Archives: Case Studies

In the fall of 2020, Liberty Latin America (LLA) completed the purchase of AT&T’s wireless business in Puerto Rico at an attractive price, merging LLA’s dominant fixed internet business on the island with AT&T’s dominant wireless business. We expect the convergence of fixed networks with wireless networks to continue for the next decade around the world. These mergers allow significant synergies as more of the wireless traffic can be offloaded at a low cost to the fixed infrastructure, the fixed connectivity deep into neighborhoods greatly reduces the cost of deploying 5G, customer churn is reduced, and customer servicing costs fall with some of the savings shared with the customer improving the offer. LLA is also pursuing this strategy of fixed/wireless convergence in Chile and Costa Rica, so we wanted to study its progress up close in their biggest market.

A couple of weeks ago, we were thrilled to have the opportunity to spend a day with Liberty Puerto Rico’s CEO, Naji Khoury, and his outstanding team. We spent time discussing their strategies for integrating the two systems and merging the customer relationships. We also discussed the business challenges and opportunities for Liberty Puerto Rico specifically and across the telecom industry. We visited one of their stores with Naji to learn how they are adapting to service fixed and mobile customers in a single retail format. We also spent time in the field with Ricardo Portela, the VP of Technical Operations, and a crew that was deploying new fiber optic cable to homes in a neighborhood and converting an existing hybrid fiber-coaxial (HFC) cable block to fiber. Essentially all new builds in Puerto Rico and across LLA are fiber to the home (FTTH). The cost to deploy fiber has declined and the costs to operate a fiber network are lower than HFC making fiber the future of fixed internet connectivity.

Figure 1. Cook & Bynum team and Liberty Puerto Rico team together in San Juan

Serendipity is an important part of on the ground research. While on the island, we made connections with smaller competitors and learned a lot from their perspective on competing with Liberty Puerto Rico. On the wireless side, we visited several stores of our two primary competitors, America Móvil and T-Mobile. Importantly, we also learned how frequent power outages are on the island since Hurricane Maria. The government-owned electric utility has been mismanaged for decades. As a result, most middle-class Puerto Ricans have some backup plan for dealing with these outages including generators, batteries, and solar panels. Management of the transmission and distribution part of the utility was recently privatized, and power outages should improve over the next few years. These outages impact Liberty Puerto Rico’s competitiveness. HFC cable systems require a power source at the junction boxes in a neighborhood to operate. When the power goes out in a neighborhood, the internet connectivity does, too. However, FTTH systems only require power at the modem in your home to operate since the signal is carried via light pulses down the fiber to a node. This difference during power outages is not material in most places in the world, but the high frequency of power outages in Puerto Rico makes it a meaningful competitive differentiator. We could not have learned of this competitive threat without visiting Puerto Rico.

In November of 2020, the FCC announced the results of the Uniendo A Puerto Rico Fund, a fund subsidizing the construction of a fixed broadband network to the entire island. Liberty won 55% of the municipalities and dollars ($71.5m) available in this process, with the remainder going to America Móvil. Each company will expand their network to provide all homes in each municipality with at least 100Mpbs service. We were encouraged that none of the small fiber overbuilders or wireless broadband competitors won any of the FCC money. We see the outcome of this process as creating a big disincentive for further overbuild on the island. In addition to the fixed broadband money, Liberty Puerto Rico has won $100m to improve its wireless infrastructure.

A few conclusions are worth sharing:

• Liberty Puerto Rico’s business is operating at a high level with significant momentum.
• We were impressed by the clarity of the objectives and the depth of the team at Liberty Puerto Rico.
• The financial benefits of fixed/wireless convergence will begin in the fourth quarter of this year and accelerate as we move towards the end of 2023.
• We expect the fixed/wireless convergence to work by increasing profits in Puerto Rico and many other markets around the world. This is significant because LLA is pursuing a similar strategy in Chile and Costa Rica.
• Liberty Puerto Rico’s most important competitor is America Móvil. In Puerto Rico, America Móvil is poorly managed with a bad brand, poor customer service, and spotty mobile and fixed networks.
• T-Mobile is being aggressive in the less desirable pre-paid mobile space and is acquiring customers. Liberty Puerto Rico plans to counter this threat by introducing a better pre-paid mobile program in the fourth quarter.
• Small FTTH internet companies are building networks in the wealthiest neighborhoods with the goal of stealing customers from Liberty Puerto Rico’s fixed HFC cable internet business. These buildouts have accelerated Liberty’s conversion of those neighborhoods from HFC to fiber. One of the competitors we met with has less total subscribers than the number of subscribers that Liberty Puerto Rico added last quarter. We will continue to watch what these small fiber overbuilders are doing closely, but it is not currently a major threat to Liberty Puerto Rico’s profitability.
• Power outages are a major problem in Puerto Rico, and Liberty Puerto Rico is accelerating the conversion of its HFC network to FTTH to address it.
While on the topic of LLA, we would like to highlight and update some of the topics we referenced in our first quarter 2018 letter when we first introduced the investment.

