Fomento Economico Mexicano SAB de CV (FMX) 2006 Q3 法說會逐字稿

Good afternoon, everyone, and welcome to FEMSA's third quarter 2006 earnings results conference call. [OPERATOR INSTRUCTIONS].

During the conference call, management may discuss certain forward-looking statements concerning FEMSA's future performance and should be considered as a good faith estimate made by the Company. These forward-looking statements reflect management's expectations and are based upon current available data. Actual results are subject to future events and uncertainties, which will materially impact the Company's actual performance.

And at this time, I would like to turn the conference over to Mr. Javier Astaburuaga, FEMSA's CFO. Please go ahead, Javier.

Thank you, hello. Good morning, everyone, and welcome to FEMSA's third quarter 2006 earnings conference call. As always, we will be brief with our prepared remarks and spend the majority of our time focusing on your questions. Joining me today are Federico Reyes, Gerardo Estrada, Hector Trevino, Juan Fonseca, all of whom you know well. We also have Alan Alanis, who as you know, is moving on to take on new challenges in FEMSA after today.

I am pleased to report to you that we have achieved another quarter of solid top-line growth, driven by the success of our marketing initiatives as well as by continuing strength in consumer demand trends. All of our core operations, Soft Drinks, Beer and Oxxo stores, contributed to deliver double-digit growth in total revenues, which were up 13.9%, reaching MXN32b or $2.9b in the quarter.

In Mexico, beer volumes grew 4.2%, lapping prior year growth of 5.5%. And Coca-Cola FEMSA volumes in Mexico grew 4%. At Oxxo we opened 116 new stores to reach 4,482 nationwide. Outside of Mexico, our operations exceeded our domestic growth rates.

From a top-line perspective, these results demonstrate our ability to deliver volume growth consistently, despite difficult comparisons, while at the same time capitalize on the growth opportunities of our increasingly diverse operations.

On the costs front, we experienced continued margin pressure from higher raw material costs. But in the quarter, our gross margin contracted 140 basis points, reaching 45.1% of total revenues, which [means] sustained raw materials pressure at both Coca-Cola FEMSA and at our beer operations.

Aluminum, sweetener and resin prices increased year-over-year significantly. Furthermore, the rapid growth of Oxxo and the inclusion of Kaiser in our results also weighed on the consolidated gross margin. However, we were able to mitigate a significant amount of the new -- of the raw materials pressure with efficiency and productivity improvements across our businesses, which effectively lessened the gross margin contraction for the quarter.

Our consolidated operating income grew 3% with margin compression of 150 basis points, reaching 13.8% of total revenues. When most of the margin pressure is attributable to raw material prices, the growing weight of Oxxo's lower margin, the inclusion of Kaiser and increased operating expenses in the quarter at our beer operation put additional pressure on the consolidated operating margin for the quarter.

Let's move on to our operations in more detail. In Beer, for purposes of clarity and consistency with the first and second quarters, we will report FEMSA Cerveza excluding Kaiser for the remainder of 2006 until 2007, when we will have comparable numbers.

Ex-Kaiser, our third quarter domestic beer results demonstrated a robust pricing and consumption environment. In Mexico, as I mentioned, we achieved beer volume growth of 4.2% and price per hectoliter growth of 3.3% in real terms. Our market initiatives and product innovation continued to drive demand and improve our competitive position.

In particular, I would like to mention two new products that were launched in the third quarter. In September, we launched Tecate Light in a non-returnable glass bottle, completing a full line of presentations for the brand. We also launched Soul Citric, the first ever Mexican flavored alcoholic beverage, which was rolled out in all of our Oxxos nationwide and targets a non-traditional beer drinking consumer, women aged 18 to 35. Besides Oxxo, the product will be distributed through the upper segment on premier channel.

On the domestic pricing front, the increased real price per hectoliter reflects an important increase in our direct distribution volume, as well as revenue management initiatives and, to a lesser extent, a shift in mix and favorable geography. We continue to see a rational pricing environment in the marketplace.

In exports, our results for the quarter and year to date are slightly ahead of our growth expectations for 2006. Volumes increased 16.7% in the quarter, lapping 18.7% growth in the comparable period of last year, reflecting very healthy double-digit growth in our U.S. exports.

Year to date, export volumes increased nearly 16%, well on track to achieve our volume objectives for the year. Our export price per hectoliter decreased 2.3% due to the year-over-year strengthening of the peso in real terms and a channel mix effect in the U.S., as our 24-ounce presentation of Tecate continued to grow in the off-premise trade. The growth of Dos Equis is ahead of the growth of Tecate in the U.S., but from a much smaller base.

