2023-07-04 03:08:26 ET
Summary
- Brazilian holding company Ultrapar has seen a resurgence in its share price due to expected improvements in gross margin and recent financial deleveraging.
- The company's gross margin decline since 2018 has been attributed to rising gasoline prices in Brazil, but changes in PBR's price policy could reverse this trend.
- Ultra's management has successfully reduced the company's debt, which peaked in 2020 at $17.4B BRL and has since been brought down to $11.8B BRL.
- Higher margins, less debt, and a pending cut of interest rates are what is driving Ultra's stock and will likely take it further. Ultra is a buy.
Background and Main Thesis
Ultrapar ( UGP ) is a holding company in Brazil known for three businesses: Ipiranga (Service Stations), Ultragaz (Liquified Petroleum Gas, LPG) and Ultracargo (energy storage and transportation). It has more than 80 years of history in the energy business and is considered, by revenue, one of the largest companies in Brazil . During the 2000s and 2010s, the company saw an impressive performance in share price given the good performance of its businesses, the acquisition of Ipiranga, M&A and relatively stable gasoline prices. Note that given the BRL/USD depreciation that started in 2013, the ATH in BRL is in 2018 and the ATH in USD is in 2013. After likely hitting bottom during 2022, it has staged a comeback and gained +80% YTD.
This article will cover what I believe to be the two main reasons behind Ultra's appreciation and why they will likely continue to push the stock higher:
- The expected improvement of Gross Margin in Ipiranga given the new gasoline price policies (called PPI in Portuguese) dictated by Petrobras.
- The financial deleverage that has happened in the recent years.
Gross Margin Comeback
In my opinion, the decline in Gross Margin that started during 2018 is the main reason why Ultra saw its valuation drop so much in the past. As you can see in the graph below, the Gross Margin historical data for the three main competitors in Brazil paint a similar story to all of them. Beginning in 2018, all three saw substantial Gross Margin decline and two are still to hit bottom - given that Ipiranga has marginally rebounded from its 2021 low.
Historical Gross Margin % 2012-2022 (Ultra IR, Vibra IR, Raízen IR)
The reason behind the decline is the same why Petrobras ( PBR) has seen its Net Income jump from USD $(135) million in 2017 to USD $35.6 billion in 2022. Since 2017 gasoline prices have been rising in Brazil, mainly driven by three factors:
- BRL depreciation versus USD: R$5.29 at the end of 2022 from R$3.31 at the end of 2017.
- Brent Crude Oil up to USD $86 at the end of 2022 from USD $66 at the end of 2017.
- PBR adoption of PPI (Preço de Paridade de Importação, in Portuguese) which meant that PBR would no longer subsidize gasoline prices and adjust them once a year but rather adjust it daily based on the new BRL/USD rate and the Brent Crude Oil price.
These three factors resulted in the below gasoline prices between 2004 and 2022. Given that Gas Stations do not add value to the product and their only function is to distribute a finished product, their margin is based purely on the spread between how much they pay for the product and how much they are able to sell it. After 15 years of relatively stable prices and easy to manage inventories, all three companies started to face difficulties to plan inventories and keep the same spread that they were able to sell before 2017. Gasoline prices doubled between 2017 and 2021.
Average Price of Gasoline Liter in BRL (ANP)
However, light may be appearing at the end of the tunnel. Even with the new oil cuts made by OPEC, some analysts are still forecasting a fall on oil prices (and they have already fell from USD $120 in March and June 2022). The BRL/USD has dipped below R$5 and could go lower depending on the new fiscal policy in Brazil and new announcements over interest rate both from the FED and the BACEN. But the main reason may be what will Lula (Brazil's elected president and former president between 2002-2010) do with PBR and its PPI .
PBR has already announced its new policy and it ends the PPI with its price adjustment driven by USD/BRL rate and Brent Crude Oil prices. Exact details weren't made clear, but the company said they will look into "alternative costs for customers" and "marginal value to Petrobras". I understand this as the government using, once again, the Petrobras for political purposes. By not making the new price policy clear, it means they can adjust it freely and still be able to justify a decrease when prices should be going up. Since the big theme in Brazil is Lula's pressure over BACEN to decrease interest rates, a decrease in gasoline prices would help inflation and thus convince BACEN to decrease interest rates. A lower gasoline price - or even just stable - is good news for Ultra and I think the market has noticed it.
