- Arca Continental (OTCPK:EMBVF) (OTCPK:EMBVY) is slightly overvalued with 10% downside to the 2025 base case FVPS.
- It has exclusive rights to manufacture and distribute Coca-Cola products in Mexico, the United States, Peru, Ecuador, and Argentina. The company also has a snacks business in Mexico, the United States, and Ecuador.
- Over the last five years, the Mexican business (39% of 2019 sales) grew revenue at an annual rate of 9.8% with volume growing by 3.9% per year and average selling price (ASP) increasing by 5.7% per year. Arca’s Mexican business was also very profitable with a five-year average return on assets (ROA) of 17.4%.
- The United States business (33% of 2019 sales) is two adjacent territories that were both acquired in 2017 for MXN38.9 billion, which equals 0.75 times revenue and 9.9 times operating income. In 2019, the US business grew sales by 5.6% driven by increases in ASP. The profitability of the US business is much weaker than Mexico with a three-year average ROA of 4.6%.
- Arca entered Peru (10% of 2019 sales) when it made it first purchased 47% of Corporacion Lindley in September 2015. Over the next three years, it increased its position to 99.78%. The total purchase price was MXN25.85 billion equal to 1.6 times sales and 11.1 times 2019 operating income. From 2016 to 2019, Peruvian sales grew by 3.8% with volume declining 2.1% per year and ASP increasing by 6.3%. Since acquisition, the Peruvian business’s average ROA was 4.8%.
- Ecuador (7% of 2019 sales) saw revenue grow by 9.1%, with volume declining by 0.9% per year and ASP increasing by 10.1% per year. The strength of the US dollar relative to the Mexican pesos caused the majority of the ASP increases. In local terms, ASP only increased by 2.2% per year. ROA of the Ecuadorian business averaged 6.1%.
- Despite strong growth in local currency terms, the Argentinean business (3% of 2019 sales) is declining in Mexican peso terms. Over the last five years, revenue declined by 5.0% per year. The macroeconomic weakness within the country is hurting demand with Argentina’s volume declining by 4.1%. ASP fell by 1.0% per year. ROA of the Argentinean business averaged 20.6% over the last five years, but declined from a high of 34.6% in 2015 to 5.9% in 2019.
- Other business including the snacks business was 8% of 2019 sales. Over the last five years, other business revenue grew at a CAGR 9.1%, while its operating profit declined by 16.4% per year. The ROA of other businesses averaged 3.0%.
With over 94 years of history, Arca Continental (Arca, AC*:MM) is the second-largest Coca-Cola bottler in Latin America. Arca is the result of a 2001 consolidation of the three oldest bottlers in Mexico (Argos, Arma, and Procor). Arca has made many acquisitions since, but none was more important than the 2011 merger between Embotelladoras Arca and Grupo Continental. The MXN21.2 billion merger valued Grupo Continental at an EV/Sales of 1.8 times and an EV/EBITDA of 10.6 times. From 2010 to 2011, Arca’s revenue increased from MXN27 billion to MXN45 billion, primarily due to the merger.
It sells Coca-Cola branded products in Mexico, the United States, Ecuador, Peru, and Argentina. In addition to Coca-Cola products, it has a snacks business that sells branded snacks in Mexico, Ecuador, and the United States. Its territories have a population of over 123 million.
The charts above show Arca’s 2019 sales and EBITDA by business segment. The company’s largest market is Mexico, which produced 40% of sales and 50% of EBITDA. The United States was the company’s next largest business generating 33% of sales and 24% of EBITDA. South America was the third-largest business unit accounting for 23% of sales and 22% of EBITDA. The Foods and Snacks business was the smallest business at 4% of sales and EBITDA.
By channel, the traditional channel is the largest at 48% of 2019 sales followed by supermarkets at 18%, convenience at 14%, and on-premise at 9%. By category, colas were the largest at 51% of 2019 sales followed by flavored soft drinks at 20%, jug at 11%, water at 10%, and stills at 8%.
In 2019, Arca’s Mexican operations generated 40% of its sales. Within Mexico, Arca operates in 4 regions and 14 states. It has 20 bottling plants, 97 production lines, and 116 distribution centers.
