A Tale Of 2 FEMSAs

Summary

• FEMSA produced on-target second quarter results, though holiday timing and a mix shift pressured OXXO comps.
• Although OXXO saw higher wage and store opening expenses, Health margins improved nicely.
• Coca-Cola FEMSA has more work to do, as the Brazil recovery program is working, but the Filipino operation needs work.
• FEMSA shares look undervalued below $100.

All in all, Mexico’s FEMSA (NYSE:FMX) continues to perform relatively well, though there has certainly been a sharper distinction lately between the strong performance of the retail operations and the lackluster-to-disappointing results of Coca-Cola FEMSA (KOF). With improved profitability in the drugstore business, a good long-term growth plan for the core OXXO operations, and opportunities for Coca-Cola FEMSA to do better, I continue to believe this is a good core holding for investors who want exposure to Mexican/Latin American consumers.

A Little Noise, But A Largely In-Line Quarter

All in all, FEMSA’s overall second quarter results were basically on target (within 1% to 2% of sell-side targets on revenue and EBITDA). Ongoing weakness at Coca-Cola FEMSA is a concern, but there are long-term plans in place to drive better performance, and the company’s retail strategy looks like it's working well.

Revenue rose almost 9% as reported and roughly 9% on an organic basis. Revenue at Coca-Cola FEMSA was up a little less than 5% on an organic basis and closer to 8% on the company’s self-reported “comparable” basis. Volume was sluggish (down 1.4% on a comparable basis), but pricing was strong. Volume continues to improve in Brazil, as the restructuring program proceeds, while volume in the Philippines (down 4%) was weaker than expected.

OXXO revenue rose nearly 10%, as a 3% same-store comp improvement complemented greater than expected store openings. Although same-store sales growth was a little sluggish (traffic up 1%, ticket up 2%), some of that was due to the timing of Holy Week this year (which boosted first quarter comps) and some was to due to a greater mix of services (which have smaller ticket values). Relative to the Mexican retail sector as a whole (as reflected in ANTAD numbers), OXXO comps were lackluster (3% vs. 4.5% ANTAD growth), and OXXO lagged Walmex (OTCQX:WMMVY), but the first half comps are less concerning.

Drugstore comps improved significantly (up almost 12% versus 1% growth in Q1’18), driving 17% overall growth in Health. Drugstore same-store traffic grew at a low single-digit rate in Mexico and Chile, with a double-digit improvement in Colombia, and a more favorable currency translation was the prime driver here. In the Fuel business, revenue was up more than 21% on a 5% improvement in same-store sales (driven by double-digit price increases).

Higher raw material costs in the Coca-Cola FEMSA business (sweeteners, PET, et al) weighed on gross margin. Overall gross margin declined 10bp with a 150bp decline at KOF offset by a 130bp improvement at OXXO (helped by more financial services revenue), a 140bp improvement in Health, and a 160bp improvement at Fuel.

Operating income declined 1% on an organic basis, with the decline at Coca-Cola FEMSA (down 3%, or down 6% on a comp basis) driving the pressure. OXXO profits were up almost 8%, as higher wages and store opening costs compress margins, while profits were substantially higher at Health and Fuel, but the margins remain considerably below the company average.

Although I’m not a big fan of selective analysis, I think in this case it does offer some insight into the underlying health of FEMSA’s core retail businesses. If you extract Coca-Cola FEMSA from the results, revenue rose 12%, while EBITDA rose 13%.

A Good Plan Is In Place

FEMSA management had cautioned the Street after first quarter earnings that performance would likely be at least a little weaker through 2018 given various economic, operational, and political uncertainties in Mexico. To whatever extent FEMSA “underperformed” this quarter, I think it was only in the context of analysts/investors not really believing that first quarter guidance. All in all, though, I believe FEMSA is executing on a good growth plan.

OXXO will see slower store openings in the second half of the year, particularly in the fourth quarter, as management has realized it's better to focus on sales execution in the fourth quarter and maximize the opportunities in that higher-potential quarter. At the same time, the company continues to expand its service offerings, including financial services (taking deposits for banks) and delivery services (a partnership with Amazon (AMZN)). Long term, there remain opportunities for management to take the OXXO concept “on the road” into other Spanish-speaking markets and possibly the U.S. (though the Heineken (OTCQX:HEINY) ownership stake is an issue there).

With the drugstore business, management seems to have scaled up the learning curve faster than I’d expected. Looking ahead, there are still opportunities to benefit from store-level drivers like greater generic sales (which compress ticket, but boost margins). I also expect FEMSA to use M&A to expand its drugstore footprint, as it still has less than ideal operating scale.

Coca-Cola FEMSA has more moving parts to consider. In time, I expect lower sugar prices to benefit the company’s gross margins, but there are pressures like higher plastics pricing and excise taxes (basically “sin taxes” targeting soda) pushing back. Management has fixed a lot of its deficiencies in Brazil and hopefully it can replicate that initial success in the Philippines, as performance there remains weaker than anticipated when the company entered the market.

The Opportunity

FEMSA remains a good way to play the growth of consumer spending in Mexico, and in Latin America to a lesser extent. OXXO is a major retailer in Mexico, but one that still has meaningful growth potential, with same-store sales likely to continue growing in the mid-single digits and the company continuing to add stores and expand service offerings. Other opportunities like Health/drugstores are largely just getting started, and I won’t be surprised if FEMSA uses its drugstore operations as a launching pad for wider operations in markets like Chile and Colombia.

This quarter was basically as I expected on balance and even adjusting for the moving parts, there aren’t many changes to the long-term outputs. I’m still looking for long-term revenue growth in the high-single digits (7% to 8%), with slightly slower FCF growth, but more leverage in the future as the company spends less on growth capex.

The Bottom Line

I continue to believe that FEMSA shares are undervalued below $100, and I believe the Mexican market has largely moved past the turbulence seen in anticipation of the presidential election. While trade relations with the U.S. remains a wild card, the recent news there has been more positive, and I like the basic outlook for a Goldilocks Mexican economy (strong enough to support good same-store growth and consumption, but not so hot as to create inflation worries). I continue to view FEMSA as a core holding with good return potential from here.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

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.