Description

The following investment idea is about GRUPO ELEKTRA. This is not a Mexican listed company, however, I should say that (i) This is in my opinion a truly exceptional value & growth play in Mexico and Latinamerica; (ii)Mexican regulation is everyday more focused on minority-rights protection and the new Mexican Securities Law (recently approved by Congress), was modeled after the US Securities Law; and (iii) A member of V.I.C. (valueguy 201) wrote a great piece on TV Azteca, Elektra’s sister company. I assume some of you might already be familiar with Ricardo Salinas and Elektra as you researched TV Azteca. (I highly recommend reading Valueguy201’s post on TV Azteca. In my opinion, he did an outstanding job in explaining the Company’s legal issues to great detail and those issues by themselves are one of the main reasons why both TV Azteca and Elektra are so undervalued currently).

Now back to the idea…

Grupo Elektra represents a truly outstanding investment opportunity. The company has been very successful with their business model for more than 50 years now. The investment opportunity arises because of recent controversy regarding one of its most important shareholders (Mr. Ricardo Salinas Pliego), and the complexity of its recently developed financial business. This is a textbook case of both an underappreciated and misunderstood story.

Elektra has two divisions: Retail and Financial.

The company is the clear market leader in electronics, home appliances and furniture sales to Mexico’s middle and upper-low income people (the C+, C, D+ & D segments), which represent 73% of the Country’s population or 17 million households.

Part of their success in achieveing this leadership position was due to Elektra’s willingness to finance purchases for their customers when nobody else would. This market segment (mid to low income Mexicans), was basically neglected by Mexico’s banks and most of Elektra’s customers had access to financing through the informal channels only and at very unadvantageous conditions.

In a nutshell, the company designed a very clever credit approval and collection system that involved visiting their prospecting client’s home in order to determine how much they could afford to pay each month (depending on such things as how many rooms the house had, number of lights, people that lived there, etc, etc.), before approving credit.
On the other hand, when a customer was late on their weekly or monthly payments, a company collector would visit him at his home (wearing a flashy yellow uniform with “collector” written on the back…), to discuss why he was late in his payments and encourage the client to regularize his credit or risk having his living room repossesed! This strategy (somewhat simplified by the writer), allowed Grupo Elektra to increase sales at a 14% CAGR for the last 10 years while maintaining a very low past due to total loans ratio.

Throughout the years, the company has gathered credit, financial and demographic information from more than 10 million customers. This customers are not in the credit bureau and that by itself constitutes a core competitive advantage of the company and a strong barrier of entry for new participants.

During late 2003, the company decided to leverage their positioning and their credit expertise by applying for a financial group licence. Their strategy was to provide banking, insurance and pension management services to the same segment of the population that they’ve known so well for years.
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Today they own Mexico’s fastest growing bank, which now has over 1,400 branches and enjoys financial metrics like a 32% net interest margin and 27% ROE!

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Elektra’s value derives from three main assets:
1. It’s retail business,
2. It’s financial services division, and
3. a 7.6% stake in TV Azteca (Mexico’s #2 broadcaster)

The company’s valuation is the following:

Stock Price (ELEKTRA* MM) 96 pesos
Shares outstanding 232 million
Mkt Cap 22,272 mm pesos
Fx 10.6
Mkt Cap (US$) $2,101mm
Net Debt (Cash) ($153 mm)
Enterprise Value $1,948mm

Let’s go through a strip-down analysis, using 2005E numbers:

E.V. $1,948mm

Value of TV Azteca Stake
Stock Price (TVAZTCPO MM) 6.88 pesos
Shares outstanding 2,973 million
Mkt Cap 20,454 mm pesos
Mkt Cap (US$) $1,929mm
7.6% Stake $147mm

Value of Banco Azteca
Net Profit (US$) $65 mm
P/E 10x
Mkt Value $650mm


ELEKTRA E.V. $1,929mm
- TV Azteca Stake 147mm
- Banco Azteca 650mm

Adjusted Elektra EV $1,132mm
Retail EBITDA (05Est) $295mm
Adj EV/EBITDA 3.8x

Elektra’s retail division is being valued at 3.8x EV/EBITDA eventhough it should grow EBITDA by 15-20% during the next few years and has a track record of EBITDA growth of 14% during the last 10 years!

