MEXICAN SOFT DRINK INDUSTRY

Transcription

1 Latin American Equity Research New York, September 17, 2004 Sector Report Mexico Beverages MEXICAN SOFT DRINK INDUSTRY A Closer Look at the Coke Bottlers: A Perfect Storm? Alexander Robarts Alonso Aramburú (212) (212) arobarts@schny.com aaramburu@schny.com In this report, we analyze the fundamentals of the Mexican bottling sector into 2005 and remain cautious despite an expected moderate recovery in consumption. We are lowering our earnings estimates on Coca-Cola Femsa (KOF), introducing our 2005 target price, and downgrading the stock to Hold from Buy. We are also initiating coverage on Arca and Contal, both with Underperform ratings. Our new sector concern is our expectation for incremental margin pressure in the next six months from rising raw material prices, particularly PET resin, and sugar, which account for approximately 40% of cash cost of sales. During the second half of 2004, we expect PET resin prices to be significantly higher year on year on the back of the surge in oil prices, leading to an estimated basis point gross margin reduction on a pro forma basis. Prolonged intense competition leads us to estimate real price declines in 2005 for the third consecutive year (we had estimated in line with inflation). PBG Mexico has a new CEO and a new marketing campaign. B-brand producer Kola Real expects its new plant in Monterrey to be operational by February 2005 and to double its installed capacity by The ongoing industry shift toward lower margin one-way packages should further pressure gross margins. However, soft drink and water industry volume growth in Mexico should begin to recover during 2H04 after contracting 1.5% during 1H04, ending the year flat. Our Mexico-based economics team forecasts non-durable consumption spending growth to stabilize in 2H04, after a decelerating 1Q04 and a modest acceleration in 2Q04. In the current difficult operating environment, we believe revenue management and cost cutting will be even more critical to profit growth. Furthermore, we think industry consolidation could accelerate as economies of scale and financial resources become increasingly important competitive advantages. In the context of a weak bottling sector, we expect KOF to outperform Arca and Contal. In our view, KOF s economies of scale, solid execution and revenue management capabilities give it a superior platform to outperform its peers in a highly competitive environment. We believe KOF has mostly contained the competitive threats, while Arca and Contal should begin to face intensifying competition from Kola Real in 1Q05. Also, KOF s non-mexican assets enjoy improving economic conditions and should post EBITDA growth faster than in Mexico. However, in our view, these positives are more than offset by new concerns that lead us to downgrade the stock to Hold from Buy. We now expect a significant increase in raw material costs in 2H04 and slower water volume growth. We also incorporate management s warning on its 2Q04 results conference call that net cost synergies with Panamco would be US$20 million less than expected and that the expected US$50 million in savings from best practices should not be attainable in Mexican Coca-Cola Bottlers (U.S. Dollars in Millionsa) Price Target Upside/ Net Earnings P/E FV/EBITDA Mkt. Company Rec. 09/14/04 Price Down E 2005E E 2005E E 2005E Cap Arca Uperf % ,523 KOF Hold % ,824 Contal Uperf % ,168 Average NM NM NM 8.3% NM a Except per share/adr amounts. NM Not meaningful. Important disclosures/certifications are in the Important Disclosures section of this report. U.S. investors inquiries should be directed to Santander Investment at (212)

2 A Closer Look at the Coke Bottlers: A Perfect Storm TABLE OF CONTENTS Water to Outpace Carbonated Soft Drinks... 4 Pricing Outlook: No Improvement Expected... 7 Pepsi Bottling Group (PBG)... 7 Kola Real... 8 Raw Material Prices to Pressure Gross Margins... 9 Containing the Non-Returnable Packaging Trend Industry Consolidation to Continue Consumption Outlook Arca Financial Statements Contal Financial Statements Coca-Cola Femsa Financial Statements Appendix A. Beverage Sector Valuations Important disclosures/certifications are in the Important Disclosures section of this report. U.S. investors inquiries should be directed to Santander Investment at (212)

3 RECOMMENDATIONS, TARGET PRICES, AND ESTIMATES Inv Code 2005 Target Price EBITDA 2004E EBITDA 2005E EBITDA 2006E Company From To From To From To % From To % From To % Arca NA Uperf NA 1.90 NA 270 NM NA 267 NM NA 271 NM Coca-Cola Femsa (KOF) Buy Hold NA % 1, % NA 911 NM Contal NA Uperf NA 1.55 NA 161 NM NA 162 NM NA 165 NM All data in US$. NA Not available. NM Not meaningful. Source: Company reports and Santander Investment estimates. Figure 1. Mexican Coke Bottlers - Operating and Financial Indicators (2004E-2005E) Company 2004E Total Vol (MUC) 2004E Total Vol Growth 2004E EBITDA Margin 03/04E Real EBITDA Growth 04/05E Real EBITDA Growth 2004E ROIC 2004E FCF Yield Net Debt /Equity 2005 Dividend Yield Arca % 22.6% -10% -2% 13% 8% 5% 5.8% Coca-Cola Femsa % 24.8% -16% 3% 9% 11% 89% 1.4% Contal % 18.9% -12% -0% 10% 7% 0% 6.2% KOF s EBITDA growth (pro forma) and volume figures are for KOF Mexico. Figure 2. Latin America - Select Macroeconomic and Consumption Projections, F F 2005F Mexico Real GDP (%) CPI Inflation (%) US$ Exchange Rate (Year-End) US$ Exchange Rate (Average) Private Consumption (%) Real Payroll Growth (%) Argentina Real GDP (%) CPI Inflation (%) US$ Exchange Rate (Year-End) US$ Exchange Rate (Average) Private Consumption (%) Real Payroll Growth (%) Brazil Real GDP (%) CPI Inflation - IPCA (%) US$ Exchange Rate (Year-End) US$ Exchange Rate (Average) Private Consumption (%) NA NA NA NA Real Payroll Growth (%) Colombia Real GDP (%) CPI Inflation (%) US$ Exchange Rate (Year-End) 2,867 2,778 2,767 2,961 US$ Exchange Rate (Average) 2,506 2,877 2,721 2,949 Private Consumption (%) Real Payroll Growth (%) Venezuela Real GDP (%) CPI Inflation (%) US$ Exchange Rate (Year-End) 1,403 1,600 1,920 2,500 US$ Exchange Rate (Average) 1,164 1,610 1,895 2,496 Private Consumption (%) Real Payroll Growth (%) NA NA NA NA NA Not available. Source: Santander Investment forecasts. Important disclosures/certifications are in the Important Disclosures section of this report. U.S. investors inquiries should be directed to Santander Investment Securities Inc. at (212)

