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

Q3 2007 Earnings Call

October 29, 2007, 12:00 PM ET

Executives

Javier Astaburuaga - CFO

Juan Fonseca - IR

Analysts

Lauren Torres - HSBC

Tufic Salem - Credit Suisse

Reinaldo Santana - Deutsche Bank

Andrea Teixeira - J.P. Morgan

Loredana Serra - Morgan Stanley

Alexander Robarts - Santander

Robert Ford - Merrill Lynch

Sohel Amir - Lucite Research

Presentation

Operator

Good morning everyone and welcome to FEMSA's Third 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 can materially impact the company's actual performance.

At this time, I will now turn the conference over to Javier Astaburuaga, FEMSA's CFO. Please go ahead, Javier.

Javier Astaburuaga - Chief Financial Officer

Thank you. Hi good morning everyone. Welcome to FEMSA's third quarter 2007 earnings conference call. Joining me today are José Antonio [ph] and Juan Fonseca, both of whom you know well.

Our third quarter results once again show progress across our operations. But there were sensible differences among businesses and among markets. At Coco-cola FEMSA, our performance in the key Mexican market continued to improve, while most of other territories again delivered strong numbers. At Oxxo, same-store sales continued to recover after a slow start of the year and margins expanded significantly.

At FEMSA Cerveza, a promising start for the quarter in Mexico, quickly deteriorated as rainy weather again played a role in September, this time mainly in the Southeast of the country; and the competitive environment intensified as the level of promotional activity increased across several markets. On top of that, we continued to feel sustained pressure from higher raw material prices, mainly in soft commodities. And following our long-term strategy, we continue to invest in our brand building efforts in Mexico, Brazil and the U.S.

However, what said and done for the quarter, FEMSA consolidated achieved robust revenue and operating income growth above 7% in real terms, and majority net income increase up 10.4%.

Moving on to our business units; at FEMSA Cerveza, their margin growth in Mexico started strong during July and August, but slowed down significantly during September, delivering a 3.5% growth for the quarter. In Brazil, we managed to grow volumes by 6.7%, even as lapped the inventory build-up ahead of the relaunch of brand Kaiser in September of last year and brand Sol continued to perform according to plans.

In exports, volumes grew by just 2.3%, but wholesaler inventories depletions continued to run in the teens, on-track for full year double-digit volume growth, on the continued strength of Dos Equis, and Tecate.

Pricing in real terms in Mexico was flat year-on-year, are now at 1.6% sequentially. The three main reasons behind these numbers: one, the low inflation price increases implemented during the first half of the year; second, some favorable geographic and product mix effects; and third, the positive pricing effects of incremental domestic volume growth on their direct distribution during the second and third quarters through several small transactions across the country.

In Brazil, where we implemented a price increase late in the first quarter, revenue per hectoliter increased 1.7%, while in our exports revenues per hectoliter were 3% of the effect of inflation and a strong Peso offset a moderate increase of 0.7% in dollar terms.

Finally, revenues for packaging again fell during the quarter, reflecting the fact that we're no longer making any third-party sales of glass bottles, of Sol capacities being used to meet our own demand.

On the cost of sales front, we saw an increase of 6.4% resulting mainly from total volume growth of 4.1% and from higher prices for grains, which are now rich [ph] are up are up almost 30% year-over-year. However, the reported cost increase would have been in the high single-digits, were in not for the strong behavior of the Mexican Peso and the Brazilian Real. So pressure on our gross margins remained higher than we have anticipated.

Income from operations decreased 8.8%. Administrative expenses were again well contained during the quarter, following by 0.5 percentage point and selling expenses increased 7.9%, but still contribute with over a third of the increase, as we continued to invest in our brand portfolio. Yet we again managed to breakeven at the operating income level in Brazil for the quarter. It is important to note, that while our performance in Brazil is advancing according to plan, we are seeing a widespread increase in marketing activity by the Brazilian Brewer industry in general and therefore we are stepping up our own efforts accordingly.

Selling expenses ex-Brazil grew at the lowest rates in the past eight quarters, but still ahead of revenues. As we have mentioned in the past, the actual level of spending in our three main markets Mexico, Brazil and the U.S. is linked to our continuing investment in initiatives aimed at strengthening our long-term competitive position in Mexico and developing our brands in our three key markets.

All in, these results are better than the previous two quarters, but certainly weaker than our expectations for a marked recovery in the second half of the year. Softer Mexico volumes late in the quarter have prompted increased promotional activity, pressuring price across the board, a phenomena that we see continuing into the fourth quarter.

Given the increasingly adverse cost environmental in soft commodities, it is now evident that we will see a decrease in operating income for the full year that could, if the current pricing environment persists, potentially break into the double digits. Such a scenario would imply compression of FEMSA Cerveza's 2007 operating margin on the order of 180 basis points versus 2006 levels.

