40 minute read

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Preface

I originally wrote this analysis on December 8, 2024, which led me to invest in the company at a price of $32.8 pesos per share. Since then, the share price has increased significantly, validating my thesis. As of November 8, 2025, the stock trades at $55.8 pesos per share, representing a 70% gain.

I am publishing this article now to document my investment process for future reference.

Why is it worth analyzing Médica del Sur?

Medica del Sur is a single hospital operator in Mexico city that offers general and highly specialized clinical services. In the last twelve months the company generated $420 million net operating profit after tax.

Aside from its hospital operations, the company owns a 5 hectares plot of land next to its hospital complex. This real estate property was purchased in 2009 for $695 million and remains practically unused. Inflation adjusted, this property should be conservatively worth $1,110 million.

I believe the market is ignoring the value of this property. The company currently sells at $3,144 million, in equity terms, and is almost debt neutral, with $26 million in net debt. At this price, the company sells at 7.5 times normalized net operating profit after taxes, akin to earnings, given the company’s debt position.

The current valuation provides significant margin safety, factoring in the value of the company’s real estate property, we would be paying a multiple of 4.8 times earnings for the hospital business. This is very attractive, considering that a business with the growth prospects and competitive position of Medica del Sur should at least be worth 10 times earnings.

Market Valuation

Share Price: MX $32.84

Shares Outstanding: 95,739,768

Equity Market Cap: MX $3,144 million

Cash: MX $973.5 million

Total Debt: MX $999.5 million

EV: MX $3,170 million

TTM Normalized NOPAT: $420 million

TTM EV/NOPAT: 7.5

Business Overview

Business Understanding

The company’s hospital complex has 189 beds and 20 surgical rooms and is located in the southern part of Mexico City in the Tlalpan district (within walking distance of Estadio Azteca).

General hospital services include basic surgeries, emergency care, maternity care, and routine inpatient stays. These services typically have higher patient volumes but tend to be more commoditized and less profitable than highly specialized clinical services because more hospitals can offer them.

Operating capacity of general hospital services is determined by the number of beds and surgical rooms available in the hospital. Think of this as the limiting factor driving hospital sales. As such, an important indicator for hospitals is the occupancy rate. The higher the number the better because fixed costs can be spread out more efficiently. The occupancy rate in 2023 was 68%, slightly higher than the average since 2014 of 66%.

As for highly specialized clinical services, this mainly include oncology, radiotherapy, radio surgery, gastroenterology, urology, imaging, and PET-CT.

Highly specialized clinical services are more profitable than general hospital services because few hospitals offer them, giving pricing and negotiating power to the few that do. A limited number of hospitals offer these services because they require significant capital investments in specialized equipment and facilities, creating natural barriers to entry. This scarcity gives these hospitals negotiating and pricing power with insurers. Hospitals can negotiate better reimbursement rates and charge more for these services.

In 2023, revenue from general hospital services and highly specialized clinical services represented 50.4% and 45% respectively.

The other 5% that makes up the company’s top line is rental income, and other minor activities like hotel operation and farmacy. The company’s hospital complex has 556 medical offices, of which 159 are leased. The rest were sold when the hospital was built. The complex also boasts 5 restaurants inside and 2 bank branches. In total, rental income in 2023 was $50.2 million.

Determinants

The main factors that drive hospital revenue for general and highly specialized services.

• Doctors network

• Relations with insurance companies

• Available capacity, and utilization

As mentioned before, available capacity is tied to the number of beds and surgical rooms that a hospital has. Medica del Sur is a large hospital relative to competitors, being one of the 5 largest hospitals in Mexico.

A hospital’s physician network is very important for patient volume. Doctors have private practices and refer patients to the hospital they are associated with. In this sense, doctors are an important distribution channel for the hospital.

Factors that drive the doctor’s hospital choice are: reputation, the quality of the doctors there, and available medical equipment. Medica del Sur has an association with more than 2,000 members. I expect that the company will maintain and continue to grow its physician network thanks to its reputation and highly specialized medical equipment.

Similarly, a hospital’s relationship with insurance providers is very important because they also refer patients. Being part of an insurer’s covered options results in more patient volume.

Barriers to Entry

The hospital industry has two main barriers to entry, which explains why we typically see existing hospitals expand capacity rather than new competitors entering the market.

In Mexico City, Médica del Sur competes with several large hospitals operated by just four hospital groups:

High upfront capital investment

Building a high-quality hospital requires investing large amounts of capital before receiving a single dollar.

Developers must:

• Acquire suitable land (scarce and expensive in Mexico City),

• Construct the hospital, and

• Purchase specialized medical equipment.

Total investment typically ranges from $1,000–$2,000 million pesos, before a single patient is treated, making the economics prohibitive for new entrants.

Physician network development

Hospitals rely on independent physicians who bring their patient base with them. New hospitals must convince these doctors to switch from their current affiliations—an uphill battle given that established hospitals already provide infrastructure, prestige, and referral volume. Physicians are scarce, so attracting them away from an existing ecosystem is difficult.

Payer Mix

The company mostly has two types of customers: privately insured and out of pocket patients. Privately insured patients represent 2/3 of sales, and out of pocket patients represent 1/3.

Billing & Payment Collection

To fully understand the financials of the company, it is important to consider how they bill and collect payments.

Large hospitals in the private sector do not employ medical specialists and only in-house physicians for emergency care and diagnostic services. Most physicians are self-employed and are allowed to practice in the hospital by being part of the hospital’s network.

Doctors receive payment for their professional services through what’s called “professional fees.”. Accounting wise, these payments are considered direct costs and show up in cost of sales of Médica del Sur. The flow of operations works like this:

• Hospital bills insurance for both professional and facility fees

• Hospital collects total payment

• Hospital pays physicians their portion

• Shows up as higher revenue and higher costs (pass-through) on hospital financials

Shareholders

• Neuco SAPI de CV is the majority holder, owning 57% of outstanding shares.

• 31.4% are owned by public investors

In 2017 ProActive Capita, a private equity fund led by Jose Antonio Fernandez Carbajal, chairman of FEMSA, announced a 40% purchase of Neuco, thereby controlling 20% of Medica Sur shares.

Miseal Uribe Esquivel and wife are the other majority owners of Neuco. Misael is currently the chairman of the board.

Overall there is limited information available of other owners of Neuco beyond the ones mentioned above.

Health Industry in Mexico

Industry Overview

The Mexican health system consists of three main components operating in parallel:

• Employment based social insurance (IMSS)

• Public assistance services for the uninsured

• Private sector which includes hospitals, insurers, and pharmaceutical and medical device manufacturers and distributors

Choice between public and private medical providers is mostly associated with the patient’s economic class. People with more money generally prefer private providers because public health providers are seen as untrustworthy.

• 83% of Mexican households situated in socioeconomic strata E (extremely poor) to C (below the poverty line) opt for services at low cost in consulting rooms adjacent to the pharmacies.

• The more advantaged households (in socioeconomic strata C+ to A, making up 17% of households) opt for private providers and are served by 15,500 independent specialist physicians mostly through self-referral. Specialists are increasingly located in consultation clinics adjacent to the country’s 94 largest private hospitals, which serve as their primary source of referrals for high-technology analyses and admissions.

• 27% of the population in strata C+ to A are privately insured, mostly through policies reimbursing hospital expenses.

Health Spending

Mexico has consistently had the lowest level of health spending as a proportion of GDP in the group of countries with similar or higher levels of development in the Americas, such as Argentina, Brazil, Canada, Chile, Costa Rica and the USA.

In 2023 health spending as a percentage of GDP was 5.3%, vs an average of 8.8% for OECD countries.

Insurance Market

The insurance market is highly concentrated. 27 private insurance companies offer health insurance in Mexico, but 57% of policies is concentrated in three companies. GNP as the leader with 24.5% market share, followed by AXA with 17.5%, and Metlife with 16.5% market share respectively.

In 208, only 10% of the population had private medical insurance, up from 7.8% in 2015. This figure has constantly increased since 2000 as more people have entered working age.

Demographics

Mexico’s demographic profile creates unique and attractive market dynamics for private healthcare:

Population Size & Composition

1. Population Size: 132 million people

2. Gender distribution: 52% women, 48% men

3. Median age: 29.6 years.

4. Youth concentration: 57% of the population is under 34 years old.

5. Working-age pipeline: A large segment of the population will transition into working age.

Aging Shift

• Since the 1970s life expectancy has increased and fertility has decreased, contributing to a shift in the population pyramid to a more mature distribution.

• By 2030, 30.5 million Mexicans will be age 60+, representing 22.2% of the total population. This means Mexico is beginning a demographic transition similar to developed economies, though still at an earlier stage.

Insurance Penetration Link

• In Mexico, private health insurance is tied to formal employment.

• As more individuals enter the workforce (and formal economy), insurance penetration rises.

• When individuals have insurance, utilization of private hospital services increases materially, driving higher patient volume for hospital operators.

Healthcare Spending and Age

Healthcare spending tends to increases exponentially with age. Expenditures rise sharply after age 55, driven by hospital inpatient specialty services, long term care, and prescription drugs.

Implications for Médica del Sur

The combination of a young working-age pipeline and a rapidly growing elderly population creates a rare double tailwind that will increase patient volume and demand for speciality services.

• More people entering working age → more private insurance coverage → more hospital visits.

• More elderly patients → higher medical consumption → greater demand for specialty services.

For a large specialty-oriented hospital like Médica del Sur, this translates into:

• Higher patient volume, driven by increased insurance adoption.

• Higher specialty services, as aging population requires more complex procedures

Being one of the largest hospitals in Mexico with a focused on specialty services, Médica del Sur is well positioned to benefit from this expected demand.

Analysis of Operations

Background Information

The company has undergone several significant events over the past decade that help explain its current strategic position, and management’s alignment with shareholders.

From 2014 to 2021, the company directed most of its capital allocation to the laboratory services segment (e.g., blood testing). In 2016, it acquired Laboratorios Médico Polanco for $1,492 million. Management successfully capitalized on the surge in demand for COVID testing, and in 2021 sold the laboratory business to Synlab Group for a base price of $2,250 million, plus an additional variable royalty component. The company received royalty payments of $100 million, $500 million, and $77 million in 2021, 2022, and 2023, respectively, and the final royalty payment of $39 million in 2024.

Proceeds from the sale were returned to shareholders. In 2022, the company paid a special dividend of $26.83 per share, totaling $3,019 million, and repurchased $206 million of stock, reducing fully diluted shares outstanding by 4.5%.

In 2023, the company sold a non-core real estate property for USD $12.5 million. This property previously operated as Hospital Clinic but was closed in 2017 due to low occupancy. With these proceeds, the company paid another special dividend of $6.53 per share and repurchased $429 million worth of stock, reducing shares outstanding by 10%.

Since 2019, the company has repurchased 22% of its outstanding shares. Fully diluted shares outstanding currently total 95,739,768, down from 123,281,750. The company reports 107,938,972 shares outstanding, of which 12,199,204 are held as treasury stock.

Normalized Operations

The following graphs display the company’s normalized operations, excluding extraordinary expenses, net gains from asset sales, and non-recurring income from royalties from Synlab.

Revenue from the clinical and diagnostic services division grew from $437 million in 2014 to $2,676 million in 2020. This growth was primarily driven by:

1. The opening of new lab branches,

2. The acquisition of Laboratorios Médico Polanco in 2016, and

3. Exceptional demand for COVID-19 testing.

After the sale of the laboratory business in 2021, revenue from clinical and diagnostic services declined 42%. Since then, revenue has stabilized, supported by highly specialized medical services.

General hospital clinical services performance has remained relatively stable over time. During the pandemic, demand shifted toward higher-ticket, complex procedures, which reduced the number of hospitalized patients and surgeries but increased revenue. More recently, the company has strengthened its relationships with insurance providers, resulting in higher patient volumes.

Overall, the company’s operations have now normalized.

I think going forward margins should look like the average of 2023 and 2024, which are very similar to pre-pandemic margins when diagnostic services from lab operations represented a smaller portion of revenue.

The company’s strategy to focus on its highly specialized medical services and core hospital operations should also stabilize margins going forward. The following graph illustrates the company’s gross and operating margins by year from 2014 to 2023.

Profitability

Return on invested capital has a positive correlation to occupancy rates. A higher figure indicates that the hospital can better spread out its fixed costs and have lower operating expenses as a percentage of revenue.

Between 2020 and 2022 profitability benefited from COVID, mainly from higher sales from lab tests which improved operating income.

Compared to pre-pandemic levels, more recent figures show higher profitability mainly from higher patient volume and higher occupancy rates, which has contributed to higher revenue.

Valuation

Hospital Business

Considering the hospital’s business growth prospects from an aging population and rising levels of insurance penetration, plus the barriers to entry that protect the company’s business, a multiple of 10 to 12 times earnings is reasonable. Taking the company’s $420 million net operating profit after taxes, which I think is a good proxy for earnings because the company is debt neutral, the business is worth between $4,200 million and $5,040 million.

Real Estate Properties

As previously mentioned, the company owns valuable unused real estate. In 2009 they acquired a 50,000 square meter plot of land adjacent to the hospital complex. This property is within walking distance of Estadio Azteca. The company refers to this property as “Terreno Tlalpan”.

In 2014 the book value of “Terreno Tlalpan” was MXN $695 million. Adjusted for inflation this land is now worth around MXN $1,100 million. Moreover, in 2021 the company received an appraisal for this property of MXN $3,061 million. I think a midpoint between these values is a reasonable estimate for what the property is worth, the mid-point being $2,080 million.

Apart from “Terreno Tlalpan”, the company also owns a real estate property that they call “CEDISEM”. Currently they use this property as office and teaching space but the company is actively looking to sell it. In 2019 they received a buy offer of USD$5 million, but the deal fell through when Covid-19 hit. I expect this property to be worth around MXN $100 million.

In total, I think a reasonable value for these real estate properties that are not needed to carry out the current business is between the range of MXN $1,200 million and MXN $2,180 million.

Valuation

The following sensitivity table shows the possible ranges of value for the company, considering different earnings multiples and overall real estate values.

From this analysis, we find that the company is worth between $4,560M and $7,220M, in enterprise terms.

At the base case of 10 times earnings, the value of the company is around $6,000 million, considering a midpoint in the valuation of real estate.

It is important to note that my most optimistic case scenario is not out of reach, given the reasonable multiple compared to expected growth, and that the value of Terreno Tlalpan is ⅔ of what the company says its worth.

Conclusion

Compared to the current enterprise value of $3,170 million for the company. Our most conservative scenario provides an upside of 44%, and margin of safety of 30%. Our best case scenario provides an upside of 127% and a margin of safety of 56%.

The company’s real estate assets provide really good downside protection against unexpected circumstances. If we deduct $1,200 million worth of real estate from the enterprise value (taking the lower end of our RE valuation), the earnings multiple drops to 4.7.

Considering the upside potential of 127% and the downside protection from real estate assets, I think an investment in the company is a really good opportunity.

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Introduction

Even after analyzing the cement industry, one question kept coming at me: if existing companies enjoy such high profitability, what’s stopping others from entering the market?

At first glance, the obvious answer seems to be the massive capital required to build a plant. But that alone doesn’t hold up—many firms can finance a $300 million project. I kept circling back to the question. For a while, I settled on economies of scale and the likely reaction from incumbents: slashing prices to drive new entrants into losses.

But that still didn’t feel like the whole story. If it were just about scale and retaliation, we’d expect more companies to enter anyway, gradually eroding margins until returns fell closer to the cost of capital.

Cement is an undifferentiated product. Buyers don’t care who they purchase from, so newcomers should, in theory, have equal access to customers. With no customer captivity, efficient players should eventually share the market, each reaching comparable scale and cost structures. Yet, in practice, the cement industry remains highly concentrated, with stable market shares and persistent profitability across most regions.

In this article, I explore why—despite offering a commoditized product with minimal brand loyalty or switching costs—the cement industry continues to have oligopolistic behavior and superior returns.

The Capital Intensity Barrier

Although by itself it is not sufficient to keep competitors away, I believe that the massive investment required to open a plant still acts as a barrier because for a company to enter they must commit around $300M from the start. Failure to successfully compete means a catastrophic loss, making potential entrants think twice before trying to compete.

The Local Marketshare Barrier

Cement’s low value-to-weight ratio creates natural local markets rather than a single competitive landscape.

Today, most markets are already occupied, have 1-3 national competitors with slight over-capacity, and are slow growing.

These characteristics present a very difficult “all-or-nothing” scenario for new entrants:

• To have a competitive cost structure they must operate their plant at high capacity utilization.

  • A new entrant could choose to open a smaller plant, but they would be disadvantaged in terms of cost structure.

• To operate at a high capacity means flooding an existing market with more product, which will drive prices and profits down

• To sell this large amounts of volume means capturing a large share of the market from competitors right from the start

In the face of a new entrant, this geographic reality sets the stage for the strategic interactions that protect existing competitors.

Organized Mutual Destruction Deterrence

Existing competitors can collude to drive prices down, and with a national presence and more resources, endure losses longer and force the newcomer out.

This creates a powerful barrier because potential entrants can predict the mutually destructive outcome.

Incumbents can reinforce this natural deterrent through strategic capacity management:

• Adding capacity before demand fully materializes to discourage new entrants

• Maintaining extra capacity that can be activated if new entrants appear

• Adding capacity in small increments that match market growth, leaving no market gap

• Upgrading existing facilities rather than building new plants

These capacity dynamics force potential entrants to face a clear economic choice:

• Enter a market with existing capacity (triggering mutually destructive competition), and with less resources than competitors

• Choose alternative markets or not to enter at all

The Predator-Prey Dynamic

Beyond the mutual destruction deterrence, the cement industry exhibits a predator-prey dynamic that further discourages new entry.

• Incumbents risk only marginal profitability in defensive actions

• Entrants risk their entire investment

• Incumbents have national presence and greater resources to endure low profitability periods

• Entrants only have this plant

This creates a situation where incumbents have both greater incentive and greater ability to engage in defensive competition.

The Time Sequence Trap

Finally, the timeline of cement industry entry creates additional disadvantages:

• Entrants announce their intentions 3-5 years in advance due to regulatory processes

• Incumbents can prepare competitive responses during this preparation period, such as expanding capacity to temporarily drive prices down

• By the time an entrant begins operations, incumbents have fully developed defense strategies

• Entrants face immediate pressure when they are most financially

  vulnerable

Conclusion

My exploration leaves me with this final conclusion: existing cement companies maintain their positions and profitability thanks to economies of scale in local markets with slow growth.

Because demand is no longer expanding significantly, a new entrant must capture a large share of the existing market right from the start to reach a competitive cost structure.

This is difficult, as most markets are already served by strong players. Flooding a market with excess capacity would only worsen the situation—likely leading to a price war where the incumbent, often with a national or international presence, can endure losses longer and force the newcomer out.

Considering the massive upfront investment, the risks involved, and the fact that returns would fall once new capacity comes online, most potential entrants choose to stay away.

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Introduction

In Nov 2023 when I first wrote about Cultiba, I mentioned Grupo Gepp’s growth strategy. Since 2019, the company has focused on increasing the average price per case it sells by increasing prices with inflation (nominal pricing power), and selling more bottled beverages as a percentage of cases sold. This strategy has allowed the company to profitably grow. Between 2019 and TTM 3Q 2023 the company grew EBITDA from $4,567 million to $7,890 million and operating margins increased from 4.98% to 8.77%. 

In May 2024 I wrote a second article analyzing Cultiba’s 2023 annual results and the first quarter of 2024. Both periods showed very positive developments in the operations of Grupo Gepp, with growth in volume of cases sold, revenue, and margins–operating income in 2023 increased 18.58%. 

However, although from an operating perspective Grupo Gepp reported very good results, its liquidity position did worry me. I believed the combination of high dividend payouts, increases in short-term debt, and the requirement to sustain capital expenditures put the company in a position of liquidity stress. 

Since then, the company’s liquidity position has continued to worsen. In 2Q 2024 current debt levels increased significantly, to a level where I think it is important analyze and possibly re-evaluate my investment in Cultiba.

In this article I will analyze 2Q 2023 results to understand how Grupo Gepp’s deteriorating liquidity position impacts my valuation of Cultiba and investment thesis.

Market Valuation

It is worth mentioning how cash on hand now represents 48.5% of Cultiba’s market cap. This level of cash provides us with significant downside protection. Also, Grupo Gepp now sells at a more attractive price to earnings multiple than in my original write up, 4.8 vs 5.2. 

Operating Results of Grupo Gepp

Grupo Gepp continues to benefit from price increases, a better sales volume mix, and higher sales volume. In 2Q 2024, sales volume benefited from higher than average temperatures in Mexico City. The company tends to sell more bottled beverages and jug water during periods of hot weather.

Revenue per unit case increased 5.1% year-over-year to $36.5. This compares positively with an increase in COGS per case of only 2.8% during the same period. Causing gross profit per unit case to increase 8.1% year-over-year.

