Description

Overview:

Genomma Lab is a Mexican-based company that develops and markets over-the-counter (OTC) and Personal Care (PC) products in Mexico, the US and Latin America.  As of 3q16, the business was split 38%, 49%, and 13% Mexico, LatAm, and the US.  Approximately 44% of the revenue is generated from OTC products and 56% is generated from Personal Care products.  The Mexican business is more skewed toward OTC (53% OTC / 47% PC). LABB is the market leader in the OTC products in Mexico with ~13% market share.

The company promotes its products through TV advertisements. The company has an internal production team that is able to produce TV advertisements within 2-3 days (vs 4-6 wks using an outsourced company). LABB receives sellout data daily from the modern channel (~60% of the business) and uses market data to monitor sell-out through the wholesale channel (~40% of the business).  By having its own internal production team, LABB can be more nimble and change its adverting campaigns to respond to changes in demand or competition.  Anecdotally, we have heard that, at one point, LABB’s commercials represented 40% of television advertising in Mexico. This is probably an exaggeration, but regardless, it’s illustrative of the high brand awareness of LABB’s products. Internationally, LABB is commercializing its products in Hispanic markets.  The three largest international markets are: Argentina, Brazil, and the US. In the US, the company’s largest customers are Walgreens and Walmart.

Historically, LABB would buy old brands and revitalize them with aggressive TV advertising.  The company’s model was to put a lot of inventory in the stores and run TV advertising to drive consumers to the stores to purchase the product. Under the new management, the company has pruned its product portfolio and is transitioning to more of a traditional CGP model by focusing on PoS execution.  The company has recently hired a number of executives from the large CPG companies to spearhead this transition.

Elevator Pitch: 

LABB is a turnaround story. Over the last 12+ months, the company has been going through the painful process of de-stocking excess inventory in the channel in Mexico and restructuring the business.  Trade inventories in Mexico have normalized and the company is starting to look like a normal, boring CPG company (MSD-HSD top line growth).  The de-stocking process masked LABB’s restructuring initiatives. As growth normalizes, LABB should experience significant margin expansion and double digit EBITDA growth.  Longer term, the company is building its own manufacturing capacity which should drive even more meaningful margin expansion. 

Without the benefit of the new manufacturing facility, we believe LABB should be able to generate Ps. 2.12 in EPS in 2019 (vs cons Ps. 1.63/sh).  Applying only a 17x P/E (vs in-line peers with comparable EPS growth), the stock should be worth Ps 36/share which would generate ~74% upside.

With the benefit of the new manufacturing facility, we believe LABB could generate close to Ps 3.00 in EPS in 2019 (generating 30% CAGR).  Applying a 17x P/E, the stock should be worth Ps. 50/sh which would generate 140% upside. 

Why does the opportunity exist?

LABB sold off following the US elections, however there is very little risk to LABB’s business from a Trump administration. 

However, the company has been mired with controversy over the last 12-24 mos for the following reasons:

• Channel Stuffing - LABB shares plummeted ~50% after the company reported abysmal 4q14 results.  Revenue declined 23% y/y (and was 27% below consensus), and EBITDA declined 48% y/y.  The weakness on the topline was driven by a 43% y/y decline in the Mexican business. These are typically stable businesses, so declines of this magnitude surprised the market.
  
  The dramatic decline in the business was the result of aggressive management and dislocation in the Mexican distribution channel.  In 2013, the largest wholesaler in Mexico, Casa Saba, went bankrupt.  In order to maintain double digit topline growth, the former LABB management team started stuffing inventory in the remaining wholesalers (Marzam, Nadro, and Farmacos Nationales) and large retail customers. The growth story unraveled in 4q14 when the company couldn’t place anymore inventory at distributors and retailers in Mexico.  LABB had >200 days on inventory in the channel in their Mexican business.  The Mexican de-stocking process is now largely complete.
  
• Questionable Acquisition - In 2014, LABB acquired Marzam, a distributor. The rationale the company provided for acquiring Marzam was to improve distribution to smaller retailers in Mexico and get better channel insight/data.  At the time, bears were worried that the Marzam acquisition would jeopardize the solvency of the company.
  
  In 2015, the company sold the majority of the Marzam business to a Dutch private equity fund, Moench Cooperatief. From the Panama Papers, we later learned that Nadro (the largest distributor in Mexico) had effectively acquired Marzam through Moench.  Nadro’s involvement was not disclosed to Mexican regulators (COFECE) which created concern that the COFECE could unwind the transaction and put it back to LABB.  There were a number of bidders for the business in first sale process, so we think it would not be a problem for LABB to divest the asset and it represents an insignificant % of the EPS.

