Fomento Economico Mexicano SAB de CV (FMX) 2016 Q3 法說會逐字稿

Good morning, and welcome, everyone, to FEMSA's Third Quarter 2016 Financial Results Conference Call. All lines have been placed on mute to prevent any background noise. After the presentation, there will be a question-and-answer session. During this call, management may discuss certain forward-looking statements concerning FEMSA's future performance and should be considered as good faith estimates made by the Company. These forward-looking statements reflect management expectations and are based upon currently available data. Actual results are subject to future events and uncertainties, which can materially impact the Company's actual performance.

At this time, I would now like to turn the conference over to Eduardo Padilla, FEMSA's Chief Corporate Officer. Please go ahead.

Good morning, everyone, and welcome to FEMSA's third quarter results conference call. Juan Fonseca and Roland Karig are also with us today. As we usually do, we will focus the call on the consolidated figures for FEMSA and on FEMSA's commercial results.

There's many of you who probably had the opportunity to participate in Coca-Cola FEMSA's conference call last Tuesday. So, we want to use the call to try to add some color and some qualitative elements to discussion, as well as to hear your views and answer your questions. Hopefully, you will find it useful.

Overall, our Company continued to make solid progress during the third quarter, FEMSA Commercial as a whole including its three divisions increased revenues by 40% versus the third quarter of last year. At the retail division, we saw strong growth in same-store sales at OXXO against a very tough comparison base in third quarter 2015.

However, operating margin also faced a difficult comparison given the significant expansion of 70 basis points a year ago, and therefore we saw a contraction this quarter. We'll get more into details in a few minutes. But the key message here is that the long-term margin expansion plan is very much in place. For the part, our drug store operations in Mexico also performed well on a topline basis, allowing us to continue investing heavily in the integration of our single operating platform for the Mexican operations.

And in South America, we continue to run ahead of our base case, expanding our store count both organically and through a small bolt-on acquisition in Colombia. Finally, the fuel division saw some sequential and year-on improvements in profitability, largely driven by higher prices in the Mexican market even as we continue with our sustained expansion strategy and with the rebranding of our existing stations into the new OXXO GAS image.

For its part, Coca-Cola FEMSA's again achieved growth in Mexico as well as pricing and share gains in several key markets. However, consumer environment remained generally tough in South America, where we also have certain market specific to locations, as well as high sugar prices in most operations. So, while execution has been strong across territories, we are still facing some headwinds in the region.

Moving on to discuss our consolidated quarterly numbers. Total revenues during the third quarter increased 27.4% and income from operations increased 9.3%.

On organic basis, total revenues increased 14% and income from operations increased 3.8%, reflecting margin contractions in several operations, particularly in Coca-Cola FEMSA South America, as well as the incorporation of lower-margin operations into FEMSA Comercio's Health. For the third quarter, the line labeled participation in Heineken results with FEMSA's actual 20% participation in Heineken's third quarter net income, which was reported last Wednesday using the average exchange rate for the euro during the period.

Staying on the subject of net income, we note that it increased 13.9% in the third quarter, reflecting an easy comparison versus the same period of last year, when net income contracted almost 10%. During the quarter, we also benefited from higher income from operations and from an increase in FEMSA's 20% participation in Heineken's results as well as from a lower tax rate.

Our effective tax rate was 21.9% for the third quarter -- for the quarter, reflecting a lower effective rate at quarter-quarter assumption and certain tax efficiencies at FEMSA. In terms of our consolidated net debt position, during the third quarter, it increased by MXN4.6 billion compared to the previous quarter to reach MXN58.9 billion at the end of September, mostly reflecting a reduction in net debt of Coca-Cola FEMSA and increase in cash levels at both FEMSA and Coca-Cola FEMSA.

Moving on to discuss our operations and beginning with FEMSA Comercio Retail, we opened 234 net new OXXO stores for the quarter, reaching 1,154 net store openings for the last 12 months. Revenues increased 4.3%. OXXO, same-store sales were up 5.7%, driven by a 6.4% increase in average customer ticket and small decrease of 0.6% in store traffic. This increase came on top of a very tough comparison base of 9% growth a year ago.

On the subject of traffic, we again saw an impact from the ongoing reduction in the price of prepaid cell phone minutes. However, and that has been the case recently, the growth of the service category and particularly that of financial services continued to help us offset the revenue and traffic losses from telephony. In fact -- and as was also the case in the second quarter, if we isolate the telephony category and remove it from our results, we continue to see healthy low single-digit growth in overall profit.

Moving down the P&L. For the third quarter gross margin expanded 80 basis points. This expansion mainly reflects healthy trends in our commercial income activity and a sustained growth of the service category, including income from financial services.

