FEMSA Continues To Offer Attractive Value

Summary

• FEMSA's fourth quarter results had a few soft spots, but overall the revenue and margin performance was fine, as OXXO continues to deliver reliable growth.
• Coca-Cola FEMSA saw some volume weakness in Mexico, but improved results from Brazil suggest the turnaround efforts there are working.
• The drugstore and gas station operations remain long-term works in progress, and the drugstore business likely still needs meaningful M&A to reach attractive operating scale.
• FEMSA shares continue to look undervalued below $105 to $115, though 2018 could be a more turbulent year due to the election cycle and other macroeconomic factors.

Shares of FEMSA (NYSE:FMX), a large Mexican consumer conglomerate, are always going to twitch with concerns about Mexico's economy (including the exchange rate with the U.S.), but management has demonstrated over the years that it knows how to build value for shareholders. Recent endeavors like drugstores and gas stations will take time to mature, but the underlying growth story for the company remains intact.

I continue to believe that $105 to $115 is a good fair value range for the ADRs and that opportunities to buy below $100 should be considered by investors who want some exposure to emerging market (especially Mexican) consumer spending growth. Although 2018 could be a little more challenging due to political issues, I believe high single-digit growth potential continues to support a healthy outlook for double-digit long-term returns.

Q4 Results - Certainly Not Perfect, But Not That Bad Either

In my opinion, FEMSA's results were disappointing only in the context of the company's recent track record - this wasn't a great quarter, but it certainly wasn't a bad one.

Revenue rose 3.5% on an organic basis, with weakness at Coca-Cola FEMSA (KOF) weighing on the results. Coca-Cola FEMSA saw organic revenue contract 4% (though it was up almost 6% on a comp basis), while OXXO revenue rose 10%, drugstore ("Health") revenue rose about 2%, and gas station ("Fuel") revenue rose 26%. All told, FEMSA's results were below the average sell-side estimate by an amount that would otherwise fall within rounding error (less than 1%, though different sources report different "consensus" estimates).

Margins were okay for the most part, highlighted by the company not seeing as much margin pressure/erosion as expected. Gross margin actually improved 70bp, with better results in every business and a nice boost from Health. EBITDA rose 8% from last year, while operating income rose by a little less than 12%, keeping pace with reported revenue growth as margins stayed flat. Although the bottom-line EPS figure was a sizable miss, that was due to an accounting charge tied to how FEMSA now accounts for its business in the rolling dumpster fire that is Venezuela's economy.

Coca-Cola FEMSA A Mixed Bag

Although Coca-Cola FEMSA's results in the fourth quarter weren't perfect, they were better than the Street expected. Volume was up about 2% on an organic basis, with a very strong result in Brazil offsetting weaker results in South America and Mexico. Mexico (and Central America) represents close to half of the company's case volume and the fourth quarter saw an unexpected slow down after about two years of good results. Although I'm normally pretty skeptical when management teams blame issues like weather, given the very strong historical consumption patterns (Mexicans love Coca-Cola more than almost any other country), I'm inclined to believe it. Elsewhere, it looks like the changes/improvements that the company has been targeting in Brazil are starting to pay off, and the company's Philippine operations look like they're doing really well.

Margin performance was likewise mixed - not as good as investors would like to see, but still better than expected. Gross margin improved slightly, while EBITDA and operating margin both contracted by around a point. Importantly, margins in South America (including Brazil) are showing some really good trends of late.

OXXO Keeps On Keeping On, Though At A Slightly Slower Pace

OXXO continues to perform well for FEMSA. Revenue rose 10% in the quarter, and the company opened more than 500 new stores, bringing the total to over 16,500. Gross margin improved slightly, but the company saw a little erosion in operating margin due to higher operating costs (including utilities and employee compensation). The latter is not really a surprise, as management has commented that it wants to reduce turnover and improve employee retention.

