Description

Write-up Consorcio ARA; BMV ticker: ARA* (all figures in Mexican pesos)

*See writeup with tables and images here: http://www.box.com/s/ozt07gioxt5iep02zb3m 

Business Description: 

Consorcio ARA is a vertically integrated residential & commercial real-estate developer.  The company has a long and distinguished history as a leader in the secular growing homebuilding industry in Mexico. 

With 52 developments currently in operation ARA builds around 17,000 – 18,000 homes per year across low, middle and upper-end segments.   It has a land bank of 44 MM square meters – equivalent to almost 11,000 acres – enough to build ~182,000 future homes.  It also owns and operates 7 shopping centers and 5 strip-malls that sums up to almost 2 MM sq ft of leasable area.

Note: ARA was written up by flubber926 in December of 2007.  Flubber did a great job of describing overall industry dynamics – all of which are still relevant today. I recommend people read his post.  The stock is down ~65% since that write-up, but many of his points still hold, making the risk/reward that much more attractive.

Quick Summary

ARA is a deep-value / reversion of the mean situation.  Its diversified strategy & business model are largely misunderstood by the market and its high quality non-core commercial real estate division PDCC – worth approximately 20% of today’s market-cap – is for the most part ignored.    

With its stock hovering near 10-year lows, ARA has created a level of investor fatigue and revulsion that sets the perfect stage for potentially extraordinary returns with significant downside protection. 

On a SOTP basis I estimate ARA’s current intrinsic value to be ~ $8.23.

In a nutshell, the market is pricing in a broken business model operating in what is perceived to be a mature industry with few opportunities for profitable growth.  The sell-side has all but given up on ARA and expresses skepticism about the company and the sector every opportunity they get.

While some of ARA’s recent stumbles aren’t insignificant, with clear execution missteps, the market has severely overreacted and is underestimating the likelihood that most of its problems – and that of the industry’s – can be fixed and should put it back on track to resume its historical track record of generating attractive returns on capital for shareholders. 

Despite a number of challenges, I’m hesitant to call this a turnaround situation mainly because most execution missteps seem to have a clear path toward resolution; keep in mind that returns on equity during this notoriously difficult cycle have still averaged ~8.5% despite a number of unusual expenses and a heavy capital drag from rising inventory levels (more on this later).  In other words, ARA has generated mediocre but not devastating results during a very difficult period - thus it is hard to imagine a scenario that could translate into a permanent impairment of capital for purchases made at current prices.   

Today’s distressed price is an opportunity for investors who are willing to ride-out these turbulent times.  I believe patience will handsomely reward investors who seek attractive risk-adjusted returns - considering the significant margin of safety provided by high-quality tangible assets on the balance sheet with a replacement value that is nearly double today’s stock price.

Investment Thesis

For those of you who might have missed the rally in US homebuilding stocks, Consorcio ARA is an interesting way to play the recovery of a much more interesting homebuilding market with a meaningfully superior secular growth outlook and an improving short / medium term supply-demand dynamic. 

I fundamentally like ARA over its competitors due to the wider price discount; however, I believe the entire sector is unreasonably cheap and offers plenty of upside.  ARA also has a long history of consistent profitability and a shareholder friendly management team with substantial skin-in-the-game.  Execution has been disappointing, but I believe this to be a temporary phenomenon.

ARA’s stock is trading at a substantial discount to its understated book value.  The following table outlines the assets it has on its book some fair value estimates.

Currently trading at $4.19 – equivalent to a price to tangible-book ratio of ~0.6 x – the stock offers significant downside protection with plenty of optionality on the upside, translating into an asymmetric risk / reward profile that has explosive upside if company-specific problems are addressed and/or industry tailwinds resume their historical course.

Why is the stock cheap?  An ugly recession, increased competition and a number of company-specific issues have driven ARA's volumes and gross margins lower.  G&A de-leveraging has also led to lower EBIT and net income margins, causing ROIC and ROE metrics to plummet.

However this difficult period has led ARA to rethink and revamp its strategy while investing in new concepts that should bear fruit in upcoming years and solidify its footing within the homebuilding industry as a differentiated competitor whose primary focus is on quality.

In terms of earnings, ARA is currently trading at 6.5x forward-looking consensus EPS estimates.  These estimates understate the normalized earning power of the business.  Mid-cycle earnings could easily grow by over 50%+ over the next 2 years - back up above $1,000 MM - with plenty of opportunities to grow beyond these levels as it optimizes its cost structure and operates at a level closer to its installed capacity.

Additional upside exists from a potential corporate event that could unlock value of a hidden-gem currently being neglected by the market – a non-core commercial real-estate arm, called PDCC, that could be monetized through a sale or spin-off into a REIT.  

