Consorcio Ara: Why I'm Not a Fan of Mexican Homebuilders
Publishing Note: This originally appeared on Ian’s Insider Corner in August 2021 and was written with ARA stock trading at around MXN $4.60. I am presenting it here today as I keep getting questions about ARA and it’s an example of my deep dive process on a LatAm security.
I've been debating whether or not to write about Mexican homebuilder Consorcio Ara (OTC:CNRFF) (Mexico-ARA) for months now.
A prominent Twitter user has pitched Ara stock, suggesting it is the cheapest security in North America. I'm always up for cheap stocks in Mexico. I applaud anyone looking at off-the-beaten path stocks in Mexico and hardly want to discourage it.
However, after looking at the pitch, I saw some issues I have with it and knew that I was unlikely to buy the stock.
Ara is also not particularly liquid or well-known. The pink sheet shares listing -- CNRFF -- have minimal trading volume and a huge spread. Shares regularly ping-pong between 20 cents and 30 cents (despite the underlying not moving in Mexico) as folks accept a huge premium to buy or sell the U.S. shares. Be careful when buying anything that can have a 50% spread between bid and ask.
That said, many U.S. and European-based investors have access to the Mexican stock exchange directly through Interactive Brokers or other alternatives. There are no issues buying a decent sized Ara position on the Mexican exchange.
Regardless, I'm not real keen on buying Ara stock. I'm also not that excited about talking down a Mexican stock other people are fired up about. It's hard enough to get anyone to care about Mexican stocks, I'm not rushing to be a buzzkill.
That said, the person pitching Ara went on a popular podcast last week to talk up the stock and I got more member requests (up to five total now) to analyze the thesis. So, you all have spoken and I will oblige.
What's Ara?
Ara is one of Mexico's large homebuilding firms. It's been in business more than 40 years, which is an impressive feat. Three of Mexico's leading homebuilders went bust in the 2010s for reasons we'll get to, so it's impressive that Ara survived that and even remained profitable. In addition to building homes, Ara also has some interests in shopping malls, though this is a small piece of their business.
Ara takes a traditional land bank approach (as opposed to, say, NVR's call option way of controlling land). Thus, Ara buys up huge parcels of land and then slowly builds subdivisions or other developments on those properties as demand arises. Based on 2020 levels of building, Ara has more than 20 years of land in its reserve to develop before it would run out, though presumably homes will be built at a faster pace post-Covid. Regardless it has at least 10 and maybe 15 years of land inventory on the balance sheet.
The bulls claim this land is dramatically undervalued. Ara has around M$11 in reported book value per share versus its current M$4.50 price. The bull case’s author believes Ara's assets may actually be worth M$15 to M$20 per share once you factor in appreciation on the company's land holdings, as it holds the land at the price it paid for it rather than reflecting current market value. Classic value opportunity with tailwinds into a surging economy, right?
I will argue, on the other hand, that Mexican land values have not gone up dramatically -- in fact, in many cases, they've gone down.
Mexico's government gave massive stimulus to the housing industry from 2000-onward and then torpedoed it entirely, creating a unique situation that doesn't fit much of a pre-existing pattern. Regardless, some views Mexico in 2021 as a U.S. in 2011-type opportunity to buy cheap housing before a boom. I see a more complicated and less lucrative situation.
Ara's Book Value: I Don't Think It's Understated
One of the bullish argument’s main premises is that Ara is deeply undervalued because it trades at a large discount to book value. Book value, in turn, is made up of land the company (primarily) bought many years ago.
A takeaway from the post-2008 U.S. housing market was that you really make money from the land appreciating, not the houses, when the market turns.
That's certainly true in some markets. I'd argue, however, that this is a fundamental misconception as it pertains to Mexico and that it's far from clear that the Mexican land Ara owns is worth much premium to stated book value.
The bullish argument is that Mexico has a housing shortage of nearly 11 million units. Mexico has favorable demographics and in theory should have a lot of household formation. A ton of people in my age range still live with their parents or grandparents in Mexico instead of getting their own place.
Mexico has tried to address this problem before, namely with a massive subsidy program to build U.S.-style suburban housing outside its large cities. This project ran for more than a decade and was a massive failure.
Get-rich-quick developers and private equity latched onto the program and threw up tons of shoddy houses virtually overnight far from major city centers. The government eventually cancelled the subsidies and refocused its efforts on promoting development within urban settings.
This left homebuilders with tons of virtually worthless land far outside major cities. Three of the leading publicly-traded Mexican homebuilders went bankrupt during this period. One resorted to a $3.3 billion accounting fraud scheme to try to survive. To my knowledge, this is the biggest fraud ever committed against American investors by a Mexican company (which speaks well of Mexico generally but poorly of this industry in particular).
