Description

Fomento Economico Mexico (FEMSA), which was the subject of a previous VIC write-up in July 2003, is Mexico’s largest beverage company. FMX owns i) 45% of Coca Cola FEMSA (NYSE:KOF), Latin America’s largest Coca Cola bottler, with over 2/3 of the Mexican market; ii) one of two dominant beer companies in Mexico (controls 44% of the market), and iii) the largest convenience store chain in Latin America. FEMSA’s stock is very cheap, its management team outstanding, ands its prospects for growth are strong.

FEMSA operates with the benefit of monopolistic and duopolistic characteristics in good growth markets. Purchase of the shares affords ownership of two dominant beverage (soft drinks and beer) businesses as well as a high-growth distribution arm. Powerful synergies exist among the three distinct divisions, including combined sourcing, logistics, distribution, strategic planning, and information technology.

One can purchase the entire business for under 10x estimated 2006 free cash flow (defined as cash from operations less minority interest less maintenance capital expenditures) and at a considerable discount to comparable companies. The businesses together generated ROIC of 15.7% over the trailing twelve month (TTM) period and the company has significantly reduced leverage, with $2.6 billion (USD) in debt, down from over $4.3 billion at yearend. Debt/EBITDA has declined from 2.4x to 1.3x. Additionally, significant operating leverage is evident in all three divisions.

The current cover story in Barron’s highlights Mr. Buffett’s interest in Anheuser-Busch. One measure of profitability, EBITDA/Barrel, is mentioned in the report as a rationale behind ownership of Anheuser. At $38 per barrel, indeed this measure exceeds that of both Miller and Molson-Coors (the article notes by about 2x). It should be stressed that FEMSA generated EBITDA/barrel of over $36 in 2004 and $38.60 in the most recent quarter (assuming 10.8 pesos/USD).

The operating divisions of FEMSA are as follows:

Coca Cola Femsa—NYSE: KOF—45% ownership
Coca Cola Femsa, with $4.8 billion in TTM revenues, is the second largest (behind CCE) Coca Cola bottler in the world, and the #1 in Latin America. The company possesses 70% market share in Mexico and 50-65% market share in the other Latin American countries it serves. Femsa is the most profitable bottler in the world--its 21.5% TTM EBITDA margins are even 770bps higher than Coca Cola Enterprises (CCE.) KOF is jointly owned with Coca Cola (NYSE: KO), which owns another 40% and the public, which owns 15%. While Femsa is based in, and derives the majority of its economics from Mexico (53% of volume, 58% of revenues, 69% of EBITDA), the company also has operations in Brazil, Venezuela, Columbia and Argentina.

Cervesa—100% ownership
The 115 year old Cerveceria Cuauhtemoc Moctezuma, which generated $2.2 billion in 2004 revenues. is the second largest beer brewer (with approximately 25 million hectoliters in 2004 volume) in Mexico, essentially splitting over 95% of the market with Modelo, which brews Corona, the leading beer in Mexico and the #1 US import. Cervesa’s brands include Tecate, Dos Equis, and Sol. The company’s Mexican market share is about 44%.


Femsa Comerico (Oxxo Stores)-100% ownership
The Oxxo convenience store chain, with $2.0 billion in 2004 revenues, consists of 3782 stores as of September 30, 2005 and is growing at a rate of about 600 stores per year (the company notes that a new store opened approximately once every 14 hours during 2004). Oxxo ultimately targets having 12,000 locations, and the real estate division selects sites in conjunction with Cervesa management. These convenience stores, similar in look to 7-11 stores, carry standard convenience store fare—however, given the ownership, only Femsa beers and Coca Cola products are sold in the beer and soft drink categories. Beverages comprise about 38% of sales, and the Oxxo chain is actually the largest single client of the Cervesa and Coca Cola businesses. The closest competitor is Modelo, which has under 1000 stores, and 7-11 has 491 stores. A typical store costs about $150,000 to open, and cash recovery of this investment occurs within 3 years.

Notably, Oxxo is the only truly national convenience store chain in Mexico, with geographic diversification across all four quadrants of the country. The division is estimated to have 50% share of the convenience store market. The company notes that Oxxo sells 2x as much beer in the Mexico than all supermarkets combined.

