Management’s Discussion & Analysis

Fomento Económico Mexicano, S.A.B. de C.V. and Subsidiaries, Monterrey, N.L., Mexico

Audited Financial Results for the twelve months ended December 31, 2017 Compared to the twelve months ended December 31, 2016.

Fomento Económico Mexicano, S.A.B. de C.V. (“FEMSA”) is a Mexican holding company. Set forth below is certain audited financial information for FEMSA and its subsidiaries (the “Company” or “FEMSA Consolidated”) (NYSE: FMX; BMV: FEMSA UBD, FEMSA BD). The principal activities of the Company are grouped mainly under the following subholding companies (the “Subholding Companies”): Coca-Cola FEMSA, S.A.B de C.V. (“Coca-Cola FEMSA” or “KOF”), (NYSE: KOF, BMV: KOFL) which engages in the production, distribution and marketing of beverages, and FEMSA Comercio, S.A. de C.V. (“FEMSA Comercio”), including its Retail Division which operates small-format chain stores, a Health Division, which includes drugstores and related operations and its Fuel Division which operates retail service stations for fuels, motor oils and others.

The consolidated financial information included in this annual report was prepared in accordance with International Financial Reporting Standards (“IFRS”) as issued by the International Accounting Standards Board (“IASB”).

The 2017 and 2016 results are stated in nominal Mexican pesos (“pesos” or “Ps.”). Translations of pesos into US dollars (“US$”) are included solely for the convenience of the reader and are determined using the noon buying rate for pesos as published by the U.S. Federal Reserve Board in its H.10 Weekly Release of Foreign Exchange Rates as of December 29, 2017, which was 19.6395 pesos per US dollar.

This report may contain certain forward-looking statements concerning Company’s future performance that should be considered 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 could materially impact the Company’s actual performance.

FEMSA Consolidated
2017 amounts in millions of Mexican pesos

FEMSA’s consolidated total revenues increased 15.3% to Ps. 460,456 million in 2017 compared to Ps. 399,507 million in 2016. Coca-Cola FEMSA’s total revenues increased 14.7% to Ps. 203,780 million, including the results of the Vonpar acquisition in Brazil and the consolidation of its operations in the Philippines beginning in February, supported by price increases aligned or above inflation in key territories and by the positive translation effect resulting from the appreciation of the Brazilian Real and the Colombian peso despite the depreciation of the Argentine Peso, the Philippine Peso and the Venezuelan Bolivar, all as compared to the Mexican Peso. FEMSA Comercio – Retail Division’s revenues increased 12.4% to Ps. 154,204 million, driven by the opening of 1,301 net new OXXO stores combined with an average increase of 6.4% in same-store sales. FEMSA Comercio – Health Division’s revenues increased 9.2% to PS. 47,421 million, driven by the opening of 105 net new stores combined with an average increase of 6.7% in same-store sales. FEMSA Comercio – Fuel Division revenues increased 34.1% to Ps. Ps. 38,388 million in 2017, driven by the addition of 70 total net new stations in the last twelve months, and a 19.8% increase in same-station sales.

Consolidated gross profit increased 14.9% to Ps. 170,268 million in 2017 compared to Ps. 148,204 million in 2016. Gross margin decreased 10 basis points to 37.0% of total revenues compared to 2016, reflecting the growth of lower margin businesses in FEMSA Comercio.

Consolidated operating expenses increased 16.3% to Ps. 128,829 million in 2017 compared to Ps. 110,777 million in 2016. As a percentage of total revenues, consolidated operating expenses increased from 27.7% in 2016 to 28.0% in 2017.

Consolidated administrative expenses increased 12.1% to Ps. 16,512 million in 2017 compared to Ps. 14,730 million in 2016. As a percentage of total revenues, consolidated administrative expenses decreased 10 basis points, from 3.7% in 2016, compared to 3.6% in 2017.

Consolidated selling expenses increased 16.7% to Ps. 111,456 million in 2017 as compared to Ps. 95,547 million in 2016.

As a percentage of total revenues, selling expenses increased 30 basis points, from 23.9% in 2016 to 24.2% in 2017.