In terms of operating margin, this quarter the retail division posted a contraction of 50 basis points, reflecting the tough comparison base in the third quarter 2015 when operating margin expanded 70 basis points, reflecting the added benefit of low electricity tariffs last year and the strengthening of OXXO's organizational structure to maintain the fast pace of growth.

In fact, if we compare the operating margin for this third quarter against the comparable periods of two years ago, that is third quarter 2014, we see that the margin is expanding within our long-term expected range of between 10 basis points to 20 basis points per year.

Moving on to FEMSA Commercio's Health Division. During the quarter, we added 67 drugstores to reach 2,101 units across our territories at the end of September, including a small bolt-on acquisition in Colombia. On an organic basis, revenues increased 10.7%, driven by the continued store expansion across markets in Mexico, but dampened by the softness in certain territories in the Southeast as well as by the longer maturation curve of new stores we opened in the new regions like Veracruz and Mexico City, where our brand is not yet well known.

Gross margin expanded 540 basis points, driven by the contribution of Socofar, which has structurally higher gross margins than the Mexican operations. Operating margin expanded by 80 basis points in the third quarter, also reflecting higher margins at Socofar. This higher level of profitability more than offset higher expenses in Mexico as we continue to build infrastructure and prepare for further growth while we integrate our four negative drug store operations into a single platform in Mexico.

On organic basis, income from operations decreased 86.3%, reflecting the significant initiatives we are carrying out in Mexico as I just described.

Finally, FEMSA Commercio Fuel added 13 gas stations during the third quarter added 13 gas stations during the third quarter to reach 248 units at the end of September and 75 net new service stations for the last 12 months.

Same-station sales were up a healthy 10.3% for the third quarter, as average volume increased 10.3% in liters while the average price per liter increased 2.8%, driven by the national price increases instituted during the third quarter. Gross margin expanded by 40 basis points, reflecting the benefit of price increases on existing inventory, as well as higher operating leverage. Operating expenses increased slightly above revenues as we continue to build the infrastructure required to drive further expansion. Nevertheless, operating margin expanded 20 basis points to 1.2% of revenues, mainly driven by the national price increases as described above.

Moving on briefly to Coca-Cola FEMSA. Topline increased 12.5% during the third quarter and Mexico delivered growth in transactions, volumes and pricing. We saw value share gains in many markets, driven by continued focus on price. However, volumes were weak in South America, reflecting tough macroeconomic -- macro environments as well as certain operational disruptions in Argentina and the shortage of sugar in Venezuela.

Reduced operating leverage combined with the various exchange rate trends and the high price of some raw materials -- I'm sorry, we have reduced operating leverage combined with various exchange rate trends and the high price of some raw materials, particularly sugar putting meaningful pressure on profitability in that region. So, stronger execution is helping Coca-Cola FEMSA navigate these challenging environments, but there is more work ahead. If you were unable to participate in the conference call earlier this week, you can access a replay of the webcast for additional details on the results.

As we head into the last months of the year, we'll continue to face tough comparisons in Mexico and conditions for Coca-Cola FEMSA will probably remain challenging in some South American markets in the short term. But we feel cautiously optimistic about the outlook for 2017 and we will redouble our efforts to perform against our high expectations.

Now, let me turn it over to Juan for a moment.

Hi, everyone, just a quick reminder that we will take just one question per caller. As you know, this has worked well in the last couple of calls and we'd like to make it permanent. So, thank you for that, and let's open the call for questions. Operator, please.

(Operator Instructions) Lauren Torres, UBS.

We continue to see some very impressive same-store sales growth at OXXO. So, I guess my one question is related to Mexico and the momentum behind this number. You mentioned tougher comps, but just curious to get your perspective on consumer environment, the ability to sustain these types of numbers, how you're driving these higher average ticket sales. And that would be it, I guess. Thanks.

We have the -- Mexico really is leading through a very particular stage, where we see the consumer environment is still strong. And on the other hand, there are some macroeconomic variables that are putting some pressure on the macroeconomic conditions in Mexico.

But there is full employment in Mexico and I think -- and that figures which is the Mexican Union for all these -- the modern trades and retailers in Mexico. They are also reporting good figures. Although, our figures are better than them. I would say that the inclusion of our sales in different locations is also helping us to perform well and I think we are gaining share in some of those locations within the Mexican market.

And I think having those six consumer locations that we manage and being focused and very much disciplined that part of the OXXO value proposition is linked to those six consumer locations and I think that discipline has kept us little by little gaining share and gaining better approval really from the consumer. I don't know if you want to add anything, Juan?

