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Edited Transcript of LALAB.MX earnings conference call or presentation 30-Apr-19 3:00pm GMT

Q1 2019 Grupo Lala SAB de CV Earnings Call

GOMEZ PALACIO May 27, 2019 (Thomson StreetEvents) -- Edited Transcript of Grupo LALA SAB de CV earnings conference call or presentation Tuesday, April 30, 2019 at 3:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Alberto A. Arellano Garcia

Grupo Lala, S.A.B. de C.V. - CFO

* David González Peláez

Grupo Lala, S.A.B. de C.V. - Head of IR, Treasury, and Risk Management

* Mauricio Arboleda

Grupo Lala, S.A.B. de C.V. - CEO

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Conference Call Participants

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* Alan Alanis

UBS Investment Bank, Research Division - MD and Latin American Equity Strategist

* Antonio Gonzalez Anaya

Crédit Suisse AG, Research Division - Senior Analyst of Latin American Equity Research

* Felipe Ucros Nunez

Scotiabank Global Banking and Markets, Research Division - Analyst

* Fernando Olvera Espinosa de los Monteros

BofA Merrill Lynch, Research Division - Associate

* Luca Cipiccia

Goldman Sachs Group Inc., Research Division - Equity Analyst

* Luis Miranda Valenzuela

Santander Investment Securities Inc., Research Division - Head of Food and Beverage

* Sergio Takeshi Matsumoto

Citigroup Inc, Research Division - Research Analyst

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Presentation

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Operator [1]

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Ladies and gentlemen, thank you for standing by. Good morning. My name is Brenda, and I'll be your conference operator today. At this time, I would like to welcome everyone to Grupo LALA's First Quarter 2019 Results Conference Call. Please note that today's conference is being recorded and will be available for replay.

I'll now turn the conference over to David González, Grupo LALA's Head of Investor Relations. Please go ahead, sir.

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David González Peláez, Grupo Lala, S.A.B. de C.V. - Head of IR, Treasury, and Risk Management [2]

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Thanks, operator, and good morning, everyone. Thank you for joining us to review LALA's first quarter 2019 financial results. A related press release was issued yesterday and has been posted on our website at grupolala.com. As usual, we've created slides to accompany our earnings presentation. You will also find the slides posted on our website this morning together with the updated fundamental spreadsheet.

Participating on our call today are Mauricio Leyva, our Chief Executive Officer; and Alberto Arellano, our Chief Financial Officer. At the conclusion of our remarks, we will open the call up for questions, and I will be available later for any follow-up questions.

Before we begin, I must remind you that the discussion during the call today is likely to contain forward-looking statements. Forward-looking statements are statements other than those which are historical in nature. All forward-looking statements are subject to significant uncertainties, and actual results may differ materially from those suggested by the statements.

Today's discussion will be as follows: Mr. Leyva will provide an overview of our 4 priorities that we first communicated during our third quarter 2018 results call. He will then provide an update on the various strategic initiatives underway in LALA's 4 geographic markets. Along with our performance in those markets, the updated progress on the 4 priorities will be addressed within the highlights of each region.

Next, Mr. Arellano will explain changes in our reporting under IFRS 16 and the new auditor regulation within Mexico. Then, he will review our quarterly financial results in more details. When making year-over-year comparisons, he will be referring to them on a comparable basis, which takes into account IFRS 16 as well as the deconsolidation of Elopak, which also took effect at the beginning of this year.

It's now my pleasure to hand the call over to Mr. Leyva.

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Mauricio Arboleda, Grupo Lala, S.A.B. de C.V. - CEO [3]

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Thank you, David, and good morning, everyone, and thank you for joining us. During the first quarter, we continued to make significant progress in 4 key fronts, namely: nurturing talent at Grupo LALA; secondly, focusing on our key markets and driving the virtuous cycle; thirdly, being more efficient with capital allocation; and fourthly, enhancing transparency. These priorities have evolved from ideas now to specific actions and the results thereof.

So please move to Slide 5, where, in a nutshell, I'd like to share the main results related to our top priorities. First of all, we have refocused our attention on key markets [being] Mexico and Brazil, and we have reversed the drags in the U.S. and Central America, while putting in place a strong foundation for sustainable long-term growth. As a result, all 4 regions have achieved positive EBITDA for the second quarter in a row.

And most importantly, as part of the plan, we continue to expand margins versus the previous 3 quarters. Strong recovery of controlling net income with 17.1% growth versus prior year. Capital expenditure is well below our full year guidance. We continue to make [headwind] in improving working capital. Alberto, our CFO, will detail later on. And finally, we have set ourselves a target to accelerate our deleverage, therefore, by 2020, we aim to have a net debt-to-EBITDA ratio below 2.5x.

On Slide 6, just a highlight to show that we will discuss what drove our performance in each of the regional businesses during the quarter and relate them to our key priorities. So moving to Slide 7. Mexico is LALA's fundamental business, solid and in place. Comparable sales in Q1 increased 5.3% versus prior year following a combination of volume, mix and price aimed at continuing to recover our margins.

Our EBITDA margin in Q1 was at 13.5%. According to plan, we have implemented a price increase in both the traditional and modern channels. The full benefit of these increases will appear in the second quarter. As part of our priority of driving the virtuous cycle in Mexico, during the quarter, we invested in fueling growth by modernizing LALA's brand, targeting the new generation of consumers and additional consumption occasions. We launched new campaigns that emphasize on flavor, which is the highest attribute of our category, the quality of our products and the variety of our portfolio, especially by advertising not just milk but also the value-added dairy as part of the lives of all Mexican consumers.

