• Ambev, the largest Latin American brewer, is an excellent business: 25% FCF margin, 20%+ ROC and expected mid-to-high single digit growth.

• The stock price is down 40% since mid-March, which has sparked our curiosity.

• We value the business based on current earnings and realistic growth prospects. We argue for a currency risk premium.

• We find that despite the price decline and so much to like, the stock remains expensive. At $4.60/share, there is room for further downside.

This piece is part of our Stocks in the radar series, in which we search for high-ROC growth opportunities selling at attractive prices as potential additions to the IW Portfolio.

Today, we are focusing on Ambev S.A. (ABEV), the largest Latin American brewer, headquartered in Sao Paulo, Brazil, and majority owned by beer giant Anheuser-Busch InBev (AB InBev, BUD, BUDFF).

We will refer to US dollar (USD) as $ and to Brazilian Real (BRL) as R$, and use today's spot exchange rate of $1 to R$3.86 for currency conversions.

In 2017, Ambev generated $5.2 billion of EBITDA. The geographic EBITDA distribution was 57% Brazil, 24% Rest of South America, 10% Canada and 9% Central America and the Caribbean. Despite moderate diversification, Brazil is the largest and most profitable market and the biggest growth opportunity.

The Good

Competitive advantages

The company produces, distributes and sells beer and non-alcoholic beverages in South America, Central America and Canada. It holds pseudo-monopolistic market shares in most of its territories, including Brazil (68%) and Argentina (81%), thanks to leading local brands such as Brahma and Skol in Brazil, and Antarctica in Argentina.

It also owns exclusive distribution rights to the premium brands of the AB InBev group in its territories, mainly Budweiser, Stellar Artois and Corona.

This dominant market share allows for economies of scale in production and distribution across the Americas. It has enabled the company to sustain exceptional margins (42% EBITDA and 25% FCF margin) and, together with its brand equity, abnormal returns on equity (24%, using our estimation of normalized FCF and reported book value).

Sample of Ambev drink portfolio (source: company website)

Growth prospects

Current business is solid and is likely to get better.

FCF has grown at 8% CAGR since 2007, and we expect FCF growth to remain in the mid to high single digits for the foreseeable future.

Ambev has pulled and will continue to pull several levers to keep the growth momentum. Growth initiatives include elevating the value of local brands, such as Brahma, Skol, Antarctica, and Quilmes; accelerating the premium import segment, with the already mentioned exclusive distribution rights to the brands of the AB InBev group; and increasing affordability and thereby consumption in underdeveloped Brazilian regions through packing and distribution initiatives.

Other positives

Other attraction points for an investment in Ambev are the defensive characteristics of a market-share leading brewery (Ambev has thrown out relatively stable FCF through good and bad times in the Brazilian economy) and the possibility of a future acquisition offer by AB InBev, which already owns a 62% majority stake (FAHZ is the other major shareholder, with a 10% stake and veto rights in important decisions until 2019).

With so much to like in the business, and with the stock price down almost 40% since a maximum in March, it is no wonder that the company picked our curiosity.

The bad

But even at $4.65/share (R$17.95), the company remains expensive, in our opinion.

Distributable cash and earnings power

As of Q1 2018, the number of shares outstanding was 15,713 million.

Starting from the balance sheet, we estimate distributable cash, net of interest-bearing debt, of R$3,163 million. That is  R$0.20/share or US$0.05. Hence, at $4.65/share, the stock trades at $4.60/share ex-cash.

Moving to earnings power.

2017 revenues were R$47,900 million. Our estimate of normalized cash flow from operations (CFO) before tax is R$20,200 million. With a effective tax rate of 20%, normalized CFO after tax is  R$16,160 million.

Capital expenditures were R$3,200 million in 2017, unusually low and below D&A charges of R$3,600 million. Since 2007, capex have exceeded D&A charges by an annual average of about R$1,000 million.

We believe that normalized maintenance capex are closer to R$4,000 million, which results on an estimation of normalized FCF of R$12,160 million. On a per-share basis, that is R$0.774/share or $0.200/share.

Even if we use 2017 D&A charges as maintenance capex, FCF increases to only $0.207/share. 

Valuation

At $4.65/share, the stock is selling for 23x TTM FCF ex-cash.

Even though we expect FCF to grow at 6-7% CAGR in the upcoming years, and after acknowledgment of the defensive characteristics of an investment in Ambev equity (owed to FCF dependability), we see that multiple as excessive.

The main argument: currency risk.

Currency risk

Investors with a base currency other than BRL are exposed to currency risk when holding Ambev equity, whether directly in São Paulo’s B3 market (under ticker ABEV3) or through USD-denominated ADRs trading in the NYSE (under ticker ABEV, with 1 ADR representing 1 share).

Currency depreciation is not expected to impact business financials in local currency since Ambev can pass cost increases to consumers without affecting real prices. But the value of a share of Ambev in US dollars is impacted by exchange rate movements.

As of March 2018, Brazil short-term interest rate is at 6.5%, 450 bps above US interest rate. Hence, arbitrage in the money market suggest expectations for 4.5% annual depreciation of the BRL relative to the USD.