On the cost front, sustained upward pricing pressure from raw materials finally caught up with us. Therefore, during the quarter our gross margin decreased 90 basis points, reaching 59.6% of total revenues. To put the impact of raw material prices in perspective, it represented 175 basis points of total revenues in the quarter, but we were able to offset almost half of that impact through continued productivity improvements and better fixed cost absorption.

Operating expenses at FEMSA Cerveza increased 14.2% in the quarter, slightly ahead of revenue growth, due to increased selling expenses. As you read in our release, the causes for the growth in selling expenses in the quarter are related to increases in our direct distribution and calendar shifts in our marketing spend, as well as the strengthened sales structure and expenses related to the services we provide to retailers to improve our competitive position in the marketplace.

As a result, our operating margin contracted 250 basis points during the third quarter, but was flat year to date at 20% of total revenues.

Let me stop here a minute to address an issue that I know is important, which is the fact that, even though our volumes and top line have grown strongly in recent quarters, we have not raised our expectation for stable operating margins for the year.

Let me begin by reflecting on the fact that our top-line growth has not been [casual]. We have been able to grow slightly ahead of the industry and realize slightly stronger pricing precisely because we continue to build our business and work to strengthen our competitive position. Our increased focus on brand building is yielding results on the top line and our brand health indicators are at all-time highs.

Building better brands is imperative to better segmentation and revenue management. We are achieving this while maintaining profitability and, as we have stated all year, we are still on track to achieve a stable operating margin on a year-over-year basis. After 11 years of consistent operating margin expansion, today we are aiming to realize earnings growth by driving the top line and holding profitability constant, while continuing to build our competitive strength vis-a-vis current and potential new competitors.

Moving on to Kaiser, as promised, we finished the third quarter already for the Brazilian summer. We made significant progress in our brand and portfolio strategies and in October launched several initiatives ahead of the highest volume season in the country, including a new version of our brand Sol that is tailored to Brazilian preferences and repositioning of brand Kaiser with a more regional emphasis and an already very noticeable new marketing campaign.

Although it is too early to tell, the initial market reaction to our initiatives has been positive. Moreover, our consistent approach to strengthening Kaiser's management team, aligning our selling and distribution system across Brazil and improving execution, is yielding results.

Year to date, we have achieved margin and volume growth improvements in the business, a business that had a long history of declining volumes and profits. In the quarter we achieved operating income of MXN28m and EBITDA of MXN74m. Although we are slightly up year to date, we still maintain our EBITDA breakeven guidance for the year as marketing spending is expected to grow in a very significant way in the fourth quarter.

As mentioned in our press release, during the quarter we settled substantially all of Kaiser's outstanding tax contingencies, for which FEMSA Cerveza is not indemnified, in the context of the fiscal amnesty programs, both at the federal and state level in Sao Paolo. Kaiser paid approximately $200m, realizing important savings. And we have taken off Kaiser's books substantially all contingencies for which we were not indemnified by Molson Coors when we acquired control of the company.

This represents an important step for us and is another sign of the way we do business, and of our continued full commitment to the Brazilian market. All in, we are excited about the developments taking place at Kaiser and are on track for 2006.

Turning to our Soft Drinks business, Coca-Cola FEMSA delivered strong revenue growth with all territories contributing, although Central America did stand out with a remarkable performance. Notably, in Mexico the unit price dynamics improved from the second quarter of this year, but the price of raw materials put pressure on gross margins again.

Central American revenues grew over 19% and operating income for the quarter grew over 75%, with operating margins expanding 480 basis points during the quarter. Colombia also delivered strong operating income growth, of almost 30%, and operating margin expansion of 210 basis points.

Many you listened to Hector Trevino on Coca-Cola FEMSA's conference call last Friday. If you were unable to participate, you can access a replay of the webcast if you need additional detail on the results.

At Oxxo, our top-line results were very good, up 18.5% in the third quarter. We added 116 net new Oxxo stores, representing an increase of 698 net new stores from the third quarter of 2005 and showing that we are on track to open 650 net new stores for the year.

This quarter also marked another consecutive period of same store sales growth, up 6%, as a result of improved promotional activity with our main supplier partners and category management practices that are enabling Oxxo to drive more customers into the store. Traffic grew 3.9%, while strong category management drove a 2.1% increase in average ticket.

At the gross margin level, we experienced 100 basis point expansion to reach 26.9% of total revenues, driven mainly by better purchasing terms and coordinated efforts with our supplier partners, as well as very successful promotions during the summer.

In income from operations, we achieved a 60 basis point margin improvement, as the improved gross margin offset increased operating expenses resulting from higher energy tariffs mainly. Going forward, we will continue to aggressively grow our store base and strengthen our position as the leading convenience store chain in Mexico.

