Is It Time to Prepare for Growth? Consumption-Linked Stocks Seem Ready to Prosper

Is It Time to Prepare For Growth? Consumption-Linked Stocks Seem Ready to Prosper. We Are Fine-Tuning Our Portfolio. November 20, 2019

Strategy Team

Lucas Tambellini, CNPI Jorge Gabrich, CNPI André Dibe Guilherme Reif +55-11-3073-3023 +55-11-3073-3048 +55-11-3073-3222 +55-11-3073-3066 [email protected] [email protected] [email protected] [email protected] Is It Time to Prepare For Growth?

The market is already anticipating the data. Consumption-linked stocks are up 28% year to date while the Ibovespa is up by 20% for the same period. This group of stocks have been outperforming the benchmark since July 2019, when CAGED numbers were still in the 30k range. Investors are still increasing weight in these stocks, as commodities and non-consumption domestics appear to have a larger consensus.

How we find our growth picks. We decided to look at metrics pertaining to companies’ operational potential (degree of operating leverage), operational performance (recent revenue growth), funding sources (cash generation), leverage (net debt to EV), relative valuation (price-to-book z-score) and investor sentiment (crowdedness index).

Brazil Buy List changes. We are removing Petrobras (PETR4), which has appreciated by 53.9% since its inclusion, while the Ibovespa increased by 33.3% in the same period. We are also removing Vale (VALE3), -7.6% vs. +0.5%, to add Renner (LREN3) and Ambev (ABEV3).

In this report we explore how best to Why Ambev and Renner? Both are highly resilient names (as we concluded in our “What If Winter Comes?” report), and they are linked to local economy. This is consistent with our reduction in commodity names as we grow uncomfortable with the approach the growth theme. We also increasing global volatility and more confident with the local scenario. Additionally, Ambev is one of the most discounted stocks in our coverage (when measured against its own history), and a pickup in volumes could propel an outperformance fine-tune our portfolio for next year against the index. In Renner we see considerable operating leverage before the fourth quarter (seasonally stronger) with a and take a close look at each growing retail sales trend.

company in our Brazil Buy List. We prefer domestic exposure. Our investment thesis is based on three factors: i) yield curve flattening; ii) an upturn in the credit cycle; and iii) companies with compelling stories. Our allocation includes an overweight in domestic names (70%), an underweight in commodities (10%) and an underweight in Financials (20%).

When the risk is global. We still see a persistent deceleration risk in the global economy due to trade-war woes. This is the first time in a while when the main problems arise from the global context and not the local backdrop. In this report, we aim to provide guidance on what we perceive to be the themes for next year, but the constantly changing global scenario could cause further course deviations in the near term. 2 Is It Time to Prepare For Growth?

Chart 1: CAGED is Posting Data Above 50k Chart 2: Retail Segment is Leading Credit Recovery (in BRL Mln) (in BRL Mln) Seasonally Adj. Net Job Creation 3 Months Mov. Brazil Loan Book (in BRL Mln) The Market Is Already 160% 2000 Avg. 160% 160% 2000 2000 1800 1800 280 140% 140% 140% Anticipating the Data 1600 1600 120% 120% 120% 1400 1500 1400 180 100% 100%  CAGED is our best gauge at this moment. The formal job 100% 1200 1200 80% 80% 100080% 1000 1000 80 market is considered to be on a positive trend when 60% 60% 80060% 800 600 600 monthly net job creation (CAGED) is consistently above 50 40% 40% 40% 500 -20 400 400

thousand jobs. Brazil finally lost this level on May 2014 Thousands 20% 20% 20020% 200 in after years of steady job creation. Since then, the indicator -120 0% 0% 00% 0 0

only broke through this level in October 2018, November

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2018 and now in September 2019. Additionally, this job Dec-14

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creation is occurring especially in sectors that generate