Yes, I think there is (inaudible), there is a sentiment issue, which maybe has begun to turn a little bit. I mean as Eduardo was saying, the actual variables if you look at employment, if you look at inflation, if you look at obviously the remittances coming in, which in local currency have been growing even faster because of the weaker peso. There are a lot of conditions in place for a very healthy consumer. But we -- actually we were expecting for the second half of this year for a slowdown, which has not yet materialized, maybe you were as well. But there's no question that there begins to be some pressures on the inflation front. We have had very little pass through, as you know, in terms of the devaluation. But electricity costs are starting to trend up and I think we are a little bit cautious going forward that the government, as you know, is tightening its own belt somewhat to adjust for external shocks.

So we need to be cautious, but the truth is that on the ground right now things continue to be quite strong, and as Eduardo said, the initiative that we have in the store, the financial services, the daily and replenishment categories, which continue to grow very well, introduction of new products and the remittances initiative that we now have going on, the fact that we brought more partners on the correspondent banking. There is just always stuff going on, prepared food, getting a little bit more traction, all of that helps keep the same-store sales number up.

Maintaining this mid-single-digit or mid-single-digit same-store sales growth target that you've spoken about in the past is sustainable in light of a potential slowdown?

Yes, I think that the mid-single digit range is in place. Yes, it should be.

Antonio Hernandez, Barclays.

My question is regarding the proportion of drugstores and also the OXXO GAS that have been consolidating their operating platforms and the rebranding in terms of OXXO GAS. Thanks.

In terms of drugstores, we are -- first we have to -- we are really coming up with four drugstores chains in Mexico, and in order to benefit and to gain scale and improve our leverage with suppliers, and in terms of operations, we are designing and we are installing a common platform for the whole -- for those four chains and that platform would be identical. Since these four chains were acquired from different owners, the platforms were completely different. What we take is we pick the one that fits better and we are really improving it and that improved platform is going to be installed in all the three chains.

Also the branding is an issue and we are in the process of defining our branding for next year. And basically what we're seeing is that although these chains have strong local branding, they don't -- they are not very well known outside their local environment. So, what we are trying to consolidate is come up with one single brand and we will try to find a way to support the local brands, and at the same time, enhance this new brand that will cover up all these new operations, in a way we will pretend in the medium and long term to have only one brand.

And I think the same is happening with OXXO Gas. In OXXO Gas there was -- sometime before the energy reform, it was very difficult to support branding in Mexico, because Phoenix regulations didn't allow us many degrees of freedom to come up with a strong brand proposal. But we found -- even that -- when we had those requisites, we found our way to position our brand and to position our brand in a better way. What we are doing now is really remodeling the gas stations and focus and enhance the brand even more and now the consumer would have no doubt that that a particular service station is an OXXO Gas brand and really the consumer feedback we are getting from our users, they are very happy, the brand is, I think, I would say, the most, how to say, reputable brand in Mexico and we're really making -- leveraging ourselves in that brand growing regionally, because that brand is very well known in some local markets. And by growing organically in those local markets, I think we are leveraging the brand even more. So, those two things combined, local expansion plus the new imagery in the service stations are really enhancing our market position in the markets where we are currently operating.

Yes, just to finalize the start on the gas stations, we are -- right now, we have about seven or eight that have been converted or really where you see the new branding, the new image. It is not a new brand, because it's always been OXXO Gas, but the new caller scheme and getting rid of the old PEMEX signage and the objective is still to have 50 of them done by the end of the year, mostly in and around Monterrey.

Jeronimo de Guzman, Morgan Stanley.

I had a follow-up question on the pharmacies. When I look at the organic trends, I get into around the 2% EBITDA margin for the, I guess, it's for the Mexico pharmacies in the quarter. So, this is, I guess, below what we had seen last year, but also below what we've seen in the first half. So, I just wanted to get a better understanding of what is driving the margin weaker? Is this kind of third quarter where you intensified a lot of these restructuring efforts and how should we think about the margin going forward?

Yes, thanks for the question. Basically, as we said, there is a general incremental expense, because we're investing in these new platforms for the new chain for the medium and long term. And this is going directly to the income statement. But the second thing really is the new store expansion, it's been stores in some South Eastern states, where the economy is not doing very well, because those states were used to rely very much on the oil income for their growth.

And secondly, our brand is not as well-known as some of the competing brands in those places and those new stores in those regions in Veracruz and Tabasco, they are really -- the maturity curve for -- the maturation curve for those new openings, it is taking and I agree with you, longer than expected. And what we're really doing is, how to be more cautiously opening stores in those places, although we want to keep growing. And at the same time, how to speed up the pace for the new platform being installed, so we will be ending this investment probably by, I don't know, third quarter next year.