As a benchmark, consider that Mexican retail (excluding Walmart de Mexico), trades at around 6.5x EBITDA.

It is obvious that there is value here, however the cake’s icing is to take into consideration the financial division and it’s growth potential during 2006 and 2007.

Now let’s discuss each division and what I believe will be the drivers of growth for the coming years.


RETAIL BUSINESS

· Elektra is the clear leader in the electronics, home appliances and furniture sales to Mexico’s middle and upper low income people (C+, C, D+ & D segments), which represent 73% of the Country’s population or 17 million households.
· Revenues have been growing at a 14% CAGR for 10 years to TTM sales of US$2.8bn.
· EBITDA has grown at a compunded 14% rate as well for 10 years, with TTM EBITDA of US$288mm.
· Elektra has 1,022 retail units. 741 Elektra stores that target the D and D+ market which accounts for 55% of population, (these are the company’s flagship stores); 73 Salinas y rocha stores which sell mainly furniture and appliances to the C and C+ market (18% of population); and 81 Bodega de remates stores which sell discounted and reposessed goods to the lower D segment. They also have a new format called Elektricity (45 units), which specialize in electronics and are geared to the higher, C+ and B segments. Outside of Mexico, the company operates 82 stores in Guatemala, Honduras and Peru.


MEXICAN CONSUMER

· Consumer credit has been growing at a 47.5% CAGR for the last three years to almost US$20bn. Mainly as a consecuence of stable economic conditions, lower inflation and falling interest rates.
· Job creation has been very strong and I think this trend should continue for a while with 400,000 new jobs expected for 2006.
· Real wages are growing.
· Consumer confidence is at multi-year highs aided by the Country’s economic stability. Controlled inflation, moderate GDP growth and a stable peso have certainly helped.


MEXICAN DEMOGRAPHICS

· 63% of the population is 29 years or younger.
· 685,000 new marriages every year, 1MM if you take into account unions.

I believe the Mexican consumer will continue to be very strong during the next years because of all the above listed factors and Elektra should benefit proportionally.
After all, those new million households will all need a place to live, furniture and a TV and most likely the great majority will want to buy those goods on credit.

Now let’s talk about the Finance Division:

BANCO AZTECA

· Total Deposits US$2.3 bn (54% YOY growth)
· Total Loans US$1.3 bn (48% YOY growth)
· Equity US$200mm (110% YOY growth)
· Net Income (2005E): $65mm (80% YOY growth)
· NIM: 32%
· ROE 27%
· Past due loan ratio: 4.6%
· Loan loss reserve to past due loans: 156%

Banco Azteca has 7.5mm active credit accounts and I expect that they should end 2006 with around 12mm accounts.
Management instituted savings accounts like “guardadito” that can be opened with as little as $50 pesos (US$4.80). I expect initiatives like this one to provide for continued expansion of the Bank’s portfolio.

Banco Azteca has over 1,400 small branches. It’s branches are more like kiosks, probably averaging 800 sq ft., strategically positioned in Elektra’s retail stores and other locations that are very accesible to their target market.
To put this in perspective, Banorte has 980 branches and is Mexico’s third largest Bank.

Another thing to consider is that in general Mexican Bank’s ROE’s have been very high during the last couple of years, partly aided by the high interest rates environment in Mexico. Rates in Mexico are most likely to remain low in the near future partly due to the low inflation environment that the Country now enjoys, therefore I expect Bank ROE’s to normalize at around 18% during 2006.

Banco Azteca, on the other hand, will probably slow down their branch expansion during the coming years and the lower rates should have a lesser effect on profitability going forward because of the Bank’s target market, therefore I expect Banco Azteca’s ROE to average 30% during the next 5 years.

