Coca Cola Femsa S.A.B. de C.V. (KOF)

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Claudio Freitas

www.zacks.com

Coca-Cola FEMSA S.A. de C.V. (KOF) produces, markets, and distributes Coca-Cola trademark products, as well as water, and additional beverages in nine Latin American countries, including Mexico, Guatemala, Nicaragua, Costa Rica, Panam , Venezuela, Colombia, Brazil, and Argentina. The company operates in the largest urban centers in Latin America (Mexico City, Sao Paulo, Buenos Aires, Caracas, and Bogota). Coca-Cola FEMSA is the largest Coca-Cola bottler in Mexico and Argentina and is one of Coke's two anchor bottlers in Latin America. The May 2003 acquisition of Panamco (PB) transformed the company into the largest Coca-Cola bottler in Latin America and the second largest Coca-Cola bottler globally, in terms of sales volume. Coca-Cola FEMSA produces Coca-Cola, Sprite, Fresca, Quatro, Powerade, Extra Poma, Etiqueta Azul, Kin, Fanta, Lift, bottled water, and other beverages. Production occurs in a substantial part of central Mexico, including Mexico City and southeast Mexico in Guatemala City and surrounding areas Nicaragua, nationwide Costa Rica, nationwide Panama, nationwide throughout most of Colombia Venezuela, nationwide Brazil, in greater Sao Paulo, Campinas, Santos, and part of Mato Grosso do Sul and in Gran Buenos Aires, Argentina. After the recent acquisition by FEMSA (FMX) of some shares from "The Coca-Cola Company" (KO), The Coca-Cola Company now owns 31.6% of the company, with FEMSA (FMX) owning 53.7%. The float is relatively small at 14.7% of outstanding shares. The company has 32 bottling facilities in Latin America and serves more than 1.5 million retailers in the region. Coca-Cola FEMSA currently accounts for almost 10% of Coca-Cola global sales and approximately 40% of all Coca-Cola sales in Latin America. Mexico is the largest contributor to consolidated volumes and operating income. Revenue breakdown for Coca-Cola FEMSA during the first half 2007was as follows:

Coca-Cola FEMSA has been taking advantage of the positive economic environment in Latin America and the strength of the local currencies over the last few years. During the second and the third quarter of 2007, we noted that the very positive results in many Latin American countries outside Mexico, mainly Brazil, Colombia and Venezuela compensated the Mexican boring results. We believe that this development is very positive, as it makes the company more geographically diversified and less dependent on the Mexican economy. In this sense it was very encouraging the agreement between KOF and the Coca-Cola Company during the second quarter 2007 in order to acquire a bottling franchise called "Remil" in the State of Minas Gerais in South East Brazil. This agreement will be subjected to a confirmatory due diligence and must be approved by the board of both companies. Nevertheless we found the announcement very positive, since Remil covers a population of 15 million people, including the city of Belo Horizonte, the third largest city in Brazil. The deal is expected to close during the first quarter of 2008.

We understand that the geographical diversification of the company will be very helpful in the following months due to the uncertain economic environment in the U.S. in the very short-term. Indeed, the likelihood of a recession in the U.S. in the following quarters has been increasing, a fact that would for sure undermine the Mexican economy since the two countries have strong economic ties. We believe the company's exposure to other Latin American economies that are less exposed to an U.S. economic downturn will be an important factor to sustain earnings in the very short-term. Despite the difficult business environment in the U.S., we continue to have a positive outlook for economic growth in most of the Latin American countries in the very short term. Moreover, Latin American demographics should support solid growth in the company's operations in the medium-to-long term. Growing economies in the region and the hot weather are positive factors for the South American beverage industry.

