Edited Transcript of LALAB.MX earnings conference call or presentation 21-Apr-20 3:00pm GMT

It’s now my pleasure to hand the call over to Mr. Celis.

——————————————————————————–

Arquímedes Adriano Celis Ordaz, Grupo Lala, S.A.B. de C.V. – Interim CEO & Lead Director [3]

——————————————————————————–

Thank you, David. Good morning, everyone, and thank you for joining us. Please move to Slide 4. I would like to start by addressing the current coronavirus situation and its impact on the countries in which LALA has a presence, with the understanding that the duration, the scope and impact are extremely difficult to predict at this time. However, we have the benefit of observing what has occurred in countries that were impacted early on, mainly China and Italy, and more recently, the United States.

Several stories of consumer spending in these countries during the first quarter made clear that the food product industry has been generally resilient and a beneficiary in certain categories. Further, our industry is, of course, considered essential by governments. Nevertheless, we will face challenges. But as a company, we will benefit from unique competitive advantages, which place us particularly well positioned and well prepared. Importantly, dairy is one of the most affordable proteins in our markets and its derivatives help support the body’s immune system. Further freshness and availability will be critical during this crisis to our performance in Mexico, ensured by the strength of LALA’s extensive refrigerated distribution network.

That said, how and to what extent COVID-19 affects the economies and consumer environments of the countries we serve remains to be seen. As in other countries, we have also seen panic shopping in our markets but consider this a temporary trend. We are confident that we can effectively address the current crisis, as I will explain based on the steps we have taken to strengthen our organization and what we know today about COVID-19 and its impact to date.

Please move to Slide 5. In the months ahead, LALA’s existing strength will afford us distinct competitive advantages based on a preliminary assessment we have made. First, LALA has a broad product portfolio, one that addresses all market segments and across demographics. More significantly, our product offering is comprised of key food staples. On the supply side of the equation, our raw milk supply remains stable and the rest of our supply chain has not been interrupted, and we maintain close contact with our clients. The full breadth of our product portfolio is available throughout our markets.

In terms of market channels, in Mexico, only 1% of our sales come from Food Service, although it accounts for 20% of our sales in Brazil. In total, only 4% of LALA’s consolidated sales are comprised of Food Service revenue. As a final point on this slide, roughly 60% of our products are chilled and the other 40% shelf-stable.

Please move the slide to review how we have been responding to COVID-19. With a risk assessment of all LALA operations, we swiftly implemented a business continuity plan throughout our operations, which includes a range of robust measures to safeguard LALA’s stakeholders and operations. As a starting point, we established in mid-March a nerve center that closely monitors developments in our markets, and which coordinates our responses accordingly. This committee is comprised of a multidisciplinary team in each region. We have undertaken a scenario planning and developed contingency plans for each of the potential scenario we have identified. These plans, as well as the measures we have already taken, are closely aligned with the COVID-19 guidelines and regulations of each country.

I will now review the key response measures we have either reinforced or implemented, starting with safety of our employees, suppliers and clients. Employees who do not require an on-site presence at our operations, are working remotely from home. And those who are particularly vulnerable due to age or pre-existing health conditions are required to stay at home. COVID-19 safety training is ongoing throughout the organization. This training includes prevention practices for both their homes and workplace.

Under our new safety measures, we have access protocols at all LALA’s facilities, and all employees are required to comply these new processes. All of these measures extend to food safety, which have long been the fabric of our organization’s culture and a compelling driver behind consumers’ preference for LALA products. In order to reinforce food safety, we have implemented a special SQF continuity protocols and systems for circumstances such as this. I would like to note here that for more than 10 years, LALA has been SQF certified, a food safety standard that is internationally recognized as well as independently audited. This includes HACCP certification of our procedures and systems, which provides another layer of assurance and control.

Please move to Slide 7. Across our production platform, our operations have continued interrupted (sic) [uninterrupted] to date. We are prioritizing high demand products and accordingly increasing critical raw materials and SKU inventories. We have also increased the number of critical temporary employment positions at LALA to ensure we keep pace with this demand. Our strength is also reflected in our ability to fund LALA’s ongoing operations as well as maintain the continuity of our growth strategy. We remain financially liquid. And as some precautionary measure, we boosted LALA’s cash position by drawing upon some of our existing credit lines.

In order to maintain liquidity, we have taken a variety of steps. We are reducing all nonessential expenses, postponing innovation launches, reinforcing our efforts to reduce working capital, and we are focusing on essential CapEx while deferring nonessential investments. We also think it’s prudent to suspend share buybacks for the time being. As a final point on LALA’s financial liquidity, I would like to point out that we do not have any significant debt maturity until 2021.

Let’s now turn to Slide 8. As some of you may know, LALA is very active in social support through our Fundación LALA charitable foundation, where emergency protocols have been activated to identify those regions and groups which are most vulnerable and require assistance. And we are directing funds and additional support accordingly. In response to COVID-19, we are reinforcing aid to seniors and retirement homes and at migrant shelters. We are also redirecting funds from student dining rooms and shelters currently not being used to grocery care package boxes for families in need, among other actions.

Please move to Slide 9 for an update on the progress we have been making against our strategic priorities. Since I assumed my role earlier this year, margin recovery in Mexico has been our primary focus. I would like to emphasize that COVID-19 has not affected our recovery efforts to date. On the contrary, it has helped us be more focused and effective. In fact, we have made significant strides in Mexico in terms of stabilizing our operations and improving profitability.