Consensus:

The Street projects a +7.5% revenue and 6.0% EPS CAGR ’16-’19.  This implies no margins expansion.  LABB currently trades at 2x EV/Sales and 13x P/E.  LABB’s peers trade at a significant premium.  Mexican consumer product companies trade at 3.0 – 5.0x EV/Sales and >17-19x P/E.  Based on the valuation, the market is embedding a much worse operating scenario than consensus.

Variant Perception:

• There is significant operating leverage in the model.  We believe LABB should be able to grow revenue mid- to high- single digits going forward. EBITDA should grow much faster than revenue due to cost reduction measures already taken.  LABB (i) reduced the Mexican workforce by >40%, (ii) eliminated significant trade discounting & promotions, (iii) reduced TV advertising, and (iv) eliminated under-performing brands and re-focused on core brands. In our opinion, the benefit of these cost reductions and restructuring initiatives was being masked by the de-stocking process.  Now that the Mexican business has normalized, the benefit of the cost reductions should become apparent.  In addition, LABB management has indicated a willingness to further reduce costs in the future. The company currently generates 21% EBITDA margins.  Historically, EBITDA margins were 26% and consumer peers 26-34% EBITDA margins.  With the benefit of cost reductions and leveraging top line growth, LABB should be able to earn 25% EBITDA margin again.
• LABB represents a strategic asset to an acquirer. LatAm/Mexican assets are scarce and command premium valuations. In the past, OTC companies/products have been acquired for >5x sales.  Most notably, Reckitt Benckiser paid Bristol Myers $482M in 2013 (or 5x LTM sales) for the right to market Bristol’s Mexican OTC products for three years and the option to acquire the products at the end of the three year period.  It’s believed that the option to the acquire the products is based on an EV/Sales multiple significantly higher than 5x.  More recently, TEVA acquired Rimsa for 10x TTM sales.
  
  Multinationals have already expressed an interest in LABB’s business. Along with the poor 4q14 results, LABB announced that they had signed an NDA with a “recognized multinational company to analyze a possible co-investment across Latin America… In Nov 2014, [LABB] had a clear indication about the possible structure and valuation for the transaction… The transaction was cancelled by [LABB’s] board on Feb 26, 2015.”  At this time, LABB was trading at Ps 31/sh (the average share price in Nov 2014).
  
  
• Manufacturing Facility – LABB currently outsources its manufacturing. At the recent Analyst Day, the company announced that over the next 24 mos they would build their own manufacturing facility and shift all their manufacturing internally.  By insourcing their manufacturing, the company expects to generate 700-910 bps of margins improvement or $0.65-0.85 in incremental EPS.

Management: 

LABB has made some notable management changes which are positive for the thesis.  In July 2015, LABB announced that Rodrigo Herrera would transition from CEO to Chairman of the Board / President of the Operations Committee and Maximo Juda, former the COO, was promoted to CEO.  Mr. Herrera is the founder of the LABB and is extremely talented in product development and marketing.  As President of the Operations Committee, he will be able to focus more on product development and marketing.  Mr. Herrera is still heavily invested in LABB. He currently owns 30% of the company.  Following the decline in the share price after the 4q14 results, he acquired ~USD$25M which is the most he could acquire without having to do a tender offer. 

The checks that we conducted on Mr. Juda are very positive.  He is an operational and P&L-focused executive.  He is credited with profitably growing the international businesses and generating EBITDA margins higher than the corporate average in those businesses.  He has made the difficult choices necessary to restructure the business and improve profitability during the turnaround.

In Dec 2015, the Oscar Villalobos (CFO) was replaced by Antonio Zamora Galland who was previously the Chief Corporate Officer at Cydsa (2015) and the CFO of Grupo Industrial Lala (2010-2014).  In addition, in mid-2014, a former P&G executive Marco Sparvieri and his entire team joined LABB.  Sparvieri is implementing P&G merchandising and point-of-sales strategies at LABB.  According to mgmt, LABB’s strength in advertising combined with P&G-style merchandising will be extremely powerful.  In addition, the executive management team is investing Ps 15M personally in LABB stock.

Risk/Reward:

• Bull Case: We believe LABB could likely earn Ps 3.00/sh in 2019 with the benefit of the new manufacturing facility.  As the market gets comfortable that the business is not deteriorating further, then we think the multiple will expand in-line with peers (17x).  Therefore, we think there is 140% upside.
  
  
• Base Case:  We think LABB could earn Ps. 2.12/sh in 2019 with margin expansion but without the benefit of the new manufacturing facility.  Again assuming that it trades in-line with peers (17x), we think there is 74% upside.
  
  
• Bear Case: At this valuation, we feel there is a significant margin of safety.  In a worst case scenario (1) no topline growth  and (2) margins never recover, we estimate that LABB could earn Ps 1.38.  Assuming the trades at a trough valuation (11x), then there would be 27% downside.

Catalyst

Earnings reports showing continued sell-out growth, margin improvement, and FCF improvement