Arca Bottling Mexico Coke Is Best of 74 Stocks: Riskless Return

By Brendan Case and Jonathan J. Levin

Oct. 23 (Bloomberg) ‐‐ Bottling soft drinks in the country with the largest per‐capita consumption of Coca‐Cola products is making Arca Continental SAB the safest consumer staple investment in the Americas. Latin America’s second‐largest Coke bottler has climbed 14% in the past five years after adjusting for price swings, the most among 74 consumer staples companies in the Americas, according to the Bloomberg Riskless Return Ranking. Brazilian drugstore chain Raia Drogasil SA was second with a 10.1% gain, while Souza Cruz SA, the Brazilian maker of Lucky Strike and Dunhill cigarettes, was third with an 8.6% advance. Arca Continental is offering home delivery of soft drinks as well as traditional distribution to stores to tap into demand after Mexicans’ per capita intake of Coca‐Cola products soared 58% in the past decade to 728 eight‐ounce servings a year. The Monterrey, Mexico‐based company, which was called Embotelladoras Arca before it bought smaller bottler Grupo Continental last year, reported a 46% jump in second‐quarter sales as it absorbed new customers from the purchase, expanded in South America and exported Mexican Coke to the U.S. “All the stars lined up when these two companies decided to merge,” Eric Conrads, who helps manage $1 billion in stocks at ING Groep NV, said by phone from New York. “Mexico over the past 12 months has been the flavor of the emerging markets, and that stock is a consumer play story.” Merger Benefits The bottlers’ combination is on track to generate cost savings and added revenue of 1.4 billion pesos ($109 million) by the end of 2013, Chief Executive Francisco Garza said in a conference call July 20. Arca Continental closed two plants after the acquisition and is also saving on costs for administration, raw materials, packaging and technology. Without adjusting for price swings, Arca Continental shares have surged 72% this year, more than double the 30% rally for Coca‐Cola Femsa SAB, Latin America’s largest Coke bottler, and more than five times the 14% advance for the benchmark IPC index of 35 Mexican stocks. It was the gauge’s best performer in the period after Grupo Financiero Banorte SAB, Mexico’s third‐biggest lender, and steelmaker Industrias CH SAB, which ranked first with a 73% gain, according to data compiled by Bloomberg. “The catalyst was the merger,” Alan Alanis, an analyst with JPMorgan Chase & Co. who has an overweight rating on the shares, said in a telephone interview from New York. “It was a piece of art.” Exporting Soda Arca Continental’s business of exporting soda pop to the U.S. may have room to grow after accounting for less than 1% of volume in the first half, fueled by demand for sugar‐ sweetened Mexican Coke in glass bottles. During the past four years, the company has tripled exports to the U.S., as consumers there seek out the Coke recipe served at taco stands throughout Mexico. Per‐capita consumption of Coca‐Cola products in the U.S. was the equivalent of 403 eight‐ounce servings last year. Coca‐Cola Co., which traces its roots back to the namesake soda fountain beverage that began selling in 1886, makes concentrates and syrups, owns soft drink brands and handles marketing. While it owns some bottling operations, it also works with outside bottling partners such as Arca Continental that manufacture and package the final drinks and distribute them to stores, restaurants, street vendors and movie theaters.

