Originally published in Valuabl on February 3rd, 2023.

> Mexico’s biggest poultry producer is expanding into new markets, including pork production. The spread of avian flu and a trade spat over corn between Mexican and American lawmakers threaten to hurt the business in the short term. Still, the firm’s economies of scale and efficient operations will help them serve the growing demand for chicken. I rate the shares a Buy as they offer an 89% upside, 16% IRR, and have over half the market capitalisation in cash.

Industrias Bachoco (Bachoco) is a vertically integrated Mexican chicken and pig company. The firm owns and manages 1,212 farms, 22 hatcheries, 23 feed mills, 20 processing plants, and 80 distribution centres across Mexico and the US. Bachoco is the biggest chicken producer in Mexico, accounting for 35% of the Mexican market, and the sixth largest in the world, processing almost 15m chickens per week.

Three-quarters of the firm’s sales come from Mexico, while the remaining quarter comes from the US. While the company also produces eggs and animal feed, most sales come from chicken.

The Mexican chicken market has grown at 6% per year since 2014, and Statista, a market forecaster, reckons it will continue to grow at 10% per year until 2027. They estimate over Ps300bn will be spent on chicken in the country by 2026, up from the Ps198bn spent last year.

Mexican chicken consumption has grown at 3% per year, and analysts expect that trend will continue. Mexican households, like their American and European counterparts, have started to prefer chicken to beef as it’s more affordable, higher in protein, and lower in fat.

International meat prices have surged recently as meat demand outpaced supply coming out of the covid19 crisis. But as consumption and production trends come back into balance, economists expect the price of chicken in Mexican pesos to keep going up. The per kilo price of chicken has risen 7% per year since 2014, faster than the 4% rate of Mexican inflation. Thanks to the relative demand for chicken, producers have been able to raise prices, and diners have had to swallow them.

Bachoco’s yearly sales have grown consistently. For the past 20 years, the company’s top line has grown at twice the 6% growth rate of the Mexican chicken market. Bachoco’s sales have grown from Ps12bn in 2003 to Ps97bn in the past year at 12% per year. But, over the past three years, the annual growth rate accelerated to 18%, above the 11% growth rate for the median company in my sample of 150 public food companies across the Americas.

The number of chickens the firm processes each week has gone from 7m in 2002 to almost 15m in 2021, a 4% per year production growth rate. The most significant jump was in 2011 when the firm bought O.K. Industries, an American poultry company.

While still volatile, the company’s net operating profit margins have become steadier over time and are converging towards 8%, their long-term average. The poultry industry is naturally cyclical as higher prices and profits are followed by overproduction, leading to periods of lower prices and profits.

The most considerable cost for poultry producers is chicken feed, and the most significant component of that is corn. In Mexico, domestic crops are limited. Therefore, poultry companies import a large proportion of corn used to feed chooks from the US. In 2021, Bachoco imported 80% of its grain from North of the border. Corn’s price is volatile because of weather, harvest size, transport and storage costs, regulatory policies, and currency exchange rates. As a result, the firm’s cost of goods moves around a lot. But, to offset this, the firm hedges feed prices.

Despite this, Mexican companies importing corn have to pay more than American companies because of the additional trucking expense—which rose rapidly during the pandemic. The price of US corn was about $200 a tonne in 2017, while the cost of Mexican white corn was about $300 a tonne.

Over the past three years, the firm’s margins have been average compared to its peer set. Both gross profit and EBIT margins hovered around the median.

As the firm grew, fixed costs declined as a proportion of overall costs, and the operating leverage ratio came down. That helped steady profit margins as fluctuations in gross profit have less impact on operating profit.

The company has benefitted from economies of scale and has become more efficient the bigger it is. It now produces Ps2.70 in sales for every peso of capital invested in operations. That is up from the 1.4x ratio two decades ago. Bachoco is more efficient than 80% of its peer set and is in the top quartile of working capital turnover, the ratio of sales to working capital.

Over the past three years, the firm has produced a pre-tax return on invested capital (ROIC), excluding goodwill, of 20%. That is above the 12% median of the peer set and puts it in the top quartile of food-producing firms. Its after-tax ROIC of 15% is above its cost of capital, suggesting the firm creates value.

The firm’s competitive advantage comes from its economies of scale. Because of its size within the Mexican poultry industry, the firm’s fixed cost base, as a proportion of total costs, is lower than its competitors. As it’s so big, vertically integrated, and operationally efficient, the company can produce more chickens than other companies, sell them for less, and deliver them faster than other food businesses. Its high revenue-to-capital ratios evidence that. The company doesn’t produce higher profit margins, but it does a lot more business, helping it make large profits.

> Story: Mexico’s largest poultry producer will grow as demand for chicken does. The firm’s economies of scale will help them keep costs down while they increase production and expand into the pork market. The company’s size and efficiency will help keep margins in line with its peers, while the low operating leverage helps de-risk cash flows. But with most of the firm’s operations in Mexico, it’s exposed to substantial country risk, increasing the cost of equity.

Bachoco’s share price is below the first percentile on the Monte Carlo distribution and, as a result, has a Buy rating. The Mexican listed (BMV: BACHOCOB) shares are uncorrelated enough with what I own for me to start buying.

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