Description

Jose Cuervo (CUERVO MM) is a fantastic business with opportunities for growth and margin expansion. It’s trading at a large discount to peers on forward numbers and I estimate value of approximately 50-65 MXN over the next 1-2 years, up 50%+ from current levels.

Before going any further, let me warn you: the stock trades in Mexico, coverage is poor, liquidity is limited and the historicals are a bit messy (and require some translation). If that didn’t scare you off, read on. The good news is that I expect much of this to change.

Cuervo was posted in February as a long, focusing on the appeal of increased vertical integration and that report is worth reading. While insourcing is an important part of the story, I’m re-presenting the idea as I think it’s a good one with more to discuss.

The thesis is as follows:

1. Cuervo is a good business with leading share, strong barriers to entry and attractive margins
2. There’s an opportunity for HSD top-line growth given Cuervo’s category exposure (Tequila and Irish Whiskey), improved distribution and ongoing premiumization
3. There’s an opportunity for 400bps+ of margin expansion from vertical integration, scale and mix shift
4. Taking this into account, Cuervo trades ~12x CY19 EBITDA vs peers at 20x
5. Part of the reason for this discount is that Cuervo tripped up after its recent IPO due to a price increase that pulled forward sales and led to disappointing initial results
6. Additional reasons for the valuation discrepancy (liquidity, disclosure, lack of a US listing) should change with time and I wouldn’t be surprised if Cuervo is eventually acquired  

Jose Cuervo, which formally goes by the name Belle SAB de CV, is a global spirits business and the market leader in tequila. Clearly, its namesake brand is iconic and, as I’ll discuss, Cuervo itself is a scarce and valuable asset. It’s currently a $7b market cap with sales this past year of $1.4b and 26% EBITDA margins (all in USD).

While a 250 year old business, Cuervo only recently came public in February of 2017. It was all primary shares (no insider selling). As a result, Cuervo currently has net cash of just over $500m in USD. It’s the only spirits business in the world with a net cash balance.

The Beckmann family is still heavily involved and control over 80% of the shares. The elder Beckmann, Juan Beckmann Vidal (78) is Chairman and has been involved in the business since 1964. His son, Juan Domingo Beckmann (50) is CEO, a title he’s held for 15 years. As a result of the concentrated stake, trading value is relatively thin at ~$3m/day in USD. Cuervo, however, has some important differences vs other family controlled spirits companies and I think the ownership and liquidity picture is likely to change in the coming years.

A common misperception is that Cuervo is just Jose Cuervo. This is far from the truth. In reality, Cuervo has several major brands (Cuervo, 1800 Tequila, Bushmills Irish Whiskey and Kraken Spiced Rum) and a number of fast growing craft brands across Whiskey, Rum, Gin, Vodka and Mezcal. In total, tequila represents 59% of revs, of which Cuervo accounts for 37%, 1800 is ~13% and the remaining 9% are other tequila brands like Dobel and Gran Centenario. Non-tequila spirits are 20% of revs, with Kraken and Bushmills each representing ~5% and the other 10% attributable to craft brands such as Tin Cup, Stranahan’s, Boodles and the recently acquired Pendleton Whiskey. The remaining 21% of sales are comprised of non-alcoholic mixers (where Cuervo has dominant share) and ready-to-drink cocktails.

Another misperception is that Cuervo is just a Mexican business. In reality, Cuervo is the most US-centric of any spirits company with 75% of segment earnings coming from the US and 90% derived from outside of Mexico. As a corollary to that, Cuervo stands to be a meaningful beneficiary from US tax reform, which doesn’t appear to be appreciated by investors or yet reflected in Street numbers.

