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Fomento Econmico Mexicano, S.A.B de C.V (NYSE:FMX)

Q2 2007 Earnings Call

July 30, 2007, 2:00 PM ET

Executives

Javier Astaburuaga - CFO of FEMSA

Juan Fonseca - IR

Analysts

Andrea Teixeira - JP Morgan

Robert E. Ford - Merrill Lynch

Loredana Serra - Morgan Stanley

José Yordán - UBS

Alex Robert - Santander

Reinaldo Santana - Deutsche Bank

Celso Sanchez - Citigroup

Presentation

Operator

Please stand by. We are about to begin. Good morning everyone and welcome to FEMSA Second Quarter 2007 Earnings Results Conference Call. As a reminder, today's conference is being recorded and all participants are in a listen-only mode. At the request of the Company, we will open the conference up for questions-and-answers after the presentation.

During this conference call, management may discuss certain forward-looking statements concerning FEMSA's future performance and should be considered as good faith estimates made by the Company. These forward-looking statements reflect management's expectations and are based upon currently available data. Actual results are subject to future events and uncertainties, which may materially impact the Company's actual performance.

And at this time, I would like to turn the conference over to Mr. Javier Astaburuaga, FEMSA's CFO. Please go ahead, Javier.

Javier Astaburuaga - Chief Financial Officer of FEMSA

Thank you. Good morning everyone and welcome to FEMSA's second quarter 2007 earnings conference call.

Joining me today are Jose Fernandez and Juan Fonseca, both of whom you know well. Our second quarter results reflect progress made in every one of our businesses in the context of continued challenges such as tough comparisons as well as inflation pressures in certain key raw materials. Despite the slowdown in our key Mexican market, we again delivered strong consolidated top line growth of 7.4% in real terms.

Consolidated income from operations grew a slight 0.6%, combining soft but improving results of FEMSA Cerveza, a solid quarter for Coca-Cola FEMSA and another good quarter for Oxxo, with gross margin expansion compensating for some weakness in same store sales growth.

Below the line, a reduction in our expense and the positive effect of a strong Peso more than offset an increase in interest expense. And the lower effective tax rate contributed to an increase of consolidating net income of 32.5%.

Moving on to our business units. At FEMSA Cerveza beer volume growth in Mexico again started the quarter very slow. Resembling the dynamics of the first quarter as a slightly lower consumer demand across the country was accentuated by unseasonably cold and rainy weather in the North, specifically during the first half of the quarter. Again, as the quarter progressed, so did volume growth. And for the quarter, we were able to deliver a 3.2% growth in Mexico.

In Brazil, we achieved volume growth of 8.1% with our brand Sol delivering the majority of the growth even though it was launched only nine months ago. Year-to-date, we are up 11.4% and continue to grow ahead of the industry. In exports, volumes grew a robust 27%, driven not only by the rapid growth of Dos Equis in the Eastern U.S. and Tecate in the Southwest stronghold, but also by a solid performance of Sol in other key markets.

In terms of pricing in Mexico, we implemented a selective price increase starting in late May and through the month of June. And therefore, the quarter’s revenue per hectoliter figure of 2.2% down does not reflect the full benefits of this increase. It will do for the third quarter.

In Brazil, where we implemented a price increase late in the first quarter, revenue per hectoliter increased 2.8%. While in our exports, revenue per hectoliter fell 3.6% as the effect of inflation and a strong Peso offset, an increase of 3% in Dollar terms.

Finally, revenue for packaging fell during the quarter reflecting the fact that at this point, we are not making any third party sales of glass bottles. Our full capacity is being used for FEMSA's own requirements. So, total revenues grew 2.7% for the quarter.

On the cost of sales front, we saw an increase of 7.3%, resulting mainly from total volume growth of 6% and from higher prices for grains as the price of aluminum is gradually trending towards last year’s levels and is no longer the main raw material problem. To a lesser extent, we were also impacted by the fact that we are buying some glass bottles from third parties as our own glass facilities are working at full capacity. In the short-term, this we will continue to be the case as our volumes keep growing.

Income from operations increased 16.8%, reflecting our moderate ability to take pricing in Mexico as well as increase of grain expenses in northern markets. Our administrative expenses were welcome thing during the quarter growing by only 1.4%. However, selling expenses increased 11%. Brazil contributed three of the 11 points increase and yet we managed to breakeven of the operating income level in Brazil for the quarter. Selling expenses ex-Brazil grew slightly below the trend of previous quarters. This road is linked to our continued investment initiatives aimed at strengthening our market position in Mexico and developing our brands in Mexico and the U.S.

In Mexico, we continued to strengthen our Cola Sol and Tecate franchises, while we further develop our portfolio with new brand expansions such as Sol Cero, our non-alcoholic beer as well as Bohemia Escura, a high end dark lager with super premium positioning. And in the U.S., we are increasing the support for Dos Equis on launching Tecate Lite in selected markets.

All in, these results are slightly weaker than our expectations for the second quarter, and we can sum up the main reasons as poor weather, delayed pricing and raw material pressure in grains.

