Ambev Stock: A Currency That Produces Beer (NYSE:ABEV)

The 1-Second Thesis

Ambev’s (NYSE:ABEV) valuation is tied in to the strength of the Brazilian Real. That simple.

Beer as a Forex Investment

The most basic assumption in investing is that the share price of a company will reflect earnings, free cash flow and revenue growth over a long period of time, thus the usefulness of discounted cashflow models. However, using this type of analysis is almost useless in the case of Ambev, the Brazilian juggernaut in the brewing industry. That is, unless one can somehow use the rollercoaster-like behavior of the country’s policy interest rate (Figure 3) to nail down a proper discount rate. For the skeptical, Figure 1 below should put all doubts to rest. It shows scatterplots for Ambev’s share price and earnings per share (EPS), free cash flow (FCF) and revenue in this order since 2012. Remarkably, the (weak) correlation is negative between share price EPS and between share price and Revenue. As for FCF, there is no correlation whatsoever. And I would say the company has done well during this period, growing revenue at a rate of around 8.5% per year, generating profits and FCF every single year along the way. Not what one would expect for a “normal” company.

Now, let’s contrast that with a scatter plot of Ambev’s share price and the USD to BRL exchange rate in Figure 2 where I used weekly data since January 2012. The correlation is negative and very strong. Despite the healthy revenue growth, Ambev’s share price shrank by about $1.56 for every Brazilian Real bought with the same US Dollar. This relationship is also shown in Figure 3 by plotting the historical data for the exchange rate between the two currencies and Ambev’s stock price. The Brazilian Selic Interest Rate is also plotted for reference. The Real and Ambev’s share price have only known one direction: down!

At this point, no matter how much one stresses that correlation is not causation, our brains will tell us otherwise. Unlike the other Brazilian giants Petrobras (PBR) and Vale (VALE), which have a worldwide presence, save for some Canadian business, Ambev is a regional company, strongly tied in to the strength of the Brazilian and South American economies. The Real is a bit like gravity to the company. To reach escape velocity, revenue and profit would have to grow above the devaluation rate of the Real. In reality, these rates are fairly similar. The Real has lost about 7.8% per year, not far from the 8.5% revenue growth I mentioned above. The numbers seem to leave one of two paths for a profitable investment in Ambev:

1. The Brazilian real will regain value in the future

2. Ambev’s Revenue and profits will outgrow the weakening rate of the real

The Company Beyond The Currency

Let’s ignore the currency factor for a bit. Despite calling Ambev a “regional company”, Ambev sells beer over a significant part of Latin America and even reaches to the Canadian market, where the company derived about 12% of its 2023 revenue. To give an idea of the sheer size of Ambev, I put the largest 40 beer companies in a pie chart showing millions of hectoliters produced using data published by BarthHaas. Ambev is not listed among those 40 largest companies because it is part of AB InBev (Anheuser Bush) who controls 61.8% of the company, but we can split the production of Anheuser Bush and that of Ambev using information provided in the company’s 20F filing. Ambev would come third with 183.7 million hl, behind Heineken with 256.9 million hl, and leading the 4th largest producer by over 61 million hectoliters. When it comes to beer, there are basically five Oceans (AB InBev, Ambev, Heineken, China Res. Snow Breweries and Carlsberg) and then many smaller Seas. Ambev is truly a giant.

The Fundamentals

Ok, Ambev makes a lot of beer, but how does it compare to the industry in terms of profitability and capital allocation? It crushes! In Figure 5 I compiled some key metrics and compared them across some of the industry leaders and well-known names. Ambev tops all of them except in gross margin where it comes in third behind its parent company AB ImBev (BUD) and Constellation Brands (STZ). However, it leaves its competition in the dust when it comes to net margin which more than doubles Heineken’s and Constellation Brands’ at 18%. Although there has been some consolidation across the industry with acquisitions skewing the average net income, the fact that Ambev’s net income is so high shows the consistency of the company in generating profits. Ambev has slowed down when it comes to acquisitions and yet, it also leads in revenue growth which Carlsberg and Heineken boosted with major acquisitions in the last couple years. But where Ambev absolutely destroys its competition is with its balance sheet. Whereas the other companies in the table need on average 6.4 years of FCF to pay their debts, Ambev has no debt to speak of. The company has had a negative net debt since 2012 – Figure 6 (I have not looked back further). This financial discipline is finds its roots in zero-based budgeting implemented by the company over a decade ago.

Return on Invested Capital (ROIC) is one of the metrics I pay attention to the most, and there are no complaints here either. Ambev is in a totally different league when compared to its peers, almost doubling Carlsberg’s ROIC.

Ambev is an exemplary company no matter how one slices it.

Tailwinds

Ambev is a wide-moat and monopoly-like business. It controls about 80% of the market in Argentina, 70% in Brazil and 60% in Peru. As long as it stays true to the strategy it has been implementing for years, I don’t see a reason for significant changes in performance and profitability. Its size will allow it to keep a competitive advantage when it comes to cost control and profitability.