I think one thing to keep in mind, Jeronimo, I mean growing the way that we're growing organically through opening new drugstores in places like Veracruz and more recently Mexico City. We already have about a dozen of them in Mexico City. It's very inexpensive, but the flip side of that is that it does take a while for those stores to become well-known and to get up to speed. I think this is the difference between the gas business and the drug store business, because obviously in the gas business, the OXXO brand is very well-known all across the country, whereas in the drug store space, if you're opening [ESAP] brand in drugstores in Mexico City, which is what we're doing, it's going to be a while before we can build the reputation on good value proposition and good execution. So, I think to Eduardo's point, we are seeing (inaudible) basically in the Southeast of the country and Veracruz, Tabasco, Campeche, those are all very oil-dependent parts of the country and we are seeing some weakness related from the efforts that PEMEX itself is doing to reduce its own cost base. But there is a couple of things going on here. The effort to integrate the platforms and put the ERP and all the systems in place, that should take us a few more months.

But the actual rolling out new drugstores into parts of Mexico, where we don't have a presence, that would probably go on for longer. And we're going to have that situation where it takes the stores a little bit longer to get to where they need to get and therefore to get the operating leverage.

So, it's kind of the trade-off of growing organically with a new brand for all practical purposes as opposed to making acquisitions, which right now as you know we've made some acquisitions, but there aren't that many assets to acquire.

And also, I think the accountants do not help us, because all these losses that go into these new stores, they go directly to income statement, whereas when you buy running operation, all this new goodwill, which is the fact that you go -- that we pay above the cost of really the drugstore itself goes directly to the asset base. And I think in the long run, I think it's better off to grow -- to come up with organic growth, although it will reflect some losses at the beginning in the income statement from these new stores that we're opening.

Just one clarification. You said you will end the investments -- these investments should continue until third quarter next year, you are meaning some of these investments on opening in new regions, because I assume the integration (multiple speakers).

No. I'm sorry, I was talking about the new platform investment and I think we will have all these stores being converted by third quarter next year.

(multiple speakers) which one is in the next couple of months, I guess that's where I'm not sure, kind of which ends in the next couple of months and then what continues.

No. I mean I think it is stages, it is not that you finish in a single day the whole thing. But it's definitely 2017, we will be done with the integration,

But I would say by the end of this year, Northwest will be completely done and then Southeast will be done by the first semester next year.

Luca Cipiccia, Goldman Sachs.

Actually wanted to follow up on the discussion about the drug store and the pharmacy. Just to clarify, should we read -- should we interpret that [ESA] will be the model that you're -- the brand that you're going to roll out nationally, I don't know if you already commented on this, but if you can clarify? And when you were talking about the conversion by the end of next year, does that relate to the back-end, the infrastructure or also sort of the more unified (inaudible) and format? And with the stores that you're opening now in territories where you are not present, Mexico City in the North and so on, what is -- can you remind us what is the size, the mix, the ideal type of positioning that you are pursuing, and if you're going to do that under the [ESA] brand or some other format? Thank you.

Okay. Well, you cannot see my face, but you were telling if ESA was going to be the brand, I just would smile but I cannot say anything more.

We didn't want to wait. Look, until we were finished with a whole brand analysis, we didn't want to wait before starting to open stores in Puebla and in Mexico City. And so that's the brand that we're using. The decision on what the national brand is going to be is not 100% finalized.

But there will be some re-imagery installed and I think I don't have exactly when, but I think it will be by the end of this quarter or the beginning of next quarter in the next year, where there will be new stores being opened with the new imagery.

I think it's first quarter of next year.

First quarter of next year, yes.

We know you like names that are short and that of [main], so that's like--

With some consonants in them.

Yes. But I think we should be very cautious, because the current brands that we have are very strong locally wherever they are placed, that will be very subtle.

Yes. There are -- some of the Northwest brands, it's going to take a while to evolve them into a different brand, because they are very, very strong (multiple speakers)

We have to be very cautious.

The other parts of your question, Lucas, you were saying on the integration, what was your--?

And then on the new openings that you're doing, just to remind us what is it. I would assume you're starting with your idea of size, mix and type of format. So, if you can remind us what type of variability you're using between one location relative to the other (multiple speakers)?

Our stores are -- will be like 700 square feet, 800 square feet --

800 square feet.

800 square feet and we have a good variety on the fore and at the back of the store. So, medicines prescription and over-the-counter probably will represent two-thirds of the mix. And then you have health and beauty with maybe 20%, 30% and just a little bit of front end, soft drinks and the type of things that you would find in an OXXO. So, definitely a format where you have an opportunity to drive the health and beauty parts of the equation, which up until now in Mexico the supermarkets are really the place where people buy cosmetics and shampoos and mascara and things like that.

So we want to drive that in a way taking a page from the Brazilian proposition, where obviously the drugstores are the place where these things are bought and sold. But to have a significant two-thirds, almost two-thirds of the mix be medicines and within that mix to drive the generics component up from a very, very low base where it is today.

But we have to -- we want to install our platform very much based on convenience. And we know convenience works and we think convenience could be enhanced very much in the drugstore environment.

