Consorcio Ara ARA* MM
December 26, 2007 - 2:25pm EST by
flubber926
2007 2008
Price: 11.99 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 1,430 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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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 1/10th 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.
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    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 1/10th 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.

    Messages


    SubjectHappy Holidays and best wishes
    Entry12/26/2007 02:33 PM
    Memberflubber926
    Happy Holidays and best wishes for 2008!

    SubjectQuestions
    Entry12/27/2007 11:10 AM
    Memberthoreau941
    1. What are typical loan to value ratios for the loans used to finance homes in Mexico?

    2. What are typical credit losses on home loans?

    3. How has pricing of homes in Mexico trended in recent years?

    4. I have been hearing anecdotal evidence that the Mexican economy is slowing. How will this affect Consorcio Ara?

    SubjectRe: Questions
    Entry12/27/2007 06:02 PM
    Memberflubber926
    With respect to LTV ratios:
    Since the mortgage industry is still in its early development stages, excesses haven't happened yet in my opinion,
    Typical LTV loans are 80% it is extremely rare that the typical homeowner will be able to get a loan with less than 20% down payment.

    With respect to credit losses and home prices:
    To give you an example, Infonavit's NPL (91 days or longer), are 4% of the number of granted loans and trending down every year. - It is important to remember that a credit culture was practically non-existent in Mexico 10 years ago. People are now starting to access credit and the financials institutions as a whole are doing a good job in advertising the benefits of a having a good credit history.

    With respect to home pricing, as seen in the writeup, lower-affordable homes prices have basically trended inflation. Affordable and middle-income homes have appreciated below inflation.

    Typically the homes that Ara builds are located in areas where little infrastructure existed before, therefore land was very cheap. Once a 5,000 home development is created, shopping, dining and entertainment options follow and land tends to appreciate so a MXN$260K home would normally appreciate in value above inflation.

    With respect to the Mexican economy slowing, you are totally right. Consumption is showing signs of weakening and Mexico's economy will be hard hit in the event of a US recession. Affordable housing should be little affected and Ara should have no trouble in acheiving mid double digit top line growth.
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