Ambev also benefits from the relationship with its parent company AB ImBev whose portfolio of brands it can access.

The company says there has been substantial growth with their “premium and super premium” brands in 2023 which allowed it to offset decrease in volume. Ambev recognizes this trend and sees it as one of the drivers of profitability going forward.

Headwinds

Front and center is the one I started the article with: currency and the myriad of factors that directly or indirectly influence its strength. And this extends to the markets beyond Brazil. Hyperinflation is almost the norm in Argentina, and the political instability is unlikely to ameliorate things in the near future. Brazil itself has a rather volatile federal interest rate (Selic rate) and the results from the last election show that the country is politically fractured. The economy has improved under Lula. Inflation has come down and so has unemployment. The country’s economy is expected to grow 3%, far better than previous expectations, but reasons for concern remain.

I am not sure I would call the “regional market” Ambev operates in a headwind, but I can understand why investors would not value it the same way as the North American or European markets. Brazil has been considered an emerging market for a long time and it feels like the promised land of a developed economy is always 10 years in the future.

Is Ambev a Tasty Investment?

I believe Seeking Alpha readers are familiar with the fact that stock-related articles require a “buy”, “sell” or “hold” tag. Obviously, that classification is ultimately in the hands on each individual investor. There are no guarantees when it comes to investing and even the wisest of investors are wrong every now and then. I would say this is one where people should tread carefully if they don’t have the most important organ an investor can have according to Peter Lynch: the stomach. For full disclosure, I own 2,780 shares of the Ambev S.A. ADR at a cost basis of $2.48.

How did I come to the conclusion that it is a good investment? It definitely isn’t because I know what the intrinsic value of the company is. As usual, it’s about my assessment of the downside risk. First rule of investing: Don’t lose money, although sometimes it does happen. In the case of Ambev, I think the downside is rather limited, whereas the upside is quite attractive. To reach these conclusions, I often play with pessimistic scenarios. For the sake of argument let’s erase Argentina from Ambev’s sales. In fact, Argentina is included in Ambev’s Latin America South region which also includes Peru, Bolivia, Paraguay and Uruguay. This region represented about 17% of Ambev’s revenue in 2023. Because I cannot isolate Argentina, I assumed 2024 sales at the same level of 2023 minus 17% and projected zero sales growth for 10 years. For reference, the global beer market is expected to grow at about 4% per year until 2032. My scenario is quite catastrophic, I would say. These assumptions are shown in Figure 7. Assuming a cash flow multiple of 15 at the end of 10 years, I end up with an Internal Rate of Return (IRR) of 14.06%. This assumes no significant deterioration of the Real. I think that is fair giving that I am making some radical assumptions on the revenue side. To arrive at the cashflows in Figure 7 I also assumed an EBITDA margin 5% below historical average and an FCF conversion of 65%, this one in line with historical averages. I would be happy with an IRR of 14%.

Another way I looked at the downside was by looking at the strong correlation between the USD to BRL exchange rate and Ambev’s share price. I know historical data is not indicative of what the future will bring, but this approach should show how undervalued/overvalued the stock is assuming the correlation would remain (Figure 8). With the current exchange rate of 1 USD to about 5 BRL, one would expect ABEV’s stock price to be between $2.89 and $3.29 for the ADR shares based on an 85% confidence interval for the slope and intercept in this model – Scenario 2 in Figure 7. This would represent an upside between 16% and 32%, which indicates that the stock might be trading undervalued.

According to some forecasts, 1 USD to 5 BRL is also the expected rate in 12 months time. I make no attempt in making any predictions on the strength of the Real, but looking at Figure 3 above, it is clear that COVID and the mayhem that ensued was a catalyst for the weakening of the currency. Brazil was not immune to the inflation spikes that all economies experienced and things seem to be improving, at least in the short term. The decrease of the Selic rate in the same graph shows that inflation is subsiding and for these reasons, I would not be surprised to see some strengthening of the Real in the coming years. Will it go to pre-COVID levels? That I don’t know.

If the Real experiences a continued devaluation, a decline in share price will probably be in the cards, and this is where the stomach is important.

I have not mentioned the dividend because that is not the main reason I decided to invest, but Ambev pays one and it is quite high at about 6%. This is the way Ambev uses to reward shareholders and it stems from tax benefits in Brazil related to dividends paid. This Tax policy is under review by the Brazilian government and, for that reason, those attracted to high yield should keep that in mind to prevent any future disappointment.

Final Thoughts

Ambev is a world-class company when it comes to profitability, financial discipline and capital allocation. Its monopoly-like positions in the markets it operates in make Ambev a wide-moat company with a reduced risk of being disrupted. Save for the volatility in the strength of the Brazilian Real, shareholders have no reason to be fearful of the future.