Gruma S.A.B. de C.V. (GMK)

jpenabad (60.58) Submitted: 7/13/07 3:17 PM : Start Price: $14.92 GMK Score: -8.30

I believe Gruma is the dominant player in the tortilla industry in the US that is enjoying fabulous growth due to demographics (growth of Mexican food popularity and Hispanic population) and is the hands down leader in corn flour in Mexico (75% market share) that is the primary input for tortillas. Due to political factors and soaring corn/wheat prices, the company's profitability is due to suffer in 2007. But looking into 2008 and 2009, the company should see a rebound in profitability and I believe the shares are worth $22 per ADR, implying upside of 47% from today's price. I love this stock anywhere from $13.50 down.

Gruma is the leading producer of tortillas and corn flour in the US and corn flour in Mexico. Their tortilla brands in the US are sold primarily under the name Mission in the US and they supply corn flour to chip makers as well. To say that they are the dominant player in this market is an understatement - they have 30% market share for tortillas in the US and an estimated 75% market share in corn flour in Mexico. The second closest competitor in each market is at 10% in the US. Furthermore, they are the #1 supplier of wraps/tortillas to McDonalds, Chipotle, and Taco Bell, just to name a few. And last, but definitely not least, they own a 10% stake in Grupo Financiero Banorte, a publicly traded Mexican bank that has been performing terrifically for the last two years due to the boom in consumer credit in Mexico.

How important is the bank stake? Let me spell out the math: Gruma has 482.5 mm shares and trades at P$40 (the ADR is at 4:1), equalling a market cap of P$19.2bn. They own 199mm shares of Banorte, which trade at P$50 per share. Assuming they pay 15% taxes on these shares, you have a value of P$8.5bn of value in shares. So today, you get the core business for the equivalent of P$22 per share (P$19.2 - $8.6bn from Banorte divided by 482.5mm shares). Essentially, you are buying the core business at 0.7x sales in 2007, 7x 2006 EBITDA and 13x EPS for the #1 producer of these products in Mexico, with an enormous competitive moat. For the book value junkies in the crowd, it also trades just below replacement cost with most of its assets in the U.S.

So why do I like it? I think the company at today's prices is trading at 5x 2009 EBITDA an 8.5x 2009 earnings. The issue is that due to soaring corn prices, input costs are soaring. At the same time, the Mexican gov't has put a moratorium on price increases through August 15. So Gruma's cash cow business, the Mexican corn flour biz (GIMSA), has seen margins cut by 60%. However, this is temporary as the company will soon be able to raise prices again and will quickly regain margins. I have gotten comfortable with their ability to raise prices in Mexico. Furthermore, their US business has not been raising prices as quickly because smaller suppliers have kept prices lower in order to keep up volumes. So Gruma's volume growth has slowed down and it hasn't been able to pass along additional price increases. Sounds bad right? However, there is only one of two ways this plays out, in my mind. Either corn prices come down (which they have), which helps Gruma by increasing margins again, or corn prices go up more, which would force the smaller players to increase price with Gruma. Increasing prices would lead to improved margins as well. What if corn stays at today's prices? Well you might see the industry take longer to pass along prices, but eventually it will happen. Prices rising or falling just bring about improvements more quickly. Can you increase price in the US? Before, this was much harder. But as wraps become more and more popular, passing along an additional $0.10 per package of wraps becomes a lot easier since the end consumer is wealthier.

There are some other issues here, such as their Venezuela operation. At this point the company will sell it at a decent price, so I imagine it will be gone in 12-18 months.

Overall, I believe you are buying a market leading business in a boring industry that, although Mexican in name, gets over 60% of its profits from the US. It is cheap due to temporary factors and its comps trade at 8-9x forward EBITDA on average. Buying the market leader at 30-50% the market multiple combined with the bank stake and with a clear view on how this cloud on the industry should go away, this company just seems way too cheap.

I am not an aggressive buyer here, but would buy at US$13.50 and below. I think the 2Q earnings will stink and moreover, I think management will have to take down guidance on this call. Be patient and pounce as this comes below US$14.

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