KOF - FEMSA Undervalued Despite Ongoing Excellence Of Execution

2023-10-30 14:51:45 ET

Summary

• FEMSA performed well in the third quarter, including double-digit volume growth from Coca-Cola FEMSA and mid-teens same-store sales growth in its core OXXO operations.
• The company's capital return plans and potential entry into the U.S. convenience store market are areas of interest for investors, but details have been slow to arrive.
• FEMSA's retail operations, particularly Oxxo, have significant growth opportunities in Mexico, Brazil, and other Latin American countries, as well as the U.S.
• Today's price gives too little credit to the quality and growth potential of this leading Mexican consumer business.

It’s hard to find much to criticize with FEMSA ’s (FMX) recent operational execution. Not only has management delivered on its promise to exit non-core operations (that many investors never embraced), and done so well, management has also continued to deliver strong results from the bulk of its core operations.

There are a few boxes left for management to check. The Street wants more clarity on its capital return plans, but I believe that may be tied to the company finalizing its plans for a potential entry into the U.S. convenience store (or c-store) market. I believe the Street would also like a little more clarity on management’s plans for the Mexican pharmacy operations, but that’s likely a lower priority.

I continue to expect mid-to-high single-digit long-term revenue growth, underpinned by the company’s exceptionally well-run retail operations. These operations still have ample room to grow, not just in new markets like the U.S., but also in Mexico, Brazil, and other Latin American countries where FEMSA has really just scratched the surface of its potential in retail. With double-digit return potential, I continue to view this stock as a high-quality core holding for investors who want some exposure to growth opportunities in Mexico (and to a lesser extent Latin America).

Not A Perfect Quarter, But Quite Good

FEMSA came up a little short on a few metrics that I consider less important, but on the drivers that really count, the company once again did quite well in the quarter and there are really no areas of major concern at this point.

Revenue rose more than 19% as reported and close to 12% in organic terms. While this was modestly below sell-side expectations (3% to 5%, depending upon which aggregator you use), it looks like the miss was driven by forex. Given the difficulties of accurately modeling forex, this isn’t a particularly concerning issue.

Gross margin improved almost a point (to 38.3%), with a point or better improvement in both the retail operations and Coca-Cola FEMSA (KOF). EBITDA rose 15% as reported and close to 8% in organic terms, a slight miss to a 2% beat (again depending upon the source), while operating income rose more than 12%, or about 10% in organic terms (with margin down 50bp to 8.5%), beating by around 8%.

Coca-Cola FEMSA

The Coca-Cola FEMSA business reported 10% revenue growth, with volume up close to 12% and realized pricing impacted by forex. Volumes remained very strong in Mexico/Central America (up almost 14%), healthy in Brazil (up more than 7%), and healthy in South America (up 10%, with Colombia and Uruguay up double-digits, offsetting 3% growth in Argentina). Gross margin improved 140bp to 45.9%, while EBITDA grew 11% and operating income grew more than 15%.

Proximity

For Proximity, the retail operations, it was strength across the board, with revenue up close to 21% on 15% same-store sales growth. Core OXXO sales rose about 21%, with same-store sales up 15%, while Bara reported over 15% same-store sales (and revenue up almost 37%) and Grupo Nos reported over 12% comp-store growth and over 151% total revenue growth. In Mexico, Oxxo continues to grow well in excess of underlying specialty store same-store sales growth, with balanced growth between ticket and traffic. The company’s European business saw almost 9% year-over-year growth.

For profitability, Proximity saw a one-point overall improvement in gross margin to 41.2%, with EBITDA up a little less than 14% and operating income up about 15%; margin was down year over year on higher labor costs.

Health & Gas

Revenue from the drugstore operations was up slightly as reported and up closer to 14% in constant currency, with same-store constant currency sales up almost 5%. While results in Mexico were lackluster (comp sales down more than 5%), Colombia was up more than 12% and Chile was up better than 2%. Gross margin declined 30bp (to 29.2%), with EBITDA up slightly as reported and operating income down 10% as reported.

The fuel station business saw revenue growth of just over 14% on 8.1% same-store sales growth, including 4% volume growth. Gross margin declined 40bp to 12.4%, EBITDA rose 7%, and operating income rose 3%.