While on the topic of LLA, we would like to highlight and update some of the topics we referenced in our first quarter 2018 letter when we first introduced the investment.

On the subject of mergers & acquisitions, we wrote:

“Thinking beyond the company’s existing Latin American and Caribbean markets, Liberty LatAm is positioned to become a scale player in a region that currently lacks one. Liberty Global CEO and Liberty LatAm Executive Chairman Mike Fries is on record stating, “There is a massive consolidation opportunity in a market that remains highly fragmented.”

We expected LLA to be active with M&A at attractive prices, and they have exceeded our expectations by deploying more than $3 billion of capital in intelligent deals during the past three years. This amount exceeds LLA’s current market cap. Their deals include acquiring Cabletica in Costa Rica (2018), Searchlight’s minority interest in Liberty Puerto Rico (2018), UTS in Curaçao (2019), AT&T Puerto Rico (2019), Telefónica Costa Rica (2020), America Móvil Panama (2021), and forming a joint venture with America Móvil in Chile (2021). We anticipate reaping the benefits of these deals in upcoming years as meaningful cost and revenue synergies flow through.

We wrote about the opportunities to improve profitability in their Cable & Wireless unit:

“Liberty LatAm is continuing to improve the profitability of C&W, which itself was the result of the merger of C&W Communications and Columbus International in 2015. Since it acquired C&W in 2016, Liberty LatAm’s management has been focused on taming the company’s bloated cost structure, and the team expects to realize $150 million in annual savings by 2020 via headcount reduction, improved equipment procurement, and scale content acquisition.”

You can see in the chart below the progression of margins at Cable & Wireless, despite the headwinds posed by the pandemic in 2020 and so far in 2021.

Chart 1. LLA has significantly improved C&W margins

Source: Company filings.

We, also, wrote about the value offered by pay TV in LLA’s footprint when compared to that offered by U.S. cable operators.

“About 19% of the company’s 2017 revenues came from cable TV. While cable TV will be under both pricing and volume pressure as over-the-top alternatives (e.g., Netflix) continue gathering subscribers, cord-cutting is much more prevalent in the U.S. than other markets due to the historically high prices of cable TV in our country. Outside of the U.S., cable TV is much cheaper, and it provides some of the best value per entertainment dollar spent (expressed in cost per hours of content consumed). In fact, in many of Liberty LatAm’s markets cable TV remains underpenetrated and aspirational. With these cheaper prices, the incentive to cut the cord is greatly decreased, which makes cable TV revenues defensible and stable for some time.”

Note the table below to see how this has worked out so far. On an organic basis, LLA has gained organic pay TV subscribers while U.S. operators have lost them.

Chart 2. Unlike in the U.S., Pay TV is a stable part of LLA’s business

Source: Company filings.

The days of being a sleepy cable monopolist are long gone. Cheap capital, higher broadband penetration rates, and falling deployment costs are encouraging some overbuild nearly everywhere in the world. A great network, customer service, and fixed-mobile convergence are key to preserving profitability in the face of overbuild for cable companies. Liberty Latin America has been proactive on all these fronts and has done the right things to strengthen its competitive position everywhere. Being a converged player with the combination of the best fixed and best mobile network allows you to offer a better product to customers at a lower cost. This powerful combination enables market share gains and profitability as you are at a huge advantage to unconverged or poorly converged players. LLA is now fully converged in all markets, after M&A in Puerto Rico, Chile, and Costa Rica and years of fixed network upgrades in C&W. LLA remains one of the cheapest positions in our portfolio and trades at 8x our estimate of owner earnings. After it integrates recent acquisitions and completes accelerated network upgrades over the next two years, we expect LLA’s free cash flow generation to improve significantly.

Archives: Case Studies

Just prior to quarter-end, we successfully exited the Fund’s investment in Corporación Lindley.  Based in Lima, Lindley bottles, distributes, and markets soft drinks, fruit juices, water, and sports drinks 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).

In late 2015, Arca Continental agreed to acquire a controlling interest in the business. This change in control dislodged other shares, and we started building our position in early 2016 and have added to our stake opportunistically on a couple of occasions since. Lindley was a unique opportunity for the Fund – one that we identified and were prepared to take advantage of because of our underwriting history with the company and our familiarity with Arca, the Coca-Cola system, and South American businesses generally. Given its limited float and concentrated ownership by the Lindley family originally and by Arca now, the company neither had nor has any sell-side analyst coverage in the U.S. or in Peru.