The longer-term thesis, however, is based more on the fact that ARA will liquidate its problem-inventory (at a profit) and continue redeploying capital within its high-quality land & development pipeline.  The projected IRR's of these developments will improve the overall company's returns which should drive the multiple to expand closer to its historical average of 1.5 - 2.0x book. 

While some broad changes in the industry could cause an overall rise in construction and sales cycles; in ARA’s case these headwinds should be largely offset by the elimination of some legacy problems that have been hurting their results – namely a municipality-cost-overhang (described below) and other indirect costs being aggressively cut in 2012.   

It is hard to predict where margins will be in the short-term but I believe that ARA should be able to operate closer to capacity and thus achieve leverage and efficiencies on both its COGS and G&A with a much higher top-line.

In the unlikely scenario that the industry’s overall margin structure is hit harder than expected, I still expect ARA to dramatically improve its inventory turnover cycle and working capital management – and additional offsetting factor towards improving overall ROICs.

Importantly, it is worth noting that management owns 41.1% of the company and has been buying additional shares in the open market.  Management is shareholder friendly and willing to return cash to shareholders having paid $1.62 ($2,130 MM) in dividends during the last 6 years. 

As noted above - the B/S provides significant downside protection.  The land bank is carried at ~$5,600 MM on the books – a figure likely 25% to 35% below fair market value (not appraised; based on rough "scuttlebutt" estimates). 

Mark to market accounting was historically used for a number of years, however raw-land markups were deliberately kept as low as possible to minimize the fiscal impact of appreciation.  Accounting rules changed in 2007, linking book value adjustments to the rate of inflation above a certain threshold.  No adjustments have been made for the last five years.  The total buildable area represents 180,000 homes – a 6-year supply assuming volumes ramp back up to historical levels.

General Background on Industry and ARA

It can be argued that homebuilding, in general, is an industry that tends towards commoditization.  I don’t necessarily disagree.  There are no significant barriers to entry – capital requirements and scale can be replicated – and most cost-based efficiencies and technological advantages tend to be short-lived.  Pricing power associated with brands is virtually non-existent and pricing discipline among competitors is hard to achieve given the fragmented nature of the industry.  Furthermore, the lower the end market and the fewer bells and whistles attached to a given home, the less differentiation and the more it becomes a business focused on executing large volumes with thin margins. 

On occasion, one player might have a dominant position in a particular market or have a defacto local monopoly and enjoy superior economics - but even these tend to be temporary as the opportunity is exhausted or competition encroaches, eventually leveling out the playing field. 

In conclusion, one could argue that in order to generate adequate returns on capital it all basically boils down to favorable supply and demand dynamics and timing the cycles right.  In other words, if a solid management team possesses superior knowledge and experience over its markets this could lead to outsized profits over time.  Despite the recent execution problems, ARA possesses a great long-term track record and should be given the benefit of the doubt.  Management eats, breathes and sleeps ARA and are highly incentivized for its success, owning ~41% of the company while recently accumulating more shares in the open market. 

The homebuilding industry in Mexico – which I will touch upon with more detail later – is on the cusp of a second wave of growth.   At the same time there are certain technical hurdles that will prevent smaller developers from expanding their supply to meet demand.  This is creating an opportunity for the larger integrated players – like ARA – to take share. 

ARA in recent years has sold around 17K - 18K homes per year at an average selling price of ~$420K.  Unit sales exceeded the 20,000 mark for a few years, but organizational setbacks and a problematic underwriting / inventory overhang, described in next section, have materially hurt unit sales and revenues numbers for the last few years.

For those of you unfamiliar with the industry, here is some quick background: large-scale homebuilding in Mexico is often compared to manufacturing.  The business model is grounded on setting up small to medium sized “production plants” that can manufacture thousands of homes while attempting to realize EOS and minimize unit costs. 

The life of these developments is typically several years and their operating and financial paths can be pretty bumpy – i.e. sizeable up-front costs and capital requirements with back-ended profitability.  The early years can be painful and often can bankrupt undercapitalized or poorly planned developments, but if done right, once up and running, a successful development can be extremely lucrative.

Lifecycles, operating characteristics, and economics can vary depending on the segment and type of development.  Obviously volume-based and cookie-cutter developments are the most commoditized products where success is based on cost-advantages and supply and demand dynamics.  On the other hand, higher-end developments are less-dependant on the cost side of the equation and more on the sales and marketing strategy being followed.  I am generalizing here, but it is important to understand these differences because ARA has a much broader product-line than its competitors and these different dynamics are often a source of confusion.  

Now, there is a variety of combinations in terms of the business models currently being pursued by the largest homebuilders, but to simplify they can be bucketed into two groups: 1) the specialized / capital-light models, and 2) the vertically integrated models. 

