Ultrapar: Over Invests, Speculative Play On Brazil (NYSE:UGP)

Ultrapar Participacoes (NYSE:UGP) is a Brazilian holding with important market shares in gas stations, LPG distribution and hydrocarbon port storage. The company has recently divested two unrelated segments.

In previous articles from January 2022 and September 2022, I did not recommend the stock based on its businesses lack of competitive advantage, low margins and low return on invested capital. Above all, I criticized UGP’s capital allocation strategy, considering it more valuable to repay debt than to continue with capital expenditures.

These considerations have not changed. In this review, with data from 3Q22 and the 2023 Investment Plan, I reconsider other aspects, like the cyclicality of Ultrapar’s industry, and its correlation with the Brazilian economy. Although I still do not consider UGP a valuable long-term investment at these prices, I do consider it an interesting speculative play on Brazil and on its downstream hydrocarbon industry cyclical recovery.

Note: Unless otherwise stated, all information has been obtained from UGP’s filings with the SEC.

Historical operations

For a more thorough review of UGP’s operations, please read the previous articles from January 2022 and September 2022. In this article I will only mention the key aspects of my previous thesis.

UGP participates in low return commoditized businesses: UGP participates in service stations (Ipiranga), bottled LPG (Ultragaz) and hydrocarbon port storage (UltraCargo). These three segments suffer from similar diseases: high fixed asset requirements and mostly undifferentiated products, which cause high competition and very low margins.

This can be seen in UGP’s low return on assets (calculated as operating profit over total assets) and return on invested capital.

Procyclical capital allocation: Ideally, a business can enhance its return on invested capital when participating in a low return or cyclical industry by investing contrary to the cycle. That is, accumulate cash during the upturn in the industry, refrain from investing, and when the downturn finally hits, buy assets at a discount. Unfortunately, the chart below shows that UGP’s management has followed a very procyclical investment route.

Underrepresented depreciation: UGP’s net income is overstated by depreciation that does not represent the true capital deployments needed to keep the business running.

The first evidence of this is the consistent positive difference between CAPEX and depreciation. A second piece of evidence comes from the company’s 2023 investment plan, where they expect depreciation expenses of almost R$1.2 billion against yearly depreciation charges of R$750 million.

Cannot earn its cost of debt: The company’s return on invested capital (rarely above 8%) is lower than the cost of its debt (rarely below 8%). This means that the company is paying more to service the debt used to purchase assets than what those assets generate.

A speculative play in the future

Reducing debt: UGP started the process of reducing its debt leverage a few years ago. It has accelerated this process after the divestment of Extrafarma (pharmacy stores) and Oxiteno (chemicals), two businesses unrelated to its core industry. Long term debt stands at R$12.1 billion (about $2.4 billion) as of 3Q22, and ideally the company should be repaying (not rolling over) another R$3.5 billion this year, but it has no cash to do so given its planned investments.

Continued over investment: The company’s 2023 investment plan includes a R$2 billion CAPEX account, against R$750 million of depreciation. With CFO close to R$2 to R$2.5 billion in the past few years, it will be difficult for the company to invest and repay debt at the same time. I would go for the latter.

Super beta Brazil: UGP’s profitability and share price are closely related to Brazil’s destiny. In my opinion this is caused by capital inflows making the country more or less expensive by cycles, which in turn affects UGP’s profit at the unit level.

For example, data below from the National Petroleum Agency shows the rise and fall of petroleum products sales (first table), compounded by falling prices in dollar terms (second table in reais per liter). The price of a liter of gasoline was almost $1.5 in 2014, but only $1.15 in 2021. This fall in volumes and prices affects UGP’s profitability because the company takes prices from the market, rather than having its own pricing power.

Not for the business but for the speculation

I do not believe UGP is a great long term investment. The reason is industry undesirability coupled with bad capital allocation policies. However, the stock may outperform based on a cyclical recovery in Brazil and the industry.

Brazil cycle: It seems that the country has at least temporarily broken its downward trendline in GDP growth, growing in 2021 and 2022 (caveat: I know nothing and pretend to know nothing of macroeconomics).

UGP cycle: UGP has also recovered sales at a fast pace, given the rapid increase in reais denominated fuel prices in dollar equivalents, added to the recovery of volumes. The question remains whether that recovery will also lead to higher margins. My understanding is that it should, especially if it is based on higher dollar equivalent prices of gasoline.

The recovery of profitability could also provide a recovery in multiples. The chart below shows an average P/E ratio of 23, against a current P/E ratio of 15 (the chart below ends in 2020 for presentation purposes).

Sorry but my answer is still no: I do not speculate on multiple or macroeconomic trends. UGP as a business is not a great investment, and is not valued at a super cheap ratio (15 is already high for me). I understand some readers might prefer more speculative strategies, and UGP may be part of such a strategy.