And finally, I would like to comment on two significant items that relate to our bottling operations and very directly to our partner in that business, the Coca-Cola Company. The first piece of news is that we will acquire 8% of the equity of Coca-Cola FEMSA from the Coca-Cola Company, and that the transaction will take place this next Friday, November 3.

As you know, this transaction was contemplated in our understanding with Coke back in 2003 when we acquired Panamco. Our economic stake in Coca-Cola FEMSA will grow to 53.7%, while Coke will own 31.6%. The price will be 28.88 [sic - see press release] per AVR, which was the average closing price for the 30 trading days between June 13 and July 25 of this year.

Obviously we are very excited to acquire an incremental stake in what we consider to be the best bottler in the world at a reasonable price. The transaction will be immediately accretive to our earnings.

The second item relates to a new cooperative framework we have arrived at with the Coca-Cola Company. The framework is comprehensive and addresses what we consider to be the key issues in our relationship. First, the basis on which the partners will support the growth of carbonated and non-carbonated beverages going forward. Second, the avenues for horizontal growth for Coca-Cola FEMSA. And finally, a long-term perspective on the economics of the relationship.

I know that you are all very interested in knowing more about what this all means. I would like to have some hard numbers. However, at this time we cannot give you much more than what you have read or what Hector was able to share with you on Friday.

What I can tell you, though, is that this framework addressed much more than the incidence increase and it puts us in a good position and gives us a strong incentive to go after the growth of our non-alcoholic beverage business going forward. After a year of intense conversations with our partner, the groundwork is now laid for the next stage of growth for Coca-Cola FEMSA.

And with that, we can now turn to your questions. Operator, please?

[OPERATOR INSTRUCTIONS]. And we'll take our first question from Tufic Salem. Please go ahead, sir.

Yes, good morning, everyone. My question is specifically related to the operating costs of the business at the beer level. I understand you are investing in the business but you specifically mentioned some additional expenses to retailers, the taking up of the direct distribution in Veracruz, and also a marketing shift. Could you just detail a little bit more about the direct distribution, because you also got a benefit on pricing, so is there some cost reductions that can be done there once you take up that distribution? And also, does this mean that, for 2007, we should also not expect an expansion in operating margin for the beer business?

Yes. Good morning, Tufic. First, just to explain the comment on the price increase driven by increased distribution, we have said in the past that we, during the year, in different between -- around second quarter, we took two very large distributors in Mexico. We got to an agreement to acquire a stake in the distributor in Ciudad Juarez, which was by far the largest one, and we went to operate on a direct way the Veracruz market also.

So what's going on now is that now we're having, on price, the increase of not giving away any more the margin and that helps to drive a slight increase in the price per hectoliter. But now we're recording in the expenses which are related to operating those markets. The transition in the Ciudad Juarez market was very smooth because, again, we ended up having an agreement to acquire that distributor. But in the case of Veracruz we are now incurring in a number of starting-up expenses for that operation, and that is affecting the structure -- the expenses structure to operate that market, even though we are now having very good performance, volume-wise.

So that's the phenomena that is now during 2006 pushing price per hectoliter a little bit higher than in the past. But, at the same time, that's also putting some pressure on both administrative and selling expenses on the numbers that you're looking at.

Another comment was that in some cases now where, with certain retailers in some markets, we are changing some of the margin help or support that we used to give to them and we're changing from a variable to a more fixed kind of structure. So that also is helping us to increase slightly the price per hectoliter that we are realizing on those segment of retailers but, at the same time, we're having to spend now on some support and components that we were not incurring in the past.

And so that's basically the explanations that I can share with you on your questions. And I think it's still a little bit too early to talk about 2007, to tell you the truth.

Okay. Well, could you just say how long do you think this transition is going to take, at least on the distribution or the retailing side, until we see these fixed costs being diluted away?

Yes. But on the distribution I think you will keep on looking at the next, maybe, two quarters on numbers that do not lap yet over 2005. So the second quarter of 2007 I think numbers will be perfectly comparable. But for the next two quarters, I think you will still see some increasing price per hectoliter driven by that, and increasing operating expenses also driven by that.

And also I will share that with these two now direct distribution operations, I think we have got to the point that we thought in the past was the right way to go. Now we are distributing slightly above 80% of the volumes of the Company and, if you remember, we are coming from as low as 65% only five years ago.

Great, thank you.

Thank you.

Thank you. We'll take our next question from Reinaldo Santana from Deutsche Bank. Please go ahead.

