Description

Yes, it's time once again for your monthly Mexican ADR. Grupo Imsa is a diversified, NYSE-listed Mexican industrial concern with operations in construction materials, steel processing, prefabricated metal buildings, and automotive battery manufacturing across Mexico, the USA, Spain, and Central and South America. The businesses are fairly boring, and the situation here perhaps isn't as unique as ASR or Radio Centro (both of which I liked a lot); but Imsa is a dominant and structurally low-cost producer in many of its markets, has seen substantial growth in export revenues making it increasingly independent of the domestic Mexican economy, and has the kind of reasonable valuations to basic ratios that have become increasingly difficult to find north of the border. Still off significantly from a high of $27 per ADS after its NYSE IPO in 1997, IMY trades at a price to sales ratio of 0.37, price/tangible book of 0.79, 2.5X EBITDA, and EV/EBITDA of 4.76. The P/E is 7.21 times US GAAP earnings for FY 02 and 4.36 times an average of 2004 analyst estimates. Management has projected EBITDA of $365 million for 2003 and "in excess of" $400 million for 2004. Imsa paid down debt by $37 million during the last quarter and is continuing to focus on debt reduction. 2004 capex is projected at $100 million, and with interest expense totaling just $43 million during 2002, the company should have substantial room to do so.


Market cap $945 M
Net debt $878 M
EV $1821 M
EBITDA (ttm) $377.9 M (2.52X)
EV/EBITDA (ttm) 4.82
FY02 US GAAP Net Income $132 M (7.21X) *
FY02 US GAAP Operating Income $296 M (3.21X)

* includes a $65 M net foreign currency loss


BACKGROUND - BATTERY MANUFACTURING

Apart from basic undervaluation of the group as a whole, Imsa owns an interesting manufacturing business with some attractive "deep moat" characteristics. Imsa's Enermex subsidiary is easily the largest manufacturer of automotive batteries in Latin America, and has begun to produce related products such as vehicular oil and air filters. In addition to selling to wholesale distributors and directly to large customers, Enermex distributes its product line to local auto supply/repair customers and is authorized to collect used batteries deposited at these sites, which are otherwise quite difficult to dispose of legally. Through a proprietary process that management claims has significant advantages in the purity and cost of extracted lead, the company recovers a substantial fraction of the lead and polypropylene content of each battery for use in newly manufactured products. Lead and polypropylene raw materials represent over 40% of the cost of a manufactured battery, and Imsa is currently able to source 47% of these raw material needs from used batteries it obtains at a nominal cost. With over an 80% market share in Mexico itself, Enermex' distribution and recycling infrastructure creates a potent barrier to entry for competing firms, and is beginning to generate efficiencies that have contributed to growth in operating margin at the division to 19.3% from 12.2% since 1998. Top-line growth has so far been disappointingly slow, but any expansion into neighboring markets could further solidify IMY's cost advantage and generate value-added earnings growth.

In 1998, Imsa formed a joint venture with US manufacturer Johnson Controls (NYSE: JCI) to develop a battery manufacturing and distribution network serving the US, Canada, and South America. Imsa has rapidly become a significant exporter of batteries to the US and Canada, as well as a significant importer of used batteries; according to the June 20-F, Enermex has achieved a 40% compound annual growth in North American revenues since 1996. The car battery market in South America is highly fragmented, with many local operators running small, unlicensed factories that generally avoid tax and environmental liability. This has made initial penetration difficult, but management believes that volumes at its complex in Brazil are beginning to build to the point that scaling efficiencies enable it to outcompete "informal" rivals while complying with the law. US and Canadian laws mandate proper disposal of lead-acid batteries, but these same regulations have made it economically unfavorable to operate lead smelters in either nation. Enermex currently provides just over a quarter of the group's EBITDA; I believe it represents a defensible low-cost franchise with the as yet unrealized opportunity for some substantial growth.


BACKGROUND - STEEL & OTHER PRODUCTS

Imsa's steel processing and construction products businesses are profitable but somewhat commoditized, though specialization into coated and pre-painted steel products and a proprietary zinc-aluminum-silica alloy galvanization process have created some scope for differentiation. Imsa now has over a 50% domestic market share in Mexico for most of the steel products it produces, and is the largest Mexican producer of fabricated aluminum products. Together with its growing export volumes, this generates economies of scale that should secure IMY's position as a North American low cost producer. The Bush administration is under increasing pressure to repeal or modify the measures it enacted to protect struggling US-based integrated steelmakers. Imsa Acero (steel processing unit) has doubtless benefited from tariffs on hot-rolled and cold-rolled steel through the exemptions it enjoys as a NAFTA company, but is an equally large consumer of unprocessed steel, which has been under equally heavy protection. Global pricing for processed steel products appears to be strengthening amid booming demand from China, and is actually higher in many countries outside North America.

With the recent integration of Pinole Point Steel and MSC Pre-Finish Metals into its US-based Steelscape business unit, Imsa combines low-cost facilities in Mexico for initial processing of raw slabs into cold-rolled steel with facilities in the western US for on-demand processing of rolled steel to a range of customer specifications. Asian imports can still compete, but by focusing on local steel processing centers filling smaller custom orders with shorter lead times, IMY should be able to continuing to earn consistent margins on processing given a decent economy. Imsa has also recently acquired Varco Pruden Companies, a significant custom designer, manufacturer and installer of pre-engineered metal buildings, from US steelmaker LTV Corp in a bankruptcy proceeding. Again, the combination of large scale Mexican production of low-cost processed steel with a strong customization and service presence in developed markets appears to be setting the stage for sustainable profit margins over the long term. I mention this only to emphasize that IMY's processing and service businesses have significantly better long-term economics than those of an overleveraged, high-fixed-cost integrated steelmaker, and that steel processing in North America isn't about to go the way of the dodo.


OWNERSHIP, GOVERNANCE AND DEBT

Like many large Mexican enterprises, Imsa is principally owned and controlled by its founding family -- the Clarionds own 81% of the outstanding stock and are committed to retaining at least 51% of the voting shares indefinitely. Voting control is a real concern, but management ownership of an extremely large equity stake should create incentives to maximize long-term value if this investment is ever to be monetized. Compensation appears somewhat rich at a total of $16.6 million for the 10 listed officers, but otherwise management seems to have treated shareholders fairly, and appears reasonably competent in operations and the allocation of capital (for instance declining to pursue an expensive 1999 takeover of struggling integrated steelmaker AHMSA). The group is currently undergoing a "6-Sigma" operations review process meant to improve efficiency, product quality and profitability -- it's unclear what actual impact this has had aside from the improving margins at Enermex, but it is at least encouraging evidence of an adaptable and results-oriented corporate culture.

With a series of recent bond issues and syndicated loans, the company has significantly improved the rate and maturity profile of its debt, and EBITDA interest coverage now exceeds 11 times. Since Imsa is increasingly an export-oriented firm, its low-rate dollar-denominated loans don't create the same degree of currency risk found in many emerging market companies, and its businesses are gradually becoming more insulated from any weakness or volatility in the domestic Mexican economy. There's still currency risk here, but as this financing is part of an aggressive plan of debt reduction I don't see a real problem. As a final note, IMY shareholders currently enjoy a 3.22% dividend yield, and the firm has considerable scope to raise this using current cash flow.

Catalyst

Basic undervaluation and debt reduction. The low end of management's projected $400+ million EBITDA in 2004 would leave IMY trading at 2.3X EBITDA and 4.5 EV/EBITDA -- probably less on the second figure as the company has been paying down debt. A recovery in the North American economy would be strongly felt by Imsa's export businesses and could further boost results.