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Under $3 Brazilian Turnaround Play Could Deliver 100% Upside
More than a half decade removed from a deep crisis, the U.S. housing market is on the mend. Home prices in many cities have been rising again, and the PHLX Housing Sector Index has risen more than 250% from its March 2009 lows.
The other major economy of the Western Hemisphere is still in the midst of a housing hangover. After decades of robust growth that catapulted its economy into the seventh slot in terms of GDP, Brazil's economy in general, and the housing market in particular, is in a pretty deep funk.
As a result, most investors are overlooking a classic turnaround play. Gafisa (NYSE: GFA), a Brazilian homebuilder, has seen its shares plunge by nearly 90% since the global economic meltdown took root in 2008. And though shares are unlikely to re-visit those heights, this fallen stock now has at least 100% upside.
While Brazil was booming, Gafisa's management stepped on the gas, acquiring other homebuilders while greatly expanding its own construction plans. The spending took a huge toll on the balance sheet. Gafisa generated a cumulative -$2 billion in free cash flow from 2006 through 2011, pushing its debt-to-assets ratio above 90%. The eventual housing bust in Brazil led to concerns that this 60-year-old company wouldn't even survive into the next decade.
To rescue the balance sheet, Gafisa sold a large stake in its Alphaville division to the Blackstone Group (NYSE: BX) in July 2013. As a result, its debt-to-assets ratio has fallen toward the 50% mark. Gafisa retains a 30% stake in this high-end homebuilder, which is faring well even in these tough economic times.
Gafisa's management met with analysts in December to issue a fresh operational outlook: Debt, as a percentage of assets, is likely to stay at current levels; based on current construction plans, the company expects to generate around 15% return on capital employed (ROCE); and overhead is likely to drop to around 7.5% of sales in coming years.
Despite a brighter outlook now that the balance sheet is healthier, shares failed to respond as management had hoped.
So, in early February, management took another step aimed at unlocking shareholder value. Gafisa is looking at spinning off its struggling Tenda housing division, which focuses on lower-income buyers. The move would help investors to better grasp the profitability at the core of Gafisa's business, the value of which is being weighed down by Tenda.
David Lawant, who follows Gafisa for Brazil's Itau BBA, sees the move "as an interesting way of allowing investors to control their capital allocations and better price each asset in the market." He cites GFA as a "top pick," noting that "the stock provides the best risk-reward option among the turnaround stories we cover." His target price is 62% above current levels, expressed in Brazilian reals (U.S. investors own stock through ADRs).
But I think Lawant's upside projection is too conservative. Shares of GFA currently trade for around 30% of book value. At their nadir, U.S. homebuilders traded well below book value also, but now typically trade for 1.2 to 2 times book value.
Even if you doubt that Brazilian homebuilders will trade up to even 1 times book value, it's not hard to justify a price-to-book ratio of 0.6 or 0.7. For GFA, that means shares have at least 100% upside from current levels.
The good news: Investors don't need to wait for a full-fledged Brazilian housing recovery for shares to move higher. Instead, they just need to see further clarification of the company's financial picture once Gafisa and Tenda have been separated. That process should be competed in 90 days.
Recommended Trade Setup:
-- Buy GFA up to $3.25
-- Set stop-loss 15% below your entry price
-- Set initial price target at $5.25 for a potential 62% gain in six months