Hi, guys, good morning. Well, my first question has been already answered and the second one has to do with Kaiser. In terms again of marketing expenses that you mentioned that you have started to increase marketing expenditures in that country, should we expect that kind of heavy levels of marketing expenses for how many quarters in Brazil? And if you have any forecast in terms of EBITDA margin contribution for Kaiser for 2007? Thank you.

Sure. Hi, Reinaldo. When we say a significant increase in marketings, what we're saying, and I think we've been clear on this, is that we have had a terrific year, I think, in Brazil, in terms of achieving basically all the objectives that we set ourselves, in terms of fixing the operating model and taking all the synergies that we put into our evaluation when we acquired the business, understanding in a much better way the market, the Brazilian market, in terms of the segments of consumers. And what I think we achieve is to really bring discipline to the business in all fronts, both operating the supply chain the way it should and also understanding better where our opportunities were.

So what we're basically doing is we're reinvesting in the business, basically, all of the savings that we were able to achieve during the year and that will increase significantly - and by that I mean a big number - the amount that we are now putting behind the brands. As we showed in the past, we think that some of the problems that the business was facing in the past were somehow related to a not very consistent portfolio strategy, which we think is desperately needed, and we're working on that. But at the same time, we don't think the business was, because of the operating problems it was facing, I don't think it was receiving the fair amount of resources it needed to really build brands for the long term.

So we're putting a lot of money now behind Kaiser but in a very different way, looking at it from a very more regional basis, not trying to work with the brand on a national basis as it was done, we think, in the past. And at the same time now we're launching, as I said, a Sol -- a Brazilian Sol, which is pretty much tailored to the Brazilian needs, both in terms of packaging, liquid and positioning. And of course, being a start-up brand, it needs a lot of support in the early stages.

We are very enthusiastic about the prospectives of the brand. But also, as we said, turning around this business will really demand a lot of consistency and investments in the medium term. We have shared that we see this as a turnaround from the market and the brand side that could take, maybe, a couple of years, at least.

So you should expect for us to continue very committed investing behind the portfolio of brands. And that would represent increased, in a significant way, marketing investments as compared with the past. And what we're just trying to achieve is to really find sources of funding through efficiency, internal efficiency, basically driven by an optimized supply chain and a consolidation of some functions and areas there in Brazil that could generate also savings.

Thank you.

You're welcome.

And we'll take our next question from Lore Serra from Morgan Stanley. Please go ahead.

Yes, just a couple of clarifications. In your opening comments, did I hear you say correctly that you're expecting EBITDA breakeven in Brazil this year? I was under the impression that the target was EBIT breakeven.

No, it was EBITDA breakeven, Lore.

Okay. Okay. And in terms of the SG&A expenses in beer, well, one question. Would it be possible for you to isolate the effect on either pricing or operating expenses of those purchases of third party distributors in the quarter?

Hi, Lore. Yes, if we can isolate the -- you mean the third party distribution that came direct?

Yes, if you could give me a sense of, okay, your revenue grew 8% in the quarter, right, and if you hadn't had the purchases of a third party distributor, year-on-year, what would have been the revenue growth? And also the same question on the operating expenses?

On a price per hectoliter basis, Lore, it affects above 50%.

So out of the 3.3%, slightly above or half of it is related to the change in the distribution mix.

And on the operating expenses?

On the operating expenses, it's about 30%.

And as you look into 2007, I understand what you're talking about in terms of your laps, you won't lap until the second half of the year or comparable direct distribution structure. But as you think about the fundamentals of the operating expenses, is there any reason to think, absent those adjustments, that the operating expenses will go up importantly or in excess of inflation for '07?

So I think we are now, after working the last two to three years, as we have said in our comments, reinforcing the structure and really building a stronger pipeline, and increasing our level of spending behind the brands. We are now, for 2007, looking at a more, what you can call, reasonable growth in operating expenses. And what we have seen in 2006, a double-digit growth rate, that's not what we're now forecasting for 2007, Lore.

Great, thank you.

Thank you.

And we'll take our next question from Bob Ford from Merrill Lynch. Go ahead, sir.

Hi, good morning, everybody. I had a question with respect to the change in the structure in Mexico and I'm just curious. When you look at -- or when you make the comments in terms of strengthening the sales structure and changing or improving the services you provide the retailer, is this simply taking -- modifying your existing go-to-market platforms so you can grow with perhaps some of the potential changes that we expect will occur over time with respect to point of sale exclusive limitations? Or are there some additional net benefits that you anticipate that you could talk about with us on this call?

Maybe part of the answer, Bob, will be that in some cases -- we have talked about this in the past a lot, and we feel that we have been adapting our business model to what may be a much more open and competitive environment in the future, both because of regulations or because of new competitors coming into the market, whatever.

