Coca-Cola FEMSA's (KOF) Management on Q2 2016 Results - Earnings Call Transcript

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Coca-Cola FEMSA, S.A.B. De C.V. (NYSE:KOF) Q2 2016 Earnings Conference Call July 27, 2016 11:00 AM ET

Executives

Hector Trevino – Chief Financial Officer

Analysts

Jeronimo de Guzman – Morgan Stanley

Andrea Teixeira – JPMorgan

Luca Cipiccia – Goldman Sachs

Lauren Torres – UBS

Alex Robarts – Citi

Jeronimo Contreras – GBM

Operator

Good morning, everyone, and welcome to Coca-Cola FEMSA’s Second Quarter 2016 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 Coca-Cola 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 subjective 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 Mr. Hector Trevino, Coca-Cola FEMSA’s Chief Financial Officer. Please go ahead, Mr. Trevino.

Hector Trevino

Good morning, everyone, and thank you for joining us to discuss our second quarter 2016 results. Our transactions continue to outpace volume growth. We maintain market share gains across the markets such as Mexico, Brazil, and Argentina. We’ve leveraged our operating focus, our price flexibility, and our financial discipline to weather a generally volatile currency environment and poor consumer dynamic in our South American territories. And we ultimately delivered another set of solid comparable top and bottom-line results.

For the quarter, our consolidated comparable revenues rose 9%, and our comparable operating income grew 12%, while we increased our comparable EBITDA by close to 13%. These results, fueled by more than 5% growth in transactions on a comparable basis, reaching close to 5 million interactions with our consumers for the quarter.

More than 70% of our incremental transactions came from our robust sparkling beverage portfolio, while the balance came from both water and noncarbonated beverages. In the process, we continued to improve our point-of-sale execution and product cover and to bolster our packaging and brand innovation in order to present our consumers with a growing array of choices across our multicategory portfolio.

Each of our operations delivered a solid set of comparable results. In Mexico, a positive consumer environment helped our volumes to grow more than 7%, while our transactions increased more than 9%, and our average price per case improved 5%. Consequently, we delivered 13% revenue growth for the quarter.

We grew our volumes across every category. Our sparkling beverage volumes increased by more than 6%, supported by more than 4% growth of brand Coca-Cola and 13% increase in Coca-Cola Zero, continuing improvement in the performance of [indiscernible] together with the recently launched sparkling orangeade and lemonade Naranja & Nada and Limon & Nada. Our personal water volume grew more than 20%, driven by Ciel and Ciel Exprim flavored water. And our bulk water volume increased 4%.

Moreover, our noncarbonated beverage volume grew 19%, driven by more than 20% growth in Vallefrut orangeade and the del Valle juice portfolio, along with Santa Clara, which more than doubled its volume to almost 6 million units. In addition, we continue to expand our leading position in the sports drink segment across our territory. Mexico’s solid top-line performance combined with our operating discipline and our currency-saving strategy enabled our operations to maintain almost flat EBITDA margins in the face of currency volatility and higher local sugar prices.

In Central America, we grew our volumes by more than 7%. By country, Nicaragua and Costa Rica grew more than 11% each, while Guatemala resumed growth at a 7% pace, and Panama experienced a slight decline. Transaction growth that outpaced volumes coupled with our local pricing initiatives and operating discipline enabled us to expand both gross and operating income margins in the region.

Once again, our Brazilian operations delivered solid results in the face of continuing currency volatility, a tough consumer environment increasingly affected by high inflation and unemployment rates, and very difficult weather conditions. Although our volumes declined in the mid-single digits, we continued to gain market share in every category and transactions grew slightly outperforming volumes by 5 percentage points. We remain focused on enhancing our execution initiatives across all channel formats while we have achieved improvements in every aspect. We continue to seek greater opportunities to improve point-of-sale activation and price compliance indicators.

Key highlights of our sparkling beverage portfolio performance include the continued strength of our returnable presentations, which grew 4% for the quarter, and performance of Kuat, which once again grew significantly, driving the growth of our flavored sparkling beverage volumes during the quarter. Our increased focus on improving point-of-sale coverage of still beverage continues to drive the growth of these categories. We continue to deliver double-digit volume growth, driven by FUZE tea, while water grew 5% for the quarter.

More importantly, our local pricing and revenue management initiatives, our currency-saving strategy, and our focus on cost control enabled our Brazilian operations to expand EBITDA margins by 150 basis points during this quarter. In Colombia, our volume declined 12% in the face of a decelerating consumer environment, affected by macroeconomic slowdown, high inflation rates the devaluation of the currency, cooler temperatures, and an aggressive competitive environment. Despite this slowdown, our transactions once again outperformed volumes growing almost 3%.