Convenience and proximity, right. I mean, having small outlets near where the consumers are.

I don't want to get -- too long on this, but just to conclude on the topic. When you say finished by end of next year or third quarter of next year some of these processes, what does it mean in terms of control of the distribution centers, relationship with wholesale and is that something also that you see more achievable by then. And then in terms of pace of expansion, I remember you were guiding for 20% or so, if I'm correct, in Mexico. Maybe if you can just give an update if that is still the type of pace expansion that we should look for for drugstores? And that's it from my side.

Yes, without doubt, all the logistics and distribution will be also enhancing for the drugstore operation. Currently, the companies we bought didn't have strong warehousing or strong distribution capabilities. And I think those capabilities are being installed in the Northwest and the Southeast too. And I think, yes, little by little, that part of the thing that by hiring a new platform, that communicates very much well with merchandising and with the warehouse management systems, that is something that we would love to have installed, so we can enhance the operations and enhance the leverage. So, we are having our own distribution capabilities for our own drugstores.

And with a little over 1,000 units now in Mexico, gradually we're being able to have more direct dialogs with the pharma companies and in a way gives a little bit our reliance on the wholesalers and third party. So definitely, I think that's something that's going to happen in parallel. We will be more self-sufficient in distribution. And in terms of the organic growth, yes, it should be somewhere between 15% and 20% in terms of new stores. Right now, we're probably running around 15% in terms of new stores.

Robert Ford, Bank of America.

Eduardo and Juan, I realize there is some ambiguity, but I was hoping you might be able to talk about some of the regulatory developments and possibly your outlook around the detail in the liberalization of the gasoline trade as it relates to Mexico. And what the implications might be for OXXO Gas?

Well, I think the Mexican authorities are liberalizing the price of gasoline, and I think before I think the liberalization was going to be installed in 2018 and I think they are coming back to it around 2017. There will be some regulations installed and we just have to understand better how to cope with them. And -- but yes, what we understand now, the current Mexican price of gasoline, if you deduct the tax [enrollment] within the gasoline, currently I will say that the price of gasoline in Mexico is cheaper. If you take the net, the tax effect is cheaper than it is in Texas if you take the taxes also out.

So, I think the Mexican authorities have tried a way to reduce the subsidy that really is going through the PEMEX operation and they will rather have the blame if prices go up to somebody else. But I don't know really if that is something that we -- within this new environment, we don't know this environment of price liberalization. In OXXO Gas, we have the help of couple guys that went through all this experience and they very much know what happened of the liberalization of gasoline in South America. And they're very strong and they are very good consultants for us and we are incorporating within the OXXO Gas staff people that have lived through all these experiences. And I think that particular thing is something that we have to learn. We have to be very cautious, because margins are so low that we cannot absorb any of these fluctuations, and I think in the meantime really what we're doing is getting to understand these better and be prepared whenever it comes. I don't know if you want to add anything, Juan?

Yes. I think as you said Bob, and Eduardo confirmed that there is still some ambiguity in terms of is this something that will take place in 2017 or do they stick to the original plan and keep it in 2018. But the expectation when you look at the price and to Eduardo's comment, it does look like, right now, there is a subsidy in place.

Because of the exchange rate. I think the exchange rate also will effect.

And because there was a cap on what the price could be and obviously during the third quarter, PEMEX raised the price to the consumer a couple of times during the quarter and basically hit that cap. But once this year is over, we believe there is a chance that the prices are going to keep crawling up to reduce that subsidy that right now the government is kind of paying for.

So at least in the short to medium-term, it does look like the trend is slightly up, which is the better alternative from our standpoint, because as you've seen and you saw this quarter, small increments in price translate into good things in our P&L. But the broader question I think we're still missing some answers in terms of exactly how this is going to pan out.

And in the meantime, what we're trying to do, as you know, is keep scaling up, keep opening more stores, transform our stations, learn about the last mile distribution, and we're ready to be a strong player when the dust kind of settles.

So when do you expect to see some better visibility when it comes to transfer pricing or leasing agreements for some of the upstream infrastructure? And as you mentioned, does it -- what are the implications for you as you start to roll out a little bit more of that last mile?

I wish it could answer this better. But I think we have been approached by PEMEX and also we've been approached by some other people outside of Mexico in order to align or be partners with them, and they're still not very much -- it is not still very well communicated, how the PEMEX infrastructure, is it going to be shared, is it going to be particular for PEMEX, those things really because there is no infrastructure in Mexico, but the one that PEMEX has. So that will be a major advantage or disadvantage for the players.

And still we don't know exactly how well visible, but I think we are very much well prepared compared to many of our competitors in Mexico to cope with this. And this anxiety that you share with us, we do have it. And with this anxiety we'll have those two years to be very much prepared and be ready when it comes alive.