4 A Closer Look at the Coke Bottlers: A Perfect Storm MEXICAN BOTTLING INDUSTRY OVERVIEW Total industry volume growth contracted in 1H04, but only a modest recovery is expected. We expect Mexico s soft drink and water industry volume sales to stabilize in 2H04 after contracting (about 1.5%) during the past two consecutive quarters for the first time in many years. By 2005, industry volumes should begin to accelerate modestly after several years of deceleration. According to our data, total soft drink and water industry volume sales grew at an average annual pace of 4.7% between 1999 and 2003, reaching 3.1 billion unit cases by 2003, 20% more than in However, this growth has two distinct stages. First, between 1999 and 2001, when macroeconomic indicators were relatively strong and competition was relatively tame, average annual volume growth was 7.8%. The second stage is between 2001 and 2003, when job losses were rampant and competition increased with the entrance of both Kola Real and the Pepsi Bottling Group (PBG). In this period, average annual volume growth decelerated considerably to an average of 1.8%. For 2004, we expect industry growth to be flat and reach 2.0% in 2005, for an average growth of 1% over these two years. Figure 3. Soft Drink and Water Volume Growth in Millions of Unit Cases ( E) 14% 12% 10% 8% 6% 4% 2% 0% -2% -4% -6% -8% Industry Ave Volume Growth : 1.8% E: 1.0% 1Q01 2Q01 3Q01 4Q01 1Q02 2Q02 3Q02 4Q02 1Q03 2Q03 3Q03 4Q03 1Q04 2Q E 2005E Industry KOF Mx ARCA Contal PBG Note: Arca volumes do not include jug water. PBG began operations in Mexico at end of Sources: Company Reports, INEGI and Santander Investment estimates. Are selling prices too high? While the largest Coke bottlers in Mexico Arca, Contal and KOF mostly outperformed the decelerating period from 2001 to 2003, they underperformed during 1H04. During the period, their outperformance versus the industry was supported by economies of scale and marketing muscle relative to the smaller Coca-Cola and PepsiCo bottlers in Mexico, in our view. Another factor could be the relative weakness of the competition. However, the underperformance in 1H04 suggests that their average selling prices may still be too high in light of the persistent competition from PBG and B-brands, including Kola Real. We also note that jug water volume growth at Arca and KOF have been particularly negatively impacted as they both seek to increase profitability in that category through price adjustments and outright distribution route closures. WATER TO OUTPACE CARBONATED SOFT DRINKS We expect water to continue to be the fastest growing category in Mexico s non-alcoholic beverage industry, while colas (rather than flavor carbonated drinks) should continue to be the laggards. This has been the trend for the past five years. As a result, colas share of the beverage industry has declined from 54% in 1999 to 47% in Meanwhile, purified water s share of the total market volume has increased from 17% to 24% between 1999 and Important disclosures/certifications are in the Important Disclosures section of this report. U.S. investors inquiries should be directed to Santander Investment at (212)

5 Contal sets the pace Among the three Coke bottlers, Contal has been the most aggressive growing its jug water business. In fact, both Arca and KOF are deemphasizing the jug water segment due to its lower profitability with respect to soft drinks and water in personal sizes, and intense competition from formal players like PBG and informal competitors. Despite showing a 13% average annual growth, the other beverage category still accounts for less than half a percent of total industry volumes. Finally, flavors, the second largest category after colas, and mineral water have maintained their share steady during the same period at 26% and 4% of industry volumes, respectively. Going forward, we expect most of the industry growth to continue to be driven by the water and other beverages segments, line extensions mostly in the flavors category, and packaging upsizing. Figure 4. Mexican Non-Alcoholic Beverage Industry - Compounded Annual Growth Rate by Category ( ) 16% 12% 13.2% 14.3% 8% 4% 4.4% 1.4% 2.1% 4.7% 0% Flavors Colas Other Purified Water Mineral Water TOTAL Source: INEGI and Santander Investment. Upsizing and innovations should drive cola volumes. In the case of colas, in the absence of growth in consumption per capita, we believe that the short term volume will continue to be driven primarily by packaging upsizing and innovation. However, we see the introduction of larger presentations reaching its limit. In our view, the value obtained from a family-size presentation may start losing its convenience beyond 3 liters. The largest cola presentations are currently the 3.1 liter format from Kola Real and the 3.0 liter format from Arca. All other major bottlers PBG, Coca-Cola FEMSA, and Contal have upsized their presentations to 2.5 or 2.6 liters in the past two years. Although PBG and Coca- Cola bottlers may be able to introduce another upsizing, in the long term, growth in consumption per capita should be the main driver of the cola segment. Consumption per capita of colas grew an average of 0.1% annually from 1999 to 2003, compared with 13% for purified water. Important disclosures/certifications are in the Important Disclosures section of this report. U.S. investors inquiries should be directed to Santander Investment Securities Inc. at (212)