Volumes of brand Coca-Cola declined slightly, while FUZE tea and Brisa personal water continued their significant growth. Our pricing initiatives implemented to compensate for increased inflation rates, the devaluation of the Colombian peso, and higher local sugar prices, coupled with our operating discipline and our hedging strategy, enabled us to mitigate macro pressures at the EBITDA level.

In Argentina, consumers continue to face constrained disposable income, as revised salaries in large related to strike of inflation [indiscernible] and continue to remove sur rates. For the quarter, our volume declined 12%, and transactions outperformed this contraction by a couple of percentage points.

Despite this performance, our robust portfolio offering, innovation, and our infrastructure investments continue to give positive market share gains across every category. Furthermore, our currency-saving strategy and our operating and financial discipline continued to deliver solid improvement in our EBITDA margin, which expanded by 10 basis points for the quarter.

In Venezuela, the tough operating and economic environment, we were forced to temporarily stop production this quarter due to a shortage of sugar for industrial use. This led to volume declines of more than volume declines of more than 40% for this quarter. As the supply of sugar resumes, we continue to underscore our commitment to our Venezuelan consumers by further reinforcing our sparkling beverage portfolio without calories.

Our Philippines operation continued to deliver solid results, achieving volume and transaction growth of 10% and 11%, respectively. This performance was driven by 18% volume growth of brand Coca-Cola, driven by a more competitive returnable glass portfolio and the continuous sales of our one-way PET glasses. Our core sparkling flavored volumes increased by 12%, mainly supported by our Mismo, single-serve one-way presentations.

More importantly, our business in the Philippines continued to deliver positive operational and financial results this quarter. We are particularly encouraged by this franchise evolution to sustain profitability.

Moving onto our financial performance, as of June, our net debt-to-EBITDA ratio was 1.82 times as compared with 1.56 times at the end of 2015. For the quarter, our comparable net income declined 13% to MXN1.06 per share.

Net income was affected by the foreign exchange loss resulting from the devaluation of the Mexican peso as applied to our US dollar denominated net debt position of $700 million and higher interest expenses in Mexican pesos mainly driven by the effect of the depreciation of the Mexican peso has applied to our interest payments denominated in US dollars and Brazilian reais.

This decline was partially offset by a lower tax rate resulting from certain tax efficiencies across our operations and lower effective tax rate in Colombia as a consequence of moving parts of our local production to our new plant in that tax-free zone and ongoing efforts to reduce nondeductible items across our operations. Going forward, we expect these initiatives will continue to positively affect our consolidated tax rate.

This quarter, we reached another important milestone in our relationship with our partner the Coca-Cola Company. Coca-Cola FEMSA and the Coca-Cola Company reached a new broad cooperation framework. This cooperation framework seeks to maintain a mutually beneficial business relationship over the long term, which will allow both companies focus on continuing to drive the business forward and to generate profitable growth.

We have agreed that concentrate prices for sparkling beverages in Mexico will gradually increase over a three-year period beginning July of 2017. Based on our internal estimates for revenues and sales volume mix, we currently expect the incremental annual cost in Mexico on an annualized basis to be approximately $35 million for the years 2017, 2018, and 2019. Both companies are committed to implementing marketing and commercial strategies and productivity programs to maximize their profitability. At Coca-Cola FEMSA, we are confident that these initiatives will mitigate the effects of concentrate price adjustments. Potential future concentrate price adjustments for sparkling beverages and flavored water in Mexico will consider investment and profitability levels that are beneficial to the business of KOF and KO.

The Coca-Cola Company recognizes Coca-Cola FEMSA’s strong operating model and execution capabilities. With respect to the Coca-Cola Company’s Bottling Investment Group territories that it might divest in the future, we have reached an understanding to assess on a preferred basis the acquisition of specific franchises in Latin America, the United States, and other regions. This agreement sets the stage for Coca-Cola FEMSA’s next wave of inorganic growth, allowing us to consolidate our position as a truly diversified multicultural, multi-category global leader.

For the first half of 2016, we delivered solid comparable results across our operations in the face of high currency volatility and a tough consumer environment through our South American market. As we enter the second half of the year, we are certain that we have taken the necessary actions to bolster our top-line results by increasing our market share, growing transactions at a faster pace, and implementing appropriate price increases.

More importantly, we have the operating and financial discipline to protect our profitability and cash flow generation. For the mid- to long term, we have strategically set the stage for continued organic and inorganic growth. We have also reinforced our commitment to invest in the growth of each of our markets. Over the past two years, we have enhanced our production capacity in Argentina. And we have invested more than $500 million to build new state-of-the-art ecofriendly bottling plants in Colombia and Brazil to offer the flexibility for future expansion while building substantial gains in operating profitability and efficiency.

