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S&P likes the Mexican homebuilder's steady revenue growth and conservative lending practices, and ranks the shares strong buy
by Kenneth Leon, CPA
From Standard & Poor's Equity Research

While the U.S. housing market continues to suffer, homebuilding has been thriving just south of the border. The Mexican housing sector, representing 3% of that country's gross domestic product (GDP), delivered impressive growth in the past few years, in our view, pushed by the pressing need for affordable homes, economic stability, and strong government support.

We view Mexican homebuilder Desarrolladora Homex (HXM; recent price, 61) as a compelling growth company in an emerging market. We think the combination of high market growth potential in the Mexican housing market with its low penetration of home ownership, along with the company's conservative cash management practices, will lead to positive earnings growth and a strong balance sheet. We also believe Homex will perform above U.S. homebuilders on most financial and operating metrics.

Another factor in our strong buy recommendation is that Mexico and Homex use conservative lending practices compared to the U.S. market, in our opinion. Mortgage loan issuers (government agencies and private banks) use fixed interest rates, have up-front fees of up to 3%, provide loans with terms of up to 30 years, require down payments of 10% to 20%, and require unemployment insurance. .Mortgages also provide interest expense tax-deduction benefits. In addition, Mexico's largest mortgage lender, Infonavit, is offering credits for homes bought with solar water heaters, energy-efficient lightbulbs, and other energy conservation items.

Mexican Housing Market
Although the U.S. economy, which accounts for about 80% of Mexico's exports, may be in a recession, the Mexican government believes the U.S. subprime mortgage situation and resulting economic woes will have only a limited impact on Mexico beyond the volatility created in the financial markets.

We believe it is unlikely a subprime mortgage problem will spread to the Mexican mortgage market where 100% of mortgage-backed offerings are made with fixed-rate mortgages.

By our analysis, there appear to be more conservative lending requirements in Mexico. These include mortgage insurance supported by federal and private institutions, detailed credit/risk analysis on all mortgages, credit bureau verifications, and required down payments in the 10%-to-20% range.

The Mexican government has pegged construction as a strategy for growth. Between 2007 and 2012, the Mexican government expects $250 billion will be invested for the construction of infrastructure, and $200 billion to be approved to cover estimated demand for 650,000 new households per year, resulting in the need to build 4 million new homes. This is in addition to about 2.1 million families that require independent housing today.

Most homes in Mexico cost less than $40,000. In spite of the advances in Mexico's housing sector, the market shows no signs of a bubble, in our view. Housing prices increased about 40% between January, 2000, and May, 2006, compared to a 107% rise in U.S. prices in the same period.

By 2010, government officials estimate there will be 30 million homes in Mexico, which will require the creation, on average, of 740,000 homes per year for the period between 2001 and 2010. By the year 2020, the 25-to-50 age bracket is expected to account for 38% of the country's total population. We believe structural changes in the country's mortgage market should enable the homebuilding industry to realize growth in the affordable entry-level and middle-income housing segments.

But according to Mexico President Felipe Calderón, Mexican housing growth will slow, as the industry reached a government target, with homebuilders planning to invest 8% in housing this year, compared to 16% in 2007 when lenders authorized a record 1.2 million mortgages. Mexican homebuilders Homex, Geo, and Urbi Desarrollos Urbanos also expect slower growth due to shortages in land reserves and delays in building permits.

Nevertheless, we believe there are additional strengths in the Mexican housing and mortgage market, including fiscal reform that may provide more resources for additional investments; 37% of the population being between 20 and 45 years old; government infrastructure policies ($40 billion average annual investment); government subsidies for housing; and opportunities for growth in vacation and retirement housing.

We do see some factors that could slow Mexican housing and mortgage growth. Mexico is highly dependent on the U.S. economy, and in our view, foreclosure procedures are slow. In addition, there is deficient urban planning, insufficient infrastructure, and slow modernization of public property registries, by our analysis.

Company Profile
Homex is one of Mexico's largest residential developers and builders. Principal shareholders, the de Nicolas family (32.9%) and Equity International Properties (EIP) (13.1%), held a combined 46% of Homex's outstanding share capital as of May 15, 2007.

The company traces its origins to 1989 and established its current structure in 1998. Beginning in 1999, various strategic investors including, in 2002, EIP, an entity affiliated with Equity Group Investments, an investment company founded by Samuel Zell, made equity investments in Homex.

As of Dec. 31, 2007, Homex had 62 developments under construction in 21 Mexican states and 33 cities. Homex is one of the leading homebuilders in Mexico's top four markets—Mexico City, Guadalajara, Monterrey, and Tijuana—and continues to have a leading position in the other 29 cities.

Homex's principal competitors include public companies such as Corporación Geo, Consorcio Ara, Urbi Desarrollos Urbanos, and SARE Holding, and nonpublic homebuilders including Grupo Sadasi and Ruba.

Regarding the company's corporate strategy, Homex is a vertically integrated homebuilder engaged in the development, construction, and sale of entry-level, middle-income, and upper-income housing in Mexico. Homex claims scalable and standardized business processes that are designed to enable rapid and efficient entry into new markets.

The company refrains from construction until at least 10% of the planned number of home buyers are qualified for mortgage financing. Homex focuses on rapid construction times using standardized methods. Almost all of the construction labor force is unionized, but the company had suffered no labor strikes through 2007.