And we have shared the belief that we are very, very comfortable with the way the market has been segmenting and bringing a new barrier of entry, not because of being so high in returnables or because the exclusives or whatever in Mexico, but now because we have different propositions for consumers in different price points, liquid profiles and packaging and positioning of the brands.

In some cases the mention that I made on the changing sum of the relationship model that we have been using with some retailers, the intention is basically to really fuel more growth in some retailers with the brewery putting some more resources at disposal of retailers, but most of them in the form of equipment and start-up expenses for the business, or expansion or modulations.

And I think that the main benefit we will get is to have a longer-term relationship with some retailers. And we are gaining also a foothold in terms of being able to, let's say, influence a little bit more the retailer agenda in terms of development of the beer category. And also, as I said, we will have a longer-term relationship with some of those retailers.

So those are some of the benefits that we're looking at when we mention that we are now in some cases adapting the relationship model, not only with the way we relate to retailers but with the way we approach the consumer now in the Mexican beer market.

Do you know, Javier, I can't believe you didn't just start doing this. You must have had a pilot program. Is there anything you could share with us about your pilot in terms of the behavior of those points of sale with perhaps the average point of sale for FEMSA Cerveza and the length of the pilot?

Well, again, as I said, Bob, in some cases again when I'm saying this would allow us to extend relationships with the group of retailers, what you're talking about in some cases is just you're securing long-term relationships with some of those. So short term, you may be incurring some expenses in the short term, but now what you're getting is it's a more longer-term perspective with the way you're going to relate with them.

So it's not like we did a lot of piloting and then we're rolling out these things. It's like we're evolving the way we relate with some retailers. And in some cases, we're betting hard on volume development. In some others we're just betting on securing long-term relationships. So it's not like a one factor driven strategy.

Okay. And Javier, are you done rolling this out nationally or are we going to see some additional incremental expense as you make this program more broadly?

On these types of programs, I think we will continue to work on, going forward.

Okay. And then I was just curious, could you go over the actual cash flow impact of this $200m tax payment in Brazil? Because there is some mention of a partial indemnification from Molson Coors.

Bob, this is Juan. I think we need to separate the two. The payment was made by Kaiser and the reference is to indemnification made to FEMSA Cerveza when we acquired the operations. I think basically what this means is Kaiser now has taken off its books a large amount of the contingencies. And this is Kaiser funding. Right now -- with regard to FEMSA Cerveza but it's basically debt taken at the Kaiser level.

Okay. So Juan, the $200m payment that was previously reserved for buying Kaiser, right, will there be anything that flows through the income statement? And am I to assume that it was a single payment of $200m or is there some type of an installment or plan of payments going forward?

Bob, this is Gerardo. The valuation that we took was considering that the tax continued -- the tax liability. The liabilities were already there at the time that we acquired, but it was in a different level. It was in other liabilities. Now, we are just changing that to debt. And certainly we're saying something about a little bit above $60m.

So you will ultimately book a $60m gain, is that it, Gerardo, versus what was previously reserved for in the balance sheet at Kaiser?

Yes, but you will not see that as a gain. It's a reduction on the goodwill that we registered at the beginning.

Great. So no balance sheet impact, a single lump payment of $200m in the third quarter, and we'll see it in cash flow and on the balance sheet, right?

Yes, that is correct.

Great. Thank you very much.

Thank you.

And we'll take our next question from Sohel Amir from Lucite Research. Please go ahead.

Yes, good morning. My question was with regards to the 8% stake that you're purchasing. How is this going to be financed? And has the financing been done already?

Yes. It's going to be financed with cash at hand and some peso bank long-term debt which has already been executed, so we're ready to do a transaction next Friday.

Right. And could you give a breakdown of how much of it will be debt and how much cash?

It's, I think 2 --

60% of it is cash and 40% is debt.

Great, thank you.

Thank you.

And we'll take our next question from Alex Robarts from Santander. Please go ahead.

Yes, Santander, thanks. Hi, everybody, two questions. I guess Oxxo was something that we were particularly interested in this quarter, seeing the 100 basis point expansion in the gross margin. Can you give us some more color as to what really was behind some of these -- or the ability to get these better terms with the suppliers? What was that about as far as is this something that maybe we can see as a new level for your gross margin going forward?

And any news and color as to the lottery that Televisa seems to be talking about locally? Is this something that you plan to participate in with your stores?

On the margin side, I wouldn't think that this is a new level. I think that we just did a mention, a small mention, that on the quarter we have very, very successful promotions. And because of being so successful, we received some special support from some supplier partners that really helped to expand the margin for the quarter, but you shouldn't expect this.