6 A Closer Look at the Coke Bottlers: A Perfect Storm Figure 5. Mexican Bottlers Beverage Sales Category Breakdown (2003) 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 0.6% 0.5% 0.3% 20.9% 13.4% 26.3% 20.1% 45% 18.7% 16.6% 30% 59.8% 65.9% 56.8% 25% KOF ARCA CONTAL PBG ources: Company Reports and Santander Investment estimates. Colas Flavors Water Other S In our view, significant investments in advertising, packaging innovations, and coolers are needed to increase future consumption per capita in colas. As a result, bottlers will have to decide whether additional volume growth can be obtained without sacrificing profitability. Striking the right balance depends on each bottler s success with its revenue management levers, including new packaging introduction and cost cutting initiatives. This year, the biggest innovation came from PBG, which during May and June 2004 introduced the Carolina PET bottle to help drive volume growth. The concept behind this new package is better gripping and, as a result, convenience in carrying the bottle. Figure 6. Mexican Bottlers Revenue Management Indicators Arca Contal KOF PBG Mexico Pre-Sale (% of Volume) 95% 60% 90% 95% Direct Distribution 100% 100% 95% 95% Handhelds (% of Volume) 95% 60%-70% 90% NA Cooler Penetration Index a 80% 59% 70% NA Average Price Gap vs. Big Kola b 40% 50% 60% 30% a Total coolers as a percentage of total points of sale. b In 2.5L NR packages; PBG and KOF in Mexico City NA not available. Coca-Cola bottlers are also becoming increasingly reliant on revenue management to help boost beverage consumption and increase revenue per unit case. The result of this strategy can be seen in the recent introduction of an array of new packages at many different price points and for many consumption occasions. For example, over the last year, we have seen the roll-out of new format sizes, including the 710 ml PET bottle and the 225 ml mini can. We expect these revenue management initiatives to gain increasing importance as the market becomes more competitive. However, implementing these complex strategies successfully requires a significant amount of sophistication and accurate information at the point of sale, which require large investments in technology. Coke s strength is technology. Arca, Coca-Cola Femsa, and Contal have made significant investments to modernize their operations and distribution routes. As a result, they have secured a clear competitive technological advantage vis-a-vis smaller bottlers or other competitors. In our view, among the three Coke bottlers, Coca-Cola Femsa has been the most effective in executing this practice. On the other hand, Contal shows the weakest indicators, but we note that this also stems from the low density population and rural characteristics of its territory. 6 Important disclosures/certifications are in the Important Disclosures section of this report. U.S. investors inquiries should be directed to Santander Investment at (212)

7 PRICING OUTLOOK: NO IMPROVEMENT EXPECTED We expect declining real prices in 2005, for the third consecutive year. From 2003 to 2005, we expect the three Coke bottlers to post minimal nominal price increases, resulting in average annual real price declines of between 2.5% and 3.5%. According to our estimates, 2005 should be the third consecutive year without a real price increase. We also do not see pricing flexibility for PBG. On a year-on-year basis, for all bottlers, we expect 2004 to be the toughest period compared with 2003 and The declining real prices stem primarily from a persistent, and in some cases, intensifying, competitive environment which began changing significantly in 2003 when PBG and Kola Real completed their first full year of operations in Mexico. Also, we highlight that the recovery in non-durable consumption spending forecast by our Mexico-based economics team for 2005 is expected to be far from robust. Figure 7. Mexican Bottlers Peso Price per Unit Case (Water and CSD), E Bottler 1Q03 2Q03 3Q03 4Q03 1Q04 2Q E 2005E 03-05E CAGR (nominal) Arca % Contal % KOF Mexico % YOY % Real Growth Arca -4.8% 0.1% 0.4% 0.1% 1.6% -5.7% -5.6% -2.5% NM Contal -4.8% -7.8% -4.3% -3.6% -2.4% -2.6% -4.3% -1.6% NM KOF Mexico -2.7% 2.5% -2.9% -3.4% -3.8% -8.7% -5.1% -0.5% NM CSD Carbonated soft drinks. Note: Panamco is consolidated into KOF in May NM Not meaningful. Low inflation environment also hinders price flexibility. Compounding the negative effect of the industry s competitive dynamics on pricing in Mexico has been a period of historically low inflation. This makes it more difficult for bottlers to raise prices in real terms. According to our Mexico-based economics team s forecasts, inflation in Mexico for 2004 and 2005 will be 4.0% and 3.5%, respectively. In this environment, raising prices beyond inflation is a challenge, especially if the low inflation is accompanied by limited growth in consumption and total payrolls. Despite growing employment, total payroll growth in 2004 is expected to be similar to the rate in 2003 (2.5%) on the back of real wages growth of 0.7%. PEPSI BOTTLING GROUP (PBG) From the Coke bottlers perspective, we see PBG as the most threatening player in Mexico s bottling industry because of its recent management changes, marketing prowess, and financial resources. It is also likely to be the most rational competitor, in our view. However, over the last few quarters, it has appeared less rational. In 4Q03, PBG lowered prices approximately 15% throughout its territories. We understand there was some debate about this strategy, and during 4Q03, PBG saw a change at the helm of its Mexican operations. Starting in January 2004, Frito Lay veteran Rogelio Rebolledo took over as CEO at PBG Mexico and as of May, joined PBG s Board of Directors. During an analyst/investor meeting in Monterrey in June 2004, he outlined a long-term strategic plan aimed at building brand equity and market share, which stands at approximately 20% of Mexico s soft drink industry. In terms of pricing, one of Rebolledo s first moves was to selectively raise prices in 1Q04 back to pre-october 2003 levels. This was done mostly in the center of the country and in Mexico City, where KOF operates. As such, in many markets where PBG operates, prices are still where they were at year-end This has had an effect on the Coke bottlers volume growth, particularly at Contal and Arca. Our estimates suggest that in the 2.5 liter one-way package, PBG offers discounts of between 15% and 25% versus the largest three Coke bottlers. Important disclosures/certifications are in the Important Disclosures section of this report. U.S. investors inquiries should be directed to Santander Investment Securities Inc. at (212)

