Ambev S.A.: A Solid Company Facing Headwinds In 2019

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About: Ambev S.A. (ABEV)
by: Damian Mark
Summary

Ambev S.A. is a leading Latin American brewer with a dominant position in a number of South American markets.

Sales volumes declined in 2018 compared to 2017, and gross operating margins are roughly 10% below the 2012 peak.

Slowing global growth, coupled with high inflation in Brazil and Argentina, is a headwind, and the company's 2019 guidance was tepid.

Ambev S.A. (NYSE:ABEV) is a well-run company that is highly levered to the global economy and global commodity markets in particular. With the majority of its activities in South and Central America, the company is also subject to currency, inflation, and political risks. With headwinds in front of it in 2019, including a slowing global economy and high inflation in some of its key markets (e.g., Brazil and Argentina), the company is currently a HOLD in my view.

Introduction

A Brazil-based company, ABEV is the largest of the Latin American brewers by total beverage volume and the third largest in the world. ABEV is also a marketer and distributor of carbonated products, juices, teas, and other drink products across the Americas.

ABEV's activities are primarily divided into three segments:

1) Latin America North, including operations in Brazil, Dominican Republic, Saint Vincent, Antigua, Dominica, Guatemala, El Salvador, Nicaragua, and Cuba;

2) Latin America South, including operations in Argentina, Bolivia, Paraguay, Uruguay, Chile, Ecuador, Peru, and Colombia; and

3) Canada, which primarily comprises sales of Labatt in Canada.

ABEV markets products under various brand names, a full list of the company's brands being found here.

[All photos included in this article are from ABEV's website.]

Notably, ABEV owns two of the world's largest beer brands by volume, Brahma and Skol (Skol is sold solely in South America).

ABEV is 62% owned by Anheuser-Busch InBev (NYSE:BUD), which affords ABEV exclusive distribution rights to BUD's portfolio, which includes major brands such as Budweiser, Corona, and Stella Artois, among others. In Brazil, ABEV's Brahma is a premium brand with a loyal customer base. Overall, with Brahma, Budweiser, Stella Artois, and Corona in its stable, ABEV appears well positioned for the future, particularly if the South American economies can stabilize and strengthen. In this regard, with the premium beer segment representing just 5% of Brazil's beer volume (compared to approximately 15% in Argentina and Chile), ABEV's portfolio of premium brands may have a growth runway in Brazil going forward.

(Very) Brief History

Brahma, a beer brand owned and managed by 3G Capital ("3G"), a private equity firm that has partnered with Warren Buffett and Berkshire Hathaway (BRK.B) from time to time, merged with Antarctica of Argentina in 1999. Post-merger, the surviving company (controlled by 3G) changed its name to Ambev.

With 3G backing, ABEV then proceeded to buy up brewers throughout Central and South America. The resulting, present-day company has impressive volume market share in several large South American markets.

ABEV is and has been a highly profitable business, which is part and parcel of 3G's disciplined approach and culture. ABEV's hegemony in its primary markets reduces manufacturing costs, leverages the firm's high-fixed-cost base, and results in the company's relatively low average cost of production.

our-history-2008

Recent Results

Overall, 2018 was a relatively poor year for ABEV, with volume down 2.6%. From the Q-4 2018 earnings call transcript:

On a consolidated basis, in the fourth quarter, top line was up 5.3%, as volume drop[ped] 3.8%, was more than offset by the growth in net revenue per hectoliter of 9.4%. In the full year, net revenue was up 6.9% with volume declining 2.6% and net revenue per hectoliter growing 9.7%... Normalized net profit was BRL3.7 billion, 17.3% lower than in Q4 2017. In the full year, normalized profit was BRL11.6 billion, 5% lower than 2017."

[Emphasis added]. Guidance for 2019 was not particularly impressive either. High cost inflation in Brazil and Argentina will likely eat into margins as the company will have difficulty passing the increased costs along to consumers. With respect to Brazil, management noted that:

On the cost side, we expect the full year cash total COGS [Cost of Goods Sold] per hectoliter in Brazil to increase by mid teens as we will face pressure from currency depreciation and commodity prices (our average hedging rate for 2019 is of 3.61 BRL/USD versus 3.16 BRL/USD in 2018).