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2008 2004 2000 Total Credit Volume, rhs Corporate Individuals Total Credit Volume, rhs Corporate Individuals more economic stability, such as construction. Chart 4: …But Investors Still Appear to Be  Credit cycle on the positive side. Brazil’s retail-side credit is Chart 3: The Market Already Seems to Be Pricing In a Increasing Weight in This Theme driving the growth in this segment while corporates are Recovery for Consumption-Linked Names… still lagging. We believe that interest rates will remain low Crowdedness Index 33% Consumption and credit growth could increase as employment 28% Linked 15.0 improves further. 28.1% 13.0 11.6 11.9 12.0 12.6  23% 9.3 The market is already paying for this growth. IBOV 9.0 Consumption-linked stocks are up 28% year to date, while 18% 20.2% the Ibovespa is up by 20% in the same period. This group 13% has been outperforming the benchmark since July 2019, when CAGED numbers were still in the 30k range. 8%

 Still not that crowded. Investors are still increasing weight 3% Malls

in this theme, as commodities and non-consumption -2% Retail

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domestics appear to have a larger consensus. May

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Homebuilders Food andBev.

Source: Itaú BBA, Bloomberg, IBGE 3 Who is Better Positioned?

Chart 1: Companies With High Operating Leverage and Positive Operational Momentum Could Be Affected First  A better macro outlook. Our macro team recently revised its 2020 GDP growth forecast 47.0 to 2.2% from 1.7% due to the stronger effect of monetary policy on activity. Additionally, FTGS VVAR3 funds that are currently being released could help further propel revenues in the retail 46.0 segment, just as they did in 2017.  Who is better positioned to enjoy this growth? Degree of operating leverage (gross profits 5.0 RADL3 over operating income) could help answer that question. Seventeen of the 26 Consumption-

COGN3 MGLU3 linked companies we cover have operating 4.0 ARZZ3 leverage greater than 3x, generating a HGTX3 MDIA3 LREN3 significant pool of companies to delve deep

GUAR3 into. LAME4 CYRE3  But who can deliver? We have decided to look 3.0 into the recent revenue growth histories of SEER3 YDUQ3 TEND3 companies to determine which ones have positive operational momentum. MRVE3

Degree Degree ofOperating Leverage 2.0 ABEV3  Who do we like? Via Varejo and Renner appear to be good options. For Via Varejo, this is due MULT3 to its huge operating leverage (highest in our IGTA3 coverage) and its turnaround story. For 1.0 Renner, this is due to its notable and consistent 0% 5% 10% 15% 20% 25% 30% growth and its considerable operating 2 Year Revenue CAGR leverage.

Source: Itaú BBA, Bloomberg, Economatica 4 The Growth Source

Chart 1: Be Prepared for the Type of Growth the Company Is Seeking to Attain  Know the funding. Cash generation is key to

25% understanding the finances of a company. The Self-Funded Expansion amount of leverage is important in

SEER3 understanding a company’s options. The two 20% metrics we used are: i) Free Cash from Operations + Free Cash from Investments over Total Assets; and ii) Net Debt/Enterprise Value. 15%  Why does it matter? Companies with ABEV3 HGTX3 externally funded expansions tend to grow ARZZ3 CYRE3 10% YDUQ3 faster, especially if capital is readily available to LREN3 them. On the other hand, companies that rely EVEN3 NATU3 EZTC3 BRML3 on their own operations for growth (self- 5% RADL3 funded expansion) usually generate growth MDIA3 IGTA3 MRVE3 that is more consistent and reliable. This MULT3 TCSA3 ALSO3 TEND3 CVCB3 second group is less at the mercy of stressed 0% markets and can more easily change toward LAME4 externally funded expansion if needed. MGLU3 GUAR3 VVAR3

-5%  It’s important to interpret the data. Companies Cash Cash Generation (FCO+FCI Over Total Assets) in the midst of a turnaround could be located in either group and migrate frequently between BTOW3 -10% COGN3 them, as they are still grappling with their new objectives. This chart helps us to understand Externally-Funded Expansion their options and the impact of strong cash -15% generation. 0% 5% 10% 15% 20% 25% 30% 35% 40% Net Debt / Enterprise Value

Source: Itaú BBA, Bloomberg, Economatica 5 What to Pick?