In some cases developers have opted to spinoff their land banks off their balance sheet and form JVs to option their land needs while also outsourcing and franchising significant parts of their construction and selling activities.  All things being equal, the capital-light model should, in theory, have thinner gross margins but much higher asset turns while the vertical model fatter margins and lower turns.  If efficiency is achieved throughout the value chain ROICs shouldn’t vary too much between both models. 

ARA follows a mostly vertical model that involves the acquisition of raw land, investing in the legal / physical development, in-house architectural design and master plan development, sourcing and processing of on-site materials, sub-contracted labor, and a commission based sales-force.

Although ARA continues to compete in the low-income segment alongside the competition, in recent years it has slowly increased its focus on the middle / higher end segments.  While some investors have embraced this strategy, it has been a source of contention among analysts.  This context is important because for all practical purposes ARA is a family-run business, and as such, it has been managed with an owner mentality and sole goal of creating value over the long run.  Management doesn’t care if its business strategy complicates the analyst’s ability to model out the business or compare it to peers.

Management has also refused to succumb to analyst pressure – who often criticizing the company’s business strategy as being too conservative in terms of volumes and targeted growth.  For example, analysts have insisted for years that ARA should lever up their balance sheet and use financial engineering to improve the company’s WACC despite the historical precedent suggesting that, in Mexico, due punctuated boom and bust cycles, which have often led to severe instability in credit markets and interest rates, developers should use a very moderate levels of debt.

The analyst community has also suggested that ARA divest its land bank and switch to the capital-light model, arguing that FCF and ROIC in the short term would shoot up.  What analysts seem to ignore is ARA’s long-term historic success in the land development business – driven by a keen capability to consistently find great plots of land at cheap prices, invest time and resources into the licensing and permitting process, and sit and wait for the appropriate moment to develop these plots into master planned communities.  Historically, the land component of ARA’s business has helped generate attractive IRRs and ROEs over a multi-year period.

The land divestiture approach isn’t necessarily a terrible idea and it does indeed make logical sense especially if the market isn’t recognizing the value of land assets.  In fact, this strategy is currently being pursued by a few of ARA’s competitors and has been successful.  But the key point as it relates to ARA, is that they have demonstrated to be savvy buyers when it comes to land and this has been a key capability and differentiator that, over the long run, should be a driver for healthy ROICs.

Working capital management & cash conversion cycle trends have hurt ARA’s results recently.  This can partly be explained by recent land purchases and the change in business mix which has lowered inventory turns due to longer construction and sales cycles, but there is no doubt that ARA is facing some unprecedented problems with some of its inventory (more on this later).

I expect 2011 to be the bottom of painful transition period for ARA with unit volumes bottoming out at ~ 16K with an ASP of $440K.  The competition, composed of Urbi, GEO and Homex, have averaged much higher unit volumes of 39K, 54K and 51K respectively, and ASP of $364K, $347K and $370K.

As I mentioned above, relative to the competition, ARA has a much more diversified product mix with significant and growing number of developments focused on middle and higher-end residential developments.  Emphasis on these segments has been stronger in recent years due to the growing opportunity set in these markets, as the middle class expands, and management’s desire to pursue a more differentiated less-commoditized business vis-à-vis the crowded low-income segment (albeit where the government support is the strongest). 

ARA has a total of 52 developments in operation.  The middle and higher-end “residential” categories together currently represent close to 47% of revenues (22% of unit volume).  Segment profitability detail isn’t disclosed, but gross margins are indeed substantially wider, albeit with much longer construction and sales cycles.  Putting it together - using very rough estimates - gross IRR’s before corporate overhead for the middle / residential segments can fall anywhere between 28 – 35%, while lower income developments range between 27 – 30%.  In normal years, these numbers should translate into healthy ROICs.

ARA has developed the Rialta brand for its higher-end developments.  These developments provide a major point of differentiation; and while the economics aren’t vastly superior it is a less competitive, and less volatile (not subject to changing government agency standards), source of business.  Keep in mind the higher end homes are still only $1,900,000 pesos - which is around $158,000 USD.  This is much higher, however, than the lower end segments which are in a range of $250,000 to $350,000  (~25,000 USD). 

The overall market tends to discount ARA for its focus on these segments, given that most of the secular-growth story is in the low-income “social” segment, but ARA insists that targeting both segments is the most sensible strategy given the trends it is seeing.  As mentioned above, this strategy seems to be a headache for analysts, but for investors, the way I see it, is that ARA is following an more opportunistic and entrepreneurial strategy.   

