Value Investing

IP Capital Partners 2Q18 Commentary: Long ANHEUSER-BUSCH INBEV

IP Capital Partners commentary

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IP Capital Partners

As discussed in previous reports, Fed’s decision to unwind its balance sheet and remove market liquidity would have ramifications on general asset prices. In recent months, these impacts have become more evident. The fear that followed the rise in the 10-year Treasury rate troubled many markets. On our part, we only have reasons to celebrate.

These situations can be distressing for those who invest attempting to foresee market movements. For those investors, if opportunity costs (interest rates) rise, market prices must fall. Investors who believe this is the beginning of a longer cycle of increasing interest rates often attempt to anticipate market trends and sell assets before prices drop even further. These investors will not only miss more attractive asset prices but may also take permanent losses in untimely sales.

On the other hand, investors focused on absolute longterm returns view any market shake-up as a blessing. If projected cash flows of invested companies, assuming reasonably accurate estimates, already indicated attractive returns before the share price drop,
logically, future returns should increase as shares cost substantially less. For exceptional companies, trading at decent prices, a 1% or 2% increase in interest rates – after a significant stock price decline– would not make additional purchases unattractive.

As previously stated, markets are cyclical and subject to shocks every now and then. It is helpful to understand the rationale of other market participants, but our primary concern is never to anticipate macro trends or the shocks themselves. Our primary concern is to be prepared. We want to anticipate which companies can create value on their own merits, with consistency, and who can take advantage of future adverse scenarios.

PORTFOLIO

The recent shake-up in the American market was most welcome. The drop in share prices, combined with the consistent growth of individual businesses created excellent opportunities to use part of the cash we had been storing in previous quarters.

We initiated two small investments: Facebook and Charter. These are businesses for which we’ve held particular admiration and which suffered significant price declines for reasons we believe to be temporary. We’ll further comment on these cases in future reports.

We significantly reduced our investment in Amazon after the more than 30% share price increase in 2018. We choose to still participate in its impressive evolution, however, with a smaller position.

In Brazil, our key investments — Itaú/Itaúsa, Energisa, and B3 — were reduced after significant increases given the euphoric beginning of 2018. More recently, following a period of greater complacency with the uncertainties in upcoming elections, risks have finally started to reflect on asset prices. While shares of state-owned, cyclical and lower-quality businesses soared following a decompression of the economy and the appreciation of certain commodities, some companies within our universe have returned to more reasonable valuations.

We metaphorically compare our funds to little bonsais. There are no shortcuts to good results: it takes careful cultivation alongside much energy and dedication.

The recent performance of our fund tells a somewhat limited story about our investments. The investment optimizations, although conservative, are constant. This year, the dispersion in returns within our portfolio positions has been higher than average, which allowed us to make interesting adjustments. Increased volatility, coupled with the ability to quickly allocate capital in opportunities both in Brazil and abroad, gives us the flexibility to increase potential returns. It is a privilege to be able to restrict ourselves to truly outstanding companies. Over time, this improves the quality of the businesses in our portfolio and, consequently, safely increases our funds’ performance.

We believe we are well positioned to face whatever looming scenario. To successfully navigate market turmoil, nothing beats a portfolio of strong, profitable businesses that grow, generate cash, and trade at reasonable prices — in addition to a very comfortable cash cushion.

In this report, we will comment on our investments in Alphabet (Google) and Anheuser-Busch InBev.

ALPHABET

In our 2Q17 report, we explained the rationale for our investment in Alphabet, the holding company for Google. Since then, the company’s rhythm has remained strong. In the second half of 2017, growth accelerated to 23% per year and has continued so
through the first quarter of 2018. Even the US search business, its most mature, has sustained growth rates of around 20%. Such growth is boosted by YouTube, which we estimate to be at 30% per year, and segments such as Google Play (apps), Hardware (Google Pixel smartphone) and Cloud, which together grow at 40% per year. A spectacular performance for a company
with annual revenues of over US$100 billion.

In Search, by far its most significant segment, Google has innovated to reduce friction and become more valuable and integrated for users and advertisers. An example is the recently announced Shopping Actions, an e-commerce solution that permits users to add products from different vendors to a single shopping cart, directly from the search page. Only a single payment is necessary and free delivery is offered above a minimum purchase amount. The advertisement fee is calculated as a percentage of sales and not by clicks, allowing Google to capture more of the transaction value. Another example is the evolution of Google Hotel Ads, a solution thatstarted to reflect on asset prices. While shares of state-owned, cyclical and lower-quality businesses soared following a decompression of the economy and the appreciation of certain commodities, some companies within our universe have returned to more reasonable valuations.