Arca’s soft drink volume share in its Mexican territories was 73.8% in 2019, down from 74.6% in 2014. In 2019, its volume share of non-alcoholic beverages was 59.1%. Its principal competition is Pepsi (NASDAQ:PEP). Other competitors include Peñafiel and its Cadbury Schweppes brand. There are also several smaller brands, like Big Cola and Jarritos, which compete on price. Coca-Cola products have a premium price, meaning Arca’s 2019 market share was 79%, higher than its volume share.
Over the past five years, sales in Mexico grew at a compound annual growth rate of 9.8% with volume and ASP growing by 3.9% and 5.7% per year, respectively.
Arca saw healthy growth across all categories. The slowest growing category was Colas with a 2.5% annual growth rate. Colas is also the largest category in Mexico at 57% of volume in 2019. The fastest-growing, but the smallest category was still beverages, which includes teas, isotonic, energy drinks, juices, nectars, and fruit beverages. The still beverages’ volume grew by 10.4% per year.
Over the last five years, operating margin averaged 19.3% with a high of 21.0% and a low of 17.4%. Except for 2017, Arca’s asset turnover was stable averaging 0.84 times. Without 2017, pre-tax operating ROA averaged 16.6% and pre-tax operating ROE averaged 44.9%.
Arca entered the United States in 2017. On April 1, 2017, Arca exchanged 20.14% of its businesses to Coca-Cola Refreshments USA, Inc (“CCR”), a subsidiary of The Coca-Cola Company (KO, “TCCC”) in exchange for the rights to be the exclusive Coca-Cola bottler in Texas and some parts of Oklahoma, New Mexico, and Arkansas. These exclusive rights, 9 production plants, and 34 distribution centers within the territories are now Coca-Cola Southwest Beverages LLC. (CCSWB), a 100% owned subsidiary of Arca. The transaction was valued at MXN38.895 billion. If the territories had been acquired on January 1, 2017, Arca’s share of the revenue in the territories would have been MXN43,628 million and its net gross profit would have been MXN7,790 million.
On August 25, 2017, Arca acquired Great Plains Coca Cola Bottling Company (Great Plains) from CCR for MXN3.6 million. Great Plains operates as bottler and distributor of Coca-Cola in the state of Oklahoma. Its territories include the two most important cities in Oklahoma, Oklahoma City, and Tulsa. Its territories are adjacent to CCSWB’s territories. If Arca acquired Great Plains on January 1, 2017, its pro forma share of revenue would have been MXN6.5 million and its pro-forma share of net gross profit would have been MXN102,586.
The total investment in the two US businesses was MXN38.9 billion. In 2018, the first full year under Arca’s control, the businesses generated MXN51.6 billion in sales and MXN4.3 billion in operating income, which values the businesses at 0.75 times revenue and 9.9 times operating income.
After the acquisitions, Arca’s United States business produced 33% of the company’s 2019 sales and 24% of its EBITDA. At the end of 2019, in its US territories, Arca had 7 production plants, 30 distribution centers, and 24 production lines. The total population within its US territories is 32 million. In March 2020, it was opening a new production line in the city of Houston, Texas. In 2019, it had a 43% volume share and 46% market share in the territories in which it operated. Pepsi is the largest competitor with a 13% market share.
Given the acquisitions in 2017, 2018 is the first full year of the US operations. In 2019, volume declined by 0.4% year on year. The soft drinks category was the largest category at 70.8% of total volume. It grew by 0.4%. Water and still beverages were the remaining 29.2% of the total volume. Still beverages was the fastest-growing segment at 4.3% YoY. Water was the slowest growing category declining by 9.4% in 2019.
In the first two full years under Arca’s control, its US businesses’ average operating margin was 8.6%. Its asset turnover was 0.57 times, leading to a pre-tax operating ROA of 4.9%. ROE averaged 7.4% over the last two years. Given the strength of the competitive position of the Coca-Cola brand, you would expect higher profitability. The operating margin and asset turnover in the US business are much lower than the Mexican business, so there is significant room for improvement.