Again, the value proposition of Oxxo still is pretty much based on managing very affordable and comparable prices in a number of categories against other retail formats. So I would just say this is one -- this was a very, very successful quarter, but you shouldn't be expecting expansion on gross margins at the rate that the quarter experienced.

And on the lottery, as we said, we are working on a number of initiatives, lottery being one of them, but we still have nothing to really talk about that yet.

Okay. I guess, turning to the beer, there are two quick items I wanted to ask about. First of all, you seem pretty keen on saying, look, breakeven EBITDA Kaiser this year, and you're well ahead of that, first nine months $20m or so in the EBITDA. Fourth quarter, it seems to me, I guess the implication is with new Sol and the repositioning of Kaiser that there's going to be -- you've told us a significant amount of spend, but it seems like you're going to be in the $50m to $100m range for the fourth quarter alone, behind the marketing in Brazil.

And I guess, related to that, we've seen publicly -- well, numbers in the Brazilian press talking about a marketing program with Fischer around the $100m to $150m level. I don't know if this is multi-year, but any kind of indications or guidance you can give us on really how important and significant is this marketing spend going to be with Kaiser?

I guess my first suggestion would be not to read that much of the press in Brazil about beer market. These guys are very emotional in terms of, I think, Amber being the leader there and having now, I would say, the competitiveness of FEMSA. And we are doing so many things, I think you're going to find all sorts of articles in the press.

What I can share again is that -- and again this is something which is -- we have a going-in position in terms of what we think we need to do to really grill a competitive portfolio in the Brazilian market. And as we said, it's going to require a lot of money, a lot of consistency but good consumer insights in order to be successful medium term.

So the numbers that we're putting into our plans are the best reflection we have around what we think we need to do. But as you may know, the level of spending, somehow, sometimes depends on the level of spending of the rest of the players. So, just to give you an example, we're aiming for a certain share of [boys] in the media spending in the Brazilian market, assuming certain level of spending of the rest of the players. The level of spending of the other players, maybe the one we are assuming or it may be another one, either higher or lower. So we'll keep on adapting what we need to do in order to build our brands on market conditions.

So, sorry for not sharing specific numbers. What I can share with you is the full commitment of FEMSA's management that we're going to do whatever we need to do there to really build the brands in a rational, long-term consistent way. And that what we're anticipating is that we're willing to reinvest into that business all of the synergies and savings that we've been able to get from the business in order to really build a powerful and truly competitive portfolio of brands.

So, we're spending, yes, significantly above what this business was spending in the past and we think it's the right way to really, let's say, be consistent with the decision of going into the Brazilian market acquiring this business. The entry ticket for the Brazilian market we think was a very, very reasonable one in terms of acquiring such a large capacity and a business which had a good foundations to build on. But, at the same time, we recognized in the beginning that we needed to do a lot of work and put a lot of money into the business, and thankfully we are finding sources of funding on the savings we have been able to achieve.

Okay. Fair enough. And just finally on the aluminum, it looks like some brewers are talking about this, others are not. In your case, did you make some purchases for future quarters of your can needs in the third quarter? And roughly how are you tracking on a year-to-date basis with your can costs, please?

As you know, we acquire -- we produce basically all the cans that we need. So basically what the business has been hit by is by the rising aluminum prices. And we used to have some hedges in the past. Basically almost -- full 2004 was hedged, some of 2005 was hedged. But since the aluminum prices started to rise significantly, we started to lose some of that protection. And to tell you the truth, we haven't found really conditions that tells us it's still a good idea to hedge again aluminum prices again.

So we have been badly hurt by that. And I just mentioned the increase of close to 100 basis points in the quarter for beer. And that partly, I would say the majority of that, has been driven by aluminum. The third quarter of 2005 was, considering 2005 and 2006, the lowest cost per ton of aluminum that we had because we had some hedges still there in 2005 third quarter. And now in 2006 we have experienced a higher price per ton of aluminum, so that hurt a lot the quarter. So, going forward we continue to think and to review and monitor which would be the best timing for again hedging some of our aluminum needs going forward. We are about 100% exposed as we speak today.

Alright, thank you.

Thank you.

We'll take our next question from Carlos Laboy from Bear Stearns. Pleas go ahead.

Good morning. I think I heard Federico Reyes is there. I have a question for Federico. That is that you've done a lot of negotiations with Coke over the years. Can you expand on how profound it is for FEMSA that the Coca-Cola Company is moving away from incidence rate models in Latin America for non-carb and seems to be moving toward what Muhtar Kent called more comprehensive partnerships and JVs?

