Summary
- FEMSA's fourth quarter results were mixed, with healthy core traffic at OXXO, but some softness in retail margins and higher expenses for the digital businesses.
- Management completed their strategic review and announced a return to the company's core operations (retail, Coca-Cola FEMSA, and digital), with the Heineken stake and logistics/distribution operations to be sold.
- FEMSA's U.S. logistics/distribution operations were better than the Street gave credit for, but I believe refocusing on retail opportunities across the Americas is the better use of capital.
- FEMSA shares have done very well over the last six months or so but should still offer double-digit annualized return potential from here.
I have written many times that companies go against what the Street wants at their own peril - while visionary management teams have certainly succeeded by taking a long-term view and going their own way, short-term consequences be damned, those short-term consequences can be serious and rile up the shareholder base. Such has been the case with FEMSA ( FMX ), where management's forays outside of its core operations have contributed to meaningful multiple compression and underperformance in recent times.
But no more.
Management announced earlier this month that it would shift strategy and go back to its core, focusing on the retail operations ( OXXO , Valora , and other operations like drugstores), Coca-Cola FEMSA ( KOF ), and digital opportunities, while disposing of non-core assets. The shares had already been outperforming, due in part to improving conditions in Mexico but also anticipation of the outcome of this strategic review, but the news helped take the shares even further.
Up over 40% since my last update , a lot of that conglomerate/capital allocation discount has been wiped away. I still don't consider the shares expensive, though, as I believe these core operations can support mid-to-high single-digit long-term revenue growth with mid-to-high single-digit FCF margins and double-digit FCF growth.
Fourth Quarter Results A Little Better Than They May Appear
Missing sell-side expectations is rarely good for a stock, but in the case of FEMSA's fourth quarter results, I'm not too troubled by an EBITDA miss that was largely driven by investments in digital, though I would have liked to have seen better margin performance from the core OXXO operations.
Revenue rose 23% as reported, or a little more than 13% in organic terms, coming in 2% below expectations when excluding the Valora acquisition in Europe. Coca-Cola FEMSA reported 15% revenue growth on 5% volume growth, including healthy demand in Brazil and Argentina.
Core OXXO revenue rose 17%, with same-store sales up 11% (better than the average for Mexican specialty retailers), on 4% traffic growth. Health (drugstore) revenue improved 6% in constant currency on an 8% improvement in constant currency same-store sales, and Fuel sales rose 25% on a nearly 20% same-store sales improvement driven overwhelmingly by volume. Logistics and distribution revenue rose 34% in organic terms.
Gross margin declined 110bp yoy and improved almost two points sequentially to 38.4%. KOF gross margins were stable-ish (down 80bp yoy and down 30bp to 44.2%) despite ongoing input cost inflation, while OXXO gross margin improved almost four points sequentially (declining two points yoy) to 44.2%.
EBITDA rose about 13% as reported and 7% organic, missing by about 5%, with margin down 130bp to 14.2%. KOF EBITDA rose 12% (margin down 50bp yoy to 19.5%), beating by 3%, while OXXO EBITDA rose 14% (margin down 50bp to 17.5%), a bit shy of expectations. Valora's EBITDA margin came in at 11.9%, while Health improved 70bp yoy to 10.4%, Fuel improved 30bp to 6.6%, and Logistics & Distribution declined three points to 7.6%.
Back To The Core - Understandable, And Perhaps Better For The Long Term
Overshadowing the earnings report was the news from February 15 that management had completed its strategic review and decided to change its operating plan in some significant ways. The new plan, FEMSA Forward , is basically going to see a simplification of the business, a return to its core roots and expertise, and a greater emphasis on capital returns to shareholders.
Refocusing on the core business means that FEMSA's priorities going forward will be the retail operations (OXXO, other retail concepts like Valora, the drugstore businesses, and the fuel business), Coca-Cola FEMSA, and its digital finance operations like Spin (a digital wallet and e-payments operation).
Anything outside of that core is going away. That means selling the Heineken ( HEINY ) ( HKHHF ) stake (the company has already announced the sale of about 40% of it), selling its position in Jetro (cash-and-carry restaurant wholesaling and distribution), selling or spinning off Envoy Solutions, and selling other small non-core operations.
Once this process is finished, which management believes will take 24-36 months, management is targeting a 2x net debt/EBITDA capital structure and bigger returns of capital to shareholders (including dividends and buybacks).
I've maintained for some time that the company's ventures into distribution and logistics (Envoy in particular) are better than the market has been crediting, and indeed Envoy has outperformed management expectations. In any case, the market wasn't rewarding the capital allocations here, and I do think FEMSA can get a good price for the assets (though a spin-off is a possibility); allowing up to three years for this restructuring to reach completion certainly helps avoid any "fire sale" pressure.
While I may be a bit sorry to see Envoy go, on the whole, I like this shift. Selling Heineken will not only raise cash, it will allow the company to enter the U.S. convenience store business, whether through organic expansion or M&A (or both). I also like the news that management will look to accelerate its retail expansion in Brazil, Columbia, Chile, and Peru, using different store formats as appropriate to the local market. I've said in the past that I believe OXXO is one of the better-run retailers in the world and is a business with significant long-term growth potential outside of Mexico.
The Outlook
On the whole, I like where FEMSA is at. Inflation and low economic growth remain concerns for Mexico, and OXXO traffic is still below pre-pandemic trends, but I believe above-market recovery growth is likely from here, particularly with FEMSA choosing to hold back a bit on pricing (average OXXO ticket was up 7% this quarter, though food/beverage inflation in Mexico is running closer to 14%).
I also like the longer-term growth opportunities. While I thought management's diversification into logistics and distribution in the U.S. (and Brazil) was a good use of their hard-won expertise, I'm more bullish on the idea of capital being used to expand the core retail operations - not only within Mexico (where there's still room for meaningful store growth), but in the U.S. and South America as well. I'm particularly interested to see what expansion into the U.S. can achieve, particularly if they can leverage their digital payments platform through those stores - money transfer between the U.S. and Mexico is a big business and FEMSA could be well-placed to get a lucrative piece of that.
The only real issues I see in the short term concern execution and patience with the disposals. Management has already moved to sell a big piece of the Heineken stake, but I hope they take their time and get the best available prices for the remaining assets. With that, I see a risk of some impatience from analysts/investors regarding the timing of future buybacks and the possibility of management prioritizing M&A (to enter the U.S. C-store market) over buybacks in the next 12-24 months.
Longer term, I'm still comfortable with a revenue growth rate in the high-single-digit (7% to 8%). I believe a capex-intensive program of store expansions could impact FCF margins in the short term, but I believe high single-digit FCF margins are attainable over time, driving double-digit FCF growth and a fair value above $110/share for the ADRs.
The Bottom Line
I think going back to basics was the right choice, and the market clearly agrees for now. I do see some modest risk that easy near-term gains are off the table, but I still think the shares are priced to generate low-double-digit long-term annualized returns, and I think these shares are still very much worth owning.
For further details see:
FEMSA Returning To Its Core, And The Street Approves