Consolidated income from operations increased 10.7% to Ps. 41,439 million in 2017 as compared to Ps. 37,427 million in 2016. As a percentage of total revenues, operating margin decreased 40 basis points, from 9.4% in 2016 to 9.0% in 2017 reflecting: i) the incorporation of structurally lower-margin results from Coca-Cola FEMSA Philippines; ii) an operating margin contraction across businesses; and iii) the integration and faster growth of FEMSA Comercio’s three divisions, whose lower margins tend to compress FEMSA’s consolidated margins over time.

Some of our subsidiaries pay management fees to us in consideration for corporate services we provide to them. These fees are recorded as administrative expenses in the respective business segments. Our subsidiaries’ payments of management fees are eliminated in consolidation and, therefore, have no effect on our consolidated operating expenses.

Net financing expenses decreased to Ps. 3,216 million from Ps. 4,619 million in 2016, mostly driven by a positive result caused by a foreign exchange gain related to the effect of FEMSA’s US Dollar-denominated cash position, as impacted by the depreciation of the Mexican Peso during the period. This cash position increased during 2017, mainly as a result from the sale of 5.24% of the combined interest in the Heineken Group; this movement was enough to offset an interest expense increase of 15.3% to Ps. 11,124 million in 2017, compared to Ps. 9,646 million in 2016 resulting from new debt acquisition at Coca-Cola FEMSA in connection to the Vonpar acquisition.

Income before income taxes and share of the profit in Heineken results increased 39.0% to Ps. 39,768 million in 2017 compared with Ps. 28,600 million in 2016, mainly as a result of growth in FEMSA’s income from operations, higher non-operating income resulting from the sale of 5.24% of the combined interest in the Heineken Group completed on September 18, 2017, and higher foreign exchange gain related to a higher U.S. dollar-denominated cash position at FEMSA, coming from the aforementioned sale of Heineken shares.

These impacts more than offset higher financing expenses as well as the change in the accounting method for Coca-Cola FEMSA’s Venezuelan operation booked in the fourth quarter, which resulted in the reclassification of a recorded foreign currency translation charge in equity. This was a non-cash, one-time impact to the other non-operating expenses line of the income statement, in accordance with IFRS standards.

Our accounting provision for income taxes in 2017 was Ps. 10,583 million, as compared to Ps. 7,888 million in 2016, resulting in an effective tax rate of 26.5% in 2017, as compared to 27.6% in 2016, slightly under our expected medium-term range of 30%. The lower effective tax rate registered during 2017 is mainly related to certain tax efficiencies related with the one-time non-operating income recorded by the partial sale of Heineken Group’s shares and the consolidation of Coca-Cola FEMSA Philippines, Inc. both during 2017.

Consolidated net income was Ps. 37,206 million in 2017 compared to Ps. 27,175 million in 2016, resulting from growth in FEMSA’s income from operations, higher non-operating income resulting from the sale of 5.24% of the combined interest in the Heineken Group completed on September 18, 2017, and a higher foreign exchange gain related to a higher U.S. dollar-denominated cash position at FEMSA, coming from the aforementioned sale of Heineken shares. Controlling interest amounted to Ps. 42,408 million in 2017 compared to Ps. 21,140 million in 2016. Controlling interest in 2017 per FEMSA Unit¹ was Ps. 11.85 (US$ 6.03 per ADS).

Coca-Cola FEMSA
Coca-Cola FEMSA total revenues increased 14.7% to Ps. Ps. 203,780 million in 2017, compared to Ps. 177,718 million in 2016, including the results of the Vonpar acquisition in Brazil and the consolidation of its operations in the Philippines beginning in February. Total revenues were also driven by price increases aligned with or above inflation in key territories, supported by the positive translation effect resulting from the appreciation of the Brazilian Real and the Colombian Peso, despite the depreciation of the Argentine Peso, the Philippine Peso, and the Venezuelan Bolivar; all as compared to the Mexican Peso. On a currency-neutral basis and excluding Venezuela, total revenues grew 3.6%, driven by average price per unit case growth across most of our operations, volume growth in the Philippines, and flat volume performance in Mexico and Central America, which was partially offset by volume declines in South America.