As discussed on our fourth quarter earnings call, weak demand planning previously led to costly problems. With that in mind, we have returned LALA’s corporate structure to a functional organization, one that is more effectively aligned with our operations teams. This is facilitating and speeding adjustments in demand planning, which have led to a significant reduction in product waste. Another way we are stabilizing our Mexico business is through continued reductions of unprofitable SKUs, something that is also reducing the complexity of our supply chain.

To recover margins in Mexico, we have also addressed the previous overinvestment, which resulted in a sequential reduction in OpEx for the first quarter 2020. We are reducing costs as well as complexity by rationalizing and focusing product innovation. To this end, we are reducing new product launches from 25 to 4 or 5 this year. And we have eliminated promotional limited edition in and out products, which have impacted negatively our margins by focusing too narrowly on a given demographic at a high cost. Most important, all of the initiatives I have discussed on this slide have generated a 250 basis point increase in Mexico’s EBITDA margin. That said, we recognize we still have further to go.

As I also noted on the previous earnings call, we are prioritizing the underdeveloped areas of LALA’s portfolio. We are also adjusting the pace of our execution, including scaling back the implementation of point-of-sale execution in the traditional channel in order to achieve suitable returns on our efforts to capture greater market share.

Please move to Slide 10 for an overview on the quarter’s results. Starting with the top line, our volume gains drove a 5.1% increase in branded sales on a constant currency basis. Margin contractions in Mexico and Brazil led to a 15% year-over-year decrease in our consolidated EBITDA margin, which was 9.4% for the quarter. However, as I noted earlier, we have already started recovering margins in Mexico on a sequential basis.

Lower operating profits in Mexico and Brazil led to a 53.8% decrease in net income. Negative working capital in Mexico drove a 270 basis point improvement in our working capital ratio. The margin contractions I have highlighted accounted for a leverage ratio of 3.2x, well above our target of 2.5x, which we remain committed to. Lastly, as I noted earlier, we increased our cash position more than 4x.

Please move to Slide 12. In Mexico, we benefited from volume growth in both the traditional and other channels, which drove branded sales 5.2% higher during the first quarter. The revenue growth was a combination of factors, and the spike in sales coming within the upper income demographic, which we believe is related to fears surrounding the coronavirus. Similarly, UHT sales also performed better during the quarter.

Please move to Slide 13. Our Mexico business finished the quarter with an 11% EBITDA margin, an improvement on a sequential basis but 250 basis points lower than first quarter 2019. The sequential margin improvement was driven by the operational improvements and cost-cutting measures I mentioned earlier, which have enabled us to respond to market conditions in a more timely and profitable way.

Please move to Slide 14. At our Brazil operation, we restored sales growth during the first quarter. Volumes drove a 4.9% increase in revenues. Sales growth was partially offset by the decline in Food Service revenues, which have stemmed from COVID-19. Despite the economic slowdown in this country, which continue to impact overall consumption levels, volume growth was mostly driven by UHT Milk sales and by yogurt in the Value segment, both of which resulted in an unfavorable price/mix.

Please move to Slide 15. The unfavorable price mix contributed to a 180 basis point contraction in Brazil’s EBITDA margin, which was 5.8% for the quarter. However, excluding a onetime tax benefit in the quarter, our margin was 4.3%. On the import side, the margin was also impacted by a 3.9% sequential increase in raw milk costs and a 23% increase in the price of soybean oil due to reais’ depreciation.

To address the deterioration in Brazil’s margin, we have already implemented a variety of corrective measures. At the end of the first quarter, we implemented price increases to partially offset a percentage of the margin erosion. We are also optimizing our portfolio with regard to ingredients and packaging to reduce production costs. We also expect to generate cost savings from improvements to our distribution operations by simplifying our distribution network in São Paulo, one of our most important markets. Further, as we noted on our fourth quarter 2019 discussion, additional high-margin parmesan cheese from our new storage facilities comes on stream during the month of April and will be available for sale in the quarters ahead. Lastly, we are adjusting production levels at our Food Service business.

Please move to Slide 16. At our U.S. business, we continue to maintain a strict financial discipline. While structural changes we have successfully implemented are enabling investments in profitable growth, price increase that we implemented in this market led to branded sales growth and a contraction in volumes. Nevertheless, total sales show a 1.8% decline as co-packing in the Food Service channel was impacted by COVID-19, which was compensated by panic shopping through March. We continue increasing distribution of Promised Land milk through new retailers and additional points of sale. Our 2% margin was in line with the first quarter of 2019. We executed a planned trade spending increase to reignite sales using funds generated from our continued cost discipline.

Let’s move on to Slide 17 and our review of LALA’s Central America business. Building on the strong fundamentals of this business, we delivered a 13% increase in revenues on volume growth across the region, which consisted of double-digit volume growth in our other dairy and milk categories. Although ice cream showed a strong performance during the quarter, in March, we began seeing a shift towards milk in our product mix, again, related to the current pandemic. Finally, EBITDA was in line with our breakeven plan at 0.4%.

That concludes my part of the presentation. I’ll now turn the call over to Alberto for a closer look at our performance and will return for your questions.

——————————————————————————–

Alberto A. Arellano Garcia, Grupo Lala, S.A.B. de C.V. – CFO [4]

——————————————————————————–

Good morning, everyone. Please move to Slide 19 for a look at our sales by region. A combination of volume and price increases drove total sales 5.5% higher in the first quarter in constant currency terms, with branded sales rising 5.1%. In addition to UHT volume growth, Mexico 5.2% revenue increase was driven by all other product categories, except cheese. In Brazil, volume growth within the Value segment was behind the nearly 5% increase in sales, although this adversely impacted our price mix. Growth in UHT, along with Value Yogurt and cheeses, was partially offset by the decline in Food Service sales. Brazil sales were affected by a 12% negative translation effect in consolidated figures.

