Description

 

Description:

Becle SAB de CV (Cuervo) is the holding company of Cuervo, a family-controlled spirits company. Tequila represents

55% of Cuervo’s sales. Cuervo is headquartered and trades in Mexico, but sales are predominately in the US and

Europe. Julio Beckman (known as Don Julio) is Chairman with 85% of the company’s stock with the rest floating on

the Mexican exchange. Julio Domingo Beckman is and Don Julio’s son and Cuervo’s CEO.

 

Thesis:

 

Investors can buy a high-quality, growing spirits company with net cash at Street’s 2019E 12x EBITDA – a discount to

M&A multiples and other publicly-traded spirits companies (using EBITDA for better comparison to peers given FX

and capital structure).

 

The opportunity exists because the company has only disappointed since its IPO (February 2017). Poor

communication and management turnover worsened investor’s perception of the company. Recently the company

has hired a new CFO with public-market experience to help this family-owned company communicate better with

investors.

 

A new investor will benefit from (a) the current recovery in sales after a short-term, self-inflicted inventory problem,

and (b) the margin expansion we expect in 12-18 months as agave costs fall. Cuervo is also a beneficiary of a

depreciating Mexican peso, given that ~70% of its sales are in US$. Today’s current price of P$23 (33% below its IPO

price at the height of “Build the Wall” rhetoric) assumes no growth in US sales, no improvement in margins (a

historical low) and a 16x P/E by 2021. There is a put option on Cuervo being bought by a larger spirits company.

 

What went wrong?

 

 

Part I: Busted Price

Cuervo went public in the Mexican stock exchange with significant US investor participation at P$32. The success

was short lived with their first quarterly announcement. Cuervo’s leading brand, Cuervo Especial Gold, sold 2.2

million cases in 2017, or 10% of the company’s sales. Especial Gold is Cuervo’s best-known brand but has languished

as the market has moved towards premium tequilas (known as 100% agave) and silver (vs. gold, añejo or reposado).

 

Management raised the price of Especial Gold in January 2017. They thought that a price increase (a first in 5+ years)

would raise the brand’s profile. What happened was that distributors pulled forward almost 1 million cases at the

old price. It then took longer for Cuervo to absorb the spike in inventory because a competitor, Sauza, lowered their

price to take advantage of Cuervo’s mistake.

 

After a year of the pig going through the python, 3Q18 sales came in stronger than expected. Cuervo Especial Gold

sales have stabilized with a 1.7% yoy volume growth after having dropped -12% in 2Q18. Its other tequilas and

spirits – which had remained healthy since the IPO—increased volume 13% yoy. Overall sales in 3Q18 were up 11%.

 

Part II: Backtracking on Margin Guidance

 

Cuervo’s stock fell -15% after 3Q18 earnings due to margins. Investors expected a margin expansion for the next 2-3

years, but instead gross margins collapsed almost -5% this quarter vs. the prior year due to agave prices. Cuervo also

reneged on future margin expansion.

 

Demand for premium tequila has squeezed agave supply. The price of agave has soared to P$22-P$25/kilo from

below P$4 in 2016. Cuervo is the low-cost producer of tequila given its vertical integration -- 70% of its agave supply

is from internal sources at cost of P$4-P$5/kilo (vs. $22-$25 at spot). Cuervo had promised investors that its cost

structure would improve even more as it would be 90% vertically integrated by 2019/2020. Moreover, premium

brands like 1800 or Gran Centenario are growing sales double digits and have 300-500bps margin improvement over

the Cuervo Especial brand.

 

I’ve talked to people in the industry and they explained that they’ve been hit by the unexpectedly strong demand for

premium tequila. The industry plants agave 5-6 years ahead since that is the time for the plant to mature, so they

have struggled to adjust to a stair-step increase in demand. Tequila demand historically had been in the 3% yoy

range and a lot of it was what is called Mixto tequila (e.g. Cuervo Especial), which uses only 50% agave sugar (3 kilos

of agave per liter). In 2015 growth accelerated to 7% and shifted to Premium tequila, which is 100% agave sugar (7

kilos of agave per liter). Companies and farmers are harvesting “young” agave (harvested before 5 years), which may

have a yield 50% less than a fully-grown plant given its smaller size and lower sugar content. In other words, real

prices for agave have increased (as adjusted for sugar per plant).