Before our initial investment, we had spent time on the ground in the country during a series of research trips, including meeting with Lindley’s management and surveying the bottler’s execution in the market.  Our findings suggested that Lindley was falling short – there were clear opportunities to improve execution and increase investment in certain parts of the business.  Given our history and familiarity with Arca, we understood that the Mexican-based bottler was the perfect partner to help address and solve these operational shortcomings in Peru.  Since taking over in late 2015, Arca has successfully completed a series of initiatives and instilled best practices at Lindley[1] to: (i) overhaul point of sale execution to drive revenue gains, and (ii) materially improve distribution across the Lindley network to enhance customer service and decrease delivery costs.  For example, Arca made long-term investments in coolers to increase sell-through overall and of higher-margin SKUs, expanded and improved Lindley’s returnable offerings to satisfy consumer demand, and enhanced operational efficiencies with capital investments in new production and distribution facilities.  The impact on absolute earnings and margins has been pronounced:

Figure 1. Annual Operating Profits (in Peruvian Sol) and Margins since Arca’s Purchase

The fundamentals of Lindley’s end markets were and are attractive.  According to the World Bank, Peru grew its GDP over 3% on average since 2015, which is a nice tailwind for personal consumption.  The company also benefited from increasing annual per capita consumption of ready-to-drink products.  Arca has been focused on increasing this per capita consumption from the low 200s of eight-ounce servings of Coke products to a level closer to its other markets.  For example, per capita consumption is over 900 in Arca’s Mexican territory, while per capita consumption in Chile and the U.S. is greater than 400.  We expect countries with per capita GDPs like Peru to steadily switch to ready-to-drink beverages over the next 20 years.  Despite some obstacles and with the benefit of these demographic tailwinds, Arca was able to improve the business substantially.

Thanks to the strong operational results and improvements in Lindley’s business, we achieved a successful outcome despite (i) a contraction in Lindley’s valuation multiple from 7.5x forward enterprise value-to-EBITDA[2] when we bought shares in early 2016 to 7.1x forward when we sold these shares, and (ii) a ~10% weakening of the Peruvian sol against the U.S. dollar.  Lindley generated these strong operational results in the face of a GDP growth slowdown, a sugar tax increase, and an implementation of nutrition labeling laws, which many analysts cite as enormous risks for Coca-Cola bottlers, but which we believe are readily manageable.  We remain constructive about Lindley’s future.  It may take until late 2021 or early 2022 for Lindley to fully bounce back from the pandemic, but the company is well-positioned to continue growing revenues and improving margins over the long term.  Lindley had also recently completed a major capital expenditure program to support this growth, which means that free cash flow will be greater than earnings in upcoming years.  With this cash flow, we expect management to continue paying down debt, and the business could begin distributing meaningful dividends in the intermediate term.

We sold our shares at a significant premium to Lindley’s then-prevailing market price.  While this sales price is below our estimate of per share intrinsic value, the current opportunity cost is high for this capital.  When we invested in Lindley in 2016, publicly listed emerging market Coca-Cola bottlers traded at an average of 10x trailing enterprise value-to-EBITDA, and they now trade at 6.5x trailing enterprise value-to-EBITDA (we bought our Lindley shares at a discount to peers and sold them at a premium).  All investment decisions require a careful weighing of competing alternatives, and it made sense to liquidate our investment in Lindley to take advantage of more attractively-priced assets that were available.  At the time of the exit from Lindley, Arca Continental and Coca-Cola Icecek were trading at 7x and 6x forward enterprise value-to-EBITDA.  As a result, we are actively redeploying Lindley’s sales proceeds into Arca and Coca-Cola Icecek shares, which both have larger margins of safety and are more liquid than Lindley.

[1] Arca has used the same playbook to improve margins substantially in its U.S. territories it acquired in 2018.  We expect Arca to use this playbook again in future acquisitions.

[2] We prefer multiples of operating earnings (EBIT) or owner earnings, but multiples of EBITDA (Earnings before Interest, Taxes, Depreciation, and Amortization) are commonly used and often the only datapoints available for bottlers.

Archives: Case Studies

Embonor produces and distributes Coca-Cola products.  Approximately half of the business serves parts of Chile outside of metro Santiago.  As previously highlighted, Embonor’s business in Chile grew strongly through the double shock of protests and COVID-19 shutdowns in the fourth quarter of last year and in the first quarter of this year.  Second quarter results will be weaker as the loss of jobs affects consumers’ purchasing power in Chile and Bolivia, but Embonor will still produce positive free cash flow in 2020.

Embonor sells for ten times the net income it earned over the last twelve months, which has been a challenging period economically.  Embonor will almost certainly be a bigger business in ten years through an increase in per capita consumption of its current portfolio with the growth of the middle class in Chile and (particularly) Bolivia, product innovations such as its Guallarauco fruit juice joint venture that grew 400% in the first quarter, and alcohol distribution deals like the recent contracts with Diageo and Capel.  The Vicuña Family, which owns a controlling stake in Embonor, seems to agree; family members bought additional shares in March above the current share price.

