Going back to some of our first trips to Mexico, we have always been struck by the strength of the Coca-Cola business there. In Mexico, Coca-Cola enjoys a much better competitive position relative to Pepsi and to other brands than it does in the United States due primarily to:
- Brand Dominance. More than sixty years ago, when it first entered the Mexican market in a significant way, Pepsi attempted to gain market share by offering its products at a lower price point than Coca-Cola. Mexican consumers, as consumers typically do with low-priced, branded consumer products, equated the cheap price with low quality. That brand positioning in the minds of the Mexican consumer has not changed appreciably since. Our extensive channel checks across Mexico find Pepsi consistently selling at a 10-30% discount to Coca-Cola on the shelves of many different sizes and types of retailers. Pepsi is generally priced similar to the important B-brand, Big Cola, which is produced by a Peruvian company. In fact, we think it is more accurate to think of Pepsi as a “B” brand in Mexico, with no “A” competition for Coca-Cola at all.
- Distribution Excellence and Reach. In Mexico, about 64% of beverage sales occur in the informal market of “mom and pop” stores. These stores can be converted living rooms, roadside stalls, or small corner shops and are logistically difficult for a bottler to service. Because of their sheer numbers and the low sales from each, being able to profitably distribute to all of these mom and pop stores requires substantial market share and scale. Only four companies in Mexico have built these advantages: Coca-Cola (the bottler in each territory), Grupo Bimbo (bread & confectionary), and the dominant brewer for each area. We have visited hundreds of these “mom and pop” stores. In a very small one, we typically will not find Pepsi or other B-brands for sale at all. In a medium-sized store, we may find competing brands, but what stands out most are the advantages that have accrued to the market share leaders in each category. In these stores, Coca-Cola products will be available cold in refrigerators while competing products almost always will be hot on the shelf. The Coca-Cola bottler installing a cooler in Latin America can typically triple the sales of a particular point of sale, materially aligning the interests of the vendor with Coke. Pepsi scale in both capacity and brand presence is too small to afford the necessary capital expenditures to invest in coolers or the other aspects of a first class product presentation.
- Product Offering Depth & Breadth. Volume leadership gives the Coke bottlers the critical mass to run a successful returnable bottle network. Returnable presentations still represent more than a third of sales in Latin America. The profit margins on soft drinks sold in returnable bottles are substantially higher than those for beverages sold in disposable PET (plastic) presentations. With superior market share, Coca-Cola can offer Coke, Coke Light (Diet), Coke Zero, Sprite, and Fanta in single serve, one liter, 2 liter, and 3 liter presentations in many points of sale. By contrast Pepsi is typically only able to offer a single returnable presentation, if a returnable presentation is available at all.The returnable offering benefits consumers as well as the bottlers. The breadth of presentations available to the Coca-Cola bottler provides strategic options with their pricing to different economic groups. If Pepsi is selling its 2 liter PET presentation for 14 pesos, Coke can offer a returnable 2 liter presentation at the same price (with inherently better margins) along with a 1.5 liter PET presentation at the same price. This “bracketing” is powerful; a consumer can choose between a cold returnable Coke in the same size and price as the hot Pepsi in a nonreturnable bottle, or choose a cold Coke in a smaller-sized nonreturnable bottle. Over and over again consumers choose the Coke product, reinforcing the brand’s position in their minds.
Research of and Investment in Arca
These favorable market dynamics are strengthened by the tailwind of a generally young population for whom Coke is a cheap, aspirational good. We have previously owned a sizeable stake in FEMSA, which among other things owns about 1/3 of Coca-Cola FEMSA, which is the largest Coke bottler in Mexico and Latin America. We bought FEMSA in part because we recognized what a wonderful business they had in Coca-Cola FEMSA. Unfortunately, the free floating shares of Coca-Cola FEMSA did not trade cheaply enough relative to intrinsic value for us to purchase directly (i.e. it provided an insufficient margin of safety). So we began looking at the other publicly traded Coke bottlers in Mexico and Latin America more generally to see if there were any with similarly robust business dynamics at cheaper valuations.
Embotelladoras Arca fit the bill. Arca sole territory at that time encompassed most of northern Mexico, which is the best Coke market in the world. Citizens there consume over 600 (8-oz.) servings per capita per year of Coca-Cola products compared to U.S. per capita consumption of about 400 (8-oz.) servings per year. Northern Mexico is generally hot and dry and home to most of the Mexican manufacturing base for U.S. exports, which helps make the territory the wealthiest per capita in Mexico.
Arca was created through the merger of three independent, family-owned bottlers in 2000: Proyección Corporativa, S.A. de C.V. (“Procor”); Empresas El Carmen, S.A. de C.V.; and Embotelladoras Argos (“Argos”). The newly formed company subsequently went public in 2001. Because the overwhelming majority of the company’s shares were controlled by the three families, free float was small. Without a large free float available to trade, Wall Street firms were unable to generate large commissions by creating research pieces about Arca. A rather extraordinary company with a $2Bn U.S. market capitalization and solidly growing business remained underfollowed.
