Big dog learns new tricks: Mexican soft-drink king FEMSA is bigger than ever. So why worry about a tiny Peruvian cola maker?

In Latin America's tough soft-drinks industry, size matters, and Fomento Empresarial Mexicano (FEMSA) has just grown bigger. In May, the Monterrey-based group completed a US$2.7 billion acquisition of Pan-American Beverages (Panamco), the largest-ever international takeover by a Mexican company. The buy turns FEMSA into the second largest Coca-Cola bottler in the world after Coke's Atlanta headquarters, with franchises in nine countries including Mexico, Brazil, Argentina, Venezuela, Colombia, and most of Central America.

One out of every tell Cokes sold worldwide every day rolls out of a FEMSA bottling plant. In Latin America, the ratio is one out of every three. The company sells a staggering 29 million liters of soft drinks a day to 167 million people throughout the region. FEMSA, which also has interests in beer and convenience stores, posts estimated annual sales of $4.6 billion. The 113-year-old company, CEO Jose Antonio Fernandez points out, has cranked up operating income by an average of 15.5% each year over the last decade. According to the LATIN TRADE Consensus Forecast, FEMSA's income will rise by more than 80% in 2003 on the Panamco purchase and more than 16% in 2004.

But size and experience, together with Coke, one of the world's best-known brands, doesn't make a company immune to competition. Take the heartland market of Mexico City, where in the historic downtown area, a small drinks and candy shop recently started selling something called Big Cola. Better-known brands like Coke and Pepsi are heavily marketed and delivered through state-of-the-art, computer-controlled distribution systems; to get Big Cola, a store owner would have to drive out in his own vehicle and pick up a few cases from a warehouse in Iztapalapa.

Big Cola is a classic upstart, the product of a Peruvian company that quietly began its Mexican invasion less than two years ago through Puebla and Guadalajara and just now has reached the capital. With almost no marketing or distribution budget, Big Cola gained an edge by introducing a slightly larger, 2.5 liter bottle--popular with families--and slashing the price to as little as $0.84, versus as much as $1.47 charged for smaller, 2-liter units sold by market leaders Coke and Pepsi. Using that tack, Big Cola has taken a 6% market share. But Jose Antonio Martinez, an equity analyst at Interacciones Casa de Bolsa, says Big is unlikely to gain much more ground after this guerrilla attack. "It will be very hard for them to maintain those prices in view of their costs and the need to invest in distribution," he says.

What the Big Cola story does show is how agile FEMSA can be, despite its size. The Coke bottler is known for its constant market research and willingness to change the way its drinks are packaged and presented. The company claims, for example, that it already had been working on its own plans to launch a 2.5-liter family-sized product in a returnable plastic bottle at the same price it used to charge for a 2-liter disposable bottle, $1.17. Through initial promotional discounts it cut the price of the new bottle as low as $0.88. FEMSA launched a crash program to replace all its 2-liter bottles with 2.5 liters in the first half of 2003.

If anyone got left behind it was the other cola rival, Pepsi. "Time and again, Pepsi has paid the price in Mexico for refusing to believe that large returnable packages can play a constructive role in driving up per-capita revenues and providing an affordable package to the lowest income consumers," says Carlos Laboy, a beverages industry analyst with Bear Stearns in New York. Laboy is impressed with FEMSA's performance in its Mexican home market, as well as the successful recent launch of Ciel, the new mineral water brand. FEMSA seems to be going further in the transition from one-size-fits-all colas to true multi-brand operations. The total number of soft drink "presentations" it sells--combinations of drinks and packaging formats--is now up to 153, compared to only 54 a few years back, in keeping with marketing trends common in Japan and the United States.

Laboy bluntly describes the acquisition of Panamco, meanwhile, as "the takeover of Coke's worst-managed bottler in the world by its best operator." Martinez too is optimistic, stressing that FEMSA has the discipline, focus. and operational excellence to knock Panamco into shape. Where he is more cautious is on the management of the debt mountain that came as part of the deal: FEMSA found itself taking over $880 million worth of Panamco debts.

FEMSA's CEO remains very bullish about the future. "Our Coca-Cola business is an ideal consolidator, with a proven track record of extracting value from new franchises, impeccable performance in tough markets such as Argentina, and the infrastructure and scale to execute both large and small transactions," Fernandez says. To counter debt worries, he expects to reduce FEMSA Coca-Cola's debt levels to zero over the next six years. Carlos Salazar, head of the Coke bottling subsidiary, recently announced that his target was to cut the debt by $550 million this year, to $2.15 billion. Progress on this front is certainly what shareholders will be watching for.

Setting Sol. If there is a question in investors minds, apart from the debt issue, it's beer. For the last 10 years, FEMSA has been gradually losing market share at home to archrival Grupo Modelo, which has relentlessly pushed its Corona brand, particularly to export markets such as the United States. After being top dog for years, FEMSA is now definitely the No. 2 brewer in Mexico. It was not always like that. "Do you remember in the late 1980s, when all the trendy young professionals in London's bars were drinking FEMSA's Sol beer?" says Rupert Brandt, an analyst at Foreign & Colonial Emerging Markets in London. "Well, they threw it all away by nickel and diming their U.K. distributor. You'll have a hard time finding a Sol here now."

While acknowledging good performance in soft drinks, Brandt says he is unimpressed by FEMSA's beer story. "Every time I visit them in Mexico, and I've been doing that for the last six years, they seem to be in the midst of a management restructuring, the fruits of which are just around the corner. They seem to have management consultants in permanent employment."

Fernandez takes this kind of criticism on the chin. He has repeatedly denied that the brewing operation might be sold off. "We do not trivialize our loss of ground," he says, but argues that the company is positioning itself for a comeback in the longer term, making the changes now in beer that were earlier introduced for soft drinks, and which he says will pay off in the end.

The key, Fernandez says, is "differentiated product offerings," coming up with a tailored suite of brands and presentations: Sol in central Mexico, Tecate in 16-ounce cans for the northwest, and Indio for "young urban drinkers, the consumers of the future," while at the same Lime vigorously cutting costs and streamlining operations. FEMSA Cerveza now offers no less than 45 different products. "Almost 40% of Mexico's population is under the age of 18, and over the next decade, more than one million people will join the ranks of potential beer drinkers every year," says Fernandez.

Certainly they'll be drinking something. Barring a drastic change in the market, that something will likely have been bottled and sold by the troops at FEMSA.