Price increases in the U.S. led to a decline in volumes, as we anticipated before, although we benefit from increased panic sales in March. Sales were also impacted by the lower Food Service sales associated with our co-packing operation. In total, U.S. sales decreased 1.8% during the quarter. Strong volume growth income, particularly in the milk and yogurt categories, drove the 13% top line growth in the region, but the mix has recently shifted mostly to milk.

Please move to Slide 20, where we break down EBITDA by region. Despite sales growth and the significant progress we have made stabilizing our operations in Mexico and restoring profitability, our EBITDA margins in this business contracted 250 basis points versus last year’s quarter. As Arquímedes noted, the corrective measures we have taken continue to gain traction, and we expect additional sequential margin improvement in the following quarters.

Brazil’s margin decreased 180 basis points year-over-year due to the shift in product mix towards Value and to higher costs, including the nearly 4% increase in raw milk in the country. Despite the revenue decline, our U.S. margin was unchanged at 2% thanks to the financial discipline we have maintained all across these months in this business. Lastly, on margins, CAM remained above breakeven, supported by the strong sales in the region.

Moving to the bottom line. Please turn to Slide 21. The operating cost we have been addressing in Mexico led to a 53.8% year-over-year decline in net income, along with a lower margin in Brazil. The quarter was also impacted from higher financing costs due to an increase of MXN 63 million in exchange rate losses due to unrealized exchange rate fluctuations of U.S. dollar liabilities with suppliers in Mexico.

Please move to Slide 22 for a look at the composition of LALA’s debt. At the end of the quarter, we continued to maintain a healthy balance sheet. LALA’s debt has a long-term maturity profile, with an average duration of 4 and 1.9 years for our Mexico and Brazilian debt, respectively. 92% of our debt is in pesos and 59% of it is fixed. Other than credit lines that help fund our working capital requirements, none of our debt is due until 2021. Put another way, 83% of our debt is long term.

As Arquímedes noted earlier, we have nevertheless taken precautionary measures to preserve liquidity given the current unpredictable nature of COVID-19. In addition to enhanced cost, working capital and CapEx discipline and the suspension of share repurchase, we boosted our credit lines and drew upon existing ones, increasing our cash position by approximately MXN 4.3 billion. Finally, on this slide, our weighted cost of debt went down from 8.16% at the year-end of 2019 to 7.53% at the end of this quarter.

On Slide 23, you can see that our leverage ratio rose again. This was due to the MXN 324 million decrease in EBITDA. We are above our target level, but remain committed to a 2.5x objective, which we should reach in the following years.

Please move to Slide 24. We did, however, continue to make progress with regard to working capital in Mexico, Brazil and the U.S., with the ratio to sales falling to 0.3% from 3% in the first quarter of last year. As you can see on this slide, days payable continue to this improvement at 84 days versus 70 days in last year’s.

Please move to Slide 25. Working capital was again negative in Mexico, reaching minus 2.2%.

Please go to Slide 26. We remain focused on ROIC and, as Arquímedes explained, are deferring nonessential investment for the time being. Starting this quarter, we’re adding to the CapEx ratio the cash outflows related to leasing of vehicles, machinery and equipment. Therefore, first quarter CapEx was 2.5% of sales.

Thank you for your attention. Before we open the call for questions, Arquímedes has a few closing remarks. Arquímedes, please go ahead.

——————————————————————————–

Arquímedes Adriano Celis Ordaz, Grupo Lala, S.A.B. de C.V. – Interim CEO & Lead Director [5]

——————————————————————————–

Thank you, Alberto. In summary, although the duration, scope and ultimate effects of the coronavirus are currently unknown, our business is expected to be relatively resilient based on what we have observed in other countries. Further, we have implemented a range of robust measures to safeguard LALA’s employees, clients, end users, supply chain and business, all of which is supported by our distinct competitive advantages as well as a strong operating management team and balance sheet. We have calibrated our growth strategy with a near-term emphasis on stabilizing our Mexico business and restoring its profitability.

Early results are encouraging with higher volume driving consolidated branded sales of 5.1%, while Mexico’s EBITDA margin expanded 250 basis points sequentially. Negative working capital in Mexico once again contributed to enhancing LALA’s capital efficiency, resulting in a 270 basis point improvement to 0.3% of sales.

And finally, in order to reinforce the steps we have taken to help mitigate COVID-19 risks and reinforce LALA’s strength, we have also undertaken a number of precautionary measures to boost our financial liquidity.

That concludes our prepared remarks. Operator, please open the call for questions.

================================================================================

Questions and Answers

——————————————————————————–

Operator [1]

——————————————————————————–

(Operator Instructions) Our first question comes from the line of Felipe Ucros with Scotiabank.

——————————————————————————–

Felipe Ucros Nunez, Scotiabank Global Banking and Markets, Research Division – Analyst [2]

——————————————————————————–

So I wanted to focus a little more on the long-term on the post-COVID period and thinking about what most analysts are predicting is going to be a tough recession in Mexico. And I was wondering how you guys are prepared to deal with the slowdown environment? And more importantly, if you could give us some comments on how the category and especially how LALA performed during the last crisis and what you expect going into this one?