Clearly, this is surely not to be a year where most external variables that impact our big business have moved in the wrong direction, greater input costs, competitive environment and in the meantime, we must continue to execute, our long-term strategy, even if these means putting incremental pressure on our short-term results. Longer term, we are convinced that our strengthened brands and improved competitive position will serve us very well for years to come.

Turning to our soft drink business; Coca-Cola FEMSA delivered a solid quarter where Mexican operations once more showed improving volume on profitability dynamics, while most operations outside of Mexico again delivered outstanding results. Total revenues increased 6% and income from operations increased 11.5% representing an expansion of 80 basis points in the operating margins.

In the key Mexican markets, revenues increase 3.3%, beer pricing was down 1.5 driven by the fast volume growth of jug water, but was perhaps ex-U.S. [ph]. Brand Coca-Cola continued to drive high-margin growth with volumes up 4.5%, better CNG pricing and lower PET resin costs offset pressure from high fructose sweetener, and operating income grew by 3.4%, deferred such increase in third quarter.

Operating income generated by our operations outside of Mexico continued to represent the growing share of the total. And for the third quarter it reached 39%, up from 34% in 2006. If you were unable to participate in Coca-Cola FEMSA Conference Call last Friday, you can access replay of the webcast for additional details on the results.

Finally, at Oxxo, same-store sales continued to recover and grew 3.4% for the quarter, driven mainly by sustained profit growth as we continued to broaden the product assortment at the store. We opened 140 new stores during the period, 24 more than in the comparable period of last year for a total of 755 net openings in the last 12 months, on-track to our full year objective. As a result, revenues increased 15.2% during the quarter. Gross profit improved 18.9%, driven once more by the implementation of improved pricing strategies and promotions, as well as by a strong performance from some high margins at beverage, such as coffee and alternative beverages.

Operating expenses grew slightly below revenues and helped or boost income from operations by 47.5% for the quarter. Operating margin expanded by 120 basis points to reach 5.4% of revenue. So Oxxo once more delivered strong set of numbers and continues to execute ahead of plan.

Summing up, in spite of the challenging environment, our integrated beverage platforms delivered results while we stick to our long-term strategy, including the strengthening of our brand portfolios and the evolution of our business models, not only developing the capabilities to operate multiple beverage categories across multiple markets.

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

Question And Answer

Operator

Yes. Thank you, Javier. The question-and-answer session will begin at this time. [Operator Instructions]. Our first question is from Lauren Torres with HSBC. Ms. Torres please state your question.

Lauren Torres - HSBC

Yes, hi, I was hoping, you could talk a little bit more about your cost outlook at FEMSA Cerveza. Any color as far as your outlook on... particularly, on grain costs, and also in Mexico, pricing outlook if you could talk about your expectations for this quarter and potentially if you could even talk about your outlook for next year, that would be helpful. Thanks.

Javier Astaburuaga - Chief Financial Officer

Sure, on the cost outlook, as I mentioned we have been seeing that pressure on soft commodities. I would say all sorts of grains, not only grains but also crops were about kind of seeing pressure on a global basis. And I would think that that will continue into 2008. As you remember, we negotiate most of our barley needs here in Mexico, but we also import a significant amount from outside and at least for the first six months of next year, we would be still facing pressure on grains, basically barley and the corn starch also. And that's basically the cost outlook in terms of the most significant factor that would be putting pressure on our cost side. We don't think the cost of what we've been discussing with you, in terms of hedging our aluminum prices needs. So I think aluminum is going to be not putting pressure anymore on the cost side, but grains will continue to do so going forward.

And the pricing outlook as I said, we are looking an increased promotional activity for the last couple of months and we are seeing that continue into the fourth quarter of this year. So, that's kind of our take. And to talk about 2008, I think it's a little bit premature. We have been seeing both the pricing activity and the... I would say increase not being able to recover, not even general inflation but specific inflation for the beer industry in 2007 is basically a fact for the full year already. So, going into 2008, we would... I would say, think a little bit more positive going forward, but still very early to tell anything really about 2008.

Lauren Torres - HSBC

But you are seeing that activity go on into the fourth quarter?

Javier Astaburuaga - Chief Financial Officer

Yeah, and that's kind of what we're looking in the marketplace nowadays.

Lauren Torres - HSBC

Okay. Thank you.

Javier Astaburuaga - Chief Financial Officer

Thank you.

Operator

We'll go next to Tufic Salem with Credit Suisse.

Tufic Salem - Credit Suisse

Yes good morning. My question is regarding your investment behind the brands, I understand your long-term strategy is to support your portfolio. But I want to get a better sense of... do you see more competitive environment now and into the fourth quarter. You can give us a better estimate of when you think we'll see higher returns from those investments? In other words, when can we see sales grow faster than the expense or the sales expenses into these brands, if you have a better idea now that would it be either with this comparative environment; and also if, do you expect this will be from higher at sales or it will be from reaching a level of investment that is satisfactory for you?