We have further modernized and optimized our supply chain across our operations. More importantly, we have made these capital investments while maintaining our financial flexibility and increasing dividend payments to our shareholders. Through our centers of excellence, we are building a sustainable competitive advantage through capability development, focusing on our commercial distribution and logistics, manufacturing, and IT areas. They provide significant opportunities to generate top-line growth, operating efficiencies, and savings, while driving innovation and fostering talent developing across our organization.

The transformation of our [indiscernible] operation continues to take hold. And we are encouraged by top and bottom-line performance going forward. And we [indiscernible] the consolidation of this result beginning in 2017.

Finally, the new cooperation framework with the Coca-Cola Company provides for long-term guidance on the relationship’s economics, allowing us to capture the next wave of growth and further territory diversification, consolidating Coca-Cola FEMSA position as a truly global, multi-cultural, multi-category leader in the industry.

As always, thank you for your continued trust and support. And, operator, now, I would like to open the call for questions.

Question-and-Answer Session

Operator

Thank you. [Operator Instructions] And we’ll take our first question from Jeronimo de Guzman with Morgan Stanley.

Jeronimo de Guzman

Hi, good morning. I had a question on the – or a couple questions on the cooperation framework with Coca-Cola Company. You mentioned that KOF will get a preference in looking at certain assets from Bottling Investment Group. And I just was wondering if you – if there was any specificity on what assets those would be, whether it’s what Coca-Cola still has in the Western United States, the remaining assets in Uruguay and Guatemala, or if there’s – or the bottling assets in Southeast Asia.

And then I also wanted to know if this could also possibly mean an acceleration in the potential to take over some of those assets in the Asian region, which in the past you’ve mentioned could take a little longer.

Hector Trevino

Good morning, Jeronimo. Let me – we have gone into a lot of specificity on the M&A transactions. Let me give you a little bit of background. We were into these negotiations or this cooperation framework with the Coca-Cola Company for a few months. Since we just agreed on the delivery [ph] and price increases in Mexico, this is also what they negotiated together with us.

And you have I think a very clear picture of what are the BIG territories and the areas where we mentioned. We mentioned the U.S., and we mentioned Latin America and other regions. Latin America, you’ve just mentioned it’s Guatemala and Uruguay, are basically territories of they own. In the U.S., you have a picture of – that is public of what territories are available.

And I think that, with respect to other regions, what I can tell you is that, when we – we have been operating in the Philippines now for four years. I think that we are successfully transforming these operations. We have previously expressed our interest in Southeast Asia and saying that we were going to the Philippines as a beachhead [ph] for us trying to expand in the future.

We have this option to buy the remaining 49% that is owned by the Coca-Cola Company of the Philippines. That option expires in 2015. And I think that once we proved ourselves to the Coca-Cola Company that we are a good operator for that market and once we will exercise the options that, as I mentioned will expire in 2017, I think that we will have possibilities to also look at other territories in Southeast Asia.

I think that those are probably the three geographic areas that I envisioned as part of this agreement.

Jeronimo de Guzman

So, just to clarify, the timing in Southeast Asia, though, hasn’t changed as much in terms of that you would probably first look to consolidate or to buy the remaining portion of Philippines before looking at other assets, or do you think that this could help you move faster into the other territories?

Hector Trevino

No, I think that the timing has not changed. I think that, again, we have – we will start to exercise our option on the other half of the Philippines that we don’t own. And then we will potentially move to other territories. But, I’ll keep that in a medium-term basis.

Jeronimo de Guzman

Okay. And then just the second question that I had was on the marketing and commercial strategies that you mentioned you will develop with Coke. Again, just kind of wanted to know if there was any specifics that – in terms of actions that could help mitigate the increase in concentrate prices, as you mentioned. And I guess, more specifically, is there a commitment by Coca-Cola to funding a larger part of the marketing expenses in Mexico, as I believe had happened in 2006? And is there anything else in terms of productivity savings or anything like that that is also helping mitigate the increase?

Hector Trevino

I think that, with respect to the marketing investments and how – or the agreement that we have with the Coca-Cola Company basic compensating this, I think that the most important element, and we have mentioned this in previous conferences, is that supporting – a few years back, now the Coca-Cola Company and Coca-Cola FEMSA are both fully committed or fully of the idea that we should use a better revenue by management initiatives. And that basically leaves pricing. In the past, as I have expressed in other conferences, we were a little bit more focused on revenues. And the Coca-Cola Company was a little bit more focused on volumes.

And now, I think that the two companies, we are pretty much in tune with the idea that we should take advantage of this trend that we have in the marketplace, both from the strength of the brand and also from the popularity and the reach that we have day-to-day approach in the streets, as we reach thousands of outlets. So, I think that the most important element for us to compensate part of this included in the concentrate prices has to do with the pricing going forward in Mexico.

