Description

Fomento Economico Mexico (FEMSA)

I believe FEMSA presents investors with the opportunity to buy a business with strong fundamentals at a cheap price, along with a catalyst that will unlock significant upside value. FEMSA, one of Mexico’s oldest and largest corporations is a beverage company with two primary divisions: Femsa Cerveza, one of the two major beer brands in Mexico, and Coca-Cola FEMSA, the second largest bottler of Coca-Cola products in the world. FMX trades as an ADR in NY. The website has good list of investor presentations and financial information (www.femsa.com).

Currently, FEMSA trades at an EV/EBITDA multiple of 5.3x 2004E (median of brokers). The company has superb and stable cash flow, and trades at a FCF yield of 11% and a P/E (2004E) of 5x. The company has modest debt ($500mn), less than 1/3 of EBITDA.

First the business, then the event.

BUSINESS DESCRIPTION

Femsa Cerveza (54% of 2002 sales, 56% of EBITDA): the 12th largest brewery in the world in terms of sales volume and one of the two leading beer producers in Mexico. Femsa Cerveza exports to 67 countries worldwide, operates 6 breweries in Mexico and produces and distributes 14 brands (mainly Tecate, Carta Blanca, Sol, Superior, Indio and XX Lager). FEMSA Cerveza is 70% owned by shareholders, 30% owned by Interbrew/Labatt’s. The Mexican beer market is the 7th largest beer market in the world and is characterized by a duopoly industry structure, regional market share differences (driven by local scale advantages given high costs of distribution) and favourable demographics in the beer drinking population (34% of the population is under 18). Since 1985, Mexico has had 2 independent domestic beer producers: FEMSA and Grupo Modelo (publicly traded, brews Corona, Modelo, Victoria and Pacifico).

Coca-Cola FEMSA: Coca-Cola FEMSA is the largest Coca-Cola bottler in Latin America (40% share) and the second largest bottler of Coca-Cola products in the world. Coca-Cola FEMSA operates in Mexico, Guatemala, Nicaragua, Costa Rica, Panama, Colombia, Venezuela, Brazil and Argentina. On May 6, 2003, Coca-Cola FEMSA completed the acquisition of Panamco, then the largest soft drink bottler in Latin America (sales of $2.4bn and operating income of $131mn in 2002). The Panamco acquisition made a lot of sense, and significantly increased the geographic diversity of Coca-Cola FEMSA’s operations and created cost and revenue synergies. Coca-Cola FEMSA is 54% owned by Coca-Cola.

Other divisions: FEMSA Comercio operates the largest chain of convenience stores in Mexico under the trade name Oxxo. As of 12/31/02, FEMSA Comercio operated 2,216 stores located in 24 states of the country. In addition, FEMSA Empaques produces and distributes packaging materials for the beverage industry, including aluminium cans, bottle caps and glass bottles.

CATALYST AND VALUATION

FEMSA is attractive due to its market position in Mexico and the stability of its cash flows and margins. While this is one reason to buy the stock, what I am particularly excited about is the catalyst. What has depressed the share price of late is the market’s uncertainty over FEMSA’s relationship with Interbrew, who holds 30% interest in FEMSA Cerveza (FEMSA also owns 30% of Interbrew’s US operations). The growth of FEMSA’s brands in the US has for several years lagged Grupo Modelo which has been a source of conflict between the two companies. Interbrew’s acquisition of Beck’s forced FEMSA to invoke its rights as a 30% shareholder, seeking an injunction against the acquisition. The lower courts found in FEMSA’s favour about a year ago, a decision that was immediately appealed. The case is still in the courts, likely because the judge is putting this on the back burner awaiting the company’s negotiated solution. This situation will be resolved, and FEMSA is largely in the drivers seat, given the Beck’s transaction is critical to Interbrew, in addition to the fact that both companies need to resolve this conflict in order to simplify their corporate structures. What is especially interesting and new about the situation is that Interbrew has a new CEO at the helm, who has recently suggested an interest in resolving this situation.

I expect FEMSA and Interbrew to negotiate a resolution over the next few months to a year, which would likely entail each party buying one another out. An upside and possible scenario would be for FEMSA to sell its beer business outright, which yields even higher upside. But as a buyer of the stock, I would place a low probability on this scenario in order to be conservative. When fully incorporating the effect of the Panamco acquisition, FMX trades below its 10 year average on an EV/EBITDA basis (currently 5.3x vs historical average of 5.9x). Given Coca-Cola FEMSA is a publicly traded entity, one can back out the value of this business, leaving an implied valuation on the beer and other business (beer is lion share). This implied EV/EBITDA multiple is 3x EV/EBITDA, substantially lower than its 10 year average of 4.2x, Grupo Modelo’s valuation (200% premium) and other global beer companies (median of Heineken, Interbrew, SABMiller, Scottish & Newcastle and Carlsberg are 7x). The valuation of the beer business is the cheapest in the brewing world, in addition to having strong fundamentals.

On a sum-of-the-parts basis, my conservative target for FEMA is $58/share, implying 45% upside (I value FEMSA Cerveza at $3.6bn, which is the average valuation using an installed capacity approach, EBITDA multiple and EBIT multiple approach, Coca-Cola FEMSA at $4.6bn and the rest worth $1.5bn, less net debt of $500mn). If the beer unit were sold at the median valuation of global comps, the expected share price jumps to $70-90/share, yielding a substantial upside. Even if the chances of this event are 10%, the upside is substantial if one were to take an expected returns/probability weighted approach.

A downside scenario would entail FEMSA/Interbrew dragging their feet on the situation and FEMSA trading at its 10 year trough valuation for beer. Based on 1 standard deviation below the 10 year average, my downside yields a price/share of $32 (downside of 20%).

RISKS

Complicated ownership structure. Holding company discount will run off as negotiated settlement is reached.

Macro risk with Mexico. Currently Mexico appears to be stable although as we have seen in the past, Latin American countries can disappoint. Therefore, an investor with the opportunity to invest in Mexico deserves a higher risk premium. The valuation levels (or upside/downside) combined with the quality and stability of the business gives me adequate comfort.

Catalyst

Resolution of conflict with Interbrew
Realization of cost and revenue synergies from Panamco acquisition
Improving fundamentals combined with multiple appreciation (move in line with public comparables)