Coca-Cola FEMSA Stock: Cracking Open Could Prove Refreshing (NYSE:KOF)

Despite a multi-quarter run of better-than-expected results, Coca-Cola FEMSA (NYSE:KOF) still isn’t getting its due in the market. The company has had to deal with input cost inflation, economic turbulence in multiple markets, and more distant challenges like labeling and taxation changes and a sometimes-contentious relationship with Coca-Cola (KO), but the company has executed strongly in recent quarters and if anything is better-leveraged to easing input costs than vulnerable to higher costs.

Mid-single-digit revenue and FCF growth can support a double-digit return from here, and the shares likewise look undervalued on an EV/EBITDA basis given the company’s growth, margins, returns, brand value, and strategic opportunities.

Another Quarter, Another Beat

Coca-Cola FEMSA kept a strong trend going in the third quarter, with another set of results that were better than sell-side expectations.

Revenue rose 18% year over year as reported, beating expectations by about 4%. Revenue in the Mexico/Central America segment rose almost 18%, while South America rose almost 22% and drove more of the beat. Company-wide volume rose more than 8%, while average pricing improved more than 9%.

Within Mexico/Central America, volume rose 9% on high single-digit growth in Mexico and double-digit growth in Central America. Pricing was strong, too, with average pricing up more than 7% in the quarter. For the South American business, volume rose 7% (or 4% in organic terms), with double-digit growth in Argentina and solid growth in Brazil. Pricing rose more than 11% in the quarter.

Margins remain pressured by inflation, including inputs like sweeteners and PET, as well as logistics and labor costs. Gross margin declined 70bp to 44.5%, with the Mexico/Central America operations declining 250bp to 46.9% and South America improving 200bp to 40.9%.

EBITDA rose 14% yoy (beating by 7%), with margin down 70bp to 18.6%, though underlying margins were actually stronger on an underlying comp basis. In Mexico/Central America, EBITDA rose 18% (margin up 10bp to 21.2%), while South American EBITDA rose 6% (with margin down 180bp to 14.8%) as reported, but with underlying margin up 40bp (and adjusted EBITDA up over 21%).

Out-Executing Macro Challenges

As mentioned above, there is no shortage of operational challenges across Latin America for Coca-Cola FEMSA. Strong brand value has allowed Coca-Cola FEMSA to offset some of the pressures with pricing, but the company has also relied on other operational options to offset this pressure.

One way of enhancing affordability (and offsetting pricing) is to offer returnables programs to customers. While straightforward in concept, these programs are actually not easy to execute – there are not-insignificant upfront capital requirements that small distributors can’t really afford, and the logistics of managing returnable packaging are complex (but play into the company’s strong logistics capabilities).

Coca-Cola FEMSA is also benefiting from diversification. The Brazilian business has thrived not only by leveraging its logistics expertise (as well as the expertise of parent company FEMSA (FMX)) to untangle the challenges of the Brazilian market, but also by working closely with vendors to improve pricing and branding compliance – in the past, Brazilian mom-and-pop stores would ignore suggested pricing and would often put non-Coca-Cola products in coolers provided by the company for its products. Part of that improvement has come from expanding the product offering, including beer (Heineken (OTCQX:HEINY) in particular), energy drinks, and other non-carbonated beverages), making it even more worthwhile for vendors to stay in Coca-Cola FEMSA’s good graces.

Coca-Cola FEMSA is also moving into omnichannel marketing. It’s a relatively small part of the business now in terms of revenue-generation (maybe around 1%), but many of these projects are pilot-stage or just barely beyond that and have yet to mature. Even so, the company now reaches more than half of its Mexican client base through these efforts and around two-thirds of its Brazilian client base.

Another pilot program worth watching, and one that could help offset some future pricing challenges, is the company’s pilot beer distribution arrangement with Heineken (Irapuato) that is looking to expand Heineken’s points of sale in Mexico.

The Outlook

Despite government-led efforts to curb soft drink consumption (including labeling changes and higher taxation), Coca-Cola remains an extremely popular brand across much of Latin America (and most especially Mexico). While a wave of health consciousness is a theoretical threat, it’s one that the company is already starting to partly mitigate by continuing to expand its portfolio of products beyond carbonated soft drinks.

At this point, I don’t see much incremental risk from further input cost inflation. If anything, I expect inputs like resin and sugar to ease off, and that could give Coca-Cola FEMSA a period of elevated margins before rivals start leveraging those improved margins to compete on pricing. While I could see some execution risk from the recently-announced senior management changes (the CEO and CFO are stepping aside at year-end), the new CEO will be the current CEO of Coca-Cola FEMSA Brazil, and his strong performance track record there should put concerns to ease.

One risk factor worth noting is the possibility of further M&A. The company’s foray into the Philippines didn’t go well, and there isn’t a lot of “low-hanging fruit” in the Coca-Cola distribution world. Management does still believe they have some M&A opportunities, but I’d expect them to be smaller, incremental tuck-in deals.

I’m looking for long-term revenue growth in the mid-single-digits (around 5%), with the company continuing to benefit from an expanding distribution portfolio as well as underlying consumption growth. I expect margins to improve modestly over time, driving FCF margins into the double-digits, but I’m only looking for around 6% long-term FCF growth today.

The Bottom Line

Between discounted cash flow and margin/return-driven EV/EBITDA, I believe Coca-Cola FEMSA shares are undervalued. My cash flow modeling suggests a double-digit long-term total annualized return, while an 8x EBITDA multiple on my 12-month estimate supports a fair value about 20% above today’s price.

Coca-Cola FEMSA may not be the most exciting emerging market name in terms of revenue growth or margin leverage, but I believe this is a well-run company that is undervalued enough today to be worth a closer look.