Coca-Cola FEMSA: Coke's Largest Franchised Bottler Is Undervalued

| About: Coca-Cola FEMSA, (KOF)

Summary

As a Mexican company, Coca-Cola FEMSA has seen its share price decline predominantly due to a weakening peso over the past few years and as of late.

While the weak peso is a headwind, it cannot continue forever. In the meantime, the company has significant operations in other markets.

This is a strong business whose share price decline doesn't match up with its fundamentals. If you are willing to expand your horizons a bit, this is a good opportunity.

Introduction

The majority of my time and work focuses on U.S. equities, or at least businesses with a significant U.S. operation. I would say the two primary reasons are the high quality of companies in the U.S., and the fact that I have greater familiarity with them. As of late, especially since the election, sticking solely to U.S. equities is getting harder and harder to justify.

If there is a strong name, chances are there is a considerable premium on the share price. The stocks that are beaten up, many of which I follow, seem to be down on true weakness rather than temporary factors. Maybe there are some more opportunities out there I'm missing, but with relatively high valuations on the S&P 500 (NYSEARCA:SPY) combined with historically high profit margins, I finally decided it is time to look abroad.

The one thing that, as a U.S. investor, I do have going for me right now is the strength of my home currency, the U.S. Dollar (^DXY):

^DXY Chart

^DXY data by YCharts

There are many currencies that have significantly weakened vs. the dollar, and this has made a number of companies with these home currencies much cheaper.

Coca-Cola FEMSA

That brings me to Coca-Cola's (NYSE:KO) largest franchised bottler in the world, Coca-Cola FEMSA (NYSE:KOF). KOF has operations in Latin America as well as the Philippines, although its largest and most profitable market is Mexico. According to Moody's, Mexico accounts for 44% and 51% of the company's revenue and EBITDA, respectively. The share price has declined since mid-2013, and the beginning of the decline coincided almost perfectly with the peso beginning to weaken vs. the USD:

KOF Chart

KOF data by YCharts

The peso hit a peak vs. the dollar in April 2013, which is the same time the share price of KOF peaked. After touching a brief high near $180, KOF is down to about $62 as I write this today. With that being said, I would like to go over my investment thesis on KOF:

  1. The peso will not continue to fall vs. the dollar forever; a stabilization or change in this trend will help KOF
  2. KOF generates a substantial portion of its business outside of Mexico, so even with the peso's weakness, the share price decline looks overdone relative to business results
  3. The Mexican economy has inherent advantages with respect to Coke products, and KOF already has a dominant position there and in other markets where it will continue to expand through acquisition

The Peso

Mexico has been in the news a lot lately for its relations with the U.S. Specifically, with talks of a breakdown in trade and building a wall, many have worried about the ramifications for the Mexican economy. Just since the election, the peso has depreciated significantly vs. the dollar:

US Dollar to Mexican Peso Exchange Rate Chart

US Dollar to Mexican Peso Exchange Rate data by YCharts

I think it helps to look at the fundamental factors that are driving the peso down. When we do this, I think we will see that they are predominantly political and more likely to be temporary in nature.

At this point, I'll call attention to a recent article written by SA Contributor Ian Bezek. Ian made a great point that in going after some of our trade partners with whom the U.S. has a deficit, Mexico is not a logical first choice. Although the dollar amount may seem high at first glance, our deficit with Mexico as a % of trade stands at 12%. This pales in comparison to the 61% with China, and is also lower than France, Germany, Japan, Korea, and Russia.

The decision to attack Mexico is more likely political than it is economical. It is a convenient choice, given that it is our neighbor to the south.

On another front, I'll call attention to an article in today's (1/30) Wall Street Journal. The article title is "Banks Plan to Stay the Course in Mexico." It regards Citigroup (NYSE:C), Banco Santander (NYSE:SAN), and BBVA SA (NYSE:BBVA) who control Mexico's three largest banks. The main theme is summarized in the following quote from Citigroup CFO John Gerspach:

"Mexico does have a lot of advantages, and those advantages, as an economy, would continue no matter what would happen between trade with the U.S."

The other point he and other executives made is that although the trade war would hurt the Mexican economy, further weakness in the peso could make the country even more competitive.

