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Morningstar | Coca-Cola Femsa's 3Q Results Reflect Brand Strength in Core Mexico Market; Shares Undervalued

In our view, Coca-Cola Femsa's third-quarter results provided further evidence of its strong brand equity (which underpins our narrow-moat rating), as cola volumes grew across all of its geographies (transactions up 3% in total), and pricing in the core Mexico and Central America segment (nearly 60% of revenue this quarter) remained robust. While the challenging macroeconomic environment in parts of South America remains a source of uncertainty, with inflation in Argentina amounting to 29% year-to-date, and the region considered a hyperinflationary subsidiary since July, we posit the firm will be able to leverage its brand equity to prop up sales longer term. Further, sales in the Mexico and Central America segment are tracking ahead of our expectations, up nearly 8% year-to-date (versus our mid-single-digit expectation) on a 5% increase in average price per unit case (well above the low-single-digit rates of inflation in these countries to date); we expect strong pricing in this segment will continue to bolster profitability.  After evaluating these factors, we don't expect a material impact on our long-term outlook, which calls for mid-single digit comparable top line growth and low-teens operating margin on average over the next five years (versus adjusted operating margin slightly below 13% in 2017). However, we plan to trim our $74 per ADR fair value estimate by a few dollars to account for a less favorable exchange rate. Even at this level, we view shares to be modestly undervalued.

From a category perspective, the colas portfolio continued to lift sales of sparkling beverages, with volumes growing 3% in Mexico and Central America and nearly 7% in South America. We also continue to appreciate an ongoing mix shift in the water category from bulk water (volumes declined 3%) to higher-margin personal water (volumes grew 12%), which we think should benefit gross margin longer term.

In this context, we were pleased to see comparable gross margin expand 60 basis points to nearly 46% despite continued input cost pressure (primarily PET, as well as higher concentrate prices in Mexico) and higher dollar-denominated costs in several regions. Moreover, the firm's efforts to extract costs from operations in Brazil and Colombia helped consolidated operating income expand 110 basis points to 13%, more than offsetting the negative impact of higher freight and marketing costs in Mexico. Over the long run, we expect operating margin to approach a midteens level as pricing remains healthy and the firm is able to drive further operating efficiencies in the production and distribution of its beverages.