Low Volatility

The risk‐adjusted return, which isn’t annualized, is calculated by dividing total return by volatility, or the degree of daily price variation, giving a measure of income per unit of risk. A higher volatility means the price of an asset can swing dramatically in a short period, increasing the potential for unexpected losses. In absolute terms, Arca Continental returned 291% over the past five years, the fourth‐best among staples companies in the Americas after Raia Drogasil, Sousa Cruz and Coca‐Cola Femsa. Arca Continental beat out such U.S. stocks as Estee Lauder Cos., which ranked ninth, and Green Mountain Coffee Roasters Inc., which came in 10th. Its volatility of 20.99 was the sixth‐lowest in the group, which had an average volatility of 31.14, according to data compiled by Bloomberg. Most of Arca’s stock had been in the hands of family shareholders and its public shares weren’t widely traded before the merger, contributing to its relative lack of sharp price swings, Conrads said. While shares are more widely traded now, steady demand for the company’s products is likely to limit future volatility, he said. The company’s risk‐adjusted return over the past five years beat Coca‐Cola bottlers outside the Americas such as Sydney‐ based Coca‐Cola Amatil Ltd., with a risk‐adjusted return of 3.8%, and Athens‐ based Coca‐Cola Hellenic Bottling Co. SA, with a loss of 0.45%. Arca Continental’s rally will stall without new growth catalysts, said Paola Sotelo, an equity analyst with Monex Casa de Bolsa SA in Mexico City. The shares trade near a record 33 times trailing earnings, compared with 19 times for the IPC index. Coca‐Cola Femsa, whose 139.5 billion pesos in revenue over the past 12 months is almost three times Arca Continental’s, trades at 30 times profit. Sugar Costs “They’re trading today at quite high multiples,” Sotelo said by phone from Mexico City. “We analysts don’t see a fundamental reason to support this expensive price.” Spikes in costs for raw materials such as sugar, high‐ fructose corn syrup and plastic could dent profitability, according to Lauren Torres, an analyst at HSBC Holdings Plc in New York, who has a neutral rating on the shares. While the peso has appreciated 8.4% against the dollar this year, the most among the greenback’s 16 most‐traded counterparts tracked by Bloomberg, a weakening in the currency could result in higher expenses for commodities that are priced in dollars. Four of 14 analysts tracked by Bloomberg recommend buying Arca shares, while seven recommend holding and three suggest selling the stock. Arca’s third‐quarter sales will climb 11% as earnings per share increase 27%, according to the average estimate of analysts surveyed by Bloomberg. The company is scheduled to announce third‐quarter earnings tomorrow. Family‐Controlled Arca traces its roots back to a Coca‐Cola distributorship that began in 1926, when the soft‐drink maker first entered Mexico. By the time of last year’s merger, three families owned a majority stake in the company. Continental was controlled by the children of Burton Grossman, a Texas native who led a Coca‐ Cola distribution business in Tampico, Mexico, with distribution territories in northern and western Mexico including the Guadalajara area. The four families together own a majority stake in Arca Continental, with Atlanta‐based Coca‐Cola Co. holding 8.6% and almost 17% trading on the Mexican stock exchange. The June 1, 2011, merger fueled a 50% gain in this year’s second‐quarter net income, which reached 1.49 billion pesos. The increase would have been 9.1% if Arca and Continental had been a single company during all of the second quarter 2011. Sales climbed to a record 14.8 billion pesos, up 16% from what would have been the second quarter 2011 level of the combined entity. Acquisitions Ahead Arca’s goal is to use organic growth and acquisitions to boost sales to about 100 billion pesos by 2016, almost double its revenue over the past 12 months, according to Ulises Fernandez de Lara, the company’s investor relations chief. The bottler is exploring deals throughout Latin America after buying two bottlers in Argentina in 2008 and a majority stake in an Ecuadoran bottler in 2010. Arca had 2.21 billion pesos in cash as of June 30, and net debt was 0.9 times trailing Ebitda, the 13th lowest on Mexico’s IPC index of 35 stocks. Among its existing businesses, the strongest growth will come from non‐carbonated beverages such as teas and sports drinks, he said. The acquisition announced July 11 of dairy maker Santa Clara Mercantil de Pachuca SA by Jugos del Valle SAPI, a Mexico City‐based juicemaker owned by Coca‐Cola and eight bottlers including Arca, will add milk to the product mix. Home Delivery Arca makes deliveries to 700,000 homes in Mexico, mostly for jug water and to an increasing extent for soft drinks, Fernandez de Lara said. The company plans to boost its vending machines to 42,000 by 2015 from the current level of 30,000. It’s expanding its Bokados snack business, which includes products such as potato chips and peanuts. Arca’s operating margin topped Coca‐Cola Femsa’s in the second quarter after trailing in the first quarter and last year. The company tries to boost profitability by focusing on smaller serving sizes, increasing the percentage of returnable glass bottles in its container mix, and tracking earnings by routes and customers. “With a stock like this, investors tend to be longer‐term holders because business fundamentals don’t change that quickly,” said HSBC’s Torres. “There’s that level of security in a stable growth environment. It’s a defensive company with a strong product portfolio. They have pricing power as well as cost savings and synergies flowing through, and they continue to innovate.”