As we have stated said it since the beginning of the year, our business plan for 2007 always looked like a tale of two halves, where the first half would look weak and the second half would look strong, impacted by comparisons and the expected behavior of raw material prices. However, we did not expect such a typical weather hurting volumes during the first half and we have mentioned that pricing has been softer than anticipated. Still even where we stand right now we believe our stated objective of achieving full year operating income in line with 2006 levels in real terms remains achievable. The challenge today seems a bit stiffer than it did only three months ago, but we are stepping up our efforts accordingly. In order to get there, we basically need volume growth in Mexico to be at or slightly above 5% during the second half consistent with June and July trends. We have hedged approximately 7% of our aluminum requirements for the rest of the year already, and we expect the price of grains to remain close to current levels for the second half. We have also hedged a significant percentage of our net dollar requirements for the rest of the year at attractive rates.

We will continue to work on containing our administrative expenses while maintaining current levels of selling expenses that will allow us to continue making progress on the development of our long-term capacity position. When all is said and done for this year our Beer operations should be stronger.

Turning to our soft drink business Coca Cola FEMSA delivered a solid quarter, while the Mexican operations showed clear signs of improving volume and profitability dynamics, while most operations outside of Mexico again achieved outstanding results. Total revenue increased 8% and income from operations increased 10.5%, representing an expansion of 40 basis points in the operating margin.

In the key Mexican markets, revenue increased 4% with pricing. Despite facing a tough comparison from 2006, volumes increased 3.8% primarily from growth in brand Coca Cola including continued strong performance from Coke Zero. Better pricing and controlled operating expenses mostly offset significant raw material pressures deriving from high sweetener costs, and operating income fell by 1.6%.

Operating income generated by operations outside of Mexico continues to represent a growing share of the total, and for the second quarter it amounted to 34%, up from 27% in 2006. If you were unable to participate in Coca Cola FEMSA's conference call last Friday, you can access the replay of the webcast for additional details on the results.

For its part and just like our Beer operations, Oxxo was affected by bad weather in Northern Mexico particularly during April which included the key Easter holiday this year. As a result, and compounded by tough comparisons versus 2006, same store sales started off slow, but improved as the quarter progressed reaching good levels in June and delivering average revenue [ph] growth of 1.2% for the quarter. Traffic again was the driver increasing 1.8% while average ticket decreased 0.6%.

We opened 159 new stores during the period, and grew revenues by 12.3% during the quarter. As was the case in the first quarter, gross profit improved driven largely by the implementation of improved pricing strategies, as well as a strong performance from some high margin categories such as coffee and sweets. Administrative expenses increased by 10% for the quarter as the first layers of the Oracle IT platform were fully amortized, and operating expenses remained stable as a percentage of sales.

Income from operations grew by 36% and operating margin expanded by 90 basis points to reach 5.1% of revenues. So except for the one-off effect of the bad weather in the first half of the quarter, Oxxo once again delivered a strong set of numbers and continued to execute according to plan.

Finally, I would like to touch briefly on two developments that have taken place in recent days and weeks, both of which represent meaningful steps toward the achievement of our long term goals. First the Mexican anti-trust commission has approved the joint acquisition of Jugos del Valle of Coca Cola franchise and the Coca Cola Company subject to certain conditions. As Héctor Treviño mentioned on the Coke conference call on Friday, we expect these conditions to be acceptable from the perspective of our business. The acquisition will provide us with a strong platform to develop our portfolio of steel beverages across our operations and will crystallize our new joint venture business moral with the Coca Cola Company. We expect that transaction to close later this year.

And secondly Coca-Cola FEMSA has reached an agreement with the Coca Cola company to acquire the bottling territory of Remil in Minas Gerais, Brazil. Which includes the city of Belo Horizonte and shares approximately 50 million people. Valuation of $380 million is within Coke's current valuation on a per piece [ph] basis and is subject to customized due diligence currently taking place. Once we incorporate that volume to our existing corporations, we will represent approximately 30% of the volumes of the Coca Cola system in Brazil. From the perspective of FEMSA Brazil will contribute over 14 billion Pesos to our annual consolidated revenue or approximately 10% of the total. We expect this transaction to close in the first half of 2008.

And with that I would like to open the call for your questions. Operator, please.

Question and Answer

Operator

Thank you Javier, the question answer session will begin at this time.

[Operator Instructions]

And our first question is from Andrea Teixeira with JP Morgan.

Andrea Teixeira - JP Morgan

Hi, good afternoon, everyone. I just wanted to... my one question is regarding... I understand Hector was very, very... I'm very pleased with his explanations on Friday regarding the CFC requirement. But I would say what is the risk which is only for the callers in the Oxxo stores, what is the risk that they implement the same kind of model for the FEMSA portfolio including beer and what would be the risk in your top line at this point? In other words how much you sell to Oxxo, on the non-exclusive… on the exclusive side of the Oxxo stores. Thank you.