The other part of the – from the second half of this element to compensate, these increases have to do with internal efficiencies that Coca-Cola FEMSA has been working on. And that has to do with what we call the centers of excellence that we started to describe to you probably two or three quarters ago. And just to give you an example, we have been launching what we call our digital commercial platform, which has been rolled out in the City of Leon and Puebla. And we have been started to roll out in Mexico City.

With that, I think that it changes completely the way we are working with our sales personnel in the streets. Before, they have to spend maybe an hour and a half, up to three hours, of their daily time in going to the distributing center, getting the instructions for the day, etc. And now, we have this digital platform and devices similar to an iPhone but is a different device. They get the instructions and the strategies for the day directly into their handset device. And they can accomplish much more – they can work much easily with the owner of the retail stores in terms of showing the different promotions and work itself for the cooler. So, we have a much better targeted strategy per store.

And that’s – in some of the tests that we have done, especially in Leon and Puebla, that has translated into increased revenues when we compared to the areas where we don’t have this digital platform. Second regards the center of excellence for supply chain, where we are basically trying to be more efficient in the changeovers in the production line and planning for logistics and also in the level of inventory. And we think that there will be some savings there as we also move into doing much better analytics and we centralize part of these functions that are [indiscernible] on the operations. So, the idea is to have around 20% of the people that are fully dedicated to supply chain on a centralized basis as opposed to 100% decentralized as it is now.

We’ll continue to have 80% of the sales coming in the different countries. But, on the reporting lines, we’ll be pretty centralized to the headquarters, where we have much better quality assurance and much better analytics that will help us reduce, as I mentioned, inventories, transportation cost, and in line with the business.

So, just to summarize [indiscernible] two areas, pricing, where we feel very comfortable now with the Coca-Cola Company that we are in the same line of thinking of being aggressive on the pricing front, and internal efficiencies, especially with the center of excellence.

Jeronimo de Guzman

Okay. Just I don’t want to take up too much time, but just the last question kind of to put it all together, do you think then that you can protect margins in Mexico going forward despite the concentrate price increases, or is it more about trying to maintain an absolute level of peso at kind of EBITDA levels?

Hector Trevino

[indiscernible] try to maintain margins, obviously, we have to look at the raw material environment and the volatility that we are seeing in the currencies. That has not helped particularly this quarter, especially raw materials. For the total Coca-Cola FEMSA, we have an impact of around MXN820 million, negative impact [indiscernible] on raw materials, including the effect of hedges and everything. So, in excess of the hedges that we got, we got that impact because especially second quarter was very [indiscernible] what we saw in the first quarter.

So, taking all in consideration and knowing that there will be some volatility, there will be some pressure on sugar prices next year, so we have a better environment, we see the prices next year and with obviously increase in the concentrate cost, the idea is to maintain the margin levels that we have in Mexico and being able to absorb that. Okay?

Jeronimo de Guzman

Great. Thank you.

Hector Trevino

Thanks.

Operator

And we will take our next question from Andrea Teixeira with JPMorgan.

Andrea Teixeira

Hi, good morning there, and thanks for taking the question. I would like to talk more about, like, what you said, Hector, and thanks for the call. Obviously, the concentrate price increase is something that I see kind of like literally the glass half full. And I appreciate that you’re pretty much giving us indication now. So, I was curious to what my colleague also just asked that the indication that you’re doing this such in ahead of time is kind of like bundled together with the potential M&A.

And I couldn’t hear. Your voice was kind of muffled. Like, when you were talking about, like, the order of preference, obviously, Philippines, you have that co-option at some point. Should we think that this decision announced now, it’s an indication that we are moving quite fast in both the Philippines and also the U.S., potential opportunities, and the fact that you also dropped there LatAm as something that you might be looking, do you see – part of this question, do you see other bottlers also now sitting now on table with them, or this was more you first? I just want to put something in perspective.

And the second part of the question is, so to understand, the $35 million is compounded, obviously. The first year, should we assume $35 million and then going up to $70 million and then going up to $105 million? That’s how we should see it? And as you pass it on to price increases, this might be also offset by marketing spend, or this is like the net-net effect? Thank you.

Hector Trevino

Good morning, Andrea. Sorry about the sound. Let me see if it’s [indiscernible] that you can listen better now. I’m getting closer to the mike.

Andrea Teixeira

Thank you.

Hector Trevino

In terms of the order of preference, I think that, because the Coca-Cola Company has been very clear in their comments in the past that they would like to finish with all the refund cycle of the U.S. by 2017. So, my take on this is that, since we basically signed this agreement with respect to [indiscernible] and that, although it’s not related and it’s related to second quarter, the M&A activities, it’s somewhat related to [indiscernible] the Coca-Cola Company, although they recognize the value of having us in all of those territories because of the – of our capabilities, they didn’t want to start those conversations until we close the negotiation on [indiscernible].