It is important to highlight the trickle down effects that higher sales volume had on the company’s operating and net income. An increase in revenue of 12.8% YoY, translated into an increase in operating and net income of 25.7% and 23%, respectively.

Volume of Cases Sold: 516.8 million vs 481.4 million, a YoY increase of 3%. 

Revenue: $18,877.5 million vs $16,735 million, a YoY increase of 12.8%.

Price per Case: $36.5 vs $34.72, a YoY increase of 5.1%.

Operating Margin: 11.3% vs 10.1%.

Operating Income: $2,125 million vs $1,690 million, a YoY increase of 25.7%.

Net Income: $1,152 million vs $937 million, a YoY increase of 23%.

Solvency of Grupo Gepp

Cash: $3,650 million

Short Term Debt: $8,000 million

Long Term Debt: $2,481 million

Total Debt: $10,481 million

Net Debt: $6,831 million

Total Debt / TTM EBITDA: 1.15x

The company is in a strong position to manage its total debt in the long term, indicating good overall financial health in terms of solvency.

Liquidity Position of Grupo Gepp

To evaluate the company’s liquidity position, I will consider both the company’s cash flow generation and cash on hand in relation to its short-term debt. 

Operating Cash Flow in 2023: $5,502 million

Cash: $3,650 million

Short Term Debt: $8,000 million

Grupo Gepp’s maintenance capex is around $2,500 million. Using 2021 as reference, when capex was $1,494 million, I believe the company could temporarily decrease its Capex to $1,500 million. This leaves around $4,000 million of operating cash flow to pay short term debt. With $4,000 million and $3,650 million in cash, Grupo Gepp has almost enough funds to pay the total amount outstanding of short term debt. Most probable, Grupo Gepp is in a better liquidity position than stated in this example because the operating results have significantly improved. If operating cash flow increases 20% to $6,600 million, then the company would have enough funds to pay its short term debt.

Moreover, given Grupo Gepp’s stable business, strategic shareholders, and solvency position, it is likely that if needed, they can refinance short term debt or issue long term debt to improve their liquidity position. 

Also, I believe it's very likely that shareholders of Grupo Gepp could make a capital injection to improve the company’s financial position. Cultiba holds a lot of cash, I do not think Juan Gallardo, the CEO from Cultiba and President of Grupo Gepp, would let the company go bankrupt. 

Based on my analysis of Grupo Gepp’s overall financial health, I believe it will be able to solve its short-term liquidity problems through 1) the elimination of the dividend and temporarily decreasing Capex, 2) refinancing short term debt, 3) receiving a cash injection from shareholders. Considering these options I think the probability of bankruptcy is low.

Capex Grupo Gepp

Through the six months of 2024, the beverages division invested a total of Ps.1,668 million, compared to Ps.1,519 million in 2023. 

Based on year to date figures, it is likely that Capex for 2024 will be in the range of $2,500 to $3,200 million.

Dividends Paid by Grupo Gepp to Cultiba

In Q2 2024 Grupo Gepp paid Cultiba $1,294 million in dividends. This represents a total payout from Grupo Gepp to shareholders of $3,235 million. An unsustainable amount given that it represents 101% of TTM net income.

Cultiba’s CEO, Juan Gallardo Thurlow, has significant influence over Grupo Gepp’s capital allocation decisions as the president of the board. I question his motive to pay these dividend payouts and build a large cash position in Cultiba. It would not surprise me if his objective is to take Cultiba private. If this happens then it's good news because the tender offer would be at around double the price of what the stock currently trades at.

Conclusion

Overall, given the continued improvements in Grupo Gepp’s operations, significant cash balance of Cultiba, and a lower share price, I believe an investment in Cultiba continues to be a great opportunity.

Moreover, a potential catalyst for value realization exists–Cultiba could go private.

Going forward, I think it is important to monitor Grupo Gepp’s financial position. I believe the company will solve its liquidity problems, however, deterioration could occur, and this would cause the risk profile and my investment thesis to change.

10 minute read

Intro

This week I listened to an interview from Guy Spier where he talked about expected value and how in some situations, even if an investment has a positive expected value, if taken repeatedly, it could lead to ruin because a large loss can occur that leads to irreversible consequences.

Expected Value

Expected value is the average outcome you would anticipate from an investment or repeated bet over time, taking into account the gains and losses weighted by their probabilities. In an EV calculation, you are assess how much you can win and the probability of that vs how much you can loose and its probability, and then add those figures and compare them to the initial amount.

Knowing if an investment has a positive expected value is very useful because it allows you to know if the outcome will produce an overall reward. Generally, situations with a positive expected value provide good risk and return characteristics. 

Coin Flip Example

Take a coin flip, you lose 40% of your money if it lands on tails and gain 50% if it lands on heads. Assuming you start with $1, is this a bet you would want to take?

Calculation:

Probability of heads = 0.5

Probability of tails = 0.5

If the coin lands on heads, you gain 50%, so your new amount is:

1 + 0.5 * 1 = 1.5

If the coin lands on tails, you lose 40%, so your new amount is:

1 - 0.4 * 1 = 0.6

The expected value (EV) of this coin flip can be calculated as followings

EV = (0.5 * Gain on heads) + (0.5 * Loss on tail)

EV = (0.5 * 1.5) + (0.5 * 0.6)

EV = 0.75 + 0.3 = 1.05

The expected value is 1.05, which means that, on average, you would have $1.05 after each flip. Since the expected value is greater that the initial amount of $1, this situation has a positive expected value. 

Counter-Argument - Geometric mean

At first glance, you would want to make this investment all day long.

However, this is only true if you can you can continue to bet without limit, each time with the initial amount. 

Investing does not work this way because your capital is limited and results compound. A lose of 40% of your money can be very bad and cause irreparable damage. 

Situations like this require a different approach because the sequence of gains and looses have an important effect on the overall outcome. For this, the geometric mean is very useful, it considers the product of gains over multiple periods, and the fact that a large loss can have a more significant impact than a large gain.

If we look at the coin flip bet and consider multiple coin flips, the geometric mean provides a better sense of the expected value over time.

Here, the geometric mean is 0.95, which is less than 1. This means that, in the long run, each coin flip actually decreaes your wealth by about 5% on average, despite the arithmetic mean suggesting a gain.

The key insight here is that while the arithmetic mean suggests a favorable outcome, the actual compounding effect over time results in a loss, leading you to ruin.

The following graphs demonstrates this phenomenon. Despite the arithmetic mean suggesting a potential average gain, the geometric mean demonstrates how your wealth declines over time. This happens because the loss out weights the gain, and future gains are unable to recover past losses.

These graphs highlight why the geometric mean in more realistic for evaluating scenarios where results compound.

Ergodic vs Non-Ergodic Systems

The law of large numbers applies differently in ergodic versus non-ergodic systems.

In ergodic systems the expected value is useful because things will average out. Over many trials, what happens to an individual will look like the average of the entire system or group. Here the law of large numbers and EV applies neatly.

However, in a non-ergodic system, the experience of a single individual can be very different from the average of the entire group. Even if the expected value is positive, the outcome for someone can be very different because of the sequence of events. Once you lose a lot of money, it may be impossible to get back to where you started.

In non-ergodic systems, focusing on avoiding ruin is more important than seeking the highest possible return.

Skiing Analogy

The sport of skiing down a slope is a non-ergodic system.

Skiing faster may lead to a better score, however, it also increases the risk of a crash. If you crash badly, you might injure yourself and not be able to ski for the rest of the season, causing an irreperable loss. Thus, the faster skier does not win the season, the winner is the fastest skier who does not get injured. 

Skiiing is similar to investing in the sense that if you face a severe enough loss, it can be difficult or impossible to recover. So, managing risk to being able to stay in the game is the most important thing. Survival is everything.

Effect on my Investment Approach

Learning about the difference between ergodic and non-ergodic systems definitely changed my view on diversification, risk, evaluating investments, and focus on avoiding losses. 

The fact that an investment might have a positive expected value, but lead to ruin in the long run is very eye opening.

This deepens my belief that focusing on avoiding ruin and having downside protection as the center of my investment approach is crucial for investment success.

Furthermore, when investment in special situations and mediocre businesses selling at a significant discount, managing risk through diversification is important. Diversification minimizes the chance that a single bad outcome will causes irreparable damage.

Finally, I could not help but connect this to my current investment in Cultiba. An investment in the company has a very positive expected value, but current liquidity problems at Grupo Gepp are worrying. If Grupo Gepp were to go bankrupt, then a significant portion of my portfolio would be compromised–I would lose 50% of my investment. This investment started out being ergodic, but now with the presence of a risk of bankruptcy from Grupo Gepp, it has turned non-ergodic.

Summary of Insights

• A situation with positive expected value can still be a bad investment because a large loss can occur that leads to irreversible consequences. If played repeatedly these types of scenarios can lead you to ruin because you fall into a situation where future gains are unable to recover present losses.

• The law of large numbers applies differently in ergodic versus non-ergodic systems.

• In ergodic systems, things will average out to the expected value. 

• In non-ergodic systems, the arithmetic mean (simple average) might show a positive outcome, but this does not accurately reflect reality for individuals who experience compounding effects. The geometric mean provides a better representation because it takes into account how the sequence of gains and losses affects overall wealth.

• In no-ergodic systems, the outcome of an individual can differ a lot depending on the sequence of events. Think of the skiier, if you crash badly once you might be out of the season or your entire career. In these systems, focusing on avoiding ruin is more important than seeking the highest possible return.

• Focusing on Avoiding Ruin: In a non-ergodic system like investing, avoiding large, irreversible losses is crucial.Avoid scenarios where you lose so much that you cannot recover.

• Deeply understand the mistakes of other investors to avoid them. I want to understand where I am going to die so I never go there.

• Diversification to Manage Non-Ergodicity: Minimizes the chance that a single bad outcome will cause irreparable damage by investing up to 10% of my portfolio per investment. So the amount that I bet is not fatal if the investment does not work out.

• Investment situations in great companies are much forgiving because they are ergodic.

• Investments can start being ergodic and turn non-ergodic.

• New investing question to understand if the investment situation is non-ergodic: Is the investment situation non-ergodic?

Sources

Guy Spier Interview:

I would like to inform you about some important corrections and improvements made to my recent valuation of Consorcio Ara.

1. Correction in the Book Value of Real Estate Inventory

In my original valuation, I incorrectly reported the book value of real estate inventory. Real estate inventory is the sum of short-term inventory and land used in projects. The figures displayed for these accounts were as of Q2 2024. However, the consolidated real estate inventory figure mistakenly reflected Q1 2024 values. This discrepancy occurred because I updated my valuation shortly after the company announced Q2 2024 results but forgot to update the consolidated real estate inventory figure. The corrected book value now accurately represents the Q2 2024 data.

2. Correction in the Calculation of Value Destruction per Cycle

Initially, I calculated the value destruction per cycle using the future value of real estate inventory ($12,987.53 million) instead of the correct initial inventory value of $12,242 million. 

3. Correction in the Cumulative Present Value of Value Destruction in 10 Years

I made an error in calculating the “Cumulative Present Value of Value Destruction in 10 Years” by counting the value destruction of the first cycle twice. This overestimated the value destruction, leading to an incorrect value of real estate inventory. The calculation in my analysis now properly accounts for each cycle only once, providing a more precise valuation.

I have made these corrections in my valuation report to reflect the accurate financial position and value of Consorcio Ara.

Thank you for your understanding and continued support.

Best, Ferrucho

10 minute read

Direct vs Indirect

Last week I read an essay from Josh Tarasoff that made me re-think my plan to become a successful investor.

The essay talks about two different approaches for undergoing types of activities. Activities can be categorized into simple and complex.

Simple activities have a linear connection between inputs and outputs, where outputs are predictable. It is easy to understand what the expected output will be depending on the input.

With complex activities, the connection between inputs and outputs is non-linear, more complicated, and not fully understood. There is no set of actions that you can do to obtain a predicable result. Outcomes are unique and can vary a lot.

To illustrate the difference between these types of activities, Tarasoff compares assembling a lego tree vs growing a real tree:

In Tarasoff’s example, building a lego tree requires a direct approach because of its straightforward nature. On the other hand, growing a real tree requires an indirect approach, in the sense that the right conditions must be set for the desired outcome to come about naturally.

“The seed should be properly planted in fertile soil, ample water and sunlight ensured, and so forth—such that over time the tree grows itself.”

Investing

Long-term investing can be thought of as a complex activity because the outcome is not proportional to the input. One cannot expect to get an investment idea after X hours of work. Rather, insights and ideas emerge naturally after continuous work under the right conditions. Thus, becoming a successful investor requires an indirect approach.

What might that look like to me? I have given a lot of though to this question, and realized that to successfully apply an indirect approach, one needs to really believe in what they are doing to have a high degree of patience and determination. With an indirect approach, it can take many years to reap the rewards, but long term I believe it is what will allow me to create a foundation that naturally results in me becoming a successful investor.

To me, I believe the following conditions make up the foundation which will allow me to become a successful investor:

• Start from a foundation of studying the past and present of companies and industries that I find interesting, energizing, and promising—something pursued for its own sake, as a sort of default mode. 

• Do not knock on doors to raise outside capital. For a long period of time solely invest my own capital with the goal of compounding it at attractive rates with a generational time horizon. During these years, build up knowledge, experience, and operating capabilities within select circles of competences and create a foundational investment philosophy.

• Create a business that produces free cash flow which can be redirected to my fund for intelligent capital allocation to allow me to take advantage of market opportunities.

• Set up the correct structure of my fund/company from the beginning to allow me to have a long term investment view, not worry about short term volatility, and have an incentive scheme that promotes real returns for shareholders vs accumulation of assets to charge a management fee.

• In regards to capital allocation, be a one man shop to have a lower cost structure and more time to dedicate to investment research because I do not have to raise continually more outside capital to earn a maintenance fee to pay for employee salaries.

Conclusion

You will notice that many of the conditions mentioned above mimic the structure that Buffett adopted for Berkshire Hathaway. His structure allowed him to be greedy when others were fearful, and think long term by not having the pressures of many institutional investors. In this sense, Buffett took an indirect approach, where continuous work under the right set of conditions naturally produced the success that Berkshire is today.

10 minute read

This week I spent a lot of time thinking about what edge I could have as an investor, and how to further develop it.

I identified that edges in investing can be separated into two categories: situational and general based. For example, investors managing a small portfolio in size have the situational advantage of being able to invest in a wider range of opportunities, and overlooked companies. On the other hand, general based edges do not depend on situations. They depend more on the way an investor operates.

I believe the following to be the general based potential advantages :

• Informational edge

• Time-horizon edge

• Analytical edge

• Intuition edge

Informational edge

Most people only really consider the first advantage. Movies and TV shows like Wall Street and Billions have popularized the idea that to gain an edge in investing, investors need to have information not known by the market.

The informational advantage could also be earned by looking where other people are not. Buffet and Munger had this advantage when they started simply by looking through Moody’s manuals and finding obscure companies.

Today, the availability of information and the quantity of people analyzing it has largely arbitraged this general advantage away. Turning over stones to find market inefficiencies is harder than before. Opportunities exist, but they are harder to find. Whatever information an investor believes to be unique is almost always understood by many other market participants, and thus is not valuable. 

Time Arbitrage Edge

I believe an increase in information availability and investor numbers, which have mitigated the advantage of information, has made it easier for some investors to find a different kind of edge–time arbitrage.

I believe this advantage has always existed because of the law of compounding. The time-arbitrage edge is achieved from owning high quality businesses with durable competitive advantages, for a long time. The latter is very important. Exceptional duration is the foundation of this advantage.

Buying great businesses at sensible prices has always been challenging. However, I think increases in market volatility from short term holding periods have created an opportunity by making it easier.

When Munger and Buffet started, stocks were held over 10 years on average, today the average stock is held for just a period of months. These buying and selling decisions are largely made for reasons other than the intrinsic value of the security in question, and thus create volatility in stock prices that don’t always correspond to volatility in business operations. This increase in volatility makes it easier for investors with a long term time horizon to buy great businesses.

Achieving a time-arbitrage edge might sound simple. Buy a great business at the right price and hold it for many years. In practice, however, it is incredibly hard.

The competitive position of most companies is fragile, being able to determine with a high level of conviction that a company will continue to enjoy superior economics for the next 10 years is the hardest, but most necessary part. Long term thinking on its own means nothing if not combined with durable advantageous economics.

Analytical Edge

Developing a time arbitrage edge begins by being a long term investor, and is seconded by having an analytics edge.

The successful implementation of long term investments requires insights which allow an investor to determine the durability of a business’s competitive position. Without an analytical edge you cannot determine the durability of a business for the next 10 - 20 years, which makes it very risky to buy and hold what seems like a great business today.

The process to acquire an analytical edge is indirect in the sense that the outcome of effort is not predictable. Real insights do not happen linearly. In the sense that you do not get 1 insight per 10 annual reports read. Rather, they emerge on their own from continuous work on a foundation that allows them to come naturally.

Josh Tarasoff wrote a great essay on the difference between direct and indirect approaches, highlighting this process for him as:

To me, this means starting from a foundation of studying the past and present of companies and industries that I find interesting, energizing, and promising—something pursued for its own sake, as a sort of default mode.

Intuition Edge

The quest to develop a time arbitrage edge also requires investors to face a difficult question. What happens when the margin of safety is no longer present?

Long holding periods inevitably lead investors into this situation. The gap between price and value at which they bought the company no longer exists and now the company is fairly valued by the market. What then? A time arbitrage edge is founded on the idea of exceptional duration, but it leads to holding companies that no longer offer a margin of safety.

I think the answer is being able to manage two convictions (implicit and explicit) which co-exist in tension, with intuition. Josh Tarasoff wrote great essay which expands on these two types of convictions. An implicit conviction is like the trust you have in your best friend, it comes from intuition. While an explicit conviction comes from what you can analyze, like a low valuation.

A great example of this dual conflict is Bejamin Graham’s purchase of Geico. Graham is known as the father of value investing for having developed and successfully deployed a strategy of buying undervalued companies which offered a great margin of safety.

His investment firm, Graham-Newman Corporation, operated from 1936 to 1956, achieving extraordinary results. However, it is with surprise that most of Graham- Newman’s profits were attributable to a single investment in a growth company—GEICO, the auto insurer, which now writes $40 billion in premiums—held for the last 8 or so years of Graham-Newman’s life.

This investment was held on even after not affording the initial margin of safety. He writes, referring in the third person to himself and his partner, Jerome Newman:

Graham’s decision to buy based on the moderate “price in relation to current earnings and asset value” (explicit conviction), while holding on for a 200x+ gain owed to thinking of the company as “a sort of ‘family business,’” with which they had become “closely identified” (implicit conviction).

Implicit conviction sounds very abstract, and it is, akin to intuition. This is what allows an investor to hold a company even after the margin of safety has eroded. Intuition edge is thus the missing part of the puzzle that allows an investor to reap the fruits of time-horizon edge.

Conclusion

As a small investor, today I have a situational edge of size that affords me a temporary informational edge. I will continue to try to exploit this edge by looking for opportunities in places where other investors are not, such as small companies, different markets and special situations.

Long term, however, I hope to develop a time arbitrage edge. Achieving this edge will take a long time and requires setting the foundations of continuous work to first achieve an analytical and intuition edge. These two sub-advantages are complementary, together providing a far deeper and more complete picture than either on its own.

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30 minute read

Introduction – Reason to Revisit the Company

In October 2023 I published a deep dive on Consorcio Ara, where I analyzed and valued the company to determine if it was an attractive investment opportunity. At the time of my writing, the company sold at a share price of MXN$3.4. 

I was initially attracted to the company because the market valued it at a multiple of 0.3 times book value, placing a discount of 78% on current home inventory, valuing long-term inventory at zero, and land bank at cost. At a first glance, this seemed incorrect, Consorcio Ara had negative net debt, was profitable, generated free cash flow to the firm, and owned valuable tangible assets.

During my analysis I found out that the company’s housing business generated very poor returns on invested capital. Furthermore, capital could be locked up in land for many years. These factors led me to think that the company would perpetually destroy value. A reason to dismiss an investment in the company.

Another reason to pass on the company as an investment was that I did not fully understand the working capital requirements of the company, and thus could not have certainty on the continued availability of the dividend and earnings power.

Between then and now I have realized that any company at a price can be a buy. A mediocre business can be appropriately discounted to reflect its poor returns, and at a low enough price can be an opportunity. This does not mean that an investment in a bad business at a cheap price is a good long term investment. Rather, it is a way to capitalize on short to mid term correction of the multiple that the market places on the company. It is important to mention that value traps exist, and bad businesses burning through cash can quickly reduce the gap between price and value. To mitigate this risk when no catalyst is present, like in the case of Consorcio Ara, it is critical that the company’s intrinsic value is not eroding.