Glass Production Facilities
The company, unlike its primary competitor Modelo (and for that matter, US brewers), has its own captive glass bottle production facilities. The rise in natural gas prices worldwide has recently enabled bottle manufacturers, such as Owens Illinois to put pricing pressure on domestic brewers (this fact was cited on the recent Anheuser-Busch call). With captive capacity, as well as government subsidies for natural gas provide the company the ability to control a significant cost component of its operations that has plagued other brewers.

Barriers to entry

Dominant position in Coca Cola bottling, with protected territory. These contracts are usually long and exclusive, and Femsa has a near-monopoly on the portion of the Mexican population it serves (again, about 70% of the total Mexican market). Coke’s ownership in KOF solidifies this dynamic.

Exclusivity with Oxxo Stores and Others
The company counts its own stores as its largest client. Control over the country’s largest convenience store network has obvious advantages, including pricing power. The size of the brewer gives it significant leverage over the fragmented “on premise” market as well.

Duopolistic Market. Modelo and Femsa split over 95% of the Mexican beer market, which is a 54 million hectoliter market. Recently, this has been (October 25) deemed a duopoly by Dow Jones. Both companies work actively with local markets to protect this structure through exclusive and semi-exclusive relationships with points of sale. It should be noted that the control of liquor licenses, a necessity in Mexico, is at the local level, and the number of new licenses is limited.


Three Pronged Growth Platform

The Cervesa Division has grown revenues at 15% compounded over the (1995-2004) period, with EBITDA growth of 14.8%. For the first 9 months of 2005, the company produced 4.1 billion Pesos in operating income, an 8.1% increase in operating income over the first 9 months of 2004, on a total organic revenue increase of 6.3%.

KOF revenues have grown at a 22% CAGR over 10 years (1995-2004) with EBITDA growth of 28% CAGR. In the most recent quarter, KOF volumes increased 3% Y/Y, with operating margins stable Y/Y, at 17.3%, despite pressures on energy and raw material costs. For the first 9 months of 2005, KOF grew operating income 10.8% on organic revenue growth of 5.8% (to 6.2 billion Pesos).

OXXO revenues have grown at a 31% CAGR from 1995 through 2004, with EBITDA growing at a 35% CAGR. Oxxo’s operating leverage is notable, particularly since the company has been adding stores at a significant rate (644 stores added in the TTM period ended June 30). Typically, the company invests $150,000 in capital to start a new store, with recovery of the investment within 3 years. In the most recent quarter (reported Friday), Oxxo grew revenues 20.7%, with 122 net new store openings and a 7.4% increase in same store sales. For the first 9 months of this year, OXXO grew operating income 26.5% (to 744 million Pesos). The Oxxo business is particularly attractive as a growth engine, as the company is currently expanding Oxxo’s footprint at a rate of 1.6 stores per day. At this opening rate, the company can achieve its 12,000 unit target by 2018. OXXO currently operates in about 90 cities, with the strongest penetration in the North of Mexico (the south is under penetrated). Currently, while national penetration is about 1 convenience store per 30,000 inhabitants, cities like Monterrey have 1:6,000; this clearly points to further expansion opportunity. We note that OXXO has about 7x the footprint of 7-11 and 3.5x the footprint of Modelo’s stores at present.


Favorable Outlook
All three of the company’s components will benefit from 1) population and GDP growth within Mexico, 2) geographic expansion into faster-growth Latin American countries, 3) increasing per-capita consumption of beer. Mexico has a younger population skew, a positive vs. the US, and per capita beer consumption has been growing in Mexico at 1% per year since 1990 (vs. a 0.9% compound annual decline in the US). Approximately 75% of the Mexican population is under 40, compared to 55% in the US—accordingly, the pessimism pervasive in the US of an aging population switching from beer to wine, is significantly less applicable in the case of Mexico.


Penetration into the US market
On January 1, 2005, the company entered into a new distribution agreement with Heineken, whereby Heineken distributes FEMSA brands in the US, including Tecate, Dos Equis and Sol. Competitor Corona (with a 7.2% share on a dollar basis), already successful in the US, has pioneered the Mexican beer category in the US, making it easier for other Mexican brands to grow. As a result of Corona’s significant marketing spending, the average American associates Mexican beer with sun and the beach, among other things (i.e. adding lime slices to beer). Most, if not all, of this profile-raising marketing expense was borne by Corona. Heineken is the number 2 import in the country (3.0% share), with a strong distribution network. Femsa’s brands collectively comprise only a small portion of the US market. The popularity of Corona, coupled with an attractive (and growing) Latin American demographic in the US, provide strong potential for growth. Despite limited distribution prior to the Heineken deal, Tecate is currently the number 3 import in the US, while Dos Equis is the number 17 (Lager) and 18 (Amber).


