Description

The company subject of this write-up enjoys superior business economics, has a very large and growing potential market and should in no way be affected in the event of a US-led global slowdown or recession. More importantly, it is run by a very talented manager-owner team that has a proven track-record.

Now, please promise that you’ll keep reading after I say this: I am talking about a Mexican homebuilder here... – However, as I’ll do my best to explain, this is by no means your typical homebuilder.  - Economic cycles should have little or no impact on the number of homes that Consorcio Ara will build and sell for at least the next 5 years or so.

Ara has grown revenues and EBITDA at a 21% CAGR pace for the last ten years, has 24% EBITDA and 15% net margins, an 18% return on equity, no debt, pays a dividend (it is the ONLY homebuilder in Mexico that pays dividends), and should grow its top line by at least 12 to 15% for the next five years.

Because of the superior business economics and inherent growth of the housing industry in Mexico, homebuilders and Ara in particular have seldom traded at multiples that entice value investors, ourselves included.

Nowadays, however, Mr. Market is presenting us with the opportunity to buy what is arguably the best-run company within this superior sector at what are almost distressed prices. You can buy the company today for less than 10x earnings and 5x EBITDA!

Needless to say, Consorcio Ara is on sale today… - It trades at a large discount to what we estimate is its conservatively calculated intrinsic value, versus its peers, versus its history, etc.

Fellow members that are already familiar with the affordable housing industry in Mexico and its demand and supply dynamics can skip straight to the company’s description and valuation. Otherwise, I’ll do my best to take you step-by-step in the following manner:

1.       Mexican demographics – Demand for affordable housing in Mexico

2.       Financing , government sponsored mortgage institutions

3.       Political implications of housing in Mexico

4.       Introduction to the homebuilding industry in Mexico

5.       Ara and its peers

6.       Why is the stock so cheap?

7.       Valuation

8.       Catalysts

9.       Risks

 

I.                    Mexican demographics - Demand for affordable housing in Mexico

Mexico’s population is around 105 million people today, up from 50 million in 1970 and 25 million in 1950.

Although population growth has slowed (Mexican’s now on average have 2 siblings per couple), growth rates were north of 3% during the 1970’s. Those people, today in their 30’s, are the main drivers of current demand for housing.

Mexico is a young country: a full 48% of Mexicans are 24 or younger and 56% of Mexicans are 34 or younger.   This by itself explains why housing demand should remain strong for the foreseeable future.

Official statistics estimate that the number of homes will double in 23 years.  The logic behind that is simple: In the year 2000 42 million Mexicans were 19 or younger, by 2030 it is estimated that there’ll be 34 million Mexicans aged between 20 and 39 years. Most of them will need homes.

 According to government statistics in the 2000 census, 22 million families were living in Mexico. The government projects that by 2030 there will be 45 million families, effectively doubling the demand for homes.

Furthermore, today we have a 5 million deficit in homes and every year,  800,000 new homes are needed in Mexico!

It is easy to understand why affordable housing is one of the top priorities for the Mexican government…

 

II.                  Financing housing – Government sponsored mortgage lenders

Now that we’ve touched upon the demand dynamics in Mexico, the obvious question is: How is housing being financed?

Let’s talk history for a while. – After the tequila crisis, banks in Mexico all but closed the doors to mortgages. To shed perspective: year to date commercial banks and SOFOL’s have authorized a total of 125,963 mortgage loans.  Prior to the tequila crisis commercial banks alone granted 100,000 mortgage loans a year!

Because of the latter and housing’s priority status, the Mexican government created and strengthened four government sponsored mortgage facilitating institutions: Infonavit, Fovissste, SHF and Fonhapo.

The mission of these institutions is to facilitate loans for low and middle income people regardless of commercial banks efforts. – So far they have been very successful in doing that and it is widely perceived that the strengthening of these mortgage granting bodies was the largest accomplishment of President’s Fox past administration.

The stability of government finances that led in part to the virtuous cycle of low inflation and interest rates that Mexicans have experienced for the last seven years, has been pivotal to the development and growth of the mortgage loan market as can be seen in the table below:

Year	1 year interest rate (CETES)	Mortgage loans granted
1995	48.6%	220,935
1996	27.2%	181,977
1997	18.8%	202,406
1998	33.6%	203,162
1999	16.4%	318,054
2000	17.0%	374,542
2001	6.3%	326,757
2002	6.9%	400,291
2003	6.1%	500,721
2004	8.5%	532,012
2005	8.2%	578,462
2006	7.5%	750,000
YTD	7.7%	N.A.

