A Mexican Blue Chip Bargain

Recently, and for the first time in a while, I took a dive into Mexican stocks. The Mexican stock market is much like those of many other emerging markets economies. Trading is concentrated in a short list of leading conglomerates, banks, infrastructure companies, telecoms, and other “investable” stocks. Beneath, there are several dozen other companies that get reasonable attention from locals but rarely attract the notice of foreign investors. Bringing up the rear are another few dozen small, thinly-traded stocks of interest only to the truly deranged. My focus is, of course, on these neglected companies.

I am long-term bullish on Mexico. The country’s problems with lawlessness, corruption, and the illicit drug trade are well-documented. Less well-known is the fact that despite these issues, Mexico’s per capita GDP is up 53% this century. Millions of Mexicans have achieved middle-class status in the last decade, and Mexico itself is now a “middle-income” economy. The population is both young and better-educated than ever, and this will translate to continued growth in discretionary income.

While I see positive trends at work in the economy, the Mexican stock market is another story. For years, the exchange has suffered from a dearth of new listings, declining volumes, and some notable departures from buyouts and mergers. The ten-year (price only) annual return for the main Mexican stock index is a woeful 2.2%. While the Mexican government and the exchange are working on initiatives to encourage IPO activity and make it easier to raise capital, it could be a while before any positive impact is felt. Interest rates are another confounding factor. With no point on the Mexican yield curve offering less than 9.5%, it is difficult to convince investors to come off the sidelines and buy equities.

Still, I am excited by the value that Mexican equities offer. Today, I would like to present a family-owned consumer packaged goods manufacturer with incredible brands, multiple partnerships with blue chip American food companies, solid capital allocation, and a bright outlook.

Grupo Herdez, founded in 1914, is a major Mexican food company. Herdez has a dominant position in several different grocery store categories, including mayonnaise and pre-made salsas. The company’s market capitalization is MXN 15.2 billion, or USD $900 million.

Grupo Herdez is lead by Héctor Hernández-Pons, grandson of the company founder. CEO Magazine did a brief profile of Mr. Hernández-Pons in 2021. The interview touches on one of Mr. Hernández-Pons’ signature achievements: the 2009 establishment of MegaMex, now a significant contributor to the company’s earnings. Here’s another interview in Spanish in Forbes México.

Grupo Herdez conducts its business mostly through partnerships. The company’s major earning assets are:

• A 50% interest in McCormick Mexico. The remaining 50% is owned by who else but McCormick & Company, the stalwart spice and seasoning company. The partnership was established in 1947.

• A 50% interest in Barilla Mexico. Barilla is the ubiquitous blue-boxed pasta brand. Barilla is privately-held by the founding Barilla family.

• A 25% indirect interest in MegaMex, a 50%/50% joint venture with Hormel. MegaMex exports Mexican foods to US markets. Pre-prepared guacamole is a major product of theirs, as are tortillas and many other Mexican specialties.

Besides these top-flight joint ventures, Grupo Herdez has a wholly-owned “Impulsos” division that operates retail storefronts offering ice cream and other frozen treats. Unfortunately, this business was severely impacted by COVID and is still struggling to regain its former profitability. Grupo Herdez is working on a number of pricing and product strategies to improve results, and it is making progress. As is, Impulsos is something of a call option. The division operates just under breakeven but could be worth a substantial figure if it manages to restore margins to prior levels.

Here’s a look at just some of the brands that Grupo Herdez offers in the United States and Mexico, from a company presentation. Recognize any? I bet you do!

It’s difficult to overstate just how dominant Herdez’s brands are. The company has huge market share in Mexican supermarkets. Herdez is number 1 or 2 in 10 different categories of popular, frequently-purchased items.

Clearly, Grupo Herdez occupies a strong competitive position. Grupo Herdez’s products are household names. Most of these brands are past their high-growth eras, but they will be reliable sellers for a long time to come. Consumer staples businesses like Grupo Herdez usually trade at some premium to the market in general, based on the perception of strong and predictable profitability and defensive characteristics. Customers may opt for cheaper items in a downturn, but everyone needs food.

Grupo Herdez’s partners are valued highly by the market. McCormick & Company trades at 27x trailing earnings and 18x EBITDA. Hormel trades at 24x earnings and 16x EBITDA. The 500-pound gorilla that is the Kraft Heinz Company is a comparative bargain at 15x earnings and 10x EBITDA, but Kraft’s troubles with tired brands and consumer pushback on pricing are well-known.

McCormick has a 5-year revenue growth rate of 4.7% and EBIT margins averaged 16.9% over the period. Hormel’s revenue growth was 4.9% and its EBIT margin averaged 10.4%. Kraft Heinz’s revenue was essentially flat, but at least its EBIT margin averaged a healthy 21.0%.