On the next slide, we continued -- we've also been investing in our premiumization strategy as well as driving innovation forward, which is evolving according to plan. We launched a marketing and sales 360-degree campaign to support LALA Suprema milk, which sells at a price index of 106 to traditional milk and positioning the benefit of using it both as a nutritious drink as well as an ingredient and developing therefore the [bar call] to make any normal coffee, cake or milkshake into a Suprema one.

Another part of our premiumization strategy is the introduction of the UHT version of our organic milk, the newly licensed Blue Diamond Almond Breeze and our ZERO yogurt, which has no fat nor sugar. For Vita, our milk alternative that addresses the vegetable protein mainstream segment of the market, we have updated its image as well as introduced new flavors and created on-the-go packaging for consumers growing more than 35% in sales versus prior year at a price index of 160 versus UHT milk.

On Slide 9, I'd like to provide an update on our Revenue Growth Management initiative. We have given the first steps towards having a full RGM system. We have started to develop the heart of it the advanced analytics tools to help us better understand how consumers make purchasing decisions like, for example, how they react to changes in price and assortment and switch between brands, packs and categories. We have also defined our operating model for product pricing, the organizational structure and new processes within.

We already have our preliminary hypothesis for pricing, purchasing structures and elasticities with which we will work the rest of the year. As you can also see on the second bullet on this slide, we have launched our food service business unit. Now we have a new dedicated team to address the vast food service industry in Mexico. We will be addressing from fast food chains and restaurants to independent [launch] kiosks and cafeterias. We have launched our Culinary Center to train our sales force and develop specific product profiles and recipes for high volume and value clients. This business unit, which reports directly to me, will be a key growth and margin driver, leveraging one of the core strengths, which is having the biggest refrigerated distribution networks in Mexico.

On Slide 10, as you've heard me say before, nurturing talent is my passion, and we have been building a new performance-driven culture at LALA, one of agility, efficiency, team work and innovation. All of us continue to have a sense of urgency, and we are holding ourselves accountable for every initiative that's tied to our key priorities and aligned with those of our shareholders. The new compensation plan that fosters this culture and drives performance has been already implemented at the top 200 employee level. New long and short-term initiatives now make up -- new long and short-term incentives now make up LALA's merit-based compensation.

Moreover, our 2019 budget targets are aligned to LALA's Big Five KPIs, having every managerial employee in the organization being measured by volume growth, sales growth, EBITDA growth, EBITDA margin and working capital. Because we believe the right culture also attracts talent, LALA has been recognized in LinkedIn Global Top Companies ranking with a #7 in Mexico where employees want to work or the Super Workspaces ranking done by Expansión magazine, where LALA obtained 11th place between all companies of more than 500 employees in Mexico. These are just 2 examples, but our effort to have a high-performance motivating culture is being seen across the country to attract and retain the best talent.

On Slide 11, consistent with our new metric structure to foster growth, LALA's 3 new business units are in place: traditional dairy, value-added dairy and food service. And we have completed our executive committee with the recruitment of Augusto Franco, who leads Food Service; Daniel del Río, who leads Operations; and Andrés Gutiérrez, responsible for Legal and Corporate affairs. All 3 of them bringing substantial consumer products experience to LALA and all of them will help us achieve our goals and dream.

Moving now to Brazil on Slide 12. Vigor, our Brazilian business, continues delivering double-digit growth by increasing sales 13% through a combination of volume expansion up 4.4%, price and product mix. To compensate for raw milk inflation in the country, during the month of March, we executed a price increase of 6% across our portfolio. For Q1, our EBITDA margin was of 7.6%, and we will see the full price increase effect in Q2.

The historical branding campaign that we launched for Vigor late last year as well as a strong innovation platform continues to drive growth at Vigor. New product development as well as value-added initiatives such as enhancing reserves, an early indicator of economic recovery, will continue to be on top of our agenda. Our investment to quadruple the parmesan maturity capacity of Vigor's São Gonçalo plant in Minas Gerais is in line with the plan and phasing, one being completed December 2019 and the second phase by the end of 2020.

Please turn to Slide 13, where, in the U.S., our sales grew 3.3%. At the end of the quarter, we implemented a price increase for the first time in 5 years. Like in the other markets, we will see the full benefit during the second quarter of 2019. We also continue to enhance our ability to grow profitably. Our EBITDA margin improved to 2% in the first quarter and a $5 million year-on-year increase. This is the highest margin achieved since the acquisition of the business.

Roughly, half of this comes from pricing, operational improvement and the benefits derived from making the U.S. business fit the purpose. The other half resulted from last year's closure of the Floresville plant. As in Mexico and Brazil, we began updating the designs and packaging of key products. This includes repackaging and reformulation of our Yogurt Smoothie with added probiotics and less sugar.

On Slide 14. In Central America, revenues declined 8% versus prior year due that the Nicaraguan turmoil started in April 2018. However, our sales in Nicaragua have stabilized since the market contracted in second quarter 2018. On the other hand, Guatemala's sales grew 10.7% in local currency, while in Costa Rica, we're successfully expanding distribution and seeding the market at the new plant that was launched in the month of February.

In terms of profitability, we finished the quarter slightly above the breakeven point. We continue to expect $2 million in annual cost savings derived from rightsizing the business in Central America, which included closing LALA's regional office in Panama. During the quarter, we launched LALA premium-branded ice cream in all 3 countries supplied by our new plants in Guatemala and Costa Rica. (inaudible) continues to be directed at the mainstream segment of these markets. And finally, we have launched LALA branded UHT milk in Costa Rica. So a lot of moves in Central America.

