you like to learn more about Market neutral trading, you can read more about it here (or you can Google it).

Why I like this strategy?

1. It requires less capital.

2. It takes some market risk out of the equation.

When you short a stock, you have funds to use to invest in your long. Basically, you are robbing Peter to pay Paul. Therefore, you need less capital to invest. Market risk is lowered because you are neutral. You make money if your long performs better than your short.

This potential money making trade consist of longing Ambev SA ADR (NYSE:ABEV) at the same time shorting Craft Brew Alliance Inc. (NASDAQ:BREW). In this article, I cover 5 key reasons why this is a high probability trade. Before we get into 5 points, let me tell you more about the background of these two companies.

Companies

Ambev SA ADR, through its subsidiaries, produces, distributes, and sells beer, draft beer, soft drinks, other non-alcoholic beverages, malt, and food in the Americas. ABEV operates through Latin America North, Latin America South, and Canada segments. It offers beers primarily under the Skol, Brahma, and Antarctica brands. Ambev also provides carbonated soft drinks, bottled water, isotonic beverages, energy drinks, and ready-to-drink teas under the Guaraná Antarctica, Guaraná Antarctica Black, Gatorade, H2OH!, Lipton Iced Tea, Fusion, Monster, Red Rock, Pepsi-Cola, and Seven Up brands. The company offers its products through a network of third-party distributors and a direct distribution system. It was founded in 1885 and is headquartered in São Paulo, Brazil. Ambev S.A. is a subsidiary of Interbrew International B.V.

For more information about ABEV, please go here.

Craft Brew Alliance, Inc. brews and sells craft beers and ciders under the Kona, Widmer Brothers, Redhook, Omission, and Square Mile brand names in the United States. The company operates in two segments, Beer Related Operations and Pubs Operations. BREW markets its beers directly to consumers in draft, cans, and bottles at restaurants, bars, and liquor stores, as well as in cans and bottles at supermarkets, warehouse clubs, convenience stores, and drug stores. The company also operates five pubs that offer dining and entertainment facilities, and sell apparel and other merchandise. It was founded in 1981 and is headquartered in Portland, Oregon.

For more information about BREW, please go here.

Reason 1: Economic profit

In the world, there are two kinds of profits we will learn about: 1) accounting profit and 2) economic profit. If you learn the difference, then you can separate the wheat from the chaff as they say.

Accounting profit = total revenue - explicit costs = net income

What is accounting profit? It is the amount leftover after subtracting revenue minus explicit costs (or sales minus explicit expenses). Explicit costs are what most people think of as regular business expenses. These are actual payments made to others for running a business, such as paying rent, wages, utilities, equipment, depreciation and taxes.

Economic profit = accounting profit - implicit costs

or

Economic profit = total revenues - (explicit costs + implicit costs)

Implicit costs are the opportunity costs equal to what a business or individual gave up in order to do something else. Because interest expense is included in the net income calculation, we need to back it out in order to calculate implicit costs correctly. This will end our short lesson on accounting profit vs. economic profit so we can investigate how you can make more money. For more information on economic profit, please go here.

I developed an alternative method to calculate economic profit. I take the net income for the company and subtract the cost of equity. Here is my equation:

Economic profit = net income - equity * required rate of return on equity

Let's examine the profitability of these two companies.

ABEV

BREW

Accounting profit: net income

12,028

1

Equity

47,432

119

Required rate of return on equity

7.5%

6.5%

Economic profit

8,470.6

-6.7

From this analysis, we can see ABEV generates Economic Profit while BREW does not. This is the first reason why we want to long ABEV and short BREW.

Reason 2: Earnings yield

Earnings yield is defined as: EBIT / enterprise value

This figures out how much a company earns relative to the purchase price of the business.

Enterprise value = market value of common stock + market value of preferred equity + market value of debt + minority interest - cash and investments

Enterprise value is used instead of just the price of equity because it considers both the price paid for the equity in the business and the debt financing used by the company. This allows investors to compare companies with different levels of debt and different tax rates on an equal footing.

When we calculate earnings yield, we find that ABEV yields 6% while Brew yields close to 0. Since ABEV has a higher earnings yield than BREW, this suggests that Ambev is a better buy relative to Craft.

Reason 3: Effective profits

How do you measure if a company has effective profits? Warren Buffett's answer is the best!

Warren thinks that the best kind of business to own is one with high profit margins and high turnover.

Warren believes the second-best kind of business to own is one with either high profit margins or a high turnover to compensate for lower profit margins.

Warren is not interested in owning a business with both low profit margins and low turnover.