Here are a few company websites that highlight some of its higher end products:

Rialta Website: http://www.rialta.com.mx/

Cuernavaca Golf Course: http://www.paraisocountryclub.com.mx/

Crystal Lagoons: http://www.aracrystallagoons.mx/

Company Specific Issues

ARA has prided itself in remaining profitable throughout various boom and bust cycles by maintaining a laser focus on margins and sustainable growth.  The last three years, however, have been particularly challenging in the midst of the financial crisis and economic slowdown - creating excess inventory in some developments that have distorted company-wide operating metrics. 

As demand plummeted, competitors reacted quickly by applying widespread discounts to keep inventory moving.  The glut was further exacerbated as the debt-heavy balance sheet of its most direct competitor, GEO, forced it to continue building and growing in order to service its debt.  

In contrast, ARA tapped on the brakes and refused to engage in the heavy promotional activity and discounting; opting instead for a slow run-off of the “problem” assets with the hope of preserving margins.  In hindsight, this seems to have been a mistake as absorption has been much slower than initially expected.  However, I’ve discussed this with people inside the company and management expects the inventory overhang will be successfully liquidated at a reasonable profit. 

Note: this only partially explains the ballooning WIP inventory.  A few other factors that affected inventory and profitability were:

• Organizational changes - described in detail in the section below - modified the sales function structure, which has hurt sales performance.
• Cost overruns related to the inability to hand-off finished developments to certain municipalities.
• Poor execution on mortgage / credit underwriting for qualified buyers.
• G&A seems outrageously when seen relative to today’s scale and top-line figures.

It is worth noting that ARA’s operational and organization capacity was planned for double today’s production – which is essentially akin to a manufacturing plant operating at 50% capacity.  The vertically integrated business model has been a significant disadvantage for the last two years as fixed costs and indirect expenses, originally planned for much larger scale, hurt development-level unit economics due to negative operating leverage.  The silver lining, however, is that these investments should eventually pay off as problem assets runoff and ARA right-sizes its business model.

Another growing problem that has distorted development level economics is related to ARA’s “municipalization” problem.  The problem relates to the process of handing-off of a finished development to the corresponding municipal government, who by law must inherit both the taxing authority and service obligations of the ensuing community. 

A number of municipalities have been facing strained budgets and absorbing new developments can add a significant burden to their finances.  In these situations it behooves the local government to delay the process as long as possible to avoid paying for utilities, waste, and energy services as well as other maintenance related expenses.  ARA has to eat these expenses until it can negotiate an orderly handoff.  This entails running portable power plants and providing all sorts of maintenance related services.  This has overwhelmed ARA with an extraordinary burden that I estimate could represent 300 – 500 gross margin basis points.

I’ve discussed this at length with the company and they recently hired a new dedicated team to help solve this problem.   In general, the municipalities with the biggest delays have recently been turned over to new political administrations.  With a new governor in place in the Edo. De Mexico - the state where ARA’s municipalization problem has been particularly acute - and the new internal team, the hope is new negotiations can be more constructive.  The new team already seems to be making inroads in fixing the strained relationships and ARA hopes to eliminate this problem in the next 12 – 24 months.

It is hard to estimate what the normal “cost” of doing business for these types of matters is.  But on thing is almost for certain, these “expenses” should be considerably lower in the future.  ARA should save, at the very least, 250 basis points of GM.

Management and the Organizational Identity Crisis

I think it is fair if you are asking yourself, if there is a fundamental underlying cause to some of these persistent problems?  In other words, aren’t execution issues pretty serious?  The short answer is yes - but as with most things, the story is a bit more complicated than that.

Around 2007 ARA endeavored to transition away from its family business model into a more institutionally-focused organization with higher standards guiding financial, operational and administrative functions, as well as integrating best-in-class business practices in its governance and succession plans.

Investments were made in state-of-the art information systems and on-the-ground operations were reengineered and “streamlined” to improve efficiencies.  A new co-CEO was hired to lead the charge in replacing positions and functions that weren’t grounded on well-defined and established processes.  Scientific management principles were applied across the organization, while consultants and advisors offered fancy sounding acronyms – TQC & ERP – and ARA, as well a number of its competitors, were sold.  In some cases the investments did add value in others they severely backfired.  

For example, the licensing and permitting process for land in Mexico for decades has involved old-fashioned politics and personal connections to get approvals.  These relationships are complicated and aren’t built overnight - the job of wining and dining mayors and other public servants and the cultivating of new relationships can’t be ISO certified.

Ironically, an effort to upgrade the organizational foundation of the business ultimately led to the weakening of some of its most essential functions.  A number of valuable and key upper/middle managers were let go.  The former heads of operations and sales - who had been with ARA since the founding of the firm more than 30 years ago – were laid off. 

