Femsa Is A Delicate Balance Between Growth Opportunities And Valuation

By Stephen D. Simpson, CFA | Updated June 06, 2013 AAA

As a business, I love Fomento (NYSE:FMX) (also sometimes spelled as FEMSA). This company is not only the co-owner of the second-largest Coca-Cola (NYSE:KO) bottler in the world, but it operates one of largest retail platform in Mexico and is now looking to expand into new retail markets and new geographies. On the other hand, however, excitement over Femsa's stock has got to a pretty fevered level recently before selling off, and while the company's prospects are quite good, the stock is not exactly a cheap option on that growth.

SEE: Is Growth Always A Good Thing?

Growth Slows In First Quarter, But Core Results Aren't So Bad
Looking back a month, Femsa certainly saw business slow down in the first quarter after a torrid fourth quarter. Overall reported revenue rose about 5%, as strong growth in Comercio (the company's retail operations) offset weaker reported results from Coca-Cola Femsa (NYSE:KOF).

Comercio, which is largely the company's Oxxo convenience store chain, saw revenue up 14% (after a 15% increase in the fourth quarter). Same-store sales growth slid sequentially (from 7.5% to 5%), as traffic turned slightly negative. These results are still better than those of Walmex (OTC:WMMVY) and the Mexican retailing sector in general, and Femsa continues to open stores at a fast rate. On a more positive note, gross margin improved a full point and operating income rose more than 21%.

Coca-Cola Femsa had a tougher quarter. Reported sales were flat due to currency issues in Venezuela, Argentina, and Brazil, but the currency-neutral growth of nearly 11% doesn't look as good when considering the slight contraction in volumes for the quarter. Profits also declined, with operating income down about 6%.

While Femsa has no operating control over it, the company does own 20% of Heineken (Nasdaq:HEINY). Unfortunately, this large brewer is struggling due in large part to its exposure to the weak European markets, and results were down 3% organically for the period – one of the worst among the large brewers.

SEE: How To Decode A Company’s Earnings Reports

Planning For A Much Larger Future
Femsa already has a very successful business in Oxxo, and one with meaningful growth potential. The company hasn't come close to saturating its core central Mexico region, let alone areas like the southeast, and expansion into South America (the company has a small presence in Colombia already) is a very real option.

And it's not just a store expansion story – Oxxo has been increasingly leveraging the existing store base with better merchandising, adding offerings like fast food, and expanding services like deposit-gathering for the Mexican banking operations of Citigroup (NYSE:C), BBVA (NYSE:BBVA), and Scotiabank (NYSE:BNS).

But management isn't just standing pat with Oxxo. The company has been acquiring drug stores, buying two chains (YZA and Modena) in the southeast and north of Mexico, respectively. Management has also talked of expanding into discount retail (akin to what Wal-mart or Target do) and/or fast food. Fast food in particular could be an interesting opportunity, as neither McDonald's (NYSE:MCD) nor Yum! Brands (NYSE:YUM) have really established an unbeatable business in Mexico.

To this end, management recently completed a $1 billion Yankee bond issuance. As both Oxxo and Coca-Cola Femsa generate enough cash flow to fund their own expansion plans, I have to assume this cash is for new opportunities in retail and/or to increase the company's stake in Coca-Cola Femsa. Likewise, as the company continues to move forward with its international growth plans (retail expansion in South American and global bottling operations), I would think management would like to find a good way of monetizing that non-controlling Heineken stake. Management would probably love to see a larger brewer move to further consolidate the beer industry and acquire Heineken (and pay them cash for the shares in a single transaction), but that is probably a long-shot at this point.

SEE: Evaluating A Company’s Management

The Bottom Line
I've owned Femsa for a while now, and the stock has been good to me. While the company's operations in Mexico and South America have resulted in above-average volatility, the trade-off is above-average growth prospects in the retail operations. As management really does seem to have a solid grasp of how to succeed in retailing, I'm enthusiastic about the plans to expand into new retail operations and new geographies.

I do believe that Femsa can continue to post high single-digit revenue growth with low-to-mid teens free cash flow (FCF) growth. The resulting fair value around $115 isn't all that compelling today, though, which is I gave the warning that investors may want to let the market's enthusiasm cool a bit before establishing a full position. Even so, Femsa remains a high-quality choice for playing the above-average growth prospects in retailing and consumer services in Latin America.

At the time of writing, Stephen D. Simpson owned shares of Femsa.

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