Short Term Challenging for Ambev, but Long Term Bright

Brazilian brewer Brahma was the first foray into the consumer product manufacturing industry by Jorge Lemann, Marcel Telles, and Carlos Sicupira, the leaders of the private equity group now known as 3G. In 2000, they merged Brahma with Antarctica of Argentina, creating Ambev ABEV. The company has gone on to roll up brewers throughout Central and South America and holds several monopolylike positions in large markets, including 81% volume share in Argentina, 68% in Brazil, and 61% in Peru.

In part because of the favorable industry structures, and in part because of its 3G heritage, Ambev is a highly profitable business. The company has a well-entrenched cultural focus on cost management and implemented zero-based budgeting over a decade ago. Ambev’s largest market is Brazil, which represented 53% of both total beverage net revenue and EBIT in 2018. Until the current severe recession caused a large contraction in profitability, EBIT margins in Brazil had been at or above 45% since 2010, among the highest in the global beer industry, and while the entry of Heineken HEINY to Brazil may limit margin potential, we expect margins to rebound to 38% when the macroeconomic picture improves.

In addition to its strong focus on costs, Ambev is pursuing a two-prong growth strategy. First, its core markets, with the exception of Canada, offer solid long-term consumption growth opportunities. According to Global Data, their annual per capita beer consumption in the low 40 liters is below the global average of around 54 liters. Even in Brazil, Ambev’s most mature market outside Canada, annual per capita consumption of 65 liters offers some upside for volume growth. Consumption per capita is generally around 80 liters or more annually.

Another opportunity for revenue growth lies in the long-term premiumization of the market. Currently, the premium beer segment represents just 5% of Brazil's beer volume, versus almost 15% in Argentina and Chile, and we think Ambev’s portfolio of local premium brands, as well as its access to Anheuser-Busch InBev’s BUD global portfolio, positions it to benefit from a strong mix effect in the medium term.

Cost Advantage Contributes to Wide Moat We believe Ambev has a wide economic moat derived from two sources: a material cost advantage over its peers, and its intangible assets. The largest of the Latin American brewers by total beverage volume and the third largest in the world following the breakup of SABMiller, Ambev sold 159 million hectoliters of beverages in 2018. Although this volume puts Ambev at the lower end of the spectrum among the leading five brewers, its concentration of scale across a relatively small number of markets gives Ambev superior economies of scale. The company is the number-one player in several markets and holds monopolistic value market shares in Brazil (68%), Argentina (81%), Bolivia (96%), Paraguay (90%), and Uruguay (95%). This domination of its core markets reduces manufacturing complexity, leverages the company's high-fixed-cost base, and manifests itself in Ambev's relatively low average cost of production. In 2018, it 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 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).

Ambev owns two of the world's largest beer brands by volume, Brahma and Skol (in South America only), and it also has exclusive distribution rights to AB InBev’s portfolio, which includes Budweiser, Corona, and Stella Artois. Brahma is a premium brand, where brand loyalty is higher than the mainstream and craft beer segments. Even in the mainstream category, Skol has very strong brand equity among Latin American consumers and is the seventh-largest beer brand by global volume. The premium positioning of Brahma, Budweiser, Stella Artois, and Corona should lend itself to fairly strong brand loyalty in the medium term.

Sensitive to Global Economy, but Financially Healthy With 86% of its 2018 revenue coming from South and Central America, Ambev has limited geographic diversification relative to several of its large-cap brewing peers, particularly majority owner AB InBev and Heineken. Latin America presents considerable macroeconomic, political, and foreign exchange risks, although some of Ambev's markets, such as Chile, are among the more stable countries in the region. Volume is highly correlated with GDP per capita in Ambev's core markets, particularly in low-income countries, and in turn, GDP is correlated with commodity prices in Latin America, a region rich in basic materials. Therefore, Ambev's revenue is sensitive to the global economy and, in particular, commodity price inflation or deflation. This is a particularly significant risk in the current geopolitical climate. Nevertheless, beer sales are less cyclical than most industries, and our fair value uncertainty rating for Ambev is medium.

Excise tax increases could disrupt Ambev's ability to take pricing over short time horizons. The Brazilian government stepped away from a plan to increase excise taxes ahead of the FIFA World Cup in 2014, but we think it is likely that the government could leverage the fairly low price elasticity of beer to raise taxes in the future.

Ambev has the healthiest financial position of its brewing peer group, and it slashed its debt/EBITDA ratio from 0.8 in 2008 to just 0.1 by the end of 2018. We forecast the balance sheet to remain at this level for the next five years. The company has ended the year in a net cash position in each of the past eight years. Ambev's competitors all have much more leveraged balance sheets, although on an interest coverage basis, Ambev is much more in line with the group. Cash flow conversion is exceptional; it has been at or close to 100% for several years, and Ambev operates at negative working capital. We interpret this as indicative that the company is ahead of the curve in terms of efficiency, relative to other large-cap consumer companies.

Given the preferential tax treatment given to dividends in Brazil, we do not expect the company to releverage its balance sheet, and to avoid a cash buildup on the balance sheet, we model the payout ratio rising to 100% by the end of our forecast period, which implies average annual dividend growth of 10% over the next five years. With the free float being limited by the large holdings of AB InBev and FAHZ, share repurchases seem an unlikely use of capital. Bolt-on transactions are possible, although any acquisitions would probably have to be in new markets for Ambev.