Executive Summary
Brazilian Gafisa S.A (GFA) ("Gafisa") is undergoing a turnaround and the process has already shown signs of success.
I published an article describing my investment thesis regarding an investment in the ADRs of Gafisa on December 9, which was picked as an Alpha-Rich article. The thesis is reliant on
- The settlement of the sale of a 70% stake in the company's Alphaville subsidiary Alphaville.
- Refocus the Gafisa segment on its core markets.
- Launch the Tenda segment under a new business model
With (1) being a catalyst for a near-term rise in the stock price and (2+3) being value generators over the longer-term.
I outlined how undervalued the ADRs of Gafisa based on my conservative estimates for the future development in the company's profitability and growth opportunities. After reviewing my assumptions following the company's investor day on 18 December 2013 and guidance for 2014-2016, I have come the conclusion that my estimates have been too conservative.
The company has initiated several shareholder initiatives, since the publication of my thesis. They have launched a share buyback program, where the company is buying back 7.6% of the float a year. The board has furthermore approved a dividend for fiscal 2013 of R$0.309274477 per share equaling R$0.618548954 per ADR (1 ADR = 2 shares) or USD 0.259165208 per ADR. (BRL/USD=0.418989) The dividend will be paid as an interest on shareholder's equity, which is tax deductible, as set forth on §7, Article 9, Law 9,249/95 and CVM Deliberation Nº 207/96.
The company also provided further clarification on the Alphaville deal's effects on its balance sheet, following the clarification of the deal's impact on the company's balance sheet.
Guidance on future profitability has also beaten my conservative assumptions, with expected ROCE in the range 14% - 16% in 2014-2016. Exhibit 1 illustrates the potential shareholder return under a number of realistic scenarios and Exhibit 2 provides the historical P/E multiple of the company. Exhibit 1 isn't taking share buybacks and dividends into account. Such initiatives would further increase the shareholders return.
Exhibit 1: Shareholder return sensitivity analysis: ROCE and P/E multiple | ||||
ROCE | ||||
P/E | 10x | 15x | 20x | |
14% | 216% | 325% | 433% | |
15% | 234% | 351% | 468% | |
16% | 252% | 378% | 504% | |
Exhibit 2: Gafisa S.A. Historical P/E multiple |
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The company also further clarified its new operational model, which much more professional and mature that its pre-2011 model. The company has worked with the world's leading consultants in order to professionalize the company and making its operations as efficient as possible. The company is now able to track every material down to which floor it should be used as, through the company's new logistics system. Another example of the effects of this operational turnaround is it now takes the company 40 min to unload a truck full of bricks, versus 2-3 hours before the operational turnaround.
The company has learned from its mistakes in the past and will furthermore only grow revenues, if it can do so while sustaining or increasing margins according to management. This mentality is a shareholder friendly one, which paves the way for creating a tremendous amount of shareholder value going forward.
Despite the fact that the shares of the company has increased by 15.3% since I published my investment thesis, I think the company offers a more attractive risk/reward at current price, after taking renewed guidance, dividends, share buybacks, the settlement of the Alphaville transaction and the clarification of capital structure into account. The ADRs has a lower downside risk, due to the higher than first anticipated post-deal capital structure and a bigger potential reward giving the company's renewed guidance.
Profitability Guidance
The management provided guidance on 2014 launches for the Gafisa and Tenda SBUs, where it respectively expects R$1.5 - 1.7 billion and R$600 - 800 million in launches. The company's policy on leverage is in the range 55% - 65% and its long-term profitability expectations for the Gafisa and Tenda SBUs is a return on capital employed ("ROCE") in the range 14% - 16%.
Based on the company's post-deal balance sheet, one can fairly calculate the expected future EBIT and based on the company's leverage guidance and historical tax rate one can calculate long-term expected net income. One can then ad 30% of normalized net income of Alphaville and get a fairly certain assumption of the company's net income going forward. Exhibit 1 is based on such a calculation and shows the max potential shareholder return is 504% (16% ROCE and 20x P/E) from the ADRs current price. A more conservative estimate expects potential shareholder return of 351% (15% ROCE and 15x P/E).
The above-described calculation, which is used in Exhibit 1, doesn't take the return from share buybacks and dividends into account. Such initiatives can further increase shareholder return.
Dividend and share buybacks
The Board of Directors approved a special dividend of R$0.309274477 per share equaling R$0.618548954 per ADR (1 ADR = 2 shares) or USD 0.259165208 per ADR. (BRL/USD=0.418989) on December 20, 2013 after the market closed, following the board meeting the same day. As the dividend will be paid as an interest on shareholder's equity, which is tax deductible, as set forth on §7, Article 9, Law 9,249/95 and CVM Deliberation Nº 207/96. This will first of all reduce the company's tax expenses and second of all understate the company's net income in the company's earnings release for fiscal 2013 and Q4 2013. The ex-dividend date is December 27, 2013 and the dividend will paid on February 18, 2014.
The company's subsidiary Contrutora Tenda S.A.'s ("Tenda") Board of Directors has approved a share buyback of 32,938,554 of Gafisa S.A's common shares, on the condition that the company's leverage ratio (net debt/equity) is kept below 60%.
Exhibit 3 is a potential shareholder return sensitivity analysis adjusted for dividends and share buybacks.