Margin Analysis
The company has solid margins in both of its beverage operations, with over 24% EBITDA margins in the KOF division and 33% EBITDA margins in the Cerveza division as of last quarter. As one would expect, the EBITDA margins for the OXXO chain is lower then the company average (at just under 6% for 2004), but is actually 140 bps higher than 7-11’s 2004 EBITDA margins. However, margins remained intact, despite the fact that the company is adding 600 stores to the comp base every year, and these stores take 18 months to mature.

Strong Management Team:

Over the past 4 years, the company’s management has both grown and streamlined the integrated operations. Improvements on the brewery side include a 19% reduction in warehouse footprint, a 9% reduction in distribution routes and a doubling in the volume of beer sold through the captive OXXO distribution network Since 1995, EBITDA margins have expanded from 19.6% to 33.0% (TTM)—this compares quite favorably to comparables like SAB (27.1%), InBev (26.9%), Carlsberg (12.2%), and Tsingtao (14%). On the Coca Cola side, margins have improved from 15% in 1995 to 21.5% in 2004. Like the Cervesa business, the Coke bottler has rationalized production and distribution—between 2Q03 and the end of 2004, the company reduced the number of plants 42%, from 52 to 30, while increasing volumes 4%. Routes and distribution center numbers declined by 14% over the period. The bottler is also a deleveraging story, with net debt (total debt less cash) having been reduced from $2.5 billion to $1.9 billion between May, 2003 and June 2005. Further integration opportunities and thus cost savings and efficiency potential exists among the three divisions.

Cash Generation
Based on a combined EBITDA of $1.4 billion for 2005, the company will generate approximately $730 million in aggregate free cash flow (excluding the minority interest to KOF), with that number growing to over $800 million in 2006, assuming about 10% growth. It should be noted that last Friday, the company reported total revenues grew 8.1% with a 10.7% growth in operating income. The Cervesa business grew operating income 17%, while OXXO grew 18%.

In 2004, the company generated $616 million in fully-burdened FCF (operating cash flow less FULL capital expenditures, including growth CAPEX). One can argue that growth CAPEX for the company (just for Oxxo stores) is $150k per store X 600 stores= $90 million. In other words, ongoing FCF (including only maintenance CAPEX) would be more like $706 million, which is a more appropriate number to use.

Risks
The largest risk comes from currency and political volatility, rather than business risk. Movement of the Mexican Peso (90% of the companies revenues and 70% of the company’s costs are Peso-denominated) vs. the US Dollar is a risk to investors in the ADR. Raw materials (energy, aluminum, concentrate, sugar) did not appear to pressure the company’s recent results, though volatility in all four of these segments presents some short term risk. The currency risk can be hedged, to a certain extent.

On October 28, Coca Cola Femsa management indicated that Coca-Cola would be gradually raising concentrate (syrup) pricing over the next few years, culminating in what will be approximately $60 million in additional costs by 2009 for the Mexican market. This translates into about 130bps of additional pretax costs based on TTM revenues. We believe the company can cover this gradual increase through a combination of pricing and cost controls—management already indicated it will reduce marketing expenses to offset the increases. This was the first increase in concentrate pricing in over 13 years, and, importantly, that Coke gave the bottler ample (i.e. over 3 years) lead-time to make operating adjustments. Worst case scenario is that the company is unable to absorb the additional costs, narrowing its margin leadership over CCE from 770 bps to 640bps, still superior by a wide margin.

Valuation
I believe the total value of the business is approximately $102, or 15.0x FCF, which implies a 6.6% FCF yield to 2005 results—a 190 bps premium to Anheuser (4.8%), and also implies about 52% of upside potential. I believe that yield premium more than compensates the investor for “country risk”. I approach valuation in numerous ways, with the first being a DCF valuation. This valuation can be evaluated in conjunction with a “sum-of-the-parts” analysis, as there are publicly traded comparables, as well as recent transactions.