Coca-Cola FEMSA gross profit increased 15.1% to Ps. 91,686 million in 2017, compared to Ps. 79,662 million in 2016, with a gross margin expansion of 20 basis points. In local currency, pricing initiatives, coupled with currency and raw material hedging strategies, offset higher sweetener and concentrate prices in Mexico and the depreciation in the average exchange rate of the Mexican Peso, the Argentine Peso, and the Philippine Peso as applied to U.S dollar-denominated raw material costs. Gross margin reached 45.0% in 2017.

The components of cost of goods sold include raw materials (principally concentrate, sweeteners and packaging materials), depreciation costs attributable to our production facilities, wages and other employment costs associated with labor force employed at our production facilities and certain overhead costs. Concentrate prices are determined as a percentage of the retail price of our products in the local currency, net of applicable taxes. Packaging materials, mainly PET and aluminum, and HFCS, used as a sweetener in some countries, are denominated in U.S. dollars.

Operating expenses increased 17.5% to Ps. 65,511 million in 2017, compared to Ps. 55,742 million in 2016.

Administrative expenses increased 21.0% to Ps. 8,983 million in 2017, compared to Ps. 7,423 million in 2016. Selling expenses increased 16.4% to Ps. 55,927 million in 2017 compared with Ps. 48,039 million in 2016.

Income from operations increased 9.4% to Ps. 26,175 million in 2017 compared to Ps. 23,920 million in 2016.

FEMSA Comercio – Retail Division
FEMSA Comercio – Retail Division total revenues increased 12.4% to Ps. 154,204 million in 2017 compared to Ps. 137,139 million in 2016, primarily as a result of the opening of 1,301 net new OXXO stores during 2017, together with an average increase in same-store sales of 6.4%. As of December 31, 2017, there were a total of 16,526 OXXO stores. As referenced above, OXXO same-store sales increased an average of 6.4% compared to 2016, driven by a 3.8% increase in average customer ticket while store traffic increased 2.5%.

Cost of goods sold increased 11.4% to Ps. 95,959 million in 2017, compared to Ps. 86,149 million in 2016. Gross margin increased 60 basis points to reach 37.8% of total revenues. This increase reflects healthy trends in our commercial income activity and the sustained growth of the services category, including income from financial services. As a result, gross profit increased 14.2% to Ps. 58,245 million in 2017 compared with Ps. 50,990 in 2016.

Operating expenses increased 15.9% to Ps. 45,802 million in 2017 compared to Ps. 39,505 million in 2016. The increase in operating expenses was driven by i) our continuing initiatives to improve compensation and reduce turnover of key in-store personnel ii) a sustained increase in electricity tariffs, and iii) higher secure cash transportation costs driven by increased volume and higher fuel prices.

Administrative expenses increased 8.4% to Ps. 3,170 million in 2017, compared to Ps. 2,924 million in 2016; as a percentage of sales, they remained flat at 2.1% in 2017. Selling expenses increased 16.7% to Ps. 42,406 million in 2017 compared with Ps. 36,341 million in 2016; as a percentage of sales they reached 27.5% in 2017.

Income from operations increased 8.3% to Ps. 12,443 million in 2017 compared to Ps. 11,485 million in 2016, resulting in an operating margin contraction of 30 basis points to 8.1% as a percentage of total revenues for the year, compared with 8.4% in 2016.

FEMSA Comercio – Health Division
FEMSA Comercio – Health Division total revenues increased 9.2% to Ps. 47,421 million compared to Ps. 43,411 million in 2016, primarily as a result of the opening of 105 net new stores during 2017, together with an average increase in same-store sales of 6.7%, which was mostly driven by strong performance and positive foreign translation effects from our South American operations. As of December 31, 2017, there were a total of 2,225 drugstores in Mexico, Chile and Colombia.

Cost of goods sold increased 8.3% to Ps. 33,208 million in 2017, compared with Ps. 30,673 million in 2016. Gross margin increased 70 basis points to reach 30.0% of total revenues compared with 29.3% in 2016. As a result, gross profit increased 11.6% to Ps. 14,213 million in 2017 compared with Ps. 12,738 in 2016.

