FEMSA Just Keeps Rolling

| About: Fomento Economico (FMX)
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Just about everything seems to be working in favor of FEMSA (NYSE:FMX) these days. Not only have volumes and margins continued to improve in the Coca-Cola FEMSA (NYSE:KOF) business, but the company's OXXO stores are lapping the competition in terms of comp-store growth. With new opportunities in Southeast Asia, pharmacies, and financial services, the growth outlook for this Mexican consumer conglomerate looks quite solid.

A Solid Close To The Year

FEMSA's fourth quarter results point to both improving conditions for Mexican consumers and ongoing share growth, while margins continue to develop nicely.

Consolidated revenue rose about 12% as reported, with better than 15% reported growth from Comercio (which is primarily OXXO at this point) and 10% reported growth from Coca-Cola FEMSA. While KOF got a boost from the inclusion of new operations (revenue rose 6% excluding those), currency movements cut the other way - at the end of it all, organic constant-currency revenue rose 14%).

Margins also continued to improve. Gross margin improved more than a point from last year and more than a half-point sequentially, on improvements at both Comercio (up 40bp) and KOF (up 160bp). Likewise, operating income rose 25% on margin improvements at both Comercio (up 10bp) and KOF (up 260bp). On a net income basis, higher contributions from Heineken (HINKY.PK) made a significant non-operating contribution, but the gains were related to asset revaluations and not likely recurrent.

OXXO Keeps Bringing In The Shoppers

OXXO's nearly 16% revenue growth this quarter was fueled by both ongoing store expansion (FEMSA opens about 3 new stores every day) and same-store growth of 7.5%. Ticket growth improved a bit from the third quarter to 4.8%, while traffic growth eased a bit to 2.5%. At 7.5%, OXXO's same-store growth more than tripled that of WalMex (OTCQX:WMMVY), Soriana, and Comercio this quarter.

Best of all, FEMSA isn't having to resort to gimmicks or heavy promotions to bring out the shoppers. Simply put, the company has been very smart about where the company puts its stores, what they stock, and how they price - essentially Retailing 101.

Looking ahead, it's hard not to be excited about what more the company could do with OXXO. Looking at store density per capita, FEMSA could more than double the number of stores in the central region of Mexico (where close to half the people live) and more than triple the number of stores in the southeast of the country. To that end, it's well worth noting that the company's success in improving per-store revenue over the past decade has now opened up a much wider range of potentially profitable new store locations. I also don't see why the company couldn't consider expanding outside of Mexico at some point - whether south into the rest of Latin America or north into the U.S. border states.

It's also important to note that FEMSA is working on improving the store content and revenue potential. OXXO has partnered with BBVA's (NYSE:BBVA) BBVA Bancomer and Citigroup's (NYSE:C) Banamex to take deposits, and this service/fee income is basically pure profit. At the same time, the company's is test-marketing fast food offerings, and the early results seem pretty encouraging.

Longer term, the acquisition of YZA could grow into a multi-billion dollar nationwide chain of pharmacies. Likewise, soft discount and grocery stores could be on the horizon.

Smile And Sell A Coke

FEMSA's Coca-Cola FEMSA subsidiary has a more mixed outlook. While consumption patterns and volumes seem okay overall, a lot of the South America volume growth was in water and still beverages, and I'm not as confident about Coca-Cola's (NYSE:KO) long-term competitiveness there relative to PepsiCo (NYSE:PEP) and Nestle (OTCPK:NSRGY). What's more, about 20% of KOF's volume and EBITDA comes from Venezuela and Argentina, where currency devaluations and other assorted economic issues are now real concerns.

On a more positive note, the company did go forward with its bid to acquire a majority stake in Coca-Cola's Filipino bottling operations. KOF paid almost $700 million for a 51% stake, valuing the business at about 13.5x EBITDA. That looks like a steep price, particularly given the operation's high single-digit margins.

That said, it may be a better deal than it appears at first glance. First, at the time KOF entered Brazil the margins there were even worse, and the company ultimately turned those around into the mid-to-high teens. Second, the deal has a peculiar structure that allows KOF to buy the remainder at a later date and/or sell the stake back to Coca-Cola at the same EBITDA multiple. I would say that is a very valuable escape clause, and one worth paying extra to get.

Not only will these operations add about 15% to KOF volumes, but I think the long-term potential is significant. As of 2011, the average annual consumption of Coca-Cola per person was 728 8-oz portions in Mexico, 403 in the U.S. and 230 in Brazil. In the Philippines? Just 129. Moreover, it was just 93 in Thailand, 38 in China, and 12 in India. That means that KOF could have exceptional growth potential in Southeast/South Asia, using the Philippines as a launching point for countries like Malaysia, India, Thailand, Bangladesh, Indonesia, and perhaps China as well.

While I do appreciate that local tastes do vary quite a lot, and no one should just assume that India will look like Brazil, I think the point still stands that Southeast Asia could be an exceptional long-term growth opportunity for Coca-Cola FEMSA. Moreover, it's worth remembering that FEMSA has openly contemplated buying out Coca-Cola's stake - I'm not sure whether that's the best move (better to have Coca-Cola as an ally), but either way I think FEMSA has a lot to gain long-term from this move.

Strong Growth Potential, But Not Risk-Free

As is probably readily apparent, I'm bullish on FEMSA's long-term growth opportunities, both from increased sales in existing areas/businesses and new business opportunities. Certainly the health of Mexico and the Mexican consumer matters, but I continue to see reasons for optimism when it comes to per-capita income growth in Mexico.

Long-term, I see FEMSA growing revenue at an 8% rate. That growth is predicated largely on further growth in OXXO, and includes only relatively modest contributions from pharmacies or significantly expanded scale at KOF. While I see FEMSA continuing to build stores at a rapid base, the maturation of the store base will lead to more margin and free cash flow leverage - sufficient that I believe free cash flow margin will ultimately expand into the low teens over the next ten years, driving growth of around 10%.

The Bottom Line

At 10% free cash flow growth, FEMSA shares are worth about $95 all on their own. But FEMSA also owns 20% of Heineken, and the inclusion of that stake pushes valuation to nearly $120 per share. That's not massive undervaluation relative to the roughly $110 share price today, but I think it is still quite attractive in the context of what may be the best Mexico/Latin America growth story, and one that is available as a very liquid ADR listed on the NYSE.

Disclosure: I am long FMX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.