Consorcio Ara is not leveraged and produces free cash flow, so a risk of erosion between the value today and in the future is low. Cash is not being burnt, real estate inventory can be sold in a 2 year period, and the company’s land and commercial properties appreciate with inflation. These factors protect us from not having a catalyst, like a liquidation, to materialize the value of the company.

In Q4 2023 Hurricane Otis hit Acapulco, greatly damaging the city, where in 2023 15% of the company’s revenue came from. It is likely that the company will struggle to sell the remaining inventory in these developments in the near future. In view of this, management canceled its dividend. This has caused the company’s stock to decrease almost 16% year to date. 

In this article I will revisit my analysis on the company and value it conservatively, considering the poor returns that the business generates, to determine if it is an attractive investment opportunity.

Investment Thesis

Inversion

I will take an inverse approach to analyze a potential investment in Consorcio Ara, by laying a hypothesis I can identify the key variables that would make an attractive opportunity. 

Thesis

• The company has negative net debt, is not at risk of financial distress, and is not burning through its cash balance to sustain operations.

• The company’s real estate inventory has value. The company earns a low return on invested capital relative to the return available to investors, yet it is a profitable business.

• The company holds commercial malls carried at cost in its balance sheet. These properties are worth more now because they were built a decade ago, and NOI is higher today than when they were built.

• The company holds a valuable land bank carried at cost that was purchased more than a decade ago. 

• The company offers a dividend equivalent to a significant percentage of net income. 

• At a price of $X, I am getting $X in cash, $X in real estate inventory, $X in land, $X per share in commercial malls, minus all liabilities of $X, equals $X in net tangible assets. The intrinsic value of the company is unlikely to erode because the company is not leveraged and generates free cash flow. Finally, while I wait for the company’s valuation to correct, I will receive a dividend.

Key Variables

• Value of real estate inventory

  • Valuation: 

    • Present value of discounted real estate inventory to reflect poor rates of return.

• Value of land bank

  • Valuation: 

    • Land bank plus applicable appreciation.

• Value of commercial malls

  • Valuation: 

    • NOI after tax discounted by an appropriate cap rate.

• Business is profitable, and will not erode margin of safety by burning through cash

  • Analysis: 

    • Cash balance vs debt over time

    • Free cash flow (with maintenance capex) over time

    • Presence of nominal pricing power (cost inflation vs increases in home prices)

• Renewal of dividend

  • Analysis: 

    • Dividend paid and payout ratio over time

    • Management intent on renewing the dividend

Overview of Business

Consorcio Ara is a vertically integrated Mexican home builder. The company is family owned and operated. German Ahumada, the CEO, and his brother Luis Ahumada, who runs the commercial properties division, own a combined 48.6% of shares outstanding.

The company operates in 3 types of home segments–affordable, middle, and residential. 

In 2023, the average price for affordable, middle, and residential homes was $40,000 USD, $70,000 USD, and $160,000 USD, respectively. 49% of homes sold were in the affordable category, 37% in the middle level, and 14% in the residential segment. Revenue from affordable, middle, and residential homes represented 33%, 38%, and 28%, respectively.

In Q1 2024, the company had a land bank of 32 million square meters, of which 30.8 million square meters will be used to build  ~117,533 homes, and 2 million square meters for industrial or commercial or tourism projects. Most of the company’s land bank was purchased a decade ago and is carried at cost. 

In addition to home building, the company operates 6 different shopping centers–205,275 m2 of gross leasable area with an occupancy rate of 94.7%. These shopping centers are close to the company’s real estate developments. In 2023 these shopping centers generated a NOI of MXN$303 million. 

The company’s core housing business generates low returns on invested capital, yet it holds significant land and inventory in progress. Finally, its commercial real estate division generates an important amount of free cash flow.

Life Cycle of Homebuilding

Land Acquisition

1. The company invests capital to purchase land 

Development and Construction

1. The company invests capital to convert raw land into sellable housing units. These investments include urbanization costs, construction materials, permits, labor, and construction costs, and are reflected in inventory in progress.

Sales and Marketing

2. The company spends capital in marketing the project, and in agent commissions to sell the properties.

Project Completion and Handover

3. Final payments from buyers upon completion and handover of the property.

4. The company recognizes the revenue from the sale of the property.

The hardest part in the process to build a real estate project is acquiring the land. According to the CEO of Casas Acre, acquiring the land for the project and getting the permits is 80% of the work.

Working Capital Needs

Capital can be tied in land, development, and construction phases. Capital tied up in land has the benefit of appreciation and preservation, even if it is not being used.

The overall efficiency of the company’s operations can be measured by looking at the Cash Conversion Cycle, which reflects the number of days that capital is tied up in inventory and accounts receivables. They key components in understanding a home builder’s cash conversion cycle are:

• Inventory Days: Time taken from the start of construction to the sale of the project.

• Receivable Days: Time taken to collect payment from buyers after the sale.

• Payable Days: Time taken to pay suppliers and contractors.

The earnings capacity of a home builder is tied to their inventory in progress, which represents the projects that they are developing. We can conceptualize the working capital needs of a home builder through investment cycles. As soon as one project is done, the life cycle of a project ends, and the home builder has to invest capital to start a new one.

In the case of Consorcio Ara, the company has a very large land bank–enough to build ~119,607 homes–which means that new investments for land acquisition should be minimal and the company should be able to continue to make housing projects going forward. 

Analysis of Operations – Home Building

The following graph illustrates the company's operations from its housing business from 2014 to 2023. In 2023 the company generated MXN$6,444 million in revenue from this division. 

The production of homes radically decreased from 11,400 to 6,500 between 2018 and 2020 as a result of reduction in subsidies and stricter credit requirements to obtain a loan from Amlo´s administration.

The company has been able to maintain historic revenue levels by switching strategy to sell higher value homes, and passing on inflation to consumers. From 2018 to 2023, the average price per home that the company sold increased 69% vs an increase of 68% in cost inflation vs an increase in CPI inflation of 34%–reflecting nominal pricing power.

To add on, between 2018 and 2023 the company’s strategy to sell higher value homes meant building vertical housing complexes and increasing the production of homes in the middle category. 

The following graph displays an important reduction in revenue from affordable housing. In 2018, 44.1% of revenue came from developments in the affordable housing sector, vs 29.5% in 2023.

In Q1 2024, income from the affordable segment increased 32%, as a result of the opening of a development that in Q4 2023 struggled to receive a permit. Moreover, revenue from the residential segment experienced a decline of 44% due to lower sales from a development in Acapulco. The company is suffering from lower sales in Acapulco due to the damages of Hurricane Otis. For context, in Q1 2023 sales from developments in Acapulco represented 16.3% of revenue from housing, vs 8.4% in Q1 2024.

The company’s operating efficiency also changed between 2018 and 2023 as a result of the strategy to develop more mid and residential housing. The following graph illustrates how the time to build and sell a project changed from 676 days in 2018 to 818 days in 2023.

A figure of 818 inventory days means that capital is tied up for 2.24 years in the investment cycle. This number helps us understand the value destruction of the company’s housing business by comparing the return on investment during this period vs the return available to shareholders. 

The company’s housing business depends on financing from government institutions. In 2023, 59% of customers financed their home purchase with a credit from Infonavit, and 16.7% with a credit from FOVISSSTE. Only 23.3% of customers financed their purchase with a credit from bank institutions. 

Significant dependence on government financing for home purchases is a risk for the company, as policy changes can have a dramatic effect on operations, as seen in 2018. For 2024, financing from INFONAVIT is expected to increase by 8.4% relative to 2023, and remain stable for Fovissste.

This level of financing from government institutions should cause home sales to remain stable in 2024 relative to 2023.

Analysis of Operations – Commercial Malls

Properties

As of 2024, the company has 205,484 square meters of gross leasable area with an occupation rate of 94.7%. In 2023 the company’s commercial properties generated a NOI of MXN$303 million.

Consorcio Ara owns 100% of 4 four commercial malls and other unicenters and minicenters. These commercial malls include: Centro San Miguel, Plaza Centella, Centro Buenaventura, Plaza Carey.

The company also owns 50% of two commercial malls: Centro las Américas and Paseo Ventura. Centro las Américas was built in 2005 and is located in the outskirts of Mexico City in Ecatepec, near a housing development.

The company has continued to invest in expanding its commercial properties. In 2022, the company invested $172 million to expand Plaza Centella GLA by 3,000 square meters. This same year, the company invested capital to expand Centro las Américas. 

In 2022, co-owned commercial properties generated MXN$182.9 million in net income, of which MXN$108 million was attributable to Consorcio Ara.

NOI

The following graph illustrates the company’s NOI from wholly owned commercial properties plus the participation in co-owned properties.

Valuation

In 2022, the company stated that according to an independent auditor, the reasonable value for its wholly owned commercial properties was MXN$2,932 million, compared to their book value of MXN$1,065 million.

Given a NOI of MXN$303 million, a capitalization rate of 11%–which represents the return shareholders can receive elsewhere–and a tax rate of 30%, I estimate the value of the company’s investment properties at MXN$1,928 million = (303*0.7)/0.11. This figure is 37% above the book value of these assets. Compared to the valuation of the independent auditor, which does not include the company’s partially owned commercial properties, my estimate is very conservative.

Profitability of Operations

Margins

The following graph shows the profitability of Consorcio Ara’s housing and consolidated operations from 2014 to 2023. 

In 2023, gross margin per housing unit was 23%, vs the consolidated gross margin of 26.5%. The gross margin per unit is lower because the consolidated figure incorporates income from commercial properties. 

It is important to highlight that gross margin per housing unit remained stable between 2014 and 2023. As for the operating margin, figures have were fairly stable between 2019 and 2023 (ignoring 2020). Overall, these results indicate that the operations of the business are stable, and future results should be similar to current ones if the company decides to remain in the housing business.

Change in Non-Cash Working Capital

The following graph illustrates non-cash working capital levels between 2017 and Q1 2024.

Non-cash working capital remained fairly stable between 2017 and Q1 2024. In 2023 non-cash working capital increased by $1,207.3 as a result of investments in current housing projects, leading to negative free cash flow. Management has stated that they plan to focus on generating positive free cash flow in 2024, indicating that they will be more restrictive in expanding real estate inventory.

It is also important to compare non-cash working capital to revenue to understand how much capital the company needs to tie up to generate every $1 of revenue. The following graph displays non-cash working capital as a % of revenue from 2017 to 2023. 

Since 2019, when the company switched strategies to sell more homes in the middle segment, the company has needed to tie more capital for every $1 of revenue, reflecting a less efficient operation. On average, between 2019 and 2023, and excluding 2020 because of the pandemic, the company’s non-cash working capital as a percentage of revenue was 153%.

Invested Capital

The following graph shows how the company’s consolidated and per division invested capital have changed between 2017 and Q1 2024. Invested capital in the housing division has remained fairly stable during this period. On the other hand, invested capital in the commercial properties division increased 53.6%.

ROIC

The following graph shows the company’s consolidated and per division return on invested capital. In 2023, ROIC from the housing and commercial properties division was 3% and 15.2%, respectively. 

The return on invested capital from the housing division is significantly below the return available to shareholders elsewhere–the current Mexican fed rate is close to 11%. As a result, invested capital in this division, which mostly constitutes real estate inventory, should be discounted to reflect the poor returns that it generates.

Free Cash Flow to the Firm

The following graph displays the company’s free cash flow to the firm from 2019 to 2023. We observe a significant difference between the Real FCFF and the FCFF estimate with maintenance capex and non-cash changes in working capital. The principal cause for the difference in amounts is that my estimate of FCFF does not incorporate cash outflows for land acquisitions nor increases in long term real estate inventory. 

Between 2019 and 2023, Consocio Ara invested a total of MXN$296 million in new land parcels, and MXN$1,888 million in long-term real estate inventory. These investments represent cash outflows that have reduced free cash flow.

The company discloses little information about investments in long term real estate inventory.

During this period, the company generated a total real FCFF of MXN$16.6 million, and a FCFF excluding investments in long term real estate inventory and land acquisition of MXN$2,178 million. 

Consorcio Ara is not burning through cash to sustain operations, nevertheless, its capital allocation decisions are very poor. The company re-invests a large percentage of the income from its housing division back into long term assets like land that lock up the capital for many years. Land does not depreciate with inflation, but generates very poor returns once used for housing development, even after waiting many years. 

Considering this, both real estate inventory and land must be discounted appropriately to reflect the poor returns that the capital tied up in these assets will generate.

Cash Balance vs Debt

The following graph shows how the company’s cash, total debt, and net debt positions have changed between 2017 and Q2 2024. The company has historically maintained a very healthy balance sheet, with minimal levels of net debt. A built up of cash between 2017 and 2022 supports the argument that the company does not burn cash to sustain operations.

In 2023, the decrease in cash was attributed to extraordinary land purchases and increases in working capital real estate inventory.

Net Asset Value Valuation (as of 2Q 2024)

Cash: MXN$2,294.9 million

+ Account Receivables: MXN$785.4 million

+ Real Estate Inventory

Book Value: MXN$12,242 million

• Short Term Real Estate Inventory: MXN$11,052 million

• Land: MXN$1,190.4 million

Adjustment for Low Returns on Invested Capital

The company’s housing business generates very poor returns on invested capital relative to the returns available to investors. As a result, real estate inventory, which comprises most of invested capital, must be discounted to reflect the destruction in value. A destruction in value occurs because the company could have invested this capital at better returns. 

For example, $100 invested in a checking account that generates 3% annual return will be worth $103 at the end of the year. However, if during the same period investors had the option of choosing a different checking account that generated a return of 10%, then they could achieve the same result of $103 at the end of year 1 by investing $93.6. So, investors that chose to invest their money at 3% destroyed $6.4 in value because at the available return, the present value of their $100 invested at 3% is $93.6 (100 *1.03 /1.10). 

Following this same logic, the company’s real estate inventory must be discounted to reflect the destruction in value from the poor returns it generates.

My adjustment for value destruction assumes that Consorcio Ara will continue to invest in similar housing projects, maintain similar levels of working capital and achieve a ROIC of 3%. 

To adjust the company’s real estate inventory, I will use a cyclical method of discounting that considers a time frame of 10 years and a period of 2 years per investment cycle. This method will project the future value of inventory at the current ROIC for each 2-year cycle (time taken to sell real estate inventory) and then discount it back to the present value using the opportunity cost. I believe this method is most appropriate because it reflects the repeated impact of poor returns over multiple cycles.

Future Value of Inventory at ROIC for One Cycle:

Future value of initial inventory value after each 2 year cycle

FV = 12,242 * 1.03^2

FV = MXN$12,987.53 million

Discount Future Value to Present at Opportunity Cost

Present value (PV) after each 2-year cycle

PV =12,987.53/(1.1^2)

PV = MXN$10,733.5 million

Value Destruction per Cycle

Value Destruction = Initial Inventory Value - PV

Value Destruction = 12,242 - 10,733.5

Value Destruction = MXN$1,508.5 million

Discount Value Destruction Back to Present Value

For each cycle in a period of 10 years, I will discount the value destruction back to the present.

Year 2: PV = 1,508.5/(1.1^2) = MXN$1,246.69 million

Year 4: PV = 1,508.5/(1.1^4) = MXN$1,030.32 million

Year 6: PV = 1,508.5/(1.1^6) = MXN$851 million

Year 8: PV = 1,508.5/(1.1^8) = MXN$703 million

Year 10: PV = 1,508.5/(1.1^10) = MXN$581 million

Cumulative Present Value of Value Destruction in 10 Years

Cumulative PV = 1,246.69 + 1,030.32 + 851 + 703 + 581
Cumulative PV = MXN$4,412 million

Subtract Cumulative Value Destruction from Real Estate Inventory

Adjusted Value of Real Estate Inventory = 12,242 - 4,412

Adjusted Value of Real Estate Inventory = MXN$7,830 million

Discounting the value of the company’s real estate inventory to reflect its perpetual value destruction by continuing to employ this capital in housing developments, we find that the value of the real estate inventory is MXN$7,830 million. This figure is 64% of the stated book value, and it considers that the company will reinvest most of the capital back into its housing business after selling a project, thereby continuing the cycle of value destruction by putting capital to work at very low rates of return for many years.

+ Land Bank

Book Value: MXN$3,209.8 million

The value of the company’s unused land is accounted separately from the land currently used in real estate inventory.

Initially, I thought that the company’s land bank was significantly worth more than its book value because it is carried at cost and it was bought a decade ago. Nevertheless, I have come to realize that the value of the land bank is actually worth less or equal to the stated book value because the company will use most of this land for housing developments, which generate very poor returns on invested capital. So, as long as the company uses this land for housing developments, the stated book value of the land must be discounted to reflect the poor returns that it will generate.

On the other hand, an estimation of the company’s land bank at below book value could be excessive because it does not incorporate that the company holds real estate beachfront gems, and that the land bank includes 2 million square meters that will be used for industrial and tourism projects. Moreover, management has stated that they conservatively value its land bank at 1.4 book value, and that in 2014 banks estimated the value of the land bank conservatively at 1.9 book value. 

Considering all of the points above, I think it is conservative enough to value the company’s land bank at book value.

+ Commercial Malls

Book Value: MXN$1,065 million

Estimate of Fair Value: MXN$1,928 million

+ Long Term Real Estate Inventory

Book Value: MXN$2,073 million

Estimated Value: MXN$1,036 million

The company discloses very little information about long term real estate inventory. To remain conservative, I will discount this asset by 50% because of future value destruction and the uncertainty of not knowing what this asset is compromised made of. 

- All Liabilities: MXN$8,483 million

= Net Asset Value (NAV)

NAV = Cash + Account Receivables + Real Estate Inventory + Land Bank + Commercial Malls - All Liabilities

NAV = 2,294.9 + 785.4 + 7,830 + 3,209.8 + 1,928 + 1,036 - 8,483

NAV = MXN$8,601 million

Sum of Parts Valuation

To complement my net asset valuation, I will estimate the intrinsic value of Consorcio Ara by calculating and then adding together the company’s housing business, investment properties, and land bank.

Housing Business

On May 20 2024 Vinte, an established Mexican public home builder, made a tender offer to purchase Casas Javer at MXN$14.9355 per share or MXN$4,215 million for the equity part of the business. This offer was accepted by 64% of Javer’s shareholders, and approved on July 12 2024 by Vinte’s board.

Casas Javer is focused on the development of affordable homes. The company is more profitable than Consorcio Ara. 

(2023 figures, in millions of MXN)

1. Homes Built: 12,201

2. Revenue: $8,904

3. Operating Income: $1,303

4. Net Income: $564

5. ROIC: 28%

6. Invested Capital: $4,509

7. Book Value: $2,741

Based on the price of the tender offer and 2023 figures, Vinte is paying a multiple of 7.4 times earnings and 1.6 times book value, to acquire the equity part of the business.

Prices Paid by Vinte & Valuation Multiples:

1. Shares Outstanding: 282,939,106

2. Equity Value: $4,215 million

3. Enterprise Value: $5,372 million

4. Book Value per Share: 9.61

1. EV/EBIT: 4

2. P/E: 7.4

3. P/B: 1.6

Javer is more profitable, justifying a higher multiple compared to Consorcio Ara. I believe a conservative figure for Consorcio Ara is around 5 times earnings. In 2023, Consorcio Ara’s housing business generated MXN$547 million in operating income. After tax, this figure is MXN$382 million. At this valuation, Consorcio Ara’s housing business would be worth MXN$1,910 million.

Land Bank

I think it is correct to consider Consorcio Ara’s land bank separately from its housing business because of its size. Although the company needs this land to operate and continue generating earnings from its housing business, today Consorcio Ara is overcapitalized in terms of land holdings. 

Vinte’s tender offer to acquire Javer values the company at 7.4 times earnings, and this valuation includes the company’s land bank. Which is large enough to build 52,577 homes and support 4.3 years of operation. On the other hand, at current levels of home production, Consorcio Ara would take almost 20 years to use its land bank. Highlighting the excess land holdings of Consorcio Ara.

Consorcio Ara also owns valuable land parcels that will be used for non-housing development purposes. 

Considering that Consorcio Ara is overcapitalized with land, a percentage of this land bank should be added in the sum of parts valuation. Not adding it would be illogical because the company could continue to invest in land, increasing this asset account, and the value of the housing business would stay the same and not account for this value.

To remain conservative, we will only add the land bank that is not part of current real estate inventory, as the land considered in inventory supports 5 years of operations (5 = (19.6 total years * 1,190 value of land bank in inventory)/4,368 total value of land bank)).

Value of Land Bank = MXN$3,209.8 million

Commercial Properties

As mentioned before, I estimate the value of the company’s investment properties at MXN$1,928 million.

Sum

MXN$7,047 million = $1,910 + $3,209.8 + $1,928 

Analysis of Margin of Safety

Based on my NAV valuation, at a price of MXN$3,700 million, I am getting MXN$2,294.9 million in cash, MXN$785.4 million in receivables, MXN$7,830 million in real estate inventory, MXN$3,209.8 million in land, and $1,928 million in commercial malls; minus all liabilities of MXN$8,483 million, this equals MXN$8,601 million in net tangible assets. 