I think these actions speak a lot louder than any argument I could give about the peso weakness being overdone. These are executives who are going to continue doing business in Mexico, and I think this speaks to the fact that as investors, we should realize that no matter what the political headlines say, Mexico will be ok. And with that, the peso should stabilize and provide a tailwind for companies which do business and report in Mexican pesos, such as Coca-Cola FEMSA.

Significant Business Outside Mexico

With KOF as an ADR and reporting in pesos, its price will be affected by movements in the peso vs. dollar exchange rate. That'll always be true in the short term and can have an outsized effect on the stock price, but what matters in the long term should be less about currency movements and more about business performance. And the fact of the matter is that Coca-Cola FEMSA remains a very strong business with operations in many Latin American countries, not just Mexico.

Let's start with KOF's markets. We can break these down into three separate regions:

  • Mexico
  • Central America (Includes Guatemala, Nicaragua, Costa Rica, and Panama)
  • South America (Includes Brazil, Argentina, Colombia, and Venezuela)

Source: 2015 Annual Report

This graphic gives us an idea of the breakdown in terms of total volume. Mexico accounts for 52% of volume, South America accounts for 43% (Brazil is at 20%), and Central America accounts for 5%. Note that the figures exclude the Philippines, but I will touch on that shortly.

Now, what's important is not just what markets the company operates in, but how strong its position is in each of its markets. And in this respect, KOF is strong and getting stronger in most markets.

In Mexico, Coca-Cola has had around a 68% market share over the past six years according to Euromonitor International. Pepsi is number two with 16%. This compares to Coke's market share of about 40-45% in the U.S. according to Statista. This is one of the inherent advantages of operating in Mexico for KOF that I will also touch on shortly.

Now, there are undoubtedly some tough markets KOF operates in. This includes Venezuela, where the best word to describe the operating environment is brutal. On the most recent conference call, the CFO pointed out the hyperinflationary environment as a huge challenge. This makes it tough in terms of securing sugar and other raw materials. There were also problems with union disputes in Argentina and truck driver strikes in Colombia.

However, despite these tough operating environments, KOF continues to gain market share. In its most recent fiscal year (2015), the company gained over 3% share across multiple categories in Venezuela. In its second biggest market Brazil, as of the last annual report, the company had 20 consecutive monthly gains of market share. It is the leading company in Brazil across nearly all categories, including colas, iced tea, juices, and water.

Amidst the tough operating environment in South America (keep in mind Brazil being in a deep recession), in 2015, the comparable revenue and operating income in that region increased 10.8% and 16.0%, respectively.

Philippines

Also on the most recent conference call, the CFO mentioned that the Philippines will begin counting towards results as of 2017. This is a market where KOF has increased its market share in the sparkling beverage category by 8% over the past three years to 56% today in Manila. In the most recent quarter, volumes in the Philippines increased 7%.

With earnings of .99 pesos per share in the most recent quarter and assuming that pace remains constant, the Philippines could end up adding about $.20 per share in 2017. At a 20x multiple, this adds $4 to the stock price or over 6% just by including the Philippines in the financial results.

Inherent Advantages of Mexican Economy

As I earlier stated, Coke enjoys an even greater dominance in the Mexican market. When we compare the Mexican and U.S. markets, Coke's market share in Mexico is a full 25 percentage points higher. That's the U.S. we are talking about which is already an extremely profitable market for Coke. That is one advantage.

There may be an even greater advantage. While the U.S. has had a general trend towards healthier eating over the years, Mexico is farther behind in this respect. There is not the same awareness in Mexico about organic drinks and foods. Now, I'm not denying the fact that at some point this will change, and I'm also not saying I think it's a good thing this hasn't happened yet. But for Coca-Cola FEMSA, I am sure this is a good thing for the business because it buys it time while Coke expands its drink portfolio.

Source: Coca-Cola European Enterprises

To be sure, the perceived healthiness of the core product is absolutely a risk. We have seen talk in the U.S. about the possibility of taxes on sugary drinks, and in some Latin American markets such a tax already exists. This could obviously hurt the affordability of the product. The point is that relative to other markets, given the laid out risks, Mexico has as about as favorable conditions as any for Coke.