Javier Astaburuaga - Chief Financial Officer

Yes. Basic reasons behind revenues this year coming below, I would say the trend that we have had in the last three to four years is basically I would say a decrease in the real-term pricing for all beer sold in Mexico. So that really created a very, very particular scenario for the year in which again pricing was soft, both commodity prices were soft, and... what we have said here Tufic is that, we are very, very convinced that we should keep on doing the things that are good for the business long-term. So the year presented a challenge in the sense that it created a number of questions for management to try to manage the short-term, but still looking for the long term. And what we have decided and we have been executing and as I almost... I mean and as I said also, we are at some points also even increasing our investment behind the brands and that will be particularly the case of Brazil for this second semester.

We see the competitive environment and competitors doing also on a step-up in the marketing investment behind the brands, and we feel that we need keep putting money behind the brands really. I would say in a very different way creating the portfolio in Brazil and to continue strengthening our already established portfolio brands in Mexico and the U.S, we will continue to do so. What we have to do is to, I think, stick to our guns in terms of refining our business models, investing behind the brands and hoping for much better scenarios going forward, both in terms of pricing of the products and in terms of the prices of the raw materials that we need to produce our beers.

So, my answer would be, we would like the environment to be better, both in terms of pricing of products and the cost of our commodities. But if that's not the case, I don't think we are going to change our course of action in terms of investing behind the brands, what we think is the deferred share of what our brand needs to really keep on strengthening going forward. So in the end, return on our investment would be a factor... or it will be a function of how good we are doing our own stuff and how well the scenario behaves going forward. And on that second point, I think... I really do not have all the answers, as I am guessing nobody does.

Tufic Salem - Credit Suisse

Okay, so I just want to make sure and I guess I would be more... a little bit more critical about Mexico where you have a better sense of who your competitor is and your positioning. And from what I understand there is no... I am just speaking about Mexico, so there if there is no specific quarter or it's a method that you can get to where you think we can... given the current environment, do you think we could see that sales going up more than expense?

Javier Astaburuaga - Chief Financial Officer

No. Again, if you recall, we started the year with good perspectives. We initially moved our pricing and if you recall, one-third of our volume, I would say pretty much in line with the expected inflation for the year. Competitive dynamics didn't give room for us to continue on that line. So we again decided to manage the year in a better, I mean in the most appropriate way, both in terms, managing the short-term dynamics of pricing, volume dynamics; but at the same time, continued to invest for the long-term, as we think is the right thing to do. So going forward, again the market dynamics will tell us... how I would say, how good pricing or how solid pricing will it be going forward, and I would see that will be a key determinant, that if we can look at the good numbers at the bottom line or we will still continue to see some pressure on our numbers and on everybody's numbers....

Tufic Salem - Credit Suisse

Okay. Thank you.

Javier Astaburuaga - Chief Financial Officer

Thank you.

Operator

We go next to Reinaldo Santana, Deutsche Bank.

Reinaldo Santana - Deutsche Bank

Yes, good afternoon. Is there... given that the selling expenses continued to be at the high levels and you will continue to invest behind the brands in Mexico and Brazil. Is there going forward, administrative expenses at FEMSA Cerveza to decline, because in the last quarters we have not seen that clear trend to offset higher selling expenses going forward?

Javier Astaburuaga - Chief Financial Officer

Yes, so Reinaldo. Yes a couple of comments here; we have said that in the past and I would like to reiterate that the bulk of the increase on the selling expenses are now driven by incremental marketing expenses behind the brands in the three main markets, and that will continue to reaffirm turnoff, again given our brands deferred share of investment for its proper development going forward. And in terms of the administrative expenses, I think that going forward, you will see an effort to contain increases on that line, and I'm sure that's something that it's being worked, not only in the FEMSA Cerveza business but also in Coca-Cola FEMSA and in Oxxo. I think that the if you look at the quarter, you are already seeing some of that work and some effort that we show the decline on the line of administrative expenses for Oxxo and basically pretty much flat number on beer. And going forward, I think that we have some room there to work with. So yes, we will continue trying to optimize as much as we can administrative expenses to keep funding incremental marketing investment behind our brands going forward.

Reinaldo Santana - Deutsche Bank

Thank you Javier.

Javier Astaburuaga - Chief Financial Officer

Thank you Reinaldo.

Operator

We go next to Andrea Teixeira from J.P. Morgan.

Andrea Teixeira - J.P. Morgan

Hi good morning everyone, actually good afternoon. Do you see exports would have been more on, if we do the math here and you are talking about 180 basis points decline this year, in terms of its margins. We can see probably and going with your comments regarding the cost environment. So on that issue we should continue to see a decline [ph] in operating margin, that's my first question. My second question would be given that your performance, have you seen your competitor all in [ph] Mexico having a more challenging environment, for costs and I know there are some deft comments, that you are not facing as much of the cost increase, that you had some from Magellan [ph], to say in the context, of the..., do you see like longer effects of these of in the pricing that you are going to have to bear here again and you'll both of you are delaying the prices next year?

