Description

Farmacias Guadalajara was created in the year 1943, around that time there was a big transition in Mexico from" morter medicine" to "patent medicine". Taking advantage of this transition Mr. Francisco Arroyo opened the first pharmacy selling an extensive line of products ranging from medicines to consumer goods.

Growth and diversification of Fragua translated in the creation of several companies connected to Farmacias Guadalajara to complement its services in security, transport, and photo processing. 

The "SuperFarmacia" concept was created in 1989 and it has proven to be of great success, since most of Fragua´s revenues comes from there. It provides the customer the closeness of a convenience store, at the same time the client can find several products ranging from medicines, healthcare, fresh food, groceries and several other consumer goods.

Fragua became a public company in October 1997. At the time of the IPO the company had 73 stores, Fragua finished 2012 with 1,052 stores. Also in 1997 Corporativo Fragua created its "own brand" line consisting of medicines, consumer staples, perfumes and food. The company owners/managers have a reputation for cost-controlls, tight cash flow management and have shed away from debt at all times. Expansion has been controlled. Since it's very beginnings management sought to grow only when they could (with a high degree of certainty), asses if the market was ready for new stores, location had been secured and most importantly, all expansion would be financed from operating cash flows.

It was until the year 2000 when the company started a more aggresive expansion plan. The goal was to open a new store every 10 days, goal which was surpassed. Fragua finished the quarter with 1,122 stores that comprise 504 thousand square meters of sales area. The company has presence in 261 cities and 23 out of 32 states in Mexico. This quarter Fragua started operations in 8 new cities.

The company has it's own distribution system that is trully world-class. All of the merchandise is shipped to all of the stores from its Distribution Center, created in 2009, in its fully owned fleet. A new distribution center which will cost $800 million pesos, will start operations in 2014 to focus in Northeastern Mexico. Fragua has a state of the art information system called SITEC that allows the company to have real time information of store´s operation. The Distribution Center has access to that data, which translate in an effective and cost efficient distribution. 

The growth story..

From 2004 to date, Revenues have increased from $8,336 million pesos to $26,383 million (a 15.5% CAGR), EBITDA has gone from $452 million pesos to 1,513 million (a 17.1% CAGR), and net profit has climbed from 366 million to 909 million in the same period (a 12% CAGR).

During the 2008-2009 financial crisis, margins contracted slightly but essentially EBIT and EBITDA remianed flat vs. the prior years. Further testament to the strength of the company's business model. 

Beginning this year, Fragua has began it's expansion into the greater Mexico City metropolitan are.

Initial checks at SuperFarmacias in this area indicate that customer adoption, sales per square feet, traffic are all way above what the company's initilal expectations were.

Without doubt, competition in these territory's is far greater than elsewhere in Mexico, however so far the company has been successfull in entering this new territory in a successfull way.

As expanison has accelerated in the last two years, and competition has intensified, EBITDA per store has gradually declined from $400,000 pesos in mid 2011 to $300,000 pesos currently. We believe that trend should begin to reverse as Fragua enters the Mexico Metro area where EBITDA per store is close to 3x the company.  

Financials..

Our variant perception..

We believe that as a conecuence of the incursion of Fragua into the Mexico City Metropolitan area, it's continued focus on costs and new added value services (third party payments, money transfers, etc), that are now being rolled-out chain wide, EBITDA margins will gradually revert to the 6% level seen in 2011.

The company is and has historically been extremely conservative in their financial assumptions but even they see the 6.5% EBITDA margin as something achievable in the next couple of years.

Margin expansion, continued store count growth (in the 6% range), lead us to model 2014 earnings at $14.5 pesos per share, implying Fragua trades at 15.6x earnings. Backing out net cash that number drops to 14.9x.

We believe this company is not a bargain at first sight, however we see a large runway for the company to continue growing.

Fragua should at least continue to grow it's bottom line at a 12-15% pace in the next 5 years, which should result in 100% price appreciation in 5 to 6 years baring no multiple expansion. The key here is that given the company's proven and resilient business model, it's ultra-conservative management team and it's very sound financial position and cash policy, we see little risk in this investment.

On a DCF basis, using a WACC of 11.3 percent, 13% earnings growth 3 years out, and a 3.5% terminal growth rate, we derive a $266 peso/share price target. Implying 18-20% upside from here.

The key here, and why we like Fragua so much is that we believe this is truly a compounding machine that has been a superb long-term investment in the past and should continue to be so in the forseeable future.

Relative Valuation vs Mexican peers..

Relative to it's peers, Fragua would appear fairly-valued.

We believe however that the market is not fully attuned to the margin and revenue expansion that the company will see in 2014 and 2015, given in part to the fact that this is a stock which is only covered by two sell-side analysts.

Catalyst