Since ARA was growing so fast at the time, certain decisions and changes were made to prepare for its next stage of growth.  Broadly speaking, ARA went from having a compact and lean management structure, with centralized operations, sales and finance functions, to a bloated regional model with layers upon layers of bureaucratic administrative functions.

All of this led to an identity crisis with lasting effects - humbling management into a soul-searching introspective process that has helped them realize what they must do: essentially go back to its roots and revert to the old model that allows for more centralized control / decision-making combined with dedicated employees focused on the dealings with bureaucrats. 

Progress has been slow, as one restructuring effort has led to another.  In turn, this has led to widespread skepticism by the analyst community who question management's ability to execute going forward…  

This background is in effect the source of most of ARA’s problems.  Practically speaking, some of the most serious sales & underwriting setbacks in recent quarters, that have exacerbated the overall inventory overhang, have been a direct result of poor middle management.

The biggest risk going forward is management related.  This cannot be overstated.  If management is able to rebuild and develop the human capital it lost in recent years this will be a home run investment, if not, it probably will be a value trap. 

Easier said than done, right?  Well, there are promising signs of progress - I am already rambling here, so I won’t go into details – suffice to say, new blood, new incentives (higher commission component on inventory turnover), and more involvement from upper management (who truly understands the business) in the details of the business. 

Management Philosophy

As I’ve said, this is basically a family run business.  The CEO eats, sleeps and breathes all things homebuilding.  Here are some quick thoughts on management’s track record:

• Strong record in terms of capital allocation and returning capital to shareholders: paid $1.62 of dividends in the last 6 years.

• Despite conviction on the long-term secular dynamics favoring the homebuilding in Mexico, they targeted moderate and profitable growth.

• General aversion to debt-financed growth – ARA experienced distress in the mid-nineties.   Balance sheet strength and flexibility is a priority that has guided decisions in the company (future growth will likely be organic and financed internally with very modest levels of leverage).

• Related to the above point, management has always prioritized the long-term health and results of the company by following a “sleep well at night” strategy.  For better or worse, instead of focusing on the opportunity-set management seems to prepare more for what can go wrong.  They refuse to chase volume that could hurt profitability or create balance sheet stress.

• They eat their own cooking

P.D.C.C: A hidden Gem

While the core business has struggled in recent years, the PDCC division, short for Promotora y Desarrolladora de Centros Comerciales, ARA’s commercial real-estate arm, has been booming.  PDCC started as a joint venture with O’Connor Capital Partners - a NY-based real-estate private equity firm - approximately 10 years ago and has been operating independently for the last 3 years or so.

PDCC has a fifty-fifty split with OCP in 5 malls and full ownership of 2 malls and a number of scattered strip centers throughout ARA’s developments.

It is worth noting that Mexico is in its early stages of becoming a consumer society, and the big-box mall concept, while old and stagnating here in the U.S., is thriving in Latin America.  Foot traffic is growing year after year and occupancy and rent $ continue to show strength. 

PDCC has developed close relationships with virtually every retailer and anchor tenants of consequence, including: Walmex, Zara, Cinemex & Cinepolis (leading movie exhibitors), Liverpool, Sam’s Club, Comercial Mexicana, Home Depot, McDonalds, Sears, Suburbia, Aurrera etc…

Best of all, since the division doesn’t consolidate results on ARA’s financial statements, the business is virtually ignored by the market.  Very likely ARA is exploring strategic alternatives to unlock the value of these assets – possibly a spinoff into a REIT.

So, how much are PDCC’s assets worth?

Given the quality of the assets and NOI growth potential, I believe a 9% cap-rate is deserved.  Note that the blended occupancy rate is ~94% (not including Plaza Centella), and this figure includes two properties which still haven’t fully ramped up.  

ARA’s stake should be worth ~$1,121.00 using a 9%, but to be conservative I’ve used $900.00 in my replacement value analysis.

Sector-wide concerns by sell-side 

The sell-side in recent years has notably shifted their evaluation framework for the sector by emphasizing FCFE generation, instead of growth, while loosely labeling the Mexican homebuilding sector as “mature”.

This myopic outlook confuses the cyclical weakness of recent years with structural changes and ignores the long-term favorable dynamics that will continue supporting the industry.  While some tailwinds have indeed dissipated there is a number of positive developments. 

In the case of ARA, analysts have modeled out the company assuming little to no operational improvements while extrapolating recent inefficiencies indefinitely into the future.  

While it is fair that ARA be put in the penalty box due to some self-inflicted wounds, at worst I expect results to revert back somewhere close to the mean, and actually ascribe a high probability that the ongoing management restructuring coupled with new-product initiatives will lead to expectation-beating sales growth and margin expansion.