Javier Astaburuaga - Chief Financial Officer of FEMSA

Yes, I think Hector made a point that the conditions that we are… of our knowledge doesn’t really represent something that put at risks the future of the business, when looking at who is there buying [ph] on its own. And the imposed condition of, in time, going away from the exclusivity conditions from Coca Cola to Oxxo is limited to exactly that. That is Coca Cola won't be able to impose an exclusivity condition and also, it will be for Oxxo to decide what to do with that new let's say flexibility in the case of Cola products only and that is a condition which is set for Cola products only, not flavors, talking about fizzies, and of course on the non-carbonated thing also, not being able also to manage who is the buyer products on an exclusivity basis. As I'm sure you are all aware, today it also manages precisely who makes the competitors products on an exclusive basis. So that would be my comments on the fizzies, and the non carbonated products.

That doesn't have anything to do with the beer products at all, and that's very, very clear. Some of you point on what percentage of beer is sold through Oxxo on the beer products and where it is at this stage. About 10% of our products are sold within Oxxo. But we don’t see any case looking at the way the category is being commercialized and sold in Mexico, as any fresh, or any conditions being discussed at all in terms of having a condition on an exclusive or non-exclusive beer products in Oxxo for the future. So, we are not really either considering or thinking there is a risk there so far.

Andrea Teixeira - J.P. Morgan

Okay. Great. Thank you so much.

Javier Astaburuaga - Chief Financial Officer of FEMSA

Thank you.

Operator

We'll take our next question from Bob Ford with Merrill Lynch.

Robert E. Ford - Merrill Lynch

Hey, good afternoon everybody. With respect to the… to your COGS breakdown, there have been some pretty big moves in terms of aluminum, barley, the shift toward buying glass from third parties. Javier, can you give us a sense of what your COGS of your goods, your costs of good sold breakdown is today and what the outlook is in the second half as we go forward, and just asking the price increase, some additional perhaps pricing pressure from third party perghaps?

Javier Astaburuaga - Chief Financial Officer of FEMSA

Yes, Bob. Going a little bit away from the first part which is I mean the breakdown I think maybe, so Juan can spend some time later on outside the conference call. But on the second one is, as I said we feel pretty much comfortable with the outlook for the second half in terms of raw materials. I would day that barley is kind of the only, I would say piece that are still a little bit of concern because the negotiations for establishing the price within September, October are just starting and we are just kind of measuring the waters here. But in the rest of the cost components, we feel very, very comfortable, as I said. Not only because we have hedged both prices and FX for the most important requirements that we have in both aluminum and raw materials coming or linked to the dollar.

And that’s why I feel optimistic in terms of, even though we are going to have a tougher second half in order to get to the objective that we set ourselves because we had a little bit more softer quarter than the one we are anticipating for the second one, we feel pretty comfortable with the room that we have to maneuver and we are doing extra efforts to really manage the business. But, the long term, yes, looking very, very cautiously about the environment for the second quarter.

So, Bob, just I would say, domestic barley crops being the most important ones, but again the impact for the second quarter as a whole would be not very significant because we will be talking main in fact for maybe two to two and half months of requirements. So the rest of the requirements for the quarter are already being… I mean have been already negotiated for good.

Robert E. Ford - Merrill Lynch

Fair enough. And in your comments you suggested that the purchases of third party glass were tempered, is that correct?

Javier Astaburuaga - Chief Financial Officer of FEMSA

Yes.

Robert E. Ford - Merrill Lynch

I am curious when do you plan to add another furnace, and what's the CapEx investment associated with that?

Javier Astaburuaga - Chief Financial Officer of FEMSA

The impact to the P&L of the company, I think it's pretty much, I would say going forward minor for the second half. And then I think it will be better for next year due to the fact that the capacity that we lost on the first quarter it's already up there, so we are now producing full capacity and even a little bit more, because with the refurbishment of the furnace now we are having the ability to produce slightly higher capacity than we were before because that furnace was kind of something like nine years old since its prior refurbish. And the prices that we have established for the outside purchases that we are doing is already being set, not only for the second quarter, but for the next two years also. And as I said we just hedge at attractive rates, the dollar denominated purchases that we will be doing, glass as well as some other raw materials.

And looking in a much more, I would say longer term, we are in the middle of a process to finalize our analysis to conclude if we are going to expand our internal capacity on glass or we are analyzing everything in terms of long-term contracts for outsourcing our requirements. And we are measuring those against the attractiveness of increasing around capacity of glass. We think that we have a first class world operation where good quality, good cost internally but of course we are looking for external, also sources of sourcing of that capacity that we need. And we will come with a final decision on the fourth quarter of this year. And as soon as we have a decision on that we will let you know.

Robert E. Ford - Merrill Lynch

Fair enough. Thank you very much.

Javier Astaburuaga - Chief Financial Officer of FEMSA

Thank you.

Operator

We will take our next question from Loredana Serra with Morgan Stanley.