Similarly, on a sum of parts basis, which uses a multiple of 5 times earnings to value the company’s housing business, plus excess land holdings, and commercial properties, I estimate Consorcio Ara’s intrinsic value to be MXN$7,047 million.

Based on my calculations, Consorcio Ara is conservatively worth between MXN$7,047 million and MXN$8,601 million. 

These figures compare positively with the current market price of MXN$3,700 million, offering a 47% margin of safety and a potential upside of 90%, at the lower end.

The intrinsic value of the company is unlikely to erode because the company is not leveraged, is profitable, and does not burn through cash to sustain operations. The company’s main assets: land, real estate inventory, and investment properties also appreciate with inflation.

It is important to note that both valuations are very conservative–58% of book value at the higher end. My estimate of the company’s land bank assumes no appreciation, and real estate inventory was significantly discounted to reflect the poor returns that the business currently generates. Furthermore, my valuation of the company’s commercial properties is below the estimate of the company’s independent auditor. Moreover, the housing industry in Mexico is currently facing a difficult environment, which could improve given the demand for housing and change in government administration. An improvement could increase returns on invested capital and increase the value of real estate inventory.

Considering all of the above, an investment in Consorcio Ara at the current price offers an attractive return with minimal risk of losing money. My investment is protected thanks to the company’s unleveraged position and the tangible assets it owns. Meanwhile, while I wait for the company’s valuation to correct, I will receive a dividend between 4% to 5%. In the event that the market does not correct the company’s valuation, the cost of just holding the stock is reduced by this dividend payment.

Disclosure: The analysis provided is for informational purposes only and should not be construed as investment advice. I am not a licensed financial advisor, and any decision to invest or take action based on this analysis should be done with careful consideration and, if deemed necessary, consultation with a financial professional.

10 minutes

We have all heard that one should diversify their investments. That one should not place all their eggs in one basket.

While I find these common sense sayings to be true, I also believe they are frequently exaggerated and taken to the extreme by Wall Street.

To mitigate market risk and produce a fate-ending mistake, institutional investors have accepted the notion of diversifying for its own sake. To me, this seems incorrect, as it requires you to invest capital in your Nth idea, instead of investing more in your best ones.

To illustrate, here is a quote from John Mayer Keynes: “To suppose that safety-first consists in having a small gamble in a large number of different companies where I have no information to reach a good judgment, as compared with a substantial stake in a company where one’s information is adequate, strikes me as a travesty of investment policy.”

So, when and how does diversification make sense?

Market Risk

First, let’s look at diversification and its use to mitigate market risk.

Diversification addresses a small portion of the overall risk of investing in the stock market called market risk.

This risk refers to your holdings going down in value from general movements in the market.

I believe diversification is of little help to reduce this risk because even if you took the precaution of owning 500 stocks, you would still be at risk for the up-and-down movement of the entire market.

Non-Market Risk

Secondly, let’s analyze how diversification can help an investor reduce non-market risk.

The risk associated with the results of an individual investment, that is not related to the stock market’s overall movements, is called non-market risk.

This type of risk can arise when a company’s factory burns down, when a new product doesn’t sell as well as expected, or when a company goes bankrupt.

Thus, diversification can help an investor avoid catastrophic mistakes from individual investments.

How Many Stocks Should You Own?

Based on the above, diversification can, for the most part, help investors mitigate non-market risk.

So, how should an investor diversify?

According to Joel Greenblatt, statistics say that owning just two stocks eliminates 46 percent of the nonmarket risk of owning just one stock. This type of risk is supposedly reduced by 72 percent with a four-stock portfolio and by 81 percent with eight stocks.

Summary

After purchasing six or eight stocks in different industries, the benefit of adding even more stocks to your portfolio to decrease risk is small.

Overall market risk will not be eliminated merely by adding more stocks to your portfolio. 

Contrary to popular opinion, diversification for its own sake might hurt your returns because you can end up investing in less attractive opportunities.

In the end, I believe the best strategy for an investor is to own a small number of undervalued companies, with simple businesses, that you truly understand.

Monhish Pabrai, for example, likes to make investments of 10% of the value of his portfolio. This strategy can be optimal, as it reduces non-market risk by > 80% based on Joel Greenblatt’s analysis.

10 minutes

This week I questioned the idea of a smaller investor being able to achieve higher returns than large asset managers.

I started to think about this after a friend, let’s call him Daniel, asked me how I hoped to find opportunities in an industry dominated by institutional investors with much greater resources than me. With all of their analysts and MBAs, it seemed to him that the quest to make a living out of finding undervalued companies was not worth pursuing.

After careful analysis, I came to the conclusion that smaller investors have an advantage over large asset managers. Paradoxically, size is a limiting force. The more capital an investor manages, the harder it is to generate a return. Let’s dive in.

Capital Constraints

Smaller investors are more likely to find an attractive investment opportunity. In simple terms, they can fish where the fish are, and where no fishermen are near.

Asset managers and institutional investors have a handicap over smaller investors because their potential opportunities are smaller. In investing, as you manage more capital, the fewer things you can invest in, and the harder it is to compound return at a high rate.

Today the majority of the capital invested in the markets is institutional and passively indexed. According to Investopedia, institutional investors account for about 80% of the volume of trades on the New York Stock Exchange.

This means that most investors are looking at the same things. They are all trying to catch fish in the same place and with the same constraints. Because of their size, most institutional investors need to invest in companies above $1 billion in market cap. This opens the door for the smaller investor to take advantage of opportunities in overlooked companies, resulting in higher potential returns.  

Mis-Aligned Incentives

As a small investor, you do not have misaligned incentives. You eat your cooking.

Most institutional investors earn management fees. This creates an incentive to raise more and more capital from new investors. As a result, 2 things happen: First, potential investment opportunities continuously narrow because of the increase in AUM; Second, more time and attention is spent raising new capital than looking for attractive investments, leading to poor investment results.

Group Think

It is easier for small investors to have an independent mind.

A lot of investment opportunities are contrarian by nature. An investor understands something that the market as a whole does not, which when materialized, results in a successful investment. Asset managers hardly take contrarian positions for their own preservation. No one will get fired for mistakenly investing in Apple, however, one might get fired from investing in an unknown company.

Short-Term Thinking

Small investors can be patient and have a long-term time horizon without the risk of losing their jobs.

Institutional investors and asset managers are judged quarterly and even monthly. If their returns fail temporarily to meet the index, then their jobs can be at risk, or investors can withdraw their funds. This results in a short-term investment mindset and an inability to think long-term and have the patience to wait for attractive opportunities.

Institutional Requirements

Lastly, small investors are not plagued by requirements that negatively affect potential investment returns.

Institutional investors are required to diversify their positions excessively, which reduces investment returns because more capital is placed on the worst investment ideas.

Moreover, institutional investors are often prohibited from investing in companies with small share values and market caps, or that operate in controversial industries.

Summary

In summary, I believe small investors have the upper hand in the game of investing. Small investors can access an array of greater potential investments, and take better advantage of market inefficiencies.

What do you think?

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Context

In November 2023 I published my analysis and valuation of Cultiba. A holding company with significant amounts of cash, no debt, and a 40% stake in Grupo Gepp, Mexico’s exclusive PepsiCo bottler and the owner of Epura.

At the time, the market was valuing Cultiba’s stake in Grupo Gepp at 2.5 times TTM EBITDA. I believed that this valuation was incorrect, as competitors sell at multiples between 7-10 times TTM EBITDA and the company sold 11% of its stake in the company in 2016 in a private transaction at a multiple of 7.8x EBITDA. 

Since my writeup, the market has not corrected the valuation of Cultiba. At the time, Cultiba was selling at $12 MXN per share. Today the company sells at $11 MXN per share.

In this post, I will analyze the recent results from the company and understand if Cultiba continues to be an attractive investment opportunity.

Analysis of FY 2023 Results of Grupo Gepp

2023 year-end results reflect a continued margin expansion from higher volumes, price increases, and maintenance of more bottled beverages sold as a percentage of volume.

FY 2023 vs FY 2022 Results

Volume of Cases Sold: 1,757 million vs 1,676 million, a growth of 4.8%.

Volume of Bottled Beverages: 1,018.7 million cases vs 972 million cases, a growth of 4.7%.

Volume of Jug Water: 738.5 million cases vs 704 million cases, a growth of 4.9%.

Revenue: $61,348 million vs $54,605 million, an increase of 12.35%.

Bottled Beverages as a % of Revenue: 88.03% vs 88.34%.

Jug Water as a % of Revenue: 11.97% vs 11.66%.

Price per Case: $34.9 vs $32.6, an increase of 7%.

Price per Case of Bottled Beverages: $52.23 vs $49.63, an increase of 5.25%.

Price per Case of Jug Water: $9.8 vs $9.04, an increase of 8.3%.

Gross Margin: 44.09% vs 43.45%.

Operating Margin: 9.3% vs 8.82%.

Operating Income: $5,712 million vs $4,817 million, an increase of 18.58%.

Net Income: $2,958 vs $2,715, an increase of 8.95%. 

Capex: $3,105 million vs $2,455 million, an increase of 26%.

Estimate of Non-Cash Change in Working Capital: $129 million.

Analysis of Q1 2024 Results of Grupo Gepp

The company continues to benefit from price increases and an increase in sales volume.

Net income was negatively affected by financial expenses. Interest expenses increased 26% during the quarter from an increase in short-term debt.

The company faces liquidity pressure from short-term debt. At the end of FY 2023, the current ratio was 0.5. Since then I believe this has been reduced by the increase in short-term debt from $5,000 million to $6,000 million.

I believe that the company will either need to refinance the maturity of its short-term debt or issue long-term debt to pay its short-term debt, to improve its liquidity position.

Volume of Cases Sold: 411.7 million vs 399.9 million, a YoY increase of 3%. 

Revenue: 14,782 million vs 13,550 million, a YoY increase of 9.1%.

Price per Case: 35.9 vs 33.8, a YoY increase of 6.2%.

Operating Margin: 6.9% vs 6.1%.

Operating Income: 1,015 million vs 822.5 million, a YoY increase of 23.1%.

Net Income: 440 million vs 422 million, a YoY increase of 4.2%.

Short Term Debt: $6,000 million

Long Term Debt: $1,418 million

Total Debt: $7,418 million

Net Debt: $6,007 million

Dividends Paid by Grupo Gepp to Cultiba in 2023

In 2023, Grupo Gepp paid Cultiba 956.2 million in dividends.

This represents a payout ratio of 80% ($2,390/$2957). A figure that I think is unsustainable in the near term, given the Grupo Gepp’s liquidity position.

Analysis of Financial Position of Grupo Gepp

I believe the combination of high dividend payouts, increases in short-term debt, and the requirement to sustain capital expenditures places a considerable demand on the company’s financial resources.

Grupo Gepp current assets relative to current liabilities have continually decreased since 2016. At the end of 2023, the company had a current ratio of around 0.5. Today, I expect this ratio to be lower because the company increased its short-term debt by 26% in Q1 2024.

The decrease in current ratio from 2016 to 2023 has been attributed to improvements in working capital and increases in short-term debt.

Negative Cash Conversion

Grupo Gepp operates with a negative conversion cycle. This means that it sells inventory before it has to pay suppliers. Effectively, suppliers finance the company’s inventory. As a result, the company has to tie up little capital.

Furthermore, only 35% of the company’s sales are paid in credit, the rest are paid upfront. This reduces the capital that is tied up in accounts receivables.

The combination of these two aspects of the business causes the company to have a negative working capital. This is not a bad thing, operationally it means that the business has significant bargaining power and good company management.

The following graph shows changes in non-cash cash working capital, effectively displaying the movements that have helped produce a negative level of working capital.

Short Term Debt

Although the company benefits from negative cash conversion, the ratio of current assets to current liabilities is worrying.

I believe increases in short-term debt have driven short-term liabilities to a point where they now present a financial risk to the company.

The following graph illustrates the increases in short-term debt from 2016 to Q1 2024.

It is important to highlight that in 2021 Grupo Gepp paid $1,500 in dividends and $1,900 in cash reimbursements to Cultiba. I believe they financed this payout with debt.

Between 2021 and 2022, net debt increased from 1,808 million to $4,303 million. This increase came from short-term debt, which increased from $2,400 million to $5,000 million.

Long Term Debt

Most of the company’s debt is short-term, which represents 80% of the total debt. The company has maintained constant levels of long-term debt since 2016.

Net Debt Relative to Cash Flow Generation

So, is the company at risk of financial distress from its short-term debt?

The company’s ratio of current Net Debt to 2023 EBITDA - Maintenance Capex is 1.07 = $6,007 million /($8,002 million - $2,400 million).

Based on the above, the company’s overall financial position is not worrying. Net debt relative to the cash flow that the company can generate is a sustainable figure. Effectively, the problem lies with the company’s short-term debt position.

In 2023 Grupo Gepp generated a NOPAT of $3,998 million. Cash flow generation from the business plus the company’s cash position equals $5,404 ($3,998 + $1,411). Based on this, I do not think the company is in a position of financial distress. Together with its cash position, the business is able to pay most of its short-term debt. It could easily raise funds from long-term debt, reduce capital expenditures, and cancel its dividend to pay its total short-term debt.

Moreover, the company can also refinance its short-term debt to long-term debt to release liquidity pressures.

Finally, if they need to, Grupo Gepp can receive an investment from its shareholders (PepsiCo, Empresas Polares, and Cultiba) to improve its financial position.

Based on the above, I think that although Grupo Gepp is in a position where it faces liquidity pressures, viable solutions exist for the company to be able to avoid financial distress.

Analysis of Cultiba’s Capital Allocation Decisions in FY 2023 and Q1 2024

Investment in BAF and Mapesca

In November 2023, Cultiba partnered with Continental Grain, Equity Group Investments, and Castle Harlan, to acquire a stake in Baja Aqua Farms. Through this deal, Cultiba acquired 25.47% of BAF. 

Baja Aqua Farms grows and sells premium bluefin tuna in the US, Mexico, and Japan. 

At the same time, through its investment in BAF, Cultiba acquired a majority stake ownership of 50.04% in Mapesca, a company that fishes and sells bluefin tuna and sardines. Mapesca is a partially owned subsidiary of BAF, where the owners are BAF and Cultiba. 

Cultiba invested a total of US$40 million, equivalent to MX$662.7 million, to complete both operations.

It is not clear whether this was a good investment decision. The company has provided very limited information on the quality of the acquired business and financials. I believe a risk exists that the company will continue to venture outside the scope of beverages and bottled water and destroy value.

Sale to Related Party

On 29 December 2023, Cultiba made a deal to sell 3.3% of its stake in BAF for US$4,444,238 to a related party (physical person). According to the agreement, the buyer will have 7 years to complete the payment to Cultiba.

Although Cultiba mentions that this payment will have additional charges based on a percentage of the determined market value at the time. I think this is a bad deal for minority shareholders, the payment terms are too beneficial for the buyer.

No information is provided if interest payments will be charged or if there will be several payments or a single one. 

Stock Repurchases

During 2023 and Q1 of 2024, Cultiba repurchased -2.6% of its outstanding shares, spending a total of 209 million on shares repurchases.

Shares outstanding (Start of 2023): 712,460,518

Shares outstanding (End of Q1 2024): 693,900,274

Amount spent on share repurchases in 2023: 56 million pesos

Amount spent on share repurchases in Q1 2024: 153 million

Based on the attractive price that the company sells at, I believe this was a good management decision.

Resolutions from Cultiba’s Shareholders Meeting on April 30 2024

The company held its annual shareholder’s meeting on April 30, with the following resolutions:

1. Cancellation of 15,640,362 shares that were held in treasury. This does not have an impact on shareholders, as these shares had been repurchased by the company and they did not have shareholder rights because they were held in treasury.

2. A dividend payment of USD$20M, equivalent to MXN$340M or around 0.5 per share, payable by July 31 2024.

3. Agreement to repurchase up to MXN$300M worth of stock in 2024.

Conclusion

Grupo Gepp

Grupo Gepp continues to show improvements in profitability. 2023 and Q1 2024 results reflect a continued margin expansion from higher volumes, price increases, and maintenance of more bottled beverages sold as a percentage of volume.

The short-term financial position of Grupo Gepp is worrying but manageable. Although the company has significant amounts of short-term debt, which places high liquidity pressures. Viable solutions exist to improve the company’s short-term financial position given the ratio of net debt relative to cash-flow generation of 1.07x, and its shareholder group.

I believe the company will likely refinance its short-term debt into long-term debt to improve its liquidity position. In the worst case, the option exists to receive an investment from PepsiCo, Cultiba, and Empresas Polares to pay down debt.

Cultiba

Cultiba’s investment in BAF and Mapesca is worrying because it is outside the scope of beverages. A risk exists that the company will continue to make these kinds of investments, which can destroy value for shareholders.

As for share repurchases, in the past year, the company took advantage of its depressed share price through share repurchases. During 2023 and Q1 2024 the total volume of shares traded was around 45.9 million. Of the shares traded, the company repurchased 18.5 million. This means that Cultiba repurchased 40% of total shares traded in 2023 and Q1 2024.

• Volume of Shares Traded in 2023: 24,000,000 shares

• Volume of Shares Traded in Q1 of 2024: 21,900,000 shares

• Shares Repurchased in 2023 and Q1 2024: 18,500,000 shares

Going forward, I will continue to keep an eye on Cultiba’s capital allocation decisions, and Grupo Gepp’s financial position and operations.

10 minutes

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I have recently given a lot of thought to my investment strategy. 

A question I found repeatedly thinking about was whether one should simply focus on finding high-quality companies that can incrementally reinvest earnings at high rates of return (compounders), and ignore “cheap stocks”. 

The rise to this debate initially came after reading Charlie Munger’s “Poor Almanack”. In his words, “a great business at a fair price is better than a fair business at a great price”.

I thought about if what Munger said was contradictory to the tenet of only investing with a margin of safety. 

This debate become stronger after studying Mohnish Pabrai and Guy Spier, two outstanding investors.

From what I learned, Guy Spier focuses on compounders, I have not heard him talk about buying bad or mediocre businesses at really cheap prices, or investing in special situations.

Mohnish, on the other hand, has made money in both strategies, but generally remains disciplined in buying only when the price is right. Nevertheless, in recent podcasts, Mohnish has talked about being okay with paying up for a great business and has remarked how he tries to focus on better businesses now. 

So, should one focus their attention exclusively on high-quality companies?

Last week I finished reading Seth Klarman’s “Margin of Safety”. A fantastic read. In his view, it is better to buy high-quality companies at undervalued prices. However, given that these opportunities are easier to see, they are more rare. 

In addition to high-quality companies, Seth points to other attractive investment opportunities existing in undervalued companies. These companies do not necessarily have to be good businesses, if the price is low enough, they can too be good opportunities. A mediocre business selling at a very wide discount to book value can be an opportunity. 

Furthermore, in his book “You Can Be a Stock Market Genius”, John Greenblatt focuses on catalysts. Forces that will cause the realization of value to appear. 

For example, in the case of a company selling below tangible book value with significant amounts of real estate carried at cost, this value realization can be through liquidation.

Other opportunities can exist in spin-offs, restructurings, or a change in market dynamics that cause margins to improve.

Thinking of the above I do not think that one should only focus on one category and disregard the other.

If one manages small amounts of capital and has access to opportunities, why not consider both?

Valuation vs. Return on Capital--Depends on Time Horizon

I think what Munger was trying to say when he said that “a great business at a fair price is better than a fair business at a great price”, is that over a long period of time, a great business will perform better. 

A driver of returns in the short term is the market’s correcting the value gap in a company’s valuation. This normally happens short to mid-term. 

Buying a stock at 50% of book value can work out very well if/when the market corrects itself and the stock gets revalued at 100% of book value.

However, over 10-15 year periods or longer, paying 2 times a book for a great business will work out than buying the mediocre business at a cheap price. 

The factor of time then becomes increasingly important when paying a fair price for a great business.

When is it worth paying up for a high-quality company?

Because buying a great business at a fair price works over a long period of time, being right about the business becomes very important. 

A lot of things can happen during the next 10 - 15 years. A company’s competitive position can erode, and with it its margins too. 

Capitalism is brutal, as a result, it is very risky to pay up for a business in an unstable industry, where it is difficult to know what the company’s products will be 5 - 10 years from now.

I think this is why Buffett has avoided technology companies, the uncertainty of the world is simply too high to know where the companies will be in the future, and not having a margin of safety to protect the investment, makes it unattractive.

How much should you pay up for a high-quality company?

Another question that I often think about when analyzing high-quality companies is how much to be comfortable paying up.

I generally think that one should not pay for expected growth, because of the uncertainty of the future. 

I like the idea of buying a high-quality company in a stable industry with a durable moat that can grow its earnings in the future. But, I think that price is still a very important component in the equation, even when dealing with a great business.

Things can happen that we do not see, this is why a margin of safety is important. 