8 A Closer Look at the Coke Bottlers: A Perfect Storm Figure 8. Mexican Bottlers Cola Pricing by Region and Package, 3Q04E (Mexican Pesos) Bottler 2.5 Liter Returnable 2.5 Liter Non-Returnable Arca NA 14 Coca-Cola Femsa Contal PBG (Mexico City) NA 12 PBG NA Big Cola (Kola Real) NA 8-9 Coca-Cola Femsa prices in Mexico City only. Data in 1H04 support this view as Arca and Contal suffered a decline in soft drink volumes of 3.5% (pro forma estimate) and 4.5% in 1H04, respectively, while KOF grew volumes 0.8%. Although part of the declines could be attributed to unfavorable weather, mainly in the North, we believe the main cause has been stepped-up competition from PBG particularly in the multi-serve category. We also note that Arca and Contal s lower volumes occurred despite both companies lowering prices during 2Q04 in some presentations, potentially showing a less competitive picture in the center of the country, but also better execution from KOF. In the case of Contal specifically, regional competitive disparity is evident as the company s volumes had a much steeper decline in the areas of operations where it competes directly with PBG (see Map of Coke and PepsiCo franchises in Figure 14). PBG has also increased its aggressiveness in northern Mexico with its Descubrela ( Discover it ) marketing campaign, mainly impacting Arca s territories. For example, PBG s 2.5L one-way presentation which was being priced at 12 to 13 pesos in some of Arca s territories is now being priced as low as 11 pesos in some channels. This forced Arca to respond by lowering prices in its 2.0L returnable presentation from 12 pesos to 10 pesos, the same price as PBG s 2.0L one-way presentation. Contal also initiated a low-price campaign in March 21, 2004, Campaña Primavera ( Spring Campaign ) in the company s main franchise territories in Guadalajara, San Luis and Aguas Calientes. The goal was to boost volumes in 2Q04 after the very sharp drop in volumes in 1Q04. However, on the back of disappointing volume growth in 2Q04, the campaign continues in effect in 3Q04. KOLA REAL Kola Real expected to build a plant near Monterrey. Kola Real to reach 5-6% market share by 2006, in our view. The pending construction of Kola Real s new plant in northern Mexico could be the most threatening competitive event in terms of industry pricing next year, given that its discount to the Coke bottlers ranges between 25% and 50%. The plant, 18 km outside of Monterrey, is expected to be completed by 1Q05 and have 50 million unit cases of production capacity. This should double Kola Real s total Mexican capacity, which is currently one plant in Puebla with approximately 50 million units of capacity. Undoubtedly, this new plant will strengthen Kola Real s presence in the north of the country and improve profitability by saving freight costs. It also could pose a new threat to Arca, which sells approximately 30% of its volume in Monterrey. Contal is also likely to be impacted since many of its territories in central Mexico are within striking distance. We expect Kola Real, driven by its main Big Cola brand, to reach a 5-6% share of the national soft drink market in Mexico over the medium term, up from an estimated 2-3% at present. The growth should come from two sources: Flavor brand extensions from the First brand family which has already enjoyed success in the grapefruit segment, and further geographical expansion, spurred by its new plant in the north. Of Mexico s 32 states, Kola Real has no (or almost no) presence in 11 states. The company s current stronghold is in Puebla, where it competes against KOF. There, its market share once reached 7%; however, KOF believes that it is now below 3%. According to Arca s and Contal s management, Kola Real s 8 Important disclosures/certifications are in the Important Disclosures section of this report. U.S. investors inquiries should be directed to Santander Investment at (212)

9 B-brands do have their limits in Mexico. Kola Real s new marketing push. market share is less than 3% in the territories where they overlap. We estimate that Kola Real is present in approximately 75% of Contal and Arca s territories and 100% in KOF s territories. Over the longer term, we see Kola Real s growth in Mexico constrained by the industry s structure and its lack of a direct point of sale distribution network. First, and mainly, without a fleet of trucks and a pre-sale system, building relations with the majority of the points of sales is very difficult. That makes B-brand producers including Kola Real dependent on supermarkets for volume growth. Currently, supermarkets account for approximately 20% of Kola Real s volume sales. However, Mexico s industry is characterized by a very low penetration of supermarkets, which should continue to limit the ability of Kola Real to reach the mass market efficiently. In Mexico, supermarkets account for less than 4% of total volume sold. As a result, reaching a larger number of consumers requires large investments in distribution assets, something that to date only the largest Coke and PepsiCo bottlers can afford. Second, the absence of soft drink excise taxes in Mexico puts every bottler on an equal footing. In markets such as Brazil, where B-brands have market shares above 30%, many B-brand producers gain a cost advantage by paying fewer taxes due to the difficulty in collecting from small producers. Finally, although to a lesser extent, the high proportion of returnable packages puts a ceiling on the market for B-brands, as they rely almost exclusively on non-returnable presentations. As discussed later in this report, we continue to see a significant shift towards oneway packaging in Mexico. However, we think the Mexican market is many years away from reaching the levels of one-way packaging seen in countries like Brazil. We have recently seen more targeted, higher profile efforts in Kola Real s advertising to increase brand awareness and gain consumer loyalty. Kola Real recently sponsored Big Brother s Spanish version in Mexico, a program drawing a big audience of young consumers. It is also planning to advertise in Mexico s upcoming Teleton, a high profile national charity event. Previously, Kola Real had relied mainly on price as its main marketing tool and advertising had focused on emphasizing this advantage. We view Kola Real s new advertising strategy as an important step towards obtaining consumer loyalty, a crucial attribute to boost market share. Over the long term, this advertising strategy may diminish its low operating cost advantage, which helps it to sustain deep discounts to the Coke bottlers. Although we understand that there has not been any increase in Kola Real s advertising budget, in our view, a campaign designed to increase brand loyalty will require increasing and continued amounts of advertising in the medium to long term to be effective. This added cost could eat into the company s margins if prices are maintained at low levels. Sugar and PET represent 40% of cost of sales. RAW MATERIAL PRICES TO PRESSURE GROSS MARGINS We estimate that on a year on year basis, 2H04 will likely show higher raw material price increases than in 1H04, particularly for PET and sugar, putting additional pressure on gross margins. We estimate PET and sugar represent approximately 40% of total cash cost of sales for bottlers. Therefore, movements in the prices of these raw materials can significantly impact on gross margins. Our conclusion is that Coke bottlers Arca, Contal and KOF (Mexico) will experience double-digit increases in raw material prices during the second half of 2004 on a year-on-year basis. The annual impact should correspond to almost 4% of cash cost of sales and reduce the bottlers gross margins between 160 and 170 basis points on a stand alone basis. Important disclosures/certifications are in the Important Disclosures section of this report. U.S. investors inquiries should be directed to Santander Investment Securities Inc. at (212)