One of the most interesting things about Cuervo is that, despite its long history, it’s still very much a transformation story in the middle innings of a business improvement. Its main subsidiary, NJ-based Proximo Spirits, was only setup 10 years ago. For the longest time, Cuervo used Diageo, the largest spirits company in the world, for all of its distribution and marketing. Note that Cuervo only regained the full control of its Jose Cuervo brand in 2013 after the family rejected Diageo’s advances to buy the entire company (discussions were rumored to be at 20x EBITDA). Under Diageo’s watch there was reportedly a decent bit of mismanagement. Case in point: despite controlling over 70% of its “premium” niche, Jose Cuervo (prior to this past year) hadn’t taken a price increase in 10 years and was selling at a discount to its closest competitor. Management enacted a 4% price increase in early 2017.

Pricing though isn’t the only low hanging fruit. With a broader portfolio, Cuervo is now starting the process of improving its distribution, having consolidated its US distributors only two quarters ago, significantly improving its “share of voice.” Five years ago, Cuervo controlled a mere 25% of its routes-to-market. Today, that’s 90%. The company’s path to full vertical integration is just hitting stride and represents a sizable margin opportunity. In addition, international markets remain largely untapped and the company is at the beginning stages of M&A that will result in a more diversified, more global spirits company. Suffice to say, there’s a lot of opportunity for change.

The other fascinating part about Cuervo is that there simply aren’t many of these businesses around. Of course, the ones that are around, independent and publicly traded fetch rich multiples. In terms of tier 1 spirits companies, you have Diageo and Pernod Ricard. I’d argue that these are less exciting as they’re already well optimized. In addition, craft brands and M&A don’t really move the needle, and they’re unlikely to be acquired. The public tier 2 companies are Brown-Forman, Campari, Remy and now Cuervo. That’s it. Of those, Cuervo is most similar to Brown-Forman. If there’s a round of future consolidation in the industry (as some have speculated), these tier 2 players would be coveted assets and that’s partially reflected in their current valuations.

Tier 2 Spirits Companies

EV/EBITDA on CY18 Street

Source: Capital IQ and company filings

The final thing I would note is that M&A is heating up for tequila brands. Diageo purchased Casamigos last summer and earlier this year Bacardi (which is private) announced it was acquiring the remaining stake in Patron. These deals have been done at eye-popping valuations. Casamigos was valued at over $5,000/case ($1b TEV for 120-170k cases) and Patron at ~$2,000/case ($5b for 2.5m cases). To put this into perspective, Cuervo sold 20.5m cases this past year and has a current EV of $6.4b or ~$300/case. Now, Jose Cuervo isn’t Patron (it isn’t growing as fast and retails at a lower price). However, Jose Cuervo is only â…“ of volume. The other â…” of volume, including 3.1m cases of other tequila, is much more premium in nature, much more similar to Casamigos and Patron. Keep that in mind.

From a strategic point of view, Tequila is an exceptionally attractive area because it’s one of the fastest growing categories in spirits and has a very long runway for further penetration. Mind you, tequila consumption is almost nil outside the US and Mexico. However, that’s starting to change and, interestingly enough, in acquiring Patron, Bacardi led off by stating that “adding Patron to the Bacardi portfolio creates a tremendous opportunity for the brand outside of the United States.” This would be very good for Cuervo too.

Cuervo commands 30% of global tequila volume, making it the clear market leader. In fact, Cuervo owns 3 of the top 5 tequila brands and is 2x the size of the nearest competitor. In the “premium” category (defined as under $20 a bottle), Jose Cuervo absolutely dominates with close to 75% share. This is the largest market segment and there’s limited competition as the two largest players (Jose Cuervo and Sauza) control 90% of the market, enjoying significant barriers to entry from scale and supply.

Further strengthening its competitive advantage, Cuervo owns a good slug of the agave fields in Mexico, which is very important given volatile and rapidly rising third party agave prices. Unlike some other spirits categories, it’s challenging to enter the tequila business because the liquid needs to be sourced from particular regions within Mexico and is often times aged.

The knock on Cuervo is that it’s under-exposed to the fastest growing “super premium” category of tequila. Cuervo has super premium brands (Gran Centenario, Dobel and Reserva De La Familia) but these are a minority of revenue. As such, bears argue that Cuervo is losing share. This is true if you look at the tequila market in totality. However, the rapid growth of super premium is serving to expand the pie; it’s not cannibalizing Jose Cuervo. The premium market is still growing.