As part of the growth initiatives that the Bank is pursuing for 2006, consider the recently launched Banco Azteca credit card: They now have 2mm credit cards with an average balance of $900 pesos (US$84) and expect to finish 2006 with 6mm credit cards and average balances of $2000 pesos (US$175).
Again, most of their clients had no credit cards before, Banco Azteca knows their credit history and determines who is credit worthy and who is not.
Whenever you purchase something with your Banco Azteca credit card, the transaction slip will indicate what the weekly payment on your new purchase will be and what is your total balance and the weekly payment for that. Basically the same system that Elektra has used for years.

This new product will allow Banco Azteca to benefit from Mexico’s undergoing credit expansion regardless of where the Bank’s customers purchase goods.

It is important to consider that although consumer credit has grown at a CAGR of 47% during the last three years, it is still insignificant, representing less than 2% of GDP.
By comparison, Brazil’s credit penetration is close to 7% of GDP. So there is a lot room to grow from here.


SEGUROS AZTECA (INSURANCE)

· Focused on same market segment: D, D+, C and C+
· Seguros Azteca currently offers “Vidamax” which is a life insurance policy; “Credimax consumo” which insures consumer loans and “Credimax efectivo” which insures personal loans.
· Response has been spectacular: 61% of those receiving a consumer loan and 75% of those receiving a personal loan through Banco Azteca, aquire Vidamax.

To put this in perspective, consider that today Seguros Aztecas has written 6 million life insurance policies to customers that have purchased goods at Elektra stores.

The average life of the policy is 2 years (the time that’s left fot clients fully pay their balance with Elektra), and the company charges around US$1 a month for the insurance. Therefore, during the next two years, Seguros Azteca will have collected premiums equal to US$72 million, with a net margin that should be around 75-80% in my estimation. Margins should be that high because of the low probablilty that the average customer will pass-away within the short life of the policy.


AFORE AZTECA (PENSION FUND MANAGER)

· 900,000 affiliates to date (30% YOY growth)
· Second best Afore in terms of returns on assets under management (7.23% vs average of 5.88%) during 2004.


Now that we’ve discussed the business, let’s turn to valuation:

FINANCIAL PROJECTIONS AND VALUATION

Following are some rough projections of Elektra’s EBITDA and Earnings as well as its implied valuation multiples.
I will give zero value to the Afore’s (pension fund management) cash flow to further add to the margin of safety.
On the other hand, I will deduct the value of Elektra’s stake in TV Azteca from the company’s EV.

ELEKTRA
Current Market Cap $ 2,101
- TV Azteca stake $ 147
Adjusted Market Cap $ 1,954

On a P/E basis

2005E 2006E 2007E
Retail Business
EBITDA $ 295 $ 330 $ 363
Net Profit $ 145 $ 162 $ 179

Financial Business
Net Profit $ 65 $ 117 $ 193

Added Earnings(Ret+Fin)$ 210 $ 279 $ 372

Current P/E 9.3 6.9 5.2


Now, let's say Elektra retail trades at 5.5x EBITDA (15% discount to Mex. Retail)


Current Market Cap $ 2,101
- TV Azteca stake $ 147
Adjusted Market Cap $ 1,954
Net Debt (Cash) -$ 153
E.V. $ 1,801

2005E 2006E 2007E
Retail Business
EBITDA $ 295 $ 330 $ 363
Net Debt (Cash) -$ 153 -$ 233 -$ 310
EV at 5.5X $ 1,920 $ 2,194 $ 2,453

Today, you are getting a Bank, Insurance Co and pension mgmt for free!


So, now let's look at fair value in my view:


2005E 2006E 2007E
Retail Business
EBITDA $ 295 $ 330 $ 363
Net Debt (Cash) -$ 153 -$ 233 -$ 310
EV at 5.5X $ 1,920 $ 2,194 $ 2,453

Financial Business
Net Profit $ 65 $ 117 $ 193
P/E Múltiple 10x 10x 10x
Mkt Cap at 10x PE Banking$ 650 $ 1,170 $ 1,931

Added EV $ 2,570 $ 3,364 $ 4,383

Px/ Share (Pesos)$ 117 $ 154 $ 200
Current Px (Pesos)$ 96 $ 96 $ 96

Upside to Fair Value 22% 60% 108%


Note that I used a 5.5x EBITDA multiple for the retail biz which by itself is conservative and a 10x P/E for a Bank that has a 30% ROE and earnings growing at a 80% rate.