10 A Closer Look at the Coke Bottlers: A Perfect Storm Figure 9. Mexican Bottlers Impact of PET and Sugar Price Increase, 2004E (Millions of Mexican Nominal Pesos) Bottler PET 2H04E YOY Real Price Increase Est. 2004E Cash Impact Sugar 2004E YOY Real Price Increase Est. 2004E Cash Impact 2H04 Annualized Total Est. Cash Impact As a %of Cash COGS 2H04 Annualized Impact to Gross Margin (bps) Arca 14.0% % % (166) Contal 17.0% % % (169) KOF Mexico 16.0% % % (165) bps basis points. PET price hike in 2H04 may be higher than in 1H04. According to our conglomerates analyst in Mexico, Luis Miranda, PET suppliers should try to pass an additional price increase during 2H04. We estimate that it will be even higher than the one passed in 1H04. The price of PET was up approximately 8%-10% year over year during 1H04 on the back of rising oil prices (up 18% in the same period), a main raw material for PET resin. Looking at the second half of 2004, average crude oil prices during 3Q04 have been 20% higher than in 2Q04, but almost 40% higher than 2H03. Assuming the price of oil remains at current levels of approximately US$40 per barrel for the rest of the year, we estimate PET prices could increase an additional 15%-20% during 2H04. We note that all three main Coca-Cola bottlers are implementing cost reduction measures such as lightening the weight of their PET bottles. However, we expect bottlers will have at least the same gross margin pressure in 2H04 as they had in 1H04. Our analysis indicates that the sensitivity (beta) of polyethylene prices to oil prices is 0.95, implying that an average increase in oil prices produces an almost equal percentage increase in the price of polyethylene. We note that there could be a lag of up to six months for PET producers to pass on the rising prices of inputs, depending on economic conditions and purchasing contracts. Moreover, soft drink bottlers are usually some of the largest customers of PET producers, allowing them to use their negotiating power to obtain better terms. In fact, on some occasions, the bottlers buy the PET resin directly from third parties and only use the supplier to manufacture the bottles. Nevertheless, in our view, bottlers will inevitably have to cope with a higher price of PET in 2H04. Figure 10. Mexican Bottlers Polyethylene Price Index and Brent Crude Oil Index Prices (Jan 2002-Sep 2004) $50 $45 $40 $35 $30 $25 $20 $15 $ Jan-02 Mar-02 Apr-02 May-02 Jul-02 Aug-02 Oct-02 Nov-02 Dec-02 Feb-03 Mar-03 Apr-03 Jun-03 Jul-03 Sep-03 Oct-03 Nov-03 Jan-04 Feb-04 Mar-04 May-04 Jun-04 Aug-04 Sep-04 Polyethylene Index (R Axis) Crude Oil (L Axis) Source: Bloomberg and Santander Investment. 10 Important disclosures/certifications are in the Important Disclosures section of this report. U.S. investors inquiries should be directed to Santander Investment at (212)

11 Figure 11. Average Crude Oil Prices, Brent Crude Oil (US Dollars) 1H02 2H02 1H03 2H03 1H04 2H04 a Price YOY Increase NA NA 20.5% 7.7% 17.7% 38.9% Sources: Bloomberg. A Through September 10, 2004 Since its is priced in U.S dollars, PET resin is also sensitive to currency fluctuations and can see sharp price increases in periods of local currency depreciation. However, for the rest of 2004, our Mexico-based economics team expects the Mexican peso to depreciate less than 1%. As such, we expect most of the PET price increases to be driven by higher oil prices. Sugar prices could increase an additional 4% in 2H04. We expect sugar prices to increase an additional 4% in real terms in 2H04, on the back of a 5% rise in 1H04. This follows an average 8% rise in prices in Not only is the industry growing but prices are mostly controlled by the government which owns half of the sugar mills. Current prices of sugar stand at approximately M$6,300 per ton. An important development for bottlers in the purchasing of sugar has been the use of clarification facilities. This practice has been beneficial due to the estimated 20% gap between the prices of standard and refined sugar. However, the proliferation of clarification facilities has increased demand for standard sugar and, as a result, the price of standard sugar is rising more rapidly, closing the price gap between standard and refined sugar. Arca and KOF have both been very aggressive in clarifying sugar. As a result, we believe these two companies may be experiencing a steeper increase in the price of sugar. Contal, in turn, only buys refined sugar. In our view, the different practices may stem from the fact that Contal buys sugar from a sugar mill, Piazza, where it is the largest shareholder and may obtain better purchasing terms. Short purchasing cycles are accelerating the impact in the price increase of raw materials. On average, we estimate that bottlers purchase one month of inventory at a time. Although this makes for a more efficient use of working capital, in the current environment it has also made bottlers more susceptible to short term fluctuations in prices of raw materials, particularly since none of the Mexican bottlers have a hedging policy for these inputs. With the proliferation of PET bottles, glass has become a less meaningful input cost of production for bottlers. However, we note that we expect the price of glass to have a moderate increase in the second half of 2004 owing mainly to higher natural gas prices, the main input cost. We note that glass bottles are not directly expensed, but capitalized in the balance sheet and amortized over time. We estimate that glass accounts for less than 5% of the cost of sales. CONTAINING THE NON-RETURNABLE PACKAGING TREND Consumer convenience continues to drive the packaging shift. Another significant industry trend in Mexico is the ongoing growth of lower-margin nonreturnable (one-way) presentations, namely PET plastic bottles. The major factor driving this shift is consumer preference for convenience. Despite the lower profitability of non-returnable presentations, bottlers have had to react to the growing preference of one-way packaging. Developed markets, such as the United States, consume soft drinks predominantly in nonreturnable presentations. In Latin America, one way presentations are slightly more preferred than the returnable formats. In our view, B-brands and PBG, who use one-way packages in Mexico almost exclusively, are another factor driving growth of these presentations. In countries where B-brands have obtained a high market share, the use of non-returnable presentations is significantly higher than in other countries in the region. The reasoning is clear: returnable presentations are supposed to offer a value proposition to customers because the bottlers can pass along the cost advantages Important disclosures/certifications are in the Important Disclosures section of this report. U.S. investors inquiries should be directed to Santander Investment Securities Inc. at (212)

