FEMSA Muddling Through Better Than Most

| About: Fomento Economico (FMX)
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FEMSA surpassed revenue and EBITDA expectations in the first quarter, and delivered a very strong performance relative to other Mexican retailers.

New taxes and lower employment has slowed the Mexican economy, but job growth and consumer confidence appear to be rebounding.

FEMSA shares can support a $100 fair value on the basis of reliable cash flows from Coca-Cola FEMSA, growth at OXXO, and new business ventures.

This has been a pretty miserable stretch for most Mexican retailers, as sluggish employment trends, new taxes, and lower remittances have all dinged confidence and spending. To the extent that having the best house in a rough neighborhood should matter, FEMSA (NYSE:FMX) ought to be getting a little more respect in the market. Management was cautious and conservative on the call (as they often are), but this company continues to run some of the best-positioned businesses in Mexico, and is worth a closer look as the Mexican economy starts to turn up.

A Good Job In A Bad Quarter

FEMSA management did a good job of steering expectations to manageable/beatable levels this quarter. Results weren't perfect, but they were pretty solid on a relative basis and suggest good upside as the macro environment improves.

Revenue rose 14% as reported, or about 4% on an organic basis, and beat the average estimate by close to 2%. Coca-Cola FEMSA (NYSE:KOF) saw 1% organic revenue growth, as weak soft drink volume in Mexico (down almost 6% in the face of new taxes) was partially offset by better-than-3% volume growth in Brazil and stronger pricing. It is a solid testament to Coca-Cola's (NYSE:KO) brand power in Mexico that KOF could raise prices on already-expensive Coca-Cola (compared to PepsiCo (NYSE:PEP) and other brands) without losing all that much market share.

Comercio continues to drive top-line growth. Revenue rose 12% as reported, with 8% organic growth. Same-store sales were up 0.4% for the quarter, though adjusting for the shift in Easter would bring that figure up to around 2.5%.

Margins were also a little stronger than expected. Gross margin was almost flat overall, down 10bp from the year-ago period at the corporate level at Comercio. EBITDA rose almost 17% and beat expectations by almost 3%, with 18% growth at Coca-Cola FEMSA and 13% at Comercio. Operating income rose 16%, with Comercio's operating income growth limited to less than 7%, in part due to the new VAT in certain areas.

OXXO Strong As An Ox

FEMSA's key asset within the Comercio segment, the OXXO convenience store chain, continues to perform quite well. The quarter-end store count rose 10% this quarter, and the company has still only reached perhaps 80% of its near-term footprint within Mexico.

OXXO continues to outperform the Mexican retail sector. Wal-Mart de Mexico (OTCQX:WMMVY) saw a 2.6% decline in same-store sales for the quarter and less than 2% EBITDA growth. Soriana (OTC:OGZSY) saw same-store sales crater 8%, with a greater-than-12% decline in EBITDA. For Comerci (OTC:CDCUF), same-store sales declined 0.9% and EBITDA grew similar to Walmex, while Antad reported a 2.6% same-store sales decline. Chedraui was the only other retailer to post a same-store increase, with sales up 1.1% for the quarter.

There isn't anything too unusual about OXXO's success. The company has focused on creating appealing shopping environments, while also adding more grocery items and additional convenience items like prepaid cell phones, transport cards, and so on.

I am cautiously optimistic that the Mexican retail environment is turning around. Employment turned up in March, consumer confidence is rebounding, and government spending is growing again. FEMSA's management was more cautious, but that's not unusual or unreasonable.

Multiple Options For Growth

One of the reasons I'm bullish on FEMSA is that I believe the company has multiple options for future growth. OXXO's sustainable footprint in Mexico may prove to be larger than management currently estimates, and I believe the company could take this show on the road and launch similar retail concepts in other Latin American markets. I also see growth potential in the company's initial forays into pharmacies and fast food. Both sectors are fairly fragmented, and FEMSA has demonstrated that it knows how to effectively sell merchandise to the Mexican consumer.

There may also be further growth potential in the Coca-Cola FEMSA business. The company has expanded into the Philippines, and there are other emerging market geographies where Coca-Cola may prefer to see a strong operator like Coca-Cola FEMSA take over.

Last and not least is the question of the Heineken stake. FEMSA owns around 20% of the European brewer, and has the option to begin selling, if it chooses to do so. FEMSA management has shown no particular inclination to sell, and I suspect that they harbor the hope that Heineken is acquired as part of the ongoing consolidation of the beverage industry.

Good Growth Potential From Here

I am modeling high single-digit long-term revenue growth (around 8%) for FEMSA, supported by ongoing expansion in the Comercio/OXXO business and good growth at Coca-Cola FEMSA. I am also looking for the company to leverage its existing operations and assets into better FCF generation in the years ahead as less growth capex is required (relative to the company's operating cash flow base). With that, I'm looking for mid-teens growth in free cash flow.

The Bottom Line

Discounting those cash flows back and factoring in the value of the Heineken stake, I believe FEMSA is worth a little over $100 a share today. As I use a required rate of return for my discount rate, flipping the script suggests that today's price should support annual total returns in the neighborhood of 12% to 15%. I believe that's an attractive return from a very well-run emerging market company, and I remain bullish on FEMSA shares ahead of that expected recovery in Mexico.

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.