Paying a high multiple for a business leads us exposed to our investment only working if a lot of good things happen. I do not want to be in that situation. I want to be in situations where I can win a lot, and lose very little. 

Summary

In summary, I like quality businesses, I like great capital allocation, I like high returns on capital, but I demand value and a margin of safety because the future is uncertain. 

I think that both categories, “cheap stocks” and compounders, should play a role in my investment strategy. At the end of the day, it comes down to the price we pay. Both can offer high upside relative to the risk taken.

My goal is to create a low-risk portfolio with a high probability of achieving an attractive average rate of return.

5 minutes

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What does the cost of capital mean?

The cost of capital is a very simple concept, but it’s also one that becomes very confusing if you read most textbooks on corporate finance.

The calculation of the weighted average cost of capital (WACC) is an example of how corporate finance has developed this concept. Where a theoretical cost of equity is used together with the cost of debt of a company.

In his 1984 letter to shareholders, Buffett addresses the relationship between the return on invested capital and the cost of capital through what he has called the $1 test.

So what is Buffett saying here?

Three things.

1. Value creation comes from the returns that a company can generate on reinvested earnings (incremental returns on capital), not just the returns they generate on previously invested capital (ROIC).

   1. A company can have a high ROIC but not create additional value because they are unable to incrementally reinvest earnings.

2. Companies should only retain earnings if a dollar in the company’s hands is more valuable than a dollar in the shareholder’s hands.

3. The only way a company achieves #2 is to earn a higher return on that dollar than shareholders could earn elsewhere. 

Effectively, the concept of cost of capital for Buffett is “what shareholders could earn elsewhere”.

Simple $1 Test

Assume an average stock market valuation of 10 P/E, or in other words, a 10% earnings yield. 

Say a company valued by the market at $100 million earns a profit of $10 million and retains all of those earnings. The company will increase in value by $10 million if it can earn a return on that $10 million of 10%–what shareholders could earn elsewhere. 

If the company can earn a 10% return on that retained $10 million, then its earnings will rise to $11 million the following year, and assuming the same valuation of 10 P/E, the business would now be valued at $110 million, thus passing Buffett’s $1 test. The $10 million of retained earnings created an additional market value of $10 million.

This isn’t a great return, as Buffett would be looking for retained earnings to create more value than just matching the cost of capital, but this is the minimum requirement that the company must meet in his mind.

Summary

Buffett uses a common sense approach to thinking about the cost of capital. 

It all narrows down to: 

“Will $1 invested by the company be worth at least $1 or more in the future?” 

OR

“Will $1 invested by the company be more valuable than $1 invested by shareholders?”

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This is part 2 of the series “What produces high returns on invested capital?”.

In my first article, I analyzed how firms generally derive their high returns on capital through either having an advantage on the consumer side (high-profit margins) or the production/efficiency side (high capital turnover), focusing on the latter.

This article will now touch on the factors that cause a company to have a high capital turnover.

Where High Capital Turnover Comes From

Like high margins, there are numerous reasons why companies are able to achieve high capital turnover.

High capital turnover means a company efficiently uses its assets to generate sales. Effectively reducing the need to tie up capital and shorten the cycle of turning working capital (inventory and receivables) into cash.

Some companies have distribution advantages that contribute to a high capital turnover.

Efficient distribution systems enhance a company’s ability to quickly move products from production to sale, reducing the capital tied up in inventory.

Walmart's distribution system is a good example, they centralize distribution and achieve economies of scale that reduce transportation and handling costs, which reduce inventory holding times.

Another strategy implemented by Walmart is cross-docking, a logistics practice where incoming goods are transferred directly from receiving docks to shipping docks, bypassing the need for long-term storage.

Some companies focus on services rather than physical products, they require less capital to be tied up in inventories and fixed assets, which can lead to higher turnover rates. Interestingly, software and media companies sell a product, but have the characteristics of service companies. Working capital needs are very small, as the cost to add new users is minimal.

Some companies operate with negative cash conversion cycles, a result of significant bargaining power, which allows them to receive inventory and sell it before they have to pay suppliers. Effectively, suppliers finance the inventory for the company. Classic examples are PepsiCo, Dell, and Walmart. 

Vulnerabilities

Companies with a high ROIC derived from high capital turnover are not bulletproof.

A change in management can have a significant impact on the company’s operations, as they previously enforced practices of great efficiency. Banks and railworks are great examples of these businesses, where management can make or break a company’s profitability.

Summary

In summary, a business can achieve a high ROIC by having a high capital turnover.

Companies with a high capital turnover operate very efficiently, as working capital is quickly converted into sales.

In essence, to operate with a high capital turnover means that a lot of cash is produced, but little has to go back in–minimal capital is tied up in inventory or receivables.

Companies can reduce the capital that is tied up in working capital by improving the speed at which investments are turned into cash. This can include optimizing inventory turnover, reducing the time that it takes for clients to pay, and having suppliers finance inventory.

10 minute read

2 Main Paths to High ROIC

A business with attractive economics produces a lot of cash, and very little has to go back in–a low capital intensive business.

Generally speaking, companies that produce high returns on capital do so in one of two ways: by earning above-average profit margins, or by turning over its capital quickly.

Firms generally derive their high returns on capital through either having an advantage on the consumer side (high-profit margins) or on the production/efficiency side (high capital turnover).

This post will touch on where high margins come from, and then in my next post, I will outline what causes a company to have high capital turnover.

Where Margins Come From

There are multiple reasons why companies are able to consistently achieve high markups over their cost.

Some products are expensive, complex to change, and critically important for customers. These products are said to have high customer captivity. Not every user loves Bloomberg’s software, but the company is so integrated in most of its customers’ finance departments that it would be too costly to switch vendors.

Some companies have built valuable two-sided networks, allowing the companies to extract significant value from those users directly (e.g. American Express) or indirectly (e.g. Facebook, Airbnb, Google, don’t charge users, but collect high-margin revenue from companies that want to sell something to those users). These companies have created network effects.

Some companies have a product that is the only game in town. In Mexico, for example, there is only “one” stock exchange and central securities depository, Bolsa Mexicana de Valores and Indeval, both of these companies are owned by the same group–Grupo Bolsa Mexicana de Valores. Anyone who wants to buy or sell a security must use their service.

Some companies have scale advantages and are able to produce a product at a lower cost than competitors. Gruma is an excellent example, they sell 70% of the nixtamalized cornflower in Mexico, and higher volumes allow the company to produce it at 20% less cost than its competitor, Minsa.

Some companies have a product that consumers have difficulty avoiding–a “toll road”. Stripe is a toll road on every transaction that is made. Consumers have difficulty in avoiding it because there are very few other options available, and all have similar charges.

Finally, some companies are able to have high margins because of a strong brand name. This includes companies like Apple, See’s Candies, Coca-Cola, etc.

More on Brands

Brands can be divided into two categories:

• Companies that offer a better product or service than competitors (e.g. Apple)

• Companies that offer a product or service of similar quality to competitors, but are better at telling a story about that product (Coke, Tiffany’s, and Nike)

Most brands fall into the second category.

Coca Cola is refreshing, but the premium price it has over Pepsi does not come from tasting better. The premium comes from the brand’s history, reputation, nostalgia, happiness, and other factors that come to mind when you think of the brand. 

A business that depends on the “story” is often more likely to be vulnerable to shifting consumer behavior. Other brands can also invest to create and tell a story.

Buffett Knew How Important the Sees Brand Was

See’s Candies is an example of a company that had a strong brand, but required a story that had to be told and an image to be maintained in people’s minds.

While it made delicious chocolate, the chocolate itself wasn’t that much different than other available alternatives.

In his 1972 letter to Huggins, then CEO of Sees Candies, Buffett emphasizes the importance of having a story behind the image of the brand. 

“We might be able to tell quite a story about the little kitchen in California that has become the kitchen known ‘round the world.”

Buffet also hints at some fear that the brand could erode if it is displayed incorrectly:

“Brandeis has taken a number of our boxes and placed them on a counter with 25 other offerings of cheap bulk candy, and other run-of-the-mill products”.

Unless the product was presented well, it would be just another piece of chocolate. There is no pricing power and much lower margins in the cheap bulk candy aisle.

In Buffet’s mind, this aspect of image and presentation also applies to how the product is distributed:

“It seems obvious to me that if we push further with department store distribution, we are going to have very tight controls regarding merchandising conditions.”

Another important factor that Buffet mentions is exclusivity and scarcity.

“I also think we should put territorial limitations on the franchise. It should be very hard to get, available only periodically, and then (to the consumer) apparently only in limited quantities.”

I think Buffett’s comments on the importance of presentation and continuous storytelling imply that there is no guarantee regarding the sustainability of a brand.

While brands are very valuable, they are also very vulnerable. Brands can erode quickly under the right circumstances.

Summary of Discussion on Brands

A high ROIC can come from having high margins, thanks to a strong brand.

A strong brand can be from having a better product or service or being better at telling a story behind the image of a product or service.

Margins can deteriorate from a product or service that depends on its story if it’s not marketed or presented well.

In my next post, I will analyze where high capital turnover comes from and how it leads to a high ROIC.

Please feel free to check out Buffett’s letter: 1972 Buffett Letter to See’s Candies

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Thesis

Earnings Before Interest, Taxes, Depreciation, and Amortization (“EBITDA”), is analytically flawed and a wrong measure of a company’s cash-generating ability because it ignores depreciation, which is a real expense, as fixed assets must be maintained and replaced. It is not hard to understand that plant and equipment wear out from normal business use, and companies must make capital expenditures to maintain their competitive position.

Historical Context

Understanding the origins of EBITDA sheds light on why it is a flawed proxy for a company’s cash-generating ability. The use of EBITDA rose in popularity in the 1980s, when investors in securities started using free cash flow as the analytical measure of value. At this same time, the market was experiencing a strong bull run from the rise of zero-coupon bonds and the junk bond frenzy. In their efforts to justify higher and higher valuations, investors replaced free cash flow with EBITDA, a simpler number, that would quantify a company’s cash-generating ability.

Example

As an example of why using EBITDA as a measure of a company’s cash-generating ability is wrong, consider the following two businesses.

Which business is worth more?

Investors relying on EBITDA as their only analytical tool would value these two businesses equally. However, most investors would prefer to own Company X, which earns $20 million, rather than Company Y, which earns nothing. Although these businesses have identical EBITDA, they are not equally valuable. Company X could be a low capital-intensive service business that owns no depreciable assets and generates a significant amount of free cash flow. Company Y could be a manufacturing business in a competitive industry.

So, what is the correct way to evaluate a company’s cash-generating ability? 

Investors can start their evaluation of free cash flow with net operating profit after taxes. This is the amount of cash flow that a business can generate. NOPAT is a useful measure because it separates a business from the effects of its capital structure, which can be influenced by management.

A company can over or under estimate depreciation, as a result, it is important to subtract net investment or disinvestment in fixed assets of a business (depreciation and amortization - maintain capital expenditures) from NOPAT. 

Finally, investors should also consider changes in non-cash working capital. An increase in non-cash working capital means that more cash is being tied up in the business, this represents an outflow of cashflow.

For example, consider a company that increases its inventory, these assets represent cash that is being tied up and will only generate a return after they are sold.

Furthermore, a decrease in non-cash working capital means that less capital is being tied up. This can occur if a company reduces its current assets or increases its credit with suppliers. A company can benefit from having credit from suppliers because it means that suppliers finance their inventory from the time the company receives it to when they have to pay it. 

Cash is excluded because it generates a fair market return. Net interest-bearing liabilities are also excluded from the calculation because this debt is considered when computing the cost of capital and it would be inappropriate to count it twice.

Our end calculation for free cash flow to the firm looks like this:
FCFF = EBIT (1- tax rate) + Depreciation - Capital Expenditures - Changes in Non-Cash Working Capital.

40 minute read

Why is it worth analyzing Cementos Moctezuma?

Cementos Moctezuma is a highly profitable unleveraged business–in the past 5 years, it generated an average return on invested capital of 59%.

The company enjoys competitive advantages in production scale and distribution, thanks to its production capacity, location of cement plants and quarries, and the relationships it has built with railway operators that allow it access to railway spurs to load cement directly in its plants.

Today, the company sells at 10.2x earnings. This might be an attractive price for a business that is highly profitable, has significant excess cash, operates in an oligopolistic market with high barriers to entry, and has the potential to grow its earnings into the future.

Short to mid-term, the company is position to benefit from a potential increase in the production of homes and the mixed-use of the new Mayan Train in the southeast region of the country. Long term, the cement industry will continue to benefit from Mexico’s demographics, which will drive the demand for housing and infrastructure development.

Market Valuation of Cementos Moctezuma

Share Price: MX $75

Shares Outstanding: 857,435,780

Equity Market Cap: MX $64,307 million

Cash: MX $7,059 million

Total Debt: MX $169.8 million

TEV: MX $57,417

TTM Net Earnings: MX $6,165 million

TTM FCFF: MX $5,636 million

TTM P/E: 10.4

EV/TTM FCFF: 10.2

Please note that FCFF is understated, as capex in 2023 was greater than maintenance capex or necessary investments in long-term assets to operate the company’s business.

Analysis Outline

1. Business Understanding

2. Industry Understanding

   1. Market Dynamics and Competitors

   2. Determinants of Profitability

   3. Barriers to Entry

   4. Potential Foreign Competition 

3. Analysis of Operations of Cementos Moctezuma

   1. Cement Business

   2. Concrete Business

   3. Distribution

4. Analysis of Profitability

   1. Revenue

   2. Operating Profitability

   3. Invested Capital

   4. Capex

   5. Free Cash Flow

   6. Return on Invested Capital

5. Profitability of Cementos Moctezuma vs Competitors

6. Competitive Advantages

7. Durability of Business

8. Potential Growth

   1. Increase in Home Production

   2. Access to New Railway Line (“Tren Maya”)

   3. Production Capacity vs Production

9. Sustainable Earnings Power Valuation

10. Discounted Cashflow Valuation

11. Margin of Safety

12. Downside Protection

13. Conclusion

Business Overview

Business Understanding

Cementos Moctezuma is a Mexican company that produces, distributes, and sells Portland cement and pre-mixed concrete. The company sells cement in the form of individual packages and bulk to construction companies and distributors in Mexico. The company sells pre-mixed concrete to construction companies via a scheduled delivery.

The company is vertically integrated in the production of cement. They own 3 plants, located in Tepetzingo, Cerritos, and Apazapan, with a combined installed capacity of 8 million tonnes of cement. All plants have quarries next to them that can supply over 100 years of material for cement production. 

In 2019, revenue was divided as 84.90% from the sale of cement and 15.10% from the sale of pre-mixed concrete. Nationwide, the company holds a marketshare of 15% and 5% in the markets of cement and concrete, respectively.

Company History

The company was founded in 1982 by Fratello Buzzi (now Buzzi Unicem SpA), Mexican company Coconal and Mr. Óscar Alvarado when they acquired Cementos Portland Moctezuma, whose origins trace back to 1943 when the first plant was built in the state of Morelos.

The company has grown through acquisitions and the creation of new cement plants and production lines that have increased production capacity. 

In 1987 Cementos Moctezuma acquired Latinoamericana de Concretos (Lacosa). In 1988 the Spanish company, Cementos Molins, invested in Moctezuma and they consolidated operations from cement and concrete in Corporación Moctezuma, which listed itself that year. 

In 1997, the Tepetzingo plant started operations with an installed capacity of 1.25 million tonnes of cement. Three years later a second production line was built, increasing capacity to 2.5 million tonnes of cement. 

In 2004 the Cerritos plant started operations, with an installed capacity of 1.3 million tonnes of cement. The plant had a cost of $151 million dollars. Two years later they doubled the installed capacity of the Cerritos plant to 2.6 million tonnes of cement.

In 2007 the company approved a significant investment of $265 million dollars for the construction of a third plant in Apazapan, in the state of Veracruz with an estimated capacity of around 1.3 million tonnes of cement. The plant in Apazapan started operation in 2011. In 2016 the company increased production capacity to 2.75 million tonnes through the construction of a second production line.

Shareholders

Today the principal shareholders of the company are Buzzi Unicem SpA and Cementos Molins (66.7%), and Antonio Cosío (10.3%).

Cementos Molins and Buzzi Unicem are two Spanish and Italian companies, respectively, that own 50% each of Fresit BV and Presa International BV. 

Buzzi Unicem is an Italian producer and distributor of cement. The company is very profitable and also practically debt-free.

Board

It is worth noting the influence that Buzzi and Molins have over how the company is managed. Enrico Buzzi is the former chairman of Cementos Moctezuma and currently serves as the CEO of Buzzi Unicem. Salvador Fernández Capo is currently the chief Chief Operating Officer of Cementos Molins.

Industry Understanding

Market Dynamics and Competitors

The cement industry in Mexico has historically been dominated by a handful of companies. 

Between 1948 and 1980, competitors included Cementos Mexicanos (CEMEX) in the north-east with 15% marketshare; Cementos Guadalajara in the south-west with 11% marketshare; Grupo Tolteca, in the center with 25.7% marketshare; Grupo Anáhuac in the center and golf of Mexico, with 15% marketshare; San Luis Mining Company, in the Pacific, with 4% marketshare; and Cementos Cruz Azul, in the south and south-east part of the country, with 11% marketshare.

During the 1980s, the industry consolidated through mergers and acquisitions. 

In 1987 Cementos Moctezuma acquired Latinoamericana de Concretos (Lacosa).

In 1987, Cemex acquired Cementos Anáhuac, which at the time had a 13% marketshare through two cement plants located in the state of Mexico and San Luis Potosí, with an annual capacity of 4.5 million tons. Through this acquisition, Cemex increased its production capacity to 15.2 million tons, equivalent to 48% of the country's total capacity.

In 1989 Cemex acquired Empresas Tolteca, a company with an annual cement production capacity of 6.7 million tons. At the time, Tolteca was owned by Mexican construction company ICA and English cement company Blue Circle. Cemex paid US $95 per ton of installed capacity for the company.  In addition to the cement plants, Tolteca owned the most important network of concrete plants in the country and port terminals to export cement to the US. As a result, the acquisition of Tolteca not only allowed Cemex to increase its production capacity but also strengthened its distribution scale.

Today, the Mexican cement market continues to be characterized by a few dominant companies: Cemex, with a global footprint and 43% marketshare; Cementos Moctezuma, a strong domestic player with 12% marketshare; Holcim Apasco, part of the global Holcim group with 20% marketshare; Grupo Cementos de Chihuahua (GCC) with 3.5% marketshare; Cementos Cruz Azul with 15.2% marketshare; and Cementos Fortaleza with 5.6%  (Grupo Carso and Mexichem). 

The market has a total installed capacity of 65.8 million tonnes. This compares to a production of 49.9 million tonnes, and a consumption of 47.8 million tons in 2022. 

The following image illustrates the existing cement plants across the country and the respective cement companies that own them.

It is an oligopolistic market, with high barriers to entry given the significant capital investments necessary to achieve economies of scale in production capacity and distribution to successfully compete. In the past 70 years, only one new competitor has entered the market. Hundreds of millions of dollars are required to build a cement plant. Furthermore, because cement is a low-value high-volume product, efficient transportation is critical, the cost to transport cement is high and does not allow it to be profitably transported over long distances. As a result, cement plants need to be strategically located near urban centers (end market), and raw material quarries.

Due to the logistical constraints of cement, cement exports have not represented a significant percentage of cement production. Only around 3% of the cement produced in Mexico is exported. Generally, companies that want to expand their operations to new countries acquire or merge with existing companies; or install cement plants inside those markets.

The growth of the cement industry in Mexico has been influenced by both domestic and international factors. Domestically, the demand for cement has been closely tied to the construction sectors, which are influenced by urban development projects, housing, and infrastructure.

75% of cement in Mexico is sold in packages of 25 to 50 kilos, which is more expensive than bulk.

Related to packaged cement is the auto construction industry, which refers to the self-build practices prevalent among Mexican households. Autoconstruction represents a significant portion of residential construction in Mexico, with families gradually building or expanding homes as financial resources become available. Cement companies have strategically catered to this market segment by offering products and solutions tailored to the needs of self-builders, including bagged cement, ready-mix concrete, and construction guides.

Of the 35.2 million total homes in Mexico, 57.3% were auto-constructed. This sector's demand for cement and related products is a significant driver of the industry's domestic sales.

In recent years, the development of new infrastructure projects from the current administration, including the new airport of Santa Lucia in Mexico City and Tren Maya, have benefited the domestic demand for cement.

Determinants of Profitability

The most important operating factors that contribute to the profitability of a cement company are being able to achieve economies of scale in terms of production capacity, having low transportation costs, and optimizing energy costs. 

Economies of scale in production capacity are achieved by being able to produce significant amounts of cement, to distribute the fixed costs of a plant over a greater number of units. Moreover, having access to high-quality raw materials and sourcing determines the company's ability to maintain lower production costs. Companies that own the quarries to extract raw materials for cement have a cost advantage.