I assume the $730 million in FCF for the current year grows 10% in 2006, 8% in 2007-2009 (driven by continued growth in OXXO, coupled with margin expansion due to continued efficiencies achieved among the three divisions), 5% in 2010-2015 and beyond growing at 3.5%, about in line with GDP. These would imply significant and fairly rapid decreases in the rate of growth. I note that Oxxo’s current plan (600 stores per year) implies doubling the store count from 3800 to 7600 by 2012—with no operating leverage, OXXO EBITDA alone would be about $290 million (double the $145 TTM number) by 2012. My terminal value (2015) is based on a perpetuity, with a cost of equity of 11% and a 3.5% long term growth rate, in line with a guess about long term real GDP growth for served markets.

The DCF model is quite conservative—implying only a 6.5% CAGR of Free Cash during the high and intermediate growth periods of the next 10 years and GDP growth beyond, when in fact, the company has grown much more rapidly than that.

Assuming the 11% cost of equity, I arrive at an $102 fair value, which implies 15.0 forward cash flow, or a 6.6% free cash flow yield for the 3 businesses. I note, this is a free cash flow to equity valuation, so our FCF estimate has already included debt payments. To reemphasize, this 6.6% FCF yield target compares favorably to Anheuser Busch (4.8% FCF yield), which suffers with over 70% of its business in the United States, which actually has flat to down per capita beer consumption. I note that the current market capitalization implies an 11.3x multiple of trailing free cash flow (again, about $706 million), implying an 8.9% free cash yield.

I examine the free cash flow yields on comparable brewers and bottlers as well as the EV/EBITDA multiples. An analysis of 7 international beverage companies (Diageo, Anheuser-Busch, InBev, Heineken, Scottish/Newcastle, Molson Coors, Tsingtao and SAB Miller) yields a 10.4x average multiple of EV/EBITDA.

Note that while the Cervesa part of FEMSA generates 33% EBITDA margins (in line with Diageo, which actually commands a 12.6x EBITDA), it trades at a discount to Carlsberg and Tsingtao. Chinese brewer Tsingtao trades at 9.1x EBITDA, for example, while Danish Brewer Carlsberg trades at 11.7x. Tsingtao has 14.0% EBITDA margins and Carlsberg has 12.2% EBITDA margins. An 11 multiple applied to the Cervesa business would imply a $68.40 valuation (11x 740mm EBITDA/119 million shares) for the beer business alone.

A 10x multiple of the KOF business (EV/EBIDTA) could be justified because of 1) its margins are superior to all large bottlers, 2) its free cash yield, at that multiple, would still be 2x that of the mean for the large bottlers (thus relatively cheap on the measure that counts), 3) and—it is growing. KOF’s TTM EBITDA was $899 million. The 45% interest in that which belongs to FMX holders is $431.1 million—10x that is $4.31 billion, or $36.20 per share.


A major pending transaction in the convenience store market highlights the value of OXXO. The recent offer to buy the 5800-store US portion of Seven Eleven implies a near 10.3x multiple of trailing EBITDA. Applying a 10.3x multiple to OXXO’s trailing EBITDA implies $1.45 billion, or $12.20 per share. I would argue that the company’s plans to triple the business over the next 12-13 years and its growth/operating leverage trajectory could make it more attractive than Seven Eleven. I also note that the implied multiple of FCF being paid for Seven Eleven is 18.3x.

Adding these three relative EV/EBITDA-driven valuations together ($68.40 for CERVESA, $12.70 for OXXO, $36.20 for KOF) less the $2.6 billion in debt ($22.00 per ADR), yields a fair value of $95.30.

My $102 target also implies a 2.2x multiple of sales. Currently, BUD commands a 2.6 multiple, SAB Miller trades at 2.6x, and Modelo trades at 2.5x.

Catalyst

•Enhanced penetration in the US market as a result of the Heineken relationship.

•Continued consolidation of Latin/Central American presence (including potential repurchase of Molson-Coors’ Kaiser at a significant discount, which has been rumored in the press, plus potential acquisitions of other Coca-Cola bottlers).

•Addition of OXXO stores at a 600/year rate
•Continuing improvement of fundamentals due to logistics and sourcing synergies among the 3 businesses.

•Free cash used for continuing de-levering

Catalyst