Now I'll turn the call over to Alberto, who will explain in more detail the financial results but, more importantly, the reporting changes as we are not only seeing the IFRS 16 effects but also the deconsolidation of our JV with Elopak, which reduces our sales base by 1.5% and our EBITDA by 3.8% in absolute terms. This without impacting the controlling net income and therefore EPS. I must say that after reading some of the reports on Q1 coming out last night, I want to emphasize the importance of incorporating the latter into your models to have a clearer picture of the business operational results. Please, Alberto, go ahead.

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

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Thank you, Mauricio. Good morning, everyone. Please move to Slide 16. IFRS 16 became effective at the beginning of this year. A new External Auditor Regulation also took effect at the same time. It is called the Circular Única de Auditores Externos or External Auditor Regulation. In particular, this regulation has a bearing on our financial results as they relate to our JV with Elopak. Because of these regulatory changes, we have adjusted LALA's previous year's results in order to make a like-for-like comparison with our 2019 results that are now being reported under IFRS 16 and in compliance with the auditor regulation. Combined, these have a partial netting full year effect of 48 basis points in LALA's EBIT margin.

Please move to Slide 17. The accounting rules under IFRS 16 introduced a new leasing accounting model that affects operational leases. Within LALA's income statement, the effect is seen in cost of goods sold, operating expenses, depreciation and interest expense. In our company's balance sheet, the reporting change shows up as leasing assets and liabilities. In the slides to come, we will present a breakdown this impact into EBITDA by region.

The effect of applying IFRS 16 is a 72 basis point change on a consolidated basis for full year 2019 compared to the previous accounting model. With respect of our 2019 annual operating plans, we have already restated them to reflect the accounting changes. We have also improved our internal controls and fiscal processes for reviewing leasing contracts across geographies. Furthermore, these accounting rules were anticipated by Grupo LALA since 2018. So contractual covenants with banks and financial institutions are not affected by this change for they exclude operational leases from the debt definition.

Continuing on Slide 18. In compliance with the Circular Única de Auditores Externos published in August '18, Grupo LALA has had obtained a recommendation done by its external auditors of deconsolidating the joint venture with Elopak. Since 1998, we have held 51% stake in LALA's JV with Elopak, establishing control at that moment.

In 2013, with the implementation of IFRS 10, control requirements were not met anymore, but the consolidation was not in force as it was below the maturity levels for auditing purposes. In compliance with Circular Única de Auditores Externos, we are now deconsolidating our JV with Elopak. At the bottom of this slide, we present a difference in total sales, EBITDA and EBITDA margin. It is important to note that there is no impact or change in net income and therefore EPS.

Please move to Slide 19. We want to present the effect of IFRS 16 on a regional basis and on a consolidated basis as well. For Mexico and for the consolidated numbers, we are also presenting the accounting effects of the deconsolidation of Elopak. The net effect of the 2 accounting changes on a consolidated basis are minus 1.5% sales and lose 48 (sic) [24] basis points on EBITDA margin from a consolidation standpoint.

Now a closer look at our financial results for first quarter of 2019. Please move to Slide 21. Before reviewing our financial results, I want to recall that, when making year-on-year comparisons, we will be referring to them on a comparable basis, which means our pro forma results in 2018 including IFRS 16 impact and the deconsolidation of Elopak JV.

First quarter volume increased 0.4% driven by Other Dairy, mainly from the expansion of this segment in Brazil. At the same time, the Milk category in Mexico grew, but it was offset by a decline in Brazil's UHT business. Beverage and Others decreased due to the drop of sales of beverage in Mexico.

Let's move to Slide 22. Mexico contributed to 84% of total volume, which, despite the price increase, has stable volume figures for the quarter. Brazil represented 10% of our total volume and grew 4.4% behind the expansion of our value-added dairy portfolio. Quarterly volume in the U.S. decreased 4.7%, mainly due to a contraction within our Hispanic customers following the price increase. It's worth noting that this is the first time we were able to take price increases in the U.S. in over 5 years. Central America, the volume declined 2% year-on-year, mainly as a result of the socioeconomic situation in Nicaragua.

Please move to Slide 23. On a comparable figures, LALA's quarterly sales increased 3.9%, while, in constant currency, the growth of our top line was 6.1%. In Mexico, comparable net sales increased 5.3% from a combination of stable volume, improved product mix and pricing. We still expect the full benefit of the price increase to be reflected in the following quarter.

In Brazil, net sales increased 13% in Brazilian reais year-on-year, driven by strong improvements in volume, price and product mix. During the strong local currency depreciation during the quarter, sales in pesos decreased from a consolidated standpoint. Net sales in the U.S. in constant currency increased 3.3%, while Central America decreased 8% due to the market contraction in Nicaragua.

On the next slide, we see the evolution of EBITDA margin with reported and comparable figures. As you can see, after declining throughout most of 2018, LALA's EBIT margin recovered during Q4 '18 and achieved sequential improvement in Q1 2019, having the highest margin over the last 3 quarters. This increase was a combination of growth, better mix and price increases in Brazil, the U.S. and Mexico together with having the U.S. income delivering positive figures for 2 consecutive quarters.

On a year-on-year comparison, consolidated margins decreased 10% -- sorry, 10 basis points achieving a tendency change from previous quarters as shown on the table below the graph. Coming from strong margin declines, we are delivering sustained margin recovery, which we plan to keep for the quarter to come once we realize the full benefit of the pricing actions and at the same time as we keep professionalizing our Revenue Growth Management and Zero-Based Budget initiatives.

Let's move to Slide 25. In the table, we present EBITDA results per region. As you can see, all regions achieved sustainable positive EBITDA in Q1 2019. In Mexico, margin in Q1 showed a contraction versus last year on a comparable basis due to the high inflation, notably in energy and packaging, from last year, which has been transferred to price by the end of Q1 '19. We expect margins to continue recovering throughout the following quarter.

