FEMSA Stock in Doldrums: Can Growth Plans Offset Headwinds?

Fomento Economico Mexicano SAB de CV FMX, also known as FEMSA, is in the rough waters, thanks to the negative sentiment surrounding its operating margin performance. Notably, the company continued its soft operating margins trend in first-quarter 2019.

Additionally, it is witnessing soft trends in the FEMSA Comercio Health Division. Rising raw material costs, which have plagued the beverage industry, is another factor that is hurting this Zacks Rank #5 (Strong Sell) stock’s performance.

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Thanks to these headwinds, the FEMSA stock has been in the doldrums. Though the stock has witnessed growth of 2.5% in the past three months, it underperformed the industry’s rally of 10%.

With that said, let’s get a detailed view of the factors that have led to the stock’s underperformance.

Factors Hurting Stock Performance

As already mentioned, FEMSA witnessed a decline in operating margin in first-quarter 2019 that stemmed from lower margins at Coca-Cola FEMSA KOF and FEMSA Comercio’s Health Division. Moreover, organic operating income dipped 1.9%. Operating margin at the Health Division contracted 10 bps on lower gross margin. Operating margin at Coca-Cola FEMSA fell 70 bps, owing to higher labor and freight expenses along with restructuring indemnities.

Gross margin for FEMSA Comercio’s Health Division declined nearly 100 bps. This resulted from tough comparisons for its operations in South America as gross margin for this region expanded above trend in 2018. Further, the segment’s gross margin was hurt by new pricing regulations in Colombia and increased promotional activity in Chile.

Apart from soft operating margin, the company is likely to be affected by rising raw material costs that have plagued the beverage industry as it is the largest franchise bottler for the Coca-Cola Company KO. Higher tariffs charged on steel and aluminum by the Trump administration and retaliatory tariff plans put forward by China created more troubles for beverage companies, leading to an increase in packaging costs. The increase in prices for aluminum escalated the cost of producing cans for these beverages.

Escalating industry-wide freight costs and increase in other input costs are other headwinds impacting the bottling system. The effects of higher freight and raw material costs were visible in Coca-Cola FEMSA’s operating results for the first quarter.

Strategies to Support FEMSA’s Growth

While the downside story looks convincing, we remain impressed with FEMSA’s focus on strategic measures, which include increasing store count, diversifying business portfolio and focusing on core business activities. The company has been taking prudent steps to diversify the product portfolio while expanding in the small-box retail segment, which bode well for future operating performance.

As part of these efforts, FEMSA’s Cadena Comercial OXXO (OXXO stores) signed a commercial pact to sell Grupo Modelo’s leading beer brands in February 2019. Earlier, OXXO stores exclusively sold beer for Heineken’s HEINY Mexican subsidiary — Cervezas Cuauhtemoc Moctezuma — under the 10-year commercial agreement that dates back to 2010. FEMSA has also extended the existing commercial pact with HEINEKEN Mexico for another five years, with some key changes.

The extended deal includes provisions for the sale of beer brands from Heineken and Grupo Modelo in Mexico’s biggest cities, beginning from April 2019, with a gradual extension to stores nationwide by 2022. These deals will not only enhance the productivity of the beer category but also add value to the Mexico beer industry. It will also boost the value proposition of OXXO stores, which contributes nearly 35% to FEMSA’s revenues.

Moreover, the company’s focus on achieving growth via acquisitions bode well. We believe that its drugstore operations also possess significant growth potential. Furthermore, its exposure to various industries — including beverage, beer and retail — gives FEMSA an edge over competitors.

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