Loredana Serra - Morgan Stanley

Good afternoon, Javier. I wanted to ask you to talk a little bit more if you could about the pricing environment. You mentioned that you had taken some pricing in late May into June, but it didn’t show up in the quarter. Actually, it looks to me like your pricing actually declined slightly in the quarter which is in contrast to what we saw earlier when we saw Modelo report. So could you help us understand just so we can think about it how much pricing do you think you put through into May and June and why didn’t it sort of filter through in the second quarter?

Javier Astaburuaga - Chief Financial Officer of FEMSA

Sure, Loredana. The first comment I will make is what we put in pricing very late in May, when I should have said mostly affecting June was if you remember kind of a second increment, the second price increase that we did after we did some territories in that early January. So of course quarter to quarter it’s a much more smaller for you [ph] than the one that you should expect from our competitor which didn’t really increase in the first quarter and took most of its pricing during April and early May. That’s one thing.

Second one, which also creates kind of a sequential number which is different on FEMSA's numbers as opposed to our competitors' is that we had, as I said, a geography effect in the case of our northern territories having suffered more the weather effect. So there is a geography effect in terms of the highest price per hectoliter in the regions not only not growing at the pace of the national average, but as a matter of fact decreasing. So that also creates a kind of a pressure. And the third effect which would be a package mix, it’s a kind of a almost offsetting itself because still non-returnables are growing ahead of returnables but within returnables the 32, the 40 ounce presentation returnable glass in some brands, we are also rolling out to some geographies as well as the competitor is doing. And there is also kind of a pressure for price per hectoliter to go slightly down. So that’s kind of I would say the three or four main reasons that I can present to you that explains our sequential price performance.

Loredana Serra - Morgan Stanley

Thanks, that’s helpful. And if you think about the pricing you are going into or you have gone into, third quarter with can you give us a rough sense of how much higher pricing do you have today versus beginning of the year?

Javier Astaburuaga - Chief Financial Officer of FEMSA

I would say that around half of inflation maybe Loredana.

Loredana Serra - Morgan Stanley

Do you have like 2% over the last 6 months?

Javier Astaburuaga - Chief Financial Officer of FEMSA

Yes.

Loredana Serra - Morgan Stanley

Okay, thank you.

Javier Astaburuaga - Chief Financial Officer of FEMSA

Thank you.

Operator

We will take our next question from José Yordán with UBS.

José Yordán - UBS

Good afternoon, everyone. I guess my first question was answered. But the second would be you have been guiding to margin expansions at Oxxo of roughly 30 basis points per year and it seems to me like you are way ahead of that. And in the second quarter appeared to have been a bit of an inflection point and of course the margin levels of Oxxo have been much lower than they should be, I guess, long-term. So do you have a revised guidance for what we should look at in terms of margins for Oxxo going forward?

Javier Astaburuaga - Chief Financial Officer of FEMSA

Yes, hi Jose. I think we had a stellar second quarter in terms of margin expansion for the quarter and a number reasons behind that. I would say could make us a little bit more optimistic going forward and believe me, when we are looking at numbers going forward we have a very, very, I wouldn’t say, tough stance with management of Oxxo, but a very, very aggressive stance, yes in terms of developing the business as aggressively as we can in terms of generating value for shareholders. But it is still a business in which some of the explanations on a quarter by quarter basis on the performance on some categories still shows the tremendous leverage we have in terms of being a perfect solution for some suppliers in Mexico for the development of the products. And that helps a lot in terms of really I would say being successful in terms of negotiating with them specific programs. And of course because of the quarter being very, very soft in terms of same store sales because of a number of reasons I think that we were very, very aggressive. And some suppliers also were very, very aggressive in terms of pushing their products and having special promotions and specific programs.

But all in all, going forward, I would tell you that the business we are still modeling with a number that one you mentioned 30 to 40 basis points on a yearly basis seems to us, that is the reasonable thing to asset as a medium term target. And we think we have the ability to, I would say at least deliver that number and hopefully over deliver in time. But also the quarter was very, very I would say helpfully impact by the termination of amortization of the Oracle Retek IT platform that we have been putting in place. Going forward I can tell you that this is never ending story. And as we speak we are now in the process of bringing in the new generation of the point of sale solution, which will not represent such a tremendous investment in IT as the Oracle Retek IT platform in place, but it will demand some resources or incremental resources, and there was a kind of a lag between the termination of amortization of the previous Oracle Retek platform as the time when the new point of sales solution and architecture is going to be… now being roll out. So, we will have some maybe couple of quarters, which will have the full benefit of that. But going forward it will be an increase. So all-in-all I would say, qualitatively we are very optimistic in terms of, now Oxxo, as you know being, reach a scale of more than 5,000 stores.

José Yordán - UBS

Also, as more of sales are generated from Oxxo, I'm just wondering if there is a secular long-term trend in terms of your working capital position becoming weaker in the longer run.

Juan Fonseca - Investor Relations

Hi, Jose, this is Juan. You mentioned inventory days going up in what business?

José Yordán - UBS

Well, I can’t tell you in what business, generally in total, because you have one balance sheet right?

Juan Fonseca - Investor Relations

Right, so you are talking consolidated numbers.

