KOF - FEMSA Propelled Higher By Healthy Results And Capital Redeployment Opportunities

2023-08-17 12:55:10 ET

Summary

• FEMSA posted healthy second-quarter results, with OXXO same-store sales well ahead of its comparable sector, though margins were pressured by ongoing reinvestment into digital capabilities.
• Management has moved quickly to divest non-core operations, selling its Heineken stake, selling Jetro, and reportedly nearing a sale of Envoy.
• The reported sale prices of Jetro and Envoy underline the underappreciated value that management was creating, but now the focus will shift back to organic expansion of existing operations.
• FEMSA shares still offer attractive long-term potential as a well-run play on consumer spending growth in Latin America with increasing capital returns to shareholders.

After years of struggling with largely sentiment-driven headwinds, FEMSA ( FMX ) is enjoying a renaissance in investor enthusiasm that has propelled the shares more than 25% higher since my last update and up more than 75% over the past year, handily outperforming the U.S. S&P 500 as well as comps like Wal-Mart de Mexico (“Walmex”) (WMMVY), Alimentation Couche-Tard (ATD:CA), and Seven & i (SVNDY). Not only has the market embraced the company’s decision to refocus around its traditional core retail operations, but the company has also been posting quite healthy financial and performance numbers in recent quarters.

I never had the issues with FEMSA’s diversification efforts that many investors had, but I nevertheless have long favored more investment in the core retail operations (convenience stores, or c-stores, and drug stores), including potential expansion into the U.S. While there are still some outstanding questions around the company’s capital allocation/reallocation plans and CEO succession plan, I believe the shares remain attractively-priced for long-term investors.

Second Quarter Results Showed Ongoing Momentum

While there was some margin pressure in FEMSA’s Q2’23 results, that pressure was tied to ongoing investments in digital capabilities – capabilities that have already shown the capacity to drive revenue growth – and I believe the Street is willing to look past those costs for the time being. Apart from that, the quarter saw healthy volume growth at Coca-Cola FEMSA ( KOF ) and strong same-store sales growth within FEMSA’s retail operations.

Revenue rose a little more than 18% in reported terms and more than 9% in organic terms, beating expectations by about 2%. Revenue from Coca-Cola FEMSA rose 7% as reported and closer to 17% on a comparable basis, spurred by 7% volume growth, including decent (4%) growth in Brazil, 8% growth in Mexico, and double-digit growth in Guatemala and Central America.

Proximity Americas (largely OXXO) reported nearly 20% growth, with 15% same-store sales growth at OXXO, nearly 23% same-store growth at Bara, and a little more than 20% same-store growth at Grupo Nos. OXXO same-store growth was driven by a balanced mix of ticket and traffic, with the company continuing to see healthy beverage and snack demand.

That 15% same-store growth at OXXO is far above the 3.4% same-store growth seen for the Mexican specialty retail sector (as reported by ANTAD, which includes but is not exclusively made up of c-stores) in the second quarter, and OXXO continues to outperform the broader sector.

The company’s European retail business, Valora, saw over 8% revenue growth in the quarter.

Drugstore revenue was up a little less than 1% as reported, with same-store sales down 3.7%, but on a currency-neutral basis sales were up more than 14%, with same-store sales growth of nearly 8%. Business remains healthy in Ecuador and Colombia (not withstanding currency pressures), while the company works through some tougher comps in Chile and Mexico.

The Fuel business posted over 9% revenue growth, and over 3% same-store sales growth, on sub-1% volume growth. The Envoy business grew 23% in the quarter.

Looking at margins, gross margin improved 50bp year over year (to 37.6%), with Coca-Cola FEMSA up 30bp to 44.4%, OXXO down slightly (down 20bp to 41%), Valora flat (42.1%), Health up 170bp to 30.2%, Fuel down 30bp to 12.0%, and Envoy up 170bp to 29.2%.

EBITDA rose about 8.5% in organic terms and 16% in reported terms, with the non-KOF businesses growing 23% and seeing about 10bp of margin erosion (to 11.5%). FEMSA continues to invest in digital capabilities and new growth projects like Spin and that is having an impact on margins, as are higher labor and operating costs (utilities, et al).

Rapid Progress On Asset Sales, With Future Capital Allocation Decisions To Come

FEMSA management has in no way dragged their feet, executing on their promises to simplify the business and get back to FEMSA’s long-term core operations. After another offering of shares in May, the company has largely sold its stake in Heineken (HEINY) (there are still some residual holdings tied to a convertible) and also sold its stake in Jetro in May for $1.4B.