12 A Closer Look at the Coke Bottlers: A Perfect Storm (relative to one-ways) since the packages can be reused a number of times. This makes returnables typically more profitable than one-ways. However, since B-brand producers price their one-way products at a discount to the leaders comparable size returnable presentations, the value proposition from returnable packages is lost. This, in turn, forces the Coke bottlers to continue shifting away from their high margin returnable presentations in Mexico, hindering profit growth. Figure 12. Mexican Bottlers Packaging Mix (2003) and Shift Toward Non-Returnable Packaging in Percentage Points ( E) 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 34.0% 66.3% 10.0% 90.0% 55.4% 51.3% 44.6% 48.7% 100.0% % Coca-Cola Femsa PBG ARCA Contal Kola Real Non-Returnable Returnable 0 Coca-Cola Femsa Contal ARCA E Change Source: Company reports and Santander Investment estimates. Arca continues to bare the brunt of the shift to oneway packaging. Consolidation will continue, in our view. In Mexico, among the large Coke bottlers, we estimate that Arca is in the midst of the biggest shift to one-way packaging, pressuring gross margins. Arca s proportion of one-way packages increased to 52.4% as of 2Q04 from 35.2% in From 2003 through 2005, we expect to show an 8.4 percentage point shift in its packaging mix between one-ways and returnables. This shift has been one of the main causes of Arca s 560 basis points contraction of gross margin in the past two years. Contal has also increased its packaging mix towards one-way presentation from an estimated 41% in 2002 to approximately 49.5% currently. KOF has had the least impact in recent years, owing to the fact that the company already sells a much larger proportion of non-returnable presentations than its peer Coca-Cola bottlers. INDUSTRY CONSOLIDATION TO CONTINUE We believe consolidation will continue among both Coca-Cola and PepsiCo bottlers. Among the Coke bottlers, the three largest account for almost 75% of Coke s volume in Mexico and should lead the way since they will be able to offer the highest prices. Among the PepsiCo bottlers, we suspect that PBG will be the logical consolidator. We see the main drivers behind future consolidation as: 1. The disparity in size between large bottlers Arca, Contal, KOF and PBG Mexico and the smaller bottlers; 2. Limited domestic growth opportunities for small bottlers beyond current franchises owing to limited financial resources: 3. Ongoing pressure on profitability from B-brands and PBG, which the smaller Coke and Pepsi botters should be less able to sustain owing to their lack of economies of scale. However, we note that despite the expected lower returns of smaller soft drink franchise operators as a result of increased competition, they continue to offer their private owners other benefits. One example is a higher economic status and more political power among their peers. In 12 Important disclosures/certifications are in the Important Disclosures section of this report. U.S. investors inquiries should be directed to Santander Investment at (212)

13 our view, this may make negotiations more difficult and may slow the consolidation process, but not stop it. Recent consolidation activity such as Arca s acquisition of the Meoqui Coca-Cola franchise in 1Q04 and the merger of Geusa and Bret (PepsiCo bottlers), also in 2Q04, support this view. An Arca/Contal business combination has also been subject to market rumors in the recent past. The Geusa and Bret combination: These two PepsiCo bottlers recently merged. The combined annual sales of both companies represent an estimated 28% of the sales of PepsiCo products in Mexico (or 160 million unit cases), compared with PBG s estimated 63% of sales. Bret covers the territories of Puebla, Oaxaca, Veracruz and Tabasco, while Geusa operates in Nayarit, Jalisco, Colima, Michoacan and Guanajuato. We also would not discard the entrance of a third party, such as AmBev, into a potential transaction in the near future. We note that Ambev has used the acquisition of PepsiCo bottlers to enter new markets in the past (Peru, Central America and the Dominican Republic) and is keen to operate in Mexico. An Arca/Contal Merger? The combination of these two bottlers has probably been the most talked about potential merger in the sector over the past twelve months. Although both management teams have disclosed that they maintain a good relationship, we think it is unlikely that these two companies will join forces in the short term. Longer term, as competitive pressures from PBG and Kola Real continue to affect both bottlers, we believe a business combination may become a more tangible possibility. Currently, despite having higher average revenue per hectoliter, both companies have lower EBITDA margins than Coca-Cola Femsa. Part of this profitability gap may be attributed to execution, but undoubtedly scale is an important element in the mix. In our view, such scale could be achieved through a business combination. In terms of unit cases, a combined Arca/Contal enterprise would sell approximately 800 MUC annually, 25% less than KOF Mexico s one billion unit cases (proforma) sold in At the average FV/Unit Case multiple of 3.47 past transactions (see Figure 16), an Arca/Contal combination would be worth approximately US$2.6 billion. Figure 13. Mexican Coke Bottlers Firm Value/Unit Case Transaction Multiples, Date Territory/Country Acquirer Stake Unit Cases FV/Unit Case Sep 1994 Buenos Aires, Arg KOF 51% Oct 1994 Santos, Brazil Panamco 100% Nov 1995 Costa Rica Panamco 100% Feb 1996 Buenos Aires, Arg KOF 24% Feb 1996 San Isidro, Arg KOF 100% May 1997 Venezuela Panamco 100% Aug 1997 Nicaragua Panamco 100% Sep 1997 Buenos Aires, Arg KOF 25% Nov 1997 Tapachula, Mexico KOF 100% Sep 1998 Mato Grosso do Sul, Brazil Panamco 100% Oct 2000 Paraguay Coca-Cola 58% May 2003 Regional KOF 100% Average 3.47 Important disclosures/certifications are in the Important Disclosures section of this report. U.S. investors inquiries should be directed to Santander Investment Securities Inc. at (212)