We metaphorically compare our funds to little bonsais. There are no shortcuts to good results: it takes careful cultivation alongside much energy and dedication. The recent performance of our fund tells a somewhat limited story about our investments. The investment optimizations, although conservative, are constant. This year, the dispersion in returns within our portfolio positions has been higher than average, which allowed us to make interesting adjustments. Increased volatility, coupled with the ability to quickly allocate capital in opportunities both in Brazil and abroad, gives us the flexibility to increase potential returns. It is a privilege to be able to restrict ourselves to truly outstanding companies. Over time, this improves the quality of the businesses in our portfolio and, consequently, safely increases our funds’ performance.

We believe we are well positioned to face whatever looming scenario. To successfully navigate market turmoil, nothing beats a portfolio of strong, profitable businesses that grow, generate cash, and trade at reasonable prices — in addition to a very comfortable cash cushion.

In this report, we will comment on our investments in Alphabet (Google) and Anheuser-Busch InBev.

ALPHABET

In our 2Q17 report, we explained the rationale for our investment in Alphabet, the holding company for Google. Since then, the company’s rhythm has remained strong. In the second half of 2017, growth accelerated to 23% per year and has continued so
through the first quarter of 2018. Even the US search business, its most mature, has sustained growth rates of around 20%. Such growth is boosted by YouTube, which we estimate to be at 30% per year, and segments such as Google Play (apps), Hardware (Google Pixel smartphone) and Cloud, which together grow at 40% per year. A spectacular performance for a company
with annual revenues of over US$100 billion.

In Search, by far its most significant segment, Google has innovated to reduce friction and become more valuable and integrated for users and advertisers. An example is the recently announced Shopping Actions, an e-commerce solution that permits users to add products from different vendors to a single shopping cart, directly from the search page. Only a single payment is necessary and free delivery is offered above a minimum purchase amount. The advertisement fee is calculated as a percentage of
sales and not by clicks, allowing Google to capture more of the transaction value. Another example is the evolution of Google Hotel Ads, a solution that compares hotel prices between various websites, including Expedia and Booking, and encourages hotels to advertise directly on Google. The result has been a gradual strengthening of hotels versus online travel agencies (OTAs), once again letting Google capture more value.

Margins, on the other hand, continue to compress. The reason for this is that the currently fastest growing businesses (YouTube, Hardware, and Cloud) have structurally lower margins when compared to Search. The fact that search is increasingly used on mobile devices, in which the company must pay manufacturers (such as Apple) to maintain Google as their standard search engine, does not help. Nevertheless, its annual recurring gross profit has grown in the 17-20% range. The net income has been evolving at similar levels when deducting recurring expenses in proportion to revenues.

Sundar Pichai (CEO) and Ruth Porat (CFO) continually remind investors that Alphabet’s objective is not to expand margins but to increase profits in absolute terms. Thus, investors should expect strong investments to enable future growth, through research and development, marketing or investments in fixed assets (CAPEX). In the first quarter of 2018, CAPEX reached US$7.3 billion, half to expand offices and facilities, and the other half to increase the company’s computational capacity to manage processingintensive services, such as artificial intelligence (AI). Sometimes, such numbers frighten the market and allow us to increase our position at attractive prices. We see no problem with investing heavily towards the future. Quite the contrary — Alphabet is positioned to lead and extract enormous value from AI technology, which is hardware intensive by nature.

For example, its self-driving car initiative Waymo is no longer just theoretical. In Phoenix, Arizona, Waymo is piloting a 100% self-driven transportation service.1 By the end of 2018, it will be available to the city’s residents. Waymo’s cars have amassed 9 million kilometers in test-drives and are at the forefront of the technological race to become truly functional and secure. The goal of the company is to have fully automated vehicles, not just on well-signaled roads and other more straightforward situations, as do the Tesla cars today. The argument is that people do not know how to operate with partial autonomy safely. Tests indicate that users quickly become too reliant on the automated system and get distracted. A system that works 95% of the time but can surprise the driver in critical situations can be more dangerous than no autonomy at all. In recent cases, such as the cyclist being run over by a self-driven Uber car, and the fatal accident of a Tesla client when crashing into a wall, the driver’s distraction was critical and seems to confirm that full autonomy is the correct path. Waymo is one of Alphabet’s Other Bets, does not generate significant revenues, and is not considered in our valuation calculations. Its development gives us hope that the Other Bets may not be a waste of capital after all.

The greatest risk to our investment lies in potential regulation, especially antitrust. Last year, the company received a €2.4 billion fine for its product price comparison solution in Europe. The decision is under appeal while the company complies with the demands from the European Commission. This discussion may still not be over for Alphabet, as well-organized lobbying groups are exerting public pressure for an even more favorable solution for them. They want Google to direct users to their websites, free of charge, something difficult to defend legally.

The Android issue is more delicate. Alphabet is being investigated for non-competitive practices, such as requiring from manufacturers the pre-installation of the Google Play Store, Search, Maps, and YouTube on all smartphones. The company has sought to resolve the issue with the European Commission, but we would not be surprised if there were other substantial fines along with specific conditions for the commercialization of Android products. One possibility may be to prevent Google from enforcing smartphone manufacturers to adopt all of their apps at once, letting users choose each app individually.
Another possibility is the creation of a competing app store. Either way, Alphabet would lose its bargaining power with manufacturers and could have higher acquisition costs for Search traffic. Such scenarios must be considered. However, we believe the services offered by Search, Maps, YouTube and the Play Store are leaders on their own merits and not by mere imposition. Therefore, we think this scenario can ultimately be managed by the company.