Yes. Hi, Carlos. I think this represents a new view of the Coca-Cola Company and also the bottling system of what this business segment needs to be developed properly. For these -- for non-carbs, we -- I think he indicated that in his remarks. For non-carbs it was imperative that the whole system move to another type of arrangement and that is what is being done. When you are entering into these new products and new categories, you have to do it in a more equal basis in which both of parties share the risks and share the upside in a more equitable fashion. The incidence models works very well when you have plans that are more strong and more fully established.

So, I think this is -- for us it's an extremely good indication of new flexibility of looking at the markets that is coming from the Coca-Cola Company. We are very happy with that. And the dialogue we have with the Coca-Cola Company relating to these issues was very open, it was very frank, and it was not easy at all times. But it was, at the end of the day, I think the whole system is going to be much stronger.

How does a partnership on one side of the business, Federico, you think, affect the other side of the business?

I don't get the meaning of your question.

If you have a partnership relationship with Coca-Cola on non-carbs and if it's safe to assume, say, 50/50 partnership or whatever, how does that change the discourse on CSDs and on the type of relationship that you have on CSDs when that's an incidence rate formula? In other words, on one side you're a partner, on the other one you're still renting brands.

No, Carlos, I think it's -- the incidence structure on CSDs is one in which we know the rules of the game and the bottling system works well within those. We know how much we can make. We know how much we can receive from them in marketing support and sharing of other expenses. And it works. And the fact that it works is that our profitability is still a very good one.

I think the main point was that that model does -- everybody believed that it had to be readjusted for other type of beverages and non-carbs is the perfect example. But I don't think it's we basically view it as two different segments, two different pools, and that both of them are being addressed in different manners but both of them in a good way.

Thank you.

My pleasure.

[OPERATOR INSTRUCTIONS]. We'll take our next question from David Winters from Wintergreen Advisors. Please go ahead.

Congratulations on buying more Coca-Cola FEMSA. That's a huge positive, isn't it?

We are very happy with it, yes. Very, very happy.

Hi, David, this is Juan. Obviously, as you know, we view Coke FEMSA as one of our main avenues for growth going forward. It is the best bottler in the world as far as we're concerned. It is a high-return business and of course we're happy to get it at the right price.

I know. Just I'm thrilled. It's just it's such a great move, and you've done such an incredible job with integrating Panamco and everything you've done. And I agree with you; it's the best Coca-Cola bottler in the world.

Thank you, thank you very much.

We'll take our next question from Celso Sanchez. Please go ahead.

Hi. Actually a couple of questions, a little more, I guess, off the beaten path. This new flavored alcoholic beverage you've launched, can you give us a little bit more color on what the thinking was behind that in terms of both the lead-up into the development and launch, and also what that might mean for further expansion away from beer or in addition to beer, I should say? What channels particularly, do you think that's suited for? Is it the on-premise and more for Oxxo, or is it really just the on-premise after the launch through Oxxo? That's my first question. Thanks.

Yes, Celso. This is -- first of all, this is a product that should be judged against its own category. And the intention basically is we think that we've been working very hard in the marketing area of the brewery in getting a number of consumer insights that we have applying to our existing beer portfolio. And at the same time, we have seen the evolution of some of these flavored alcoholic beverages in the Mexican market in a very segmented way, both in terms of packaging and pricing.

And the first experience that we are now having is basically at the very, very top range of the price of this category, which basically accounts mainly for 10% maybe of the whole flavored alcoholic beverage. And basically these kinds of products are very, very skewed to both modern trade, convenience stores and on-premise in certain, let's say, top-notch kind of on-premise outlets. Basically for young people and very, very skewed to women.

So what we're trying to achieve here is to just really tap on some of our manufacturing flexibility, our knowledge of consumer insights, on younger people. And again, it's just a new, let's say, area of focus of the brewery. And what we're very, very sure and very, very careful about is that these products receive the amount of importance and attention that they do deserve. So, there's not a change of mindset on people thinking about whether this is the future for the Company. But again, we're on a marginal basis working on developing products which we think can work very well.

And what I can share is that it's been only in Oxxo for the last five weeks and it's doing great. But again, I wouldn't spend a lot of time either me talking or you spending on doing some research on this new category.

Okay. And to help me finalize the research, can you give us an idea of what the profitability of these types of products might be relative to beer, higher or lower? Obviously scale's an issue but --

Yes, it's significantly higher. In the early stages, of course, you need some marketing investments in the, let's say, first 12 to 18 months. But after all, this is a product which is sold at basically twice the price of a bottle of returnable beer and 80% above what's been sold in non-returnable beer.

