FEMSA Stays Neutral

We have maintained our long-term Neutral recommendation on Fomento Economico Mexicano S.A. ( FMX - Analyst Report ) with a target price of $72.00 per share. Headquartered in Mexico, the company has 31 bottling plants across 10 countries in Latin America, including Mexico, Brazil, Argentina, Colombia and Venezuela, and exports its products to the U.S., Canada, Europe, and Asia.

FEMSA is the largest Coca-Cola bottler in Latin America holding a 20% stake in Heineken, the third largest global brewer. The company markets a strong portfolio of globally-recognized brands, including Coca-Cola, Ciel, Fanta, Sprite, Tecate, Sol, Carta and Blanca Indio. This provides a strong upside potential for the company.

Moreover, FEMSA reported a strong second-quarter 2011 result with net income from continuing operation surging 7.1% to MXN 4,066.0 million ($346.4 million) compared with MXN 3,795.0 million ($302.1 million) in the prior-year period.

Moreover, the company has a strong balance sheet with cash and cash equivalents of MXN 31,176.0 million ($2,618.8 million) for the quarter ended June 30, 2011 and long-term debt (including current maturities) of only MXN 26,677.0 million ($2,240.9 million), or roughly 14.7% of total capitalization, offering it the financial flexibility to drive future growth.

Further, the company’s recent divestment of its brewery operations will provide management strategic and financial flexibility to focus on the core bottling and convenience store operations and implement organic and inorganic expansion plans. The deal also offers the company an opportunity to reward shareholders through increased distribution of surplus cash in the form of higher dividends and share buybacks.

However, The Coca-Cola Company ( KO - Analyst Report ) owns indirectly 31.6% stake in Coca-Cola FEMSA and approximately 99% of the sales volume is derived from the sales of Coca-Cola trademark beverages. This gives Coca-Cola Company a significant influence over the company’s operations. There may be certain conflict of interest between the two companies, which may result in Coca-Cola FEMSA taking actions contrary to the interests of its remaining shareholders.

Further, increasing costs of raw materials, ingredients, or packaging materials, such as aluminum, HFCS (sweetener), PET (plastic), fuel or other cost items are a major concern for FEMSA, as the company may not be able to pass the increased costs at once to its customers due to fear of losing customers to its competitors.

FEMSA is the largest convenience store operator in Mexico and commands a countrywide chain of over 8,426 OXXO stores at the end of fiscal 2010. Furthermore, FEMSA plans to aggressively expand the network of OXXO stores to 12,000 by 2014; thereby offering a strong upside potential to the company’s top-line.

FEMSA currently has a Zacks #2 Rank, implying a short-term Buy rating on the stock.