In full disclosure, I covered bonds of a bankrupt Mexican homebuilder when I was a hedge fund analyst at Kerrisdale. So I have deep knowledge of this subject but also bias as that investment didn't pan out.
Ara survived this downturn due to its strong balance sheet. But its profits and share price dipped, as you'd expect.
Bulls argue that this now creates a compelling opportunity. Far fewer homes have been built annually since the government pulled the plug on the subsidies. Meanwhile, more Mexicans keep reaching young adulthood. So aren't they all going to buy new homes?
For one thing, there are currently an estimated 5 to 7.5 million vacant homes in Mexico, many of which resulted from the previous shenanigans described above. My understanding is that a fair chunk of these can be rehabilitated and turned into proper housing, and that local governments -- in many cases -- wish to do this as vacant housing lowers property values and leads to crime. It seems questionable that the government would leave millions of vacant houses to further decay while funding subsidies for even more new houses. So the housing shortage may not be as large as stated.
The second issue is that most people lacking homes don't have much money, and thus aren't going to produce fat profit margins for Ara.
Mexico already has a higher home ownership percentage than the U.S. so it's not like there's all that much pent-up demand in general. The people that don't own by-and-large don't have the income to afford anything beyond the most basic of starter homes.
Ara consistently sells 60% or 70% of its units to low income people but only gets around a third of its profits from that segment. So pointing to a bunch of poor people in Mexico City as needing homes doesn't necessarily guarantee they have the means to buy something nice from Ara.
Also, housing, as always, is a local market. Speaking about a "national" housing shortage obscures some important details.
The Cancun Problem
For example, nearly a third of Ara's land bank is in one state, Quintana Roo. Quintana Roo is home of Cancun and very little else. It makes up less than 2% of Mexico's total population. So when you consider the supposed size of the Mexican housing shortage, realize that 30% of Ara's land is useless in addressing that problem since it's in a touristy state where very few Mexicans actually live or wish to live.
This would be the equivalent of a U.S. homebuilder loading up on a ton of land in, say, South Carolina and then saying that it will address the whole U.S.' nationwide housing shortage. Unless everyone wants to move to Charleston, that's not going to work.
Let's dig into Ara's land ownership in Quintana Roo. Here's a satellite map of Cancun, courtesy of Google.
I'm guessing Ara owns large tracts of the jungle around Cancun proper that has very low value now that the government has stopped subsidizing new greenfield suburbs outside of existing urban areas.
If you look closely at the map toward the northwest side of Cancun, you can see many partially-built areas that have big pockets of green within the city (Ara owns at least one of these that I located).
These are suburban areas that -- poking around Google Maps streetview -- were built primarily in the early 2010s and were left partially completed and then abandoned once the government pulled the subsidies for shoddy housing.
Given that sizable chunks of planned housing in Cancun have been left abandoned for many years now, color me skeptical that anyone is clamoring for Ara's undeveloped land farther out in Quintana Roo state. If anything, the value may have gone down since 2010.
Recall that private equity had overcapitalized the Mexican homebuilding industry and bid up the prices of land then to profit off the government's incentive gravy train. Marks for much of Ara's undeveloped land -- such as jungle swamps outside of Cancun -- may actually be overstated versus current conditions.
I'd also note that Ara's large luxury project in Cancun has had massive quality problems (article in Spanish but describes how the luxury development has lacked basic amenities such as running water and trash pick-up. Locals have renamed it from "Dreams Lagoon" to "Lagoon of Nightmares".) I'd guess this will hurt their efforts to sell future developments in Cancun where -- again -- they hold a TON of land.
I was also watching videos on abandoned housing developments in Cancun, and several claimed that Ara had committed fraud or otherwise burned homeowners. For example:
Translation: Fraud at Vista Azul/Crystal Lagoons. Don't buy problems with Ara. They seek you out to sell to you, but when it's time to resolve problems, they hide). | Source.
I haven't done the work to try to analyze Ara's land holdings everywhere, so I won't offer an overall view of their land package. However, as the adage goes, if you find one cockroach, you should be on the lookout for others.
I'd say it's more likely than not that Ara's land in Quintana Roo/Cancun (30% of their total holdings) is worth less now than what they paid for it in 2010 or earlier. And if I went digging into the other 70% they owned, I could probably find more problems too.
More broadly I'd note a lot of the land they own near Mexico City looks like this at the moment:
Source: Google Maps Streetview
There's a future where this gets developed and they can turn a nice profit since it's not that far from existing subdivisions. But with the government prioritizing more urban developments instead of promoting new greenfield construction like it used to, you can see why properties that look like this have sat on Ara's balance sheet for years instead of turning into houses and cash flow.