In Brazil, margins in Q1 showed a decline versus last year on a comparable basis, mainly explained by higher-than-expected milk costs. Let me recall that raw milk prices in Brazil are set by market dynamics, resulting in higher volatility than the prices we have in Mexico. Over the past week, we have started to see net volatility in prices and raw milk cost stabilization in Brazil. In any case, pricing actions were promptly taken throughout Q1 to compensate for this cost pressure.

In the U.S. and Central America, we have delivered EBITDA results above breakeven for the second quarter in a row. The U.S. had a year-on-year comparable increase of MXN 101 million due to the actions implemented on the previous quarters, notably the signing of 3 co-manufacturing agreements, the launch of a completely renovated Promised Land portfolio with higher margins and now the opening of a facility in the East Coast where we also produce Promised Land. And at the same time, the reorganization fit for purpose that we have been talking about over the last months.

As we have mentioned before, these actions are meant to maintain and gradually increase our margins in the U.S. EBITDA in Central America increased by MXN 8 million on a comparable basis following a difficult 2018 impacted by the crisis in Nicaragua. As we have said before, we have decided to rightsize our local operations. To continue recovering margins in the region, plans are in place to drive sales in Guatemala and Costa Rica following the recent launch of LALA-branded ice cream and milk.

Let's move to Slide 26. As you can see, the financial expenses stayed at the same level of the same quarter last year. Income taxes decreased sharply from 37.2% to 32.6% due to an improvement in the Mexican tax rate behind a reduction of our nondeductible expenses and lower inflation level. Given the above, net income for the quarter increased 11.5% reaching MXN 560 million. More importantly, controlling net income grew 17.1%, which more accurately reflects the performance of the business given that 2018 figures do not include the Elopak JV being fully comparable to Q1 '19.

Please go to Slide 27. At the end of the quarter, total debt stood at MXN 26.6 billion, a net debt-to-EBITDA ratio of 3.2x. This ratio was negatively affected by IFRS 16 and the deconsolidation of Elopak by 0.08x. Of our total debt, 90% is denominated in Mexican pesos, 53% has a fixed interest rate and 87% of our debt has a long-term maturity. Overall cost of debt stands 60 basis points above TIIE for Mexico and 50 basis points above CDI in Brazil.

Let's move to Slide 28. We have been talking about our emphasis in working capital optimization as part of our objective to improve [leverage]. As you can see in the chart, LALA's working capital efficiency has progressed sharply with our working capital over sales ratio floating across the quarters. Some of the key actions taken to drive down these results includes renegotiation of trade terms with some of our key suppliers and optimizing inventory levels across the supply chain. We continue with an aggressive plan in all regions to improve this metric throughout the year.

On the next slide, we continue to focus on CapEx investment as a key optimizer of capital allocation. As Mauricio pointed out earlier, we are being fairly disciplined in our investments with year-to-date CapEx decreasing to a 2.1% of sales remaining below the guidance we have provided last quarter to keep the CapEx over sales ratio between 3.5% and 4%.

I will now turn the call back to Mauricio for some closing remarks, and then we will open the call for question and answers. Mauricio, please go ahead.

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Mauricio Arboleda, Grupo Lala, S.A.B. de C.V. - CEO [5]

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Thank you, Alberto. And please let's move to Slide 34 for some closing remarks. So to conclude, let me go back to the slide where, in a nutshell, we disclosed the main results from our top priorities as we strongly believe and remain committed to them.

So first of all, all regions are achieving positive EBITDA. And as part of the plan, we have expanded margins versus the previous 3 quarters. There is a strong recovery of consolidated net income with 17.1% growth versus prior year. Capital expenditure is below our full year guidance. Working capital improvement is also a fundamental focus point of our capital allocation strategy, and we will keep on looking for opportunities to optimize our cash flow.

Finally, the organization is aware that we must transform this effort into strong and continuous financial results. That is why we're committed to reach our deleveraging target below 2.5x of EBITDA by 2020. Thank you.

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David González Peláez, Grupo Lala, S.A.B. de C.V. - Head of IR, Treasury, and Risk Management [6]

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Thank you for your time. And with that, I would like to turn the call over to the operator who will open up the line for Q&A.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first questions are from the line of Felipe Ucros with Scotiabank.

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

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It was good to see another quarter of sequential margin improvement despite the cost headwinds in results. So let me start with this first one on the Brazilian performance. It was great to see such a good top line performance in Brazil, especially in reais terms. Can you discuss the effects? Obviously, other operators in Brazil have discussed the calendar effect and maybe even some weather, which I'm not sure is applicable for you, have had some effect on the numbers. So I wanted to kind of gauge how much of an impact do you think that was and how much a normalized figure would look like. And of course, when you put that in context of the whole cost and price increase, your pricing plan was arranged before this 25% cost increase. So I'm wondering whether you think you're going to need more price increases as the year goes by in Brazil. And also, if you can give us some commentary about whether you think this is the last cost increase that you're going to see from the milk producers or you see some more instability in terms of the milk-producing market in Brazil?

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Mauricio Arboleda, Grupo Lala, S.A.B. de C.V. - CEO [3]

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Yes. Thank you very much, Felipe, for your questions. First of all, let me talk about the top line. So we've seen very interesting performance of our top line behind the investment of what we called gondola project, Projecto Gondola, which has been an investment in top line and at point-of-sale to promote our Vigor brand and the total portfolio. This investment, which started in the last quarter of 2018, has continued and is giving a top of mind volume and quite interesting turnaround of product at the point-of-sale. So this is giving us the double-digit 13% plus growth in volume in Brazil and therefore gaining also market share behind a close to 6% price increase that was done behind the month of February -- in the month of February and starting the month of March. We have not seen the competition following suit in that pricing increase until very recently, so not definitely in Q1.