I think we've covered some ground in terms of understanding the different parts of the stream and of course, as you said, we're already, somewhat involved in even testing. We already have some trucks on the streets of Monterrey delivering gas more or less as we speak, understanding what the cost savings from doing that part of it ourselves as opposed to the unions, which, of course, play a big role in the cost structure of PEMEX. When we've looked at the storage infrastructure and the pipeline infrastructure, there is some excess capacity there. And it's not completely clear who will be the players. I mean, obviously, there are a number of people that have looked at this and I'm sure are crunching the numbers right now, but what we believe also is that in either of the states of the world, whether it remains for a while with just PEMEX or eventually, you have a second provider of midstream capacity that if you become the largest player and you're an ordinary player that plays by the rules, that pays taxes, you're an attractive partner for whoever is doing the midstream and the upstream. So even in the current status quo where PEMEX is the only game in town in the upstream and the midstream, we believe -- and to Eduardo's comment about conversations that have taken place, we believe we would be in a position to have an attractive partnership with whoever is in charge.

And I think OXXO got image, been such a strong image within the consumer, we really become a very attractive partner to be aligned with, because I think the values and promise that we do give to the consumer are very much aligned with some of these transnational oil companies that are around.

And you operate in a way that brings discipline to the marketplace, and all of those things, I think, are positives whoever you end up partnering with.

And given this ambiguity, is there any reason for you to consider not expanding your last mile distribution to the entire chain as long as the densities of a given market justify?

So, it's going to take us a while. I think you're right. But right now, we're just testing a portion of Monterrey where we have very good densities, and you're beginning to get the economics kind of cleared up for us in that sense. So right now, I think we're fine. Another element to consider in terms of our own business is that we are investing very little CapEx, right? I mean, as you know, we are leasing the gas stations themselves, and we only have 20 trucks right now driving around. So it's a very small controlled pilot in the greater scheme of things. And we can adjust, right? I mean, we can adjust either way based on our findings.

That was very helpful. Thank you very much.

Alex Robarts, Citi.

I was keen to go back to the health business. And I appreciate the granularity you're giving us around timeline and initiatives with the integration process. The one element that I was keen to ask about of this integration process relates to the direct purchasing from the drug manufacturers. You've mentioned that, that process has begun in Mexico, and I was keen to kind of hear a little bit more about your thoughts on how that is going to ramp up the timing. We understand that Nadro has had some issues, the fill rates going into some of our supermarkets that we cover are complaining, wondering if you're seeing some of this as well? And might that spur you to try to accelerate the direct purchasing? And finally, kind of the last bit of this question is do you think with [Logistica] and the excess space that you get or have with the DCs of OXXO that we could get to a meaningful number of direct purchases in your supply around health by next year? Thanks.

Well, yes, we are, as I said before, really a major task that we are trying to solve is how to leverage ourselves in logistics and distribution. And we do see a major opportunity and being these for a small chains together, they have the scale and the potential to come up with better terms and better variety for the stores.

And I think, generally, we've been operating these stores independently and the very first thing that we try to put together where the merchandisers but little by little by not having the same system, it is difficult to install the same merchandising platform for these to -- for a change. So, that's why I insist that the IT platform and the processes installed, the common process will be the major enabler to come up with all these potential threats that you see or opportunities that you are mentioning in the Mexican market.

Yes, it would take time and the link it with OXXO, I think the link it with OXXO is more informal, the merchandisers talk to each other and they do communicate, but it will be very difficult to leverage the drugstore operations from the OXXO platform. I think there are things to be learned, things to be shared, but I think its complexity will be so high that I think the benefits of scale or the benefits of having this platform together will be -- cannot be compensated by the complexity of trying to put things together.

I think what we're trying to promote is really the merchandisers to speak to each other. Whenever you have these annual gatherings of merchandisers for OXXO, obviously the OXXO people are invited and they go to the same [fare] of suppliers, but I think really what we try to do is to -- and we try to duplicate all these personal involvements within -- among teams. But it will be very difficult to use and to share the logistics for the merchandising platform.

I think just to remember Alex, the number of SKUs is maybe as much as four times larger in the case of drugstores, you're talking about maybe 10,000 SKUs, you're talking about more frequent visits to the store. Basically, it has to be done on a daily basis for many of these SKUs. You're doing it with smaller vehicles.

So, certainly there is some cross-fertilization, I mean some of the people that are involved in logistics on the pharma side came from OXXO or other parts of the Company. And so there is knowledge that is shared and to Eduardo's point, there is a lot of communication between the two teams.

But in terms of the actual physical space or the actual sharing of the trucks, that's something that's going to be really, really hard to do. So probably it won't really take place in any major way.