[Emphasis added]. For 2019, the high inflation and currency depreciation will likely only continue a negative trend that has been in place since 2012 when ABEV's gross margins peaked at 68%, only to fall below 62% in 2018. The entrance of Heineken (OTCQX:HEINY) into the Brazil market will not help ABEV either going forward, and this competition could also eat into margins. Nonetheless, these margins are still relatively high, even if trending in the wrong direction.

Management (see link above) has also acknowledged recent difficulties but contend that they are investing for the long term:

Our ownership mentality requires a focus on long-term sustainable value creation, even if temporary volatility has put pressure on our results in the short term. We are not satisfied with our performance in the year [2018] and we are committed to improving results based on the execution of our clear strategy. Our plan is supported by: (I) our robust and unique portfolio, which allows us to play in all the segments of the Brazilian beer market reaching a more balanced top-line growth between volume and revenue; (II) our unmatched distribution capability; (III) exciting innovations we have in the pipeline; (iv) commercial investments targeted to improve consumer experience; and (V) our people."

ABEV is working hard to contain costs and had success in the fourth quarter of 2018, as administrative expenses, as a percentage of revenue, were down by BRL 250 million and by 70 basis points.

Moreover, with respect to the competition, ABEV does maintain a cost advantage over its competitors, including Heineken. Specifically, according to Morningstar:

In 2018, it [ABEV] incurred total operating costs of BRL 209 per hectoliter of beer produced, just over half of the BRL 357 (at a euro/real exchange rate of 4.30) incurred by Heineken, a brewer with comparable volume but a different geographic mix. For a regional comparison, Heineken's Latin American arm, CCU, produced 28.5 million hectoliters of beverage in 2018 at an average operating cost of BRL 263 per hectoliter (at a real/Chilean peso rate of 175).

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ABEV's cost advantage actually provides a relatively largely economic moat for the company. Thus, according to Morningstar, ABEV is ranked number one in Brazil (68%), Argentina (81%), Bolivia (96%), Paraguay (90%), and Uruguay (95%), in terms of market share volume.

Risks

1) With such a dominant position already in South and Central America, Ambev's sales volume is very sensitive to the region's GDP growth. GDP growth in the region, particularly in Brazil, is very dependent on global demand for commodities. With global growth slowing, this appears to me to be a very important risk at the present time.

2) With most (more than 80%) of its 2018 revenue coming from South and Central America, Ambev has very limited geographic diversification.

3) Canada (approximately 14% of 2018 revenue) is not as profitable as the other segments, and it is hard to see where the Canadian segment fits into the company's future plans.

4) Currency depreciation, inflation, and political risks abound in South and Central America.

5) With the 3G disciplined management culture in place for almost two decades, margin upside is likely now limited, as the easiest cost cutting and efficiency measures have already been taken.

Valuation/Concluding Thoughts...

According to Morningstar, ABEV trades at a forward PE of near 21, a trailing PE of approximately 24, and a price to free cash flow of 18.2. Meanwhile, the Brazilian stock market as a whole trades at a forward PE of 12, a trailing PE of 14, and a price to free cash flow of 12.

While ABEV is a solid company, with growth limited for the reasons addressed above, and with uncertainty in global markets relatively high, the premium afforded the company, as successful as it has been, seems too high (I do think some premium is warranted, however).

In addition, as a company with a market capitalization of near $70 billion, growth is just not going to come as easy as it once did, particularly with the company having such high market penetration rates in its primary markets.

Keeping the above risks in mind, and with my admittedly very conservative outlook for global growth and with an ABEV valuation that appears a little rich, I reiterate my view noted above that ABEV is a Hold.

If ABEV shares retest $4 or fall below $4, however, I could get interested. Saúde (Cheers)!

Disclosure: I am/we are long BRK.B. 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.