José Yordán - UBS

That’s right.

Juan Fonseca - Investor Relations

I quite frankly I need to look into and follow-up with you offline, because, I, you know, this is not something that we track on regular basis, but we can certainly follow up.

José Yordán - UBS

Okay, that’s fair enough. Could you perhaps tell me whether in terms of any particular business you are seeing inventories of either raw materials or finished goods being higher?

Javier Astaburuaga - Chief Financial Officer of FEMSA

No, not at all. No, I mean business is… well, it's business is usual and there has not been a significant extraordinary event that we can comment on.

José Yordán - UBS

Okay. And finally then, in terms of with Oxxo taking up more of the sales, consolidated sales, do you see that your cash position in terms of working capital management, is it going to tilted more towards a drain on cash or is it going to mean that your working capital position is going to improve over time?

Javier Astaburuaga - Chief Financial Officer of FEMSA

For the, I would say for the short to medium term, we are looking at a business which still is generating all the resources it needs to grow, and that was technology case last year and this is basically the case this year. It will depend a lot on our long-term perspective on, if we were going to continue at the pace, the number of stores that we have today, if that’s the case, also we will start to generate more resources than it needs to grow. And then it will be a decision of allocating both resources within the FEMSA, different business units going forward. But for the short and medium term, I don’t think that’s going to be a huge number because of the again the pace of growth that we have had and also it's basically one that really consumes all the cash that it generates. It doesn’t need capital infusions, but it doesn’t really generate a lot of excess cash yet.

José Yordán - UBS

Great, thank you very much.

Juan Fonseca - Investor Relations

Thank you. And just to add to that, Jose, this is Juan, I mean in terms of working capital as you know, Oxxo is a negative working capital business whereas obviously the beverage businesses are the highest consumers of capital.

Operator

And we will take our next question from Alex Robert with Santander.

Alex Robert - Santander

Hi everybody. I guess the one question I would like to pose here is that the guidance that really for the beer assets for the rest of the year, and I am kind of… 32%, I guess has been the decline in the first half in operating income. And I can appreciate the steep kind of second half objective that you really are going to need to get into the flat overall guidance for the yea. And I can also appreciate barley as being one of those things that’s tough to track but I guess, as I put in that the 5% year volume growth that you are talking of the second half I am still find it really difficult to get to this breakeven. And I am wondering really as far as the OpEx is concerned and I know I guess for the first half of the year, your OpEx has been outpacing the sales growth by a rather high multiple and whether it’s the marketing in the US with Tecate, and Dos Equis whether it’s the Brazilian marketing and selling expenses are the launches that you are doing in Mexico. Those three elements. I mean what is, and could be the reason why that OpEx kind of slows down, well kind of slows down, so we can perhaps some operating leverage and towards your target if you could kind of comment on the OpEx line that will be great going forward.

Javier Astaburuaga - Chief Financial Officer of FEMSA

Yeah, sure I’ll explain that. Again the second semester should look very different from the first one to really achieve our goal. And you are right, I mean the 5% looks different than the 3% we have got in the first semester. But again we feel comfortable with… June-July trends tells us that those numbers can be there and when you look at the comparisons, that we are going to face are going from August to the December, we think that, that number could be there and that it will depend on a number of things of course. But at least that’s the number we're modeling in or estimate. Pricing, well it’s going to be different, once we’ve taken at least this almost half inflation number that we did in the first semester, it’s going to help. And the raw material we disclosed that that we feel much more comfortable because both because we have hedge and because of the trends that’s on raw materials trends have today that we are comfortable. So all-in-all operating expenses is one what I would say things that we are managing for the second semester, but also we have things that makes us optimistic in terms of our goal. Third one is, just remembering that last year, we had also a very different look for the two semesters. We grew close to 20%, our operating profit on the first semester in 2Q [ph] and that was our comparison base and basically the operating profit for the second half was slightly below ’05. So, we are going to have much more, if it comes well into the second semester.

And Brazil also we're shared in the first quarter that the curb of spending because of the job that we are doing in terms of repositioning Kaiser and Bavaria Premium and also with the launching of Sol, the level of expense as opposed to revenues for the first quarter as opposed the fourth quarter are going to be totally different. We started to launch of Sol on the fourth quarter of ’06 and that was, I mean the highest spending in marketing, that when you look at the full eight quarters ’06 and ’07 Brazil is going to have. So also, we are going to have, also a lift job because of the comparisons we are doing.

All-in-all those are the comments that of course… being very challenging in the second half in order to reverse a red number for the accumulated June figures all demand very, very decisive actions. And also kind of the environment behaving the way we are describing to you guys, in terms of volumes and pricing and specifically some raw material specifics, such as barley for example in Mexico. But all-in-all, the operating expenses are pretty much are all following the rationale that I just described.

Alex Robert - Santander

Okay. And just on the marketing that last follow-up would be, interested to hear that those at least focused or at least the ramp up there, is it safe to assume that that brand going forward, might really get kind of the lion share of the incremental marketing, is there kind of a thinking now in terms of that, that could be a second, if not maybe primary brand to have in the US. And who did you think you took share from, because you clearly on the first half [technical difficulty]?