Poor Profitability Leads To Persistent Low P/B Ratio
Switching gears, I'd also note that if it takes forever to get cash out of book value assets, it probably deserves to trade at a discount to book value. Ara earns very low profit margins on its business:
Source: QuickFS
The company is holding something like 10-15 years of land inventory on its balance sheet and when it finally does get around to putting that land to use, look at the decidedly mediocre returns it gets from building. Yes, you are getting assets at a discount but if you earn less than 4% annually on said assets and you have to hold the land for 15 years before it can turn into a house, you're still likely to get a modest return on your investment even if you buy at a discount.
If Ara had a plan to monetize its land bank much more rapidly, that'd be something. But other Mexican homebuilders have stepped in and grown rapidly in the wake of the previous round of bankruptcies while Ara continues to fiddle around and build no more homes now than it used to.
The bulls say that Ara has a sterling business reputation and is excellent at capital allocation. And yet, for the past 20 years, Ara stock has done precisely nothing:
Making matters worse, shares are actually down 50% if you calculate in Dollars instead of Mexican Pesos. This underperformance could be blamed on external factors along with the management team's conservative nature and unwillingness to use high degrees of leverage.
However, there's another Mexican company that infamously keeps 40% of its market cap in straight cash on its balance sheet and operates in an unloved sector (poultry).
How's that long-term stock chart look? Glad you asked:
This is Bachoco's Mexican stock listing. It's more commonly known by its "IBA" New York Stock Exchange ticker.
Over the past 20 years, Bachoco is up 800% in dollar terms (even more in Pesos) whereas Ara has lost 50% of its value. You can't just hand-wave that away due to management being conservative or its industry going through a rough patch in the early 2010s. 20 years of operating history has included two Mexican housing cycles, during which Ara has generated virtually no shareholder value.
Editor’s Note: Bachoco was subsequently acquired in 2022, whereas Ara has not attracted any activist attention and shares have further declined.
The Malls: Not A Major Feature
Ara owns all or partial stakes in six Mexican shopping malls. These tend to be more middle class-oriented shopping properties rather than high-end luxury stuff. The most exposure is to areas around Mexico City.
The company, from what I can tell, has one fairly large mall - Plaza Las Americas -- which is just shy of 1 million square feet. That's a good-sized regional mall though hardly anything crazy.
I lived in Queretaro, Mexico, which is home to the 2.9 million square foot Antea mall and which is one of Mexico's most valuable retail properties. In the U.S., the Mall of America is 4.8 million square feet. Within Mexico City proper, the largest mall is 2.3 million square feet. So Ara's one big mall is not really competitive as a destination mall and its other five properties seem fairly dinky.
That's not to say they're bad properties necessarily, but they only generate 5% of Ara's business and I'd take the other side of the bulls bet that mall income will "explode" post-Covid. A newspaper report (Spanish) from earlier this year about Ara's largest mall said business is poor and some retailers are considering closing their stores.
I'd also note that Mexico's largest publicly-traded mall and department store operator, Liverpool, has been in a massive downturn over the past five years, so keep that in mind before assigning any hidden upside to Ara's commercial properties:
Liverpool, another company that is way better at long-term shareholder value creation than Ara despite being in an unpopular industry.
I want to reiterate that the point of this isn't to slam Ara or to go after the author of the bullish piece. I want more people looking at Mexican stocks.
However, there's more than 100 listed Mexican equities. I don't have capital or research time available to dedicate to all of them. Some discretion is needed; I'm not going to be the guy that just slaps a buy rating on every Mexican stock because the overall market there is undervalued.
If you just want to buy a really cheap safe stock in Mexico, it's hard to beat something like Bachoco -- and poultry is a far more stable and regulation-proof business than homebuilding. You'll never see your poultry business dry up overnight due to a change in subsidies. And if you want leverage to Mexico's growing economy and consumer class at a fine price, other options such as the airport operators, Domino's/Starbucks franchise operator Alsea, or Femsa tick those boxes nicely.
I hope Ara stock goes up because I hope everything in Mexico goes up. The country has been in a bear market for many years now, and it's about time that that change, particularly with the favorable post-Covid economic outlook. That said, Ara looks like a really complicated vehicle to play the Mexican recovery and I see ways in which it could continue to be a value trap.
The fact that Ara stock has lost 50% of its value over the past 20 years should be a major red flag for starters, given that you could have octupled your money over that same period buying really mundane Mexican securities such as Bachoco or Walmart Mexico.
Ara is definitely at a large discount to book value, I won't dispute that. But given the uncertainty in the value of those assets and the extended time horizon to convert those assets into cash, the discount seems quite justified.
(Disclosure: I own Walmart Mexico, Alsea, and Femsa stock as of Sept. 2022)