Peru is Arca’s largest market in its South American business, generating 10% of 2019 sales. Arca entered Peru in 2015 when it acquired Corporacion Lindley (“CL”). On September 10, 2015, Arca purchased 308.8 million shares of CL equal to 53.16% of the voting rights and 47.52% of the total shares outstanding for MXN15.2 billion. On January 4, 2016, Arca acquired another 38.4 million equal to 6.6% of the shares outstanding for USD1.57 per share or MXN1 billion. At the end of 2016, Arca raised its share of voting rights to 61.25%. On September 26, 2018, Arca acquired TCCC’s 223.8 million common shares representing 38.52% of the common shares outstanding for MXN9.6 billion. After the acquisition, Arca held 99.78% of CL’s voting shares. The total purchase price was MXN25.85 billion equal to 1.6 times sales and 11.1 times 2019 operating income.
At the end of 2019, Arca’s Peruvian business had 6 plants, 65 distribution centers, and 38 production lines. The company has the exclusive Coca-Cola bottling rights in Peru, allowing it to serve all 32 million Peruvians.
In Peru, in 2019, Arca had a leading position in the soft drinks category with a 66.5% market share. The largest competitors in the soft drink category are Aje with 15% and CABCORP with 10.3%. In 2015, Arca’s soft drink market share was 74.6%, Aje’s was 9.1% and CABCORP’s was 7.0%.
In 2019, in the bottled water segment, Arca is in the second position with a 23.6% market share behind Aje with 46.7% of the market. The third-largest player is Backus at 12.1%. Over the last four years, Arca lost 12.4 percentage points of bottled water market share. Aje gained 12.1 percentage points and Backus lost 6.2 percentage points of market share.
In 2019, Arca had a 43.2% of the juice market followed by Aje with a 31% juice market share and Gloria with an 11.7% market share. Over the last four years, Arca gained 13.2 percentage points of juice market share. Aje lost 5.2 percentage points of market share and Gloria lost 5.8 percentage points of market share.
Within Peru, in all the above categories, competitors have been able to take share easily. Particularly in the soft drinks category, market share is typically much more stable. Over the last four years, the average annual market share change in the soft drinks category was 433 basis points, in the bottled water category it was 780 basis points, and in the juice category, it was 605 basis points. If competitors can take customers from competitors so easily, there are little to no demand-based advantages.
Arca’s first full year in Peru was 2016. From 2016 to 2019, volume declined by 2.1% per year. Over the same period in MXN terms, ASP, revenue, and operating profit grew at CAGRs of 6.3%, 4.1%, and 5.7%.
To get a proper assessment of the performance of the business, it is best to look at growth figures in the local Peruvian sol. From 2016 to 2019, the Peruvian sol declined by 3.1% per year. The MXNPEN exchange rate ended 2015 at 0.199 and ended 2019 at 0.175. The average exchange rate declined by 1.6% per year.
Given the decline in the average exchange rate in Peruvian sol terms, ASP grew by 4.6% per year, revenue grew at a CAGR of 2.5% and operating profit increased by 4.0% per year. The volume declines, market share losses, and volatility in market share are concerning. In most markets, soft drink market shares are very stable as customers typically have a preferred soft drink and do not switch. This does not seem to be the case in Peru. Despite the market share losses the company was able to grow ASP consistently although at a decreasing rate. To stem market share losses, Arca may be forced to cut prices and increase marketing spend within Peru.
Within Peru, Arca’s average operating margin was 13.8%. Its asset turnover was 0.35 times and its pre-tax return on assets was 4.8%. Profitability is low. Peru’s operating margin is well below the average Mexican operating margin of 19.3%, but above the average US operating margin of 9.2%. Capital efficiency is poor, which means there is significant room for improvement. The Mexican business has an average asset turnover of 0.91 and the US business has an asset turnover of 0.51 times. While the asset turnover is low, it has improved from 0.31 times in 2016 to 0.38 times in 2019. This will be critical to improving the profitability in the business. If asset turnover doubles and operating margin does not change, pre-tax ROA will reach 11%.
In 2019, Ecuador represented 7% of Arca’s total sales. In 2010, Arca entered Ecuador by acquiring 75% of the voting shares of the Ecuador Bottling Company, the sole Coca-Cola bottler in Ecuador. Arca paid USD320 million for 60% of the voting shares, USD25 million for 475 preferred shares with no voting rights, and exchange of 25% of the capital of Arca’s Spanish subsidiaries RockfallSpain and Franklinton for 15% of the Ecuador Bottling Company. The value of the net asset acquired including goodwill and intangibles was MXN7.3 billion. In April 2016, Arca acquired the non-controlling interests in its Ecuadorian, Argentinean, and Spanish subsidiaries.