All told, the key takeaways are as follows. Demand remains quite healthy for Coca-Cola FEMSA across its major markets (arguably excluding Argentina), and the business continues to benefit from its expansion beyond soft drinks in markets like Brazil. Oxxo continues to perform exceptionally well, even though labor costs are impacting margins. Health is still “mixed”, and I continue to believe more scale in the Mexican operations would help.

From Strength To Strength In Retail

Oxxo remains arguably the most exciting driver for FEMSA today. While the store footprint is already quite large, there are still worthwhile store growth opportunities, particularly in the southern parts of the country. There are also significant growth opportunities outside of Mexico’s borders; the expansion into Brazil has gone very well so far, and I believe there are numerous markets where FEMSA could basically duplicate this model.

The company is also still executing on opportunities to drive per-store growth. I believe the company’s agreement in 2019 to start introducing Anheuser-Busch InBev ((ABI)) products into its stores was largely forgotten during the pandemic, but with full implementation in place, this does seem to be improving the company’s overall sales momentum, and that’s likely particularly true in southern markets where ABI’s products (including Corona and Modelo ) are more popular than Heineken ’s (HEINY) (including Dos Equis and Tecate ).

FEMSA is also seeing strong growth and interest in its Spin program. Spin by OXXO saw 16% sequential user growth in the third quarter (adding 1.2M users), with transactions up a similar amount, while growth in active users did slow a bit (up 12% sequentially). Spin Premia saw almost 12% sequential growth in users and 12% growth in active users. As a reminder, management continues to look at Spin as a means of creating an entire fintech ecosystem that goes beyond its own stores.

What the company has in mind for the United States remains a key question. With the sale of its stake in Heineken, the company is clear to enter the U.S. market, but I think the market’s reaction to past M&A has likely made the company a little more cautious about a big initial foray. I wouldn’t be surprised to see the company open a few stores organically in a market like Texas and then look to acquire a regional chain to add scale.

Waiting For More Information On Capital

In late August the company announced the final major move in its restructuring, with an agreement to combine its Envoy Solutions with Brady IFS (a business owned by Kelso and Warburg Pincus ). The rumors I mentioned in my last article turned out to be not entirely true, as the company didn’t sell Envoy but instead agreed to merge it with Brady IFS, getting $1.7B in cash and retaining 37% ownership in the new operation (a large business focused on distribution for facility care, foodservice, and packaging).

Given that FEMSA paid about $2B to build Envoy, I still consider this a good outcome for the company, as this new business will generate dividends and could eventually go public and allow the company to divest the remaining stake.

Investors have been waiting for more definitive statements from management on what they’re going to do in terms of returning more capital to shareholders, and that wait goes on. As I said in the open, it’s plausible to me that the company is looking to finalize its plans for entering the U.S. c-store market (and/or other LatAm markets) before committing to a large capital return, but I would expect more information with (or before) fourth quarter earnings.

The Outlook

FEMSA has done a little better than I’d expected for this year, but with slowing overall retail activity in Mexico, I’m choosing to be cautious on boosting my expectations. I’m still looking for double-digit growth this year and high single-digit growth next year, as well as long-term annualized growth in the neighborhood of 7%. On margins, I’m looking for EBITDA margin to improve to over 14% next year (from around 13.75% this year), and improve further in FY’25. Longer term, I expect free cash flow margins to move toward the high single-digits, driving a few percentage points of growth beyond revenue.

Discounting those cash flows back, I believe FEMSA shares are still attractively-priced for a long-term total return in the double-digits. The shares also look undervalued on 7.5x forward EBITDA (a multiple far lower than what I use for Walmex (WMMVY), though I’ve not found a reliable basis for a “fair” forward multiple here, as there’s not much consistency between what investors will pay for given levels of growth, margin, returns (ROIC, ROCE, et al).

The Bottom Line

With strong execution across the large majority of its businesses, there’s little that concerns me operationally with FEMSA today. Slowing underlying economies are a risk to growth, but management has seen numerous cycles over the years and expectations seem to already acknowledge slower growth next year. Given what I see as undervaluation next to a long runway of profitable growth, I think these shares are worth owning today.

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