 

The Opportunity:

 

I am pitching this idea because Cuervo has several ways to win, despite facing temporary challenges:

 

1. Revenue growth – Cuervo could grow volumes 5-7% for several years because tequila demand in the US still has

room to grow and is just being discovered globally. Tequila sales are tiny compared to whisky and vodka. In 2017

there were 17mm 9L cases of tequila sold in the US vs. 72mm 9L cases of vodka, 65mm of whisky and 25mm of

rum. Tequila has been discovered because it’s a versatile, craft and lower-calorie drink. If investors gain

conviction on Cuervo’s revenue guidance of mid-single digit growth for the next years, the stock will be

rewarded.

 

2. Margin expansion from premumization - Cuervo has the widest array of tequila brands from low-end to ultra-

premium. Cuervo produces Mixto tequila like Especial at $18-20/bottle and five major brands of 100% agave,

including 1800 at $28/bottle and Reserva de la Familia at above $200/bottle. These 100 agave/premium brands

are growing double digits in the US and have a higher gross margin.

For example, 1800 is a premium tequila that sells 1.1mm 9L cases in the US (1.5mm in total) growing 10% yoy

with a gross margin of 67% vs. 64% for Especial. Gran Centenario is a new release in the US and sells 80,000 9L

cases growing 25% yoy with a gross margin of 73%.

 

 

3. Margin contraction is temporary – Commodity cycles play themselves out. An agave farmer breaks even at

P$5/kilo; therefore, they have been minting money for 3-4 years and are furiously planting while the going is

good. My contacts expect that prices may start coming down in 2020 – and could go below cost by 2024. Cuervo

is also committed to reaching a vertical integration target of 90%, even though that goal has been delayed.

Serious competitors like Herradura (Brown Forman) are at most 50% integrated. Cuervo’s internally sourced

agave costs P$5/kilo results in the best cost structure in the tequila industry.

 

4. Industry is rationalizing – Dovetailing with the above, high agave prices could help Cuervo, including the

probability that some smaller/independent players will leave the market. It’s believed that 20% of the Mexican

market and 15% of US market is supplied by these small players with no vertical integration. Larger companies,

like Sauza, may become more disciplined and follow Cuervo in price.

 

5. M&A thesis will work – Cuervo has $700mm in cash from the IPO, which it can lever 3x for acquisitions. The

company has been slow to deploy the cash, but the acquisition of Pendleton whisky was a good/accretive

acquisition (see below). The new CFO will be more focused on M&A. An acquisition of a non-tequila brand would

further diversify the company’s portfolio, possibly boosting its multiple.

 

6. Improved management – The family has recognized the need for leaders with public-market knowledge. The

new CFO was previously at Volaris, Mexico’s successful low-cost carrier that trades in the US. He should help

improve communication with investors. Cuervo is searching for a new CEO of its US business. That position could

be filled by someone from a publicly-traded spirits company, providing further help towards Cuervo’s transition.

 

7. Tailwind from a Mexican Peso depreciation – The peso will continue to weaken based on Mexico’s new left-

wing government. Most of Cuervo’s fixed costs are in pesos but its revenues are in dollars, expanding margins

approximately 1% for every 5% the peso depreciates.

 

Attractive Valuation:

 

• Comparable Valuation: At a depressed 2019E EV/EBITDA of 12x, Cuervo trades at a discount to the global spirit

peer average of 16x. Even on a 2019E P/E basis (which is harder to compare given FX) it trades at 20x vs. 24x

average for its peers.

 

 

• M&A valuation: Recent M&A transactions in the tequila sector have come in at a meaningful premium to

Cuervo’s valuation. Cuervo today trades at a valuation of US$208/case. Bacardi bought Patrón for $2,500/case

and Diageo bought Casamigos for $5,830/case (only initial investment, not the performance bonus). A

theoretical example shows that just two of Cuervo’s most valuable premium brands could be worth Cuervo’s

market cap at Patrón’s valuation. Cuervo’s 1800 alone would be worth close to US$3.75bn (slightly below

Cuervo’s current market cap of US$4.2bn) if it were sold at a valuation of US$2,500 per case.

