Description

Fomento Economico Mexicano FEMSA was the subject of two great previous VIC write-ups where the business is flawlessly explained.

FEMSA is a collection of three great businesses: Coca-Cola FEMSA, FEMSA Cerveza and the OXXO Convenience store chain.

The company sold around 2,243 million cases of soft drink last year and 41 million hectoliters of beer and is the number 1 player in all of its regions as Coke Bottler and number 2 in beer in Mexico. - Coca-Cola FEMSA is the largest Coke bottler in the world, after CCE in the US, accounting for one out of every ten Coca-Cola products sold globally.

Barriers of entry are high in this business... FEMSA has more than 9,500 distribution routes and more than 2million points of sale where they serve 350 million customers. As well, FEMSA has a dominant position in the Coca Cola bottling system, with protected territory. This enables the company to operate as a near-monopoly over the population it covers.

The company counts its own stores (OXXO) as its largest client. FEMSA Cerveza's sales in OXXO stores represent more than 10% of its total revenue. The exclusivity of the Coca-Cola and FEMSA Cerveza brands in OXXO (largest retail chain in Mexico) represent in itself another barrier of entry.

The company now operates little over 7,000 OXXO convenience stores (up from a base of 1,000 in 1998), and expects to reach 12,000 stores by the year 2015.

The company grew revenues and operating profits at a 16% compounded rate from 1998 to 2008.

A brief abstract of FEMSA's segments:

1. KOF Coca-Cola FEMSA (53.7% owned):

Largest KO bottler in Latam & second in the world, representing for The Coca-Cola Company:

• + 10% of global volume,
• + 35% of Latin America,
• + 40% of Mexico,
• + 30% of Brazil

Higher margins than worldwide leaders:

KOF has better terms in its purchasing agreement with The Coca-Cola Company than most bottlers.  Its retail arm gives FEMSA a great leverage...

KOF has presence in 4 of the top 10 CSD per capita consumption markets: 2- Mexico; 6-Argentina; 7- Brazil; 9-Colombia.

Since the 90's, Mexico has surpassed the US in per capita consumption of products of the Coca Cola brand, becoming the biggest per capita consumer country of the company names...

2. OXXO (100% owned)

Largest company-operated store chain in the Americas:

*100% of stores are company operated.

77% market share of the Mexican convenience stores chain market. 

New objective of 12,000 stores by 2014, more than 2 new stores per day!

Growth opportunities in central and southern Mexico (Mexico City ~ 35,000 inhabitants per store vs. ~ 7,000 in Nuevo Leon)

OXXO started its expansion to other LATAM countries through Colombia, where it has launched operations in the last months. Management is very optimistic with the results seen in the Colombia's initial operations.

3. Beer (100% owned)

FEMSA has presence in three of the largest and most profitable beer markets in the world: Mexico, Brazil and the United States. Its flagship brands include Sol, Tecate,

FEMSA recently announced the sale of 100% of FEMSA Cerveza (its beer business), to Heineken in return for a 20% equity stake and the assumption of $2.1bn in debt. This leaves FEMSA debt free after the transaction.

Becoming FEMSA the second largest holder in Heineken, and obtains right to appoint two members to Heineken NV Supervisory Board

Transaction Value of US$7.4billion, includes US$2.1 billion of assumed net debt with implied EBITDA multiple of 10.9X

Transaction has been approved by FEMSA Board of Directors, subject to shareholder and regulatory approval and expected to close in 2Q 2010

The market was apparently expecting a higher price for the beer business or a cash sale. Since the deal was announced FEMSA's shares have sold off and now trade for about 10% less than its 2010 high.

If we deduct FEMSA's share in Heineken and it's participation on Coca-Cola FEMSA (both are public companies), from its market value we end up with the value the market is assigning to the OXXO convenience store business.

We estimate that the market is valuing the OXXO stub for around 6.7x EBITDA. A valuation we consider extremely low considering the franchise itself and the very favorable growth prospects that it has.

In contrast Walmex (main retail peer) trades at 18.9x EV/EBITDA. Though both business differ in many aspects as the scale of sales and business model, the valuation gap is wide enough to evidence the great discount at witch the market is valuing OXXO; specially when considering the historical growth of both companies (EBIT growth 5 years: Walmex: 18% vs. OXXO: 35%), the presence of OXXO stores through the country and the future growth potential in both revenue and margin expansion that OXXO presents...

In our view a fairer valuation of FEMSA's retail business would be at 15x EV/EBITDA, witch would mean a 31% upside for FEMSA stock price according to our valuation.

Giving OXXO a more conservative multiple of 13x, the upside for FEMSA would be of 25%!! 

Needless to say FEMSA is a quintessential blue-chip in Mexico. We really appreciate the defensive characteristics of its businesses, the predictability of its cash flows, its pristine (debt free) balance sheet and its management, which we consider to be top-notch.

Catalyst

Inorganic growth as the bottling industry consolidates in KOF's territories and abroad...

Expansion of OXXO stores to new countries

Better economic conditions in Mexico and Latam countries