Juan Fonseca - Investor Relations

Andrea hi this is Juan. you were breaking up a little bit during, as you were asking your question, so I assume we got it right. Your first question is... has to do with the margins next year, I mean if we are saying that EBIT margin could compress in '07, up to a 180 basis points, are you asking us what our expectation would be for next year?

Andrea Teixeira - J.P. Morgan

Because the comments that you've made on the cost pressures and the... because of the [indiscernible] from a given source for the first half of next year?

Juan Fonseca - Investor Relations

Yeah, I mean, assuming lets say normal conditions up in the top line part of the income statement, if volumes behave the way we think they will and if pricing becomes a little bit more rational, you should expect us to go for a stable margin. The earnings growth model of the beer business for a number of years now has been driven by growth in the top line holding the margins constant and then that gets you to a mid single-digit type of EBIT growth. That's what you should expect again assuming a normal volume and pricing dynamics.

The second part of your question has to do with Coke-FEMSA and the concentrate increases next year and implications of that? Is that correct?

Andrea Teixeira - J.P. Morgan

Oh no actually I am sorry is [indiscernible] year and the pricing environment from U.S. and the competitor given the fact that they made public statements in their conference call, they are not seeing much of a cost increase next year. So in that sense you are going to be more of a price follow as usual and then waiting to see if there will be a price increase to compensate that cost increase that you are facing now?

Juan Fonseca - Investor Relations

Yeah I am not sure about the competitors hedging or provision for trying to reduce pressure on grains, but what I can tell you is, we will continue to manage pricing strategy here in Mexico, both by taking actions and following the competitor dynamics. So, it's lot like we are just at looking at what's going on, but its not like we're out being if we were alone.

So it's a very, very competitive environment both of us of course are looking to do what we think is best for the business. I am assuming that we will as I told you, we would be looking at pressures from the grain side. I am assuming that our competitors here in Mexico will still look at that and we will have a very different year next year, now that the crown thing is already there. So we may need to wait until the first quarter to see how things develop.

Andrea Teixeira - J.P. Morgan

Okay, great. Thank you very much.

Juan Fonseca - Investor Relations

Thank you

Operator

We'll go next Lore Serra from Morgan Stanley.

Loredana Serra - Morgan Stanley

Yes, I wanted to ask two questions; just quickly on Oxxo, can you update us in terms of the number of expected store openings for 2007? And then going back to beer, can you just give a little bit more description or detail behind the change in competitive environment, that I guess you are saying you have seen since September, if you could talk about regional or product or channel trends that would be helpful? Thanks.

Javier Astaburuaga - Chief Financial Officer

Yes, Lore this is Javier. We are estimating 720, 730 at the most openings and of course, you can recall that the fourth quarter is the quarter in which the bulk openings takes place. So the people are also are always crossing their fingers, so they can accomplish their objectives and the of course that's a big part of also their compensations. So, as in the past, we are confident they will achieve those targets, as they have done in the past.

And in the terms of I would say there competitive environment, the best way to look at it is I think that... again the very, very radical behavior of the month of September I think prompted both brewers to take actions in terms of trying to protect volumes going into the fourth quarter. So the vast majority of the things we would be looking at are cost promotional kind of activities. I wouldn't say, we are looking at a number of destructive on un-rational kind of promotional activities. As a matter of fact, at least what we are trying to do is to kind of couple promotional activities with the step-up of marketing investment behind the brands, trying to give it the right level of support to keep on building the strength of the category. And my sense is that the categories are strong, there are some healthier assets [ph]. I think there's a number of features starting with weather but going also with maybe, a little big softness of the consumer, available income. So I would say that's it's a very, very different picture once you go in through different regions. Each brewer is taking I would say the initiative on trying to build, I would say volumes, on the different brands and they still use which they feel is more appropriate, and in some cases, I'm not saying that we are only reacting as I said, we are taking the initiative in those markets in which we feel it's important for us to really stimulate demand and to help a little bit consumers, so volumes are there. And in some others we're basically reacting to some of the activities that our competitor is putting into the marketplace.

So, all in all, I would say there is not a really one way of doing all across the country and it's not in all country what we're looking in terms of promotional activities. So its a little bit mix, it's a mixed picture. But I wouldn't say its promotional activity which has been either un-rational or destructive because again it's coming a long way with a the good level of support that the brands deserve when we are in the middle of promotional activities, so this is why we are in.

Loredana Serra - Morgan Stanley

But let me just understand, when you are using the word promotional, do you mean discounting or do you mean sort of buy three, get one free; and help me understand the difference between rational and irrational, because some of your comments earlier on sounded like you were leaning more towards the irrational end of the spectrum, when you are saying it's not irrational. So help me understand that please?

