Arca’s Progress in the U.S.
We enjoyed hosting Arturo Gutierrez, Arca CEO, and Jean Claude Tissot, President of Arca Coca-Cola Southwest Beverages (CCSWB) division, in Birmingham in December. Our discussion covered strategic capital allocation considerations and tactical in-market operational activities. We have been following Arca’s progress at CCSWB closely, as it is the company’s first foray into the U.S. system with operations in Texas, Oklahoma, and New Mexico. Coke bottling in more mature U.S. markets has some fundamental differences to emerging markets, particularly in a bottler’s go-to-market approach. Retail channels are much less fragmented in the U.S., which lessens distribution advantages and makes it easier for competitors to challenge Coke brands. This more consolidated marketplace sustains Pepsi and Dr. Pepper as ‘A’ brand competitors in the U.S., while Pepsi is a ‘B’ brand in almost all emerging markets and Dr. Pepper is essentially non-existent.
Despite this tougher competitive environment, Arca has transformed CCSWB over the past two years. Arca has shifted the organization’s overall focus and overhauled the incentive system to reward profitability over volume growth. At a recent industry event, Arturo and our friend Matthew Dent, President of Pepsi bottler Buffalo Rock, both expressed their expectations that soft drink prices would rise faster than inflation in the U.S. in 2020. Arca is investing prudently in manufacturing and distribution improvements, including the U.S. system’s first new major bottling plant in a decade. In March, CCSWB will cut the ribbon to officially open this facility, which promises to decrease operating expenses materially in its growing Houston market. The fruit of these efforts isreflected in the outstanding margin expansion that Jean Claude and his team have achieved.
In 2018, Arca had to deal with macroeconomic and political issues simultaneously across several of its markets but was still able to grow volumes by 6%, revenues by 14%, and cash flows from operation by 14%. For the first nine months of 2019, volumes are up slightly, revenues have expanded over 4%, and operating earnings have risen 8%. These operational results were led by (i) strength in Mexico, (ii) the profitability improvements at CCSWB, and (iii) revenue growth and profitability gains in Peru. Argentina (about 5% of revenues) remains challenging as a lack of confidence following the recent election has returned the country to an inflationary recession, and Ecuadorian volumes have been essentially flat this year. Across the Arca system, the mix of low/no-calorie offerings has grown as Arca and The Coca-Cola Company have responded to customer demand; a continued shift should have a positive impact on gross margins over time.
Despite this earnings growth, the Fund investment in Arca stock was marked down by 3% for the year in U.S. dollar terms, making it a slight detractor to performance for the year. This result was not only incongruous with this year’s operational progress, but also with our expectations for the business. We project revenue to grow more than 5% annually for the next half-decade, with earnings compounding in the high-single digits annually over this same period. We also anticipate capital expenditures to fall, free cash flow to rise, leverage to remain low, and opportunistic acquisitions to continue. Share buybacks may play a role in shareholder returns, as well.
We believe we understand Arca better than any other outside investor in the company. Our long-standing relationship of trust with the outstanding Arca management team further reduces the risk that the business will underperform our expectations for it. At current stock price levels, the Fund investment in Arca is substantially undervalued.