Alphabet trades, according to our estimates, at approximately 20x its 2018 recurring net income. We remove net cash from the company’s market value and capitalize (rather than expense) the Other Bets. The current price is quite attractive for a business with such growth prospects, and thus we increased our position during the first months of the year.

ANHEUSER-BUSCH INBEV (ABI)

ABI’s business model is attractive in numerous ways. The beer business is reasonably predictable, generates strong cash flows, has the potential for organic growth and has a small risk of suffering from technology shocks (especially in developing countries). In addition, ABI has a massive market dominance (generating around 30% of global beer volumes and almost 50% of the industry’s profits), and a talented, well-aligned management team with an envious execution track record.

In recent years, our investment in the company ranged from a small to medium position. Recently, a combination of factors gave us an opportunity to increase our stake.

Over the last five years, ABI’s share price appreciated only 20%, while the S&P 500 climbed 84%2. The main drag was the 9% drop in earnings per share between 2012 and 2017, due to: (i) the lack of organic volume growth, primarily a result of the economic recession in Brazil, (ii) the devaluation of emerging market currencies, generating a negative cumulative impact of approximately US$6.6 billion on EBITDA, (iii) the increase in debt from 1.9x net debt/EBITDA to 4.7x in the period due to the SAB Miller (SAB)
acquisition, and (iv) the shareholder dilution from this same acquisition.

In 2018, ABI’s market capitalization fell by about 10%, from US$210 billion to US$189 billion3, following the increase in long-term Treasury yields, a general decline in the prices of global consumer goods companies, and a few company-specific concerns.

We believe some concerns may have been exaggerated and the company-specific risks are indeed manageable. For example, recently, many investors have questioned the ability of the culture employed by 3G Capital’s partners to encourage innovation and
create organic growth at both ABI and Kraft Heinz. We see these situations distinctly: different businesses, in different regions, with different teams and thus have different future perspectives. Although ABI has not grown organically in the last five years, the company is now better prepared to grow following the acquisition of SAB.

The decline in US beer volumes, which peaked in 2108, also causes concern. Since this is the most profitable and cash-generating region for ABI, a rupture could cause significant operational deleverage and jeopardize the company’s ability to maintain its dividends and/or manage its debt. The Budweiser and Bud Light brands, which account for roughly 60% of volumes, have been suffering from worsening competition. The volumes of these brands have dropped 5.8% and 6.5%, respectively, during the first four months of 20184. On the other hand, the Super Premium category, which accounts for approximately 15% of volumes and has high margins (i.e., Michelob Ultra), grows at double-digit rates, helping to offset the declines of the more popular brands. We believe that, over the next few years, the change in mix will result in smaller reductions in revenues than expected. In any case, the region has been losing its relevance within the company over the years given its relative performance and some strategic acquisitions. In 2012, the United States represented 38% of total EBITDA, while in 2017 this number fell to 26%.

Another issue is debt. From 2015 to 2016, after the completion of the SAB acquisition, net debt increased from US$42 billion to US$108 billion and concluded 2017 at US$104 billion. There are three critical risks regarding this increase in debt: (i) the risk of a normalization (increase) of global interest rates, (ii) refinancing risk and (iii) the risk of a mismatch between the cash flows denominated in multiple currencies and the mostly (90%) Euro and US dollar-denominated debt. Albeit these risks, a few points are comforting: (i) 93% of debt is fixed with an average cost of 3.7% per year, (ii) over 60% of outstanding debt will begin to be amortized only in 5 years, long enough for the company to grow its business and improve its net debt/EBITDA ratio, and (iii) the company’s cash flow is higher than its net income due to its negative working capital.

Where will growth come from?

Despite the risks discussed above, ABI can deliver sustainable growth in the upcoming years, for the following reasons:

Firstly, ABI is currently more geographically diverse and has greater exposure to growing economies. The beer market in mature regions, such as the United States and Western Europe, is no longer growing. In these markets, beer has been losing market share to spirits and wine, and breweries have directed their production to more premium brands to keep revenues stable. On the other hand, the beer market still grows in regions such as Colombia, Mexico, China and Africa due to populational growth, increased disposable income, increased beer consumption per capita and market share gains from informal beverages. The acquisition of SAB brought not only access to growing markets but also access to regions with elevated market shares, thus facilitating operational improvement and the expansion of its global brand portfolio.

The chart below illustrates the evolution of beer consumption per capita, by country, between 2004 and 2014 and ABI’s current approximate market share in each region. The combination of a growing market with dominant market share is killer. In 2018, a little over 70% of ABI’s volume will come from nascent or developing markets.

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