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Morningstar | Double-Digit Growth in Health and Fuel Businesses Boosts Femsa's Top Line in 2Q

Narrow-moat Femsa continued to post solid top-line growth in the second quarter, with consolidated sales up nearly 9%, driven by strength in its commercial business, and we continue to think the company is poised for high-single-digit growth over our forecast period. Growth in the health (11% of sales) and fuel (9%) divisions was especially pronounced, with sales up 17% and 22%, respectively. However, margin pressures from higher input costs at Coca-Cola Femsa (which contributed above 40% of sales for the quarter) coupled with a negative mix impact from the lower-margin health and fuel segments led operating margin to contract 50 basis points to 8.6%, matching our expectation for the year. We find incremental operating margin expansion feasible as the company scales these newer businesses, but still expect operating margin to average slightly below 10% over our explicit forecast, comparable to its three-year historical average, as the benefits of operating leverage are offset by structurally lower profitability in the faster-growing commercial business (which includes retail, health, and fuel) relative to the beverage business (Coca-Cola Femsa). We don't anticipate a material change to our $90 per ADR fair value estimate, outside of exchange rate adjustments, and view shares as fairly valued.

Sales in the retail segment (35% of sales) were up nearly 10% during the quarter, driven by new store openings. While same store sales appeared slightly light (up just 3%, below the 7.5% rate in the first quarter), we note this partly reflects challenging comparisons (same store sales grew 10% in the prior year period). Year-to-date, same store sales are tracking around 5%, driven by ticket growth of 3.4%. We expect further gains in ticket over the next several years as the firm continues to benefit from value-added services at OXXO stores. In this context, income from financial services helped Retail gross margin expand 130 basis points to 38%.

While the health and fuel businesses continue to lag Femsa's other segments in terms of profitability, we were pleased to see improvement in each segment's operating margin, bolstering our confidence that profitability is poised to improve with additional scale. Operating margin in the health segment expanded 180 basis points to 4.7% thanks to the integration of an operating platform in Mexico that led to better execution. While operating margin in the fuel business stands at just 0.7% of sales (versus essentially zero operating income in the prior-year period), we were encouraged to see improved operating leverage offsetting expenses related to regulation, technology upgrades, and expansion efforts.