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FEMSA Stays Neutral

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We have maintained our long-term Neutral recommendation on Fomento Economico Mexicano S.A. (FMX - Free Report) or FEMSA with a target price of $96.00 per share. Our long-term recommendation is supported by a Zacks #3 Rank, implying a short-term Hold rating on the stock.

Recently, FEMSA reported a robust first-quarter 2012 result with net income from continuing operations surging 13% to MXN 3,748 million ($288.2 million) from MXN 3,318 million ($274.4 million) in the year-ago period. The improved results were primarily driven by an increase in comparable income from operation and inclusion of 20% economic interest in Heineken Group. Moreover, total revenue grew 25.2% year over year to MXN 53,746 million ($4,133.1 million), mainly driven by solid performance at Coca-Cola FEMSA and FEMSA Comercio.

Moreover, the company boasts a strong balance sheet with cash and cash equivalents of MXN 27,249 million ($2,128.1 million) for first-quarter 2012 and long-term debt (including current maturities) of MXN 23,929 million ($1,868.9 million), reflecting a debt-to-capitalization ratio of 11.7%, which offers financial flexibility to drive future growth.

Besides, being the largest convenience store operator in Mexico with 9,699 OXXO stores at the end of first-quarter 2012, the company is aggressively looking to boost its market share by expanding its store counts to 12,000 by 2014. We believe the strategy will certainly drive its top line.

We believe the divestment of the company’s brewery operations has provided management strategic and financial flexibility to focus on the core bottling and convenience store operations and implement organic and inorganic expansion plans. Moreover, the transaction also facilitated FEMSA 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 - Free Report) indirectly owns 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 hold 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.

Moreover, 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 all of a sudden to its customers for fear of losing them.

Above all, FEMSA faces intense competition in the beverage segment from PepsiCo Inc. (PEP - Free Report) . Further, the company also encounters competition from local and regional players in the respective countries. To retain the existing market share, the company may have to reduce its sales prices, which could affect its margins.

Headquartered in Mexico, 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, 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.

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