——————————————————————————–

Arquímedes Adriano Celis Ordaz, Grupo Lala, S.A.B. de C.V. – Interim CEO & Lead Director [3]

——————————————————————————–

Thank you, Felipe. We all know that it is almost impossible to really estimate the economic impact on the — COVID-19 will have in the consumption. But even though I think that for sure we will have a decrease in the GDP, particularly in the Latin American countries where we operate. Even though it’s not strictly comparable, we have a reference, the last crisis we faced, and a strong one, it was in 2009.

That year, Mexico’s GDP went down 5.3%. And even in that very difficult scenario, we were able to grow our sales. We grew 3.7%. And the volumes, the volume decreased only 1.6%. I’m not saying — again, I’m not saying that this is strictly comparable, but as a reference, I think it shows the capability of LALA to understand not only consumer mix, but the purchasing power that is going to be affected in the coming months. And as a result of that, I think we are well prepared to face that scenario.

——————————————————————————–

Felipe Ucros Nunez, Scotiabank Global Banking and Markets, Research Division – Analyst [4]

——————————————————————————–

That’s very good color. And if I can ask a follow-up. I was wondering if you could give us some details about what you experienced in that crisis in terms of down-trading from consumers. I mean, as we know, typically in recessions, consumers become a little more conservative and sometimes go into brands that are tailored to lower price points. And obviously, you’re very well prepared having Nutri present in the portfolio. So I’m wondering if you could comment a little bit about the economics of Nutri compared to the LALA brand, how margins compare? And how that brand performed during the downturn?

——————————————————————————–

Alberto A. Arellano Garcia, Grupo Lala, S.A.B. de C.V. – CFO [5]

——————————————————————————–

Yes, let me tell you that the Nutri brand performance by that year was very good. We maintain, as you know, a price difference between LALA Milk and Nutri.

And particularly because of the prices, that particular year, Nutri had an excellent performance. And generally speaking, what we did that year, we focused in the efficiencies all along our supply chain to be able to have very affordable prices of all of our products. In some of them, we are just content to maintain them accessible. And the combination of that worked well.

——————————————————————————–

Operator [6]

——————————————————————————–

Our next question comes from the line of Sergio Matsumoto with Citi.

——————————————————————————–

Sergio Takeshi Matsumoto, Citigroup Inc, Research Division – VP [7]

——————————————————————————–

It’s Sergio Matsumoto from Citi. My question is, if you could address (technical difficulty) the competitive landscape may look like (technical difficulty) hello, yes.

——————————————————————————–

Alberto A. Arellano Garcia, Grupo Lala, S.A.B. de C.V. – CFO [8]

——————————————————————————–

Sergio, I’m sorry…

——————————————————————————–

Sergio Takeshi Matsumoto, Citigroup Inc, Research Division – VP [9]

——————————————————————————–

Shall I you repeat it?

——————————————————————————–

Arquímedes Adriano Celis Ordaz, Grupo Lala, S.A.B. de C.V. – Interim CEO & Lead Director [10]

——————————————————————————–

Yes. Your question is not coming through clearly.

——————————————————————————–

Sergio Takeshi Matsumoto, Citigroup Inc, Research Division – VP [11]

——————————————————————————–

Let me try again. My question is what advantage you have over competitors in this COVID-19 environment? And what the competitive landscape may look like after the economic recovery?

——————————————————————————–

Alberto A. Arellano Garcia, Grupo Lala, S.A.B. de C.V. – CFO [12]

——————————————————————————–

Yes. So yes. Thank you, Sergio. A couple of thoughts here, and then I will let Arquímedes also add on. The first one is, when you look at the competitive landscape and when you look at how LALA is structurally conformed, we have 2 major assets, which are, first of all, our first line, which is the supply of 82% of our milk from, as you know, a very strong and long-lasting relationship with roundabout 200 suppliers in Mexico, which is something that competition does not have. That certainly plays, first of all, the strength when it comes to the supply of milk.

And then the second part of the question would be your last mile. We have roundabout 1,000 trucks that supply — our product from the plants to the distribution centers and then roundabout 6,000 trucks that go and deliver this product to the final customer. So — and this is also something that we own and that we manage completely. So that, I would say is an important strength, and again, it’s the biggest chilled distribution network in the country. So that’s, I would say, for the first part of your question. And then you were asking — you asked about the competitive advantage, which was one. And then the second was the landscape?

——————————————————————————–

Sergio Takeshi Matsumoto, Citigroup Inc, Research Division – VP [13]

——————————————————————————–

Yes, after we return to normal or when the economic recovery happens, what that competitive landscape may look like?

——————————————————————————–

Alberto A. Arellano Garcia, Grupo Lala, S.A.B. de C.V. – CFO [14]

——————————————————————————–

Yes. So on this front, a couple of ideas that I would share. It’s — first of all, when you look at the industry, and when you look at the cost of protein, animal protein, dairy, it’s certainly one that is, I would say, very well placed to be a defensive one in a crisis. The cost of animal protein in this is lower than the cost of egg, than the cost of chicken poultry, than the cost of pork and beef. So on that front, we believe it’s well placed to at least be as defensive as it can be.

Now another important benefit that we have versus our competitors, and it’s the way we are structured from the hedging — the natural hedging perspective. Some of our competitors import more milk than what we do, and this is obviously subject to the fluctuation of the dollar. We have roundabout 18% of our input costs, dollar wise. So — and this is certainly one of the lowest in the industry. So that, I would also say it’s a natural competitive advantage we have — we have with our competitors.