Exhibit 3: Shareholder return sensitivity analysis: ROCE and P/E multiple adjusted for dividends and share buybacks | ||||
ROCE | ||||
P/E | 10x | 15x | 20x | |
14% | 250% | 367% | 484% | |
15% | 269% | 396% | 522% | |
16% | 288% | 425% | 561% | |
Stronger post-deal balance sheet than first anticipated
The post-deal balance sheet guidance presented at the company's Q3 2013 earnings release turned out to be too conservative. Exhibit 4 compares the guidance presented in the Q3 2013 earnings release on the Alphaville transaction impact on the company's capital structure with the post-deal actual impact of the transaction.
Exhibit 4: Alphaville transaction Q3 2013 guidance vs. actual impact |
Q3 2013 guidance on Alphaville transaction's impact on capital structure |
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Alphaville transaction's actual impact on capital structure |
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As Exhibit 4 shows the actual post-deal leverage ratio is 48%, which is lower than the 55% that the company first expected. This has made the company able to initiate share buybacks and a special dividend while stile keeping its leverage ratio within its leverage policy of 55% - 65%.
Operational Excellence
One of the reasons the company had negative net income in 2011, was that the company experienced cost overruns in the construction process at a number of projects at the Gafisa segment managed by third parties. This should now be less likely given the company's new logistics platform.
(click to enlarge)
Chart 18 from the investor day illustrates how the company's new logistics platform works. The company is now able to track every material until the usage of the material down to floor. This makes it easier to cost control and manage the whole construction process. The tracking and control is made by a third-party. The company has also restructured its supply chain, with the establishment of shares services center, in 2011, which has increased the productivity of the employees, together with focus on improving planning, control and supply chain operation processes. A greater part of the company's supply chain was outsourced pre-2011, which made a lot the company's processes slower than optimal. These process have now been streamlined. The company is now evaluating every supplier and making longer-term supply agreements with loyal and high-performing partners.
One example of the improvements that Mr. Louis Carlos Siciliano outlined at the investor day is that the company is now able to unload a truck of bricks in 40 minutes compared with 2-3 hours in the past. The material is also now ready every workday at 7am at the right floor. The company has furthermore decreased the amount of decision made at the jobsite and half of the decisions are now made from the office in the HQ.
The company has further invested customer relations. Despite a 50% increase in client portfolio from 2010 to July 2013 has kept average monthly volumes of interactions across all service channels stable.
Competitive Advantage - Gafisa and Tenda
The main source of the company's competitive advantage was outlined in my previous article on Gafisa and the company's focus on operational excellence contributes to the company's competitive advantage. The company presented the result of annual research conducted by a third party company regarding the main KPIs regarding customer preference and awareness. The result is presented in the following chart, taken from the investor day presentation.
(click to enlarge)
As shown in the slide above, Gafisa leads the main KPIs, which demonstrates brand strength in the Brazilian homebuilding market.
The company presented further details on the competitive position of Tenda. Slide 29 from the presentation on the investor day illustrated the development in launches of Tenda and its competitors.
(click to enlarge)
It showed that the launches peaked at R$ 10.5 billion in 2010 and has decreased by 70.5% to R$ 3.1 billion in 2013 (9 months annualized). This has been due too that the units in this segment are constructed under the Minha Casa Minha Vida ("MCMV")(translated into "My house, my life") program. The implementation of this program has been rather complex and leaves little margin for error. This has led away large players, which has reduced competition significantly. Tenda's restructuring of its business model has made it well positioned to profitably benefit from the MCMV, due to its ability to handle the complex implementation of the program.
Downside risks
The downside risks associated with an investment in the ADRs of Gafisa S.A. has decreased since the publication of my last investment thesis on the company. The risk that has decreased is the risk of the Alphaville transaction not getting settled. Despite that, the other risks mentioned in the article are the same.
Conclusion
The ADRs of Gafisa S.A. provides an excellent value at current price. All investors might not have noticed the settlement of the Alphaville transaction in time, because the company didn't issue a press release through business wire as it uses to do. It posted the press release under highlights and filed a 6-K filling. This resulted in the press release not showing up on the company's news feed on financial websites and brokers.
However, with settlement of the Alphaville transaction and the company's increased profitability guidance an investment in the ADRs in Gafisa S.A. seems more attractive at its current price from a risk/reward perspective, than it did on December 9, 2013 factoring the information available to investors now versus the information that was available on December 9, 2013 (settlement of Alphaville transaction and long-term profitability guidance).
The company has matured its supply chain with the help of the world's leading consultancies. It has set its strategy together with Bain & Company, the management consultants. After reading Lessons from Private Equity Any Company Can Use (Memo to the CEO) , written by the chairman of Bain & Company, Orit Gadiesh and Hugh MacArthur, partner at Bain & Company, I have derived a bigger understanding of the thoughts behind Gafisa S.A.'s strategy. I recommend reading the book, if you want gain an understanding of the thoughts behind Gafisa S.A.'s strategy.
What investors essentially get now is a mature company with a focus on growing long-term on the condition that the company is able to sustain or increase its margin's at a deep discount to its intrinsic value. With the special dividend, share buybacks and the headline 2013 EPS functioning as near-term catalysts for Mr. Market to recognize the value in Gafisa S.A.
Disclosure: I am long GFA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)
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