Javier Astaburuaga - Chief Financial Officer

No, I would say, it's not reducing prices. It's more like stimulating consumption. So, I wouldn't say like buy two and get three; that will be very, very aggressive. It's much more softer than that and it's... in a number of places, it's a combination with some cross-promotional products. It's not only driven by beer, it has some very different mechanics. And I would say that promotional activity is not something which we feel is hurting, either the brand equity of the brands or the practice of the beer category in it's own. And I was not trying to convey the message that the promotional activities being un-rational, what I was trying to convey is that regretfully, it's coming into a time in which we are being hurt by not only both soft pricing, but and commodity price is going up, but also a slowing of demand. A lot of which, I would say is still driven by weather, but a little bit of that also is driven by consumer, which is may be today not as confident and spending that it was in the last couple of years. So that's kind of the environment that I can describe to you Lore.

Loredana Serra - Morgan Stanley

Great, thank you.

Juan Fonseca - Investor Relations

I would just add one thing Lore, this is Juan; on the, also the question... when you asked about the number of stores. If you look at the last 12-month opening, I think we are at something like 755. So it would look like we are going to hit a bigger number possibly, but really what's happening is, if you remember we've been trying to open more stores in the first quarter as opposed to the fourth, and I think in the first quarter and the third quarter, we managed to do that. So, that the run rate looks high but we're still aiming for a few more stores than we opened last year, which the number last year was 706. So that's how you reconcile the 755 last 12 months to the 727-30 that Javier mentioned.

So, I think also it's exceeding in pushing a little bit more openings to the first few quarters, so that you capture more sales throughout the year and put less pressure on the structure during the fourth quarter, which is a big quarter to actually just to push sales.

Loredana Serra - Morgan Stanley

Got it. Thank you.

Operator

We'll go next to Laban Von Gartem from Roth Capital [ph].

Unidentified Analyst

Good morning Javier. I want to talk a little bit about and get a better feel from you in terms of not being able to release price to inflation. Obviously, yourself and your primary competitor there, is there something you think that it's happening from their perspective, as I think one of the previous callers had kind of alluded to whether if they may have something from a cost perspective that allows them the price under inflation, or is there something particular that's happening that won't allow you to price at least to a inflation?

Javier Astaburuaga - Chief Financial Officer

Yes I'm not really sure about our position on that. But I heard some comments on. Again it sounded to be elusive. I think that 2007 was very, very... I would say particular year for our competitor at least during Mexico, because of the crown input kind of effect on the financial structure, on the number that our competitor deliver in this year. And that's not going to be the case in 2008 but as far as we know again. Not only us but also them fulfill more of their needs through domestic crops in terms of the barley needs. The two companies do not use exactly the same formulation for the products as you may well know, but what we've been looking at least on the Mexican side is a continued pressure on that cost.

When we look at the international, again trends on barley and the rest of the grains but still there is going to be a significant pressure, and then anticipating that our beer business is going to have an impact on that. And at the same time, I am trying to convey the message that we will continue as we did in this year to try to really I would say send the right messages and do the right things for the business, in terms of the pricing environment. I think that the beer industry in Mexico is today in a much more stronger position in terms of having different brands and unless we use position in different price segments, which makes it very, very hard for anybody to think that it may be successful, may be entering. And I think that speaks well for the industry in terms of I would say satisfying different consumer needs for different products at different price points. And that's a good thing for the industry I think. But going forward I think that as long as I would say, consumer demand is not as strong as we would like it to be and steel commodity price is putting pressure on both companies' margins, I would hope that an environment for rational pricing will be out there. And but at the same time I am just trying also to convey the message that we would manage the business for the long-term in terms of investing behind the brands and still trying to push as much as we can for the more proper pricing environment in the short-term, not only by waiting to see what happens, but also by trying to take advantage of some of the many margin opportunities that we may see from a different region to another from a different brand....

Unidentified Analyst

And you have alluded to it earlier, is there a way for you to maybe give us a sense of the increase step up promotional spend, what percentage of it kind of was associated with trying to push these additional volumes versus some of the brand differentiation, versus some of the more competitive side of the business? I guess what I'm looking for is to try to understand if there is any change in thinking from your perspective as to when we may be seeing more competition entering in the market or a timing related that?

Javier Astaburuaga - Chief Financial Officer

No. I would tell you the bulk of the increase on the selling expenses, basically driven by increased marketing investment behind the brands into three markets and I am speaking about Mexico, U.S., Brazil; significant amounts are driven by very different reasons as I have stated in the past. Basically in U.S. we're complying with the three-year agreement that we've had with Heineken, when it all started three years ago. So that's basically a contract-driven kind of step-up marketing which has a clear investment rationale, and I think that we are at least very pleased with the results going into the third year of this relationship with Heineken in the U.S.