Cement is a local business because of the logistical costs to transport the material. The distance between the raw material quarries, cement plant, and end market needs to be small for a cement company to compete effectively. Cement can be profitably transported in a radius of 400km from the plant through freight trucks. Large cement companies have been successfull in incorporating rail as a transportation method to reach new markets far from the cement plant–up to a 900km radius. Low transportation costs are thus achieved by having access to raw materials near or next to the plant, proximity to the end market, and railway as a transportation method. 

Low energy costs are achieved by optimizing fuel source, using advanced and fuel-efficient machinery, and having access to cheap energy. For example, in 2004 Cementos Moctezuma replaced oil with Petcoke as an energy source to power the kilns that make clinker. As a result, the company was able to reduce energy costs by 60%. 

Barriers to Entry

The necessary capital and know-how required to build a cement plant act as barriers to entry for new competitors. Companies that wish to enter the market and develop a small to medium-sized cement plant that generates between 800,000  - 1.3 million tonnes of cement must invest between US $150 - US $250 million. For example, in 2015 Cementos Fortaleza invested  US $250 million to expand production capacity by 1.5 million tonnes through the development of an additional production line.

Furthermore, competitors that wish to enter the industry must find a location that is close to the end market, complies with environmental regulations, and has access to a nearby quarry to reduce logistical costs. Environmental regulation and lack of available locations have increased the value of available plots, making it harder for new competitors to enter the market.

Potential Foreign Competition

Mexico imports a relatively small amount of cement compared to its exports. In 2022, the value of cement imports was only US $23 million. Reasons for the lack of significant foreign cement imports are strong domestic competitors, surplus production that can lead to a price war, and the logistical costs associated with transporting cement. 

Analysis of Operations

Cement Business

As previously mentioned, the company owns 3 cement plants that mainly serve the center, southwest (“bajío”), and southeast region of Mexico.

The Tepetzingo plant, built in 1997, and located in the state of Morelos, near the city of Cuernavaca, can produce 2.5 million tons of cement annually. This plant is next to the Eje Metropolitano highway, which allows the company to efficiently transport cement by truck. An added benefit of the location of this plant is its proximity to Mexico City–109 km distance.

Location of Tepetzingo Plant:

Tepetzingo Plant:

The Cerritos plant, built in 2004 and located in San Luis Potosi, can produce 2.75 million tons of cement annually. This plant has access to a railway spur to directly load cement onto a railway to more efficiently transport cement. Moreover, the plant is next to the ‘Autoposita Rio Verde’ highway, which allows it to efficiently distribute cement by truck to the center of the country.

Cerritos Plant:

Zoom In of Railway Spur at Cerritos Plant:

The Apazapan plan, located in the state of Veracruz, can produce 2.75 million tons of cement annually. This plant started operations in 2010 and allows the company to profitably sell cement in the southeast region of Mexico (Campeche, Chiapas, Quintana Roo, Tabasco, Veracruz, and Yucatan), thanks to its access to a railway spur. The company uses the railway to transport 30-40% of the cement produced. 

Finally, this plant is next to a highway (“Carretera Villa Emiliano Zapata”), which allows it to also efficiently transport cement by truck.

Location of Apazapan Plant:

Apazapan Plant:

Railway Spur in Apazapan Plant:

Zoom In of Railway Train in Apazapan Plant:

In total, the company has the capacity to produce 8 million tons of cement annually.

The company sells cement in bulk directly from its plant and in packaged form to its network of independent distributors. The company's distributor network allows it to meet the demand of the auto construction market.

Concrete Business

The concrete business suffers from low barriers to entry given the small capital requirements necessary to build a concrete plant and compete. This has caused margins to decrease as more competitors have entered the industry. 

To protect the profitability of its concrete operations, since 2013 management adopted a strategy to prioritize profitability over geographical coverage by reducing its operations in less densely populated areas to concentrate on the most important cities where it operates. This strategy has benefited the company. In some cities, the company now produces the same amount of concrete with fewer plants.

Furthermore, management also focused its operations on projects that small concrete companies cannot compete in, like large commercial and infrastructure projects that require significant amounts of concrete.

Today the company owns 31 concrete plants and 238 mixer trucks that are used to transport concrete.

The company's concrete client base primarily includes construction infrastructure companies, home builders, commercial construction companies, and retail customers that participate in the auto-construction sector. The company does not have a single client that currently represents more than 10% of sales.

Distribution

The company distributes the cement it produces through its network of independent distributors, concrete operations, and directly to customers from its plants. 

As for transportation methods, the company currently transports 80% and 20% of the cement it produces by truck and railway, respectively.

The use of the railway has allowed the company to efficiently sell its cement in the southeast region of Mexico. Previously to the opening of the Apazapan plant, the company transported cement to the southeast region directly from the Tepetzingo plant located in the state of Morelos, via truck.

Analysis of Profitability

Revenue

From 2011 to 2023 revenue grew at a CAGR of 7.5%, driven by investments to expand production capacity, development of railway terminals to reach new markets in the southeast region of the country, growth of the construction industry in Mexico, strong demand for cement from big government infrastructure projects, and price increases.

Notable Events

• Decrease in revenue in 2013 due to the crisis in the housing sector in Mexico

• Increase in revenue in 2015 due to strong construction demand from housing and commercial projects, and greater use of production capacity.

• Increase in revenue in 2016 from the expansion of production capacity from the conclusion of the development of the second line of the company's Apazapan plant.

• Decrease in revenue in 2018 and 2019 from the pause and cancellation of important construction projects by the new administration. An increase in uncertainty reduced construction investments from the private sector.

• In 2020 the industry experienced a significant decrease in economic and construction activity from COVID. Demand for cement was offset by the large infrastructure projects from the government.

• In 2023 revenue increased as a result of price increases to pass inflation to clients. The construction industry benefited from a more stable environment and economic optimism from nearshoring, appreciation of the Mexican peso, and lower inflation.

Operating Profitability

As part of the company’s strategy to prioritize profitability over geographical footprint, concrete as a percentage of revenue decreased from 25% in 2013 to 15.1% in 2019. During this period, revenue from concrete remained constant, changing from MX $1,997 million to MX $1,931 million; meanwhile, revenue from cement increased significantly–from MX $5,961 million to MX $10,855 million.

Between 2016 and 2023, after the opening of the second production line of the Apazan plant, the company’s operating and net margins averaged 40.8% and 30%, respectively. In 2023 operating margin was 42.2%.

Invested Capital

Impressively, the company was able to grow revenue by 139% from 2011 to 2023 without requiring much additional capital. Invested capital decreased from MX $8,876 million to MX $6,500 million during the period, thanks to working capital optimizations. Non-cash working capital decreased from MX $2,283 million to MX $-936 million during the period. PP&E remained relatively the same, from MX $7,025 million in 2011 to MX $7,028 million in 2023. 

From 2011 to 2023, the company returned excess cash in the form of dividends and share repurchases, averaging a payout ratio of 96% and paying a total of MX $40,478 million.

Capex

Historically, D&A has been higher than capital expenditures during periods of no investments to expand production capacity. From 2012 to 2023, D&A as a percentage of revenue averaged 4.5%, I estimate this number to be a good representation of the necessary investments that the company must make each year in long-lived assets to maintain operations.

Free Cash Flow

Taking into account necessary investments in long-lived assets and changes in non-cash working capital, we observe that the company is a significant generator of cash. From 2016 to 2023, FCFF as a percentage of revenue averaged 30%. 

During the same period, free cash flow increased at a similar rate to revenue, with a CAGR from 2012 to 2023 of 8.3% vs 7.5% for revenue, respectively.

Return on Invested Capital

Between 2016 and 2023, the company averaged a return on invested capital of 59%, demonstrating its superior economics. During this period, ROIC benefited from an increase in production capacity from the development of the second production line in the Apazapan plant, which allowed the company to achieve greater economies of scale by spreading the fixed cost of its plant in greater units, and optimizations in working capital. The following graphs show how the company’s ROIC by year from 2012 to 2023.

Competitive Advantages

Cementos Moctezuma has competitive advantages in production scale and distribution thanks to its production capacity, location of cement plants and quarries, and the relationships it has built with railway operators that give it access to railway spurs to load cement directly in its plants. 

Regarding production scale, the company benefits from economies of scale in each of its 3 plants. On average it has a production capacity of 2.6 million tons per plant, which is greater than most competitors.

The location of its plants allows it to be a low-cost producer because it can access high-quality raw materials at a low cost thanks to the closeness of the quarries to its plants. 

Furthermore, all of the company’s plants are strategically located near end markets with strong demand for cement through the segments of infrastructure, housing, and commercial developments. The company can profitably sell cement in the center, southwest, and southeast regions.

As for distribution, the company's extensive distributor network in areas with high demand for autocontrusction and public works allows it to be closer to clients and position its brand. 

Finally, having access to railway as a transportation method is also a significant competitive advantage for the company. It is 30-40% less expensive to transport cement by railway than by truck. A railway can transport up to 100 tons of cement while a truck can transport up to 36. Furthermore, while cement companies can only efficiently transport cement to a radius of 400 km from the plant via truck, through railway this distance increases to 900 km, allowing the company to reach new markets.

Competitors that want to take advantage of railway as a transportation method need to have their plants close to railway lines, invest significant capital to develop railway infrastructure to transport their product and operate with sufficient scale for railway companies to want to develop railway spurs to efficiently load cement. For example, the management at Cementos Fortaleza mentions that they are only able to transport 2% of their product through rails, even though it's cheaper than trucks because their plants do not have access to railway spurs. 

Durability of Business

The necessary capital requirements to establish a cement plant have historically deterred new competitors from entering the industry. In the past 70 years only one new company has entered the market–Cementos Fortaleza founded in 2014, and backed by Carlos Slim and Antonio del Valle. To start, Cementos Fortaleza invested US $230 million to develop a cement plant from scratch next to a quarry with reserves to 99 years, and a production capacity of 600 million tonnes. Relative to the size of the cement plants from industry leaders like Cemex, Holcim Apasco, and Cementos Moctezuma, this is a small plant.

Going forward, I expect that the industry will continue to be dominated by a handful of competitors because of the capital requirements needed to compete.

Are current cement prices unsustainably high when considering the surplus in product capacity? Are prices likely to come down?

In 2023, Cruz Azul’s cement plant in Tula de Allende was not operational due to internal problems at the company. This plant has an estimated installed capacity of 2.5 million tonnes. Cement production will likely increase from 2023 levels once this plant becomes operational again, which can cause the price of cement to drop. In general economic terms, if the supply of a product increases while demand remains constant, the price of the product is likely to decrease.

Considering the domestic total installed capacity of 65 million tonnes vs production of 46.9 million tonnes, the industry only used 72% of total production capacity in 2023. This production level compares negatively with previous years–between 2005 and 2015 the average level of production capacity used was 84.1%.

An increase in production capacity of 2.5 million tons would increase production to 49.4 million tonnes, or 76% of installed production capacity.

Future Growth

Mexico Demographics

Mexico’s population is around 126 million people. Although population growth has slowed (Mexicans now on average have 2 children per couple). Mexico is a young country, 40% of Mexicans are 24 or younger and 58% of Mexicans are 34 or younger. By 2030 it is estimated that there will be 34 million Mexicans aged between 20 and 39 years, and most of them will need homes. The country’s population has more than tripled since 1960 and is projected to grow to 146.9 million by 2030–a 2.5% growth rate. This demographic structure offers the opportunity to seize a ‘demographic dividend,’ defined as the potential economic growth from having a large labor force and relatively few dependents to take care of. This by itself explains why demand for housing and government infrastructure projects should remain strong for the foreseeable future. 

Is the production of new homes likely to increase from current levels?

INFONAVIT reports that today there is a shortage of housing available compared to the number of households being formed. It is estimated that the number of private homes in the country's 74 metropolitan areas increased from 22.2 million in 2010 to 26.4 million in 2020. This represents an average annual growth of 1.7% during the period. However, this growth seems insufficient compared to the increase in the number of households during the same period, which had an average annual growth of 2.5%. 

Current levels of production of new formal homes are at a decade low because of government cuts to housing subsidies and decreases in mortgages granted by National Housing Agencies. 

Semester Production in 2023: 60,800 (Registro Público de Vivienda).

A symptom of the current housing scarcity is price increases. The housing price index shows an increase of 53.7% from 2018 to 2023, compared to a 29.3% increase in the consumer price index and a 45.8% increase in the residential construction price index.

Considering that 58% of Mexicans are under 34 years old, the current housing shortage relative to households being formed, increases in home prices, and the fact that new housing production is at its lowest in the last decade, we maintain a thesis that home production must eventually increase to meet the country’s needs. A catalyst for this is a change in the government’s administration coming in the second quarter of 2024.

Increased use of Railway as a Transportation Method

The cement industry is posited to benefit from the development of the Mayan Train. This train will transport both passengers and cargo, which will give cement companies the ability to transport cement through the Yucatan peninsula at a low cost. As a result, cement companies with operations in the southeast region of Mexico will benefit from lower transportation costs.

The following graph shows the railway routes that the Mayan train will cover (purple line).

It is estimated that the Mayan Train could transport up to 3.6 million tonnes in 2024, and reach 8.4 million tonnes in 2033.

Corredor Interoceánico del Istmo

The southeast region will benefit from the development of the “Interoceanic Corridor of the Isthmus of Tehuantepec”, a trade and transit route that will connect the Pacific and Atlantic Oceans through a railway system. Analysts expect this government project to be the most important from AMLO’s administration, given the opportunity that this infrastructure has to compete with the Panama Canal. The government expects that this project will boost the economic development of the region. Ten industrial parks will be constructed around the new railway line. I expect that all the growth in economic activity in the region will benefit the cement industry.

Is the company positioned to benefit from the above?

Cementos Moctezuma is positioned to benefit from an increase in home production. The company serves the center (Valle de México) and southeast regions of Mexico, where demand for new homes is highest. The following graph illustrates home deficit by region, according to a report made by INFONAVIT.

Furthermore, we expect that Cementos Moctezuma will benefit from the conclusion of the Mayan Train. In 2019 the company transported 166,000 tonnes through the region covered by the train. This represents 23.4% of the total volume of goods transported in the region that the train will cover. In the short term, the benefit that this train will provide to the company is not significant, as the amount transported in 2019 only represents 2% of installed production capacity. Longterm, however, the company could leverage the railway lines of the Mayan Train to reach new markets that were previously unattainable because of transportation costs.

Also important, we believe the company is positioned to benefit from the economic development that the “Corredor Interoceánico del Istmo” will have in the southeast region of the country. This government project represents a great opportunity to compete with the Panama Canal and establish a great avenue for Asian companies t to reach the US. We expect that the company will benefit from this development, given its presence in this region of the country.

Finally, we think Cementos Moctezuma will likely see a small benefit from nearshoring thanks to its geographical footprint in the center of the country and its closeness to auto-part hubs in the southwest region of the country.

What does the company need to materialize this growth? Will they have to build a new plant or production line; or do they have unused production capacity?

In 2022, Cementos Moctezuma reported that their cement plants operated at an average capacity of 85%. This figure is similar to the average capacity reported by the industry of 84% between 2005 and 2015.

An operation capacity of 85% means that the company is currently producing around 6.8 million tonnes of cement annually. Based on this, in 2023 the company sold each ton at an average price of $2,891 pesos or $170 USD, at an exchange rate of US $1 per MX $17. When considering that the price per ton in the US in 2023 was $150 USD, a price of $170 USD appears a correct estimation.

In the short term, the company could increase its production capacity to 93% to meet an increase in demand. This would increase production to 7.44 million tonnes, and sales to MX $21,501 million. This represents an increase of 9.3% from 2023 revenue of MX $19,662 million.

Afterward, if there is unmet demand, the company can invest capital to expand production capacity through the development of an additional production line. Based on the investments of MX $1,332 million that the company made in 2015 and 2016 to increase production capacity by 1.6 million tonnes through the development of the second production line of the Azapan plant, we estimate that the company invested MX $832 for every additional ton of capacity–MX $1,231 today. Thus, an increase in production capacity of 1 million tonnes through the construction of a new production capacity would require the company to invest MX $1,231 million. This investment would increase the company’s production capacity by 12% and revenue by MX $2,687 million, assuming that the production line operates at 93% capacity. This revenue increase translates to MX $24,188 million in revenue or a growth of 12.5%.

The above growth could occur in the next 5 years, with the new government administration acting as a catalyst for the production of new homes, the start of operations of the Mayan Train and Corredor Interoceánico del Istmo, and the industrial developments from nearshoring.

If in year 5 revenue increases to $24,188 million and the company can maintain the average net profit margin achieved between 2016 and 2023 of 30%, then net income in 2028 would be $7,256 million–17% more than in 2023.

Earnings Power Value Valuation

I will first value the company through an earnings power valuation with no growth, where I capitalize the company’s normalized earnings (“sustainable earnings power”) at an appropriate rate to estimate its intrinsic value. 

Revenue:

I believe it is too optimistic to use 2023 for normalized revenue considering that cement prices could decrease given the surplus in installed production capacity of the industry, and the high probability of Cementos Cruz Azul’s plant resuming operations in the short term. To remain conservative, I will take the average revenue from 2022 to 2023, this computes a normalized revenue of MX $17,972 million–8% less than the 2023 results. 

Operating Margin: 40.8% (average between 2016 and 2023)

Tax Rate: 30% (corporate tax rate in Mexico)

NOPAT: MX $5,132 million (5,132 = 17,972 * 0.408 * 0.7)

Maintenance Capex:

D&A correctly reflects maintenance capex, so an additional reduction is not necessary.

Earnings Power: MX $5,132 million. 

My estimate of normalized earnings compares positively to a net income of MX $4,386 million and MX $6,165 million achieved by the company in 2022 and 2023, respectively.

Discount Rate: 10%

I will use a discount rate of 10%, which represents my opportunity cost of investing in the company.

Earnings Power Value

Capitalizing the company’s earnings power of $5,132 million at an appropriate rate of 10%, I estimate that the intrinsic value of the company in enterprise terms is MX $51,320 million.

DCF Valuation

I will now value the company through a discounted cashflow valuation that incorporates future revenue growth in the next 5 years, and a conservative sales multiple in year 5. 

My DCF valuations incorporate the following assumptions:

Revenue:

I will use the 2023 results as a starting point for revenue. 

I will assume a 5% annual growth rate from year 1 to year 5, driven by an increase in demand for cement from the production of new homes, the development of the Mayan Train and Corredor Interoceánico del Istmo, and the economic development from nearshoring in the center of the country. I believe a 5% growth rate is a conservative estimation for the next 5 years, given the magnitude of the projects and developments highlighted above.

I estimate that to materialize this growth the company will need to increase production capacity to 93%, and then invest capital to increase production capacity by an additional 1 million tonnes.

FCFF as a % of Revenue: 30% (average between 2016 and 2023)

Maintenance Capex:

D&A correctly reflects maintenance capex, so an additional reduction is not necessary for the years where no investments to increase production capacity are made.

Growth Capex: MX$1,230 million + 30% (buffer) = MX$1,599 million

Capital investment to increase production capacity by 1 million tonnes, divided into two years, based on cost per additional ton from investments made in 2015 and 2016 to construct a second production line in the Azapan plant.

Discount Rate: 10%

I will use a discount rate of 10%, which represents my opportunity cost of investing in the company.

Sale Multiple: 12 times earnings

A multiple of 12 times earnings is conservative given future growth in demand for cement that will materialize from Mexico’s demography. Please note that because Cementos Moctezuma does not have debt and D&A correctly reflects maintenance capex, free cash flow in year 5 corresponds to the company’s sustainable earnings power that year.

My discounted cash flow to the firm valuation results in a value of MX $80,761 million for the company’s business.

Margin of Safety

At an equity market capitalization of MX $64,479 million and excess cash of MX $7,059 million, the market currently values Cementos Moctezuma’s operating business at MX $57,417 million. 

I estimate that a conservative valuation for the company’s business to be MX $51,320 million, 10.6% less than what the market currently values the company at. This valuation does not incorporate future growth, and uses a revenue amount that is 8% lower than 2023 results. Although I believe this valuation to be a good starting point to understand the intrinsic value of the company, I think this value is too conservative because it translates into a multiple of 8 times earnings (2023 results). I believe it makes sense to incorporate growth in the demand of cement, based on Mexico’s demographic tailwind, a revamp of the housing sector, and the development of the Mayan Train and the Interoceanic Railway. 

Based on the above, I value the company through a DCF valuation that assumes a conservative revenue growth rate of 5% for the next 5 years, and a sales multiple of 12 times sustainable earnings power at year 5. This produces an estimate of intrinsic value for the company’s business of MX $80,775 million, or 13 times earnings (2023 results). I believe that this valuation is a better representation of the intrinsic value of the company’s business since it takes into account future developments in a conservative matter. This valuation translates into an expected upside of 40% compared to the current enterprise market value, and a margin of safety of 28.8%.  

