Ambev Drink Up!


Highlights

    • FIFA World Cup 2014: This year Ambev and their parent company Inbev were able to lobby the Brazilian government to allow beer at football stadiums for the first time since 2003. They used this opportunity to advertise brands Brahma and Budweiser. They reported “outstanding visibility” and higher social media engagement. Ambev Management reported an incremental increase of 1.4 million hectoliters of beer sales during the World Cup.
    • Proposed Merger with Londrina Bebidas: On September 2nd, 2014 the AmBev Board of Directors announced their plans to merge with Londrina Bebidas, a beer and soft drink producer based out of Piraí, Brazil. The merger would be all equity and will be considered at an extraordinary general meeting on October 1st.


Investment Summary

Profile
AmBev, also known as Companhia de Bebidas das Americas, is the result of a merger between Brazilian breweries Brahma and Antarctica. They merger completed in 1998 and they have been pursuing organic and acquisition-based growth ever since. The principle activities of AmBev include development, production, bottling, marketing, and distribution of beer, soft drinks, and other non-alcoholic beverages. Their beer portfolio includes Skol, Brahma, Antarctica, Quilmes, Labatt, and Presidente. They also hold the rights to produce and sell Budweiser products in Latin America. They have a soft drink portfolio including Guaraná Antarctica and Fusion, while also holding exclusive rights to bottle and distribute PepsiCo products throughout Latin America.
AmBev operates in 16 countries and exports to several other countries.

Market Analysis
Brazil’s economy has been flat, missing the broad analyst expectations of 3% growth this year. In the past two quarters Brazil had negative growth, which would technically make them in a recession. This poor growth is expected to continue into next year according to analysts, who are expecting 1% growth for 2015. As a matter of comparison, the other BRIC countries have recovered and grown their GDP over the past five years at a much stronger rate than Brazil in the past five years.

The FIFA World Cup was predicted to benefit Brazil but actual created several complications for their economic growth. Due to increased holidays and transportation issues, the Brazilian economy faced a decrease in output and productivity during the past quarter. Hopefully the infrastructure investment in Brazil pays off, but citizens remain pessimistic.

The political uncertainty for Brazil’s upcoming presidential election is causing volatility in their stock market. President Dilma Rousseff has failed in her past term to grow the Brazilian economy and gain investor trust. As elections grow nearer, her opponent Marina Silva is seen as a savior for the economy. The Brazilian market is eager for Rousseff to be ousted in October and they hope that Silva can pass more pro-business legislation in the country. A prime example of this investor sentiment is that the Brazilian market plunged over 2% in a day when polling showed that incumbent Rousseff had gained enough popularity in the polls to possibly warrant a run-off with Silva in the October election.

Compared to other emerging markets stocks, consumer staples are overpriced according to analysis by Morgan Stanley. The average price to earnings ratio of the Sao Paulo Stock Exchange (Brazil Bovespa) is a mere 8.4, while AmBev has a P/E ratio exceeding 21.

Industry Outlook
The brewer and soft drink industry faced several problems in the past year. The industry revenue shrank in 2013 due to decreased volumes in both the beer and soft drink sales. These troubles were caused by high inflation rates in Brazil and increased taxes on brewers at the end of 2012. This is certainly one of the reasons AmBev had negative net income growth in 2013, following years of double digit expansion.

The pocket of opportunity for brewers in South America can be found in the consistent growth of the premium beer market. Less than 10% of the Brazilian beer market is premium quality. As urban populations and the middle class begin to grow in Brazil and other Latin American markets, the consumption of premium beers will increase along with overall economic growth. This industry trend is a main focus of AmBev this year as they market Budweiser and Stella Artois to the changing Brazilian demographics.

Revenue
Brazilian beer and soda sales contributed to strong 2nd quarter growth for AmBev this year. The World Cup was responsible for helping this growth, and investors should not expect as much revenue from Brazil in the near future.

COGS
AmBev’s costs of goods sold increased 15.5% for the 2nd quarter, which they attribute to high costs for a specialized packaging mix for the World Cup. These special packaging mixes served as a promotional tool and contributed to the one time record-setting sales over the period of the
World Cup. The cost of goods sold was also affected by strong commodity hedges and failed currency hedges.

