Thesis: We are recommending a short position in Grupo Elektra, a misunderstood Mexican white goods retailer and bank, which offers at least 40% downside valuing it on a sum-of-the-parts basis as follows:

 

 

We believe this is conservative given: 1) the controlling shareholder’s historical abuse of minority investors 2) stagnant commercial segment sales despite a robust Mexican retail environment and internal financing for 70% of commercial revenues 3) highly cyclical retail end markets 4) acceleration of banking NPLs from 4.5% to 13% over the last 2 years and 5) participation in and reliance on opaque derivatives transactions tied to their own stock price performance for 75% of their net income in the TTM and 70% in the latest quarter 6) above industry commercial margins sustainable only through inadequate risk pricing of banking loans.

Description:  Grupo Elektra operates 979 stores that sell white goods to low and middle income consumers in Mexico and is increasingly trying to expand into new geographies (Brazil) and markets (automobiles). The company also operates Banco Azteca, whose primary role is to provide financing for customers at its commercial operation. In 2007, the company’s retail operations accounted for 49% of total sales and 54% of operating profit, the bank divisions was 51% sales, and 46% of profit as reported.

 

·    1.  History of corporate governance malfeasance-  Ricardo Salinas, Elektra’s CEO owns ~50% of the stock and does not have a reputation for being shareholder friendly. Grupo Elektra stock delisted from the NYSE in 2005 when Salinas faced charges of stock fraud in which he profited from a complex debt scheme at the expense of investors. Currently, Ricardo Salinas is pursuing noncore business ventures such as selling Chinese imported cars. While we discount anecdotes, Mexican contacts have given us a less than favorable feedback on Mr. Salinas.

 

·      2. Questionable operating decisions-  Elektra finances 70% of the sales in its retail stores, which creates an opportunity to over-extend credit to low quality borrowers in order to sustain sales growth. It also gives the company flexibility in how it allocates net income and cash flow as they don’t report the interest rate charged to the customer.  Its’ expansion decisions in both the commercial segment (auto manufacturing) and bank segment (unsecured lending and credit cards) are questionable.

·      3. Rising NPLs at Banco Azteca- Banco Azteca’s loan book has deteriorated significantly in the past 2 years. NPLs averaged 10% in 2007, up from 4.5% in 2006 and recently reached 13% in 2Q08. We believe NPLs are spiking higher partly due to an attempt to drive commercial sales, but mostly this is being driven by Elektra’s  attempts to enter unsecured lending. Elektra’s ~P10bln unsecured loan book has ~20% NPLs, which compare unfavorably with Compartamos and Independencia’s NPLs of 4.0-7.7% .

·     4. Non-operational gains driving financial performance- Grupo Elektra has been increasingly dependent on one time, below the line gains as a source of net income. These gains are coming from a derivative that the company holds on its own stock. The contribution of these gains to its LTM rolling net income has increased from <10% in 2005 to 85% as of the last quarter. These gains are rumored to be derivatives that the company holds on its own stock.

·     5. Competitive market- Grupo Elektra operates in a competitive market as both Coppel and Famsa are increasing their store overlap with Elektra and have started to extend credit to their customers. The market will become even more competitive as Best Buy is looking to enter the Mexico within the next year. On the banking side, in addition to traditional banking competition, Walmex and Soriana are both expanding their consumer lending units which is indicative of the growing competition for Mexican banking customers. 

·     6. Non-fundamental reasons for stock movement-  Elektra’s stock price has been supported (+23% YTD) by a change in Mexican pension fund regulation which has lead  to >$2bn flowing into Mexican equities since April 2008. Given that Elektra’s stock is illiquid and comprises 3% of the Mexico Bolsa Index, this has lead to incremental buying of ~3%of Elektra’s free float since April because 95% of the capital flowed into the Mexico Bolsa tracker. In addition, we believe that hedging operations related to the aforementioned derivative may have accounted for as much as 75% of the underlying equity volume for the last 2 months.

·     7. High valuation regardless - On a naïve, consolidated basis, Elektra is trading at 3.5x 2008E Sales and 15.5x 2009E EBITDA, which is a 2x the valuation of Mexican comp and international comps. Given the business economics, we believe that this is unjustified regardless of your opinion of the appropriate division of economics and sum-of-the-parts valuation.

·     8. Difficult macroeconomic environment- Mexico is experiencing macroeconomic pressures from higher inflation (rates and consumer spending), slowing GDP and is reporting the lowest consumer confidence in 7 years which does not bode well for the retail sector. Retailers such as Soriana and Walmex are seeing significant slowdowns in real SSS and we believe Elektra’s product offering should be particularly sensitive to a weak economic environment (similar to ANTAD’s specialty SSS of -8-9%). Remittances were -2.2% in 1H08, declining for the first time since the Mexican Central bank started keeping records.

 

            Grupo Elektra is the largest retailer of white goods in Mexico, and is increasingly trying to expand into new geographies (Brazil) and markets (automobiles). We believe its retail operations face a particularly tough operating environment given its mix of electronics (26% sales), white goods (25% sales) and furniture (10% sales) and an average ticket size of $250, growing competition and deteriorating macro conditions. The majority of its sales (70%) are self-financed. In addition to having an overly aggressive collection practice, Elektra assumes a loan is recovered when the asset is repossessed despite the fact that it is subsequently sold for a 30% or greater discount in company “discount” stores [the company was unable to provide us with specific accounting treatments]. The company is taking increasingly aggressive steps to expand by selling automobiles with plans to gradually move into automobile production with no previous experience.

            Banco Azteca is the group’s encumbered banking operation whose primary role is to provide financing for its commercial operation. We believe the rise in NPLs to 13% in 2Q2008 from 6% 4Q2006 and 0.9% 4Q2005 is indicative of forced growth in retail operation related loans and a misguided attempt by the bank to enter unsecured consumer lending. Reflecting the subsidies transferred to its commercial segments, Banco Azteca has generated ~0-4% ROAs over the last 12 quarters, has 7.8% equity / assets and has only 37% loans /assets compared to 15-25% ROAs (current), 40-42% equity/assets and 80-87% loans /assets for Financiera Independencia and Banco Compartamos. While these are not ideal comparables, we believe this supports the case (along with NPL problems) that Banco Azteca is unlikely to increase the profitable deployment of assets in any meaningfully manner. 

            We believe that Grupo Elektra has generated P3.3bln in net income in the past 12 months by entering derivative contracts tied to its own stock price. Admittedly, our hypotheses are based on incomplete facts, anecdotes and assumptions. Based on our work, we believe Grupo Elektra has entered into an equity swap for a notional exposure of   6.0bn pesos or 22mln shares of exposure [calculated over the last three quarters based on the quarterly stock price change and company statements that the contract includes no price ceiling/floor].  We believe that the contract was recently renewed for a tenor of approximately 3 years and is settled for cash or shares and renewed at the discretion of Grupo Elektra. It is unclear whether a counterparty has a natural source of shares, is delta hedging or some combination; however, we doubt the stock offers enough natural liquidity to hedge in the open market. We do believe that the counterparty may have accounted for significant amounts of share volume in recent months.