Deleveraging the Company
The combination of bad M&A and compressed Gross Margins invariably leads to a higher debt level and poor Net Debt/EBITDA. The chart below shows the negative trend starting in 2017 and peaking around 2019 and 2020. I've adjusted 2022 numbers to exclude any positive or negative impact in EBITDA from Oxiteno (sold to Indorama Ventures in 2022 for R$6.8 billion) and Extrafarma (sold to Pague Menos in 2021 for R$0.7 billion) as they were both deconsolidated during this year.
Total Debt and Net Debt/EBITDA, in Billions BRL (Ultra IR)
Total Debt peaked in 2020 at R$17.4 billion and has since been brought down to R$11.8 billion. Net Debt/EBITDA peaked in 2019 driven by a R$0.5 billion impairment charge - otherwise it would have been the same as in 2020 - but is now back to 2016 levels. Debt in Brazil is very expensive, so having it under control is of utmost importance, especially for a business with razor thin margins. It's important to highlight that EBITDA improvement is due to higher prices (compared to early 2010s) in Ipiranga rather than margins, but also higher share of Ultragaz and Ultracargo on total EBITDA.
Also on the positive side, it seems the debt profile of the company is in good shape as short-term maturities are well covered with Cash & Equivalents and only R$1.6 billion is maturing in years 2 and 3. There is still almost R$1 billion to be received from the sale of Oxiteno in April 2024.
Debt Profile, in Billions BRL (Ultra IR)
Now compare all this to Vibra (former BR Distribuidora), Ultra's main competitor. Total Debt has more than tripled between 2022 and 2017 and Net Debt/EBITDA is approaching dangerous levels that Ultra once saw. The market rightfully paid a premium for Vibra when they were able to keep their Gross Margins above Ultra's and Raízen's, but not anymore. With Gross Margin compressed and a ballooning debt, Vibra is now valued at R$21.0 billion, same as Ultra at R$21.0 billion. Bear in mind that Vibra had sales of R$181 billion in 2022 compared to R$144 billion for Ultra. Comparable data between 2012 and 2016 is not available so I preferred to keep the graph on the same scale as Ultra's for better visualization.
Total Debt and Net Debt/EBITDA, in Billions BRL (Vibra IR)
With all this, it seems some credit is due to Ultra's management as it was able to deleverage the company successfully and reprofile its debt at a moment when interest rates in Brazil were climbing and are now at more than 13%. This will probably be very helpful in order to fund organic growth and other initiatives.
Valuation
Conservative Scenario
Below is the detailed financial modelling for the conservative scenario. I'll explain each assumption, but note that Total Value is in BRL and shows that for a discount rate of 10% we get R$25.6 billion, which is around USD $5.3 for the stock price in the NYSE.
Ultra's Financial Modelling (Numbers in '000 BRL) (Author)
Revenue: It could be very volatile due to oil prices, but I'm assuming that we won't see it going down and actually used a 4% increase for the first 10 years and 3% in perpetuity.
Gross Margin: This is where I give the company some vote of confidence and assume that they will drive Gross Margin from ~5% to ~6%. This could be faster if Ultracargo, Ultragaz or other initiatives show better results in the short term, but I think even Ipiranga can contribute something in terms of better margins.
SG&A: Also at 4% given inflation and productivity.
Interest Expense: (Debt Interest Rate * Debt) - (Cash & Equivalents * Cash Interest).
Taxes: At 30%.
Depreciation & Capex: Growing at 3%.
Change in Working Capital: Historical data is of no use given the recent deleveraging and inventory fluctuation, so I just assumed a portion of the Net Income growing at 3%.
Debt: It's around 50% of Total Capital today and I'm assuming it will eventually deleverage to 40%.