So, we are just starting to look at this, but the order of preference would be, given the timeframe that [indiscernible] Coca-Cola Company in the past, I’d say that the U.S., by the second half of 2017 is a potential target time, and Latin America, what is owned by BIG is kind of the smallest, Guatemala and Uruguay, I think that we can take that in 2016 or 2017 [indiscernible] and we can agree on this. Remember that, in the case of Guatemala, we have also some – we have half of the operations that is under a kind of conflict enabled relationship. So, we have to be careful with that piece of the puzzle also for the [indiscernible] in Guatemala.

I think that this issue of having opportunities to acquire other territories has to do more with the fact that – with the agreement [indiscernible], you can argue that both companies are fully aligned for a long period of time. And therefore, the Coca-Cola Company is comfortable that we are the preferred partner for this territory. And we also – we, Coca-Cola FEMSA, feel comfortable that we have a long-term agreement in place that will also help us fully analyze and understand what the relationship with the Coca-Cola Company in terms of economics and fully value investment opportunities including inorganic growth. So, now that we are aligned, I think that the Coca-Cola Company and us are prepared to take advantage of our capabilities that we have demonstrated in the past. And therefore, I think that that’s the main reason for this opportunity. I’m not sure about the agreement of the Coca-Cola Company with other bottlers. I think that the other bottlers will have very similar agreements in terms of the different agreements, in terms of the increased price increases in Mexico.

I don’t know if there are opportunities for M&A, acquisitions, [indiscernible] what the Coca-Cola Company policies regularly give their – what the BIG territories, where they – what’s available or not. But, my feeling is that every bottler in Mexico will have the same territories in Mexico. Everyone [indiscernible] and that’s what my expectation was, but I think that’s a – of course, that’s a question that should be asked the Coca-Cola Company. I don’t know exactly [indiscernible] In terms of the $35 million, and you’re right, it’s $35 million each year. So, by the end of the third year, we’ll have an impact close to $100 million. We’re fully $35 million as a way of making it easier for everyone to understand, but the number is around MXN650 million. And translated at the present exchange rate, it’s around about $35 million.

Andrea Teixeira

Right.

Hector Trevino

[Indiscernible] increasing revenues, that number might be changing, or [indiscernible] decreasing revenues, that number might get lower. But, our estimate is around that number for the three years. We will start in July of 2017. So, the full impact of next year is going to be half of that. So, on a rolling basis, if you look at 12 months, it will have an impact of around $35 million. Okay? And then one on top of the other. So, after these three, that will be July – up to July 2019, it will be the impact of around $105 million as an additional cost of raw materials for Coca-Cola FEMSA. So, we think that – we can compensate [indiscernible] with prices because the Coca-Cola Company and ourselves are now more focused on profitability and revenues as opposed to just volumes. And some cost savings, as I was describing [indiscernible]

Andrea Teixeira

And just to make sure that we understand, so this is the net impact of any marketing help that they might give you on that. So, that’s definitely the net effect.

Hector Trevino

We – that is the total effect, Andrea. We haven’t disclosed any strategic support of marketing by the Coca-Cola Company, as it was done in the past. It was over 10 years ago there was a portion of the extra concentrate that they were receiving that they were dedicating to the marketplace. We don’t have a strategic agreement for that. Also, the Coca-Cola Company can very well decide to [indiscernible] a little more in the market and in the marketplace. You know that they have been launching in Mexico the one-brand strategy, which I think is very important. There is a [indiscernible] basis behind that.

But, there is no specific agreement for parts of those resources that the Coca-Cola Company will get for those to be reinvested in the marketplace. So, the total amount of the [indiscernible] that’s the effect of the $35 million per year more or less. Okay?

Andrea Teixeira

Okay. Thank you very much.

Hector Trevino

Thank you, Andrea.

Operator

And we’ll take our next question from Luca Cipiccia with Goldman Sachs.

Luca Cipiccia

Thank you. Thanks for taking my question. I wanted to follow-up on this discussion about the acquisition, M&A, and the partner the agreement with Coca-Cola. Mostly, if you can – you have answered partly to this already. But, if you can qualify a bit better whether this new framework essentially puts you in a position to look at inorganic opportunities only within these territories, or it this is in addition of other – to other opportunities that may appear. And secondly, in LatAm specifically, given that the Investment Group on has Guatemala and Uruguay, so relatively small markets, does this also include bottlers where, say, Coca-Cola is an investment or is in participation as a stake? That could be the case in Brazil. There could be other opportunities. So, that’s the first part of the question, if you can qualify that.