 

Long term planning was an almost impossible feat for most Mexicans (persons and institutions alike), the memory of devaluations, excessive and spiking inflation and interest rates all but eroded confidence on the government and the notion of stability.

Seven years of stable low inflation and interest rates helped change that to some extent and as a consequence, fueled the growth of the mortgage market.

 To shed perspective, consider that INFONAVIT  (which is the largest government mortgage providing body), finances loans up to 30 years with no down-payments from the worker! – The way it works is that all employers save a part of the employee’s paycheck in a special account called “subcuenta de vivienda”. This is money that the worker can’t access but keeps building up and compounds over the years. The only one that can access this workers’ savings is the Infonavit. The Infonavit then uses the monies as down-payment for the loan it extend and as a consequence the worker pays no money down on its new home.

Banks and sofoles have recently introduced mortgage products of up to 20 years as well.

These are major development for housing in Mexico, never seen before.

In terms of potential homebuyers, the last seven years of stability have done its part to raise employment and wages to the extent that 23 million Mexicans earn more than the 7 minimum wages a month ($10,000 pesos) minimum that commercial banks request to review mortgage applications.

CONAVI’s estimates of Mortgage loan originations:

	2008E	2009E	2010E	2011E	2012E
INFONAVIT	500,000	550,000	600,000	625,000	625,000
ISSSTE	120,000	136,000	139,000	139,000	139,000
Banks and Sofoles	120,000	115,000	110,000	105,000	100,000
FONHAPO	150,000	165,000	180,000	185,000	190,000
OTHERS	24,000	26,000	29,000	32,000	35,000
TOTAL	914,000	992,000	1,058,000	1,086,000	1,089,000

 

 

III.                Why is housing strategic? – Political implications

 

President Calderón has made housing a top priority for his administration because of the economic and social implications that it has. His goal is to grant 6 million loans during his administration (2006-2012).

I believe political will exists in the federal, state and municipal levels of government since housing is a national priority and the building industry is a large employer, therefore all incentives are aligned for the government to keep supporting the industry.

What’s more, housing is one of the very few points in which consensus exists among the three major political parties in Mexico. Not one of the parties questions the importance of housing for raising living standards, consumption and ultimately winning votes!

 

IV.                Homebuilding in Mexico

Affordable home building is a very fragmented, competitive industry.

To shed some perspective, the five largest publicly traded builders have built a total of 160,778 homes during the last twelve months whereas more than 700,000 mortgage loans have been granted!

 Given the competitive nature of this industry, company’s land reserves are of upmost importance.

In my opinion, you should evaluate a homebuilder by the efficiency of its use of working capital (key to returns), and by its land bank reserves.

Ara is one of the companies best positioned  in both respects.

 

V.                  Consorcio Ara

Ara has been around for more than 29 years, practically pioneering the affordable-housing industry.  Today it is Mexico’s fourth largest homebuilder and arguably, one of the best managed.

Management has historically erred on the conservative side, it is candid and straightforward and generally has under-promised and over-delivered.

 Ara’s management has an economic stake of 36.5% in the company, effectively aligning interests with its shareholder base.

Allow me to compare Ara to its peers in some key metrics:

 

	Units built 2006	Units built TTM	Land bank to sales
CONSORCIO ARA	22,668	23,700	6.7
GEO	41,871	44,598	3.4
HOMEX	43,044	48,042	5.0
SARE	11,109	11,472	3.3
URBI	29,280	32,966	7.8

 

TTM Volume Mix as of 3Q07:

	ARA	GEO	HOMEX	SARE	URBI
Affordable	71.2%	86.6%	90.0%	87.2%	89.4%
Middle- High Income	28.8%	13.4%	10.0%	12.8%	10.6%
Total units	23,700	44,598	48,042	11,472	32,966

 

TTM Revenue Mix as of 3Q07:

	ARA	GEO	HOMEX	SARE	URBI
Affordable	56.4%	NA	74.9%	58.5%	77.7%
Middle- High Income	43.6%	NA	25.1%	41.5%	22.3%
Total (MXN$)	8,618,256	13,130,213	14,338,451	4,678,774	11,816,585

 

TTM per-unit analysis as of 3Q07:

	ARA	GEO	HOMEX	SARE	URBI
Volume	23,700	44,598	48,042	11,472	32,966
Sales	9,096,409	14,237,391	14,939,370	4,748,584	11,817,690
Income per unit	383.8	319.2	311.0	413.9	358.5
Operating profit	2,048,449	3,152,070	3,427,302	910,943	2,979,403
Op. profit per unit	86.4	70.7	71.3	79.4	90.4
EBITDA	2,142,678	3,397,129	1,788,508	932,111	3,140,296
EBITDA per unit	90.4	76.2	37.2	81.3	95.3
Net debt	191,023	3,668,473	1,788,508	1,273,211	2,929,312
Net debt per unit	8.1	82.3	37.2	111.0	88.9
Gross margin	29.5%	27.3%	31.9%	28.8%	33.9%
Operating Margin	22.5%	22.1%	21.2%	19.1%	25.2%

 

As evidenced by the above tables, Ara is second after Urbi in terms land reserves and per-unit profitability although it is worth noting that Ara boasts the highest net margin in the industry.

The company’s strategy to build more middle and high-income homes is paying off since, as seen below, there’s ample growth and pricing power (and better margins), in those segments.

	3Q06-07 Volume Chg	3Q06-07 Price Chg	3Q07 Segment Pricing
Lower – Affordable	20.3%	3.6%	MXN$ 236.4
Affordable	-19.0%	1.2%	$ 351.4
Middle Income	16.3%	0.8%	$534.7
High Income	5.0%	4.2%	$1,901.0
Total	3.7%	-1.3%	$347.0

 

As Mexican’s pricing power increases, demand for middle and high-income housing grows exponentially. (23 million and growing Mexican’s that earn over 7 minimum wages…)

 

In a nutshell, we perceive Ara’s strengths to be:

·         Very effective production and sales cycle that minimizes working capital needs and boosts profitability. (The company builds an affordable entry-level home in under 6 weeks and a middle-income one in less than 10)

·         The second-largest land bank in the industry: 36.4 million square meters, enough to build 136,000 units and 4.9 million square meters suitable for tourist and commercial projects. Ara’s land bank has been built over the years and is strategically located in places with above-average economic growth and more potential for new housing developments.

·         Second highest weighted average selling price in the industry.

·         Very strong balance sheet and free cash flow generator.

·         Hidden assets:  (1) Ara is 50% owner along with O’Connor Capital Partners in three of Mexico’s largest shopping centers: Centro San Miguel, Centro San Buenaventura and Centro Las Américas. With total GLA of 106,000 square meters and an average occupancy of 96%. With the opening of Tijuana’s mall, Ara should increase GLA to 130,000 square meters. (2) Land investments (ex. Its land bank), that have appreciated signifficantly over time.

·         Great managers-owners whose interests are in total alignment with its shareholders.

 

 

 

 

 

VI.                Why is Ara so cheap?

All the Mexican homebuilders have sold off sharply, on average 25 %, during the last six months and although valuations were stretched, we believe that the magnitude of the sell-off is generally not justified.

Having said that, I’d recommend taking a close look at all of Mexico’s large public homebuilders.

However it is our opinion that Ara boasts an unjustified discount to its peers (it has historically traded at a premium multiple), and offers the greatest upside with minimum or non-existent downside.

	TTM EV/EBITDA	2007E EV/EBITDA	2008E EV/EBITDA
CONSORCIO ARA	5.8x	5.4x	4.8x
GEO	7.4x	6.8x	5.8x
HOMEX	9.6x	8.6x	7.3x
SARE	9.5x	8.9x	7.6x
URBI	10.6x	9.6x	8.1x
Sector	8.6x	7.9x	6.7x
ARA’s Discount vs sector	-32.6%	-31.2%	-28.8%

*EV is adjusted for land-bank Premiums (land bank premium is defined as the value of excess land bank to two years), land over two years is basically considered as cash for the EV calculation.

In early October, Ara reduced its guidance to revenue growth of 5% for 2005 and 10% for 2008, whch greatly exacerbated the stock’s sell-off.

The reason for the reduced guidance was mainly slow progress in obtaining permits, authorizations and licenses to build in the State of Mexico and the State of Quintana Roo. These delays affect 11 housing developments and effectively eliminate all of 3Q07’s revenue growth.

The State of Mexico contributes to 38% of Ara’s sales, down from 64% in 2004, but it’s still a very meaningful number and 39% of Ara’s land bank reserves are located there.

We believe concerns are way overblown and checks with local State of Mexico authorities corroborate what the company has been saying: the setbacks are temporary. The State of Mexico is going through a process of institutionalizing its license granting process and should resume its normal pace of authorizations by the second half of 2008.

The State of Mexico is by far the State with the highest population in the country, 13 million people live there (the second largest is the D.F., Mexico’s capital, with 8 million), and has the second largest density of people per square kilometer, 586 persons.