——————————————————————————–

Operator [15]

——————————————————————————–

Our next question comes from the line of Fernando Olvera with Bank of America.

——————————————————————————–

Fernando Olvera Espinosa de los Monteros, BofA Merrill Lynch, Research Division – Associate [16]

——————————————————————————–

Very quickly, if you can. I was wondering if you can give some color about the sales performance derivation so far in April? And that would be my first question. And the second one is related to Mexico. I mean, concerning that the economy is expected to accelerate significantly and with the peso appreciated around 25%, can you share what would be your pricing strategy, the remaining of the year?

——————————————————————————–

Alberto A. Arellano Garcia, Grupo Lala, S.A.B. de C.V. – CFO [17]

——————————————————————————–

Yes. (foreign language) Fernando. To your first question, in terms of sales performance, we are not seeing a significant change in April versus what we had in March. We do have — in pretty much all of the countries we play in we had some, I would say, moderate panic sales in the month of March. Sales in April are coming as expected, obviously are still strong. We don’t know if this is going to have a hangover effect in the next couple of weeks, as I would say, consumption normalizes. What we do see is that certain categories that are there to feed a Mexican family on — at home type of consumption are, let’s say, are moving as expected and very well in terms of fueling that volume.

Now when it comes to the impact of the Mexican peso, and I would say what this could bring to the consumption in the next couple of weeks or next couple of months, honestly, here we don’t know. And I would rather be modest and play modest on this front from what we have seen in some of the countries, notably in Spain, Italy, China and more recently in the U.S. And when you think that these countries are probably 6, 7, 8 weeks ahead of what we are seeing in Mexico, we have seen that the food industry is one — defensive one. And we have also seen that given our portfolio, which is roundabout half shelf-stable in Mexico and kind of half is chilled, we’re again well placed to kind of serve that with. But I wouldn’t like to venture on what are the things that we can do or what will happen to consumption a little bit further down the road.

Now when it comes to your question regarding the impact on prices given the input cost, obviously, our not only short term, but long-term strategy is to try to maintain healthy margins, healthy gross margins. So whatever happens in inflation when it comes to raw and packing materials, part of that we will need to sort out internally in terms of productivity, trying to be more efficient, trying to become more stealth in terms of our cost structure.

But yes, we also — we will also need to increase prices if needed eventually. This is something that we’re not considering, let’s say, in the next couple of weeks or short term, also because we’re very mindful of what’s happening to most of our consumers. But the question is certainly not if we’re going to increase prices really, it’s more when in the event of — in the event that the Mexican peso stays where it is at this point in time.

——————————————————————————–

Arquímedes Adriano Celis Ordaz, Grupo Lala, S.A.B. de C.V. – Interim CEO & Lead Director [18]

——————————————————————————–

I would like to add that after COVID-19, I believe that we are going to see some different behaviors of the consumers. And one thing that LALA had been able to do in its history, is to really understand consumer needs and be able to respond with the right products, with the right portfolio. So we are analyzing different scenarios in the future, and we are figuring out how can LALA — will respond to those factors that will affect consumption in the countries where we are operating. So I believe that’s a key thing.

And the capability that LALA has is to be able to adapt to the new market conditions and have a very deep understanding of the consumer behavior. Because this crisis, if you separate the health problem, in addition to that, the economic situation that will come once this health crisis finish, I’m sure that it will change consumer behavior, at least for a few years.

——————————————————————————–

Fernando Olvera Espinosa de los Monteros, BofA Merrill Lynch, Research Division – Associate [19]

——————————————————————————–

Okay. Great. If I may, can I ask you a third question really quickly. Can you share what would be the savings obtained from the distribution and network improvement that you mentioned in your initial remarks at the end? And is this to the effect reaching EBITDA margin of around 9.5% at the end of this year?

——————————————————————————–

Alberto A. Arellano Garcia, Grupo Lala, S.A.B. de C.V. – CFO [20]

——————————————————————————–

Fernando, I think your first question was regarding long-term margin. It didn’t come through very clearly. Could you please repeat it?

——————————————————————————–

Fernando Olvera Espinosa de los Monteros, BofA Merrill Lynch, Research Division – Associate [21]

——————————————————————————–

Yes, the first question was regarding the savings obtained from the distribution network in Brazil?

——————————————————————————–

Alberto A. Arellano Garcia, Grupo Lala, S.A.B. de C.V. – CFO [22]

——————————————————————————–

Savings coming from the distribution network?

——————————————————————————–

Fernando Olvera Espinosa de los Monteros, BofA Merrill Lynch, Research Division – Associate [23]

——————————————————————————–

Yes. You mentioned that you identified some savings in your distribution network — well, on the improvement of your distribution network in Brazil. I was wondering if you have an amount?

——————————————————————————–

Alberto A. Arellano Garcia, Grupo Lala, S.A.B. de C.V. – CFO [24]

——————————————————————————–

Yes. But are you referring to this call? Or are you referring to something that we guide before when it comes to distribution network in Brazil?

——————————————————————————–

Fernando Olvera Espinosa de los Monteros, BofA Merrill Lynch, Research Division – Associate [25]

——————————————————————————–

No. You mentioned, I mean, regarding your initial remarks about Brazil, about the planned actions that you are publishing. You mentioned that you identified some savings related to the improvement of the distribution network.