The other knock on Cuervo is that the numbers have been messy since coming public. A big contributor to this was the price increase management took in January 2017. Again, this was the first price increase on Jose Cuervo in over 10 years. As a result, this announcement created a very strong (and unexpected) pre-buy dynamic in Q4’16 with US volumes surging 45% and overall revenue jumping 52% in the quarter. This created a hangover effect in the 1H’17 that led Cuervo to miss estimates for its first two quarters as a public company. That now seems to be behind them.   

In terms of growth, Cuervo has some exciting opportunities to continue to expand sales. Tequila and Irish Whiskey are the two fastest growing categories in spirits and Cuervo has meaningful exposure to both, which are growing HSD or better. In addition, Cuervo benefits from an ongoing mix shift to more premium products, such as 1800, Kraken and Bushmills. These are all higher priced, higher margin products that are outpacing the growth of Jose Cuervo. 1800, for example, has a GM ~1,000bps better than Jose Cuervo. In addition, a number of Cuervo’s more craft-oriented brands are just starting to achieve scale.

If you exclude the impact of pre-buy in Q4’16, Cuervo’s volume grew ~6.5% in FY17. I would expect a similar MSD-or-better rate going forward and the positive mix shift I noted above should result in revenue growth in excess of unit growth. In other words, Cuervo should see a continued increase in price per case. Here’s a look at price/case in Cuervo’s main markets over the past few years and my expectation going forward:

CUERVO Price/Case for US and RoW in $USD terms

Source: Company filings and my estimates

Potentially more exciting is that Cuervo has an opportunity for significant margin expansion over a multi-year period. Consider, for example, that Cuervo’s GMs of 62% this past year compares to 68% for a company like Brown-Forman. These two share more similarities than differences and, with time, I think Cuervo can close that gap.

There are several factors driving this margin expansion, the most important of which is vertical integration. Cuervo was 60% vertically integrated on agave (23% of COGS) at the end of 2016 and has a clear path to reach 90%+ by next year. This represents 300-500bps of GM as Cuervo’s internal agave cost of MXN 3-4/kilo is significantly below volatile third party prices that are currently in the MXN 20+ range. Obviously, this move also further bolsters the company’s competitive position.

Pricing is another lever that was untapped historically. As noted, management took a historic price increase on Jose Cuervo this past year and, given its dominant share, has voiced ambition to take continued pricing every 2 years. Paired with mix shift to more premium brands, this is expected to add 100-200bps of margin. There should be a further leg to the margin story from economies of scale as Cuervo is able to leverage its AMP spend (currently 23% of sales), which is well above peers at 15-20%. This could add an additional 100-200bps.

When you add this all up (vertical integration of 300-500bps, price and mix of 100-200bps, and economies of scale of 100-200bps), it becomes an impressive margin opportunity and lends credence to the idea that Cuervo should not only be able to close the margin gap vs peers (26% EBITDA vs peers at 30%+) but also potentially exceed these levels.

My expectation is that Cuervo will see another two years of HSD sales growth and EBITDA margins that expand from 26% today to 31-32%. This results in FY19 EBITDA of USD $520m or 12x the current EV. In peso terms, that would be EPS of MXN 1.74 at the current 31% tax rate and 1.90 at a 25% rate (or 19x P/E), which I think is more likely. Street is currently projecting 1.56 for FY19. None of this assumes M&A or further cash build.

As noted earlier, tier 2 peers (BF/B, RCO FP, CPR IM) currently trade at 22x NTM EBITDA and 20x CY19. For Cuervo, I apply 16-20x to my CY19 estimate, which gets me to value of MXN 48-59, up 30-60% from current levels. That would imply a P/E of 25-32x on my estimate of 1.90 noted above. This is still below tier 2 peers, which trade at 33x NTM earnings. On CY20, I think value is closer to MXN 52-65 (up 45-75%), again using 16-20x EBITDA. From there, I think CUERVO will likely compound at a HSD rate driven by organic growth, further margin expansion and capital deployment.