Chart 1: Price Matters, But It’s Relative…  The price-to-book z-score. We normalized each Consumption-linked stock’s trading history through 20.0 one multiple we feel is shared by all of them: the price- to-book ratio. We used three years of data in order to see where each company is trading now in relation to 18.0 MGLU3 its own history.  Price is relative. Several companies seem to be BRML3 16.0 expensive when measured against their own histories. ARZZ3 RADL3 EZTC3 EVEN3 However, this group has already experienced a re-

LREN3 rating, as the median company is trading at a 1.3 14.0 standarddeviation above its three-year average. IGTA3 MULT3  Plan your exit. In our report “What if winter comes?”, MDIA3 YDUQ3 CYRE3 we created a new index (Crowdedness) to measure 12.0 BTOW3 TEND3 VVAR3 how crowded stocks seem to be. With this we can try to gauge the impact if our thesisdoes not materialize. NATU3 Crowdedness Crowdedness Rank 10.0  What do we like? Ambev and Via Varejo. We like CVCB3 SEER3 HGTX3 TCSA3 ABEV3 Ambev because we see it as one of the most “left- LAME4 GUAR3 MRVE3 behind” companies and anticipate a possible volume 8.0 improvement. We like Via Varejo because its COGN3 turnaround appears to have lost the market’s attention (as shown in this chart and in its recent pre- 6.0 results performance). Although the company seems to hit all the targets we have focused on for this report, it lags in terms of valuation, as our analysts’ 4.0 estimates for the name are lacking upside (target -2.0 -1.0 0.0 1.0 2.0 3.0 4.0 price of BRL 6.50 vs. spot price of BRL 7.52). For this Price to Book Z-Score reason, we prefer not to include it in our portfolio at this moment, but we remain positiveon the name.

Source: Itaú BBA, Bloomberg, Economatica 6 The Brazil Buy List

The 2020 Buy List Will Likely Remain Overweight in Domestics Bond Like Credit Ibovespa Particular Ibovespa Buy List (Yield Curve Cycle  We prefer domestic exposure. Our investment thesis is based on three factors: i) Segments Story Weights Allocation Flattening) Upturn yield curve flattening; ii) an upturn in the credit cycle; and iii) companies with compelling histories. Our allocation includes an overweight in domestic names (70%), an underweight in commodities (10%) and an underweight in Financials (20%).

 Changing the portfolio. We are removing Vale (-7.6%) and Petrobras (+53.9%) to 34% Domestic make room for Renner and Ambev. Ex-Financials  When the risk is global. We still see a persistent deceleration risk in the global economy due to trade war woes. This is the first time in a while when the main problems arise from the global context and not the local backdrop. In this report, we 70% aim to provide guidance on what we perceive to be the themes for next year, but the constantly changing global scenario could cause further course deviations in the near term. 36% Chart 1: Brazil Buy List – Performance Since Inception Financials 300% 240% 246% 180% 120% 81% 60% 20% 0% 30% Commodities -60%

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jan-16 jan-19 jan-18 10% Brazil Buy List Ibovespa

Source: Itaú BBA, Bloomberg 7 The Brazil Buy List

Yield Curve Flattening Chart 1: Yield Curve Flattening  We spoke about this subject in a previous report 8.0  CPFL offers compelling valuation, top-quality (“Breaking Open the Piggy Bank: Pay Attention to Expiring 7.5 management, efficient disco concessions and the Government Bonds”). potential to create value through M&A in the segment. 7.0  Large cash flows and a great dividend history are the main  The main catalysts for the call are the potential 6.5 points of attraction in this theme. The migration to acquisition of CEEE on accretive terms, better-than- equities could further enhance their appeal. Companies 6.0 expected synergies from the integration of RGE and with these characteristics could also benefit when 5.5 RGE Sul and a favorable outcome in the PIS/COFINS investors start to increase maturities in order to get better 3 Months Ago tax dispute. 5.0 yields. Last Month  CPFL’s current dividend policy is to distribute 50% of 4.5  Although we still like this theme, we have reduced our Actual its net income in dividends, and we see room for an overweight position in the last few weeks due to new 4.0 increase to 100% in 2023 onward if there is no M&A. nov-19 1Y 3Y 6Y 9Y 11Y uncertainties in the developing trade war. Chart 2: Real IRR