Given a Bloomberg report from yesterday , the last major step, the sale of Envoy, may come faster than expected. The company is reportedly in talks with private equity firms to sell this distribution and logistics operation for around $5B. Keep in mind that when FEMSA management announced this divestment strategy in mid-February, management said that it could take up to three years to complete the process, though that timeline also referred to reinvesting/growing existing operations. Still, the sale/divestment part of the plan has progressed apace.

I’m also going to note here that the sale prices of these assets at least partly validate my argument that FEMSA’s diversification plan was well-conceived and well-executed, and far from the “diworsification” that some investors and analysts have claimed. FEMSA spent about $1B for its Jetro stake and will have gotten back $1.6B in total ($300M in dividends and $300M in after-tax sales proceeds). A $600M return on a $1B investment in three years (technically five, given that the Jetro sales proceeds will be spread out over time) is hardly poor. Likewise, FEMSA spent around $2B over three years to build the Envoy business and could sell for something around a 100% gross gain.

I’ll take that kind of “diworsification” any day.

Now I expect analyst/investor focus to shift to how, and how quickly, FEMSA management will redeploy its capital. Continuing to grow the OXXO, Bara, and Grupo Nos businesses seems like a no-brainer, and I see a long runway of growth opportunities for c-store concepts in Central and South America. I likewise see opportunities for FEMSA to enter the U.S. c-store market now that the complications of its Heineken stake are gone, though I’d expect something more like a joint venture as opposed to a ground-up organic effort.

Beyond this are still other growth opportunities. Coca-Cola FEMSA has the capacity to do some M&A, but I don’t think acquiring other bottlers is a high priority. Instead, I expect the company to continue investing in its digital and distribution capabilities – the company has already driven digital order placement to 30% in Mexico and 60% in Brazil and this will drive ongoing margin leverage. I also expect the company to further expand its product lineup (especially in still beverages, which are <10% of volumes) and look to distribute more consumer products through its existing infrastructure; not unlike how it has used its soft-drink distribution capabilities to distribute alcoholic beverages.

I also expect further investment and expansion in the Spin business. FEMSA is seeing strong uptake (active users grew 36% quarter over quarter to 5.7M) and Spin Premia , a loyalty program that encompasses the whole OXXO ecosystem has almost 16M users less than two years after its full national launch (previously as OXXO Premia ). FEMSA has made no secret of its desire to expand Spin beyond the OXXO ecosystem, and in an under-banked country like Mexico I see meaningful long-term potential here, though it will take ongoing investment in these early years.

The Outlook

Modeling is always an exercise in “best guess” estimation, but the uncertainty around the timing and magnitude of meaningful capital redeployment into growth (like expansion/entry into the U.S. c-store market) does add to the complexity. As is, I don’t model a U.S. market entry, but I do model further expansion in newer territories like Brazil and further expansion in Latin America. I also expect further expansion of the drug store operations, particularly in Mexico.

One lingering uncertainty concerns the leadership of the company. FEMSA announced in July that Daniel Rodriguez Cofre resigned to prioritize his cancer treatment, and the former CEO Jose Antonio Fernandez Carbajal has stepped back into the role on an interim basis. I believe FEMSA has a pretty deep management bench, but I do think investors would like to see a little more clarity here.

I’m looking for around 7% to 8% long-term annualized growth from FEMSA, slowing toward the mid-single-digits at the end of the next 10-year stretch. While I do expect meaningful investments in the business to put some pressure on margins and free cash flow in the near term, I believe EBITDA margins can reach 15% in five years and I believe FCF margins can reach 6% to 7% over the longer term, helping drive healthy FCF growth.

Between discounted FCF and forward EV/EBITDA (continuing to use a 7.5x multiple), I believe FEMSA is priced for a long-term annualized total return in the low double-digits and has a 12-month fair value in the $125 to $132 range. I do believe that capital returns to shareholders, dividends and buybacks, will increase over the next couple of years, but the timing will likely be dependent on the company’s growth investment opportunities.

The Bottom Line

Although I didn’t think FEMSA needed to shift away from its former plans (including Jetro and Envoy), management has nevertheless moved swiftly on these restructuring plans and has thus far gotten good value for these non-core assets. I’m now waiting for the next stage in the growth plan; I have few concerns or doubts about the expansion opportunities for the core OXXO franchise, nor the drugstores, but I would like to see what the company has in mind for the U.S. market.

As is, I think FEMSA is still an attractive investment. Coca-Cola FEMSA generates attractive margins and cash flow and still has underappreciated growth potential in Central America and from product line expansion, while the retail operation has many years of attractive growth ahead of it. While I do think a lot of “easy money” is in hand already, I still believe FEMSA can be a market-beater over the longer term.

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