Part of Homex's strategy is to target high-return opportunities, which lately included aiming for a substantial proportion of sales from the middle-income home buyer segment. In 2007, almost 24.1% of the company's revenue came from this relatively higher-margin demographic, compared to about 21.5% in the prior year.

Increased availability of private sector (i.e., bank) financing has improved the company's ability to expand into the middle-income sector, in our view. At the same time, relatively rapid construction-to-contract times for entry-level products help this high-volume segment generate attractive returns on capital. The company offers middle-income homes in a majority of its markets, and management expects to expand these offerings in the coming years.

Company Outlook
Our strong growth outlook for Homex is based on the great potential we see for Mexico's housing and mortgage markets. Mortgages represent 10.6% of Mexico's GDP compared to about 69% in the U.S., and 58% in Spain, according to BBVA Bancomer, Mexico's largest financial institution. We believe Mexico's economic stability, innovation, and new credit conditions explain a mortgage boom period that has seen growth in mortgage loans from 5.2 million in 2002 to 23.3 million in 2007.

Revenue growth in peso terms has been strong in recent years, in our view, including an increase of almost 27% in 2007, reflecting a higher proportion of middle-income homes, 17% more homes sold, and higher average selling prices per home. The company's growth comes in the context of the Mexican economy, which experienced a period of slow growth in 2001-03, echoing a similar slow-growth period in the U.S.

With what we see as a growing Mexican economy and a stable mortgage market, we look for higher home prices to aid the middle-income segment, where prices averaged almost three times their entry-level counterparts in the fourth quarter. Average prices rose 4.2% in 2007, and we expect the Mexican housing market to remain stable in 2008 with conservative mortgage lending practices.

We believe geographic diversification in the next two years will play a key role in the company's growth strategy. Homex is developing a position in the tourism market by building communities for the second-home market in key tourist destinations in Mexico. The first stage of development involves launches in Cancún, Los Cabos, and Puerto Vallarta.

We expect stable gross margins between 31% and 33% in 2008 and 2009, and see operating margins in the 20% to 21.5% range, compared to 21.7% in 2007. Our 2008 operating earnings estimate of $3.65 per ADS assumes an exchange rate of 10.47 pesos per $1, the rate as of Apr. 24, 2008. Our 2009 forecast is $4.40 per ADS. Each ADS equals six common shares.

In our view, return on equity (ROE) provides a useful measure of the effectiveness of management all the way down to the divisional level. The company's ROE was about 26.5% in 2007, compared to 18.9% in 2006 and 20.6% in 2005. Homex's board of directors has authorized a stock repurchase program for $250 million, or approximately 8% of its market capitalization. The company's total debt to total capitalization ratio was 27.7% as of Mar. 31, 2008, well below the debt leverage ratios of U.S. homebuilders.

Valuation
Based on our EPS estimate for 2008, Homex recently traded at a price-earnings (p-e) multiple of about 16.6 times above the U.S. homebuilders, which are mostly unprofitable. With our positive fundamental outlook for Homex, the company's high earnings growth visibility in the next two years compared to the U.S. homebuilders, and our expectation for faster growth, we believe the ADSs should trade at a premium to these peers.

We arrive at our 12-month target price of $75 by applying a target p-e multiple of 17 times, in line with consumer discretionary companies with similar growth profiles and near the middle of its historical range, to our 2009 earnings per ADS estimate of $4.40. This target p-e multiple is a premium to peers, but the company is growing significantly faster.

Corporate Governance
Homex's corporate governance practices are governed by its bylaws, the Mexican Securities Market Law, and the general dispositions issued by the CNBV (Comisión Nacional Bancaria y de Valores) and the Mexican Stock Exchange. Although compliance is not mandatory, the company also complies with the Mexican Code of Best Corporate Practices (Código de Mejores Prácticas Corporativas), amended in 2006.

As a foreign private issuer with shares listed on the New York Stock Exchange, the company is subject to different corporate governance requirements than a U.S. company under the NYSE listing standards. It is the company's intention to follow NYSE corporate governance standards to the extent it deems appropriate given the different regulatory framework to which it is subject in Mexico and in the U.S. and the different business environment in which it operates.

Investment Risks
Risks to our recommendation and target price include a weakening Mexican economy. If the trend toward higher land values should reverse, the company could be affected. While Homex's operations in land development and construction are highly regulated, higher taxation or a failed mortgage industry would likely negatively impact the company's EPS outlook.

The homebuilding industry in Mexico has been characterized by a significant shortage of mortgage financing. Mexican government-sponsored entities have significant discretion in terms of the allocation and timing of disbursement of mortgage funds. Homex depends on the availability of mortgage financing provided by these government-sponsored entities for substantially all of its sales of affordable entry-level housing, which we estimate represented 75% to 80% of its total revenues in 2007.

In addition, we believe there is potential foreign currency risk to U.S. investors because substantially all of the company's revenues are and will continue to be denominated in pesos. If the value of the peso decreases against the U.S. dollar, its cost of financing will increase. Severe depreciation of the peso may also result in disruption of the international foreign exchange markets.

Lastly, while we view the current government to be stable, emerging market economies such as Mexico are exposed to political risks that may restrict free-market policies.