Arca serves Ecuador’s population of 17 million through its three production plants and 32 distribution centers. In 2019, Arca had a 70.8% market share within the soft drink category in Ecuador up from 68.0% in 2014. The largest competitor in the soft drinks category in Ecuador is CBC, 15.3% market share in 2019 down from 17.9% in 2014. The next largest competitor in the soft drink category is Aje with a 13.0% market share in 2019, down from 13.4% in 2014.
With the bottled water category, Arca was the second-largest player in 2019 with a 22.8% market share behind the leader CBC, but ahead of the third-largest player, Aje, which had a 14.7% market share. There was not a significant amount of share change over the last five years. In 2014, Arca had a 23.1% share, CBC had a 42.2% share, and Aje had 14.6% of the bottled water category.
In the juice category, Arca was the second-largest player with an 18.5% market share, down from 31.0% in 2014. The largest player is Aje with a 51.8% market share in 2019, up from 37.0% in 2014.
The table above shows growth in Mexican pesos, the reporting currency. Over the past five years, volume decline by 0.9% per year, ASP grew at a CAGR of 10.1%, revenue increased by 9.1% per year, and operating profit grew by 6.8% per annum. Like Panama and El Salvador, Ecuador’s official currency is the US dollar. Illustrated below is the Ecuadorian business’ growth in local currency terms.
In local currency terms, ASP grew by 2.2% by year, revenue increased at a 1.4% CAGR and operating profit declined by 1.3% per year as the USD appreciated against the MXN by 7.7% per year from 2014 to 2019.
Over the past five years, the operating margin of the Ecuadorian business averaged 10.2% well below the average operating margin in Mexico. Asset turnover averaged 0.61 but increased from 0.50 times in 2015 to 0.83 times in 2019, just below the average asset turnover in Mexico. The average ROA in Ecuador was 6.1% but given the improvements in asset turnover, the 2019 level was higher at 8.7%.
In 2019, Arca’s Argentinean business generated 3.4% of total sales. Arca entered Argentina in 2008 when it acquired two groups of Coca-Cola bottlers for MXN4.0 billion, at an estimated 0.62 times sales. At the end of 2019, Arca had three plants with 18 production lines and 26 distribution centers. The company’s territories in Argentina had a population of 9 million.
In 2019, Arca’s soft drink volume share was 56.7%, down from 61.4% in 2014. Its 2019 market share was 67%. The main competitors in Argentina are Pepsi bottlers and Cervecería y Maltería Quilmes. There are also smaller brands that compete on price.
In MXN terms, from 2014 to 2019, volume declined by 4.1% per year, ASP fell by 1.0% per annum, and revenue growth decreased by an average annual rate of 5.0%.
Argentina’s economy is battling high inflation and a government debt default. The inflation rate increased in 2017, 2018, and 2019 with CPI coming in at 25.7%, 34.3%, and 53.6%, respectively. The high inflation and weak GDP growth – the IMF expects Argentina’s real GDP growth rate to decline to 9.9% in 2020 – have impacted demand, and distort investment decisions. Since 2014, the Argentinean peso declined by an average annual rate of 32.8%. Given the economic conditions, the performance of the Argentinean business is best assessed in local currency terms.
In Argentinean peso terms, ASP increased by 31.6% per year, revenue grew at a CAGR of 26.1%, and operating profit grew at an average annual rate of 12.8%. Poor economic growth impacted demand and volume. The company is also losing market share. ASP is unable to keep up with inflation. Revenue growth, and more importantly operating profit growth, could not keep up with the decline in the Argentinean peso relative to the Mexican peso, meaning revenue and operating profit declined in MXN terms.