Same-store sales growth came in at 4.7%, with just under 2% traffic growth. Although the year-ago comp was challenging (up 9%), I still count this as a disappointment when Walmex (OTCQX:WMMVY) saw over 6% comp growth. Management has explained that it is seeing a greater mix of service revenue in the business (which has been a long-term goal) and that this is pressuring ticket size and comps. Even so, it's going to be a talking point for the near term, particularly with management sounding a little cautious about consumer spending in Mexico in 2018 (tied in part to the election cycle and NAFTA renegotiations).

New Retail Showing Some Improvement

FEMSA's two newest businesses, its drugstore and gas station operations, showed some improvements in the fourth quarter, though both businesses are still sub-scale and very much in the "investment" phase of their life cycles.

Drugstore same-store sales growth was not impressive (up 1.6%), but gross margin improved 140bp on better execution in the supply chain (more effective negotiations with suppliers). Most of that benefit was chewed up in operating expenses, but management did indicate that the integration process should be largely complete in 2018. I continue to expect FEMSA to expand its drugstore operations through M&A, as this is a quick way to add scale and operating leverage, bringing the business to a level that can generate more attractive long-term returns.

With the fuel business, same-store growth looked strong at 17%, but volume actually declined close to 3% as customers bought less gasoline in response to significantly higher prices. Gross margin ticked up slightly, and FEMSA actually saw a little operating leverage, but this remains a low-margin business that is more about driving and securing traffic to OXXO than really making big margins on selling gasoline.

The Opportunity

Mexico could see some economic turbulence in 2018 depending upon the outcome of the NAFTA renegotiations and the presidential election cycle. Presidential election years tend to be volatile years in Mexico and that extends even into routine food and beverage purchases. Although I expect that it will still be a good year for FEMSA, OXXO (and drugstore) results could show some added quarterly volatility.

Should OXXO comps disappoint, I believe that would be a good buying opportunity. All told, I believe FEMSA's businesses continue to operate well - Coca-Cola FEMSA has shown it can fix the problems it had in Brazil and that it can drive attractive growth in its newest geography (the Philippines) while continuing to successfully manage its core Mexican operations. Elsewhere, OXXO continues to perform quite well (one softer quarter notwithstanding), and I continue to see meaningful growth potential here as well as in the drugstore business.

One key unknown remains the pace and direction of new investments. Management sold some of its Heineken (HEINY) stake to take advantage of a temporary tax law but has yet to deploy that cash. A faster pace of OXXO store expansion is probably the backup plan if other options don't pan out. I would expect the acquisition of a Mexican drugstore chain to be the first priority, with the acquisition of other retail operations, most likely outside of Mexico, as the second choice.

I haven't really made any meaningful changes to my modeling assumptions, other than to roll everything a year forward. I still expect high single-digit revenue growth over the long-term (faster growth in the next five years, slower growth in the out years) and likewise high single-digit growth in FCF. Those cash flows support a fair value in the $105 to $115 range today and annualized double-digit return potential.

The Bottom Line

I'm sure many investors will choose to tap out of Mexican stocks this year and just sidestep whatever risks and volatility may come with the macroeconomic and political developments that the year is going to bring. As a long-term holder of FEMSA, I'm not going to play those timing games and I continue to believe that this is a very well-run emerging markets consumer products company. Although uncertainty in capital deployment and strategy aren't helpful right now, I continue to believe that strong execution in the beverage and convenience store operations will generate ample cash flow to fund more long-term growth opportunities.

Analyst’s Disclosure: I am/we are 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.

Comments

[Panzerman]

Good write up. FMX is agreat opportunity to be involved in the growth of Mexico. NAFTA will continue with likely small modifications, do I do not see that as anymore than temporary paranoia. The election is more of a concern but with the PRI's well oiled machine, the leftist will lose out as usual. My main complaint with FMX is a small dividend and a somewhat lacklustre stock. With OXXO, gas stations, Heineken and the Coca Cola position, I do not know what is keeping the stock down.