On the broader sector concerns about added complexity for vertical housing (being emphasized by the Infonavit), the sell-side ignores, some of the positive elements that could help to mitigate the increase in working capital requirements, such as the reduction of up to 30% in construction costs in the vertical model vs. the horizontal model - due to lower expenditures in urbanization and more houses per hectare. 

Even in a scenario where the housing market doesn’t expand as expected, due to less demand or credit supply, the larger homebuilders like ARA will continue taking market share from the financially strapped independent developers facing a tighter credit and regulatory environment. 

In the short term, the sell-side has downgraded the sector mainly due to lack of FCF visibility.  They expect delays in subsidy payments and are factoring in necessary investments to adapt to more stringent standards.  While both of these adjustments will hurt near-term cashflows, they are one-time outlays that aren’t that significant when thinking about long-term earnings power of these companies.

Changes, adjustments to new standards set by the INFONAVIT, particularly for the low-income segments, are a fact of life for all homebuilders.  Some analysts worry that these requirements will continue becoming more and more burdensome and raise the overall cost of doing business; however they fail to note that, over full cycles, the industry has historically passed on higher costs to buyers.  

In fact, one could argue that the more strict and technical the requirements become the more market share the larger builders will be able to absorb from smaller developers who tend to get hit harder as they are unable to meet the more stringent standards due to lack of organizational and technological infrastructure.

A Dependable Flow of Credit Will Help Alleviate System Constraints and Bottlenecks

After stagnating for nearly two years, mortgage activity in 2011 showed signs of recovery along with higher employment and improved consumer confidence.

Most credit activity for housing is undertaken by public housing institutions – close to 90% of loan volume. In 2010 the Infonavit, the biggest of the government agencies, granted 66% of the 714,998 mortgages given in Mexico.  While public agencies and overall public budgets supporting new housing are on the rise YoY, they still haven’t quite reached 2008 pre-recession levels.

Note: the Infonavit is a public institution with a social mission focused primarily on providing credit to the lowest-income bracket of the Mexican population.  It has a social mission, with two primary objectives: 1) a socially driven mortgage provider, and 2) retirement fund administrator (secondary mission).

The Infonavit recently announced it placed 501,292 credits in 2011 and co-financed 157,824 loans. 

Excluding renovation loans, on the surface the data doesn’t look as promising in terms of loan volumes (table below – note: only 11 months of data, not updated to december) - with 2011 showing a 3% contraction - and overall credits still at 87% of 2008 levels.  This was partially distorted to some internal administrative and financial problems announced by FOVISSSTE that prevented it from reaching its goal (not demand). 

But the $ amount of financing continues to show resilient growth and volumes close to 90% of ‘08 levels (numbers below only for 11 months – thru Nov 2011)

There are important differences in the segments and regions that are emphasized by the registered housing agencies Infonavit and FOVISSSTE – which tend to favor lower-income housing - representing close to 84% of the total volume of loan-placements generated.

In sharp contrast, banks are still 20% below their peak volume due to an overall contraction in the more economically sensitive middle/residential segments (lower co-financing from Infonavit, but picking up…), while the Sofol business model is virtually disappearing (being replaced by new co-sponsored public program).

All in all, credit has experienced its share of cyclical swings in recent years but has remained structurally strong due in large part to the well-financed and socially motivated government agencies.  The private mortgage market – a severely underdeveloped business - has also resumed its long-term upward trend both in terms of volume and $ terms.  

As background, it is worth noting that housing is a central component of Mexico’s domestic social agenda across its political spectrum and, regardless of the administration that takes power this year, it will continue being a strong force propelling overall mortgage supply and housing subsidies – together helping drive a somewhat less cyclical source of housing demand.

It is also important to note that commercial bank portfolios have barely scratched the surface of this market while keeping tight risk controls across their loan portfolios with LTV ratios of ~65%. 

INFONAVIT has also preserved the quality of its loans with low default rates.  For those of you keen on practicing your Spanish here is a recently published report that details the agency’s strategic agenda and financial plan: http://bit.ly/yZchPE

Effective Demand is Picking Up and Housing Needs will Continue Growing

To understand housing dynamics in Mexico, one must differentiate between social-demand - which describes the massive and growing housing deficit across Mexico - from effective-demand – basically actual underwritten sales of new homes driven by a variety of factors, including the overall health of the domestic & local economy and the general availability of credit from both government and non-government sources.

Mexico’s demographics and current stage of economic development are a homebuilder’s dream: a population of ~112 MM people, composed of mostly young families < 30, that is expected to grow to ~140 MM by 2030 with an expected household formation of approximately 800,000 families / year.