Inflation in the Brazilian economy has moderated to 2.9% but has swung all over the way from 3% to 11% since 2007. The average inflation differential wrt. the US has also been some 4%ish.

The market seems to be backing 4%+ annual depreciation of the BRL relative to the USD, in line with historical averages.

Discount rate

Was Ambev a US company operating in USD, and given the resiliency of the beer business, Ambev's competitive position and US fixed-income yields, we would be comfortable using a 6% discount rate.

But the bulk of Ambev business is in emerging economies in Central and South America, and the bulk of the business is done in BRL. That leaves foreign investors exposed to BRL depreciation, which the market expects at 4% p.a.

Hence, investors should add a 4.5% premium to the discount rate they would use in an equivalent US company when valuing Ambev.

After adding 450 bps to the USD-equivalent-business discount rate of 6% to account for currency risk, the appropriate discount rate for an investment in Ambev is 10.5%.

Earnings power value

Earnings power value (EPV), that is, the value of a stream of $0.20/share FCF in perpetuity discounted at 10.5%, is $1.90/share (0.20/0.105), almost 60% below the stock price of $4.60.

Using the more optimistic FCF estimation of $0.207/share (derived by assuming maintenance capex of R$4,600 million rather than R$4,000 million), earnings power value is $1.97/share, still 57% below the current stock price.

What this means is that, if growth disappoints, investors can expect significant further downside.

The value of growth

If annual FCF growth of mid-to-high single digits does however materialize, the intrinsic value of the business will be above EPV.

For example: assuming 6% as annual growth rate in perpetuity, 20% as return on investment capital and using 10.5% as discount rate, the theoretical value of the constant-growth FCF stream would be 63% above the value of current earnings (EPV). That is, $3.10/share, or $3.15/share after accounting for excess cash. That is still some 30% below the current stock price.

(To learn more the relation between growth and value, and how to account for future growth in your valuations, take a look at this piece we recently wrote for the IW Academy.)

Assuming 7% annual growth rate in perpetuity and keeping all other metrics fixed, value increases to $3.76, still almost 20% below the current stock price.

In our view, expectations for even more aggressive growth rates in perpetuity would be unrealistic. After prudent accounting for currency risk, that is, after revising the discount rate upwards to 10.5%, the only way to justify today's stock price would be a one-off 20% FCF increase in 2018 (unlikely but possible if Brazilian demand recovers, partly helped by the FIFA Worlcup) and 7% FCF growth thereafter in perpetuity. Quite frankly, a bit of a stretch.

The ugly

We could condense the analysis in the preceding sections in one main takeaway: we are having a hard time justifying the current stock price of $4.60/share, even under rosy growth assumptions.

This is despite excellent business fundamentals and solid prospects. We believe that insufficient recognition of all-too-real currency risk is to blame for the misvaluation by Mr. Market.

But currency risk can be hedged, you say? Well, sure it can, at a 4.5% interest rate expense, the differential between interest rates in BRL and USD assets. The is exactly the risk premium we have accounted for in the 10.5% discount rate.

But things could get even uglier.

Ambev's abnormal ROC in its core Brazilian market has attracted the interest of competitor Heineken NV (HEINY, HINKF, HKHHF). And the Dutch brewer seems willing to battle Ambev bar by bar, resorting to generous pre-payments in exchange for exclusivity to capture market share.

Success for Heineken is far from certain. Ambev has in its favor a dominant market share, lower costs and the best brand portfolio in the region, so it has many levers to pull to counteract Heineken advances. Yet even a short-lived war price would impact Ambev's stock price, that incorporates rather rosy growth projections.

We don't want to exaggerate the importance of these news.

The point is that at current stock price, and despite the close-to 40% price decline since the March peak, the downside appears larger than the upside even in absence of bad news. Was Ambev to be hurt by intensifying competition in its largest and most profitable market, shareholder losses could be substantial.

In this scenario, even a buyback offer from AB InBev could play against shareholders who buy or hold at current price. Was the stock price to come down to $3.50/share (in the thereabouts of our estimation of intrinsic value), AB InBev could succeed in acquiring the 28% owned by minority shareholders at $4ish/share, forcing a capital loss on current minority shareholders.

Takeaways and future work

We have looked at Ambev as a potential long addition to the IW Portfolio. Businesswise, there is a lot to like. Fundamentals are excellent, the competitive position is strong and prospects are solid.

But at the current stock price, the risk-reward proposition is uncompelling. If the stock price breaks down below $4/share, we will reconsider a long position. And if we do, we will share the decision with our followers.

On the other hand, and despite the rich valuation, we cannot recommend a short position. We believe in shorting overvalued businesses with weak competitive positions as a market-exposure hedge. Ambev may be overvalued, but it operates within a defensive franchise position.

Current stockholders may want to reduce their long positions, especially those with unrealized losses that could benefit from a reduction in capital gain taxes. Chances are that they will have an opportunity down the road to rebuild their long positions at prices more reflective of intrinsic value.