And then secondly, when it comes to the U.S. and the fact that you may potentially participate, arguably, there’s only one large territory left there. We saw Arca getting Texas, but also establishing a partnership with a U.S. bottler with United. Is that form of agreement something that could also work for you? Arguably, you – there is – and around California, [indiscernible] is very large, also have territories in Asia. Is this all part of a sort of a thought process or an engagement that could be broader? If you can maybe clarify some of this part, that would be great. And I’ll only ask this question.

Hector Trevino

Good morning, Luca. This agreement – this preferential process, preferential [indiscernible] has to do basically with BIG territories, so the Bottling Investment Group territories. This is what the Coca-Cola Company controls. But, at the same time, there is a recognition, very clear, and it’s expressed in our agreement that we could buy other alternatives, as we have done in the past, continue to evolve in Latin America or other regions by acquiring territories that do not have anything to do with BIG. So, it’s very clear that the agreement with the Coca-Cola Company has to do with the territories that they control. And again, they recognize or they do not have any problem if we advance and we [indiscernible] transactions with other bottlers in the region.

With respect to the U.S., we have expressed that we will look at these opportunities by ourselves and for us to decide 100% our decision if we would like to buy a potential partner or not on the venture on these territories. So, that’s totally under KOF’s control and decision. So, the idea is for us to understand this market, see what specific – what opportunities are out there, and the requirements in terms of knowledge that we’ll need in these territories and for us to do a judgment if it is better to tackle that opportunity through having a partner or if we can do that 100% ourselves. Okay?

Luca Cipiccia

Perfect. Very clear. Thank you very much. I’ll leave you to others for the other questions. Thank you.

Hector Trevino

Thank you.

Operator

And we’ll take our next question from Lauren Torres with UBS.

Lauren Torres

Yes, hi, good morning. As much as I’d like to ask about your results, I just have I guess one general question on this new framework. I guess, putting together everything you’ve mentioned so far, Hector, I understand the components of it. But, I’m just curious why this was established now. It seems like you’ve had a good relationship, or you have a good relationship with Coke, been in constant discussions with them with respect to expansion and the concentrate agreement. So, why did this come out specifically now, to be more specific and establish this framework, once again, just a general question, but just trying to understand that better?

Hector Trevino

We have [indiscernible] last time that we had a price increase was – a pricing concentrate increase or increase [indiscernible] was 10 years ago, basically, 2006. We have now agreed 2017 [indiscernible] increases.

The agreement that we had at that time basically called for a 10-year period. And the 10-year period is coming up in July of next year, 2017. So, together with the Coca-Cola Company, our partners, we decided that it was better for both organizations to start discussing this ahead of time because these are always difficult negotiations.

It’s – in a way, we can argue that the Coca-Cola Company is taking some of the profitability away from the bottler partnership. You can argue on the other hand that the Coca-Cola Company has the right to do it. So, we knew that the conversations were going to be tough, that we are [indiscernible] so, a few months ago, we decided that it was better to start that in advance and not wait until July of 2017 [indiscernible] with a lot of pressure.

What’s important always in our mind, and I think that also in the Coca-Cola Company’s mind, that it was better to take time so that we could evolve our conversations and meet up the mutual benefit that [indiscernible] again.

We have always talked about this [indiscernible] situation. And it is difficult to envision that in a situation where one partner gets a little more money from the other. That’s not [indiscernible] I think that this idea of creating value together and discussing how can we improve the pricing of [indiscernible] initiatives in Mexico, it’s what [indiscernible] opportunity, it is converted into a [indiscernible] situation.

So, basically – I don’t know if the question is, why are you doing this a year in advance? It was basically because we didn’t want to deal with a lot of pressure. And we thought it was better, knowing that these conversations are difficult, to start with a lot of time ahead of time.

I can say that these conversations have been very important with a lot of pressure for [indiscernible] for the last probably seven months or eight months. So, it took a lot of time for us to devise this framework. But, I think that, at the end of the day, we ended up with an agreement that is good for both organizations because it will give us certainty about the future and take away all the discussions that we’re going to have [indiscernible] July 2017. Okay?

Lauren Torres

Okay. So, then is it okay to assume that, starting I guess in 2019, once again, you’d have those discussions, and an absolute amount would be determined for another three-year period, or that’s not the case?

Hector Trevino

I think that the Company – both companies feel confident that, after these three years, that it will get us to a level where both companies feel comfortable. And I think that it will be better to think of this as a long-term agreement that will give us certainty for KOF to, for example, decide on continuously investing heavily in the marketplace or doing a transaction [indiscernible] and to buy another bottler, you need to factor in [indiscernible] from what the free cash flow generation would be. And the cost of concentrate is an important element. So, I think that we should look at way more than three years in terms of the [indiscernible] we are envisioning with this agreement.