Javier Astaburuaga - Chief Financial Officer of FEMSA

Yes. First of all, on the first question is, I want to speak about the lion’s share for Dos Equis, what I would tell you that these were the brands that in the past didn’t get the resources that it deserved back in the good old days before Heineken, for the very simple reason that we did not think that the brand will deserve the fur treatment in terms of its development and we were not willing to really put money behind the brand because of that. But now when we have, I would say aligned the vision for managing the true portfolio brand with Heineken, and we have really gathered some very, very helpful insights on consumers and we have fine tuned the positioning and the communication strategy for the brand, and I would say that aligned the vision for the brand going forward with the most important wholesalers in the US, we think now it’s the proper time to put resources behind the brand. So, it's going to get the amount of resources that we think the brand needs in order to achieve a vision that we have aligned with our partners, the Heineken and the wholesaling network in the U.S.

The rest of the portfolio, which is basically the more important ones, the carting [ph] out, the rolling out of Tecate Lite, are getting the resources that they need also. It’s not like we are coming up with a certain amount of money and then slicing it down to see what we can do for each brand. It's he other way around, it's building from down to top, in terms of what do we need to do to really develop these brands at it’s full potential and then putting the resources, the time and the effort between each of those brands in order to really achieve that portfolio vision. That for the first point.

For the second one I think even though Dos Equis has grown at a tremendous rate, it's still from a very, very small base. So, I would not rather say well we are gaining share from a certain brand. What I can tell you is we are gaining awareness, we are increasing the top of mind awareness. Dos Equis is a brand that with aided awareness, it has a lot of recognition but with unaided awareness, it did not. So, I think we are doing the right things in terms of bringing aided awareness, unaided awareness, distribution but now with a very, very we think… very well thought out and very well executed positioning and communication campaign. So, it's very early in the game to say well, we are gaining share from X or Y brand. We think we are gaining a share of mind with consumers and that hopefully is going to keep helping the brand to develop itself.

Alex Robert - Santander

Okay. Thank you.

Javier Astaburuaga - Chief Financial Officer of FEMSA

Thank you.

Operator

We will take our next question from Reinaldo Santana with Deutsche Bank.

Reinaldo Santana - Deutsche Bank

Yes, good afternoon, Javier. Most of my questions have been answered but I have an additional one. Are you maintaining your estimate of guidance of flat EBITDA or breakeven EBIT in Kaiser in Brazil for 2007?

Javier Astaburuaga - Chief Financial Officer of FEMSA

Yes, directionally, we are saying, this is year in which we would like to break even at the EBIT line in Brazil, Reinaldo.

Reinaldo Santana - Deutsche Bank

And sometimes you said in the second quarter, you reached EBIT breakeven but in the fourth quarter, you have very easy comps as compared to last year. Do you think if it… is there is a higher chance for… to achieve a higher EBIT than the breakeven?

Javier Astaburuaga - Chief Financial Officer of FEMSA

No, to tell you the truth we are looking at our… I think we will this year concentrate in terms of spending in the marketing specifically for the fourth quarter but again we will have much tougher comps in terms of volume because the launching of the product, it comes all the time together with filling the pipeline. So we will proper comps and volumes. So, all in all we are still managing the year in a balanced way considering those elements and we are… I would say confident in the way we are going to be able to breakeven at the EBIT but we are not so bullish to say that we are going to be better than that.

Juan Fonseca - Investor Relations

And also Reinaldo, this is Juan. Remember that in the first quarter, we have the big number that we talked about of some 200 million Pesos that we are going to be carrying. So, yes in the fourth quarter, it will help get to the breakeven but we still have a big piece of luggage from the first quarter.

Reinaldo Santana - Deutsche Bank

Thank you.

Operator

[Operator Instructions].

We will take a follow-up question from Andrea Teixeira, JP Morgan.

Andrea Teixeira - JP Morgan

Yes, just… thanks for taking that question. But just following-up on regarding the SG&A to meet the guidance. As far as I understand, what you explained is that you are going to be keeping this same sort of expenditure that you have and the part of the expenditure that you have in the first half of the year. But as I see the numbers here, the first quarter of ’06 was actually in the year that… I mean a quarter that you guys had an improvement in SG&A. Can you elaborate if that is going to mean… that they are going to be putting, I mean… as far as I remember you had some launches of SKUs in the first quarter. Is that where, over last year that’s where you're going to be saving money with? Or can you elaborate more on the SG&A expenditures, I would appreciate? Thank you.

Juan Fonseca - Investor Relations

Hi Andrea, this is Juan. There isn't any, let's say, specific launch or a specific project that moved the needle one way or the other that we lasted this year, it would make a big difference. I think, as Javier mentioned there is lot of things that have to happen. If you look at the growth of SG&A, the trend, even this second quarter we already showed slight improvement vis-à-vis the trends of several previous quarters. So, I don’t think it's one isolated thing that you can narrow it down to. We will continue to… the initiative that we have talked about now for three or four quarters in terms of supporting the brands and modifying the way that we deal with some retailers in terms of the support we provide to them and the margin that we adjust, that will continue, that will continue and there isn’t really one thing that I can point to that makes the difference. It’s really all of them put together.