Analyzing effective profits is also very important and can be broken down into two components: 1) Margins and 2) Turnover. As a result, companies can also be broken into four quadrants.

High Margins

Low Margins

High Turnover

1

2

Low Turnover

3

4

The best companies are in Quadrant 1 (the company is selling very profitable products/services AND a lot of them like Microsoft); the runner ups are in Quadrants 2 (the company is selling low profitable products/services, BUT a lot of them like Wal-Mart) and 3 (the company is selling very profitable products/services, BUT not a lot of them like Rolex); and the companies to avoid are in Quadrant 4 (the company is selling low profitable products/services AND not a lot of them like a failed discount DVD store because people are now using Netflix and the Internet for entertainment).

Margins

There are three major margin ratios to consider: 1) gross margin, 2) operating margin, and 3) net profit margin.

Investopedia's definition of gross margin is: "A company's total sales revenue minus its cost of goods sold, divided by the total sales revenue, expressed as a percentage. The gross margin represents the percent of total sales revenue that the company retains after incurring the direct costs associated with producing the goods and services sold by a company. The higher the percentage, the more the company retains on each dollar of sales to service its other costs and obligations." A high gross margin means the company makes a high percentage of profit per unit sales. It is calculated as follow:

Gross margin = (sales - cost of goods sold) / sales

Investopedia's definition of operating margin is: "Operating margin is a measurement of what proportion of a company's revenue is left over after paying for variable costs of production such as wages, raw materials, etc. A healthy operating margin is required for a company to be able to pay for its fixed costs, such as interest on debt." Operating income is gross income less total operating expenses (i.e. depreciation & amortization, research & development expenses, and interest expenses). It is calculated as follows:

Operating margin = operating income / sales

Investopedia's definition of net profit margin is: "A ratio of profitability calculated as net income divided by revenues, or net profits divided by sales. It measures how much out of every dollar of sales a company actually keeps in earnings." It is calculated as follows:

Net profit margin = net income / sales

The way you analyze the different margin ratios is by comparing the company's ratios to: 1) its major competitors, 2) its industry, and 3) its sector.

When we analyze ABEV's and BREW's margins, we find Ambev has better margins than Craft.

ABEV

BREW

INDUSTRY

Gross margin

59.8

30.8

44.4

Operating margin

37.5

1.0

9.9

Net margin

25.2

0.4

5.1

Turnover

There are two primary types of turnover ratios you should focus on: 1) Inventory Turnover for products companies and 2) Asset Turnover for products or services companies.

Inventory Turnover = Cost of Goods Sold / Average Inventory

The Inventory Turnover ratio is a measure of the number of times inventory is sold or used in a time period such as a year. How you can utilize this ratio? You can compare the Inventory Turnover ratio for Target vs. Wal-Mart and see the number of times inventory is sold over the year.

Asset Turnover = Sales / Total Assets

The Asset Turnover ratio compares a company's sales to its total assets. This ratio gauges how well a business is making use of its total assets. The higher the multiple, the more efficient the company. Like all the turnover ratios, compare the company's ratios to: 1) its major competitors, 2) its industry, and 3) its sector.

ABEV

BREW

Cost of goods sold

16,999

144

Average inventory

4,340

22

Inventory turnover

3.92

6.55

Sales

47,721

206

Total assets

79,110

204

Asset turnover

0.60

1.00

BREW has better inventory and asset turnover than ABEV. However, you need to consider whether it compensates for the difference in margins. You need to ask if the increase in efficiency make up for the lower profit margins. By multiplying gross margin times inventory turnover, we come up with a relative analysis of the two companies' performance.

ABEV

BREW

Gross margin

59.8

30.8

Inventory turnover

3.92

6.55

Gross margin * inventory turnover

234.4

201.7

After considering both margins and turnover, ABEV generates more profits than BREW in this relative comparison.

Reason 4: Owner's earnings yield

Owner's earnings yield measures the return by taking the sum of net income + depreciation & amortization - average 3-year capital expenditures and dividing by its market capitalization. I modeled this after the famous Warren Buffet. This metric allows you to see what an owner is really making. For more information on owner's earnings, please go here.

ABEV

BREW

Net income TTM

12,028

1

Depreciation & amortization

3,480

11

Average 3-year capital expenditures

4,861

17

Owner's earnings

10,647

-5

Shares outstanding

15,740

19

Owner's earnings per share

0.68

-0.26

Current stock price as of 1/4/17

5.11

17.25

Owner's earnings yield

13.24%

-1.51%

ABEV has a positive 13.24% owner's earnings yield, which is much better than the -1.51% BREW yields.