For its part, Grupo Herdez recorded five-year annual revenue growth of 11.5% and an average EBIT margin of 12.5%. This EBIT margin figure includes the losses of the Impulsos division. Excluding Impulsos, the 2023 EBIT margin was 16.9%.

Despite much better revenue growth and comparable profitability, Grupo Herdez shares trade at only 11.6x earnings and 5.8x EBITDA. For both ratios, I have adjusted the figures for the non-owned portions of McCormick Mexico and Barilla Mexico. MegaMex is equity-accounted, so the actual EV/EBITDA ratio would be lower using proportional consolidation. Return on equity hovers in the mid-20s despite a significant corporate cash buffer.

Here is Grupo Herdez’s fourth quarter 2023 report. It was a great year for Herdez, despite the continued losses in the Impulsos segment. Every segment saw increases in revenue and operating results. The company paid down debt and benefited from the late 2022 acquisition of Mediterraneo, a producer of Lebanese snacks and dips. Free cash flow generation was excellent. Both strong earnings and normalizing working capital levels contributed.

I also recommend checking out this English language presentation which gives a more qualitative overview of the company’s product line, operations, and strategy. The company also conducts its quarterly earnings calls in English.

I think Grupo Herdez shares are way, way too cheap. A more reasonable price/earnings ratio of 18x would put shares at MXN 71, 55% higher than today’s MXN 46. An 8x EBITDA multiple would put shares at MXN 75.

My valuation assumes no change in the status of the loss-making Impulsos segment. If this segment’s profitability improves or Grupo Herdez chooses to wind it down, the benefit to earnings would be substantial.

I know what you may be thinking. The financials might look good and the valuation may be compelling, but this is an emerging markets company. And emerging markets companies are notorious for mistreating shareholders, particularly when they are controlled by a single person, family, or entity, like Grupo Herdez is. Cash flows, profits, assets, they’re all wonderful. But they may as well not exist if shareholders don’t see the benefits. Just ask anyone who has sent their money to languish on the Hong Kong or Singapore stock exchanges, myself included.

Fortunately, Grupo Herdez has a long history of treating shareholders well. The company rewards its owners with steady dividends and share repurchases. Acquisitions and investments are performed only when they conform to sound financial logic, not out of vanity or for empire building. Since 2013, Grupo Herdez’s share count is down 24%. Recently, the company has hit the pause button on repurchases, opting instead to pay down debt. Entirely sensible when doing so earns a risk free pre-tax return of 10%. If and when interest rates decline, the company will return to buying back shares.

Now for the risks. I don’t think it’s right to discuss a stock without mentioning the negatives and the risks, whether actual or merely possible. Among them are:

• Currency fluctuations. The Mexican Peso has been very strong against the US Dollar lately. This reduces the profits that Grupo Herdez earns from exports and from the MegaMex segment. On the other hand, a weaker Mexican Peso would increase these profits. Herdez’s substantial US-derived revenues and earnings provide a natural hedge for USD-denominated investors.

• Commodities fluctuations. Grupo Herdez may have difficulty passing through increases in inputs costs. Additionally, some segments are particularly sensitive to changes in the cost of agricultural products. The company identifies avocados as a large input cost for MegaMex, causing profits to decline when avocado prices surge.

• Changing consumer behavior. Marketers and economists have long pointed out how Mexican consumers are unusually loyal to national brand names, preferring them over store brands or generic label products. If this were to change, it would be to Grupo Herdez’s detriment.

• Political risk. Mexico is a relatively well-functioning Western democracy, but its politics can be “colorful.” The election of an anti-corporation and/or “anti-elite” populist government would be a negative.

• Controlled company. Insiders own about 70% of Grupo Herdez shares. They call the shots. They have called them well over time, but shareholders have little recourse if management goes off the rails.

Despite these risks, I think Grupo Herdez represents a compelling opportunity. Buying dominant consumer franchises with healthy balance sheets, good growth potential, and capable management at <12x earnings typically works out well over a reasonable time frame. Grupo Herdez shares trade at low volumes but relatively consistently on the Mexican Stock Exchange. It could take time for investors to rediscover “off the run” Mexican equities. As I noted above, it is difficult to make the case for Mexican equities when Mexican bonds are yielding 10%. But Grupo Herdez will continue growing its earnings, making the occasional smart acquisition, and returning capital to shareholders. At some point the market will take notice.

Alluvial Capital Management, LLC holds shares of Grupo Herdez, S.A.B. de C.V. for client accounts it manages. Alluvial Capital Management, LLC may hold any securities mentioned on this blog and may buy or sell these securities at any time. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at info@alluvialcapital.com