Andrea Teixeira - JP Morgan

And, I appreciate that, Juan. But I think like one of the… think of its sitting, in past fiscals also regarding… and Javier was explaining in terms of increasing the distribution of the prices of a bunch of attributers, that works against you in terms of SG&A level. But what is it that I am not understating of a better… I understand that you sense the point [ph], but can you give a just anecdotal evidence of saving, is that the ERP systems that are now some of the consultants that you have hired before. Now you don’t have that expense, what's really that you are saving if you are putting… I understand that in order to make it for the sharp [ph] increase from 5% minimum to reach the breakeven, the top-line you cannot save a monthly initiatives. So, what's being in the downside here in terms of expenses?

Juan Fonseca - Investor Relations

Well, you point to one that is accurate which is the amortization of the ERP, similar what's happening also, we are getting to the point where the first layer is having fully amortized and you begin to see that benefit in the OpEx. But that’s just one thing that contributes. Other than that it's just overall containment of expenses and managing your launches and your strategy to provide the business with what it needs, but also keeping an eye on the management in the short-term.

Andrea Teixeira - JP Morgan

So, do you think it’s still feasible to keep the same… the 5% is definitely feasible on top of… for the top-line second half of the year?

Juan Fonseca - Investor Relations

Yes, I mean, if we get the 5% plus volume, and as I have mentioned we already put the price increases which today take us to about half of inflation, then 5% volume with 2% down in real pricing and wherever that takes. But it's still going to be a pretty good top-line number.

Andrea Teixeira - JP Morgan

Okay, great. Thank you very much.

Juan Fonseca - Investor Relations

Sure.

Operator

We will take our next question from Lorrie Serra with Morgan Stanley.

Loredana Serra - Morgan Stanley

Yes, I just… couple of quick follow-ups. Thank you. Javier did say that pricing today is like 2% higher than it was at the beginning of the year, post whatever pricing actions you took in May or June, is that correct? Like, if we take it where you are today versus where you were at the start of the year?

Javier Astaburuaga - Chief Financial Officer of FEMSA

Yes.

Loredana Serra - Morgan Stanley

Okay. And second quick question is, you mentioned that you're fully amortized most of the ERP, why did it your amortization in beer go up… a little over 7% in the quarter? It's flat… it's pretty flat for the first half but it’s up in the quarter.

Juan Fonseca - Investor Relations

That would have more to do with the point of sale, especially related to soft than the actual ERP, I mean the ERP is really the first layer, that I mean… remember that this took us a while to deploy, several years. So it’s also going to… it’s going to show well over time in terms of taking pressure off the SG&A. I would think and then we can also follow-up on this and then see if we can get more granular but it has more to do with the dynamics in the facilities [ph] then with the ERP.

Loredana Serra - Morgan Stanley

Okay. And then maybe this is beating a dead horse, but it’s interesting to hear you talk about needing 5% volume growth to hit your numbers because your volume trends have been pretty good, I mean in aggregate, I mean they haven’t been down. And I guess the question that we are trying… I'd lobe to be able to understand a bit better is it, sort of the SG&A has grown above sales on sort of a sustained basis for the last couple of years. And are you basically telling us you're just going to tighten your belt for the second half of the year to be more accountable for hitting the [inaudible] all your numbers? Are you telling us that there are ways in which you could sort of change that equation and have selling and administrative expenses grow less than sales on a more than sort of six months basis.

Javier Astaburuaga - Chief Financial Officer of FEMSA

This is Javier Astaburuaga. I would say that it’s a combination of things, I can share maybe a couple of examples without going to try to reconcile the whole operating expenses line on the P&L. But we have talked a lot about de-fencing the spending of marketing resources in different markets Brazil, Mexico things like that. We have talked about, for example these finalizing the amortization of the ERP, having some effect on the second quarter but having a much more of an impact on the second half than it did for the first half. I can share with you, for Mexico for example we have talked in the past that, we invested a lot in certain things such as building infrastructure and let's say, installing certain capacities in terms of processes and technology in certain markets, which we call the, well, let's say the operating model way of doing things at FEMSA Cerveza. And we have to talk about the need to now develop competencies, and capabilities within people to really use to its full potential that kind of infrastructure and there was kind of a number of projects going on in brewery. And last year, if you look at how much we spent, we spent a lot of money which we are going to do also this year but with different seasonality as the one we are going to do this year. So, we spent the bulk of this last year on the second half, and we spend now more evenly during the year. So, there are some other things that just by… because of the arithmetics of where the money were spent in the different quarters. Now we are going to have the benefit from the second half as opposed to being hurt in the first half.