It is also worth noting that Mexico has an expanding middle class, a segment ARA is increasingly emphasizing, and is experiencing an accelerating rise in per-capita GDP thanks to labor reforms and a more educated workforce.  Mexico will also benefit from further development in the banking / credit sector, potential energy reform, improving labor competitiveness with China (good article here: include link), all of which support the long-term secular dynamics of the homebuilding sector. 

Builders as a Whole, Lag in Short-term Supply

The existing housing stock of 26.7 MM homes is severely inadequate for the overall latent demand; it suffers from a persistent unit deficit of close to 9 MM units – a figure that is still growing year after year as social demand supersedes supply. 

Homebuilders, as a whole, struggle to keep up with effective demand with housing starts in 2011 below those of 2010 –mainly due retrenchment by the fragmented market, as larger homebuilders took share. 

To offer some perspective on the approximate size of the TAM, public companies, which represent ~23% of the market, as a whole will build ~168,000 this year and have an average land reserve to fulfill 6 – 7 years of aggressive growth plans, yet in terms of units their land bank will supply only 1.3 MM units which barely scratches the surface of the existing deficit. 

As explained above, plenty of social demand exists and in time it could translate into true effective demand if the various bottlenecks - mainly credit and underwriting – continue to be targeted, both by the government and private sector, thus improving overall systemic capacity. 

In the meantime, the supply side continues to evolve while attempting to meet the broad needs of homebuyers and adjusting their business models to accept the various credit products and subsidies designed by the various agencies to assist homebuyers. 

In general, persistent political emphasis and continued innovation and development on the financing side of the equation, has translated into a gradually rising tide and a positive sum game for all the constituents – particularly homebuilders. 

On the other hand, despite the visible structural tailwinds homebuilding in Mexico is still a complicated and bureaucratic industry with a growing list of requirements dictated by the government - which all homebuilders need to adhere to in order to avoid losing market share.  What’s more, it is a competitive, capital intensive and economically sensitive business.

For example, the INFONAVIT has recently raised standards on land use and density, as well as logistical and technical requirements favoring developments closer to existing transportation and utilities infrastructure.  The downside to these environmental and social sustainability prerequisites is more business complexity, added investment capital, and longer building & underwriting cycles as the burden of collections from credit agencies lengthens. 

General risks also include an overall lag in credit-development; politics; drug-war instability; and the economy.

These trends and risks notwithstanding, the homebuilding industry has an extraordinary track record of successfully adapting to Mexico’s very volatile environment.  The rising standards, while visibly taxing in a variety in $ terms, creates significant new technical barriers for the entrepreneurial developer that makes up over 75% of the market – which could translate into driver propelling further consolidation and market share gains for the public homebuilders.  This in turn, could lead to better coordination within the industry and more pricing power.

In the short term, new construction supply will be somewhat constrained by the logistical, technical and financial difficulties as the industry adapts to the new policies and construction models.  Plenty of homebuilders, including ARA, have also been erring on the conservative side as the residual effects of the recession created a number of inventory gluts - particularly severe in certain regions - that are slowly being eliminated.

So, How Much is ARA worth? 

The balance sheet itself is a somewhat reliable measure of value at the very least highlighting the wide margin of safety in a potential break-up / liquidation.  However, ARA should be looked at as a going concern by evaluating the earnings power and growth potential of its core business + its PDCC business.

I ran a simple model running three scenarios with a downside, base and upside case with probabilities of 25%, 50% and 25% respectively, which lead me to an intrinsic value of $8.23 - an upside of 92% above today’s stock price. 

The main assumptions I use are:

I am not modeling very far into the future assuming it takes ARA approximately three years to deliver improve results (or not).  I use a 12% rate to discount my expected values in 2015 – which are based on a FCF multiples that I believe will largely depend on the evolution of the cycle and the overall sentiment towards the sector.

I don’t feel any of these assumptions are particularly aggressive.  I am assuming flat to very slight market growth for my base case with an increase in share from the larger integrated homebuilders.   In fact, I believe my assumptions are probably overly conservative - the upside scenario is essentially a reversion to 06 – 07 levels while applying a lower multiple to its historical average in those conditions.

Here are the three per share present value IV outputs for each scenario:

One could argue that the likelihood of a $3.00 downside scenario ($4.00 without discount) is further minimized by the tangible asset-value – which could be unlocked through strategic maneuvering.  There have been numerous private equity and pension / state real-estate funds spawning up in Mexico looking to put capital to work in land assets.  If ARA’s problems were to persist indefinitely, there would be plenty of options for an orderly unwinding of the company (this is just a passing thought as I believe there is a very low probability that conditions deteriorate much further from here).  In other words, the worst-case scenario ARA will result to be dead money. 