So in general, that has given us one stronger brand health by investment in top line, in advertising and the campaigns with Vigor. Secondly, the consumers have followed through in purchasing intention and total volume base even after the price increase that we've done. And thirdly, what we've seen is that the dynamics of the Brazilian market are interesting, though, it is taking some time to come back to levels where we had in prior years. So even though it is better than what we've seen in recent quarters, some of the dynamics and results in the market clearly far from where we were some years ago regarding the total sales of the category within Brazil. The good news is that we've been gaining share, so we've been gaining growth out of total brands and therefore volumes. However, not necessarily have we seen yet the total industry volumes and value come back into positive territory, which we expect to see relatively soon. Alberto, if you want to talk about pricing of milk, and I can come back in with additional comments regarding it.

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

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Yes, absolutely. (inaudible). First of all, raw milk prices from Brazil have been increasing in the neighborhood of 31% if you look at total industry in Brazil. Our invoice for that from the producers we are buying milk from, it's around 25%. So we did an exercise back in Q4 and early in January. And we basically were able to pass through most of the price increase to 92% of our portfolio, which is the value-added dairy. I'll say an anecdote on this. We have 8% of our volume mix, UHT milk, in Brazil, which is -- I would say has more pressure in terms of margin. And given that we were not being able to pass through 25% of price increase to the consumer, we actually decided not to produce for a couple of weeks these categories and these products. So in a nutshell,, the 6% that Mauricio mentioned has been enough, at this point, to pretty much contain the inflation in terms of pricing.

Now just a couple of words on how do we see the market and what are we expecting. At this point in time, if you look at a decision by the seasonality of the milk prices in Brazil, we should be in a position where prices should be increasing. And what we're seeing is that prices are stabilizing and even easing up a little bit, which is a very good indication because, at the end of the day, there is less supply of milk in the market and prices are [evening] up. So we tend to believe that over the next couple of weeks we will continue to see this, I would say, relief in prices. And therefore, this is why we have said a couple of times that we're also expecting margins to recover to a level before the raw milk price increase.

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Felipe Ucros Nunez, Scotiabank Global Banking and Markets, Research Division - Analyst [5]

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Great. Just to make sure I got that correctly. You're saying that you expect some price relief in the coming quarters?

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Alberto A. Arellano Garcia, Grupo Lala, S.A.B. de C.V. - CFO [6]

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Yes. But I'm talking about raw milk price.

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Operator [7]

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Our next question comes from the line of Alan Alanis with UBS.

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Alan Alanis, UBS Investment Bank, Research Division - MD and Latin American Equity Strategist [8]

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I have a question regarding -- you mentioned you've been gaining market share in Brazil. Could you make some comments regarding market share and the trends that we're seeing in Mexico? And that would be the first question, only 2 questions.

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Mauricio Arboleda, Grupo Lala, S.A.B. de C.V. - CEO [9]

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Yes, Alan, thank you. So we give -- we disclose market share. We agreed on and disclosed last quarter. We said we would disclose twice in a year, so that meaning results after December and results after June. So we will be much more specific in the next quarter. However, what we can say is that what we are seeing in Brazil which is quite interesting regarding the growth of our sales in Vigor vis-a-vis the category in dairy in total in Brazil has shown some positive effects for us. In the case of Mexico, what we've been seeing as well is that the category has been growing in different terms. So for example, we've seen a holding and slightly declining sales of formula, so formula milk, while UHT milk has continued to increase as well as fresh milk. And therefore, altogether, the total milk sales are flattish and growing a bit versus prior.

However, we're seeing a higher increase in yogurt, in creams and in cheeses. And we'll be more specific on numbers and market shares. We have gained some share mostly, let's say, in the added-value categories like desserts and some of the other products. However, in yogurt, we've seen more of a challenge in recent months as we've taken price before other competitors have. And therefore, this has affected some of the volume where we continued to gain and grow and should see some acceleration in the coming months and quarters. But we can be much more specific in the coming quarter as we release numbers and market share.

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Alan Alanis, UBS Investment Bank, Research Division - MD and Latin American Equity Strategist [10]

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Understood. That's very useful. Just a quick follow-up on that same direction, and I really appreciate the increased level of disclosure. It's excellent, makes life much easier. In this increased level of disclosure that you have in your press releases, you publish your return on invested capital, and we see a substantial decline in that return on invested capital. Could you speak a bit about the reasons of the decline and what actions? Or how do you see that trend going in the coming quarters and in the next few years?

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Alberto A. Arellano Garcia, Grupo Lala, S.A.B. de C.V. - CFO [11]

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Sure, Alan. If you look at our reported figures in Q1, we reported 10.1% and now reported 6.7%. But if you look at Q4 '18, we have already reported a ROIC in the lines of what we're showing now, so we reported 6.2%. Basically, the reason of the contraction of our ROIC, and this started in 2017, as you know, was the acquisition of Vigor by $1.2 billion. Given that the calculation of the ROIC has a 12-month trailing EBITDA figure, once you have the full effect of EBITDA in Brazil, then your ROIC goes further down. That's basically the explanation. And then...

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Alan Alanis, UBS Investment Bank, Research Division - MD and Latin American Equity Strategist [12]

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Got it. And how do you see it going forward?