As further potential upside in the investment, we believe a merger between Embonor and the larger bottler Coca-Cola Andina will be compelling at some point for the controlling shareholders of both companies.  The companies already work closely on joint ventures, and a combined business would benefit from substantial costs savings, particularly in their adjacent regions in central Chile.  If such a combination were to happen around the historic valuations of similar mergers, Embonor shareholders would enjoy a 60%+ premium to its current price at the current earnings level.

Archives: Case Studies

The first half of 2020 is a tale of two continents for Arca.  Mexico represents almost 50% of Arca’s profits.  Before COVID-19, Mexico was enduring anemic economic growth due to the business-deterring policies of President Andrés Manuel López Obrador, commonly known as “AMLO.”  Uncertainties about the seeming capriciousness of some of AMLO’s decisions have retarded foreign direct investment at the very time Mexico should be one of the primary beneficiaries of America’s trade war with China.  Mexico was slower to implement COVID-19 regulations, and Arca grew volumes slightly, revenues by 6%, and EBITDA by 9% during the first quarter.  The regulations in Mexico are not having a major impact on Arca’s ability to do business, and there is some evidence of pantry stocking.  Arca will likely benefit modestly from forced brewery closures in the country as consumers shift some consumption from beer to soft drinks.

Arca’s second biggest division, Coca-Cola Southwest Beverages, serves almost all of Texas and parts of Oklahoma, Arkansas, and New Mexico.  Governments in these areas have generally imposed less stringent COVID-19 regulations, and Arca grew volumes by 4%, sales by 10%, and EBITDA by 21% in the first quarter.  We expect second quarter volumes to be somewhat weaker, and there will be some pressure on profitability from consumers switching from single serve packaging to multipacks as they stay home more.  In the U.S., the difference in profitability between the two categories is much wider than other markets around the world.  Mitigating this switch to less profitable presentations is a sharp reduction in discounts and promotions.  Frequently Coca-Cola 12 packs (12-ounce cans) are discounted to “3 for $11” or “4 for $12”.  These promotions are rarer now.  Arca is selling 12 packs for $4.98-$5.49 each with a greatly reduced advertising budget.  Please let us know what prices you see in your local stores for fridge packs.  The U.S. represents 25% of Arca’s profitability.

While COVID-19 is having only a modest impact on Arca’s North American business, the situation is tougher in South America, where Arca serves customers in Peru[1], Ecuador, and northern Argentina.  Beginning in late March, Peru and Ecuador imposed some of the tightest restrictions on their populations in the free world.  While Coca-Cola sales are deemed an essential service, many outlets are unable to open, and curfews restrict the ability of Arca to supply these outlets.  For the first quarter, South American volumes were down 5%, sales fell 2%, and EBITDA shrank by 9%.  April and the beginning of May were worse.  However, restrictions eased beginning in mid-May, and selling conditions will improve as Arca is able to meet consumer demand.  South America represents 25% of Arca’s profitability.

Despite these short-term headwinds from COVID-19 in South America, Arca’s and Lindley’s businesses are well positioned for the economic downturn we are seeing across the world. The combination of their strong brands, extensive distribution networks, and income inelastic products suggest the performance of these businesses will be much better than the average company regardless of the severity of the economic downturn. Both companies will continue meeting the varied demands of millions of consumers and will grow volumes, revenues, and earnings as expanding middle classes in Mexico, Ecuador, and Peru increase consumption on the other side of this recession. Arca and Lindley currently trade at trailing price to owner earnings multiples of fifteen times and twelve times, respectively, which provide a margin of safety to their intrinsic value.  Both companies have recently finished large capital expenditure programs to increase capacity and extract operational efficiencies, which will increase near-term cash generation and allow for share repurchases, dividends, and value accretive M&A. It is worth noting that although Arca trades at a modest premium to other public Latin American Coca-Cola bottlers (Coca-Cola FEMSA, Coca-Cola Andina, and Coca-Cola Embonor), its peers trade at valuation multiples not seen since the bottom of the 08/09 Great Financial Crisis.  We think this reflects large short-term equity flows out of Latin America.  We continue to believe that Arca is the best Coke bottler in the world.

[1] Corporación Lindley, Arca’s majority-owned subsidiary in Peru, is also one of the Fund’s holdings.

Archives: Case Studies

Backus is responsible for nearly 99% of the beer produced and sold in Peru.  From this dominant market position, Backus earns extremely high margins and returns on capital.  On March 16th, the Peruvian government deemed the production and distribution of alcohol as “non-essential,” which effectively prevented Backus from doing business.  Retailers could continue to sell the beer they had on hand, but stores ran out sometime in April.