——————————————————————————–

Alberto A. Arellano Garcia, Grupo Lala, S.A.B. de C.V. – CFO [26]

——————————————————————————–

Fernando, the — most of the benefits that are coming from that distribution network, we’re still working on them. And in general, what we are focusing on is to, first of all, find — increase the use of capacity that we have in our distribution network in Brazil and also specifically more in the São Paulo region. As you may know, we — one of — we have 2 core markets in Brazil. One of them is São Paulo and the second one is Rio de Janeiro. So for us, these 2 markets are core for our distribution. So we have found some opportunities to increase the level of capacity utilization in São Paulo. And so we’re working on that.

Now you were asking for an estimate on how much this could improve our margins, on how much we can account for that? We have not — we don’t have — we’re not sharing yet the benefits because, well, in Brazil, it’s — we’re working on several efforts to improve margins. And one of them and one of the core ones has been trying to offset the increase in raw materials because it’s something that we have seen continuously happening across the years. So that’s one of the first opportunities we have. And one of the — and the other one is working on the distribution network. So we’re not guiding yet how much would be the expectation of these benefits.

——————————————————————————–

Operator [27]

——————————————————————————–

Our next question comes from the line of Álvaro García with BTG.

——————————————————————————–

Álvaro García, Banco BTG Pactual S.A., Research Division – Research Analyst [28]

——————————————————————————–

I hope you and your families are well. My question is, firstly, on the Mom & Pop channel in Mexico. You sort of mentioned Fernando’s question performance into April. But I was hoping you can potentially give us some color on, you guys are obviously in very close contact with this channel. What you had seen from the Mom & Pop channel in Mexico through April? That’s my first question.

——————————————————————————–

Alberto A. Arellano Garcia, Grupo Lala, S.A.B. de C.V. – CFO [29]

——————————————————————————–

So what we’ve seen basically in both channels, it’s both what we saw in March and what we still are seeing in April. And as you know, we know well this channel because we will visit it 1 or 2 or 3 times on a weekly basis. It’s that the performance is pretty much stable or comparable to what we see in sales service as well. So both channels are performing relatively similarly in terms of consumers within the stores as well.

——————————————————————————–

Arquímedes Adriano Celis Ordaz, Grupo Lala, S.A.B. de C.V. – Interim CEO & Lead Director [30]

——————————————————————————–

And I would like to add that, normally, in the traditional channel in times where purchasing power is affected since the transactions, the size of the transactions that you can execute at the traditional channel are very small. People normally go to buy in a more frequently basis and spend less money than going to the organized trade where they need to spend more to buy the goods that they are needing. So we will continue increasing the distribution of our goods in that channel.

——————————————————————————–

Álvaro García, Banco BTG Pactual S.A., Research Division – Research Analyst [31]

——————————————————————————–

That’s very clear, Arquímedes. My second question is one for Alberto. You mentioned — sort of a more technical question, this leasing, which is now included in your CapEx. Was that not included there before? Maybe if you could just expand on why that wasn’t included there before and why it is now, that would be helpful.

——————————————————————————–

Alberto A. Arellano Garcia, Grupo Lala, S.A.B. de C.V. – CFO [32]

——————————————————————————–

Yes. Yes, Álvaro, sure. It wasn’t included before. And here, I’m talking about early years ’17, ’18 and so on, because it didn’t really existed. We started to use leasing as — and we are talking about leasing of our trucks in Q1 and Q2, basically as a way to try to optimize our cash flow in the company. So it really started only during the second part of 2019. And it has continued in the, I would say, in the first part of 2020.

Here we’re talking about vehicles, which we utilize either for our sales fleet or our distribution network, which we have collaboratively started to lease instead of paying it upfront in terms of CapEx. So the number that you are seeing now encompasses both everything that has to do with CapEx and cash flow of machinery and equipment, typically noted and stated as CapEx, but also the amount of money we are now using in terms of cash flow to pay for those leases. So it’s — we realized we were not including that in our, I mean, you have it on your balance sheet, obviously. But at least in the chart we are showing where we basically incorporate the evolution of CapEx over the years, was not having this information at the end of 2019. And now it does.

——————————————————————————–

Álvaro García, Banco BTG Pactual S.A., Research Division – Research Analyst [33]

——————————————————————————–

Great. Great. That’s great. So just to confirm, it’s not related to IFRS 16?

——————————————————————————–

Alberto A. Arellano Garcia, Grupo Lala, S.A.B. de C.V. – CFO [34]

——————————————————————————–

No, no, it is not. It is not. When you look at our balance sheet, we were doing things right in 2019. With the limitation of IFRS 16, it was well quoted in each one of the lines of the balance sheet. Here, it was more on the evolution of our CapEx and the fact we were showing, in terms of CapEx, over sales ratio where we were not including that small portion of it. But again, as it will start probably be a little bit heavier, we wanted to be clear on that one.

——————————————————————————–

Operator [35]

——————————————————————————–

Our next question comes from the line of Miguel Tortolero with GBM.

——————————————————————————–

Miguel Angel Tortolero, GBM Grupo Bursátil Mexicano, S.A. de C.V. Casa de Bolsa, Research Division – Research Analyst [36]

——————————————————————————–

The first one is regarding Brazil. Considering the recent measures that you launched in this region, do you still foresee the close to 10% EBITDA margin by year-end that you previously shared?

And the second one is regarding Mexico and related to a previous question. Besides the effect of COVID-19, which was already covered, I would like to focus my question on FX and its impact on margins in this regard. What are your expectations in terms of margins considering the potential effect of the MXN depreciation on the dollarized cost structure? And especially by year-end, when there will be no more FX hedges to use and probably a weak consumer environment with consumers probably not willing to take price increases?