In Brazil it's a very different story and again it's basically trying to establish a portfolio which was in a very serious problem. And in Mexico, just a continuation or I would say maybe it's a little bit intensifying our efforts in some fronts, and we are still very, very pleased with the results when we look at our internal brand equity monitoring reporting system, that we are still creating those attributes into different brands that we need to create to differentiate them from the rest of the brands. So most of it, without going into numbers, I can tell you most of the increased investments, increasing in selling expenses is driven by marketing investment.

Unidentified Analyst

Okay. And just want a clarification, I think you said earlier, you was talking about margins being down, I think it was 180 basis points versus '06. I think you said right before that, I thought you were about mid-teens kind of acquired for EBIT for the full year. Is that correct?

Unidentified Company Representative

No what we said is, if the pricing environment were to continue the way that we see it today throughout the rest of the year, the EBIT declines for the year could break into the double-digits. But, that's basically what we said.

Unidentified Analyst

Thanks guys.

Operator

We will go next to Alex Robarts with Santander.

Alexander Robarts - Santander

Hi, I also had two questions and I was hoping to first of all, just drill down into the raw materials and really barley; I mean it's kind of interesting, obviously the industry globally is facing this challenge and we can see it in the price chart that's up the grain. But, I mean you talked about a 30% increase in grains. If we could kind of just take a look at your barley and maybe get a sense... I appreciate you are doing some contracts probably now, and looking it at next year and everything is not clear for next year. But what would you think would be your barley price increase '07 versus '06? And do you think there is a... if there's some color you could give us into what it might be kind of into '08, in other words, is that a spike that your sensing? Are your grain people saying this is a spike? Are your people projecting that maybe this could be a new level for barely worldwide and therefore would be reflected next year? Any color would be great.

Javier Astaburuaga - Chief Financial Officer

Sure, yes Alex the first comment I will make is when we look at barley we... because of the way we buy the crops is significantly difference from Mexico to Brazil. The impact on the barley cost is very different from one country to another. Brazil this year didn't really have a real pressure on barley prices, because of the how the contracts were established for 2007. As in Mexico, there is very different story, there is two time... two crops in the year. There is not really possibility to establish long-term agreements. So you get, I would say a very short-term negotiation environment in which you have to deal with. There's a well-organized structure of people which are the ones in charge of raising the crops here in Mexico. So it's a very different picture from one country to another.

The second comment I would make is that, when we were mentioning 30% on the overall grain mix that we are suffering, I would say that barley is something like 5 to 10 percentage points below that 30%. So the rest of the grains are the ones which are experiencing more serious pressure.

And finally, speaking about prospects going forward, as I said, at least during the first semester of 2008, we will continue to see pressure on prices on grains. Going beyond that, I feel a little bit glory [ph] for us and we don't see any reason of why prices should come down dramatically going into the second part of 2008, and I wouldn't dare to talk about 2009. It's really still a timing which there is a number of reallocation of land being planted by different grains and our people at the brewery are still looking at the developments on the different regions of the world, to trying to come with a proper set of decisions and mechanisms that will allow us to really contain the cost the most but we can. But that's basically our stake today.

Juan Fonseca - Investor Relations

And one more thing I'll comment; this year in addition to the, let's say the bio-fuel driven pressure that has affected most grains in the case of barley specifically, you had weather-related events, basically draughts in Australian fronts which are big growers. So it also was kind of a bad year generally speaking for barley. And we should assume that's not going to be the case every year. So keep our fingers crossed.

Alexander Robarts - Santander

Okay, so it's safe to assume that perhaps the 20% year-on-year barley increase has been more recent and in fact the '07, '06 increase on average is probably lower than the 20%?

Javier Astaburuaga - Chief Financial Officer

You are saying a '08, '07?

Alexander Robarts - Santander

No, '07, '06.

Javier Astaburuaga - Chief Financial Officer

I would say that when the year closes it may be around that numbers. Once you take into account that we're still left with the fourth quarter, which prices are going to be significantly higher than fourth quarter 2006. So, I think it's a good number for the full year.

Alexander Robarts - Santander

Okay. Great that's helpful. And just but the last one a question is more strategic and I am kind of thinking about FEMSA Beer in the context of Argentinea and Brazil and kind of expansion, acquisition-type of ideas. I mean we've seen this Centro [ph] brand in Brazil up for sale. Obviously it's a small Rio de Janeiro-based brand that has been up, or so I guess up until today or Sunday. But, also we've seen a movement in Chile vis-à-vis ICSA and three smaller beer brands there. Have you been interested in looking at the brands that have come up for sale and/or are for sale. And how do you kind of think about in medium-term basis, how you might go and kind of build out beer in Brazil and Argentina?