Operating expenses increased 12.8% to Ps. 12,595 million in 2017 compared with Ps. 11,166 million in 2016. The increase in operating expenses was driven by the integration of a single operating platform in Mexico, building our distribution capabilities and increased services at our drugstores such as on-site doctors and home delivery in the key Mexican market.

Administrative expenses decreased 7.1% to Ps. 1,643 million in 2017, compared with Ps. 1,769 million in 2016; as a percentage of sales, they reached 3.5% in 2017. Selling expenses increased 15.9% to Ps. 10,850 million in 2017 compared with Ps. 9,365 million in 2016; as a percentage of sales, they reached 22.9% in 2017.

Income from operations increased 2.9% to Ps. 1,618 million in 2017 compared with Ps. 1,572 million in 2016, resulting in an operating margin contraction of 20 basis points to 3.4% as a percentage of total revenues for the year, compared with 3.6% in 2016.

FEMSA Comercio – Fuel Division
FEMSA Comercio – Fuel Division total revenues increased 34.1% to Ps. 38,388 million in 2017 compared to Ps. 28,616 in 2016, primarily reflecting a national price increase established at the beginning of the year, as well as the opening of 70 net new OXXO GAS service stations during 2017. As of December 31, 2017, there were a total of 452 OXXO GAS service stations. Same-station sales increased an average of 19.8% compared to 2016, as the average price per liter increased by 21.1% reflecting the national price increase mentioned above, while the average volume decreased by 1.1% mainly from consumer reaction to the higher prices.

Cost of goods sold increased 35.1% to Ps. 35,621 million in 2017, compared with Ps. 26,368 million in 2016. Gross margin decreased 70 basis points to reach 7.2% of total revenues. This decrease reflects the effect of gross profit per liter remaining flat in peso terms for the first half of the year, while the consumer price per liter increased significantly, as described in the preceding paragraph. As a result, gross profit increased 23.1% to Ps. 2,767 million in 2017 compared with 2016.

Operating expenses increased 25.2% to Ps. 2,497 million in 2017 compared with Ps. 1,995 in 2016.

Administrative expenses increased 21.3% to Ps. 154 million in 2017, compared with Ps. 127 million in 2016; as a percentage of sales, they remained flat at 0.4% in 2017. Selling expenses increased 24.9% to Ps. 2,330 million in 2017 compared with Ps. 1,865 million in 2016; as a percentage of sales, they reached 6.1% in 2017.

Income from operations increased 6.7% to Ps. 270 million in 2017 compared with Ps. 253 million in 2016, resulting in an operating margin contraction of 20 basis points to 0.7% as a percentage of total revenues for the year, compared with 0.9% in 2016, as expense containment and operational efficiencies only partially offset the contraction in gross margin described above.

Key Events during 2017
The following text reproduces our press releases exactly as originally published.

The Coca-Cola System welcomes AdeS® as the newest member of its expanding ready-to-drink beverage portfolio
On March 28, 2017 The Coca-Cola Company, together with its bottlers in Latin America, announced the closing of the acquisition of Unilever’s AdeS® plant-based beverage business. The Coca-Cola Company became the sole owner of the AdeS® brand.

On June 1st, 2016, The Coca-Cola Company and Coca-Cola FEMSA, S.A.B. de C.V. (BMV: KOFL; NYSE: KOF) entered into an agreement with Unilever to acquire the AdeS® business. Other Coca-Cola bottlers joined to participate in the investment prior the closing of the transaction. Founded in 1988 in Argentina, AdeS® is the leading soy-based beverage brand in Latin America. As the first major brand launched in the category, AdeS® pioneered the development of the second largest global market for soy-based beverages. The AdeS® brand currently has a presence in Brazil, Mexico, Argentina, Uruguay, Paraguay, Bolivia, Chile, and Colombia. AdeS® will become part of the expanding beverage platforms of the Coca-Cola System in Latin America.