Lauren Torres

All right. Very good. Thanks. Yes, thank you.

Operator

And we’ll take our next question from Alex Robarts with Citi.

Alex Robarts

Hi, everybody. Thanks. I wanted to get back to the nuts and bolts here of the second quarter at KOF. And one question’s on Venezuela, and a second on Brazil. Just trying to understand and confirm the volume impact here of I guess the quarter’s production disruptions, when we think about the 40% decline in Venezuela volumes in the quarter, what percentage of production was impacted by production disruptions? And I guess it’s safe to assume that this will probably be the softest quarter in Venezuela. In the past, you’ve been able to kind of get back margin with raising prices toward the very high inflation. As inflation gets – and it seems to accelerate. Did you think you will continue to have that ability to get pricing toward the inflation in the second half of the year? So, that’s the first question.

And the second question is on Brazil, if I could just wait for that.

Hector Trevino

Okay. Alex, good morning. Venezuela, basically, the situation in Venezuela – and I really want to send my really recognition and admiration to the team that we have there. It’s very tough. We didn’t have sugar. We had to close – basically stop production for a couple of weeks. We had some inventories. We ended up having the market without our products for a week, basically. But, bottling was down 40% in the quarter because, obviously, it’s not only sugar. Sometimes, it’s plastic caps. Sometimes, it’s electricity. So, it’s on and off we have been going into the production restraints that we have in Venezuela.

We have not had any problem in terms of passing inflation to the consumer, very high price increases. Sometimes, in a month, we’ll increase 40% – 30%, 40% versus the previous month. But, you have to understand that inflation in Venezuela is running with some estimates as high as 300% or 400%. So, prices have not been an issue in Venezuela. It’s more the supply of raw materials to be able to produce our products.

Given the fact that we know that – and Venezuela produces sugar, but some of the sugar mills, they don’t have the spare parts to continue producing or electricity. Everyone is suffering a little bit with the same issues.

So, the idea that we have in Venezuela and I think that will help us going forward is that we are starting to launch products without calories. It’s not necessarily the same formula that Coca-Cola likes, and it’s not the same product that the Coca-Colas use. But, it’s product that we are selling with the same red labels, same original flavor, one that says no calories, and one that says light flavor.

And these are different formulations that the Coca-Cola company has developed in the past and that they are in agreement of using in this specific situation because of the lack of sugar in Venezuela and, basically, for us to be able to place products in storage. You know that this not only was us, but many other products are very scarce in Venezuela.

So, a final comment on Venezuela, we were – the previous year, we produced around 240 million unit cases. Our forecast calls for around 170 million. So, we were already anticipating an important decline. This quarter was specifically tough because of the shortage that we have in our production plant. My feeling is that third and fourth quarter will be more in the 170 million unit case kind of budget for the year. Okay? But, certainly, the second quarter was very tough.

Alex Robarts

Thanks for that. I just wanted to understand what you said on the pricing. We appreciate that you’ve been able to get very close to the – if not at the inflation so far this year in Venezuela. Did I hear you say that you have confidence that you can – with it kind of increasing and being higher here, inflation rate, that you can match that kind of higher expected inflation in the second half? Is that what you stated, sorry, just to clarify that?

Hector Trevino

Yes, Alex. Our idea is to price with inflation on the internal cost inflation that we have. We try to pass that to the consumer. Obviously, it’s a very tough market. And listen, you have to understand that there’s a lot of scarcity. There is a lot of inflation. So, nobody knows exactly what prices should be.

But, the important element is that you have the product on the store shelf. And consumer will pay whatever is needed to buy from that. And there is a lot of lack of control of – with the retail system and the clients in terms of the pricing that we charge to the final consumer because there’s a lot of volatility going on. But, from our perspective, we are – our strategy is to continue passing inflation to the consumer. And I don’t envision us being [indiscernible] inflation in the second half of the year. That’s [indiscernible] Okay?

Alex Robarts

Okay. Okay. Fair enough. Thanks for that. And on Brazil, just it’s a volume question. Thinking about – no secret it’s a tough consumer environment. And thinking about the 5% drop in the quarter with your average volume, it was interesting that the noncarbs, still beverages fell less, 2% or 3%. And yet, you also booked an equity method loss from that joint venture with the stills and Coca-Cola in Brazil.

And I guess I’m wondering, is the nature of losing money in Brazil with noncarbs and the still the fact that you’re related to – that you’re just reinvested in marketing? Is there something else beyond that? And do you think the business in still and noncarbs can make money or net profit in the second half of the year? Thanks very much.

Hector Trevino

With respect to Brazil, in general, you have during the quarter maybe – the drop in volume has mainly – has to do with brand Coca-Cola. Remember, and I have said that in the past, that brand Coca-Cola has the largest market share of – in terms – versus Pepsi [indiscernible] where we operate. So, the area that is softening a little bit more has to do with brand Coca-Cola.