Under the government’s return to normalcy plan, Backus will be able to restart its production in June.  Recently, Backus was able to resume distribution of its existing inventory, but that only bridged about nine days of typical consumption until production recommences.  Because of fermentation times, it takes about fourteen days for bottles to start rolling off productions lines after the brewery is restarted.  Management already has a plan in place to begin this production immediately under tight compliance with global work safety guidelines.   As would be expected given the severe government restrictions, second quarter revenues and profits will be down sharply.  Fortunately, we do expect beer sales will bounce back quickly given pent-up consumer demand and the relative strength of the Peruvian economy.  From a balance sheet perspective, Backus could not have been better positioned to weather this type of shutdown, even if it ends up being extended or even recurs.  The company has no debt, and, as result, has no liquidity issues.  Additionally, and perhaps most importantly, this lost quarter and any ramp it takes during the rest of 2020 to get back to full steam has little bearing on Backus’ long-term earnings power and, by extension, its intrinsic value.  Backus is a resilient, non-cyclical business whose moat is a function of its dominant brands/customer loyalty and superior distribution; its balance sheet gives the company tremendous staying power.  The business also benefits from Peru’s status as one of the healthiest economies in global emerging markets.  On the other side of this crisis, Backus should grow owner earnings at 5-10% annually for the foreseeable future.

Archives: Case Studies

Liberty Latin America (“Liberty LatAm”) connects and entertains people through broadband internet access, premium TV, mobile services, and undersea fiber.  Liberty LatAm provides these services in Chile, Panama, Puerto Rico, Costa Rica, and across the Caribbean.  Demand for its offerings has never been higher as customers are working from home, seeking ways to connect to friends and family digitally, and consuming more digital entertainment than ever.  Liberty LatAm’s fixed broadband network has seen a 40% increase in demand, for example.  Broadband access sales have risen with this increased demand.  Across its markets, first quarter revenues and operating cash flow were up 2% and 4%, respectively.

About 12% of Liberty LatAm’s business is selling access to its mobile network to customers via prepaid cards (i.e., prepaid mobile).  This part of the business is the most economically sensitive as wealthier customers typically pay for mobile access by the month under traditional plans (i.e., postpaid mobile).  Additionally, since many customers are at home, they are consuming data more through their broadband connections rather than over mobile towers, which further depresses prepaid mobile demand.  Liberty LatAm’s mobile business is primarily in the Caribbean where lost tourism will impact the consumer more than other Liberty LatAm regions where fixed connections are the primary offering.  Even though the biggest COVID-19 pinch for mobile is happening during the seasonally low summer period for Caribbean tourism (high season runs from mid-December to mid-April), we expect prepaid mobile revenues to decline substantially in 2020.

Liberty LatAm’s biggest competitor is financially troubled.  Digicel recently reorganized its debt again, as it converted some of its existing bonds to convertible notes to give the company breathing room on its interest payments.  Even with this restructuring, Digicel remains on life support and falling prepaid mobile revenues will add to its business challenges.  The company cannot afford to be aggressive in its pricing, nor can it fund capital expenditures to enhance its network.  We view Digicel’s distressed financial position as an advantage for Liberty LatAm.

Reflecting Liberty LatAm’s utility-like fixed network offering, we expect revenues and profitability to be only modestly affected by COVID-19.  Management has reacted prudently to the environment by reducing fixed operating costs and capital expenditures by $150 million this year to help ensure financial health and flexibility, and the company expects to generate free cash flow in 2020.  Appreciating the opportunity offered by the current stock price, Liberty LatAm’s board of directors initiated the company’s first share buyback program in late March.   With the stock price cut in half despite only a modest impact to the underlying business, the directors believed that allocating capital to buybacks at prevailing stock prices promised strong long-term returns for shareholders.  Demonstrating personal confidence in this corporate decision, insiders have purchased shares in the open market throughout the COVID-19 market selloff, with CEO Balan Nair buying shares as recently as May 13th.  Additionally, pending regulatory approval, Liberty LatAm will complete its purchase of AT&T’s Puerto Rico wireless business later this year, which will combine its dominant broadband offering on the island with AT&T’s dominant wireless business.  Liberty LatAm will be able to cross-sell a complete bundled solution to customers, reduce costs, and shrink customer churn in a deal that will be immediately cash flow accretive to Liberty LatAm’s shareholders.  This strategic combination is an important step in management’s plan to build a scale telecom provider in the region.  Given the strength of Liberty LatAm’s core business and the organic and M&A/consolidation growth opportunities potentially on the horizon, we believe the business is undervalued at seven times its owner earnings.  We bought additional shares in mid-March at even lower prices.

Archives: Case Studies

In October 2019, two weeks after we met with Embonor senior management team in both Santiago, Chile, and Santa Cruz, Bolivia, political and social turmoil broke out in both countries.  The protests in Chile had a particularly large impact on the Chilean stock market and currency in the fourth quarter, which combined to materially impact the U.S. dollar value of the Fund stake in Embonor.  Subsequently, we have talked with Embonor management team and extensively with our other contacts in Chile to assess the impact on near-term operational results, although Embonor territory does not include Santiago where protests have been most disruptive.  Our current information indicates the impact might be smaller than the market is expecting.  Coca-Cola Andina, the other Chilean bottler whose territory does include Santiago, recently reported that the protests have had only a minimal effect on its business so far.  In fact, Andina Chilean volume grew 1.9% in the fourth quarter.  We do expect GDP growth in Chile to be modest next year, which will dampen Embonor growth in 2020.