14 A Closer Look at the Coke Bottlers: A Perfect Storm Figure 14. Mexican Coke Bottlers Franchise Map CHIHUAHUA Arca Contal Coca Cola Femsa Embotell. de Guerrero Fomento Queretaro Jordan Independ. Grupo Tampico Cimsa Bepensa Rica MONTERREY SAN LUIS POTOS GUADALAJARA VERACRUZ CANCUN MEXICO CITY PUEBLA Source: Santander Investment. Figure 15. Mexican Pepsi Bottlers Franchise Map CHIHUAHUA PBG GASEOSAS S.A. GEUSA/BRET GRUPO EMB. SURESTE BEBIDAS PURIFICADAS MONTERREY SAN LUIS POTOS GUADALAJARA VERACRUZ CANCUN MEXICO CITY PUEBLA Source: Santander Investment. 14 Important disclosures/certifications are in the Important Disclosures section of this report. U.S. investors inquiries should be directed to Santander Investment at (212)

15 CONSUMPTION OUTLOOK Economic Indicators point to a modest improvement in 2H04. Mexican macroeconomic indicators show modest improvement in the second half of The economy grew 3.9% in 2Q04 supported by growth of the service and industrial sectors. Our Mexico-based economics team sees GDP growth reaching 4%, up from 1.3% in 2003 on back of increased government spending and exports. As has been the case during previous economic upturns, the growth of the U.S. economy has driven the recovery in the maquilas sector, where employment is showing an encouraging positive trend both in northern Mexico as well as nationwide during 1H04. Despite the encouraging macroeconomic data, we remain cautious as to the magnitude of the forecast recovery in non-durable consumption spending growth for the remainder of 2004 and into Figure16. Mexico, Maquiladora Industry Employment (Year-on-Year Growth), Oct 2000-Jun % 15% 10% 10% 5% 5% 0% 0% -5% -5% -10% -10% -15% -15% -20% -20% -25% -25% Oct-00 Dec-00 Feb-01 Apr-01 Jun-01 Aug-01 Oct-01 Dec-01 Feb-02 Apr-02 Jun-02 Aug-02 Oct-02 Dec-02 Feb-03 Apr-03 Jun-03 Aug-03 Oct-03 Dec-03 Feb-04 Apr-04 Jun-04 National Border States Source: INEGI and Santander Invesmtent. As a result of the recent upturn in exports, employment at the national level in the maquilas sector reversed a 10-month negative year-on-year growth trend in 2Q04. We note that the most important U.S. industries for the maquilas sector, such as the auto industry, have underperformed the growth of the U.S. economy. In addition, some exports in textiles and electronics have been lost to China s more competitive industries. As a result, the boost from the U.S. economic recovery may not be as strong for the Mexican economy as it has been in previous economic upturns. Furthermore, Mexican exports may have limited upside if the U.S. starts to show softer data on the back of a tightening monetary cycle. Finally, structural reforms that could increase the country s competitiveness seem unlikely under the current political environment. Important disclosures/certifications are in the Important Disclosures section of this report. U.S. investors inquiries should be directed to Santander Investment Securities Inc. at (212)

16 A Closer Look at the Coke Bottlers: A Perfect Storm Figure 17. Mexico, Insured Employees by Region (Year on Year Growth), Dec 2000, Jun % 8% 6% 6% 4% 4% 2% 2% 0% 0% -2% -2% -4% -4% -6% -6% -8% -8% Dec-00 Feb-01 Apr-01 Jun-01 Aug-01 Oct-01 Dec-01 Feb-02 Apr-02 Jun-02 Aug-02 Oct-02 Dec-02 Feb-03 Apr-03 Jun-03 Aug-03 Oct-03 Dec-03 Feb-04 Apr-04 Jun-04 Mexico Center North Source: INEGI and Santander Investment. Looking at the growth of employment in the Mexican economy as a whole, the first half of 2004 showed an increase of 224,022 jobs (IMSS insured employees), with the trend pointing to continued growth in the near term. This trend is in line with our Mexico-based economics team expectation of a reduction in unemployment from 3.2% in 2003 to 2.8% in Employment data also shows that employment growth has been the weakest in the center of the country, the region least affected by the growth in the maquilas sector, suggesting that a meaningful national consumer recovery has not yet started. We expect non-durable consumption spending growth to stabilize during 2H04 after decelerating during 4Q03 and 1Q04, before modestly accelerating in 2Q04. In 2004, it should reach 3.6% compared with 3.0% in Figure 18. Mexico, Select Consumption Trends (Year on Year Growth), E 12% 10% 8% 6% 4% 2% 0% -2% -4% -6% -8% -10% Decelerating Non-durable Stable Non-durable 12% 10% 8% 6% 4% 2% 0% -2% -4% -6% -8% -10% 1Q01 2Q01 3Q01 4Q01 1Q02 2Q02 3Q02 4Q02 1Q03 2Q03 3Q03 4Q03 1Q04 Durables Non-durables Services 2Q04 3Q04E 4Q04E Source: INEGI and Santander Investment estimates. 16 Important disclosures/certifications are in the Important Disclosures section of this report. U.S. investors inquiries should be directed to Santander Investment at (212)