For reference purposes, the multiples at which Mexican retailers trade are:

RETAIL VALUATIONS

PRICE MKT CAP E.V. P/E 05E EV/EBITDA 05E YOY EBITDA GROWTH
COMERCI 16.4 1,668 1,843 12.1 6.9 4%
SORIANA 48.9 2,767 2,482 12.7 7.1 8%
GIGANTE 7 635 891 10.4 5.4 4%
WALMEX 60.7 25,239 23,566 28.2 16.8 9%

ELEKTRA 96 2,101 1,948 9.3 4.6 15%


I think there is a lot of value here.


So, why is the stock so cheap?

Early this year, the SEC filed a complain against Ricardo Salinas Pliego (who is one of the largest shareholders of Elektra), and TV Azteca, a company he controls.

The complain finds its merits on a deal that dates back to 2003 in which Ricardo Salinas and a partner of his bought back vendor financing from Nortel at about a third of face value.
Some months later, Unefon (a mobile company also owned by Mr. Salinas and his partner), after receiving fresh money from the sale of spectrum to America Movil (Mexico’s largest wireless player), repaid the debt at face value, creating an immediate gain of close to US$220 million for Mr. Salinas and his partner.

The problem was not the profit made or that Mr. Salinas bought at a discount the debt but that the whole deal was not disclosed to the board of TV Azteca or the public. (TV Azteca owns 46.5% of Unefon)

The case was settled with the Mexican authorities but is still pending with the SEC.

What the SEC is seeking is return of the profit made and the barring of Salinas from having a position in any board of a US public Company.

Salinas denies any wrongdoing and has entered into a very public dispute with the SEC that recently resulted in Mr. Salinas delisting TV Azteca, Elektra and Iusacell from the NYSE. It is important to note, however, that the three company’s still file their financials as required by US law, the companies were delisted but they are still registered in the US.

There is no question that Mr. Salinas is far from being an example of corporate governance, however I think that his track record speaks volumes on his managerial abilities.

The SEC complaint is in my opinion the main factor as to why the stock is so undervalued. Salinas is plainly out-of-favor and investors apparently decided to bail out.

My personal belief is that this case will be resolved soon (next 6 months or so), most probably by a settlement.

Now, let me make an important point here: whereas Ricardo Salinas is the majority shareholder of TV Azteca, with a 65%+ stake, he IS NOT majority owner of Elektra. His father, Mr. Hugo Salinas Price is actually the largest shareholder and Ricardo Salinas’s stake is around 25%.

Furthermore, the SEC complaint has no effects on Elektra whatsoever.

While Elektra may never trade at market multiples because of Ricardo Salinas involvement in the company, I believe there simply is too much value in the company for investors to neglect the opportunity.


Risks

Competition is always a risk, however Elektra is the clear leader in their market niche and their closest competitor (Coppel), has been around for more than 60 years now and is a fraction of the size of Elektra with only 430 stores.

Coppel is now venturing into financing activities as well, however, I believe them to be still in the early learning curve process as evidenced by their 28% past due loan ratio!

In my opinion, the main risk to this thesis is Mexico’s economy slowing and that causing a drag on the consumer.

Other than that, political risk is always a factor and Mexico will hold Presidential elections this year.

If desired, you could simply buy a Mexican credit default swap or short the peso to hedge Mexican systematic risk.

Catalyst

· Bank’s earnings growth and Investors discovering the hidden value of Elektra’s financial division.
· Spin-off of Financial group.
· SEC case against Salinas resolved.
· Both the company and insiders have been buying back stock VERY aggresively for the last three months.