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Morningstar | Brazil Soft Again in 3Q for Ambev; Lowering FVE Slightly, but Upside Remains. See Updated Analyst Note from 25 Oct 2018

The second-quarter rebound in Brazil proved to be another false start for Ambev, as the company missed our third-quarter estimates due to weak beer volumes in Brazil and Latin America South. We have lowered our short-term volume estimates for these regions and lowered our gross margin assumptions for the remainder of this year and next because we suspect price competition in Brazil may last a few more quarters. As a result, we are lowering our fair value estimates modestly, to BRL 20 per share from BRL 21, and to $5.50 per ADR from $6. Despite the volatility in the business, we still believe in Ambev's wide economic moat because of its dominance in many Latin American markets. We believe most of the challenges facing the company are cyclical and that the shares offer upside to the current market price.

Third-quarter organic growth of 5.8% was a significant slowdown from the 11% achieved in the second quarter, and the miss came from volume declines in Beer Brazil (down 3.1%) and Latin America South (down 4.7%), versus our expectations for a very modest increase. The volume miss in Brazil was partly driven by the macroeconomic environment, with the market down 2.5% according to management, but the miss seemed inevitable after Heineken yesterday announced a strong volume performance in Brazil. If Heineken continues with its aggressive market share grab, volumes could remain weak for several more quarters. Pricing was nevertheless strong, however, with revenue per hectoliter up 4.6% in Beer Brazil. We take encouragement from this, and we believe holding steady on price is the right strategy for the long term in a fairly concentrated market with a large industry profit pool. Ultimately, we expect Brazil to remain a market with rational pricing in which Ambev and Heineken can coexist with portfolios across the price segments.

Positive pricing is also pleasing amid commodity cost inflation. Cost of goods per hectoliter is up by 5% year to date, so Ambev will need pricing of at least 3% to sustain its gross margin. In the third quarter, the consolidated gross margin was flat but the underlying EBIT margin slipped by 130 basis points. The two regions at fault were Canada, where weak price/mix failed to offset commodity cost inflation, and Central America and the Caribbean, where Ambev is spending at an above-average investment rate in order to build infrastructure in Panama, which is growing in the double digits. Margin expansion is a cornerstone of our investment thesis, and once the current pressures from commodity costs and currencies subside, we expect Ambev to be more profitable to the tune of 6 percentage points. Our midcycle margin estimate of 40% is some 4 percentage points below the peak margin achieved in 2013, however, primarily because of the impact of Heineken in Brazil.