Reason 5: Valuation and margin of safety

Relative valuations

Price-to-earnings valuation

The current PE multiple for the Industry is 25.5. If we multiply it with earnings we come up with a fair value estimate. For ABEV, taking the average of the EPS 12-month trailing of $0.76 and 1-year forward EPS estimate of $0.30 times 25.5 gives us a fair value estimate of $13.52. For BREW, taking the average of the EPS 12-month trailing of $0.05 and 1-year forward EPS estimate of $0.45 times 25.5 gives us a fair value estimate of $6.38.

ABEV

BREW

Price-to-Earnings (TTM)

21.90

342.00

Price-to-Earnings (Forward)

16.80

38.00

Price-to-Earnings (Industry Average)

25.50

25.50

EPS

0.76

0.05

EPS Estimate

0.30

0.45

Implied Valuation (TTM)

19.38

1.28

Implied Valuation (Forward)

7.65

11.48

Implied Valuation (Average TTM & Forward)

13.52

6.38

PEG

1.40

1.50

Price-to-sales valuation

I modified the tradition price-to-sales valuation by adding a premium/discount factor based on net profit margin relative to industry average. I believe this is a better measure of value when you do relative price-to-sales valuation. A company should be worth more if its net margin is better than industry. At the same time, a company should be worth less if it has a lower than industry net margin because for every dollar of sales it generates less earnings.

ABEV

BREW

Sales Growth Year over Year

(2.44)

0.94

Sales Growth 3-Year Average

N/A

N/A

Sales Growth 5-Year Average

N/A

N/A

Price-to-Sales (Industry Average)

3.30

3.30

Sales per Share

3.01

10.84

Net Margin (Industry)

5.10

5.10

Net Margin

25.20

0.42

Premium/Discount

4.94

0.08

Implied Valuation

49.11

2.95

Price-to-book valuation

The current PB multiple for the industry is 4.50. If we multiply it with Book Value per Share [BVPS] of $0.92 we come up with a fair value estimate of $4.14 for ABEV. If we multiply it with BVPS of $6.17 we come up with a fair value estimate of $27.77 for BREW. The following is a summary of my analysis:

ABEV

BREW

Price-to-Book (Industry Average)

4.50

4.50

Book Value per Share

0.92

6.17

Implied Valuation

4.14

27.77

Combined PE (TTM & Forward), PS and PB fair values

Combine fair value estimate for Ambev = ($13.52 * $49.11 * $4.14) ^ 0.33 = $14.01

Combine fair value estimate for Craft = ($6.38 * $2.95 * $27.77) ^ 0.33 = $8.05

Enterprise multiple

The enterprise multiple is a ratio used to determine the value of a company. It looks at a firm as a potential acquirer would, because it takes debt into account (an item which other multiples like the P/E ratio do not include). The enterprise multiple based on EBITDA is calculated as: enterprise value / EBITDA. The enterprise multiple based on EBIT is calculated as: enterprise value / EBIT

Enterprise value = market value of common stock + market value of preferred equity + market value of debt + minority interest - cash and investments.

ABEV

BREW

Industry Enterprise Multiple (EBIT)

24.13

24.13

Industry Enterprise Multiple (EBITDA)

19.93

19.93

EBIT

15,886.00

2.00

EBITDA

19,366.00

13.00

Preferred Equity

-

-

Debt

3,602.00

31.00

Minority Interest

2,002.00

-

Cash & Investments

13,835.00

1.00

Shares Outstanding

15,844.00

19.00

Implied Valuation (EBIT)

24.71

0.96

Implied Valuation (EBITDA)

24.88

12.06

Average fair value estimate and margin of safety

ABEV

BREW

Implied Valuation (EBIT)

24.71

0.96

Implied Valuation (EBITDA)

24.88

12.06

Combined P/E (TTM & Forward), P/S & P/B Valuations

14.01

8.05

Average Fair Value Estimates

21.20

7.02

Current Price

5.11

17.25

Margin of Safety

75.90%

-145.64%

Based on the average fair value estimates, we find that ABEV is undervalued and has a margin of safety of 75.90%. In contrast, BREW is considered overvalued and has a margin of safety of -145.64%.

Conclusion

Are the valuations precisely correct? No one can give an exact value of a company, but you have a range of confidence. As Warren Buffett teaches, "It is better to be approximately right than precisely wrong." We analyzed the quality of these two stock and came up with an estimate of fair value. Based on this fundamental analysis, ABEV has a high probability of outperforming BREW on a relative basis. This is the reason why I believe longing ABEV and shorting BREW is a great market neutral trade.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.

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