Now, that's clear. But I mean, I guess with 1,000, right, drugstores, you are able to go and say to a drug manufacturer, look, I'd like to start engaging in some purchase arrangements and that was kind of the other piece of the question, I feel and how is that going? In other countries, we see levels of 50%-plus direct purchasing happening with --?

Yes. We're really aiming for the same -- for those levels.

Got it.

I was going to say if you look at the other big competitors in the industry that is basically three large operators, each of which have a little bit more than 1,000 stores and all of them have their own distribution platform. That's definitely the aspiration, Alex. And of course, that has margin implications, because if you wean yourself from the third parties in any significant way, that's going to represent quite a bit of pick-up for your margin.

Sure. And just the 1.1% organic same-store sales growth here in Mexico with the drugstores. There wasn't an issue with supply and field rates or --?

No, that has a lot more to do with what we were mentioning on the Southeast. We do have a lot of stores in the Southeast, both the legacy stores that were already in places like Campeche, Tabasco from the ESA brand as well as some of the Veracruz stores that are -- I mean they are new, but some of them have been around for more than a year. And definitely that part of the country and those regions where our brand is new aren't growing as fast as other parts of the country.

And also I would add that our competitors are reacting really. They are reacting probably the way we are getting, probably they didn't take us as seriously as they are now taking us now. But we're accustomed to that.

Yes, we're used to that.

Jose Yordan, Deutsche Bank.

I just wanted to clarify the comments about all the integration expenses and all that at the health division, because looking back at my notes for the second quarter and delving into the reasons why pro forma EBIT was going down 40% at the time. I think you had mentioned that all these integration expenses would be over by the fourth quarter of this year. And what I'm hearing now is third quarter of 2017, so the question is, what changed? Has the amount changed or just the time it takes to get the integration done or both?

No, I agree with you. The major investment will take place this year. Although, there will be some others being done the next year, because it will be installment more and less development. This year has been development and installment of the new platform with the companies and the stores. So, I think basically I would say that we are thinking within the same terms.

Yes, I think the bulk of it or maybe the way to think about it is, it's kind of gradually tapering off. As we head towards the end of this year, that would be heavier spending, and then next year, it's more deployment and rollout.

So, the actual amount you needed to spend hasn't really changed. It was just that --?

Yes, no it hasn't changed (multiple speaker)

Pedro Leduc, JPMorgan Chase.

And the question on FEMSA Comercio retail division itself, very nice gross margin expansion this quarter and on services et cetera, but also little bit on the SG&A back [investors], there is tough comps from last year et cetera, but is this somewhat related to the gross margin gain with the SG&A, meaning that you are needing to invest in order to get those services up and running. And if so, is there like a penetration at the store level that you are already using these services, and then if we can expect at least for the full year to retain the usual 20 bps, 30 bps of EBITDA margin expansion at the retail level? Thank you.

Yes, I think nothing really changed, Pedro, in terms of the expectations. If you look, this was a strange quarter in a couple of places where you had either a very tough or very easy comparisons when you look at the consolidated numbers. We were talking about net income for example, right. So, we -- more than usual, we actually look at the two-year stack to isolate these ups and downs and definitely the expectation that we can do 10 basis points or 20 basis points at the operating level is very much in place. I don't think there's anything related to the services category in terms of having to spend more to capture any of their benefits. In fact, it's -- we've added a couple of banks that we were missing in the last few months.

And also we have -- another major investment who are making with us was Western Union and now it's being [stolen].

Right. Yes, we launched the remittances product nationwide and these are not things that represent a lot of CapEx necessarily, basically a lot of negotiation and a little bit of hardware here and there. But--

Well, I would add that there is some software development that is not very costly, but is very complex.

Yes, and it takes a while --

It takes a while.

But most of that is done at this point.

Yes.

So now, I mean, obviously, we worry a little bit about electricity costs because we are moving into a period where that is going to go up, and I think just generally, we have to keep an eye on inflation, right? And as of right now, our suppliers haven't taken prices up a lot. Our own inflation has behaved more or less in line with general inflation, but that might change, right? And it will also depend on whether or not there is a little bit more pass through of the devaluation, although for our mix, that's usually not a very big component as opposed to the bigger box players, which have more imported goods in their mix. But now, the long-term expectation of the 10 bps or 20 bps margin at the operating level and the EBITDA level are very much in place. No change there.

Gabriel Lima, Bradesco.

Coming back to the health division, it's getting very relevant sector here for you, and if you have any comments on the same-store sales? I know you made some comments at the beginning of your call, but more clarity of what happened this quarter, it was running at high-single digits in the first half of the year. Now, you came with a low single. So you mentioned some deceleration in the Southeastern markets. So, I just wanted to understand the dynamics here? Not only in the third quarter, but what are you looking for next year given that it's been quite volatile and you guys are working in this segment, but it's been running the same-store sales pretty independently from the Comercio division. So comments on the same-store sales on the health division will be welcomed. Thank you.