Even with that drop that we saw in brand Coca-Cola, we’re still gaining a little bit of share [indiscernible] information. So, Brazil is a case where, even the macroeconomic environment and the consumer that is so much affected, we are winning market share in every category.

With respect to the noncarbonated drinks, we are basically changing a little bit the focus of the joint venture, not that we are not making profit there. It’s – but, the profit that we have in noncarbonateds are already reflected in the numbers that we have in our operation. We are moving – because of some tax planning that was done in years ago, we are moving now into having now, which is the joint venture more as a cost center that will have just a small margin and be a production center for the bottlers.

And the profits or the margins of selling noncarbonateds, noncarbonated drinks, are embedded in the numbers of each bottler. So, at the end of the day, I think that, in Brazil, it’s a story where we hope to soon see the end of this recession because the rest of the numbers are very promising. It’s really gaining market share in every category, improving a lot of the execution. We are – as we discussed in the past, we were kind of in the lower quartiles in terms of the indexes of the Coca-Cola Company and the bottling system measures. Now, we are basically in the top part of – at the top half of the bottlers in terms of execution.

We have been able to pass price increases to the consumer. We have been able to improve in the margins of our operations and will improve the EBITDA margin. I have to grant it that it’s not at the same level that we had a few years ago. But, that has to do a lot with taxes that were implemented two or three years ago that reduce our margins. But, we have been improving our [indiscernible] margin importantly.

So, Brazil is a story where the top line is missing basically because of the consumer environment that we find there. So, as soon as we see a turnaround in the country, my expectation is that we will start to capture some of this improvement again in commercial execution margins, market share that we will see.

We have the plant that we just opened a year and a half ago that is very important for us in terms of investment. It’s working well in terms of the capacity and the capacity to serve returnables in that part of the country. So, I think that, again, as most of the indicators that – internal indicators that we see in Brazil are good. The issue is that volume is not there because of the consumer environment that is missing a little bit.

Alex Robarts

Very clear. Yes, very clear. Thank you.

Hector Trevino

Thank you.

Operator

And we will take our next question from Jeronimo Contreras with GBM.

Jeronimo Contreras

Hello. Thanks for taking my question. Now, it’s actually two questions. The first is related to the acquisition of AdeS and the timeframe you have in mind to conclude the deal.

And the second is related to the Philippines operations. Just wanted to understand how the progress in that region. How far are you from the – from reaching the desired levels of profitability? Thanks.

Hector Trevino

Good morning, Jeronimo. With the AdeS operates, we are basically in the process of all the antitrust approval in the different countries. Remember that AdeS operates in many different countries.

The transaction is – as you can expect, it’s subject to the successful completion of the antitrust authorization, basically from Mexico, Brazil, and Colombia. We expect to complete this by year end.

And then we have to work with Unilever with respect to some of the production plants, especially Brazil. It’s embedded – it’s together with other areas of production of Unilever. And therefore, we made us like Brazil will need to continue working together with Unilever for a few months or even a year before us having the – a full production capacity on our side.

So, I’ll say that, by year end, we should know about these antitrust processes. We have been working in – together with the Coca-Cola Company in the business model going forward and the plan to start serving the market, assuming that everything will go okay with the antitrust authorities. But, we have to wait for that final process in terms of – the final decision of the antitrust authorities, again, in Mexico, Colombia, and Brazil.

With respect to the Philippines, we are very encouraged with the performance that we are seeing. I want to say that, after many quarters, that we have been investing in new presentations and the new portfolio. We are seeing the fruits of these efforts. And we are seeing very important increase in brand Coke.

For the quarter, we mentioned 18%. But, for the first half of the year, brand Coke is increasing 21% versus last year. That is a replacement of some of the B brands that were owned by – also by the Coca-Cola Company and that we are – that are producing the presentation in our mix.

In terms of the profitability, we are again in a quarter that has in the positive side, still has levers that are very far from Mexico, which is a benchmark I guess, but in levels around 79% – excuse me, 7% or 8% EBIT margins and low teens in terms of EBITDA margin, which is very encouraging, given where we incorporate this franchise 2.5 years ago. So, I think that we are moving in that direction. We would like to see better results in the future. But, I think that we are at the right path.

Jeronimo Contreras

Very helpful. Perfect. Thanks.

Operator

And that does conclude today’s question-and-answer session. I’d like to turn it back to our presenters for any additional or closing remarks.

Hector Trevino

Thank you for your interest in Coco-Cola FEMSA and the team in our Company. And as always, myself and the team is now available for any further questions. Thank you.

Operator

And that does conclude today’s conference. Thank you for your participation. You may now disconnect.

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