820 Shades Creek Parkway, Suite 2450 COOK & BYNUM Birmingham, Alabama 35209 www.cookandbynum.com

cAPITAL mANAGEMENT, llc Tel: +1 (205) 994-2815

April 20, 2011

Dear Partners:

Below is a table showing the performance after all fees and expenses of Cook & Bynum Capital QP, LLC (“Fund”) compared to that of the Standard and Poor’s 500 plus Dividends (“S&P”) for the year-to-date period ended March 31, 2011.

Cook & Bynum S&P 500 plus Capital QP, LLC Dividends Difference (i) (ii) (i) - (ii) 2001 Aug-Dec 14.4 -2.6 17.0 2002 23.2 -22.1 45.3 2003 16.3 28.6 -12.3 2004 2.3 10.9 -8.6 2005 0.4 4.9 -4.5 2006 24.2 15.8 8.5 2007* -8.4 5.5 -13.9 2008 -32.3 -37.0 4.7 2009 63.0 26.5 36.6 2010 14.5 15.1 -0.5 2011 1Q 4.4 5.9 -1.5 0.0 0.0 0.0 Cumulative 142.2 27.1 115.1 Annualized 9.8 2.6 7.2

For the first quarter of 2011, the Fund was up 4.4% net of all costs. The S&P gained 5.9% over the same period. Since inception on August 24, 2001, the Fund and its predecessors have returned 9.8% on an annualized basis compared to only 2.9% for the S&P.i

Current Market Environment

As we write this letter, U.S. Ten Year Treasury Notes are yielding a meager 3.4%. If markets are at all efficient, attractive opportunities such as those that existed in March 2009 should be scarce. And without the prospects for satisfactory returns, we see many investors stretching for yield. Whether consciously or unconsciously, many managers are taking on much more risk despite having lower expected returns; this strikes us as folly and potentially a recipe for permanent capital loss. When others are reaching, our tendency is to pull back. Accordingly, we are finding it difficult to identify appealing businesses selling for prices that grant us the margin of safety we demand. We do remain hopeful that the market conditions will arise again that provide us the opportunity to buy securities at discount prices. 1

Copyright  2011 Cook & Bynum Capital Management, LLC. All Rights Reserved. Fortunately, it is not necessary for the overall market to decline for us to find a few compelling things to do. We simply need a selloff in a particular country, sector, or individual company. In fact, we are currently buying one such company whose stock has retreated to an attractive price. The fund’s cash levels have fallen as a consequence, but we remain committed to never deploying any capital unless we believe a proper margin of safety is present.

Dissecting an Investment

As a way of further elucidating our investment approach, we wanted to illustrate the research and investment process for one of our major holdings, Embotelladoras Arca, S.A.B. de C.V.

Coca-Cola in Mexico

Going back to some of our first trips to Mexico, we have always been struck by the strength of the Coca-Cola business there. In Mexico, Coca-Cola enjoys a much better competitive position relative to Pepsi and to other brands than it does in the United States due primarily to:

. Brand Dominance. More than sixty years ago, when it first entered the Mexican market in a significant way, Pepsi attempted to gain market share by offering its products at a lower price point than Coca-Cola. Mexican consumers, as consumers typically do with low-priced, branded consumer products, equated the cheap price with low quality. That brand positioning in the minds of the Mexican consumer has not changed appreciably since. Our extensive channel checks across Mexico find Pepsi consistently selling at a 10-30% discount to Coca- Cola on the shelves of many different sizes and types of retailers. Pepsi is generally priced similar to the important B-brand, Big Cola, which is produced by a Peruvian company. In fact, we think it is more accurate to think of Pepsi as a “B” brand in Mexico, with no “A” competition for Coca-Cola at all.