EBITDA
Ambev had a growth in normalized 2nd quarter EBITA of 5.4% year over year, which was slowed
by a decreased margin attributed to the FIFA World Cup costs. The firm expects the margin to improve now that the World Cup has finished.

Earnings Misses
AmBev fell short of their second quarter earnings estimate by over 4%. They reported earnings per share of $0.062 compared to their $0.065 in-house estimate. They have missed their earnings guidance for the past 6 quarters. While management finds reasons to blame the economy or one- time events, their continuous inability to hit their earnings targets should be alarming. Not only are targets not being hit, but they have failed to grow earnings in the past 2 years.

Q2 Conference Call
AmBev’s management seemed surprisingly optimistic during the second quarter 2014 conference call. They stressed the main successes of the quarter related to the World Cup. They attributed their strong revenue per hectoliter growth and customer loyalty to their “World Cup without Price Increase” marketing initiative. The chief financial officer tried to alleviate the concern for the business in Argentina, assuring investors that they have dealt with volatility in the region before and plan to remain profitable in the near future. Lastly, they noted how they have a stronger market share than 12 months ago. This gives AmBev more leverage with consumers should they feel the pressure to increase prices. This will mostly depend on the proposed tax increases in Brazil.

Analyst Recommendations
Latin American investment research firm Votorantim rates AmBev as “Market Perform”. They note their disappointment in the poor volume growth (ex-World Cup), poor margin growth, and missed earnings. More optimistically, J.P. Morgan gives AmBev an “Overweight” ranking, stemming from their view that the brewer will be able to increase pricing and benefit from the delay of tax increases. They also believe that commodities and currencies will not increase costs going into 2015. Both analysts explored the political risks, macroeconomic situation in Latin America, and the impact of the World Cup on AmBev’s business.

Valuation Growth Rates
Internal Growth Rate of 10.51%
AmBev has an internal growth rate of 10.51%, calculated using their return on assets and retention ratio. This suggests they could grow at that rate without additional financing. It would be costly and risky for exisiting shareholders if AmBev issued more stock or bonds.

Historic Net Income Growth Rate of 13.25%
The 5 year average net income growth for AmBev is 13.25%. The 5 year growth rate has decreased over time, making this a more conservative measure of growth. Last year’s 1 year growth rate was negative 8%, a drastic change from the double digit annual growth rates of past years. Using this growth rate assume positive net income growth, which should be achievable due to World Cup and other business growth.

Sustainable Growth Rate of 14.68%
AmBev’s sustainable growth is 14.68%. This implies the most growth AmBev can have without increasing leverage is 14.68%. Increasing leverage would be increasingly expensive as the credit outlook for Brazil is becoming gloomier.

Financial Models
Capital Asset Pricing Model
I used the capital asset pricing model to determine the expected return of 16.28% for AmBev. I used the risk-free rate of 2.55%, replicating the 10 year U.S. Treasury bond yield. Then I assumed a growth rate of 17% in the Brazilian equity markets, based on the street consensus which factored in economic indicators and dividends.

Holt’s Model
Using the Holt’s Model, also known as the Normalized P/E Model, I calculated a fair value for AmBev’s stock price. I ran the model using three different growth rates: Internal Growth Rate (10.51%), Historical Net Income Growth Rate (13.25%), and Sustainable Growth Rate (14.68%). The assumed industry growth rate of 12% is based on AmBev’s own industry forecast. After calculating the normalized P/E for each growth rate, it was determined that the average fair value was $6.50. This would imply a current overvaluation of 2.11%.

Residual Income Model
The Residual Income Model looks at the earnings of AmBev after removing the calculated cost of capital. I assumed a book value per share of $1.14. I used the average of my calculated growth rates of 12.82% and the Return on Equity of 28.57%. With a required rate of return of 16.28%, the fair value of AmBev would be $5.19. This implies a current overvaluation of 27.96%

Average Fair Value
After averaging the prices I received using the Holt’s Model and the Residual Income Model I have determined the fair value for AmBev is $5.85, implying that the stock is currently overvalued by 13.58%.


Recommendation

The fair value of AmBev is $5.85 implying mispricing of 13.58%. This overvaluation by the market compels me to recommend the Roland George Investments Program sell all 7500 shares of AmBev. There are better opportunities for risk-adjusted growth in both developed and emerging markets.

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