Downside Protection

Cementos Moctezuma currently sells at 4.8 book value, this is a high multiple to pay and provides a low liquidation value of the company’s tangible assets relative to its market price.

At the current market price, the company’s net tangible assets provides us with little downside protection.

Conclusion

Cementos Moctezuma is a highly profitable business with significant amounts of excess cash. The company operates in an oligopolistic market with high barriers to entry due to the start-up costs of building a cement plant. The company holds competitive advantages in production scale and distribution, thanks to its access to raw material quarries at its plants, proximity to end markets, and use of railway as a transportation method. 

The company has good management that runs the business for the benefit of shareholders. They return significant cash in the form of dividends and have prioritized profitability over expansion.

The demand for the company’s products (cement and concrete), will continue to be strong many years from now, thanks to the demographics of the population of Mexico, where 58% of people are below the age of 34, which will drive the demand of housing and infrastructure development.

The company sells at a high multiple of 4.8 times book value. Although this is appropriate, given the high returns that it is able to generate relative to its invested capital, between 2016 and 2023 ROIC averaged 59%, it does mean that the downside protection from an investment in the company, at the current price, is low, given the high multiple to net tangible assets that we are paying.

Valuing the company’s business using a discounted cash flow valuation with a 5% revenue growth estimate that considers the benefits of an increase in demand from a revamp of the housing sector, the Mayan Train as a transportation method, and the economic development of the southern region of the country, as well as a 10% discount rate that reflects my opportunity cost; I estimate the enterprise value of the company at MX $80,755 million or 13 times TTM earnings.

My estimate of intrinsic value offers a 40% upside vs the current market valuation of the company’s operating business of MX $57,417 million, and a 28.8% margin of safety. 

Unfortunately, the current market price does not provide a sufficient margin of safety. Only when incorporating future earnings growth is the value of the company above market price, capitalizing normalized earnings at an appropriate rate of return results in an enterprise value of MX $51,320 million, this is below the company’s market price of MX $57,417 million. 

Furthermore, a margin of safety of 28.8%, at a valuation that incorporates probable future growth, does not significantly protect us from negative scenarios, such as the entrance of new competitors, price regulations, an economic downturn, and price wars between competitors given the existing surplus in production capacity. 

Finally, considering my estimate of intrinsic value vs the current market price, my potential upside is 40%, a figure that I do not find attractive enough relative to the risks. As mentioned before, the margin of safety is low, and the liquidation value of the company is not significant.

At the moment, I consider the company to be a great business, but the price is not low enough for me to consider this an attractive investment opportunity.

Sources & Data

https://docs.google.com/spreadsheets/d/1Qf5Ay2swxH5_3t2mt0Qot_Iakz1Y_NI1MrfaL5_pp0o/edit?usp=sharing

10 minute read

What is a business worth?

The value of a business is determined based on the cashflows it can produce, discounted to an appropriate rate.

Very profitable businesses, those who generate cash flow from investments above the cost of the investments, create value. In other words, one dollar invested in the business becomes worth more than one dollar in the market–the capital’s opportunity cost.

To illustrate:

A company invests $10,000 and the opportunity cost is 8 percent.

In the first scenario, the investment generates cash flow of $500 per year into perpetuity, which equals a value of $6,250 ($500/.08). This firm is destroying value because those $10,000 could have earned $800 cashflow per year.

In the second scenario, the business earns $800 in cash flow per year, making the investment worth exactly the cost of $10,000 ($800/.08). A growth in invested capital adds no value in this case. For example, if the firm reinvests its earnings and next year earns 8% of 10,800, then the return would be the same as the amount earned in the market. As such, the business should not trade at a premium to the invested amount. As a metaphor, imagine that your checking account generates 8%, $100 dollars invested in your checking account generates the same as $100 dollars invested in the business. As such, the business should be valued at $100 dollars.

In the final scenario, the firm earns $2,000 in cash flow per year, making the investment worth $25,000 ($2,000/.08). The logic of this is that it would take $25,000 invested at 8%, which is what the market return, to generate $2,000 a year. As such, a checking account with $25,000 earning 8% a year is worth the same as a business that can generate $2,000 a year, even if its invested capital is only $10,000. 

Of course, this also means that a decrease in the profitability of a very profitable business can have a dramatic effect on its valuation. For example, imagine that the business’s return dropped from 20% to 15%, this translates into $1,500 in cashflow per year, making the investment worth $18,750 instead of $25,000 when profitability was higher. This makes it dangerous to pay up for a very profitable business with uncertain durability. Companies that can sustain high growth and high ROICs are rare. 

The faster a company can grow while sustaining high returns, the more value it creates. For example, take the business in the final scenario, the invested capital of the business would look like this if it reinvests all profits at a 20% return for 10 years:

In this scenario, during the 10 years, invested capital and earnings grew around 5 times, in a linear fashion. Assuming that the business is able to continue to generate a return of 20%, the value of the business would be $128,987 (10,319/0.08) in year 10 or $59,745 today (128,987/1.08^10). If we had bough the business at a fair value of 25,000 in year 1, then we would have generated a return of 512% in 10 years. 

On the other hand, if we had bough the mediocre business at a fair price of $10,000 and it would have reinvested its earnings at 8%, then invested capital in year 10 would be $21,589, making our return 210%. 

In summary, a great business that is able to reinvest the majority of its earnings and continue to sustain its returns will be able to grow faster and create more value than a business who generates a mediocre return. This sustains the argument that a great business at a fair price is better than a bad business at a great price.

What about a very profitable businesses that pay out the majority of their earnings?

Mature companies with high returns on invested capital may choose to stop chasing growth and return most of the earnings to shareholders to maintain high returns. How do you value these types of businesses?

Considering that the value of a business is based on the future cashflows that it will produce, discounted by an appropriate rate. The value of a business is therefore determined by the cashflows that it produces today, the earnings growth rate, and the discount rate. For most businesses, growth is a function of invested capital, thus, a very profitable business that reinvest the majority of its earnings will have a higher growth rate than a business that does not reinvest its earnings. As a result, the difference when estimating the value of a very profitable business that reinvest its earnings and one that does not, is the growth rate of earnings. 

For example, take two companies:

Company A invests $10,000 with an opportunity cost of 8 percent, earns $1,500 a year, and reinvests 100% of its earnings. As a result, it is able to grow its earnings at a rate of 15%.

On the other hand, company B invests $10,000 with an opportunity cost of 8 percent, earns $1,500 a year, reinvests 10% of its earnings, and pays 90% to shareholders in the form of dividends and share repurchases. As a result, it is only able to grow its earnings at a rate of 1.4%.

Logically, company B is worth less than company A because it is able to compound less capital at a high rate of return.  We can estimate the value of company B by taking current earnings and discounting them at the opportunity cost of 8% minus the growth rate of 1.4% from reinvesting 10% of earnings–$20,454 = 1,350/(0.08-0.014) or 14.8x earnings. We use $1,350 in our estimation of instrinsic value because this is the free cashflow left for the owners of the business, as $150 are reinvested back.

What about businesses that can grow their earnings and maintain high returns without requiring much additional capital?

The best businesses are those that can maintain high rates of return for long periods of time and grow their earnings without requiring much additional capital. For the reasons that depreciation charges roughly match capital expenditures and working capital requirements are minor.

These businesses are thus able to grow earnings in a non-linear relationship to the amount of money that they reinvest back into the business. 

This is very uncommon, as most businesses require their owners to commit more capital, usually in the form of retain earnings, to grow.

We can value these businesses by taking the current earnings and discounting them at an appropriate rate of return, with the earnings growing at a rate each year–Intrinsic Value = Free Cash Flow / (Discount Rate - Growth Rate). Akin to owning a perpetual annuity set to grow at X% each year. 

These types of businesses can return value to shareholders in the from of cash earnings each year, and still grow because they do not have to reinvest their earnings.

A great example of this is Sees Candies. 

At the time that Blue Chip Stamps (then an affiliate of Berkshire) bought the company. The nominal price  that the sellers were asking - calculated on the 100% ownership they ultimately attained - was $40 million. But the company had $10 million of excess cash, and therefore the true offering price was $30 million. The company’s tangible net worth was $7 million. 

Buffet recounts how Charlie and him, at the time, were not fully appreciative of the value of an economic franchise that allows a company to grow without requiring much additional capital. They offered $25 million and the sellers accepted.

See’s candy sales grew from $29 million to $196 million from 1972 to 1991. Moreover, profits grew even faster, from $4.2 million pre-tax to $42.4 million. 

For an increase in profits to be evaluated properly, it must be compared with the incremental capital investment required to produce them. 

From 1972 to 1991, See’s was able to increase its earnings 10 times whilst just increasing its tangible worth from $7 to $25 million. 

How was See’s able to achieve this?

In the purchase of See’s Buffett and Charlie had one important insight: untapped pricing power. A company can increase its revenues by raising prices. This is great because it does not require the business to invest more capital to produce growth.

As a final side note, please take note that paying up for these types of businesses is dangerous. As Buffett, explains in his 1991 letter to shareholders with media companies, a change in the assumption that a business can forever grow its earnings without requiring additional capital, significantly reduces the intrinsic value of company. And this, unfortunately, is the fate for most businesses. Capitalism, after all, is brutal.

30 minute read

Reason to Analyze Megacable

• Megacable is a profitable, unlevered, high-quality business that is trading at under 3.9X EV/EBITDA.

• The company generates significant cash flow through its recurring revenue subscription model.

• Free cash flow is likely to increase from the conclusion of the development of its GPON Evolution project. The company invested significant resources to build and transition 40% of its subscriber base to a fiber network (FTTH).

• Earnings are posed to increase because current figures incorporate 6-month promotional rates offered to stimulate the growth of the subscriber base in newly served municipalities, which will roll off with time as new markets mature.

Analysis Outline

1. Company Description

2. Introduction to the Telecom Industry in Mexico

3. Analysis of Megacable’s Business

4. Main Assets

5. Analysis of CAPEX Initiatives and Maintenance Capex

6. Profitability

7. Conclusion

Company Description

Megacable is a Mexican telecom company, owned by the Robinson Bours family (42% stake), that offers pay TV, wired phone, and broadband internet services. The company holds a concession to offer any telecommunication service nationally. This allows the company to offer its services in “bundles”, such as internet + video + phone, and internet+phone. As a result, the company can increase revenue-generating units and reduce subscriber churn rates.

The centerpiece of the company’s strategy is its internet service, which leverages its fiber and coaxial cable network to offer higher speeds than competitors at better prices. This strategy can reduce churn rates because market tailwinds such as the transition from wired phones to mobile phones, and pay-tv to streaming, have less impact on the company's operations. If users want to install an internet connection in their homes, they have no choice but to pay for the wired phone or subscribe to a triple play bundle.

At the end of 2022, the company had 4,397,994 unique subscribers, and a network of 76,236 km–reaching 11.5M homes passed. Homes passed is a metric used to estimate the potential customers the company can offer.

The company's customers have consistently opted for the triple-play service. By the end of 2020, the subscriber base for the triple play service stood at 57%, compared to 52% at the end of 2019.

The majority of the company’s revenue is recurring. Customers pay a monthly subscription at the start of each month for their services.

In 2022, revenue from the company’s retail segment, which includes the services listed above, was divided into 33% internet, 36% video, and 9% wired phone.

The company also generates a significant portion of revenue from its corporate segment. The company provides computer networking, consulting, and infrastructure services to corporate customers. In 2022, revenue from this segment represented 19%.

Introduction to the Telecom Industry in Mexico

TV

According to the IFT, there were a total of 16.7 million pay-tv subscribers in Mexico in 2022.

In Mexico, 95% of homes have at least one TV. 53% of homes depend exclusively on open channels to watch TV. 38% only use a pay-tv option. 9% use pay-tv and the open channels.

Televisa and TV Azteca provide open channels ("free TV"). Users can access open channels by connecting an antenna to a TV.

The pay-TV industry in Mexico principally includes DTH (satellite) and cable operators. An advantage of DTH providers is that they do not require physical infrastructure to expand their reach. However, a drawback of DTH services is that they cannot offer various telecom services through a single medium, as cable operators do. At the end of 2022, 65% of television access in Mexico was through cable.

DTH operators include Sky and Dish, with SKY holding the majority market share.

The company estimates that it holds a 20% market share of the total pay TV subscribers in Mexico.

Internet

Internet adoption continues to increase in Mexico, at the start of 2022 there were 24.1 million subscribers. According to the ENCCA (2022), 75% of people in Mexico use the internet. Being broadband access (wi-fi) the most popular access type. The main environments where people use the internet are home, work, home of acquaintances, and school.

Internet providers such as America Movil leverage their telephone lines (DSL) to offer internet services. The company has a technological advantage over these competitors because coaxial cable and fiber networks can offer higher internet speeds than DSL (copper) networks.

The company estimates that it holds a 15% market share over the total subscribers of internet broadband in Mexico.

Wired Phone

According to the IFT, there were a total of 26.6 million phone lines in Mexico.

A trend towards mobile devices is decreasing the demand for wired phone lines in homes.

The main provider of telephone services in Mexico is América Movil. Other main pay-tv cable operators, such as Izzi and Totalplay, also offer bundles that group internet services with wired phones.

The company estimates that it holds a 15% market share over the total wired phone lines in Mexico.

Analysis of Megacable’s Business

Business Performance

As mentioned before, the company makes money by selling internet, wired-phone, and pay-tv services through a monthly subscription; as well as offering a variety of services to corporate customers.

Most of the company’s revenue is recurring, providing a significant benefit to its ability to generate cash flow.

In recent years the company shifted its focus from video to the internet. Evidence of this is the company’s significant investments in building and migrating 40% of its subscriber base to a new fiber network. This initiative aims to strengthen the company’s competitive advantage, which rests on its network, to be able to provide higher internet speeds at lower prices than competitors.

In my opinion, this effort to focus on the Internet also shows management’s realization that this business segment is the one that will deliver growth and profitability for the company for many years to come. Pay TV is less profitable than before because programming costs have risen and content providers have significant leverage. Likewise, a tailwind toward adopting mobile devices has reduced the demand for wired phone lines. Up until now, the company’s internet segment has reduced churn and increased RGUs (revenue-generating units) per subscriber.

For example, the following graph shows how growth from internet subscribers has pushed the growth of wired phone subscribers because the company sells these two services together.

Moreover, in the last 10 years, the company’s operations have significantly expanded, thanks greatly to the company’s ability to finance the growth of its network from its recurring cash generation. The following graphs show the growth of the company’s revenue, highly correlated with the growth of the company’s network and homes passed, since increases in these two metrics allow for a higher number of subscribers.

Moreover, by analyzing revenue by subscriber and subscriber growth by segment, we can observe the trend of lower declining growth for video services and a greater significance for internet services.

From 2014 to 2022

Finally, we can observe how the company’s strategy to offer its services through “bundles” has increased cross-selling between subscribers and reduced churn rates.

From 2014 to 2022

Competitive Advantages

The company’s competitive advantages spur from its superior technological infrastructure that enables it to offer higher internet speeds at a lower cost than competitors; and its concession to offer any type of telecom service in Mexico. This concession gives the company the ability to offer pay TV, wired phone, and internet services. Allowing the company to offer a superior product to consumers. The long-term advantages of fiber will gradually become more and more prominent as the amount of bandwidth demand (overall and per consumer) continues to increase. The company is well-positioned to benefit from this transition.

It is important to highlight how, by being able to sell multiple telecom services, the company can increase revenue-generating units. This results in a more efficient use of the company’s network because all these services are given through it. Allowing the company to have a better cost structure because the maintenance cost of the network is less as a percentage of revenue.

It is very hard for a new competitor to enter the telecom industry due to the amount of investment necessary to build a network capable of reaching sufficient users to make a profitable business.

Currently, only a handful of competitors compete with the company in the telecom segments that it operates in.

Business Durability

The durability of the company’s operations is a key point of concern. Up until now, the company has been able to handle reduced demand declining services like pay-tv and wired-phone through “bundles”.

A regulatory change that prohibits the company from selling pay-tv or wired phones together with the Internet could have very negative implications on the company’s operations and profitability.

Main Assets

The company’s main assets are its coaxial cable and fiber network and its operating lease right-of-use assets. Right-of-use assets include the posts owned by the CFE where the company’s network passes through, and other key locations used to provide its services.

At the end of 2022, the company’s network was worth 45,775 million, and the right-of-use assets were worth 1,941 million.

Other necessary assets for the company to operate include accounts receivable and inventory.

Analysis of CAPEX Initiatives and Maintenance Capex

GPON Evolution

In 2020 the company started a project to build and migrate 40% of the company's subscribers to a fiber network (FTTH).

The purpose of this initiative was for the company to be able to offer higher internet speeds to consumers and position itself strategically as demand for the internet continues to increase. The company expects selling broadband internet will represent the majority of revenue in the future. This aligns with the company strategy to provide the highest internet speeds at the best price.

The project concluded in 2022, resulting in the construction of a 24,000 km of fiber (FTTH) network and the migration of 40% of the company's subscribers.

MEGA 2024

In 2022, the company announced MEGA 2024, a plan to reach new locations and achieve national coverage by expanding the company's network.

The goal of this project is to grow the company’s operations through the growth of its network.

In 2022, the company built more than 9,500 km of network.

CAPEX

The company’s CAPEX has significantly increased as a result of the projects mentioned above. The following graph illustrates CAPEX as a percentage of revenue from 2014 to 2022.

Based on the company’s depreciation expense I expect that maintenance capex, the necessary spending to return the company’s assets to their status at the end of the year, is around 20% of the company’s revenue. Depreciation as a percentage of revenue was 19.3%, 19.6%, and 21.4% from 2019 to 2022, respectively.

Profitability

I analyze the company’s profitability by comparing its cash earnings to the amount of capital used to generate them–Return on Invested Capital.

Based on the company’s net operating income after taxes, the cash earnings a company would have if it had no debt or excess cash. And the company’s invested capital, the assets that are necessarily employed by the business to generate NOPAT. The company’s return on invested capital is mediocre.

I estimate NOPAT by multiplying net operating income by the appropriate tax rate of 30%.

I estimate invested capital through an operating approach.

Non-Current Cash Assets - Non-Interest Bearing Liabilities + (PP&E + Operating Lease Right of Use Assets).

I exclude cash and marketable securities from Non-Current Cash Assets because they are not necessary for the company to operate. We subtract Non-Interest Bearing Liabilities, like suppliers, because they finance the company’s working capital.

Finally, I exclude goodwill and intangible assets because they do not represent tangible capital that the company uses to run its business. The company could, for example, pay too much to acquire another business and increase goodwill on its balance sheet. The value of this goodwill comes from an accounting measure and does not represent capital that is necessary for the business to run.

Based on the above, the ROIC for the company between 2019 and 2022 was 13.38%, 13.6%, 13.17%, and 10.5%. 2022 results are likely understated because of bonuses and promotions to new subscribers. However, even when they do reflect, ROIC will likely not increase much above historical results.

Conclusion

At a multiple of 6.8x earnings and 3.9x EBITDA, Mega is selling at a potentially attractive price, however, right now I do not think that there is a sufficient margin of safety considering the mediocre profitability of the business and the risk from declining demand from the segments of pay-tv and wired-phone.

For now, I will keep the company on my radar and continue to analyze how the company’s investments to expand its network affect revenue growth and return on invested capital.

Disclosure: The analysis provided is for informational purposes only and should not be construed as investment advice. I am not a licensed financial advisor, and any decision to invest or take action based on this analysis should be done with careful consideration and, if deemed necessary, consultation with a financial professional.

30 minute read

Updated on Feb 12 2023

Reason for investigation

Cultiba owns 40% of Grupo Gepp, the exclusive bottler of PepsiCo in Mexico, and the owner of Epura, Mexico’s third-largest bottled water brand. Grupo Gepp is profitable, earns high returns on invested capital, and leverages the pricing power of the brands it distributes to grow. Between 2019 and TTM 3Q 2023 the company grew EBITDA from $4,567 million to $7,890 million without requiring much additional capital. Between 2019 and 2022 invested capital only increased 9.8%.

Today only one analyst follows the company and the market is valuing the company’s stake in Grupo Gepp at $7,841 million, in enterprise terms. At this valuation, the company’s stake in Grupo Gepp sells at 2.5 times TTM EBITDA. This is cause for investigation, as competitors sell at multiples between 7-10 times TTM EBITDA and the company sold 11% of its stake in the company in 2016 in a private transaction at a multiple of 7.8x EBITDA. 

Market Valuation of Cultiba

Company Description

Company Description

Cultiba is a Mexican holding company that owns 40% of Grupo Gepp. Grupo Gepp is one of the biggest beverage bottlers in Mexico and the exclusive bottler of Pepsico. It was founded in 2011 as a co-investment between Cultiba (40%), Polmex Holding (40%), and Pepsico (20%). Through its franchise agreement with PepsiCo, Grupo Gepp bottles and sells iconic brands such as Pepsi, Seven Up, Manzanita Sol, Mirinda, Be Light, Lipton, and Gatorade. The company also distributes brands from third parties like Cosecha Pura, Jarritos, Barrilitos, and Squirt. Finally, Grupo Gepp also owns Epura, the third most popular water brand in the country.