. Distribution Excellence and Reach. In Mexico, about 64% of beverage sales occur in the informal market of “mom and pop” stores. These stores can be converted living rooms, roadside stalls, or small corner shops and are logistically difficult for a bottler to service. Because of their sheer numbers and the low sales from each, being able to profitably distribute to all of these mom and pop stores requires substantial market share and scale. Only four companies in Mexico have built these advantages: Coca-Cola (the bottler in each territory), Grupo Bimbo (bread & confectionary), and the dominant brewer for each area.1

We have visited hundreds of these mom and pop stores. In a very small one, we typically will not find Pepsi or other B-brands for sale at all. In a medium-sized store, we may find competing brands, but what stands out most are the advantages that have accrued to the market share leaders in each category. In these stores, Coca-Cola products will be available cold in refrigerators while competing products almost always will be hot on the shelf. The Coca-Cola bottler installing a cooler in Latin America can typically triple the sales of a particular point of sale, materially aligning the interests of the vendor with Coke. Pepsi’s

1 FEMSA controls beer sales in northern Mexico, and Grupo Modelo controls the central area, including Mexico City. 2

Copyright  2011 Cook & Bynum Capital Management, LLC. All Rights Reserved. scale in both capacity and brand presence is too small to afford the necessary capital expenditures to invest in coolers or the other aspects of a first class product presentation.

. Product Offering Depth & Breadth. Volume leadership gives the Coke bottlers the critical mass to run a successful returnable bottle network. Returnable presentations2 still represent more than a third of sales in Latin America. The profit margins on soft drinks sold in returnable bottles are substantially higher than those for beverages sold in disposable PET (plastic) presentations. With superior market share, Coca-Cola can offer Coke, Coke Light (Diet), Coke Zero, Sprite, and Fanta in single serve, one liter, 2 liter, and 3 liter presentations in many points of sale. By contrast Pepsi is typically only able to offer a single returnable presentation, if a returnable presentation is available at all.

The returnable offering benefits consumers as well as the bottlers. The breadth of presentations available to the Coca-Cola bottler provides strategic options with their pricing to different economic groups. If Pepsi is selling its 2 liter PET presentation for 14 pesos, Coke can offer a returnable 2 liter presentation at the same price (with inherently better margins) along with a 1.5 liter PET presentation at the same price. This “bracketing” is powerful; a consumer can choose between a cold returnable Coke in the same size and price as the hot Pepsi in a nonreturnable bottle, or choose a cold Coke in a smaller-sized nonreturnable bottle. Over and over again consumers choose the Coke product, reinforcing the brand’s position in their minds.

Research of and Investment in Arca

These favorable market dynamics are strengthened by the tailwind of a generally young population for whom Coke is a cheap, aspirational good. We have previously owned a sizeable stake in FEMSA, which among other things owns about 1/3 of Coca-Cola FEMSA, which is the largest Coke bottler in Mexico and Latin America. We bought FEMSA in part because we recognized what a wonderful business they had in Coca-Cola FEMSA. Unfortunately, the free floating shares of Coca-Cola FEMSA did not trade cheaply enough relative to intrinsic value for us to purchase directly (i.e. it provided an insufficient margin of safety). So we began looking at the other publicly traded Coke bottlers in Mexico and Latin America more generally to see if there were any with similarly robust business dynamics at cheaper valuations.

Embotelladoras Arca fit the bill. Arca’s sole territory at that time encompassed most of northern Mexico, which is the best Coke market in the world. Citizens there consume over 600 8oz. servings per capita per year of Coca-Cola products compared to U.S. per capita consumption of about 400 8oz. servings per year. Northern Mexico is generally hot and dry and home to most of the Mexican manufacturing base for U.S. exports, which helps make the territory the wealthiest per capita in Mexico.

Arca was created through the merger of three independent, family-owned bottlers in 2000: Proyección Corporativa, S.A. de C.V. (“Procor”); Empresas El Carmen, S.A. de C.V.; and Embotelladoras Argos (“Argos”). The newly formed company subsequently went public in 2001. Because the overwhelming majority of the company’s shares were controlled by the three families, free

2 For clarity, “returnables” are glass bottles that are returned by consumers when they exchange empty bottles for filled ones or for a deposit. Bottlers can reuse the returnable bottles 15-20 times. 3

Copyright  2011 Cook & Bynum Capital Management, LLC. All Rights Reserved. float was small. Without a large free float available to trade, Wall Street firms were unable to generate large commissions by creating research pieces about Arca. A rather extraordinary company with a $2Bn U.S. market capitalization and solidly growing business remained underfollowed.