Fourth quarter of 2006 and first quarter of 2007 figures showed a gross margin decrease of 210 basis points year-over-year and 170 points, respectively. EBITDA margin was also declining in the end of 2006 and the beginning of 2007. In fact, the company has been affected by raw material price pressures, including higher price for sweetener and resin. Additionally, we were concerned about weak sales in the key Mexican market. Surprisingly, second quarter results were better-than-expected with the operations in South and Central American compensating the weak sales in Mexico. Third quarter results were also better-than-expected, the Mexican business showed a small improvement in sales by volume, however the results in South America were once more highly encouraging. Even though net revenues were almost flat in Colombia, EBITDA increased 22.7% year-over-year, thanks to the strength of the local currency that reduce prices of imported goods like sweetener and concentrate and some considerable operating efficiencies. In Venezuela increasing volumes and prices coupled with lower raw material prices (like PET and sweetener) were the main reason behind the 510 basis points improvement in gross margin. Finally in Brazil, higher volume, the strength of the Brazilian real and falling raw material prices were responsible for the 540 basis points improvement in gross margin. For the following quarters we continue to expect a better performance in South America and a difficult business environment in Mexico. However, it was interesting to find out that on December 2007 KOF announced price increases in the Mexican market in order to mitigate the effects of increasing raw material costs.

After analyzing third quarter results, it is clear that the company benefited from the strength of most Latin American currencies, which increases sales and earnings in U.S. dollars and also reduces financial expenses, and the recent fall in raw material prices, including sweetener, sugar and PET. In fact, nearly 52% of the company's debt is denominated in Latin American currencies, mainly the Mexican Peso. Coca-Cola FEMSA's integral cost of finance declined by 100% during the third quarter 2007 if compared to the same period 2006. We believe that the positive trend for the Latin Currencies against the U.S. dollar will continue in the short-term, mainly considering the recent rate cuts in the U.S. Thus, we understand that KOF will continue to be benefited in the following quarters.

It is also worth mentioning that the company continued to introduce many non-traditional products like juices, flavored waters, etc. The key Mexican business had successful new products including Ciel Aquarius flavored water, Fanta Multiflavors, and Minute Maid juice-based products. Nevertheless, other countries like Brazil and Argentina also had very successful new non-traditional line of products. We believe there is a considerable room for growth in the short term in non-traditional products, and Coca-Cola FEMSA has been taking advantage of this trend. In this sense we were very encouraged by the announcement of the acquisition of Jugos del Valle. An the end of December, 2006, Coca-Cola FEMSA announced its plans to buy the Mexican juice maker Jugos del Valle for $380 million in a joint venture with Coca-Cola Co. (KO) in order to gain a greater share of the fast-expanding Latin American juice market. Additionally Coca-Cola FEMSA and Coca-Cola Co. would take on $90 million of Jugos del Valle's debt. In June 25, the Mexican Antitrust Commission (CFC) officially notified KOF of its decision to object the acquisition of Jugos del Valle. Subsequently, KOF filed a motion of reconsideration with CFC and on July 17 CFC decided to approve the deal. Finally, on September 26, 2007, the Comision Nacional Bancaria y de Valores authorized Administracion S.A.P.I. de C.V. ( a Mexican company owned by Coca-Cola FEMSA and the Coca-Cola Co.) to launch a public tender offer to buy 100% of the shares of Jugos del Valle by approximately US$370 million in cash. We believe Coca Cola FEMSA is taking the necessary steps to become a major player in the non-alcoholic beverage industry in Latin America.

It is important to remember that the company has been making a considerable effort to reduce its debt. The higher leverage was a result of the Pananco acquisition in 2003. Since then, KOF is successfully trying to generate enough cash flow to reduce its debt. Since the acquisition of Pananco, total debt was reduced by more than a US$1 billion, and it continues to be reduced, quarter-after-quarter albeit at a slower pace. We believe this strategy is positive and is already reducing the company's perceived level of risk. The recent acquisition of Jugos Del Valle will not change the company's strategy to reduce leverage in the medium term. This last acquisition was focused in a fast growing segment and it was important to state the company's leadership in the non-traditional products. Additionally, the amount involved can be absorbed by the company without major problems.

The company was once more able to post positive operating numbers within a very competitive market. For the near future we believe the growth in non-traditional products will help to sustain KOF's revenues and earnings growth. The weak economic situation in the U.S. and its effects in Mexico is a source of concern, nevertheless KOF is trading at an attractive valuation, and the company has a strong presence in the Latin American soft drink business, which is one of the most attractive areas for this kind of industry due to the positive demographics. All considered, we are keeping our current Buy recommendation on KOF.

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