Valuation

While current year earnings are depressed, a rebound is expected next fiscal year (which begins after next quarter). Analysts for Thomson Reuters I/B/E/S expect EPS to rebound from $2.50 per share this year to $3.33 next year. At a recent price of $62, this puts the forward P/E ratio at 18.6. Looking at historical multiples, this looks like a favorable price to pay for KOF.

Source: Morningstar

Now keep in mind, this chart shows trailing P/Es. However, we can see that KOF has traded at trailing P/Es north of 18.6 over the past eight years. So even if it's a forward P/E of 18.6 today, that still stacks up favorably.

Earnings peaked in 2012 for the company at 13.3B pesos. On a TTM basis, earnings stand at 9.9B pesos. That is a decline in earnings of about 25% from its peak levels, yet the share price has seen a decline of about 65% from its peak.

If we look a little closer, it seems that fundamentally the 25% drop in net income is overstated. The TTM operating margin is right at about 15%, which is on par with 2012 levels. The big difference comes from interest expense. During 2013, KOF acquired a bottler in Brazil named Spaipa. As a result, KOF issued new debt and this increased its leverage. Interest expense went from 1.37% of revenue in 2012 to 6.76% on a TTM basis.

With an active acquirer like KOF, this cyclicality in leverage is part of doing business. If it has the opportunity to do an acquisition, especially if the asset is favorable, it will not hesitate to increase leverage temporarily. If we look back in time, we can see this pattern in KOF's financial statements. For example, on the most recent conference call, the CFO alluded to the recent acquisition of a long-coveted Brazilian bottler (Lonpar). While these acquisitions may hurt the short-term financial performance, KOF's consistent market share gains over time show that they are successful in the long term.

We can also look at cash flow to see that the company is still operating quite well. Its operating cash flow is near record-high for the company, making its P/CF multiple also look attractive.

Source: Morningstar

Now you may be thinking, so what? I can find many American companies trading at a similar multiple, and besides the multiple should be lower because the company is riskier.

True, an 18.6x forward multiple is similar to the S&P 500 today, but keep in mind KOF is no ordinary business. This is a company with comparable revenues growing in the mid to high single digits consistently. This is powered through both volume growth and a pricing power that allows the company to outpace inflation with price increases.

The other thing to keep in mind is that although Mexico's economy may be seen as having more risk, Moody's assigns Coca-Cola FEMSA with an A2 credit rating. Although its most recent note assigned a negative outlook (due to the negative outlook on Mexico's economy), Moody's had this to say:

"KOF is rated above Mexico's sovereign rating, a situation that only occurs under exceptional circumstances when an issuer's fundamentals are stronger than those of the sovereign. In the case of KOF, this is evidenced by its strong credit metrics, ample liquidity, limited reliance on the local banking system for funding and cash generation outside of Mexico."

Moody's also added Coca-Cola FEMSA's strategic importance to The Coca-Cola Company as a positive. KO owns 28% of KOF, with FEMSA (NYSE:FMX) being the majority shareholder at 48%.

The company has reduced its dollar-denominated debt to just $500M as of the most recent quarter. This should limit negative currency effects in addition to the current hedging program. The CFO pointed out that the company has already hedged a portion of its dollar needs for the upcoming year at a rate of about 18.5, which is more favorable than the current market rate.

Conclusion

Coca-Cola FEMSA has seen its stock price decline ever since the peso began weakening a few years ago. This makes some sense, at least in the short term. But when you look closely at the business, you see one that is dominant in the markets it operates in. Although it does have some challenges, including some volatile economies and the possible shift to healthier and less sugary drinks, KOF continues to perform nicely.

A lot of the factors that are negatively impacting the company today are temporary. Namely, the weakness in the peso and the higher-than-normal interest expense. Both of these should subside over time, and as the company takes steps to reduce debt and the peso stabilizes, the company has more tailwinds than headwinds. It will continue to drive growth both through volume increases and price increases.

As long as you are willing to expand your horizons a little bit and ignore the political headlines with Mexico, this is a very attractive opportunity. I believe at this price, Coca-Cola FEMSA makes for a solid long-term investment.

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Disclosure: I am/we are long KOF.

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.

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