The protests in Bolivia were a bit different in nature, as they were focused on the future of a politician, rather than broader Chilean concerns about income inequality.  In fact, contrary to many countries around the world, Bolivia middle class is expanding rapidly.  From 2013 to 2018, the number of Bolivian households with annual incomes over US$20,000 has grown 17% annually, helped by “pragmatic socialist” policies of Bolivia ex-President Evo Morales.  However, many feared his re-election might lead to a more autocratic administration as the election results were perceived to be a result of voter fraud.  Ultimately, Bolivian protesters successfully removed Morales from power, although there were counter-protests in his favor.  His resignation has led to some volatility but also a more business-friendly, capitalist environment.  The short-term risk of a devaluation of the Bolivian currency has probably risen, but the opening up of the Bolivian economy should be a positive in the long run.

In October 2019, we met with CEO Cristian Hohlberg and CFO Anton Szafronov in Santiago for nearly four hours.  Cristian only meets with a handful of outside investors each year.  Like Backus and Lindley, the company publishes results only in Spanish.  In companies like these, we have observed that macroeconomic factors and investment flows often have a bigger influence on the short-term stock price than underlying fundamentals.  This reality produces a result like this year, where the stock fell 29% in the face of positive operational results for 2019, expected stable earnings through the end of 2020, and anticipated healthier growth thereafter.

Through the third quarter of 2019, Embonor revenues were up 11%, and operating income rose 16%.  Chilean results have been strong across product categories this year, and operations in the country are just starting to benefit from a recent Embonor agreement to distribute Diageo products and Capel pisco (Capel has 45% market share in pisco, and pisco accounts for one-third of all spirits consumption in the country).  This alcoholic category tailwind should last for another 2 years or so.  Embonor might soon start distributing for Diageo in Bolivia, as well.  Bolivian results have not been as positive in 2019, even as Embonor has invested in growing production capacity in the country.  Embonor continues to enjoy significant competitive advantages from dominant brands and superior distribution, but the company’s pricing power has been limited because local B-brand competitors have not raised prices in three years.  Management has made the rational decision to keep raising prices, albeit at a slower pace, which has resulted in a loss of around two percent of market share over this period.  The fundamentals in Bolivia remain interesting and consumption will grow over time as annual incomes rise in the country, especially as Embonor introduces a broader array of ready-to-drink products such as premium bottled water and fruit juices.  Additionally, and in accordance with growing per capita incomes, management is focused on increasing single-serve consumption in the country through more cooler investments (the #1 factor in ready-to-drink consumption is cooler penetration).  This focus should yield growth, although those gains will be muted as long as competitors hold down pricing.

We did decrease the position by about 20% in the middle of the year based on our moderated growth expectations (we sold at around US$2.25 per share, and the stock traded at US$1.73 at year-end).  Embonor cash flows will remain resilient and predictable, but we felt the position size at the time was too large for the future returns we expected given our revised projections for Bolivia.

Archives: Case Studies

Lindley is a business largely unknown to and overlooked by the broader market; like Backus, no sell-side analysts publish reports on the company.  On the other hand, we have been following the business closely for about a decade, including meeting with the company in Lima on several different occasions and as recently as September 2019.  We have long recognized that Lindley Peruvian markets and brand portfolio, including its top-selling Inca Kola, were and are compelling assets, but we were underwhelmed by the company’s operational effectiveness a decade ago.  While we never saw the hoped-for improvement from the legacy management team, we were prepared to act when Arca Continental purchased a controlling stake in the company in 2015.  Thanks to our long history and familiarity with Arca, we trusted that this new controlling shareholder would institute operational best practices that were missing at Lindley and would unlock full potential of the business.

Improvements began immediately under Arca.  Management’s long-term investments in point-of-sale improvements (like coolers) and operational efficiencies (new facilities and more returnable bottles) are paying off so far in 2019.  Through the first nine months of the year, revenues grew 6% and operating income rose 23%.  Operating income margins have expanded nearly 50% since Arca took control of Lindley.  The most significant Lindley capital expenditures, such as the plant in Pucusana that we visited in September, are now complete.  In combination, these dynamics have sharply grown the company’s free cash flows, and we expect increasing dividends to follow.

Peru is experiencing some political machinations and gridlock at the national level, which is hampering GDP growth and, by extension, ready-to-drink volume growth.  The country’s carbonated beverages excise tax changed in mid-2019 benefiting low calorie/reformulated beverages with lower levels of sugar, which will help Lindley on a relative basis as the company has intelligently increased its offerings in these categories over the years.  Low/no-calorie beverages now constitute more than one-third of total revenues, which is one of the highest levels in the world.