Note that a P/B approach renders even higher values – which is also contingent on ROEs reverting on the upside.  

New Programs to Pick Up the Slack Left by Sofoles

Government agencies have recently been emphasizing “non-affiliates” programs.  These new programs target workers needing housing who don’t qualify for a assistance through the traditional programs provided by the INFONAVIT and FOVISSSTE.  Over the last decade, the government has generally focused its housing assistance programs to workers affiliated to one of these two public housing institutions.  These workers tend to be highly marginalized groups who don’t qualify in terms of income requirements for privately sourced credit products.

In contrast to the government’s overall housing policy, this new program essentially attempts picks up the slack created in recent years by the financial distress of private sector Dedicated Purpose Credit Institutions (“Sofoles”) – whose focus was precisely addressing the non-affiliated segment that was being left behind by both the public and private sector. 

With a widespread contraction in credit supply from Sofoles due to rising NPLs, and no interest from regular depositary institutions to address this market, this market has essentially been orphaned. 

These new non-affiliate programs provide guarantees and subsidies to improve the credit profile of this segment, but are based on a partnership model that requires the broad participation of banks and homebuilders for it to achieve scale and successfully expand credit in any meaningful way.

Expectations are that it will take some time for the program to ramp-up and convert potential demand into real demand – with the design of the right type of credit products still under works – but estimates of the potential size and impact of this new market, are quite significant.  Recent studies suggest that more than 1.4 MM workers who could potentially qualify under the program in the medium term.  The following report provides a general overview of the new program: http://tiny.cc/ih5zx 

Putting the drug war and violence into context

I am not going to go into a lot of detail here.  I will mention that the media has grossly distorted the situation, as usual, with sensationalistic yellow journalism. 

The drug war in effect is a symptom of a country seeking fundamental change.  While it creates short-term instability, in the long run it should lead to order (there is already evidence of this happening) - this is my personal opinion and interpretation, so only time will tell. 

For investors, the more relevant question is the transparency, sanctity and enforcement of contracts, and the protection of capital providers.  I believe Mexico qualifies as a stable environment from a legal standpoint. 

Mexico is, by and large a stable, developing country governed by the rule of law.  While corruption is indeed a fact of life and an ingrained part of society and culture; there has been visible progress at all levels - individual, corporate and political.

Here is a good research note on that describes the effects of violence on the housing sector: http://bit.ly/x0MDRe 

Here is another interesting article that talks about tourism booming amid the violence: http://on.wsj.com/y5L8vB

What About the Country and Peso Risk?

While the peso currency risk could be hedged pretty inexpensively, I believe the peso exposure offers additional upside - despite a pretty strong YTD rally - with limited risk of significant depreciation.

As argued throughout this report, Mexico is experiencing a slow transformation that could surprise many economists and investors.  GDP growth is expected to be around 3.3% this year.  Here is another article that provides some interesting data points: http://www.box.com/s/q3yx1pobc7cem4eyjeqm

While overall GDP is still is very much dependant on the health of the US economy – which is showing signs of life – there are a number of structural changes that could prove to be significant.  To name a few:

• A reinvigorated manufacturing sector – e.g. significant growth in the auto sector, as automakers have reallocated production to Mexico due to weaker peso, skilled labor and cheaper in relative terms due to RMB appreciation, high transport costs from China, and location.   See interesting article on China effect on Mexico here: http://on.wsj.com/ylM3DL
• Stronger domestic demand – higher employment, credit expansion (consumer credit only 3 – 5% of GDP), improving retail sales and consumer confidence (domestic consumption and investment are leading the recovery… in dramatic contrast to historical growth which has been externally-driven).
• Prudent fiscal, monetary and FX policies

The most important observation: an increasing proportion of the labor force is educated, and cheap, with versatile skills (i.e. a middle class) – driving a domestic consumer economy that has slowly balanced its export-heavy GDP.

Some potential risks are:

• Escalation of drug violence (many believe it has peaked)
• Stalled structural reforms
• More Euro stress (though Mexico’s exposure is limited with exports to the Euro-Zone representing only 6%)
• Higher than expected inflation (wage price increases have been moderate and CPI has been kept low with telecom, retail and transportation showing efficiencies)
• US fiscal tightening

The peso has been a poor and volatile performer in recent years despite continued strength in economic indicators.  Public finances and trade deficits are at healthy levels and the central bank is flush in FX reserves of ~$150 billion.

The peso started the year ~$14.00 pesos to the dollar and is currently quoted at ~$12.75 – a 9% move more less.  So clearly some of the economic data mentioned above has been priced in, but a $12.00 exchange rate, or lower, wouldn’t be at all surprising.

Catalyst