Recent Important Events

• In 2011 Grupo Gepp was formed, combining Geusa, Pepsi Bottling Group, and Gatorade de Mexico to create the exclusive bottler of Pepsi Co with nationwide distribution coverage. Ownership of Grupo Gepp was distributed as 51% Cultiba, 20% Pepsi Bottling Group, and 29% Polmex.

• In 2014, to combat rising obesity and diabetes, the government introduced a tax on sugary beverages. This negatively impacted gross margins because bottlers were unable to increase “real” prices that year, as the the beverage tax was passed to consumers. 

• In 2017 Cultiba sold 11% of its stake in Grupo Gepp to Polmex for EU $194 million, equivalent to $3,197 million pesos, at a valuation of $29,063 million or 7.8 times EBITDA.

• In 2022, Cultiba spun off its sugar business due to low profitability and to focus on its beverage segment.

Industry History

The bottling industry was very fragmented during the early to mid-20th century. 

Naturally,  the industry consolidated, larger bottlers started acquiring smaller ones to achieve economies of scale in production and distribution. Larger operations could produce and distribute beverages more efficiently and at lower costs per unit. With scale, larger bottlers had the advantage of a more extensive distribution network. They could sell more volume and ensure their products reached remote areas, giving them a competitive edge. They could also negotiate better deals with suppliers due to their higher purchase volumes. Furthermore, large beverage companies like Coca-Cola and Pepsi preferred to work with bigger bottlers because of their capacity to produce in large volumes and distribute across vast territories. Over time, exclusive contracts and strategic alliances further marginalized smaller bottlers. Gradually, fewer and fewer smaller players were left, which led to the emergence of big Coca-Cola and PepsiCo bottling companies.

Coca-Cola and Pepsi Co. triumphed over other beverage brands thanks to greater advertising budgets, greater distribution, and greater production scale. Economies of scale allowed Coca-Cola and Pepsi to reach more customers, improve advertisement expenses per unit, and get their products at most consumption points (restaurants, convenience stores, movie theatres, hotels, etc). 

Coca-Cola has historically dominated the Mexcian market. In 2002, PepsiCo had a 19% share of the soft drink market, while rival Coca-Cola Co had over a 70% share.

In 2011 there were only 3 main beverage bottlers in Mexico: Coca-Cola Femsa, Arca Continental, and Grupo Gepp. 

Current Market Conditions

Today, the same bottlers that dominated the industry 10 years ago continue to do so. Grupo Gepp has a 27% market share in bottled beverages and a 57% market share in jug water. 

According to Canadean, Mexico is the largest consumer of carbonated beverages at a per capita level, consuming 169 liters annually. The size of this market is immense. The total market size of carbonated beverages was EU$20 billion in 2022. 

Through Gatorade, the company also competes in the isotonic beverage market. Mexico is the largest market for isotonic beverages in Latin America, with a market size of EU$1 billion. From 2017 to 2022 the compounded annual growth rate of this market was 6.5% 

Also important is that Mexico is the largest market for bottled water in the world. Sales of jug water exceeded US$2.480 billion in 2022. 

In the last 10 years, the consumption of soft drinks in Mexico decreased by 8.6%, while consumption of bottled water increased by 17%.

Grupo Gepp is in a good position to face the transition to healthier consumer preferences thanks to the company’s strong portfolio of isotonic beverages and water brands, which include Lipton, Gatorade, and Epura. 

Analysis of Operations

Business

Grupo Gepp has two business segments, bottled beverages of 10 liters or less and jug water. Bottled beverages include soft drinks, isotonic beverages, juices, tea, and bottled water. Jug water is bottled water in presentations of 10 to 20 liters. 

In 2022, sales of bottled beverages and jug water were $54,065 million, and the total volume of cases sold was 1,676 million. Bottled beverages represented 88.3% of sales and 58% of the volume of cases sold. Jug water represented 11.6% of sales and 42% of the volume of cases sold. 

As for price per case, during 2022, the consolidated price per case was $32.6. The average price for bottled beverages was $49.6 vs $9 for jug water. 

The following graph shows the company’s revenue per year.

Cyclicality

As the following graph shows, the company’s operations are not cyclical. The volume of cases sold has remained very consistent for the past 10 years. The volume of bottles beverages per point of sale only decreased -1.3% from 2017 to 2023.

Sales of bottled beverages benefit from wide availability in points of consumption, habit formation, association, and familiarity with brands. A lot of the Mexican population is accustomed to drinking soft drinks during meals and at special events. People associate soft drinks with happiness. Likewise, the price of soft drinks and isotonic beverages is similar to bottled water, as a result, many people prefer purchasing this instead. 

As for the jug water segment, sales are recurring thanks to the company’s 1.2 million client portfolio. The company delivers jug water to its customers directly to their homes every week. This generates recurring revenue.

Pricing Power

Grupo Gepp can leverage the brands it distributes to increase the prices of its bottled beverages and pass inflation to consumers. 

The following graph shows the price per case growth by category per year. 

On the same note, the following graph compares the price per case growth for bottled beverages and jug water vs inflation per year. 

We observe how the company can increase its prices to match inflation. We also observe how bottled beverages have stronger pricing power than jug water. The company has struggled to consistently raise prices of jug water. It is important to highlight the sharp increase in the price per case of jug water of 26.8% between 2018 and 2019–profitability benefited significantly thanks to higher revenue growth relative to costs and expenses.

Higher volumes of cases sold have not been the primary source for revenue growth. As we saw above, the volume of cases sold has remained relatively constant for the past 10 years, meanwhile, the price per case sold significantly grew. 

Price increases and a higher percentage of sales from bottled beverages have driven revenue and price-per-case growth at a higher rate than inflation. This is evidenced by the following graph which shows revenue growth vs inflation per year.

Based on the above, we conclude that the company can increase its prices to meet inflation, and price increases plus a better product mix have been the primary source of revenue and price-per-case growth for the company. 

Strategy to Increase Profitability

It is not a secret that selling bottled beverages is more profitable than selling jug water. Gross margins are higher thanks to greater pricing power, and operating expenses as a percentage of revenue are much lower. In the past years, the company has put effort into optimizing its product mix to sell more bottled beverages as a percentage of total volume. Management has successfully applied this strategy. 

Bottled beverages as a percentage of sales increased from 84.8% in 2016 to 88.3% in 2022. 

Similarly, bottled beverages as a percentage of total volume increased from 51.8% in 2016 to 58% in 2022. 

A higher percentage of sales from bottled beverages and price increases have benefited the company’s profitability. We observe that between 2018 and 3Q TTM 2023 the company’s gross margin increased from 40.5% to 43.3%. Likewise, operating expenses as a percentage of revenue have significantly declined thanks to a higher percentage of sales from bottled beverages–decreasing from 39.5% in 2019 to 34.5% in TTM 3Q 2023.

Are Current Gross and Operating Margins Sustainable?

Big improvements in profitability naturally make us question their sustainability. 

We argue that the current operating margin is sustainable because the company today has a better product mix than before and can increase its prices to meet inflation. If the company can maintain the current percentages of sales and volume of bottled beverages, then gross and operating margins should remain similar to today’s levels. 

Nevertheless, to avoid being overly optimistic, we calculate sustainable operating margins by taking the average from 2019 to TTM 3Q 2023.

Average operating margin: 7.5%. 

Competitive Advantages

Grupo Gepp has competitive advantages of scale and distribution.  This is evidenced by the market dynamics, the returns on capital, and the operating leverage of industry players. 

The bottling beverage market in Mexico is dominated by only 3 companies: Grupo Gepp, Arca Continental, and Coca-Cola Femsa. All players enjoy competitive advantages of scale and distribution, enjoy returns on capital of 18%-21%, and have operating leverage with suppliers.

These advantages act as great barriers to entry for new competitors and have helped consolidate the industry. Greater distribution allows for a higher volume of cases sold and more efficiency in advertisement spent. Likewise, a greater production scale allows for higher gross margins. Naturally, these advantages expand themselves by making these competitors the best bottling partners for big beverage brands. Grupo Gepp is the exclusive partner of Pepsi co in Mexico. Likewise, Coca-Cola has only 2 main bottling partners–Coca-Cola Femsa and Arca Continental. Competing without a franchise agreement from Coca-Cola or PepsiCo is not viable because sufficient scale is much more difficult to achieve. 

We conclude that the competitive advantages of Grupo Gepp arise from its distribution and production scale, which are protected by the high barriers to entry of obtaining a franchise agreement with a beverage partner and investing the necessary capital to buy production facilities and set up a distribution network. 

Business Durability

Competitive advantages of production and distribution scale plus an exclusive franchise agreement with Pepsi will continue to protect the company’s sales and returns. 

The company operates in a non-cyclical industry where product demand is slowly changing. Consumer preferences towards healthier alternatives and government actions to make soft drinks less attractive to consumers are making soft drinks less desirable to consumers. In the last 10 years, consumption of soft drinks decreased by 8.6%, while consumption of bottled water increased by 17%.

Going forward, I expect a continued gradual decline in the per capita consumption of soft drinks and an increase in the consumption of bottled water and isotonic beverages. This does not mean that I expect the soft drink market to vanish. The brands that dominate today: Coca-Cola and PepsiCo, will very likely continue to do so. Moreover, the consumption of soft drinks will likely continue to be part of the Mexican diet, tradition, and culture for many years into the future. Thanks to the current popularity of consuming soft drinks at meals, social events, restaurants, and movie theaters. As well as the psychological factors that drive the current consumption of these drinks: familiarity with brands, habit formation, positive reinforcement, and association. 

My expectation is for the decline of soft drinks to be offset by a rise in consumption of bottled water, isotonic beverages, and other drinks like tea and juices. Grupo Gepp is in a good position to face this transition. The company distributes Gatorade, and Lipton, and owns Epura, the third most popular water brand in the country. Furthermore, the company’s distribution network can be utilized to sell more products that align with evolving consumer tastes. 

We conclude that even though the market is experiencing a change in consumer preferences towards healthier alternatives that are gradually decreasing the consumption of soft drinks; Grupo Gepp is in a good position to face this transition and has a big runway ahead thanks to the strong portfolio of brands it distributes and the scale of its distribution network.

Working Capital Management

Grupo Gepp is a great generator of cash, 65% of sales are paid upfront and 35% of sales are paid in credit. 

Last reported results (2016)

In 2016, the ratio of non-cash current assets to non-interest-bearing liabilities was 1.1. 

Days sales outstanding, which tells you how many days it takes for the company to collect receivables, was 44.5. Inventory days, which measure how many days it takes for the company to sell inventory, was 32.5. Days payable outstanding, which measures how long the company has to pay suppliers, was 66.5. 

The cash cycle for the company is circular: suppliers -> inventory -> receivables -> cash ->

If we consider the above, then the cash conversion cycle, which measures the days it takes for tied-up capital in investments in inventory to be converted back to cash, was 11 days in 2016. We calculate this number by adding the days that cash is tied up in inventory and client receivables and subtracting days payable outstanding. We subtract days payable because it represents a time when cash is not tied up and the company gets financing from suppliers. The company only has to pay suppliers 66.5 days after receiving the inventory, which means that capital is tied up at day 66. If it takes 77 days to receive inventory and turn it into cash, then it means that only 11 days go by between when the company paid for inventory and received cash. 

Current Situation

Since 2016, the company has expanded operating leverage and financing from suppliers. This means that the company has increased the days it has to pay its suppliers by increasing payables. This is evidenced by the changes in the ratio of Non-Cash Current Assets to Non-Interest Bearing Current Liabilities, which has decreased from 1.1 in 2016 to 0.6 in 2022. 

Today the company is operating with negative non-cash working capital, and effectively financing its inventory with credit from suppliers. 

In the case of the company, negative non-cash working capital is not a sign of distress. Rather, it is a sign of high bargaining power with suppliers, constant and non-cyclical sales, and the ability to increase prices with inflation.

Competitors operate similarly. In 2022 and 2021 Arca Continental had negative non-cash working capital, with the ratio of Non-Cash Current Assets to Non-Cash Current Liabilities at 0.85 and 0.82, respectively. 

We conclude that improvements in working capital management together with a higher percentage of bottled beverages and price increases have helped the company increase return on invested capital. However, it is likely that the current operating leverage is unsustainable and will likely return to a level of between 0.7-0.8, closer to competitors and past results. 

If supplier credit is reduced then the company would need to tie more capital in inventory and account receivables, which would increase invested capital. If we take 2019 as a sustainable level of operating leverage and a ratio of about 0.75. Then invested capital would increase by $3,281 million.

Is this a good business?

Grupo Gepp is a good business, this is evidenced by the company’s operations, operational leverage, and profitability. The company operates in a non-cyclical industry that allows it to sell a consistent volume of beverage cases. The company has competitive advantages of scale and distribution and has an exclusive franchise agreement with Pepsi Co. These advantages act as barriers to entry, protect the company’s returns on capital and sales volume, and allow it to have operational leverage with suppliers. Furthermore, the strong portfolio of brands that the company distributes gives it pricing power and the ability to pass on inflation to consumers. As a result, the company can grow revenue with inflation and maintain gross and operating margins. All this gives it a great runway for the future and sustainable operating margins. 

In summary, the company is a good business because of:

• Competitive advantages of scale and distribution

• Exclusive franchise agreement with Pepsi Co in Mexico

• Ability to leverage brands to increase prices with inflation

• Noncyclical operations and consistent cashflow generation

• High generator of cash

• High operational leverage

• Good return on capital (ROIC of 16.5% with a sustainable operating margin of 7.5%)

Financial Position

Since 2016 the company has increased its financial and operating leverage. In 2022, equity to total assets was 0.27 vs 0.57 in 2016. Shareholder’s equity has decreased from $15,093 in 2016 to $8,713 in 2022. 

The rise in the company’s financial and operating leverage is a result of equity reimbursements as dividends to shareholders, an increase in net debt, and higher payables as a percentage of total assets. The latter is connected to improvements in working capital management, effectively increasing the number of days it has to pay back suppliers. 

The following graphs display the company’s financial position. Outlying Debt / EBITDA per Year, Equity / Total Assets per Year, Net Debt per Year.

Is the company at risk of financial distress?

Given that the increase in leverage is mainly operational and that the company generates almost enough free cashflow to the firm to pay its net debt in a year, net operating profit after taxes in TTM 3Q 2023 was $3,711 vs current net debt of $4,816, I do not think that the company is at risk of bankruptcy. 

In the event of financial difficulty, the company could issue long-term debt, use its cash on hand of $1,682 and cash flow from operations, to pay down short-term debt of $5,000 million. 

Furthermore, I expect the company’s operational leverage to decrease as days payables to suppliers decrease and invested capital increases. 

Management

Are management’s interests aligned with shareholders?

We think management's interests are aligned with shareholder’s because Cultiba’s CEO, Juan Ignacio Gallardo Thurlow, owns 66% of the company. Juan Ignacio is also the president of Grupo Gepp. In total, the main shareholders of Cultiba own about 70% of outstanding shares. 

Is management someone we can trust?

Juan Ignacio Gallardo Thurlow is a very respected businessman in Mexico. A close source tells us that he has an excellent reputation and is a person of very high integrity. 

Is management willing to return value to shareholders?

We think management is willing to return value to shareholders through stock buybacks and dividends. Since 2019 the company has returned a total of 2,288 million as dividends, equaled to a return of 28.6% compared to today’s equity market price. The company is also willing to repurchase up to $300 million worth of stock this year. 

Dividends

2019: 1,022 million pesos

2020: $1,288 million pesos

Valuation

I will value Cultiba by adding its NAV plus the equity value of its 40% stake in Grupo Gepp. I will value the company’s stake in Grupo Gepp through a discounted cash flow model in enterprise terms. Then, I will subtract net debt from the enterprise value to find the intrinsic equity value of Grupo Gepp. 

This approach allows us to estimate the value of Cultiba as if we were buying the business as a whole, getting the cash in the holding company plus the 40% stake in Grupo Gepp. 

Cultiba

Equity Value = Cash + Airplane -  All Liabilities

Cultiba’s NAV equals $2,771 million pesos = $2,579 million pesos  + $228 million pesos - $36 million pesos.

The company’s cash position takes into account the capital used in the acquisition of Baja Acqua Farms.

Grupo Gepp - Discounted Cash Flow

Revenue TTM 3Q 2023: $60,445 million pesos

Sustainable Operating Margin: 7.5%

Tax rate: 30%

Net Reinvestment Needs: Adjustment is not needed because D&A reflects maintenance capex.

Changes in Non-Cash Working Capital: Invested capital increases by $3,281 million in 5 years as capital is tied up and operating leverage reaches a sustainable ratio of non-cash working capital to non-interest-bearing liabilities of 0.75. This means a reduction in free cash flow of $656 million per year, for the next 5 years.

Growth Rate: Revenue increases by 4% for the next 5 years; and 3% after year 5. We expect the company’s operations to continue to grow with inflation.

Discount rate: 11%, our opportunity cost for investing in the company.

Intrinsic value in enterprise terms: $40,181 million pesos

Intrinsic value in equity terms: $35,365 million pesos

EBITDA (TTM): $7,890

Net Income (TTM): $2,822

EV / EBITDA (TTM) multiple: 5.1

P / E (TTM) multiple: 12.5

We do not think these assumptions are overly optimistic, the company’s competitors sell at multiples of 8-10 times EBITDA and 15 times earnings. 

Holding Company + Stake in Grupo Gepp 

$16,917 = $2,771 + $35,365*0.4

Downside Protection

At the current equity market value, we can buy Cultiba for around  $8,494 million pesos, get $2,771 million pesos, net of liabilities, and pay 5 times earnings for the company’s stake in Grupo Gepp. This is too low a price for a business that is not at risk of bankruptcy, has clear competitive advantages of distribution and production scale, and is the exclusive bottling partner of PepsiCo in Mexico. 

Furthermore, this valuation provides us with a 49.8% margin of safety vs the intrinsic value of the company based on the cashflows that it can generate. And if profitability decreases significantly to 4.5%, due to fewer bottled beverages as a percentage of total volume sold or other setbacks, then the intrinsic value in equity terms of Cultiba would be $10,103 million pesos, still providing an upside of 19%, vs the current equity market price of $8,494 million pesos. 

We conclude that at current prices, the company provides us with significant downside protection thanks to Cultiba’s cash on hand and the low multiple that the market is placing on Grupo Gepp’s business. 

Risks

• Unable to sell shares if we want to exit investment (this risk is currently reduced thanks to the company’s repurchase program of 300 million pesos)

• Bad capital allocation from management. This is a real risk, management can destroy value through bad investments. Recently, the company acquired a stake in a tuna farm business, an industry that is not related to beverages.

• Profitability decreases from fewer bottled beverages sold as a percentage of volume

Conclusion

We estimate that the intrinsic equity value of Cultiba is $16,917 million pesos. This calculation is based on the cash we can get from the holding company, net liabilities, plus the company’s 40% stake in Grupo Gepp. We estimate the value of Grupo Gepp through a discounted cashflow model that assumes a 7.5% operating margin, 11% discount rate, 4% growth from years 1-5, and a perpetual growth rate of 3%. At this valuation, Grupo Gepp would sell at 12.5 times TTM earnings and 5 times TTM EBITDA, this is an acceptable multiple considering that competitors sell at 15 times earnings and 8-10 times EBITDA. 

Based on our estimate of the intrinsic value of Cultiba, an investment in the company provides an upside of 99%. The market is currently valuing the company at $8,494 million pesos–a multiple of 5.2 times earnings and 2.5 times EBITDA for the company’s stake in Grupo Gepp. This is too low a price for a business that is not at risk of bankruptcy, has clear competitive advantages of distribution and production scale, and is the exclusive bottling partner of PepsiCo in Mexico. Evidence of this is that in 2016 the company sold 11% of its stake in Grupo Gepp at an EV/EBITDA multiple of 7.8. The market is likely valuing the company incorrectly because only one analyst follows the company, shares are not liquid, and the company does not report the results of Grupo Gepp in its consolidated financial statements.

Furthermore, an investment in Cultiba provides us with a 49% margin of safety. If profitability were to decrease significantly to an operating margin of 4.5%, due to fewer bottled beverages as a percentage of total volume sold, then the intrinsic value in equity terms of Cultiba would be $10,103 million, still providing an upside of 19%. 

Regarding liquidity, the company Cultiba has allocated up to $300 million pesos for share repurchases. If we want to exit our position, we can sell our shares to the company.

We conclude that Cultiba is a great opportunity due to the potential upside and low downside from Cultiba’s cash on hand and the low multiple that the market is placing on Grupo Gepp’s business. A business that is not at risk of bankruptcy, is not cyclical and has clear competitive advantages of production and distribution scale.