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Alberto A. Arellano Garcia, Grupo Lala, S.A.B. de C.V. - CFO [13]

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Yes. So to your second part of the question, obviously, our intentionality and obsession both from Mauricio and myself is to be able to turn our ROIC ahead of the cost of capital as soon as possible. The 2 main drivers that we are pursuing to do that is, first of all, continuing on expanding our absolute EBITDA on one hand, and the other one is something that we have not, I would say, talked about before in previous years, but it's our focus on capital allocation, meaning both CapEx. And this is why you are seeing a little bit more of disclosure on the performance of our CapEx and, secondly, on our progression in working capital. We believe this was something that was not necessarily a priority for LALA in previous years. As you have seen on the slides, we have been, I would say, very actively pursuing improvements -- important improvements in working capital. And at the end of the day, we want to use this cash to be able to deleverage as soon as possible. So I would say those first 2, so EBITDA expansion on one hand, on the other one the cash optimization towards the goal of delevering below 2.5x. That's how we are planning to build up on ROIC.

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Operator [14]

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Our next question comes from the line of Luca Cipiccia with Goldman Sachs.

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Luca Cipiccia, Goldman Sachs Group Inc., Research Division - Equity Analyst [15]

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I was hoping you could expand a bit more on the comments you made earlier about price increases in Mexico at the end of the first quarter. I wonder if you could quantify also what does it mean for profitability for the rest of the year, if you have any comment on that. And similarly on pricing in the U.S., your comment about having been able to pass on prices for the first time in a long time. If you could just maybe expand on what's behind that and how much is this market environment as compared to your initiatives? If you could give us more color on that front that would be useful as well.

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Mauricio Arboleda, Grupo Lala, S.A.B. de C.V. - CEO [16]

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Yes. So thanks, Luca. Let me start first talking about pricing and maybe Alberto can put some color on the margins. So the first thing is, in Mexico, we started, the end of last year, taking a price increase, especially in the traditional channel. So on retail traditional environment, we took a price increase of approximately 5.5% to 6%. This followed this year beginning of February, so it started basically the beginning of February, and we would say full effect by the 17th or 19th of February in the modern trade, so in supermarket and organized trade. And this is because we always have to send the message to organized retailers some weeks if not even months in advance for them to take price.

And so this happened Q1. So altogether, we will see the price increase of approximately 5.5% to 6% coming together between organized trade and traditional channel, and that's why we're saying that we should see the full effect of the price increase in Q2 as only the month of March we were seeing both channels altogether with a price increase in Mexico. And Alberto will talk about what this represents for margins, et cetera. In the case of the U.S., we haven't taken price for almost over 5 years in LALA in the U.S. We started then negotiations with some key outlets dealing there, so the likes of the Walmarts, H-E-Bs, Krogers, et cetera, of this world, which represent approximately 50-plus percent of our sales, and then with the Hispanic market.

The price increase has gone through. It's been, I would say, successfully implemented. However, it's just coming into especially the Hispanic market, the volumes of the LALA product, how the effect and coming back to where we had them before. So even though they have been increasing since, we took the price increase the beginning of, let's say, mid-Q1, we should see better effects volume-wise coming through. And that's part what we're organizing and getting together with -- or through innovation by launching packaging and new recipes and ways of innovating to consumers as part of the price increase. Alberto will talk more a little bit about margins here.

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

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Luca, so in terms of margins, what we have shared with you over the last couple of quarters, I would say, is that we wanted to be above the 13.5%, 14% margin mark in Mexico. We are now at 13.5%. I think that we will feel comfortable when we get above the 14%. More than a guidance what I can tell you that this is what we have been sharing to you as where do we think a sustainable level of margin is for Mexico. Let's also remember that our obsession at this point in time is to build on the virtuous cycle, which basically means that also some of the opportunities we might find on Revenue Growth Management and also in Zero-Based project, we would like to make sure that we're fueling the top line equation in a way that we have a sustainable level of innovation up to the expectation that Mauricio has been sharing. So on that respect, again, above the 14% mark in terms of margin in Mexico. We think it's reasonable. And just a word on mix on the U.S., it's -- we have shared that the fit for purpose and the organizational projects implemented in U.S. would give us in the neighborhood of $6 million. So that's a margin for this year, which is -- it's a low-single digit. We're now already at $2 million. Certainly we do have plans to continue expanding that, but I would say on the low single-digit margin for the year -- let's say for the year to go.

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Operator [18]

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Our next questions are from the line of Fernando Olvera with Bank of America.

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

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Most of them have been answered, but I have one. Regarding your tax rate, we saw an improvement this quarter due to better tax rate in Mexico probably due to a reduction of nondeductible expenses. So I was just wondering if this benefit should be seen in coming quarters. And what effective tax rate should we expect this year and going forward?

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

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Sure. First, this is a great question. I'm glad you put it in the table. First of all, let me remind you that in Q4 we have a nonrecurring onetime benefit in tax in the neighborhood of MXN 157 million from the depreciation of certain taxes paid in 2013 over our repatriation of some of our brands. So I just want to make sure that everyone understands that the net benefit which we have in Q4, it's a nonrecurring one. So that was kind of an outlier, and it's a one-off.

Now to your question. We have been putting a lot of emphasis in the, I would say, the tax organization and planning of Grupo LALA. We found some very good opportunities last year as you may remember, which were certain incentives that the government was providing to certain transportation companies. That's already in our base. So that's, I would say, part of an evolution on finding opportunities in our structure. And then we started also 6 months ago an important plan to reduce the nondeductible expenses in the company.

As you know, we have an important distribution fleet, more than 6,000 trucks. Some of these operators, from time to time, make and have expensive, call it, traveling, hotels and food and beverage. And some of them were not necessarily -- or did not necessarily have the requirement needed for the Mexican government to make them deductible. So we have worked tremendously on making sure that the culture was there, and we have started to see some of these benefits.

