GMKKY - Gruma: Standing Out With Pricing Power And Potential Oncoming Margin Leverage

2023-08-29 09:00:00 ET

Summary

• Thanks to its strong brand value, Gruma has been able to increase prices without losing volume or market share in the U.S.
• Lower grain prices in 2023 may improve the company's margins in the coming quarters, allowing for 16%-plus EBITDA margins and mid-teens ROICs.
• Leverage in Mexico is a riskier proposition, as an upcoming election cycle could drive more conversations around food prices and affordability.
• Between demographics, ongoing product innovation, and steady operational improvements, Gruma still looks undervalued even after a run of noticeable outperform versus the broader sector.

Gruma ( GPAGF ) has given me no reasons to regret my bullish call on this world-leading producer of tortillas and corn flour back in April of 2021. Cost inflation has certainly limited margin expansion, but the company’s strong brand value has allowed the company to push through significant price increases without losing volume or market share, and lower grain prices in 2023 do improve the prospects for margin leverage in the coming quarters.

With the local shares up more than 20% since my last update, Gruma has outperformed comparables/peers like Grupo Bimbo ( GRBMF ), ConAgra ( CAG ), General Mills ( GIS ), and Kellogg ( K ). I do see some risk to the business in Mexico this year, but overall I continue to see a path to long-term revenue growth in the neighborhood of 4% to 5% with improving margins and asset efficiency driving double-digit free cash flow growth. Even with the run of outperformance over the last couple of years, Gruma shares still look 10% to 20% undervalued to me and I think they’re worth consideration, though sentiment around global packaged foods companies is not great now.

Price Or Volume – Why Not Both?

One of the themes among global packaged foods companies in recent quarters has been the trade-offs between pricing and volume. With improved plant availability/capacity leading to better in-stock positions for private label products, price hikes among branded companies have driven meaningful volume share to private label, mitigating some of the benefit of those price hikes.

Not so for Gruma, though. Gruma has been aggressive with price hikes in the U.S. (up 20% year over year in Q1, 23% in Q2, and still up around 10% in recent Nielsen data for August), but volumes have continued to grow over that time – Q2’23 volume rose about 1% and Nielsen-reported volumes in August are up around 4% year over year. I believe this argues for the brand value that Gruma holds in brands like Mission and Guerrero , as well as the efforts the company has taken over the years to launch premium products (including flatbreads/wraps, low-carb products, and so on).

What happens next will be fascinating to me. Conventional wisdom holds that companies like Gruma seldom make meaningful cuts to their list prices; there may be more promotional activity including coupons and so on, but few outright price cuts. The “but” to that is that conventional wisdom wasn’t built over/through an era that included double-digit price increases. To that end, while I see less price risk here than for many other branded foods companies, I won’t go as far as to assume there won’t be some pressure on pricing in 2024 and beyond.

Cost Relief May Be Coming

Pricing activity among food companies has been driven in no small part by costs, and Gruma is no exception. With higher input costs (including grain, energy, labor, and logistics/transport), these price hikes haven’t really translated into meaningful margin leverage. Gruma’s U.S. prices have increased more than 50% relative to 2017-2019 levels, but EBITDA margin has moved from 16.2% in 2019 to 16.9% in 2020, 15.9% in 2021, and 14.5% in 2022.

There could be some relief in sight. Grain prices are a significant part of Gruma’s cost base (corn alone is almost 40% of company-wide COGS and over 60% in the Mexican operations), and grain prices have been heading lower this year – corn prices are down about 25% year-to-date, while wheat prices are down about 30%.

I do expect grain prices to create a tailwind for Gruma, but there are some potential risks to consider. This year (2023) is another El Niño year and in the past this atmospheric phenomenon has led to warmer, drier weather in crop-growing regions, driving lower yields and higher prices. This is also an election year in Mexico and election cycles there tend to drive a lot of jawboning over the cost of basic staples like corn flour and tortillas. Likewise, there’s been more talk of late about banning or at least heavily restricting the import of transgenic corn in Mexico, and that would almost certainly push costs up for Gruma.

Keep On Keeping On

While I’d love to list a lot of dramatic self-improvement projects underway at Gruma right now, that’s just not the case. The business runs pretty efficiently as is, and I don’t see any significant operational changes in the near term. At most, I would expect to see past investments into capacity in developmental markets like Europe slowing start generating better results, but these are multiyear initiatives/drivers.

In the meantime, I expect to see the company continue doing what it has been doing – developing new premium products for the U.S., further refining sourcing, manufacturing, and distribution in major markets (the U.S., Mexico, Central America), and looking for incremental growth and expansion opportunities in markets like Europe and Brazil.

Looking back at second quarter results, Gruma logged reported revenue growth of 6%, with U.S. sales up 5% (up 23% in local currency) and Mexico sales up 19% on low single-digit year-over-year volume growth in both regions. Gross margin improved slightly from the year-ago period (up 20bp to 35%, and up 90bp from the first quarter), and EBITDA rose 12% on 20% growth in the U.S. that more than offset 25% contraction in Mexico (though up 54% quarter over quarter). Results in Mexico were impacted largely by costs, with gross margin down 280bp (to 22.6%) and combining with higher distribution costs and sales commissions to drive weaker EBITDA (margin down 480bp to 8.1%).

Clearly the Mexico operations would benefit from a period of sustained cost improvement, as I think aggressive price action in an election year could well attract unwanted attention. As I laid out above, I think that cost improvement can come from lower grain prices, but I’d also note that the U.S. operations have long generated the majority of Gruma’s overall profits, so weaker results in Mexico don’t hurt the business as much as you might otherwise think.

The Outlook

I continue to expect Gruma to generate long-term revenue growth in the 4% to 5% range. Growth in the U.S. should continue on the back of demographic changes (a larger Latin American population), changes in eating habits, and premiumization, and I believe the Mexican market still offers upside from share growth in the “dry corn” method of making tortillas (which would drive more use of Gruma’s masa harina), as this is a faster, more convenient approach.

On the margin side, I do think that Gruma can get back to 16%-plus EBITDA in 2024 or 2025, and I believe that improved operating efficiency (a richer mix of premium product, increased volume leverage in existing plants, increased logistics/distribution efficiency, et al) and improved asset utilization (running more volume/revenue through existing plants) can help drive around 100bp to 125bp of long-term upside to free cash flow margins, leading to double-digit growth in free cash flow.

Between discounted cash flow and a margin/returns-based EV/EBITDA approach (using a 9x multiple), I get a fair value range that translates into around 10% to 20% of near-term (12 months) upside and an okay long-term total annualized potential return.

The Bottom Line

Sentiment is not especially strong with packaged foods companies right now, but I think Gruma can continue to stand out in positive ways. Although the company is not completely in the clear with respect to improving costs/margins over the next 6-18 months, I think the odds favor improvement and I see Gruma as a well-run company with above-average long-term growth potential driven by both demographics and self-improvement (especially product development/premiumization).

While I’m a little nervous about recommending the shares after such a strong recent run (outperforming other packaged foods companies, excluding Bimbo, by around 35% to 40% over the past 12 months), the numbers do still support upside from here and I don’t see evidence of cracks in the near-term performance trajectory.

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