We already had a good lay of the retail land from our many hours and miles driving throughout the Mexican countryside on previous visits to investigate other opportunities. In September 2008, we designed an additional driving trip through four bottlers’ territories, including Arca, Contal, and Coca-Cola FEMSA, specifically to compare and contrast their execution in the marketplace and to visit Arca’s headquarters in Monterrey. We set out from Birmingham and drove to Tampico along the Gulf of Mexico, inland to Aguascalientes, and then turned back north to Monterrey. It was clear that Arca was executing very well in both the cities and the countryside. The company distributes to around 194,000 points of sale in its territory of 17 million people while averaging $7,392 in annual revenue for each point of sale. If Pepsi were to distribute to all of these points of sale, it would probably average an unprofitable $1,000 per point. We had previously studied the financials and were intrigued that a company of this size could be trading for 7x forward net earnings while paying roughly a 9% dividend yield. Operating margins were above 20%, and they are generally sustainable because of the business moat characteristics mentioned above. Net debt has remained below two times EBITDA giving the company a Mexican AAA rating from Standard & Poor’s. In total, we were able to buy a wonderful business, run by outstanding professional managers appointed by the three families who had their net worths at stake. The company operates in an industry we feel comfortable predicting and was selling at a very significant discount to our calculation of intrinsic value. Once we returned, we began buying all of the shares we could find.
Subsequent developments where Arca made particularly effective capital investments caused us to like the company even more:
- Argentina. Arca purchased the bottling assets of several private bottlers in northern Argentina that did not have the capital or the expertise to invest optimally in their businesses. We flew to Buenos Aires in late fall of 2009 to examine the acquisition for ourselves as well as to check out the competitors and peers.During this trip, we drove almost 2,000 miles through Argentina and Chile over two weeks to see everything in person from bottling plants to the market. We spoke and toured with regional managers who were singularly focused on digging the moat around their businesses deeper and could not have cared less about next quarter’s earnings. Many of these folks had worked at the private bottlers and had chafed under the limitations of inadequate capital and contented owners. Under the Arca umbrella they have been empowered and incented to grow the franchise value for the long run. This change showed in their obvious passion for the business. You will not learn the same thing about a company by speaking to a polished investor relations person at a conference in Mexico City or New York City. While traveling in Chile and Argentina, it was apparent that Arca was leveraging its successful, time-tested distribution methods and readily available capital to execute better than its competitors and to compare favorably with its Coca-Cola bottling peers. In fact, in less than 18 months Arca had increased its share of its Argentine market by over 5% through a series of simple initiatives:
- In Argentina, B brands are even more important than Pepsi (in a good deal of Latin America, Pepsi simply hitches a ride on a beer distributor’s truck; presentation and stocking are frequently poor as a result). One apple-flavored B brand was especially popular in Arca Argentine territory. In response to B brands share of that market (about 7% of CSD  sales), Arca worked with The Coca-Cola Company to develop a Fanta Apple drink with a similar taste to the local B brand. In the first three months, this new Fanta Apple offering took 70% share in the apple flavor category. In a business where driving volume is critical to remaining competitive at dispersed points of sale, this type of improvement further deepens the moat around Arca’s business. The B brands have less capital to both distribute and advertise. With the success in the apple-flavored segment, Arca is duplicating the model in other fruit-flavored categories currently being ceded to local B brands.
- Relying on the software and systems they had developed in Mexico, Arca rolled out handhelds for their truck drivers that improved market sales data, inventory management, and route optimization.
- Arca began a marketing initiative to encourage the purchase of more profitable single-serve offerings in a territory where familial (large bottle) sizes were the norm. Despite having lagged Brazil, Chile, and Mexico in economic growth over the last 20 years, Argentina is still one of the wealthiest per capita countries in Latin America. Arca management was tapping the previously unfilled demand for a single-serve presentation.
- Arca invested in refrigerators and presentation/signage at points of sale.
- Bokados. As a new initiative in Mexico, Arca is leveraging the strength of its distribution network by building a snack food business. Since Arca has a relationship with all of the relevant points of sale, it makes sense to offer snack foods instead of ceding that business to Frito-Lay. Consequently, Arca purchased a regional snack food manufacturer, Bokados, and began immediately expanding the business and placing the products in Arca’s distribution channels. The first few years of results appear promising with sales rising 15% in 2010.
We love businesses that are continually confronted with “easy” reinvestment decisions like these that produce a virtuous circle for them and continuous challenges for their competitors. With these investments, we were more convinced the Arca moat was expanding as they took advantage of the opportunities presented. We increased the size of our stake as we revised our calculation of intrinsic value upwards from what we had originally estimated. Our chief regret is that at current prices, we will not be able to continue to buy the company with new investment dollars. Though this investment summary is admittedly an incomplete picture, we hope it demonstrates the framework we use to evaluate a business.
 FEMSA controls beer sales in northern Mexico, and Grupo Modelo controls the central area, including Mexico City.
 For clarity, “returnables” are glass bottles that are returned by consumers when they exchange empty bottles for filled ones or for a deposit. Bottlers can reuse the returnable bottles 15–20 times.
 Buenos Aires is controlled by Coca Cola FEMSA. Central Argentina and Southern Argentina are controlled by Chilean-based public bottlers Andina and Polar, respectively.
 CSD = Carbonated Soft Drink.