We already had a good lay of the retail land from our many hours and miles driving throughout the Mexican countryside on previous visits to investigate other opportunities. In September 2008, we designed an additional driving trip through four bottlers’ territories, including Arca, Contal, and Coca- Cola FEMSA, specifically to compare and contrast their execution in the marketplace and to visit Arca’s headquarters in Monterrey. We set out from Birmingham and drove to Tampico along the Gulf of Mexico, inland to Aguascalientes, and then turned back north to Monterrey. It was clear that Arca was executing very well in both the cities and the countryside. The company distributes to around 194,000 points of sale in its territory of 17 million people while averaging $7,392 in annual revenue for each point of sale. If Pepsi were to distribute to all of these points of sale, it would probably average an unprofitable $1,000 per point. We had previously studied the financials and were intrigued that a company of this size could be trading for 7x forward net earnings while paying roughly a 9% dividend yield. Operating margins were above 20%, and they are generally sustainable because of the business moat characteristics mentioned above. Net debt has remained below two times EBITDA giving the company a Mexican AAA rating from Standard & Poor’s. In total, we were able to buy a wonderful business, run by outstanding professional managers appointed by the three families who had their net worths at stake. The company operates in an industry we feel comfortable predicting and was selling at a very significant discount to our calculation of intrinsic value. Once we returned, we began buying all of the shares we could find.

. Argentina. Arca purchased the bottling assets of several private bottlers in northern Argentina that did not have the capital or the expertise to invest optimally in their businesses. We flew down to Buenos Aires in the late fall of 2009 to examine the acquisition for ourselves as well as to check out the competitors and peers.3 During this trip, we drove almost 2,000 miles through Argentina and Chile over two weeks to see everything in person from bottling plants to the market. We spoke and toured with regional managers who were singularly focused on digging the moat around their businesses deeper and could not have cared less about next quarter’s earnings. Many of these folks had worked at the private bottlers and had chafed under the limitations of inadequate capital and contented owners. Under the Arca umbrella they have been empowered and incented to grow the franchise value for the long run. This change showed in their obvious passion for the business. You will not learn the same thing about a company by speaking to a polished investor relations person at a conference in Mexico City or New York City.

While traveling in Chile and Argentina, it was apparent that Arca was leveraging its successful, time-tested distribution methods and readily available capital to execute better than its competitors and to compare favorably with its Coca-Cola bottling peers. In fact, in less than 18 months Arca had increased its share of its Argentine market by over 5% through a series of simple initiatives: – In Argentina, B brands are even more important than Pepsi (in a good deal of Latin America, Pepsi simply hitches a ride on a beer distributor’s truck; presentation and stocking are frequently poor as a result). One apple-flavored B brand was especially popular in Arca’s Argentine territory. In response to the B brand’s share of that market (about 7% of CSD4 sales), Arca worked with The Coca-Cola Company to develop a Fanta Apple drink with a similar taste to the local B brand. In the first three months, this new Fanta Apple offering took 70% share in the apple flavor category. In a business where driving volume is critical to remaining competitive at dispersed points of sale, this type of improvement further deepens the moat around Arca’s business. The B brands have less capital to both distribute and advertise. With the success in the apple-flavored segment, Arca is duplicating the model in other fruit-flavored categories currently being ceded to local B brands. – Relying on the software and systems they had developed in Mexico, Arca rolled out handhelds for their truck drivers that improved market sales data, inventory management, and route optimization. – Arca began a marketing initiative to encourage the purchase of more profitable single-serve offerings in a territory where familial (large bottle) sizes were the norm. Despite having lagged Brazil, Chile, and Mexico in economic growth over the last 20 years, Argentina is still one of the wealthiest per capita countries in Latin America.

3 Buenos Aires is controlled by Coca Cola FEMSA. Central Argentina and Southern Argentina are controlled by Chilean-based public bottlers Andina and Polar, respectively. 4 CSD = Carbonated Soft Drink 5

Copyright  2011 Cook & Bynum Capital Management, LLC. All Rights Reserved. Arca management was tapping the previously unfilled demand for a single-serve presentation. – Arca invested in refrigerators and presentation/signage at points of sale.

. Bokados. As a new initiative in Mexico, Arca is leveraging the strength of its distribution network by building a snack food business. Since Arca has a relationship with all of the relevant points of sale, it makes sense to offer snack foods instead of ceding that business to Frito-Lay. Consequently, Arca purchased a regional snack food manufacturer, Bokados, and began immediately expanding the business and placing the products in Arca’s distribution channels. The first few years of results appear promising with sales rising 15% in 2010.