So I would say it's a combination. As we have stated, every 10 queries [ph] we are very sure that we have built a now sound vehicles for, I would say the resources that we feel comfortable with putting behind the brands in the three markets being there, with different course of development of course and with different intentions. It’s a very, very different story that play… the game that we are trying to play in Brazil with an 8% share as opposed to the U.S. in which we have a little bit less than 20% on the Mexican input segment as opposed to the mid forties we have in Mexico, and more specifically when you look at the regions. So, I would say we are not again doing whatever it takes. We think that the right thing for the long-term for the business is, keep on increasing the investments in certain things in the second semester. We are sticking to that. But we are doing some extra efforts in some areas where they're hurting some things which we think are not going to hurt the business long-term and also we are taking advantage of the comparisons which one we have made some investments, and spending in the past as opposed to where we are going to do it now.

Juan Fonseca - Investor Relations

I would Laurie, I mean you mentioned that the volume growth we have had, it’s not bad, and we agree. I mean 3% doesn’t look bad at all. It’s not where we have been trend wise, it’s not where we want to be objective wise and of course when we make the our business plans at the beginning of the year or prior to the beginning of the year, you need to fund your spending with your volume and your pricing. And if things don’t work out fully at that end then, then you are sure short of funding. So even if your volume number looks okay it’s not what we… it’s not what we need.

Going back to the second part of your question, we do need to get some things happening not just at the SG&A level but it’s really at the volume level, at the COGS level and at the SG&A level that will get us to the objective.

Loredana Serra - Morgan Stanley

Okay. Thanks.

Juan Fonseca - Investor Relations

Sure.

Operator

We will take our next question from Celso Sanchez with Citigroup.

Celso Sanchez - Citigroup

Hi, good afternoon. I just want to talk about the pricing theme a bit again. It seems, if I am not mistaken, on a year-over-year basis, your pricing was flattered by the inclusion of direct distribution volumes that you picked up towards the end of second quarter last year to the tune of about 100 basis points, I am not sure if that’s correct. But if that’s the case, I just wonder obviously, you waited for the end of the quarter to do pricing when you are comfortable. How susceptible going -forward do you think you are to competitive pricing activity or how much of a function is your pricing policy of the competitive environment and how different might that be than five years ago when you didn’t have the systems in place that you have now to execute your management strategy?

Javier Astaburuaga - Chief Financial Officer of FEMSA

Hi, this is Javier. I would say that even though the industry has been able only to translate into pricing, a fraction of the specific inflation of the industry, the environment in terms of promotional activity is pretty, pretty rational. I think that the people that have the perpetuity [ph] to come down and travel around the country, will find I think promotional activity being done in a way in which I think it’s still working in favor of the, I would say perceived quality of the category that consumers should have. It’s not like our promos are discounting heavily, and just for the sake of it but you will find some I would say interesting promotional activity. And I would give you a example. We have now I would say first promotional activity combining Dominos Pizza and Sol brand, which was unforeseeable, I would say in the past, not only because the capabilities required to execute such promotion was not there, but also because nobody was thinking about putting together value propositions to consumer… to consumers such as that.

So my sense is that I would say that the rationale within the promotional activity is there, and I think it’s been good for the industry to increase the relevance of the category in the minds of consumers. So that will be my comment on the promotional activity.

In terms of the ability and I would say the very, very careful eye so that we may have with regarding looking at what the competitor does in terms of its pricing activity all over the place. We are very, very close. Day-by-day monitoring that and reacting as fast as we think we should in some cases, or just staying the way we are in some other things which we don’t think, our pricing strategies are one that could affect our business short, medium-term. And of course we are taking advantage of our ability to react in a very differentiated way. And we are doing that everyday in every market, let me tell you that. I mean, it’s not like there’s one thing happening or going on all over the place and we are reacting the same way. The pricing dynamics have come to be very, very that, very dynamic and I think that we are comfortable in that environment. We are in some cases provoking that and in some others we are reacting to that. And I… we think that I would say that healthier, natural development of the category has a lot to do with that. With the category we are sending to the consumers on a continuous way, propositions that would capture their attention, their imagination and hopefully that they continue to buy more beer than any other beverage product that they may think of, in the spectrum of beverages here in Mexico.

Celso Sanchez - Citigroup

Okay. Thank you.

Operator

Having no further questions I would like to turn the conference over to Mr. Astaburuaga for any additional or closing comments.

Javier Astaburuaga - Chief Financial Officer of FEMSA

Well, thank you very much for your participation, all of you, today. Plus clearly we have our work cut out for us, as we navigate the second half of the year. And I reckon the stress on those numbers was we aim to balance as much as possible the short and long term performance, it is the long term sustainable creation of value that drives our strategy and we'll be very, very optimistic about where we are going. Have a great week everyone. Thank you, again. Bye.

Operator

Thank you. Ladies and gentlemen if you wish to access the replay for this call you may do so by dialing 1-888-203-1112 or 719-457-0820 with a pass code of 4253562.

This concludes our conference for today. Thank you for participating and have a nice day. All parties may now disconnect.

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Source: Fomento Economico Mexicano Q2 2007 Earnings Call Transcript
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