Since 2015, the average operating margin in Argentina was 14.2%. Asset turnover was 1.37 times, and the pre-tax operating ROA was 20.6%. 2019 was a particularly difficult year for Arca’s Argentina business. It saw market share decline by 1.2 percentage points and volume decreased by 12.1%. Its operating margin declined by 600 basis points in 2019 after declining by 250 basis points in 2018. Asset turnover dropped from 1.61 in 2017 to 0.93 in 2018 to 0.72 in 2018, causing pre-tax operating ROA to decrease from 26.8% in 2017 to 13.0% in 2018 to 5.9% in 2019.
Food and Snacks Business
The Food and Snacks business was 6.6% of sales in 2019. Arca entered the snacks market in January 2007 with the acquisition of the majority of the capital for Bokados brands, which had a presence in the north of Mexico. In 2017, the company created a third production center for the Bokados brand intending to make it a national brand within Mexico.
In 2011, Arca purchased the Si Señor and La Abeja brands. Their products focused on the Hispanic market in California and Arizona. It now shares distribution with the Wise business. It expanded its market to include states with big Hispanic communities, which include Texas, Georgia, Florida, New Jersey, and New York.
In 2012, Arca made two snack acquisitions with the acquisition of Wise and Inalesca. In December 2012, the company acquired Wise, a salty snack producer within the United States, and Industrial Alimenticias Ecuatorinas (Inalesca), an industrial bakery and salty snack producer in Ecuador. In 2013, the company started selling Wise products in Mexico and Inalesca products in the United States.
In November 2017, through its subsidiary AC Foods LLC., Arca acquired Deep River Snacks. It produces home-style potato chips and organic seasoned corn chips under the Deep River Brand. The acquisition price was MXN1.25 million. In 2018, the company acquired Carolina Country Snack, a regional producer of fried pork rinds in North Carolina. 76% of its distribution is in North Carolina and Virginia.
The Food and Snacks business has production plants in Mexico, the United States, and Ecuador. In Mexico, it has three production plants, 17 production lines, and 45 distribution centers. In the United States, the business has 1 production plant, 9 production lines, and 34 distribution centers. Within Ecuador, it has two production plants, 15 production lines, and 17 distribution centers.
Since 2014, Arca continues to grow the top line of the Food and Snacks business with sales growing by 9.1%. Unfortunately, revenue growth did not translate to operating profit growth, with operating profit declining by 16.4% per year over the last five years.
Over the last five years, the Food and Snacks business’ operating margin averaged 4.5% but declined from 5.1% in 2015 to 1.4% in 2019. The big drop in operating margin came in 2018 when the operating margin declined from 10% to 1%. In 2018, the company changed its business segments. It moved the NPSG business from the Food and Snacks business segment to the United States business and passive investments were moved to the Mexican business. 2018 and 2019 are more representative of the Food and Snacks business performance. In 2018 and 2019, pre-tax operating ROA averaged 1.0%. Unlike the drinks business, their Food and Snack business has a wide variety of brands and assets in a wide variety of geographical locations that do not have significant market share leading to poor returns. It seems the acquisitions were more oriented toward generating growth rather than increasing the value of the company.
At the end of 2019, the Arca Continental families owned 67% of the shares outstanding, The Coca-Cola Company owned 8%, and the remaining 25% was free float listed on the Mexican Stock Exchange.
At the end of 2019, the company has a healthy financial position with a net debt to operating profit of 1.6 times. S&P, Fitch, and Moody’s rate the company’s debt as investment grade. Over the last five years, Arca’s average dividend payout ratio was 32%.
Arca is valued under three scenarios using the blended valuation of a discounted cash flow model and a residual income model. Both models have a five-year forecast period and a four-year fade to a terminal value in the tenth year. Under all scenarios, there are static assumptions and dynamic assumptions. The static assumptions are the discount rate at 10%, the tax rate at 30%, and the invested capital turnover equal to the 2019 invested capital turnover of 0.88 times. The company is improving its capital efficiency, therefore the 2019 level is used rather than a historical average.
The dynamic assumptions are sales growth, the terminal growth rate, and the operating margin. Over the past five years, sales grew at an average annual rate of 21.3% boosted by the acquisition of bottling companies within the United States. To maintain such growth rates, the company would need to continue to acquire. The Mexican business is growing at a healthy pace, but the other businesses are not. Under the base case, sales grow by 5.0% per annum over the next five years before fading to a terminal growth rate of 2.5%. The bear case assumes no growth into perpetuity, while under the bull case, sales increase by 10% per year for the next five years before fading to a terminal growth rate of 2.5%.