7.70% 7.70%  Rumo is one of the companies that benefits the most  Our positive view is based on three main factors: i) the from lower interest rates. The company has a 17-year company is expected to benefit from lower interest 6.10% duration, and 70% of its net debt is tied to short-term rates due to its high duration; ii) Multiplan’s quality rates. Moreover, low rates boost the leveraged IRRs on land bank could enable new projects in a better macro new (unpriced) projects (Norte-Sul, Sorriso, Malha Sul environment; and iii) we expect Multiplan’s premium and others). mall portfolio to continue to deliver the best numbers 3.22%  Although the swine fever could cause pain in the short in the industry over the next months. term, we believe that ASF will lead to increased  We see the MULT3 shares trading at a P/FFO 2020 of formalization of Chinese hog production, driving 20.8x vs. an average of 18.5x for the other shopping increased soybean or corn imports. We currently see mall names we cover. Rumo trading at an attractive IRR of 7.7%. CPFE3 RAIL3 MULT3 NTN-B 2045

Source: Itaú BBA, Bloomberg 8 The Brazil Buy List

Credit Cycle Upturn  Our constructive view for the macro scenario is the  The increase in formal employment coupled with cheap, main reason we like this call.  In our view Bradesco is poised to benefit from a plentiful credit is the foundation of our thesis here. We recovery in the credit cycle, driven especially by  We understand that the sector has already like to play this theme on both sides, through banks and growth in household credit. Also, the company is one benefitted from the beginning of an economic through credit-related companies. of the market leaders in mortgages and payroll loans. upturn, but we see room for more. The lower rates  Banks with extensive exposure to the retail segment are allowing cheaper financing and the increase in formal  Additionally, the new dividend pay-out policy already increasing their loan books in this segment faster jobs instead of informal ones along with an indicates that Bradesco is committed to distributing than any other. enhancement in income could continue to boost new excess capital. The bank has recently distributed BRL launches and sales. 8 billion in extraordinary dividends.  Homebuilders and retail are the segments best positioned to enjoy the greater willingness of banks to  In the sector, we prefer CYRE3 due to its higher  Bradesco is now trading at 1.9x P/B, which we see as lend. Average Daily Traded Volume. an appealing valuation within our LatAm coverage.

Chart40% 1: Individuals Credit Growth by Type (YoY %)

30%

20%  The main point in our investment thesis for Banco do  The company continues to lead the way in the Brasil is its attractive valuation relative to its peers. apparel retail industry, demonstrating premium 10% execution in the last few quarters while it still offers  Although Corporate and Agribusiness loans have good prospects for digital growth. 0% pressured BB’s loan book growth in the last few -10% quarters, we believe that the favorable macro  Additionally, it expects to generate growth by environment and the recovery in the credit cycle moving toward smaller cities and street stores. -20% could mean a resumption of growth for the loan Renner also offers strong operating leverage, making

book, especially driven by retail loans. it possible for us to capture our macro team’s recent

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Feb-16 Feb-19 Feb-18 2020 GDP growth upgrade to 2.2% from 1.7%.  We see BB generating an ROAE of 17% for 2019. Mortgage Paycheck Credit Card Auto Loans

Source: Itaú BBA, Bloomberg 9 The Brazil Buy List

Chart 1: Brazil Beer Volume to Improve in 2020

 We are anticipating ourselves to signs of improvement 90 in beer volumes. 85  We believe 2020 could be a better year due to: i) a cost of growth below inflation; ii) more consistent beer 80 market growth; iii) our belief that Ambev can stabilize 75

market share going forward with the growth of value in Mln hl brands and portfolio adjustments in the mainstream 70 and premium segments; and iv) our macro team’s call for the Selic rate at 4%, which could reduce interest 65 expenses, offsetting higher hedging costs in 60 Argentina. 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019E 2020E

Chart 2: Opportunity in Geographical Gaps Chart 3: Industry Avg. Cost vs. Verticalized Players

 We believe that Hapvida is poised to generate value % of Population With 282 through organic growth thanks to its efficiency Access to Private North Health Care 217 compared with other players. Verticalization and 9.4% 173 protocol control allow the company to offer a lower North-East ticket with higher margins. 11.5%  Also, the large addressable market could be accessed Center- by M&A opportunities with big growth potential. West 19.5%  Hapvida is extensively exposed to the Northeast and South-East North regions, which are underpenetrated by health 32.4% Industry Average GNDI Average Ticket Hapvida Average plans compared with the rest of the country. South Cost Ticket 23.1%

Source: Itaú BBA, Bloomberg 10 Disclaimer

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