So why does the opportunity exist? As noted earlier, Cuervo is a bit messy - it trades in Mexico, liquidity is limited and disclosure initially wasn’t great. Pair that with the fact Cuervo had two weak quarters out of the gate, resulting in a number of sell-siders who were either uninterested, cautious or negative. As alluded to earlier, scanner data shows Cuervo losing share so that was yet another reason to stay away. More recently, Q3 and Q4 were both strong so the narrative is starting to change but the company doesn’t give guidance so I’d argue that Street estimates remain off the mark. Finally, since most of Cuervo’s expected margin expansion is slated to occur in 2019, the stock doesn’t look that cheap on current year numbers. Consensus has it trading at 16x FY18 EBITDA.  

The good news is that a lot of this should change. Cuervo is working to improve disclosure and investor relations and will host its first investor day in New York this May. A number of new analysts have recently added coverage and Cuervo was added to the main Mexican index last year. Maybe more importantly, I think the family could eventually liquidate some of it shares and dramatically improve liquidity. Juan Domingo has two sisters who will also inherit shares from their father. They have zero involvement in the business and my understanding is that they might be future sellers. I suspect that this was part of the rationale for coming public. On that note, Cuervo is relatively unique in that outside of Juan Domingo and his father, no one else in the family is involved in the business (this is very different from the likes of Remy, Brown-Forman and Bacardi). This makes a potential future sale much easier and I trust that Cuervo would attract several eager bidders. Absent a sale, I think Cuervo will eventually pursue a dual US listing and consider moving its HQ to the US. I suspect that the next CEO will be from outside the family. All of these actions would likely serve to close the valuation gap.

In the meantime, the risk is that FY18 may be lackluster from a margin perspective as agave prices continue to rise. At least for the next 12 months, Cuervo still buys 30% of its agave on the open market. In addition, Cuervo is essentially long the dollar as the majority of its COGS are denominated in pesos. Every 5% appreciation in the dollar relative to the peso drives ~100bps in EBITDA margin. This has been a tailwind in the past but YTD the dollar has depreciated moderately, down ~2%. These near-term headwinds appear to be reflected in Street numbers but the business has been lumpy over the past few quarters and that may continue this year.      

All that being said, I think there’s a lot to like here. Cuervo is a fantastic business with room for growth and margin expansion. It’s cheap because it disappointed out of the gate and is off-the-radar of most investors. These factors should abate with time and I think it’s possible to envision over 50%+ upside over the next 1-2 years with reasonable assumptions.

Disclaimer

This report (the “Report”) with respect to Belle SAB de CV (the “Issuer”) has been prepared by the author (the “Author”) for informational purposes only. The Report contains certain forward-looking statements and opinions which are based on the Author’s analysis of publicly available information believed to be accurate and reliable. While the Author believes that such forward-looking statements and opinions are reasonable, they are subject to unknown risks, uncertainties and other factors that could cause actual results to differ materially from those projected. The Author has no obligation to inform readers of changes in such forward-looking statements and opinions and no warranty is made with respect to the accuracy or completeness of any of the information set forth herein.

As of the date the Report is published, the Author and/or certain entities (the “Entities”) affiliated with the Author hold a long position in the securities of the Issuer and therefore have a financial interest based on changes in the price of the Issuer’s securities. The Entities may increase, decrease or otherwise change their position in the securities of the Issuer based on changes in market conditions or other analysis. Neither the Author nor the Entities undertake any responsibility to inform readers of changes in such position.

Nothing in this Report constitutes investment advice.  Readers should conduct their own due diligence and research and make their own investment decisions.

Catalyst

• Continued growth
• Significant margin expansion in CY19
• Additional coverage, improved liquidity and better investor communication