Cook & Bynum Fund commentary titled, “A New Investment: Corporacion Lindley SA.”
Based in Lima, Corporacion Lindley SA bottles, distributes, and markets soft drinks, fruit juices, water, sports drinks, and concentrate in Peru. The company has the exclusive rights to produce Coca-Cola products in the country, including Inca Kola, which is the top-selling carbonated drink with a 33% market share (Coca-Cola is a strong #2). We have followed the business for some time, and since the fall of 2014 we have visited Peru three times to meet management and to survey execution at the point of sale. This research suggested that execution could be improved and that certain parts of the business needed more investment. The underlying fundamentals of the company’s end markets are attractive, however. In Peru, annual per capita consumption of Coke products is only 220 eight ounce servings, which is smaller than the 250 in poorer Bolivia. As a frame of reference, per capita consumption is 720 in Arca Continental’s Mexican territory, while per capita consumption in Chile and the U.S. is greater than 400. We expect countries with per capita GDPs similar to Peru to steadily switch to ready-to-drink products over the next 20 years. We were intrigued by the business given these attractive demographic tailwinds, but we were hesitant to invest given the company’s operational challenges and capital needs.
Fortunately, in September 2015, Arca Continental agreed to acquire a controlling interest in the business. Controlling distribution territories in Mexico, Argentina, and Ecuador, Arca is one of the Fund’s longest and best-performing holdings, and in our opinion, it is one of the best Coke bottlers in the world. Armed with investment capital, Arca’s team is uniquely positioned to build and execute a plan to seize all of the operational opportunities that we discovered at Corporacion Lindley. Their initial plan for improving the business includes a number of initiatives:
- Overhaul point of sale execution to drive revenue gains:
- Improve display/presentation and product mix, while also introducing additional products that will be new to the Peruvian market;
- Expand single serve sales, which is more profitable than selling large, familial sizes and is only 40% of current company volume (Mexico has 60%+ single serve);
- Refine price segmentation, including a better packaging mix;
- Introduce route to market analysis to better segment customers; and
- Increase cooler penetration in stores (Peru lags many markets).
- Materially improve distribution across the Lindley network to improve customer service and decrease delivery costs:
- Re-think distribution to mom & pop stores, with an opportunity to bring in-house the 85% of this effort that is currently outsourced to a 3rd party (controlled distribution is more consistent and more responsive);
- Build a vending machine network; and
- Reconfigure company-wide distribution given the new state-of-the-art plant that is now on-line south of Lima and the opportunity to bring drinks from Arca plants in Ecuador to Lindley’s customers in Northern Peru.
- Remove/reduce costs from Corporacion Lindley’s cost structure by using Arca’s economies of scale on a number of fronts, including greater purchasing power on raw materials, lower insurance costs, and cheaper software usage and implementation.
This improvement plan has been in motion for the last six months or more. We visited with Arca’s team in Ecuador, Peru, and Mexico earlier this year, and Arca’s first quarter report shows that the company is already making progress in Peru. Through these aforementioned efforts, we believe that Arca will be able to grow Corporacion Lindley’s revenues, profit margins, and cash flow at growth rates well above average over the next five years. Additionally, management has a proven track record of these types of gains as it has improved operations and grown profits substantially in the years following all of its previous acquisitions. From a valuation perspective, the per share price we paid for the Fund’s stake in the business represents an enterprise value of around 7.5x 2016 EBITDA, which is unadjusted for the profitability gains that we expect under Arca’s ownership/control. Latin American bottlers have typically traded at 9.5x EBITDA.
We are optimistic about the prospects of this new investment. We believe that, in Arca, we have an ideal partner to maximize the potential of an already strong and growing business in a country that will increase its consumption of Coca-Cola and related products over the coming decades. We hope to be long-term investors in Lindley.
Arca & Coca-Cola UNITED
To date, Arca’s beverage business has essentially been confined to Latin America. In a transformative move, Arca reached an agreement last month to assume control of its first bottling operations in the United States, which includes most of Texas and parts of Oklahoma, New Mexico, and Arkansas. Through a newly created joint venture that will house these US assets, Arca will become operating partners with Birmingham-based Coca-Cola Bottling Company UNITED. UNITED is privately held, and we have long admired its management and operation. We are confident that our friends in these two companies will bring to bear a set of best practices that will both enhance volume growth and improve profitability in an economically and demographically promising footprint in the US. We look forward to following their collective progress closely.
Corporacion Lindley – Increasing Our Odds
As the new Corporacion Lindley investment reflects, our mandate (i) is focused on finding attractive investments one-by-one and (ii) affords us the flexibility to invest capital only when we think an investment is truly compelling on an absolute basis. We assess individual investment opportunities based on our estimate of their expected returns and the likelihood that the underlying businesses will perform close to our expectations for them. This decision-making process is an exercise in assessing probabilities, and we are constantly trying to stack the odds for success in our favor. We believe two particular factors are most important for accurately predicting which investments will do best over the long-run:
- The first is the sustainability of a company’s moat. A sober assessment of a company’s competitive advantages and how long they will last is the key to understanding the long-term cash-generating prospects of a business, and hence, estimating its intrinsic value. Often this evaluation cannot be done effectively, and an investor should put the company into the “too-hard pile” and just move on. However, higher quality businesses do have competitive characteristics that allow an investor to project a company’s results to the right order of magnitude 10+ years into the future. Sometimes these advantages are on the supply side, but more often the best businesses have demand side advantages (pricing power, lack of suitable substitutes, no dependence on complementary products, patents, better R&D, etc.) that make future profitability more predictable.
- The second factor is a company’s current stock price. In what we consider a ‘law’ of investing, future returns from an asset are inversely related to the price paid for it. Buying a stock at a price that is a meaningful discount to its intrinsic value serves to prevent permanent capital loss – the biggest enemy of long-term outperformance – when an investor makes a mistake in his analysis while also providing for outsized returns when that analysis is correct. In other words, buying at an attractive price both decreases risk and increases potential return.
Alas, market participants usually value businesses with great moats accurately. When an investor can acquire such a business for a cheap to fair price, however, history suggests that Mr. Market will likely catch on sooner or later and reprice the business close to its intrinsic value, rewarding the patient investor in the process. We are in search of just such opportunities that offer both of these dynamics and meet our other core investment criteria. Richard will be in Europe in July for a series of company meetings in Germany and a few other surrounding countries. We plan to spend time in South America during the fall evaluating the ongoing progress of Corporacion Lindley, Arca, and Embonor, while also visiting with additional companies to further our understanding of what we own and hopefully identify some new opportunities.