Lindley currently trades at a 35% discount to the price Arca paid in 2018 for The Coca-Cola Company remaining ownership stake.  This large gap between the prices of voting and non-voting shares is irrational, and this discount will inevitably shrink.  Most importantly, the price we would require to sell our stake continues to increase as the intrinsic value of the business grows.  Our biggest lament is that we have not been able to buy a larger stake in the business due to Lindley’s closely-held ownership and limited liquidity.

Archives: Case Studies

Thanks to Backus’ lack of an investor relations team, its absence from passive index funds, and its Spanish-only reporting, no sell-side analysts publish research on the company.  Backus is a hidden gem that has the deepest moat of any business we own — as reflected in its 99% market share in Peru.  When we met with a potential competitor in South America in October, its investor relations team told us that they considered it “impossible” to compete with Backus in Peru.  Our October in-market site visits in Lima reinforced our understanding of the company’s competitive position and the dominance of Backus offerings at the point-of-sale.  Both revenue and profit grew in excess of 10% during the first half of the year, with a mid-year excise tax increase drying up this growth in the third quarter (Backus excise taxes paid per unit volume increased by around 33%).  This incremental tax will probably limit Backus revenue growth to the low-single digits for a few quarters.  Over the longer term, we do expect the company to grow revenues at mid- to high-single digits thanks to premiumization opportunities (price-mix improvements) and consumers who have increasing amounts of disposable income (volume growth).

The stock is more expensive than when we first built our stake in 2018 at a compelling mid-teen price-to-earnings multiple, but we remain comfortable with the position’s size.  Our downside is well-protected by the company’s entrenched competitive position, the recession-resistant nature of beer, Backus’ net cash balance sheet, and the company’s capital allocation policy of paying out a majority of its free cash flow in dividends to help its parent company service debt.  We hope to be long-term owners of this wonderful business.

Archives: Case Studies

We spent significant time on the ground in Liberty Latin America (“Liberty LatAm”) markets in 2019 and met with several local management teams, including in Chile (Liberty LatAm’s #1 market) and Panama (#2 market).  We have a visit to Puerto Rico (#3 market) planned for March, when we will have an opportunity to evaluate the company’s recently announced acquisition of the largest and most advanced mobile network on the island.  Because AT&T was pressured to sell this network by an activist shareholder, Liberty LatAm was able to purchase the business at an attractive valuation that should be accretive to free cash flow.  During the year, we also spoke with a series of competitors, suppliers, and global peers.  These calls allow us both to verify what we learned on the ground from Liberty LatAm’s managers and to better understand the competitive ambitions of these other players.

We assess potential competitive threats across Liberty LatAm’s markets in several important ways.  First, we look closely for any changes in network overbuild and overlap from one or multiple competitors.  Second, we independently track the quality of Liberty LatAm’s and competitors’ networks in each market through speed test aggregation.  We want to know if Liberty LatAm is improving the quality of its offerings on an absolute and relative basis from the consumer’s perspective.  Third, we independently record the offerings and packages in Liberty LatAm’s larger markets for both Liberty LatAm and its competitors.  This effort helps us follow price and service changes in real-time to consider who has the best value proposition and where margin pressures may be lessening or increasing.  In parallel, we try to look forward to competitive considerations that are developing elsewhere.  To that end, we follow Liberty LatAm’s developed market peers to assess business trends before they potentially migrate into Liberty LatAm’s markets.  And we follow the changes in technology that could be either threats or boosts to the industry.  All of these factors are important to reliably projecting Liberty LatAm’s long-term cash flows.

We spoke with management on multiple occasions during the year on timely corporate finance topics, and we had an extended meeting with Liberty LatAm’s CEO Balan Nair and CFO Chris Noyes at their Denver offices about strategic and operational considerations.  They are optimistic about their ability to achieve scale across the company’s markets, and we believe they have many places to deploy cash at high internal rates of return for years to come.  Liberty LatAm is focused on long-term cash generation at the expense of near-term GAAP earnings, which we support.  In fact, this near-term softness in reported earnings provided the opportunity to build the position at compelling prices.

