Defensive stocks typically do well in more economically challenging times, and with COVID-19 convincing more people to stay at home, Gruma (OTC:GMKKY) (OTC:GPAGF) (GRUMAB.MX) has definitely benefited in terms of volume and margins. While the tailwinds that are driving higher volumes and margins today will almost certainly abate, if not reverse, in a year or two as life goes back to normal, I do believe Gruma may be picking up some long-term market share that will drive improved long-term results as well.
I liked Gruma back at the start of the year, before COVID-19 was on the radar, and the illiquid U.S. ADRs have risen about 20% since then, while the much more liquid local shares have risen a little more than 25%. I would describe the opportunity here today as okay, but not compelling – with a few quarters of EBITDA beats in hand (including two straight double-digit beats), I think the word is out about Gruma’s qualities, but the shares aren’t really expensive on a mid-single-digit long-term growth outlook.
Strong Performance From Shifting Habits
The last two quarters have been good ones for Gruma, with revenue up 25% in the second quarter and 16% in the first quarter on volume improvements of 4% and 6%, respectively. In the two key geographies, the U.S. and Mexico, revenue has improved 14% and 10% in the second quarter, and 38% and 8%, as business lost to the foodservice chain as been more than recovered by improved at-home consumption. The U.S. business has also benefited from much better price realizations, with the company successfully passing through a mid-single-digit price increase and also seeing a mix shift towards more premium products (gluten-free, low-carb, et al).
That growth in the U.S. business has driven very strong margin leverage, with gross margins improving from the low 40%’s in 2019 to the mid-40%’s (44% in Q2). That may not sound like an especially large improvement, but when you have a business with high fixed costs, it’s meaningful. That stronger gross margin has driven 44% EBITDA growth in the first quarter and 15% growth in the second quarter, even as COVID-19 has created some new short-term cost headwinds in the business.
Will The Benefits Last?
Gruma has surprised the Street with its volume strength, moreso in the U.S. than in Mexico, but both regions have been stronger than expected (particularly in the second quarter). The real question is how durable these changes will prove to be.
Foodservice is a major market for Gruma in the U.S., with around 60% of sales coming from that channel. Thus far, increased at-home consumption has more than compensated for this, as Nielsen numbers indicate the company is picking up share within its category and from other competing products (flat breads, etc.). The shift from foodservice to retail has also boosted margins, as retail channel margins are typically stronger for the company.
I do expect the retail/foodservice mix to rebalance as the impact of COVID-19 fades over time and as dining habits renormalize. Maybe there will be a longer-lasting shift away from sit-down dining towards take-home, but I don’t believe where people choose to eat would impact Gruma’s product categories all that much.
The “healthy eating” trend is harder to predict, as it’s driven more by consumer whim than any real science. Low-carb is popular today, as is gluten-free, but that may reverse at some point. Gruma has shown itself to be adept at developing new products (flatbreads, wraps, chips, etc.), but at the end of the day there are only so many permutations of corn flour.
I’m more interested in the possibility of a longer-term shift in the Mexican market. While Gruma is far and away the leader in its category in Mexico, about two-thirds of the market for tortillas in Mexico still uses the “wet corn” method. That’s a more hands-on, time-intensive method, and I’m guardedly bullish on the idea that once tortillerias and home cooks switch to the dry corn method (which COVID-19 may be encouraging, as it is less labor-intensive), they’ll stick with it, expanding Gruma’s long-term addressable market.
I believe management is executing well in the U.S., or at least on the revenue side of the business. New product introductions have driven improved volumes and price mix, as well as margins. While there may still be some work that can be done on the margin side, the U.S. business already has above-average margins that are pretty healthy at close to 20% (EBITDA).
I believe execution in Mexico has also been relatively strong, though it remains to be seen if the company can hold on to these recent share/volume gains. While margin improvement is still a long-term possibility, the difference in consumption patterns in Mexico make it likely that they’ll never be as strong as in the U.S. – packaged tortillas aren’t very popular, and so Gruma will never have quite the same leverage to packaged retail product margins as they do in the U.S..
Given Gruma’s recent success in gaining share in the U.S., I’m a little more bullish about the long-term revenue growth prospects, and I’m now looking for long-term revenue growth a little north of 5%. I do expect some headwinds over the next couple of years as at least some of the benefits of changing consumer behaviors reverse, but I do think Gruma’s success in carving out more category market share will preserve a higher level of growth relative to my prior expectations.
I haven’t changed my margin expectations as much, as I want to see more evidence that recent improvements can last even when foodservice become a bigger part of the mix again. I’m guardedly bullish that margins can be higher (a richer mix of higher-margin retail products), but I don’t see the need to get ahead of the numbers, and I am still looking for long-term FCF growth on the higher side of the mid-single-digits.
The Bottom Line
Gruma’s share price is sandwiched between my DCF-based fair value, which suggests a total expected annualized return in the mid-to-high single-digits, and my EV/EBITDA-based fair value, which still suggests double-digit upside. I don’t think Gruma shares are clearly undervalued anymore, and the company is now well-appreciated and well-understood for its defensive traits, but I think there could still be some decent long-term potential for investors.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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