So it has very, very good gross margins. Of course the scale is very small but, again, it proves that it's, in some cases we think, helpful because if we are able to really grab important share of some of this -- if we have the ability to grab share in this category in some specific outlets, it may prove to be very, very, helpful to develop the Super Premium category of beer also in the medium to long term.

So it's kind of doing it because it's a good business and it doesn't take that much to really get into that category. But at the same time, it really fits well with the development of the Super Premium category in Mexico going forward, which we think is still a pending issue to do it in a significant way.

Okay, great. Thank you for that. And if I can just follow up on Coke FEMSA, one of the comments there, one of the things in the press release talked about the potential to expand in other markets outside of Latin America. Can you give us an idea, if not geographically, what kind of characteristics we should think about for markets that you might be interested in looking at?

Sure, sure. I will mention some of those. First, we think we're -- we think we have developed an operating model which is very strong when we're facing conditions in which you have to compete in a very fragmented retailer base, in which you have capabilities of managing logistics, both outbound and inbound, in terms of managing refillable or returnable presentations. Direct store distribution is one of the key things which we think we are good at.

And another set of characteristics would be marketing, which we don't feel or think that the level of segmentation is pretty well done in terms of segmenting both retailers and consumers. Flexibility -- manufacturing flexibility in order to really keep deploying new packaging on a very dynamic and speedy way. So those are the markets that we think we can add value, as we have shown in the case of Panamco, for example.

Do those include both developed and emerging, or is there an assumption that it's probable for emerging?

We think that the more developed the less likely they're going to be as the description that I just made. So I think that we are much more skewed to emerging than to developed. But we may find some developing which, because of the nature of the country's population, consumption patterns and retailer base characteristics, we may find some opportunities. But to tell you the truth, we're much more skewed to emerging.

And just as a rough final question on the same point, do you have a top five list right in mind or is this very conceptual at this point?

We do have but we're sorry, we're not able to share that, Celso.

Okay. Thank you.

Thank you.

We'll take a follow-up question from Lore Serra from Morgan Stanley. Please go ahead.

Yes. I just wanted to ask a couple of quick questions on the soft drink operations. We saw better results this quarter from Venezuela, I think, on the SG&A side. It's hard to see because the depreciation bumped up and I'm not sure whether that was in the costs or SG&A. And you talked about it differently on the call, like something changed and you're now in better control of Venezuela. So I'm wondering if you could give us a little bit of sense of what's different there than what you've seen in the past, what you've struggled with in the past 12 months?

And then just briefly on Mexico City, you talked about the strengthening on the Cola front and your competitor followed. Are you seeing any similar positive moves on the flavors side?

Hector, could you take that?

Yes. Good morning, Lore.

Morning.

In Venezuela, the main change that we are doing, as we were saying on Friday, is to try to change the model, the business model, to a model that will bring profitability to the business. We like to call it reinventing our operation in Venezuela. For that we have reduced very significantly the number of SKUs, going away from SKUs that sell very little with small margin. And also, very importantly, we are moving into changing the contractual relationship with some of our distributors there that distribute only 100% Coca-Cola products because changes in the regulations in Venezuela.

That situation, it's very -- it's common in all the industry, the second issue with the relationship with some of the employees. It's common in all the industry. But we are the first Company moving in that direction and you have seen some turmoil in the newspapers regarding those adjustments. We believe that starting next year we will be a better position because, again, we are going into a more efficient way of moving into the market. We like to express in that respect as doing the basics fine, a lower amount of SKUs, more profitable and obviously adapting to the change in regulations in the country.

With respect to Mexico, we are also seeing some price improvements in the flavor market. Obviously, for us, some of these flavor presentations are the way that we also bring affordable Coke to our consumers. Not necessarily we do that always with Coca-Cola, although we use the returnable PET presentation for that also on brand Coca-Cola. But we have increased, importantly, around 20% the prices of the family size flavors because we do see some space for that.

But do you see any competitive moves following you?

Not so far. In the case of Colas, yes, in the case of Flavors we are still basically alone on this new price front.

Okay, thank you.

Thank you and there are no further questions at this time. I would now like to turn the conference back to Mr. Astaburuaga. Please go ahead, sir.

Thank you very much, everyone. Let me close by reiterating our commitment to continue getting stronger in all of our operations, so that in turn we can continue to grow our earnings and returns and by doing so create value for you. These are exciting times at FEMSA and we thank you for your interest in our Company.

Have a great day, everyone. Thanks.

Ladies and gentlemen, if you wish to access the replay for this call, you may do so by dialing 1-888-203-1112 or 719-457-0820 with a passcode of 4885114. This concludes our conference for today. Thank you for your participation and have a nice day. All parties may now disconnect.