——————————————————————————–

Alberto A. Arellano Garcia, Grupo Lala, S.A.B. de C.V. – CFO [37]

——————————————————————————–

Yes, Miguel, I got your second question very clearly. I did not get your first question right.

——————————————————————————–

Miguel Angel Tortolero, GBM Grupo Bursátil Mexicano, S.A. de C.V. Casa de Bolsa, Research Division – Research Analyst [38]

——————————————————————————–

Yes. The first one is just considering the recent measures you’re taking in Brazil that you were previously mentioning, do you still foresee close to 10% EBITDA margin by year-end?

——————————————————————————–

Alberto A. Arellano Garcia, Grupo Lala, S.A.B. de C.V. – CFO [39]

——————————————————————————–

Okay. So it’s regarding the margin in Brazil?

——————————————————————————–

Miguel Angel Tortolero, GBM Grupo Bursátil Mexicano, S.A. de C.V. Casa de Bolsa, Research Division – Research Analyst [40]

——————————————————————————–

EBITDA margin in Brazil, yes.

——————————————————————————–

Alberto A. Arellano Garcia, Grupo Lala, S.A.B. de C.V. – CFO [41]

——————————————————————————–

Okay. Let me take me address and Arquímedes will complement if needed. Regarding Brazil, the answer is no. We will not get to 10% EBITDA margin in Brazil. We’re not dropping the towel in that market, obviously. But what we are seeing is that we’re going to have some structurally pressured quarters coming in. Round about 25% — 20%, 25% of our sales in Brazil are related to Food Service, and this is certainly a channel that is going to be strongly affected over the months to come. We have already seen some of that effect in March. We are seeing an important augmentation of that impact in the month of April, and things will probably not going to get better before they get worse. So this will not play in the favor — in our favor in Brazil.

The second point that we have seen over the last couple of weeks is also some of the consumers trading down to some more value segments. And for instance, our yogurt and pork business have been increasing much higher than what we used to see, but at the same token, our Greek yogurt, it’s been pressured. So we will certainly not be in a position where we can deliver double-digit margin. We’re doing everything that is in our control, not only to streamline the fixed cost part of our base in terms of the structure, in terms of delivering higher productivities vis-à-vis our suppliers trying to share everything that we’ve learned in Mexico on those fronts. But we will not be in a position to deliver that margin in Brazil. We are obviously working on the internal plan to try to compensate as much as we can with the business that we can control, with the business that is still there. But again, Brazil is going to get impacted, thanks to the performance of Food Service.

Then on Mexico and the impact of exchange rate, we were very well placed from a coverage perspective. And what we covered in terms of forward helped us pretty much to serve the devaluation of the Mexican peso for the first part of the year. So we have roundabout 80% of our input cost covered all the way to mid-August or so. So we are not to see an important devaluation impact in Q2. Having said that, we will certainly face an input cost increase, an important one, starting Q3 and Q4. And related to that, as I was mentioning before that, we will need to play by ear when it comes to driving productivity on one hand and probably increasing some of our prices during the second part of the year. This is obviously very high on our agenda. This has been analyzed and evaluated as we speak.

——————————————————————————–

Operator [42]

——————————————————————————–

Our next question comes from the line of Benjamin Theurer with Barclays.

——————————————————————————–

Benjamin M. Theurer, Barclays Bank PLC, Research Division – Head of the Mexico Equity Research & Director [43]

——————————————————————————–

Can you actually hear me? Because the quality of the call just got seriously worse?

——————————————————————————–

Alberto A. Arellano Garcia, Grupo Lala, S.A.B. de C.V. – CFO [44]

——————————————————————————–

Yes, Benjamin. We can hear you well.

——————————————————————————–

Benjamin M. Theurer, Barclays Bank PLC, Research Division – Head of the Mexico Equity Research & Director [45]

——————————————————————————–

Okay. I’ll try. So my first question is on your operations in the U.S., I mean, looking at some of the food companies in the U.S. in different industries, we’ve seen plant shutdowns because of coronavirus outbreaks at their plants causing delays, disruption, et cetera. So my question is, have you put in place any particular measures on your plants, first of all, in the United States, advance testing of people when they come into the workplace? And with that in mind, not only in the U.S., what measures have you implemented to guarantee safety of your workforce also in Mexico and Brazil? That would be my first question. Then I have a quick one on Brazil as well.

——————————————————————————–

Arquímedes Adriano Celis Ordaz, Grupo Lala, S.A.B. de C.V. – Interim CEO & Lead Director [46]

——————————————————————————–

Well, not only in the U.S., but in all territories where we operate, we have been implementing different processes to maintain, first, the health of our people and of course, the continuity of our operations. And that includes, as I’ve said, all countries where we operate. So in addition of the government regulations on this subject, we have had additional measures to make sure that we will maintain the continuity of our operations. And up to now, I think the plan is working well. None of our facilities in many of the countries that we operate are having any major problem. They are continuing — running. And of course, that plan and all the processes that we have implemented, take care on a detailed manner of the health status of all employees of LALA. And considering that to maintain them healthy, we only — we do not only take care of them at the facility, we are also are training them on what to do outside the working place. I mean at home and transportation from home to the facility, all the precautions that they need to take with their families. So even when we all know that this COVID-19 is something very contagious, we are doing our best. And up to now it is working well.

——————————————————————————–

Benjamin M. Theurer, Barclays Bank PLC, Research Division – Head of the Mexico Equity Research & Director [47]

——————————————————————————–

Can you hear me?