Javier Astaburuaga - Chief Financial Officer

Sure, I think in Brazil we are still I mean looking at our business, which has again more that 20 million hectors in capacity and still serving something like 10. We have, I would say still in the initial stages of positioning basically three brands; types that are sold on Bavaria with number of color, I wouldn't say niche but, yes more smaller brands such as Xingu, Heineken and even Dos Equis. So, I think that we have our hands full in Brazil and we very confident, we are everyday much more aligned, and working in a coordinated way, implementing different, I would say improvements in the way we work with out the partners, the bottling Coco-Cola networks in Brazil. So, I think we had a good chance of going to Brazil with the right way of entering, acquiring the first quality installations on a troubled portfolio. And we feel very, very pleased with what's being going on in Brazil, but still as we have been conveying the message still in the very, very early stages.

In Argentina, we've said in the past that we were interested in those brands. We've made a base for those brands in the past and we lost to somebody which back in those days was not very well qualified being an experienced brewer whatsoever. And now I think that what we are seeing is I would say... the CCU have already announced that they were starting to build a new brewery in Argentina, because they were already full in capacity. So, we were and we still are interested in having a participation in the Argentinean market, as long as we find the proper way to get into that market. And we don't think trying to get in the second round and looking at the prices that both parties have communicated are the founding price for transaction. We don't think at that level of pricing that that would be reasonable thing for FEMSA to do. So, that's why didn't really got into a much more intense process on the three brand [Foreign Language] process.

We are still looking at alternatives and we will continue to look at those not only in Brazil and Argentina, as we said in the past, we think Central America offers also a lot of potential going forward. And it's only I think a matter of again finding the right model for going into those markets, including the right timing for doing so. So, we will continue to keep on doing our own assessments and evaluation of opportunities and when we have something that we feel comfortable with, we are going to be very excited about it, be sure about that.

Alexander Robarts - Santander

Okay thanks

Javier Astaburuaga - Chief Financial Officer

Thank you.

Operator

We will take our next question from Robert Ford with Merrill Lynch.

Robert Ford - Merrill Lynch

Hey, good day everybody. Javier I had a question with respect to one of your comments. You mentioned refining the business model in Mexico as you build the plant equity or protect it certainly, maintaining your brand momentum in Mexico as well as strengthening it elsewhere. But do you see any quantum opportunities in terms of the cost structure over the end of year in terms of to fund some of that brand investment with savings domestically, would that have just increased SG&A?

Javier Astaburuaga - Chief Financial Officer

Yes Bob. I think there are some areas of opportunity. To tell you the truth, the way we run our breweries, we do lot of benchmark around that. We have basically our utilization rates going to, I would say some of the highest numbers that we feel comfortable with. So, in terms of leveraging the use of installed capacity or having a much more efficient way at brewing beer, we don't think there is much there. We think we are running a world-class operation on our breweries and we think that the bulk of the efficiency that was there would have been able to really tapering.

In terms of the rest of the cost structure, what we are saying we have continued to invest behind the brands. I also mention the efforts that we are going in terms of the administrative expenses and in some lines of the selling expenses also, that we will need to work on. We cannot really I would say stake or make plans regarding everything being positive both in terms of pricing of products or, cost of raw materials. We are still again with very low visibility going forward for the next months I think in terms of pricing. We are optimistic on that again, because of the numbers I just mentioned. But we cannot really make our own plans thinking that again pricing is going to do it for us.

So yes, we have a number of efficiency programs in place. We have just reviewed and approved those work programs from next year with a brewery and with the beer business. And again we are doing the best we can in terms of drawing as much efficiency as we can from the operations, so we can really I would say invest the amounts that we think are needed for doing the work behind the brands in the three main markets.

Robert Ford - Merrill Lynch

Okay. From a hardware popped up [ph] application perspective, just from a capability perspective, excluding all the other considerations; how far away are you from being able to merge the presale for example the Mexico City Metropolitan area with costs in terms of service?

Javier Astaburuaga - Chief Financial Officer

I would say that both businesses have... I would say build very, very... I would say powerful but distinctive morals for going to market. I can tell you that that's not something that we are considering to do in the very short-term. I can tell you also that the businesses are collaborating in a more I would say close way, but not necessarily with intention to do that in a certain timeframe. But, I would say that there is a lot of value when these two organizations do joint products... I mean joint projects in order to learn from each other. And in some cases they are coming to a conclusion saying well, there is kind of a better way of doing things, while you combine best practices of one business to the other.

But again we are not doing anything, trying to come up with a certain I would say, joint moral, to do relative markets in a combined way, in a certain timeframe Bob. It's like more the two more business working together and exchanging best practices and discussing ideas and sometimes sharing some things. In some places we have said that in the past, we are leveraging the use of infrastructure for both of them, both in terms of physical installations, but also in terms of leveraging some parts of the supply chain, not necessarily relative markets but some other parts of the supply chain.

Robert Ford - Merrill Lynch

Thank you very much.

Javier Astaburuaga - Chief Financial Officer

Thank you.

Operator

[Operator Instructions]. We'll go next to Sohel Amir with Lucite Research.

