FEMSA Following Its Plan, No Matter The Cost To Sentiment (NYSE:FMX)

There are a lot of things about FEMSA (NYSE:FMX) that I find interesting, but over the last two or three years, one of the most interesting things here is the growing gap between management’s view of their strategic plan and the Street’s view of that plan. FEMSA’s management clearly sees value in allocating capital to a global conglomerate strategy, including a recent foray into European convenience stores, but the Street seems to prefer that the company just “stick to its knitting” and reinvest in proven operations.

You go against the Street at your own risk, at least in the short term, and FEMSA shares have continued to lag despite better-than-expected earnings so far this year and a reasonably healthy operating environment in Mexico and Latin America. With the local shares down about 20% and the ADRs down closer to 15% since my last update, valuation (adjusted) is at a multiyear low. I understand the Street’s frustration, at least to a point, and there’s definitely elevated execution and sentiment risk here, but I do see value here for investors patient enough to let management prove out its strategy.

Value In Valora?

The most recent controversial move, and one that hit the stock price hard, was the company’s announcement in July of its intention to acquire Europe’s Valora (a deal that closed earlier this month).

FEMSA made an all-cash offer of around MXN 27B at a little over a 50% premium for Valora, acquiring a European convenience store and food service operator with a little over 2,000 stores, primarily in Switzerland and Germany. Valora has pretty solid margins (an EBITDA margin of 15% that is quite similar to FEMSA’s core OXXO c-store business) and the multiple FEMSA paid (8.2x expected ’22 EBITDA) was in line with the average over the past five years, but the market didn’t like this expansion into new markets generally seen as low-growth.

I think the Street may be too hasty here. It’s true that the economies of Western Europe aren’t growing that fast, but that still ignores organic growth opportunities. Germany is underpenetrated where c-stores are concerned (though differing definitions of what a c-store is do muddy cross-border comparisons), and time and time again we’ve seen how good operators can gain share in established industries by outcompeting incumbents. Organic store expansion will come at a literal cost, but given a solid margin structure, I believe this is a relatively lower-risk deal for FEMSA management that builds on core expertise in the c-store market and should generate attractive long-term FCF margins.

Refocusing On More Established Opportunities Could Help Improve Sentiment

For years, the market was concerned that FEMSA would squander the value of the stake it held in Heineken (OTCQX:HEINY), and then that concern shifted toward impatience that the company wasn’t moving fast enough to do something with it. Then, when the company did act, acquiring pharmacy operations outside of Mexico and acquiring janitorial and distribution assets in the U.S., the market liked that even less.

I said before, I understand to a point why the Street would be concerned about some of these moves. The new Logistics and Distribution operations in the U.S., for instance, carry weak EBITDA margins relative to operations like Coca-Cola FEMSA (KOF) or OXXO, and investors have questioned what sort of expertise management brings to the operations. I’ve previously argued that there is a strong, significant, and under-appreciated logistics and distribution component to FEMSA’s existing operations that are in fact complementary, but the Street hasn’t come around to this view yet, and it’s likely going to take a few years of results to change any minds.

I can make arguments as to why the Logistics and Distribution and Valora investments are better than they appear, but I do think there are credible opportunities for FEMSA to grow in more familiar areas, and I believe the Street would be more receptive to such moves. To that end, it seems that management is getting a little more responsive in terms of laying out its growth opportunities and priorities with an eye toward rebuilding some confidence and patience with institutional investors.

The Health business (pharmacies, primarily) is a market leader in Chile and enjoys strong positions in Ecuador and Colombia, but only about 5% share in Mexico. Investors were previously concerned that FEMSA would overpay to acquire scale in Mexico, but relative to the L&D and Valora investments, I think more investors would now welcome such scale-building moves.

Likewise, I believe the Street would like to see more activity in the LatAm c-store business. Management has previously stated that they believe they can continue to add 1,000 stores a year in Mexico for some time, but there are also attractive opportunities in other markets like Brazil and Colombia – now that the Brazilian operations have been running a little while, I think the market is waking up to the longer-term potential here and would like to see a more aggressive move across Latin American markets.

Last and not least is Coca-Cola FEMSA. While most of the focus here will be on core marketing and execution (including recent price hikes in markets like Mexico to offset cost inflation), management has said recently that they still see M&A opportunities to grow the business.

The Outlook

FEMSA’s upcoming third quarter results should be relatively solid even after several quarters of double-digit organic revenue growth have raised the bar. According to ANTAD (an industry trade group in Mexico), same-store sales at specialty retailers (which includes c-stores like FEMSA’s OXXO and Seven & i‘s (OTCPK:SVNDY) 7-Eleven) increased 8.5% in the third quarter, after growing 10% in Q2 and 10.8% in Q1. There has been some deceleration, with September same-store sales growth slipping below 8%, but double-digit same-store sales growth seems achievable once again.

Margin pressure remains a challenge in the face of higher input costs (particularly with Coca-Cola FEMSA), higher labor costs, and higher operating costs (utilities, fuel, et al.), but I believe this risk is well-understood, and FEMSA has been executing relatively well on costs.

As far as the outlook goes, executing well on the Logistics & Distribution expansion and the Valora integration are clearly important to the story now. Unfortunately, it’s going to take time for management to prove the value of these investments (if they can), and while I expect solid growth in OXXO and Health, so does the Street, so I don’t think that will shift sentiment quickly.

With Valora in hand, I’m looking for long-term revenue growth of around 8% and mid-teens long-term FCF growth. As mentioned above, I believe there are meaningful organic growth/expansion opportunities for Valora, as well as the LatAm operations of Health and OXXO.

The Bottom Line

Between discounted free cash flow and a margin/return-driven EV/EBITDA approach, I believe fair value for FEMSA still ranges from the low/mid-$90s to the low $100s. Clearly, the Street doesn’t agree now, as the shares trade well below those targets. I understand the fear that management is frittering away capital (as well as time and attention) on lower-growth, lower-return ventures outside of FEMSA’s core, but I believe these fears are overblown and that the shares can re-rate over time as management proves the value of these newer operations.