Over the last five years, the operating margin averaged 12.7% with a high of 16.5% in 2015 and a low of 9.7% in 2018. Under the base case, the operating margin continues near historical averages at 12.5% into perpetuity. The bear-case operating margin is 10.0%, while the bull-case operating margin is 15.0%.
All fair value calculations are adjusted by 5% to account for the disruption of COVID-19. A 5% adjustment is almost equal to eliminating a full year’s cash flow. The base-case 2025 fair value per share is MXN96.13, 10% below the closing share price on 8/14/2020 of MXN107.12. The bear-case 2025 fair value per share is MXN68.73, 36% below the current share price, and the bull-case 2025 fair value per share is MXN147.81, 38% above the current share price.
While selling Coca-Cola beverages is a defensive business, the macroeconomic environment is a risk. The company’s largest business is its Mexican business at 40% of 2019 sales. Before COVID-19, the Mexican economy was having a difficult time. The Mexican Central Bank has been one of the most aggressive in raising rates over the last few years. Mexico has been one of the most impacted countries by the global pandemic and there has been little support from the central government. In 2019, Mexico’s real GDP declined by 0.3%. In 2020, the IMF forecasts Mexico’s real GDP will decrease by 10.5% before increasing by 3.3% in 2021.
Arca’s Argentinean business is a smaller business at 3% of sales, but Argentina’s economy is a concern. Argentina is facing poor economic growth, high inflation, and a debt default. It will have a difficult time over the next few years, which will impact demand for its products. Argentina has suffered recessions, high levels of inflation, currency devaluations, and significant economic decelerations in various periods of its history. During 2016, Argentina’s GDP contracted by 2.1% and inflation was close to 40%. In 2017, GDP growth was 2.7% and inflation was close to 20%, showing a slight recovery in the economy. In 2018, Argentina once again entered into a recession and its GDP decreased by 2.5% and accumulated inflation reached 47.6%, while in 2019 the Argentine GDP contracted by 2.2% and inflation reached 53.8%. The IMF expects Argentina’s real GDP to decline by 9.9% in 2020 before increasing by 3.9% in 2021.
To combat the impact of sugary drinks’ effect on public health, governments are increasing taxes on soft drinks and other sugary drinks. In 2014, Mexico introduced a 10% tax on all sugar-sweetened drinks. According to a recent study, the tax harms demand. In the first year after the tax, demand decreased by 5.5% and in the second year, it decreased by 9.7%.
Water is important in the production of Coca-Cola soft drinks with more than 1 liter of water used for 1 liter of end-product. If there is any disruption to the water supply, Arca will have a difficult time producing products.
Barriers to entry in the industry are very high. There are economies of scale in procurement, manufacturing, distribution, and marketing. There are also habitual behaviors by consumers. Within soft drinks, consumers drink either Coca-Cola or Pepsi rarely switching between the two products. As illustrated by market share stability in each of its markets, the combination of economies of scale with a demand-based advantage makes it difficult for competition to acquire customers within the category.
Given the barriers to entry, there is a competitive rivalry among players in the market but outside players have very little influence on the competitive environment. Consumer preferences mean there is a low likelihood of switching between Coca-Cola and Pepsi, which decreases the competitive rivalry between competitors.
One of the most important competitive forces is the bargaining power of suppliers. TCCC has a tremendous amount of influence over Coca-Cola bottlers. TCCC licenses Coca-Cola bottlers. Bottlers must buy concentrate from TCCC at a price that TCCC sets unilaterally. They can only purchase sugars and sweeteners from TCCC-approved suppliers. TCCC sets the marketing program and the bottler pays for a large portion of the marketing spend. TCCC essentially determines the amount of profitability that a bottler makes. If they choose, they can extract more value from bottlers.
The bargaining power of customers is low. Customers are extremely fragmented. As indicated by market share, the end consumer wants Coca-Cola products and therefore retailers need to carry the product.
The threat of substitution is high. As consumers become more and more health-conscious, their preferences are shifting to beverages that do not contain as much sugar. Coca-Cola products do not have as strong a competitive position in these healthier categories.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.