Because of the latter, the State of Mexico is under great pressure to resume its normal pace of building activity soon. Enrique Peña Nieto, the State’s Governor, is a young rising star within his political party and a major contender for the Presidency in 2012. – There is no more effective mean to get votes than by providing housing to your constituents.

We believe that at current prices, all of Ara’s land bank reserves in the State of Mexico are effectively valued at zero.

In terms of 2008’s top line growth, it is also our impression that management is setting very low expectations and will most likely surprise to the upside.

 

VII.              Valuation

We’ll value Ara using two different methodologies:

 

1)      DCF

2)      Private market value

 

DCF

Ara is a large cash generator, depreciation and CAPEX are roughly the same and therefore the only important variable to cash flow is change in working capital.

Of course, change in working capital is of essence in a homebuilder but for our back of the envelope cash flow calculation, let’s assume that it evens out during 10 years and effectively Net Income equals cash flow.

We’ll assume starting cash flows of $1,304 million pesos in year 1, growing at a 10% pace for the first five years and at a 5% pace for the last five years. Then we’ll assume selling the business at a modest 15x cash flow in year 10.

When applying a 10% discount rate, the present value of Ara’s expected cash flows is $25,550 million pesos. Ara has 1,313 million shares outstanding; therefore Ara’s intrinsic value should approximate $19.5 pesos per-share or 62% above current prices.

Our margin of safety lies in our assumptions: 10% cash flow growth for 5 years and 5% for the remaining five is quite conservative when we take into account that Ara has increased its operating cash flows at a 22%+ rate for the last ten years and has very bright prospects for the next ten.

If we assume a more reasonable 15% growth rate for the first 5 years going down to 7% for the remaining 5 and the same 15 times multiple in year 10, our present value increases to $31,590 million; $24.1 on a per-share basis or effectively double the current quoted share price.

 

Private Market Value

 As recently as October this year, Carlos Slim through his company CICSA, announced the purchase of Urvitec, a small affordable-housing builder in Mexico.

Urvitec built 2,300 homes in 2006 and expected to build 4,000 in 2007 and has a 30,000 home land reserve.

Urvitec is roughly 1/10^th the size of Ara and has similar margins (22% operating margin).

Mr. Slim paid roughly 22x TTM P/E and 11x TTM EBITDA for Urvitec; applying the same multiples to Ara, we reach a private market value of:

 

TTM Net Profit	1,360		TTM EBITDA	2,177
P/E	22		EV/EBITDA	11
Market Cap.	29,920		Enterprise Value	23,947
			Net Debt	191
			Land-bank premium	-3,135
Shares outstanding	1,313		Shares outstanding	1,313
Price per share	22.8		Price per share	20.5
Current price	12		Current price	12
Upside	90%		Upside	71%

 

Arguably, Ara should fetch a larger multiple than Urvitec given its market share and the obvious difficulty of replicating the company’s land bank. Thus we believe this to be a conservative estimate of Ara’s private market value.

 

Intrinsic Value Estimate

                               Per-share price target

	Low	High	Average
DCF Valuation	19.5	24.1	21.8
Private market value	20.5	22.8	21.6
Average	20.0	23.5	21.7

 

We believe Ara’s intrinsic value should lie somewhere between $20 and $24 pesos per-share in the next 12 to 18 months, implying between 67 and 100% upside from current prices.

Furthermore, we are purposely NOT taking into account Ara’s 50% stake in its shopping center joint venture with O’Connor Capital Partners; which only provides for further margin of safety.

 

VIII.            Catalysts

 

1.       Santander Latam conference in Acapulco, Mexico (Jan 16-19). Santander’s is one of the most important Latam conferences. It is heavily assisted by institutional clients and has one of the best levels of representation from companies’ senior management.  Ara’s CEO and CFO will be present and take one-on-one meetings.

2.       License granting in the State of Mexico resuming its normal pace.

3.       Share buy-backs.

4.       Management low-balling expectations and surprising.

 

 

IX.                Risks

 

1.       Benign interest rate and Inflation environment in Mexico reversing itself and rising by double digits.

 

 

Catalyst

1. Santander Latam conference in Acapulco, Mexico (Jan 16-19). Santander’s is one of the most important Latam conferences. It is heavily assisted by institutional clients and has one of the best levels of representation from companies’ senior management. Ara’s CEO and CFO will be present and take one-on-one meetings.

2. License granting in the State of Mexico resuming its normal pace.

3. Share buy-backs.

4. Management low-balling expectations and surprising.