The past year was not a particularly strong one in the consumer sectors of Latin American countries like Mexico and Brazil, and that was not good news for FEMSA (NYSE:FMX). One of Mexico's largest corporations, FEMSA has a significant presence in the retail/consumer world with its stake in Coca-Cola FEMSA (NYSE:KOF), a large Latin American Coca-Cola bottler, a 20% stake in brewer Heineken, and ownership of Oxxo, the third-largest retailer in Mexico.
The challenge for investors is weighing out the short-term challenges presented by a possibly improving (but not yet strong) Mexican economy, new taxes, economic problems in Argentina and Venezuela, and competition against the long-term opportunity of growing Coca-Cola FEMSA and leveraging the retail operations into new areas like pharmacies and fast food that are still underpenetrated in Mexico.
Coke is still it, but it's getting more expensive
FEMSA owns slightly more than half of Coca-Cola FEMSA, with Coca-Cola (NYSE:KO) owning about a third (the remainder trades as KOF). Coca-Cola FEMSA is the second-largest Coca-Cola bottler in the world, supplying much of Mexico and Colombia, parts of Brazil and Argentina, and all of Costa Rica, Nicaragua, Panama, Venezuela, and the Philippines with their Coca-Cola fix.
Importantly, Coca-Cola prizes strong bottling partners and has supported Coca-Cola FEMSA's efforts to expand its operations, including the sale of 51% of the Philippine bottling operations, an option to buy the remainder, and a put option to sell it back to Coca-Cola. Coca-Cola FEMSA has also been consolidating in Brazil, now holding about 40% of the Coca-Cola system in this large country.
Coca-Cola has long been the dominant soft drink in Latin America, and PepsiCo has struggled to close the gap. Starting this year, though, it may be a little harder to hold that market share in Mexico. The government of Mexico passed a junk food tax that will see a one-peso tax per liter (pro rated) on sodas, raising the price of Coca-Cola by around 10% (and about 14% for lower-priced Pepsi). What happens next is unknown -- will Mexican consumers drink fewer sugary beverages, switch their spending around to maintain their soft-drink habits, or switch to lower-calorie soda alternatives?
It's also well worth noting that Argentina and Venezuela are convulsing with economic turmoil. These two countries represent about 25% of sales, but rampant inflation and currency devaluations are adding significant volatility to results. It's also worth noting that weak consumer spending is hurting results in Brazil (organic volume declined 11% in the fourth quarter).
OXXO the best house on a tough block
FEMSA's other major segment, Comercio, is dominated by OXXO, its franchise of convenience stores. OXXO is the third-largest retailer in Mexico by revenue, and it has been doing relatively well compared to the likes of WalMex (OTC:WMMVY) in terms of same-store sales. For the fourth quarter of 2013, same-store sales rose 2.5% on slight traffic growth but the business struggled at times in 2013 with consumer weakness and pressures in the sale of mobile phone minutes due to greater price competition from mom-and-pop rivals.
There are still reasons to believe that Oxxo has room to grow. Management's estimate of a sustainable footprint suggests room for perhaps 50% more stores, and that is just in Mexico. FEMSA is also looking to add more grocery offerings and fast food, while increasing private label penetration and maintaining relationships with large banks like Banamex (owned by Citigroup) and Bancomer (owned by BBVA) for deposit-gathering.
Management is also looking to other concepts to drive growth in Comercio, including pharmacies (still very much a local mom-and-pop industry in Mexico), standalone fast food, and perhaps other channels like discount retail. FEMSA acquired the restaurant chain Gorditas Dona Tota in September, and fast food is still an underpenetrated concept in Mexico -- Alsea, a partner for many well-known American concepts like Burger King, Domino's, and Starbucks does quite well, but McDonald's and its local franchisee Arcos Dorados don't hold much market power.
Growth today versus growth tomorrow
The first half of 2014 is going to be a period of adjustment for Mexican consumers, as the impact of the junk-food tax and a higher VAT (16% versus 11%) work their way through the retailing world. Assuming that taxes do what they typically do, FEMSA is likely to see lower volumes although the company's strong share should help it offset some of the damage. In the meantime, the company has sufficient capital to continue investing in additional growth opportunities like pharmacies.
Between low-to-mid same-store growth and footprint expansion, Comercio should be able to post high single-digit revenue growth for a decade. That may be a little harder to match in Coca-Cola FEMSA, though there are share growth opportunities for Coca-Cola in markets like Brazil, as well as opportunities to use the operations in the Philippines to extend into markets like Southeast Asia.
All told, long-term revenue growth in the neighborhood of 8% seems reasonable, with scale and operating leverage supporting low-teens FCF growth.
The bottom line
FEMSA has challenges. Coca-Cola volumes need to get better in Brazil, and the unsettled economic situations in Argentina and Venezuela remain a threat. FEMSA also most definitely needs a stronger retail/consumer environment in Mexico; sector-leading comps are a definite positive, but better sectorwide growth would be very helpful to results.
Discounting those cash flows back and adding in the current value of FEMSA's 20% stake in Heineken, a fair value of around $104 seems reasonable for FEMSA. Likewise, with the sell-side projecting low-teens EBITDA growth over the next three years, an EV/EBITDA ratio of 11 is not unreasonable. All of this assumes that current sluggishness in Mexico is just temporary, but that's often the way it works with emerging market stocks -- the best bargains only appear when investors are worried that temporary macro challenges are going to last indefinitely.