Sohel Amir - Lucite Research

Good morning. My question was more with regard to Oxxo same-store sales. On a nominal basis it seems to be up by about 4.5 odd percent in Q3 and I was wondering if this is the seasonal effect or there is something that is more secular and sustainable? Also, you do tend to mention that there has been an increase in traffic, not so much in terms of an increase in ticket. So I'm wondering going forward, do you expect some sort of a change in the mix of the products that are sold at Oxxo stores so that we can expect a higher ticket going forward, or is it going to be generally determined by traffic?

Javier Astaburuaga - Chief Financial Officer

Yes, sure. Also we are trying to again on top of a very, very I would say, strong consumer proposition is trying to I would say give impulse to some categories we think are underdeveloped. And the way to do that in some cases would imply to having much more competitive pricing in terms of how we compete with other retail format. But in some others, it would need to have to do with I would say expanding the number of products that take place in that category. Well there are there are kind of two or three main things that I think that will make Oxxo able to continue to grow some higher gross margin categories such as for example, fast food. If you recall we launched the initiative of coffee less than 18 months ago in full fledge, basically in one Montréal, and we are still in the process of rolling that solution out. And coffee has been not only a good traffic builder but also a fundamental reason for some growth margin and expansion on the category of alternative beverages.

So, I think that will continue. Some of the reasons why margin is expanding in these days has to do not only with growing the high-margin categories expanding but also, low-margin categories reducing. The most important example that I would mention would need to be sale cards in Oxxo. Sale cards are being decreasing not only in not growing, due to the fact that its low margin category, when you look at the whole mix of Oxxo you come on with an expansion again driven by a reduction of the low-margin categories and a faster growing on the high-growth categories. So I think that Oxxo, when you look at it going forward, I think is now a business which has some of the leverage and tools that now is being able to manage precisely the growth of the different categories, of course given the preference to those in which we have good margins and are underdeveloped against other retail formats. So going forward, I would say that we are still optimistic about gross margin expanding, of course, not at the pace at we have been looking in 2007, but with the combination of these two elements, I think we are still positive about gross-margin expansion going forward.

Sohel Amir - Lucite Research

Just to clarify, is there any seasonality in terms of sales for Oxxo. And related to that do you have some sort of forecast where you expect same-store sale growth to be... is there some sort of target that you are trying to achieve?

Javier Astaburuaga - Chief Financial Officer

Excuse me I didn't get that question, can you repeat again.

Sohel Amir - Lucite Research

Sure the first question was with regards to, if there is any seasonality in Oxxo sales. And secondly, with regards to same-store sales, is there a target in terms of sales same-store sales growth that you are attempting to achieve?

Javier Astaburuaga - Chief Financial Officer

Yes on the first one, yes, there is a seasonality As a matter of fact, I would say first quarter and part of the third and the fourth are the low seasons of Oxxo, and the rest is really high-season peaking in basically summer and December. And on the second one, we do internal targets and we do keeping on measuring those very, very closely. We do not communicate those to the market and we do measure that not only internally but also against the end-task, which is the association of this Con-stores in Mexico and we tend also to look at other measures, and not only at same-store sales, but also we have additional two or three other metrics to look at much more challenging ways of measuring the performance of the sales in different stores.

And of course the numbers are very different within them. In some cases and in some CDs the target is significantly lower than in others, because as you may well imagine, we have tremendous levels of saturation in some markets in which we are basically trying to either protecting market or building new stores in order to protect very profitable at 16/1 [ph] and in some others we're basically start to go into the market only. So that's a very, very different profile for this target. So, the answer will be yes we do, we do not communicate. We complement that with some other measures and it's a very different story from market-to-market.

Sohel Amir - Lucite Research

Alright, just, would it be possible for you to perhaps communicate with regards to inflation I mean, do you think the growth same-store is going to be in line with inflation above or below?

Javier Astaburuaga - Chief Financial Officer

I would say that our first effort [ph] is always to come back with at least inflation. So we're basically always trying to at least come up with coping with inflation and then building on top of that as we have indicated for the last years.

Sohel Amir - Lucite Research

Okay, thank you very much.

Javier Astaburuaga - Chief Financial Officer

Thank you.

Operator

Thank you, and as there are no further questions. I'll now turn the call back to Mr. Astaburuaga, please go ahead sir.

Javier Astaburuaga - Chief Financial Officer

Thank you, very much for your attendance. As you can see, we are continuing to have significant opportunities to save costs [ph] and that's when we will face some challenges along the way. And we are confident of settling in our long-term strategy and our ability to execute. Thank you very much again, everyone, and have a good week. Bye now.

Operator

Ladies and gentlemen, if you wish to access the replay for this call, you may do so by dialing 1888-203-1112 or 719-457-0820 with a pass code of 1468397. This concludes our conference for today. Thank you all for participating and have a nice day. All parties may now disconnect.

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Source: Fomento Econmico Mexicano, S.A.B. de C.V. Q3 2007 Earnings Call Transcript
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