Through the first nine months of 2019, Liberty LatAm grew organic revenues by 2% and operating cash flow by 6%.  Liberty LatAm’s fixed network (broadband) remains the company’s most compelling business due to its size and natural monopoly characteristics.  Revenues and margins are defendable, and Liberty LatAm has a long runway to build out its fixed network in Chile, Central America, and the Caribbean at incremental returns in excess of 20%.  The mobile business is less attractive generally, although it still produces sufficient returns in markets where the competitive profile is reasonable.  That is not currently the case in Panama, a four-player mobile market that has been a meaningful drag on Liberty LatAm’s overall results in recent years.  Given the significant financial distress of the fourth player (Digicel) and the government’s recent lift of its ban on consolidation, we expect there will be at least one — if not two — fewer players in this market soon.  This move would materially improve profitability in Liberty LatAm’s #2 market.  Elsewhere in Central America and the Caribbean, Liberty LatAm is instituting best practices, leveraging the scale of the Liberty complex to improve its products (set-top boxes, modems/Wi-Fi routers, cheaper procurement), and rationalizing costs.  This work should reveal itself in the financial results over the next several years.

Archives: Case Studies

We enjoyed hosting Arturo Gutierrez, Arca CEO, and Jean Claude Tissot, President of Arca Coca-Cola Southwest Beverages (CCSWB) division, in Birmingham in December.  Our discussion covered strategic capital allocation considerations and tactical in-market operational activities.  We have been following Arca’s progress at CCSWB closely, as it is the company’s first foray into the U.S. system with operations in Texas, Oklahoma, and New Mexico.  Coke bottling in more mature U.S. markets has some fundamental differences to emerging markets, particularly in a bottler’s go-to-market approach.  Retail channels are much less fragmented in the U.S., which lessens distribution advantages and makes it easier for competitors to challenge Coke brands.  This more consolidated marketplace sustains Pepsi and Dr. Pepper as ‘A’ brand competitors in the U.S., while Pepsi is a ‘B’ brand in almost all emerging markets and Dr. Pepper is essentially non-existent.

Despite this tougher competitive environment, Arca has transformed CCSWB over the past two years.  Arca has shifted the organization’s overall focus and overhauled the incentive system to reward profitability over volume growth.  At a recent industry event, Arturo and our friend Matthew Dent, President of Pepsi bottler Buffalo Rock, both expressed their expectations that soft drink prices would rise faster than inflation in the U.S. in 2020.  Arca is investing prudently in manufacturing and distribution improvements, including the U.S. system’s first new major bottling plant in a decade.  In March, CCSWB will cut the ribbon to officially open this facility, which promises to decrease operating expenses materially in its growing Houston market.  The fruit of these efforts isreflected in the outstanding margin expansion that Jean Claude and his team have achieved.

In 2018, Arca had to deal with macroeconomic and political issues simultaneously across several of its markets but was still able to grow volumes by 6%, revenues by 14%, and cash flows from operation by 14%.  For the first nine months of 2019, volumes are up slightly, revenues have expanded over 4%, and operating earnings have risen 8%.  These operational results were led by (i) strength in Mexico, (ii) the profitability improvements at CCSWB, and (iii) revenue growth and profitability gains in Peru.  Argentina (about 5% of revenues) remains challenging as a lack of confidence following the recent election has returned the country to an inflationary recession, and Ecuadorian volumes have been essentially flat this year.  Across the Arca system, the mix of low/no-calorie offerings has grown as Arca and The Coca-Cola Company have responded to customer demand; a continued shift should have a positive impact on gross margins over time.

Despite this earnings growth, the Fund investment in Arca stock was marked down by 3% for the year in U.S. dollar terms, making it a slight detractor to performance for the year.  This result was not only incongruous with this year’s operational progress, but also with our expectations for the business.  We project revenue to grow more than 5% annually for the next half-decade, with earnings compounding in the high-single digits annually over this same period.  We also anticipate capital expenditures to fall, free cash flow to rise, leverage to remain low, and opportunistic acquisitions to continue.  Share buybacks may play a role in shareholder returns, as well.

We believe we understand Arca better than any other outside investor in the company.  Our long-standing relationship of trust with the outstanding Arca management team further reduces the risk that the business will underperform our expectations for it.  At current stock price levels, the Fund investment in Arca is substantially undervalued.

Archives: Case Studies

Since acquiring the business in 2017, Arca Continental has been working hard to transform the culture of the Coca-Cola Southwest Operating Unit.  Arca has made tremendous progress in this territory, which includes almost all of Texas and parts of Oklahoma, New Mexico, and Arkansas.  Arca has shifted the organization’s overall focus and overhauled the incentive system to reward profitability over volume growth.  Decision-makers are no longer looking just to sell more volume but are instead looking for the right offering mix to maximize profits.  In addition to the shift in incentives, managers also have greater autonomy and accountability for the decisions they can influence and the costs they incur.

We spent a couple of days in August, 2019, with the local team in Houston to see these efforts in action.  It is always a treat to be with Arca people.  Whenever we have met with them all over the Americas, we have experienced the same focus, enthusiasm, mission, hunger, and hospitality.  This cultural advantage is part of why Arca has been so successful across its territories.  Before Arca arrived, Coca-Cola enjoyed an outstanding brand and connection with consumers in Texas.  Arca is overlaying its operational best practices onto this market, and we are all benefiting as shareholders from this powerful combination.