——————————————————————————–

Alberto A. Arellano Garcia, Grupo Lala, S.A.B. de C.V. – CFO [48]

——————————————————————————–

Yes, Benjamin.

——————————————————————————–

Benjamin M. Theurer, Barclays Bank PLC, Research Division – Head of the Mexico Equity Research & Director [49]

——————————————————————————–

Yes. And then just — I had some system issues, but I hope we get it afterwards. Now in Brazil, you’ve mentioned you have about 40 — 20% of sales is dedicated to Food Service. So my question is, how easy or not is it to adjust some of these sales short-term into the retail channel? And if there’s actually demand for those products in retail channel are the very specific Food Service channels, and we could assume that as the outbreak continues and most likely lasts a little longer in South America as it is the case in Mexico to see somewhat of an adverse sales environment in Brazil just because of the Food Service exposure?

——————————————————————————–

Arquímedes Adriano Celis Ordaz, Grupo Lala, S.A.B. de C.V. – Interim CEO & Lead Director [50]

——————————————————————————–

Yes, I can tell you that short-term and we are focusing on growing our branded sales in Brazil, making a greater penetration in the — at the retailer because we recognize that consumption at home will increase. And short-term again, while the food service is not running, we will focus completely in growing in branded in Brazil.

——————————————————————————–

Operator [51]

——————————————————————————–

(Operator Instructions) Our next question comes from the line of Alan Alanis with Santander.

——————————————————————————–

Alan Alanis, Santander Investment Securities Inc., Research Division – Head of Mexico Strategy and Sector Head for Food & Beverage [52]

——————————————————————————–

First and foremost, Arquímedes, Alberto and David, I hope all and everyone in the LALA family stay safe. My first question is more a clarification. And I don’t know if I heard this correctly. You mentioned that around 20% of your sales in Brazil come from Food Service, around 1% in Mexico. And then I don’t know if I heard correctly, you said 10% of your total sales come from Food Service. And I just — if that’s the right number, I just can’t get to the math. That would be my first question.

——————————————————————————–

Alberto A. Arellano Garcia, Grupo Lala, S.A.B. de C.V. – CFO [53]

——————————————————————————–

Yes, it’s 20% Food Service in Brazil, 1% in Mexico for a total consolidated figure of 4%.

——————————————————————————–

Alan Alanis, Santander Investment Securities Inc., Research Division – Head of Mexico Strategy and Sector Head for Food & Beverage [54]

——————————————————————————–

4%. That’s the number that I misheard. And just a quick question. On that 1% of Mexico, that includes secondary distributors that sell to Food Service. It just appears though — the percentage appears a bit on the low side. But that’s only direct to Food Service percentages?

——————————————————————————–

Alberto A. Arellano Garcia, Grupo Lala, S.A.B. de C.V. – CFO [55]

——————————————————————————–

No, it is both, Alan. It has both components, yes. The reality is that this has always been an opportunity for LALA, and we are certainly underdeveloped even vis-à-vis some of our competitors here are, for good and for bad, because it’s always an opportunity that at this point in time, we are, let’s say, well really suited to face that storm.

——————————————————————————–

Alan Alanis, Santander Investment Securities Inc., Research Division – Head of Mexico Strategy and Sector Head for Food & Beverage [56]

——————————————————————————–

Got it. That’s very clear. So my last question has to do with U.S. prices of milk. And maybe here, the question is for you to educate me, educate us a little bit if there’s any impact. We’ve seen year-to-date prices of milk in the United States basically collapse almost 40%. Does this have any impact or any potential risk or opportunity for LALA in Mexico in terms of, I don’t know, increased sales of, increased imports into — from private label into Mexico or increased competition in terms of raw materials for cheese? And in any way or form that decline of 40% in prices of milk in the United States related at all to your increase in raw milk sales in Mexico during the first quarter?

——————————————————————————–

Arquímedes Adriano Celis Ordaz, Grupo Lala, S.A.B. de C.V. – Interim CEO & Lead Director [57]

——————————————————————————–

This situation that you mentioned, Alan, has happened in the past, some years the milk is — has a lower price in the U.S. market. But considering first, the logistics and the cost of it and the quality of bringing fresh milk is affected by these 2 factors. We haven’t seen in any of those years a great impact in the Mexican market. The maximum negative effect we have seen could be only in the — at the border, but very limited. Because in order to sell pasteurized milk, you have to have a distribution, a refrigerated distribution network.

——————————————————————————–

Alan Alanis, Santander Investment Securities Inc., Research Division – Head of Mexico Strategy and Sector Head for Food & Beverage [58]

——————————————————————————–

Got it. Well, the border is practically closed. So that shouldn’t be a risk.

——————————————————————————–

Arquímedes Adriano Celis Ordaz, Grupo Lala, S.A.B. de C.V. – Interim CEO & Lead Director [59]

——————————————————————————–

Yes, exactly. But other than that, the rest of the country is not affected, Alan.

——————————————————————————–

Operator [60]

——————————————————————————–

There are no further questions in the queue. I’d like to hand the call back to management for closing remarks.

——————————————————————————–

David González Peláez, Grupo Lala, S.A.B. de C.V. – Head of IR, Treasury & Risk Management [61]

——————————————————————————–

Thank you, operator, and thank you, everyone, for joining our results call today. We look forward to talking to you on our next quarter call. And please, everybody, stay safe.

——————————————————————————–

Operator [62]

——————————————————————————–

Ladies and gentlemen, this does conclude today’s teleconference. Thank you for your participation. You may disconnect your lines at this time, and have a wonderful day.