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Driven by robust segmental performance, Fomento Economico Mexicano S.A. (FMX - Analyst Report) – also known as FEMSA – reported better-than-expected third-quarter 2012 result. This largest franchise bottler for Coca-Cola Company (KO - Analyst Report) posted net majority income of $1.03 (Ps. 1.32) per share that beat the Zacks Consensus Estimate by a couple of cents. Moreover, quarterly earnings was higher 19.8% from the year-ago quarters’ earnings of 86 cents per share.

Quarter in Detail

Total revenue grew 18.1% year over year to Ps. 59.675 billion ($4.523 billion), mainly aided by improvements in revenue at Coca-Cola FEMSA and FEMSA Comercio. On an organic basis, i.e. on a comparable basis, total revenue increased 11.7% from the prior-year period.

FEMSA’s gross profit expanded 20.5% year over year to Ps. 25.417 billion ($1.927 billion), and gross margin expanded 90 basis points (bps) to 42.6%. The increase was primarily driven by gross profit improvements at FEMSA Comercio and Coca-Cola FEMSA segments.

FEMSA’s operating income surged 24.4% to Ps. 7.383 billion ($0.560 billion) from Ps. 5.934 billion ($0.484 billion) in the year-ago period. On an organic basis operating income increased 18.1% year-over-year. Driven by margin expansions at the company’s both segments, FEMSA’s consolidated operating margin expanded 70 bps to 12.4%.

Segmental Discussion

Total revenue at Coca-cola FEMSA soared 20.3% to Ps. 36.193 billion ($2.743 billion) in the quarter, primarily driven by double-digit growth across all divisions coupled with the benefits from the acquisition of Grupo Tampico, Grupo CIMSA and Grupo Fomento Queretano in Mexico. Excluding these acquisitions, total revenue escalated 9.6%.

The segment’s operating income for the quarter surged 26.6% to Ps. 5.487 billion ($0.416 billion) from the year-ago quarter, primarily driven by robust performances across all divisions along with acquisition benefits. Consequently, Coca-Cola FEMSA’s operating margin improved 80 bps to 15.2%. Excluding the recent acquisitions, operating income was 18.0% higher than the previous-year quarter.

FEMSA Comercio registered a revenue growth of 16.0% to Ps. 22.521 million ($1.707 billion), mainly due to the opening of 178 net new stores in the quarter along with a 7.6% upside in same-store sales. The company opened 1,019 net new stores in the past twelve months.

Operating income, for the quarter under review, jumped 24.3% year over year to Ps. 1.758 billion. Segment’s operating margin expanded 50 bps to 7.8% primarily due to improved gross margin, partially offset by increased expenses due to store openings and developing specialized distribution channels.

Financial Position

At the end of the third quarter of fiscal 2012, the company had cash and cash equivalents of Ps. 30.031 billion ($2.335 billion). Long-term debt at the end of the quarter was Ps. 25.242 billion ($1.962 billion), reflecting a capitalization ratio of 11.3%. During the third quarter, FEMSA made a capital expenditure of Ps. 3.965 billion ($0.301 billion) towards incremental investments at Coca-Cola FEMSA and FEMSA Comercio.

Recent Development

Going with its strategy of focusing only on core business, in September this year, FEMSA entered into an agreement with Ecolab Inc. (ECL - Analyst Report) to sell its wholly-owned subsidiary Quimiproductos. The transaction is expected to conclude in the fourth quarter. Apart from providing water treatment, Quimiproductos is specialized in manufacturing and providing cleaning as well as sanitizing products and services related to food and beverage industrial processes.

Our Recommendation

We believe that FEMSA’s decision to divest its wholly-owned subsidiary Quimiproductos operations to Ecolab will facilitate it to pursue opportunities in its core businesses. Furthermore, FEMSA has a strong balance sheet with lower debt-to-capitalization ratio, offering greater financial flexibility to drive future growth.

However, increasing cost of raw materials, ingredients, or packaging materials such as aluminum, HFCS (sweetener), PET (plastic), fuel or other cost items are the major concerns for FEMSA, since the company may not be able to pass the increased costs immediately to its customers for the fear of losing them.

FEMSA, which competes with PepsiCo Inc. (PEP - Analyst Report), retains a Zacks #3 Rank, translating into a short-term Hold rating for the next 1-3 months. Moreover, we maintain our long-term 'Neutral' recommendation on the stock.

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