We love businesses that are continually confronted with “easy” reinvestment decisions like these that produce a virtuous circle for them and continuous challenges for their competitors. With these investments, we were more convinced Arca’s moat was expanding as they took advantage of the opportunities presented. We increased the size of our stake as we revised our calculation of intrinsic value upwards from what we had originally estimated. Our chief regret is that at current prices, we will not be able to continue to buy the company with new investment dollars. Though this investment summary is admittedly an incomplete picture, we hope it demonstrates the framework we use to evaluate a business. Certainly, not all of our investments have worked out as well as Arca. We recently sold a position in Johnson & Johnson. We lost 0.8% inclusive of dividends holding J&J. We have in the past and will again in the future purchase securities that will decline in value.

Business Developments

As we have built our firm over the last 9+ years, we have remained committed to adding outstanding people to our team that will help the firm grow while continuing to allow us to devote the overwhelming majority of our time to investment research. Recently our team has expanded to seven with two new additions: . Melissa Taylor joined as Director of Communications. She was previously a manager with SNL Financial, and prior to that she worked in the public affairs office at General Dynamics, a Fortune 100 company. Melissa graduated cum laude with a degree in communications from Vanderbilt University. . Leslie Cooper joined as Marketing Coordinator. Prior to Cook & Bynum, she served as the marketing and public relations director for Alabama Ballet and was most recently a sales manager for MyScoop Media, Inc. in its Birmingham, Nashville, and Mississippi markets. Leslie graduated magna cum laude from Samford University with a degree in journalism and mass communication.

Closing

Thank you for placing both your trust and now $160 million in assets with Cook & Bynum. We invest substantially all of our liquid net worth alongside our investors – we expect to earn the same returns as you. We have deliberately designed this Fund’s structure and our rule of investing in our funds to align, as closely as possible, our incentives with your goals. We eschew leverage to minimize risk and to maximize long-term returns. We make concentrated investments when we feel that risk is low and potential returns are high, recognizing that bigger stakes can be taken when outcomes are more certain. 6

Copyright  2011 Cook & Bynum Capital Management, LLC. All Rights Reserved. We insist on a margin of safety in the hope of avoiding permanent losses of capital, and we never feel pressured to make an investment. If you are happy with the service that you have received to date, we encourage you to expand your existing relationship with us. Additional information about our mutual fund offering, including a prospectus, can be found at www.cookandbynum.com. Hopefully either one or a combination of our investment vehicles will continue to suit your needs.

Respectfully,

J. Dowe Bynum

Richard P. Cook

$242,173 $220,000

$180,000

$140,000 $127,096

$100,000

$60,000

Cook & Bynum S&P 500 plus Dividends

This document shall not constitute an offer to sell, or the solicitation of any offer to buy, any interests described herein, which may only be made at the time a qualified offeree receives a confidential private offering memorandum describing the offering and related risk factors. Past performance is no guarantee of future results. i* Cook & Bynum Capital QP, LLC took its first clients on February 1, 2007. Returns reflect this short quarter.

The performance results set forth in the table on a preceding page and the “Hypothetical Investment Growth” shown in the graph above represent the net, pre-tax return that would have been realized by an investor who had invested $100,000 in the Composite Portfolio of accounts managed by Cook & Bynum Capital Mgt. LLC at inception on August 24, 2001, had subsequently invested the proceeds in Gullane Capital Partners, LLC upon its formation on May 1, 2003, moved this capital to Gullane Capital Partners Encore, LLC on September 1, 2006, and then moved the resulting capital to the Fund on February 1, 2007. Trade-date valuation is used for all performance calculations, and dividends and interest have been accounted for on a cash basis in the Composite Portfolio. The Composite Portfolio is comprised of all accounts on a time-weighted basis since inception and these performance results have not been audited. The performance results for Gullane Capital Partners, Gullane Capital Partners Encore, and the Fund have all been audited annually. The performance results are net of all fees, expenses, and allocations and include the reinvestment of accrued dividends and interest. Gullane Capital Partners charged a percentage of assets under management and a performance fee to investors. Cook & Bynum Capital Mgt. and Gullane Capital Partners Encore only charged investors a percentage of assets under management; the Fund similarly only charges investors a percentage of assets under management. Annualized return is calculated from inception using a 360-day year.