 

 

 

• Good Risk/Reward: Assuming Cuervo can grow US volumes 3% yoy, margins recover to 59-60% gross margins

the market places a 14x 2021E EBITDA multiple - a discount to peers to incorporate that it trades in Mexico, is

relatively illiquid ($5-$10mm/day) and is family controlled – the stock could be worth P$36/stock (52% upside),

w/out any M&A.

 

Other Info

 

• Cash flow: Cuervo is a cash generative company (slight negative of -US$25mm in 2015). Working capital is the

drag on cash, especially this year as agave prices weigh on inventory. Capital expenditures are typically 3% of

revenues, but expansion of a distillery in Ireland and a new tequila plant will take it up closer to 5%.

 

• Capital Allocation: Cuervo has never been an acquisitive company. They have been excellent developers of

brands, such as Kraken, a fast-growing rum in a challenging market for that liquor. So far, they have been more

patient with their cash than investors. Management has viewed multiples as too high and have instead made a

small share repurchase and a 50% dividend payout in 2017.

 

• M&A: Pendleton is Cuervo’s only acquisition since the IPO. Pendleton is the fastest-growing premium Canadian

whisky (17% yoy above Fireball). Cuervo paid $205mm or $740/case, which was reasonable vs. an average of

$1,500/case for M&A in the industry and $5,000/case Diageo paid for Casamigos. They bought Pendleton at

aprox. $6mm EBIT in 2017 but with synergies and growth they could get an EBIT of $35mm by 2021 (i.e. pre-

synergy multiple of 18-20x goes down to 7x). Pendleton is a boost to margins and a source of diversification (not

diworsification). With $700mm in cash, Cuervo can do many more deals like this.

 

• Management: Anyone visiting Cuervo’s operations will see excellence, and a reason why Diageo tried to buy

them. Cuervo lobbied to make tequila a liquor of denomination (like Cognac or Champagne can only be

produced in a specific area), benefitting the whole industry. Cuervo introduced tequila to the U.S. They have

made the town of Tequila a growing tourist destination. The family also owns Cholula hot sauce (which they split

from Cuervo for the IPO). They have great DNA to develop and market brands. They have also made strategic

mistakes like missing the opportunity in premium in the US. Their myopic view of how the market was

developing led them to giving Don Julio to Diageo in return for getting Bushmills whiskey. Their absence in

premium also allowed Patron to exist. Management’s communication has been poor. I think they are waking up to the realities of being a publicly-

traded company and management changes could help. They seem to have learned their mistakes and are

making a big push globally.

 

Risks:

• Agave prices: Supply crunch has been worse than farmers expected, and it could last longer than we believe.

 

• Demand: Spirit cycles tend to be relatively long and the discovery of a class of drink (premium tequila rather

than a brand) resets the long-term demand trend, but a few things could dampen demand such as taxes,

recession, legalization of cannabis.

 

• Management: I’ve seen under the hood and know it’s a terrific company – and one a larger spirit company

would love to own – but I recognize management has done nothing but disappoint so far.

 

 

 

 

Catalyst

Catalysts:

1.   Continued performance on revenue growth: If Cuervo can repeat its 3Q18 performance, it may allow investors to once again start looking at Cuervo as a compounder and focus on the longer-term opportunity.

2.   Margins: Management could provide new guidance on the timing of their 90% vertical integration on agave production, which would allow investors to have higher conviction in rising gross margins.

3.  Management changes: New CFO is a potential big step up. We are also awaiting an announcement of a new CEO for Cuervo USA. This person could be from a publicly-traded company, which would help Cuervo become more institutionalized.  

4.  M&A: Cuervo can make a sizable M&A transaction of the quality and accretion of Pendleton, providing growth and diversification.

5.  Take private: Management can easily use the cash from the IPO + US $200mm more to offer minorities (less than 15% given Cuervo has bought back some shares) with a 20% premium from today’s price. Terrible for existing shareholders, but good for new shareholders.

6. Strategic takeover: Pernod doesn’t have a major tequila brand. Constellation’s tequila brand, Casa Noble, is high quality bur relatively small. Both are at a disadvantage to Diageo and Bacardi that expanded their tequila portfolio.