Description

Idea

Jose Cuervo is a Mexican tequila producer. 

I am very confident that operating margins, which are much lower than spirit peers, will expand to ~31% by 2019 thanks to

1. A gradual insourcing of agave production (main input to tequila)
2. Continued mix improvement as the Company grows its historically lacking premium portfolio.
3. A growing end market with a brand that possess significant pricing power 

Upcycle in Agave obfuscating underlying profitability 

Agave makes up 23% of Cuervo’s COGS today which is a peak and is explained by skyrocketing agave pricing. 

Reference here for pricing, it is a function of weather and the proper or improper estimation of agave demand. With respect to Cuervo specifically, they are way under indexed to other tequila makers who generally have captive agave production. 

https://www.ft.com/content/63ee4480-78f1-11e6-97ae-647294649b28

"Agave prices have climbed steadily from 3 pesos per kilo ($0.20) in early 2015 to 10 pesos ($0.53; the currency is now stronger) today, according to growers. This is thanks to global demand for tequila, especially in the US, home to 80 per cent of Mexico’s tequila exports."

The agave plant takes at least five years to mature and does not bear fruit like a normal plant (it is a cactus and you destroy it to harvest), so the industry is prone to huge cycles naturally. 

Jose Cuervo has already planted the agave needed to bring 90% of its production in house by 2019. In-sourced agave production is about 50% structurally cheaper than out-sourcing in general, so I have modeled this transition until 2019.

Historical lack of premium priced products  

Jose Cuervo has a dominant brand, it is the largest by volume, but has not historically been in the premium tequila market (which has grown in popularity over the past few years). 

This is because prior to 2015, Diageo did all of the distribution into the U.S. for Jose Cuervo and had an incentive to prioritize its own brands in its network over Cuervo’s (though it did receive some amount of distribution fees). Diageo, specifically, owned a partial stake (with Cuervo, now divested from Cuervo) in Don Julio which is a super premium tequila brand. 

Valuation

I have a 17% risk adjusted IRR for the next four years. 

I am using 3.5% terminal growth and an 8% discount rate. I am flexing top-line which is a general function of volume growth and slight pricing power (Cuervo is predominantly a volume kind of brand, I’d expect about 4-6% volume growth with a point or two of pricing to reflect general inflation). 

Model:

Why does opportunity exist?

-Family owned; small float

-listed on the Mexican exchange instead of U.S. despite most sales coming from U.S.

Risks

-Value destructing m&a

-Agave pricing accelerates causing market perception to tank until 2019

-Peso appreciation causes short term margin compression. 

Catalyst

Sales results / Margin profile