Ultrapar: The Peak Is Here (NYSE:UGP)

I’ve written about Ultrapar Participações S.A. (NYSE:UGP) twice in the last 10 months. First, in July, I highlighted why this company was a Buy amidst the change in gasoline prices made by Petróleo Brasileiro S.A. – Petrobras (PBR). As of March 29th, investors who acted on that article captured a total return of 53.5% compared to 18.3% for the S&P 500. Then, I wrote my second piece in December and argued that the best was behind us and smart investors should start to take profits from their positions as it was unlikely that market-beating returns were still on the horizon. The stock still had some room to grow and eventually peaked at $6.33 before retreating to the $5.72 it is now, which amounts to a total return of 10.5% compared to 13.7% for the S&P 500.

Now, I’m downgrading Ultrapar once more, this time to a Sell rating. This does not mean you should short the stock, it means that market-beating returns are, in my opinion, totally off the table now. The Q4 results were the peak and I’ll evidence that in this article. Besides that, the valuation I proposed in my first article has been achieved and there are no obvious catalysts to propel the stock further. Finally, in my opinion, Ultrapar has announced some questionable M&A lately, as it may raise some questions in terms of how aligned it is to its current portfolio.

Q4 at a Glance

It may be telling that Ultrapar stock peaked so close to its Q4 earnings release, which was the best in several years. The share price peaked on February 23rd and the earnings call was on February 28th. The company was able to report significant improvement in EBITDA, Net Income, Cash Flow from Operations, and Leverage, mainly driven by Ipiranga which accounts for more than 90% of its revenue.

As can be seen in the slide above, all metrics seem to be positive and could have supported the stock price to go up. However, after a run of almost 200% since the beginning of 2023, it’s more likely that all of those gains were already priced in the stock and these numbers were no surprise to the market. Mainly because the improvement has occurred in the second half of 2023 which can be partially observed in the Q4 earnings: Q4’23 EBITDA was BRL 1 billion above Q4’22 and total FY’23 was above FY’22 by BRL 1.6 billion.

Another important improvement is the ongoing deleveraging process. Net debt peaked in FY’21 at BRL 11.8 billion and is now down to BRL 6.1 billion with Net Debt / EBITDA at 1.1x versus 3.2x in FY’21. Its Cash and Cash Equivalents are more than enough to cover short-term debt retirement and can easily support additional Capex or M&A.

In my past article, I praised the developments within Ultragaz and Ultracargo, but those represent only 10% of Ultrapar’s revenue. The main development that pushed the stock up during the last 12 months is the improvement in Ipiranga’s margins. As noted in the slide above, volume is flat on a YoY basis, but EBITDA is up +68% if we consider the “Recurring EBITDA” measure. This is driven by Petrobras new price policy, which, in sum, means that they won’t increase or decrease gasoline prices based on international oil prices. A stable gasoline price lowers volatility, makes forecasting much easier, and helps Ultrapar increase margins.

Valuation Check

In the valuation model I provided in my first article I indicated a reasonable price of $5.3 if the outcome of this gasoline price policy was positive for Ultrapar and a $6.6 price target if the outcome was very positive. It seems Ultrapar’s fuel ran out less than 10% below my $6.6 target price. I won’t detail all the assumptions I used, but the significant expectations were:

1. That Gross Margin had hit rock-bottom in 2022 at 3.5% and that it could climb back to its previous 2016 high of 6.8%. In 2023 Ipiranga managed to record 5.6%, which is a much better performance than 2022. Q4 was even better at 7.7% surpassing the past peak of 7.5% in Q4’16. However, the quarter that followed Q4’16 saw a decrease of 1.4p. in Gross Margin. The reason behind it is that Petrobras is legally obliged to sell gasoline at the same price for any gasoline station, be it Ultrapar with almost six thousand gas stations or a mom-and-pop gas station. Whenever margins improve, small owners of gas stations are less incentivized to be under Ultrapar (or any other major brand) umbrella and thus believe it’s better to have no brand at all, purchase gasoline from other intermediaries, and pocket a higher margin. That’s why I believe we have already seen peak Ultrapar performance and financials will likely stabilize in FY’24.
2. The develerage process would continue and be successful. Indeed, it has been, since Ultrapar has now one of its lowest ever Net Debt / EBITDA. This means that all the uncertainty related to whether Ultrapar would be able to pay its debt and stop bleeding with Interest Expense is gone. Also, Interest Rate has gone down from its peak of 13.75% during FY’23 to 10.75%, making Interest Expenses much lower.

Based on the advancements of these two catalysts and the fact that Ultrapar stock price has lost some steam recently, I believe the peak of the cycle is already here (if not already past us). I see less capacity for Ultrapar to surprise markets with improved financials than I did in early FY23.

Questionable M&A

Finally, Ultrapar’s M&A track record isn’t the best one. In 2013 they bought Extrafarma for BRL 1 billion, only to sell it in 2021 for BRL 0.7 billion and after incurring losses of BRL 1.5 billion during those years. Now, management has decided that the best use of the company’s cash was to acquire a strategic share in Hidrovias do Brasil, a company that owns and operates ships to transport agriculture products in rivers and on the shore of Brazil. The company is buying an additional 17% (they already own around 10%) for BRL 0.5 billion, to achieve a total of 27% of ownership in Hidrovias do Brasil. There may be some synergy with Ultracargo, but it’s likely the same synergy they thought a pharmacy chain had with gasoline stations. Although Hidrovias do Brasil has a long-term debt profile, it’s a very leveraged company with 4.2x Net Debt / EBITDA and posted a meager BRL 18 million in Net Income for FY’23. It is currently valued at BRL 3.2 billion in the Brazilian Stock Market.

Excess cash could have been used to buy back stock during FY’23 or maybe pay a special dividend. It could also have been used to continue to develop Ultracargo or any other more correlated business. Instead, it was used to buy 17% of a company that only a year ago was valued at less than half what they paid now. Besides, why would Ultrapar buy 27% of this company if not have more than 50% ownership in the near future? Are they waiting for it to increase in value to buy it entirely?

Final Remarks

In sum, Ultrapar seems to have come full circle. From its unjustified valuation of BRL 10 billion in early FY’23 to more than BRL 30 billion as of today. Investors have almost no margin of safety in this company and all positive financial performance seems to be fully appreciated in its stock price. As always, I can be very wrong if Ultrapar continues to post a Gross Margin above 7.0% throughout FY’24. That could possibly lift the stock higher and generate above-market returns. However, I believe this outcome to be not as likely as it was a year ago. Investors would probably be better off exiting their entire positions and waiting for the next cycle.