Debt Interest Rate: Today interest expense is 4p. higher than Central Bank Interest Rate and I'm keeping it this way.
Cash & Equivalents: Really depends on future M&A and Capex strategy, but it is estimated as Cash Prior Period + FCFE - Dividends.
Cash Interest: How much the company makes on Cash & Equivalents invested, assuming 4p. below Central Bank Interest Rate.
Interest Rate BACEN: The interest rate set by Brazilian Central Bank. We are close to 14% and although difficult to predict, Brazil doesn't seem to be able to have less than 8% in the long run.
FCFE Estimate: Next you can see the estimated FCFE in each year and its discounted value given a specific hurdle rate. Total Value is the sum of the years and Terminal Value. CAGR is based on 2025 as target year.
Dividends: From a ~35% pay-out ratio to ~50%. Ultra usually pays above the 25% minimum of Net Income and if they focus on their core business without any crazy M&A, I do believe it's possible to increase the pay-out.
Equity: Calculated as Equity Prior Period + Net Income - Dividends.
Debt to Total Capital: As mentioned, given the progress of Equity, I estimated it decreasing to ~40% and thus impacting the Debt calculation.
Overall, with a hurdle rate of 14% (which is what we have in Brazil today), Ultra looks fairly valued. The recent run-up seems to be related to an expected drop in interest rates (due to lower inflation) and improvement of Ipiranga's margins. Another way to look at it is that today Ultra trades at around 12 P/E and if they manage to grow Net Income to close to R$2 billion with significant deleverage and a clear strategy it could warrant a 15 P/E, which would then value the company at R$30 billion. It could even go higher if we look at how much Net Income I'm projecting in the long-term.
Aggressive Scenario
There is only one change between the Aggressive and the Conservative scenario: a 1p. improvement in Gross Margin . This could come from several sources, be it a more stable gasoline prices due to changes in PBR's PPI under Lula's guidance, higher growth in Ultragaz or Ultracargo, or even just better execution in Ipiranga as they learn how to manage inventory and deal with a more volatile price for their supplies.
Ultra's Financial modelling (Numbers in '000 BRL) (Author)
In this scenario, we arrive at R$36.0 billion (USD $6.6 for stock price in the NYSE) for the same discount rate of 10% used in the conservative scenario. This 1.0p. improvement in gross margin gives us +R$10.0 billion in market value. Now, it really seems that Ultra is a good Buy and that the market is still not appreciating the turnaround, the deleveraging and the likelihood of improvement in Ipiranga's margins.
Risks
- What the Petrobras' new price policy really means is still not clear. It seems to me that the government will likely prefer a lower or stable gasoline price, even if this decreases significantly PBR's Net Income. However, if Brazil's fiscal situation requires, the government could also increase gasoline prices once again in order to generate more dividends.
- PBR has vented the possibility of coming back to distribution , be it through a new operation or buying Vibra . A new player or even a Vibra that belongs to PBR could increase competition and decrease overall profits. However, Ultra achieved its ATH when Vibra was owned by PBR, so it's may not be exactly bad news.
- Ultra's businesses are very cyclical so they rely on how the economy performs and if it doesn't improve in the coming years, then gasoline, gas consumption and storage of products will likely grow sideways.
- The electric vehicle. It's a great question what will happen with gas stations as electric vehicles dominate the market and the majority of recharging happens at home overnight. However, I do put this in really long-term because I do see the adoption of electric vehicle as very challenging in Brazil. Electric vehicle seems inevitable, I'm just not sure when for Brazil.
Final Thoughts
All in all, Ultra has reshaped itself to focus on three businesses but the market still values them as an indebted, margin compressed business. With the changes that the company made recently and some upside to be seen in Ipiranga, it can be deemed as a Buy. Still, investors should keep an eye on PBR's new price policy and how it will evolve during 2023 because the comeback to pre-2017 policies of gasoline prices will likely merit an unanticipated increase in gross margin for Ipiranga that can really benefit the company.
For further details see:
Making Sense Of Ultrapar's Run-Up And Why It's Still A Buy