I think what you mentioned really is the Mexican operation and yes, I don't know --.

Remember, Gabriel, hi --.

But I would love to speak about that. You haven't asked yet, but since you haven't asked, I will tell how good we're performing in our Chilean operation. We're gaining share and --

Yes. Now, that's a very valid point. I mean, the two things are separate, but we might as well make the comment that South America is actually performing ahead of plan. But in Mexico, remember that the first several quarters and maybe even the first year, year-and-a-half since we entered the drugstore space in Southeast Mexico, we talked about some low-hanging fruit being available and some relatively easy improvements to the value proposition and some of the chains that we were acquiring, and I think that helped us drive same-store sales like the 10% that you described, right, way above inflation and way above what we were doing on the retail front. I think gradually, you begin to run out of this low hanging fruit, and you get into more of kind of a steady state pace. But we do have, and I think we cannot trivialize the two things that we mentioned earlier. I mean, the fact that we do skew to the Southeast of the country, which just -- even without having PEMEX going through some issues, the Southeast is definitely underperforming the North, and we see that when I look at the regional performance of the OXXO stores. The North probably outgrows the South by 5 or 6 percentage points. So it's not trivial.

But there is this other comment, which I think is secondary, but not irrelevant, that we are showing up in places where the competition is heating up, and some of the large incumbents are seeing us come along, and they're going to fight a little bit for their turf. But that's just [par for] the course. It's not something that we did not expect. And I think if you are thinking of how to model this, long-term, I would also think about a mid-single digit same-store sale growth rate. We're not there right this minute, but I think that's the number I would put it to my own model.

Alvaro Garcia, BTG.

My question is on OXXO and then store openings in OXXO. I mean, when we look at the last 12 months trend, they're firmly in place, and I was just wondering if you could provide an update on what you view as the market-holding capacity for OXXOs in Mexico and if you're experiencing a tougher time getting them opened recently? Thank you.

Basically, I think we are the ones responsible for -- I mean, the more we can add value to the value proposition, the more stores we can operate everywhere in Mexico. So, if we keep enhancing these value propositions, there will be better margins at the store level, better places where we can set up this store. And I think really -- I would say that we can -- I don't know, we can keep growing like this for, I don't know, eight years or so because we are ourselves the ones that will be limiting our own expansion. And even though it sounds not very nice, but I think it is true. If we keep -- the more we can enhance the value proposition the more it will be for us to open up new stores. If we can be very good in daily replenishments and daily reposition and pantry replenishment for the housewives, the more options we could install everywhere. And I think it has to be -- so, in a way, we are the ones that are limiting our own expansion. And so, the more we can enhance the value proposition by new services, by new merchandise and by tackling very well those six consumer locations, the better will be to open up stores everywhere in Mexico. We are installing some stores in some manufacturing plants, we're installing some stores in some office facilities, and these are places where before we wouldn't even dream to have a store, but now, because we have been able to be flexible enough to adjust the value proposition to those particular needs of those particular places, that is something that really is enhancing our possibilities to opening up stores in places that before we didn't dream of having a store. So I think we are the ones responsible for expanding the possibilities of having new stores everywhere in the Mexican territory.

Eduardo already mentioned these, what we're calling, niche stores that we're being able to open in non-traditional locations where you maybe adjust, maybe you don't sell beer if you have a store inside a manufacturing plant, maybe you don't sell cigarettes if you're inside a hospital. But the stores are able to drive very healthy economics. And we believe there are few 1,000 of these stores that we could eventually have. I mean, if you're talking about a 10-year timeframe, another thing to consider, if you just look at the strong GDP growth somewhere between 2% and 3% and population growth the way it's moving, that probably accounts for a good 5,000 stores that we could open in that timeframe.

And then the one that we keep going back to which is Central and Western Mexico are so under-penetrated relative to the north of the country. The ratio, if you compare the value of Mexico versus the border cities, is basically 6:1. So clearly, there are several thousand stores that we could open in the valley of Mexico and not get to a level of penetration that we have, never mind the border cities, but even here in Monterrey. So I would say the level of confidence that our team has in being able to keep adding 1,200 stores per year is very, very high.

It's a very clear answer, and you guys have definitely done a very impressive job of driving new location and it's almost as if every time we talk to you that timeframe continues to grow, right. So, great stuff, very clear. Thank you.

At this time, I'd like to turn it back to Eduardo Padilla for closing remarks.

Well, thanks very much for all your attendance, and thanks for the questions, and thanks for the interest. And have a great weekend.

Have a good weekend guys. Thank you.

Bye, now.

That concludes today's conference. We thank you for your participation. You may now disconnect.