Coca-Cola FEMSA announces successful merger with Mexican company owned by the sellers of Vonpar
On May 4, 2017 Coca-Cola FEMSA announced that it had successfully merged with POA Eagle, S.A. de C.V., a Mexican company 100% owned by the sellers of Vonpar in Brazil, as per the announcement made on September 23, 2016. As a result of this merger, POA Eagle, S.A. de C.V. shareholders will receive approximately 27.9 million newly issued KOF series L shares. POA Eagle, S.A. de C.V. merged with net assets for an amount of $4,082 million Mexican Pesos. Coca-Cola FEMSA, through its Brazilian subsidiary, Spal Indústria Brasileira de Bebidas, S.A., started consolidating the results of Vonpar in its financial statements as of December 2016.

Senior Leadership Succession Plan
Eduardo Padilla to Succeed Carlos Salazar as Chief Executive Officer in January 2018

On August 29, 2017, FEMSA announced that Carlos Salazar Lomelín, FEMSA’s Chief Executive Officer at the time of the announcement, would retire from his position on January 1, 2018, after a long and productive career at the Company spanning almost 45 years.

During his career at FEMSA, Carlos had the opportunity to lead many of the Company’s operations including FEMSA Cerveza and Coca-Cola FEMSA. Carlos has been instrumental in transforming FEMSA into a beverage and retail powerhouse with operations across Latin America and a growing presence in Southeast Asia. The Company also announced that Carlos would remain on the Board of Directors of FEMSA and as Advisor to the Chairman of the Board and that Eduardo Padilla Silva, FEMSA’s Chief Financial and Corporate Officer at the time of the announcement, would become Chief Executive Officer on January 1, 2018. These appointments represent one more step in FEMSA’s long-term talent and succession planning process.

Coca-Cola FEMSA Selected as Part of the Dow Jones Sustainability Emerging Markets Index for the Fifth Consecutive Year
On September 14, Coca-Cola FEMSA announced that it was chosen as a member of the Dow Jones Sustainability Emerging Markets Index for the fifth consecutive year.

Among its relevant sustainability results, the Company has benefited 1.5 million people through its healthy lifestyles programs since 2015; fulfilled the goal of returning 100% of the water used to produce its beverages back to the environment in its Mexico, Brazil, Central America, and Colombia operations; incorporated 20% of recycled resins in its PET packages across its operations; and used clean sources of energy across 29% of its manufacturing operations. In addition, Coca-Cola FEMSA has earned several awards and recognitions for its sustainability performance throughout 2017, including its selection for the FTSE4Good Emerging Market Index of the London Stock Exchange and the Sustainability and Social Responsibility Index of the Mexican Stock Exchange.

Offering of shares in Heineken N.V. and Heineken Holding N.V.
On September 18, 2017 FEMSA announced the completion of the sale of 5.24% of the combined interest in the Heineken Group, comprising a combination of existing issued ordinary shares of both Heineken N.V. and Heineken Holding N.V. The Equity Offering consisted of 22,485,000 Shares in Heineken N.V. representing 3.90% of the issued share capital at a price of €84.50 per share, raising gross proceeds of approximately 1.9 billion Euros and 7,700,000 Shares in Heineken Holding N.V. representing 2.67% of the issued share capital at a price of €78.00 per share, raising gross proceeds of approximately 600 million Euros.

Following the completion of the Equity Offering, FEMSA’s shareholding in Heineken N.V. decreased from 12.53% to 8.63% and in Heineken Holding N.V. from 14.94% to 12.26%, for an overall decrease of FEMSA’s economic interest in the Heineken Group from 20.00% to 14.76%. Following this offering, FEMSA, under the terms of the Corporate Governance Agreement dated April 30, 2010, retained its existing governance rights, including one seat on the Board of Directors of Heineken Holding N.V. and two seats on the Supervisory Board of Heineken N.V. FEMSA continues to be a significant shareholder in the Heineken Group and a long-term supporter of the group’s strategy.

 

1 FEMSA Units consist of FEMSA BD Units and FEMSA B Units. Each FEMSA BD Unit is comprised of one Series B Share, two Series D-B Shares and two Series D-L Shares. Each FEMSA B Unit is comprised of five Series B Shares. The number of FEMSA Units outstanding as of December 31, 2017 was 3,578,226,270, equivalent to the total number of FEMSA Shares outstanding as of the same date, divided by 5.