So to your second part of the question, these are benefits that are recurrent. These were not onetime benefits. It's something that has been driving our tax rate down, and it should continue in that order of magnitude. Now also please recall that the tax rate is affected by the inflation. So given that we have a lower inflation this year versus last year, (foreign language) or the annual adjustment by inflation also takes down the tax rate mechanically.

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Operator [21]

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Our next questions are from the line of Antonio Gonzalez with Crédit Suisse.

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Antonio Gonzalez Anaya, Crédit Suisse AG, Research Division - Senior Analyst of Latin American Equity Research [22]

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I guess I have just one question, perhaps more on the strategic side, for Mauricio. Mauricio, remember that on your very early interventions in the conference calls you mentioned that you wanted to bring a zero-based budgeting mentality, but also perhaps more balanced with top line growth, right? And recently, obviously, the top line growth is very heavily skewed towards pricing rather than volume. You just explained the price increase that you expect to be fully absorbed in Mexico by the second quarter and then the first price increase in a number of years in the U.S. and then Brazil similarly, right? And as a consequence, volume decelerated, right, from roughly 2%, if I'm not mistaken, comparable last quarter to roughly flat now. And obviously, I understand that we are very early in the game. I also understand that there are some cost issues that might be nonrecurring such as the raw milk cost in Brazil. But I just wanted to reconcile in these early comments that you made more on the strategic side with where you see volume growth long term. Is there any chance you share with us any big picture thoughts on what's the level of volume growth that you would aspire to? And perhaps, if you can break it up roughly by geography that would be extremely helpful. Or do you think it is more price-driven in this over the long term?

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Mauricio Arboleda, Grupo Lala, S.A.B. de C.V. - CEO [23]

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Yes. Thank you, Antonio, for the question. So first of all, let me say that part of the strategic arguments we've been using is how to invest in top line creation by the famous virtuous cycle. So yes, how do we implement ZBB, how do we bring better procurement practices by putting together some of the purchasing contracts and payment terms, not just in Mexico but globally, et cetera. So all in the pursue or need to invest in top line mainly in order to drive marketing, sales, innovation, research and development and what I've been talking about, generating a new structure with business units, so that we focus in selling not just basic dairy milk but also added value and food service. So this all comes together as part of what we've been driving.

Having said that, we must say that pricing was critical in order to fix margins, especially in Mexico as we've been discussing last year and secondly in Brazil as part of the initial plan to increase by 200 basis points the margin in the country. And therefore, the first action on pricing was critical as we said at the time. Once the price increase is done, which is why, different to prior years, we started the year, and we started end of last year and beginning of this year, the idea is to continue nurturing growth by 3 elements. One is volume, which I'll come back to you on this one. Secondly, as important as volume is mix. And thirdly is pricing.

Mix is an element, and that's why I focus and I've talked so much about premiumization. I think mix is critical for us to be able to get the top line result that we want, and normally, better mix also drives better margins. So it comes together with the pricing initiatives to expand margin. Volume, once we take the price increase, normally have an effect, and that's why you've seen in the case of Mexico it hasn't been reduced -- volumes haven't reduced. Volumes are flattish -- positively flattish versus prior year. So it's specifically 0.2% as Alberto was saying. However, we see the effect of the price increase, and that should stabilize and increase through time.

I don't want to give you specific guidance because it's part of our plan together with the equation, as I've said, pricing mix and volume, but we do want to see positive volume through innovation and the new ways business units plus food service coming through. So yes, it's not just about pricing. Definitely volume is part of the equation of increasing top line once we had a better control and fixed margins. In the case of Brazil, I wouldn't say it's that different to what I just explained in Mexico with the advantage that in Brazil, we are already growing double digit, especially because of the categories where we compete but, secondly, because we've continued to gain share as we expand, not just in Rio and in São Paulo, which are our core strengths, but actually beyond and coming into new territories, which is part of the plan and the strategy going forward.

Secondly, pricing as well, as I said, in order to recover at least the 200 basis points that we committed to, and it's all according to plan. And thirdly is how do we manage so that volumes and pricing together with mix will give us the financial results and the final margins that we're looking for as we invest in top line. We want to create this virtuous cycle both in Brazil and in Mexico. And we are actually generating, through savings and better practices, efficiencies, the resources to invest in marketing as marketing expenditure has continued to grow. And I think we've done it in a wise -- we must be also bearing in mind that it's more of an investment than an expense as real marketing has to pay through by increasing top line.

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Operator [24]

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Our next questions are from the line of Sergio Matsumoto with Citigroup.

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Sergio Takeshi Matsumoto, Citigroup Inc, Research Division - Research Analyst [25]

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My question is on the price increases in Mexico. So this quarter you began this above-inflation price mix, and I understand that this is part of the Revenue Growth Management strategy this year, and the catch-up element from last year is below inflation pricing. But when you look at what happened in 2014 during Mexico's fiscal reform, the dairy category had a higher price elasticity than other categories, let's say, than compared to sugary soft drinks. So my question to you is how do you get comfortable with the pricing strategy this year that you are implementing?

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

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Yes. Well, first of all, let me just put in perspective that the price increases that we're doing and that we have done over the last 2 quarters are not necessarily ahead of inflation. What we are really doing, first of all, it's a catch-up from 2018. You might recall that we were shy early in the year on taking further price increases pre-electoral campaign and so on and so forth. So what we're doing now is, let's say, what we would probably should have done full year in 2018. So we took a 6% price increase in Q4 in the traditional channel, and then we recently took a similar amount for the modern trade, which roundabout is half of our business. And this is why we are talking about the 3% price increase in Q1, again, because we have taken already the part for the traditional channel. So we are talking about roundabout 6%. So I would say it's more a catch-up over last year.