17 ARCA Competition Expected to Intensify UNDERPERFORM Alexander Robarts Alonso Aramburú (212) (212) (09/14/2004) CURRENT PRICE: US$1.89/M$21.84 TARGET PRICE: US$1.87/M$22.06 What s Changed Rating: Price Target: Estimates: Company Statistics Initiating with Underperform US$ EBITDA of US$ EBITDA of US$ EBITDA of US$271 Bloomberg ARCA* 52-Week Range (US$) US$2.26-US$ E P/E Rel to IPC (x) E P/E Rel to Beverages (x) 1.2 IPC (US$) Yr CAGR (03-06E) 9.8% Market Capitalization (US$ Mn) 1,523 Float (%) 10% 3-Mth Avg Daily Vol (US$ Mn) 0.36 Shares Outst (Mn) 806 Net Debt/Equity (x) 0.05 Book Value per Share (US$) 0.96 Estimates and Valuation Ratios E 2005E 2006E Net Earn (M$) 1,006 1,386 1,287 1,333 Current EPS Net Earn (US$) Current EPS P/E (x) P/Sales (x) P/CE (x) FV/EBITDA (x) FV/Sales (x) FCF Yield (%) 10.3% 8.4% 7.7% 8.4% Div per Share (US$) Div Yield (%) 6.1% 6.7% 5.8% 5.3% Sources: Bloomberg, Company Reports, and Santander Investment estimates. Investment Thesis: We are initiating coverage of Arca with an Underperform rating and a 2005 target price of US$1.87. Our rating reflects Arca s increasingly difficult competitive position. PBG has had its most aggressive pricing in Arca s territories and B-brand producer Kola Real is to complete a new plant in Monterrey in 1Q05. It also reflects Arca s limited pricing flexibility and moderate volume growth. We also see gross margin pressure from an accelerated shift to one-way packaging and higher raw material prices. Reasons for Rating/Price Target: Although we have been positively impressed by the company s ability to reduce costs, we expect modest volume growth, increasing raw material prices, and ongoing price declines to significantly hinder any net positive impact from synergies on EBITDA growth going forward. As a result, we expect Arca to post a fourth consecutive year of EBITDA margin contraction in 2004 before stabilizing at 22.6% in A moderate recovery of non-durable consumption spending may partly offset these effects. Despite our outlook, we note that Arca s cost cutting initiatives have positioned the company favorably to take advantage of an improvement in industry dynamics, and we believe the company could see a material boost to profitability if condition were to improve. Our target price implies a 2005 FV/EBITDA target multiple of 5.4 times, 8% above its two-year historical multiple of 5.0 times. We believe this premium is reasonable owing to its better execution capabilities (professional management), increased liquidity, and proven ability to deliver cost savings. However, on the back of an estimated negative 2% growth in EBITDA in real Mexican Peso terms for 2005, we find it difficult to justify a higher valuation. Valuation and Risks to Investment Thesis: We value ARCA using a DCF analysis. Our target price implies a total return of 5.0% from current levels, including a 5.8% dividend yield for Our target upside for the Mexican market is 10.4% through year-end Risks to our investment thesis include a higher than expected increase in raw materials prices and a more aggressive pricing strategy from competitors Important disclosures/certifications are in the Important Disclosures section of this report. U.S. investors inquiries should be directed to Santander Investment Securities Inc. at (212)

18 A Closer Look at the Coke Bottlers: A Perfect Storm Arca is the second- largest Coca-Cola bottler in Mexico. The company produces, distributes and sells beverages under The Coca-Cola Company brand name, as well as proprietary and third party brands. The company was formed in 2001 through the merger of three bottlers in Mexico. Arca distributes its products in Northern Mexico, primarily in the states of Nuevo Leon, Chihuahua, Tamaulipa, Coahuila, Sonora, Sinaloa, Baja California and Baja California Sur. KEY ISSUES AND OUTLOOK Net impact from synergies on EBITDA may be only marginal. ARCA is upgrading its technology. Kola Real is building a plant in Monterrey. We expect modest volume growth, increasing raw material prices (see Raw Material Prices to Pressure Gross Margins section), and ongoing price declines to significantly erode any net positive impact from synergies on EBITDA growth going forward. According to management, Arca s gross cost savings from the synergies program may reach M$700 million. The M$700 million is more than twice the initial management estimate announced in March 2003, which called for M$320 million of synergies. According to management, M$500 million of synergies were attained by March 2004, with an additional M$100 million expected to be achieved by 4Q04 and another M$100 projected for On a net synergy basis, however, we expect the total amount since 2003 could be as low as M$100 million. The bulk of the synergies have come from the closing of 8 plants and 11 distribution centers. Other sources of savings have come from changes in the corporate structure. The number of legal entities has been reduced from 40 to 21, the workforce has been trimmed by 15% to 16,400 employees, operations has been simplified with the designation of one COO (versus two before), and the human resources and administrative functions have been centralized. Moreover, the operation has become more efficient through a 19% reduction in the number of routes from 2,026 to 1,701 and a 7% increase in the number points of sale. Finally, management has been able to reduce costs through outsourcing of PET bottles (through a partnership with Amcor) and other packaging materials, the installation of sugar clarification facilities, and a reduction in the cost of freight. We view ARCA s push to modernize its information infrastructure as a necessary long term project to remain competitive. We believe that under the current competitive environment, which is increasingly relying on price competition from both B-brands and PBG, combined with a low inflation environment, companies with superior revenue management capabilities will gain a competitive advantage. Access to accurate and updated market information will be a key tool to execute such market-driven strategies. We view ARCA s investment in technology as an important step in gaining ground against the competition in this area. Arca recently completed the installation of four basic SAP modules, finance, production, procurement and warehousing and launched the installation of the human resources and supply chain modules in 1Q04. Management expects to complete the installation of these modules by March Our main new concern is that Kola Real s new plant will increase and prolong the pricing and volume pressure felt in Arca s territories. Kola Real is expected to sell product from its new plant by February It is located 18 km outside of Monterrey, with an estimated installed capacity of 50 million unit cases by Kola Real s low prices have disrupted Arca s profit growth, albeit to a lesser degree than PBG s aggressive pricing strategy, in our view. In fact, Kola Real recently raised its prices in Monterrey in its 3.1 liter presentation from 11 pesos to 12 pesos and in its 2.6 liter presentation from 9 pesos to 10 pesos. Nevertheless, the building of a plant in Arca s backyard, Monterrey, which accounts for approximately 30% of Arca s sales, and despite Kola Real already having a wide coverage of that territory, can only intensify the competitive threat, in our view. We estimate that Kola Real has approximately a 4% share of the Monterrey market, but we also believe that market share gains from Kola Real have stopped and we expect them to remain at current levels for the rest of 2004 and Important disclosures/certifications are in the Important Disclosures section of this report. U.S. investors inquiries should be directed to Santander Investment at (212)