With global economies breaking under the strain of Covid-19, consumer staples like soda, beer, and the like should hold up better on balance. Add in currency risk and worries about the health of the Mexican economy (and the Mexican consumer) and corporate capital allocation decisions, though, and you have a decidedly less supportive environment for FEMSA (NYSE:FMX) these days.
I think I can see where FEMSA management is going with its recent capital allocation decisions, but the fact remains that these are significant allocations of capital outside of what FEMSA does best, with little-to-no explanation from management as to why they haven’t decided to expand the OXXO concept more aggressively. What’s more, beer and sodas that aren’t drunk today don’t benefit from “catch up” spending later. With that, my fair value for FEMSA is lower now, though I do think the market has over-corrected here to a point where it is undervalued on the core operations.
A Decent-To-Good First Quarter
Despite some operating challenges, FEMSA came through with a decent or better quarter in the first quarter of this year. Revenue missed by about 3%, largely driven by Coca-Cola FEMSA (KOF), but strong profitability at the OXXO business helped drive a small beat at the EBITDA line, while stronger forex benefits from a larger U.S. dollar position drove a larger reported earnings beat.
Revenue rose more than 5% as reported and a little less than 3% in organic terms. Overall gross margin improved by 60bp, helping drive an 11% improvement in reported operating income and a 10% improvement in EBITDA (8% in organic terms).
Coca-Cola FEMSA revenue declined about 2% this quarter, with a small volume decline in Mexico/Central America (down 0.3%) offset by better pricing (up more than 3%), while Brazil revenue declined 10% on a 3% volume decline. Gross margin improved half a point, while EBITDA grew more than 6%.
OXXO (“Comercio Promixa”) revenue rose almost 11%, on a stronger than expected 5.5% same-store sales improvement. Traffic was down once again (by more than 3% this quarter), but a strong average ticket (up more than 9%) compensated for this. Gross margin improved nicely, up 160bp, with EBITDA up more than 14%.
Health was disappointing yet again, with a 1% organic sales contraction on a nearly 7% same-store sales decline. Underlying same-store sales were much better (up more than 3% in constant currency), but gross margin declined (down 60bp) and organic EBITDA declined, though margins were stable. The Fuel business saw flat revenue on a 1.5% same-store sales decline (volume down 60bp), with gross margin up 40bp and EBITDA down 13%.
Bracing For The Drop
Due in part to social distancing measures, as well as economic issues and supplier challenges, FEMSA is likely to see a bigger drop in OXXO’s performance than you might otherwise expect. As a convenience store, OXXO doesn’t necessarily cater to people’s true needs, and management reported a sharp deceleration in April comps (same-store sales down in the low teens).
On top of that, the company currently has a low level of beer inventory (about 10 days worth) and may actually run out of some products. Not all suppliers have resumed operations, and there has been uncertainty in the beer market created by conflicting statements from different departments of the Mexican government as to whether beer production is essential or non-essential (similar confusion has been seen elsewhere in Mexico’s government policies/announcements).
Given that products like soda and beer are premium-priced and non-essential, FEMSA is most likely going to see meaningful declines in the second quarter. Some of that will be offset by what I’d call “basic needs” spending, but overall consumer activity is down in Mexico and I would expect more Mexican consumers with relatively convenient access to supermarkets to do much more of their shopping there (again, focusing more on basic needs).
Another Debatable Capital Allocation Decision
Earlier this year, FEMSA made another substantial capital investment into a new business – paying $900M for a majority stake in a newly-formed combination of WAXIE and North American Corp, two relatively large janitorial and sanitation supply distributors. While FEMSA didn’t provide much detail, looking at comps like Bunzl (OTCPK:BZLFY), I believe FEMSA paid around 13x to 14x EBITDA for a business with around $900M in annual revenue. The newly-combined company will have a co-CEO structure, and it sounds as though FEMSA will take a relatively hands-off role at the day-to-day management level (leaving both management teams in place).
This is obviously yet another step well outside of FEMSA’s core focus on Coca-Cola bottling (and distribution) and small-scale retail, and I can understand why investors don’t like it. What’s more, management hasn’t really provided a compelling explanation of why they haven’t marshalled their capital to expand the Oxxo concept into other Latin American operating regions.
I think you can make a counter-argument, though, that these investments (WAXIE/North American, Brazil’s AGV, Justo, Jetro) aren’t as far outside the core competency as they may first appear. What these businesses all have in common, including FEMSA’s beverage, retail, and drug store businesses, is a reliance on strong supply chain management and efficient logistics and distribution. Perhaps similar to how Amazon (AMZN) has used its strong SCM and logistics capabilities to expand from selling books to a wide range of consumer (and non-consumer) products, FEMSA is betting that its knowledge and experience in logistics and distribution is transferrable/applicable into these other markets. I’d also note these are largely fragmented markets that offer attractive long-term ROICs.
To be clear, I’m not saying I agree (or at least agree completely) with that logic, but I think that is what FEMSA is doing here – focusing on a core corporate expertise in SCM and logistics and looking for opportunities where they can apply that to generate above-average long-term cash flows and ROIC.
The Outlook
Like most companies, FEMSA is looking to limit non-essential spending during this downturn, though it doesn’t sound like a full-scale cost reduction program is on the way, nor a full-stop on capital expenditures. While I think ongoing investment/re-investment in OXXO is likely, the practical realities of the Covid-19 outbreak will almost certainly stymie new store additions for the rest of the year.
In terms of operating results, I expect FEMSA to see a hit to its results, but I expect reported revenue to still grow this year, with underlying same-store-sales at OXXO still finishing up positive for the year (albeit in the low single-digits). Likewise, I don’t see too much downside risk to gross margins. While I do expect volume contraction at Coca-Cola FEMSA, I think it will be fairly limited and the business will remain solidly profitable (EBITDA margins in the high teens).
The bad news/good news is that while FEMSA won’t recapture this lost business as “catch-up spending” down the line, they’re not going to lose as much business as industrial or consumer services companies.
Long term, I still expect around 8% long-term revenue growth from FEMSA, with roughly similar high single-digit FCF growth. The success of the company’s recent investments is clearly a significant unknown, and the company has now spent its “on-hand” expansion capital (monetizing more of the Heineken (OTCQX:HEINY) still remains a long-term option).
The Bottom Line
I believe FEMSA shares have over-corrected relative to the near-term challenges in the business, and I see the stock priced for an attractive long-term total annualized return in the mid-teens. The future success of the company’s strategic investments remains a key unknown, and it will take years to see how those play out. While that adds risk to the story, the core operations (Coca-Cola FEMSA and OXXO) can more than support today’s valuation.
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