Now to your question on elasticity. What we've seen, let's say, in the last couple of quarters as well is that volume is holding. Volume is holding versus these price increases. We've also seen that these price increases have been also taken by some of our competitors, and this obviously takes pressure out of our products. But at the end of the day, we have not seen a contraction in volume. So volume for Mexico grew. And especially in the value-added categories, volume has been naturally expanding as well. So if you look at the numbers in Mexico, we lost -- even though this is less than 3% of our volume, we lost sharply close to 19% on our Beverage and Others. And the rest of the categories actually expanded in volume. So that's how we are seeing currently the elasticity and the pricing impact. So we do believe that we should come back to the historical way of implementing prices, which has been slightly in line/ahead of inflation.

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Mauricio Arboleda, Grupo Lala, S.A.B. de C.V. - CEO [27]

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Yes, and just to -- Sergio, just to paraphrase Alberto, last year, 2018, the annualized price increase effect was around 2.5%. This year, if it's around 5.5% to 6%, that will add up both years to around 7.5%. What we've seen is that inflation in Mexico of 4.5%, let's say, in average on general last year versus a 4% this year, 3.9%, 4% depending on who's -- we're using the numbers. It will give you approximately 8.5%, which is then our price increase, as Alberto was saying, on an annualized effect actually compensating for the last 24 months and should still be in line with inflation. This number will be a bit below our plan. And according to what we always talk about with our initiative and strategy is to be in line or slightly above. This will just catch up and put us in that space, and that's what we've been trying to refer and bring to the markets with different categories, but doing it in a more, let's say, scientific and strategic manner instead of what we did in the past, which was more a one-size-fits-all kind of price increase once or twice a year, too, all across the portfolio. How we are doing it now, differentiated by channels, by SKUs, by sub-brands and sub-categories in order to compete better and protect the total or the net income.

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Sergio Takeshi Matsumoto, Citigroup Inc, Research Division - Research Analyst [28]

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That's very clear. Just a follow-up on this. On your revenue management strategy, I understand that there is a new emphasis on data analytics that you have perhaps a new team or new capability. Can you [elaborate] on this, please?

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Mauricio Arboleda, Grupo Lala, S.A.B. de C.V. - CEO [29]

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Sure, Sergio. As some of you wrote yesterday evening, the reality that we have not taken the benefits of Revenue Growth Management yet in our Q1 figures, this is something that takes time. And certainly, as you are mentioning, it has an organizational impact. So we have been working now for 6 months with our external consultant, and we have already a structure, our business units, in a way that there are -- there is actually a team working on RGM. We have been working a lot on this. We have been also moving some of the people that were working previously on the price analytics to the project of RGM. And we believe -- or we are aiming at starting to have some of these health or benefit at this second semester of this year.

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Operator [30]

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(Operator Instructions) Our next questions are from the line of Luis Miranda with Santander Bank.

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Luis Miranda Valenzuela, Santander Investment Securities Inc., Research Division - Head of Food and Beverage [31]

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It's a follow-up on Mexico, and I just wanted to give you a sense in terms of internal inflation. We have seen news related to energy, labor. Wanted to hear what is -- any color that you could give us on if you are feeling the pressure in the Mexican operations? And the second point is regarding innovations. When we take a look at your portfolio and we take a look at the shelf space with the premium milk, LALA 100, Organic, Suprema grades, I know it remains relatively low sometimes in some channels, but could you give us an idea of how much it represents of your portfolio and how much it was 2 years ago?

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

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Sure. In terms of inflation, I would say the good news is that we're already lapping the important spike of inflation of last year, notably, in gas and electricity at the plants, which at the end of the day was 40% for gas and close to 50% for energy. So in 2019 and the quarters to come, we are looking at an overall internal inflation pretty much in line with what we see in the (inaudible). So that's what we have incorporated in our outlook. Now in terms of innovation, I will let Mauricio answer that question.

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Mauricio Arboleda, Grupo Lala, S.A.B. de C.V. - CEO [33]

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Yes. In the sense of innovation, what we've been focusing on is, you're right, we say milk and, beyond that, the added value, which brands like yogurts, desserts and lots of offerings. So we will be bringing the news to the market as we will be seeing in Mexico and in the other regions as well, but in Mexico, which is important, more driven by consumer insights and trends and needs. So a lot of [publishing] in other countries that we're cross-fertilizing across regions. But secondly, it's how we develop premiumization. I don't know specific -- I don't have here with me specific numbers to say about innovation through milk, so the milk category. However, David will come back to you and give you the specific numbers.

What I can say that is, in general terms, last year, innovation represented approximately 1.5% of total sales in Grupo LALA. This year, we're expecting it to go at least to 3.5%. And if we are successful with our innovation, which I'm sure we will, it will actually go beyond that. But I'm not able to give you more details, but there are some prices to come. So for example, in the next couple of weeks, I can tell you now, that we will be launching with yogurt so something big and bold as we've done in Brazil. It's going to be for the first right now being replicated here in Mexico. So just a little bit of flair of innovation coming through because we're excited about it, and this will continue throughout the year.

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Operator [34]

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Thank you. We've reached the end of our question-and-answer session. I like to turn the floor back to management for any additional comments.

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Mauricio Arboleda, Grupo Lala, S.A.B. de C.V. - CEO [35]

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Thank you, operator. And thank you all for joining us for the quarterly call. We look forward to talking to you in 3 months' time if not before. Have a good day.

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Operator [36]

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This concludes today's teleconference. You may disconnect your lines at this time. And thank you for your participation.