Introduction
In this post, I’ll take a closer look at Gafisa (NYSE: GFA BP: GFASA3.SA), a Brazilian homebuilder which I mentioned in a previous post. What’s interesting about Gafisa is that the company appears almost impossible to value, and yet it still attracts significant interest, both from Brazilian and foreign investors. Though it’s a difficult task, I’ll attempt to provide a general, and yet still very simplified, framework for an evaluation of Gafisa. My basic assumption, given the growing momentum of mortgage securitization in Brazil, is that the best way for an outside investor to value the company, is perhaps to assign some value to the company’s growing receivable balance, while taking into consideration outstanding debt obligations.

Please note: All numbers in this post are given in REAL, not in US Dollars, unless otherwise noted.

Why is Gafisa So Difficult to Value?
If one takes the time to even do a cursory read of Gafisa’s financial filings, it will become clear quite quickly that the accounting for the company is so complicated and convoluted, that it is nearly impossible to figure out how much money the company is actually making. As such, the company’s income statements, revenue, and earnings figures, are for all intents and purposes completely meaningless when it comes to evaluating the shares. This implies that valuing Gafisa based on standard multiples, such as P/E, EV/EBITDA etc., is merely an exercise in futility.

Of course, this accounting situation is not unique to Gafisa, but is a basic problem with any real estate/homebuilder company, where the accounting is always incredibly complicated and nearly impossible to decipher. However, the difficulties are compounded further for Gafisa, given the differences in Brazilian GAAP vs. US GAAP, as well as the multitude of projects the company is undertaking in different geographic areas and economic strata of Brazil.

Truthfully, the only real way to value a company like Gafisa, would be to reconstruct the individual costs and cash-flow from each of the company’s current and past real estate projects. However, such a task is impossible for an outsider of the company, and is probably also only possible for a few insiders who have the detailed knowledge of all of Gafisa’s operations.

The Balance Sheet to the Rescue
Despite the above reservations, I still think it is possible to gain some understanding of the valuation of Gafisa by looking at its balance sheet. As I’ve mentioned in the past, the balance sheet, for most companies, is generally less misleading than the income statement, and a careful analysis of the balance sheet can shed some light on how much money a company is actually making, or losing. This can then be used to figure out some rational valuation level for the stock.

As for Gafisa, the important balance sheet metrics are the company’s current cash, debt obligations, total accounts receivables both current and long term, and the land bank.

For Gafisa the accounts receivable relates to future payments due by residential buyers of its real estate. Generally, in Brazil, as in other parts of the world, residential buyers make a down payment on real estate and then pay off the rest of the balance over time. The remaining balance of payments is recorded as accounts receivable.

As of June 2008, Gafisa reported R$3.4 billion in accounts receivables, the vast majority of which should be converted to cash over the next few years. Parenthetically, because of some accounting quirks (i.e. the company doesn’t record receivables until some revenue is recorded), this figure is not deducible from the balance sheet (i.e. the balance sheet figure is lower), but is provided by the company in its financial presentations.

Even though, the valuation of accounts receivables is always problematic, I’m willing to assume that in the case of Gafisa, these R$3.4 billion in receivables is “as good as” cash. This assumption is justified by the:
• Low rate of default (i.e. less than 3% I believe) on home purchases in Brazil because of large downpayments, and other factors
• Growing bank mortgage market in Brazil, whereby Gafisa, no longer needs to finance most of the receivables (i.e. home loans) on its own, but rather can work with financial institutions to reduce receivables via mortgage loans
• Growing mortgage securitization market in Brazil, which will allow Gafisa to quickly convert its receivables to cash (i.e. the company estimated at least $200 million in securitizations in the June-08 financial report).

Moving onto other parts of the Balance Sheet, as of June 2008, Gafisa reported $1.4 billion in debt, and $775 million in cash. Notably, the company’s debt has nearly tripled in a year, while cash and receivables have about doubled. This of course is a negative factor, as in general I like to see cash generation significantly exceed debt issuance, just to provide some comfort that one is not investing in some type of ponzi-scheme. In the case of Gafisa, the large issuance of debt is something to further research, but probably relates to the company’s recent land purchases and other acquisitions.

The final item that is worth mentioning for Gafisa is its land reserve value, which the company estimated at R$13.5 billion as of June 2008. Any estimate of land value is of course highly speculative and not really worth evaluating. However, in the case of Gafisa it is somewhat important, as it gives a sense as to how much potential growth the company can have over the next five to ten years. The land reserve is composed of 225 different sites in 66 cities in 21 states, totaling 8.4 million square meters, equivalent to 65,273 units. Basically, given these land numbers it’s not farfetched to assume that Gafisa can at least double in size over the next few years.

Putting Together The Pieces: GFA’s Capitalization

According the latest Brazilian filings, GFA has about 126 million shares outstanding on the local Brazilian market. So at the current Braziliam REAL market price of about $22, the company has a market cap of about R$2.8 billion, and an enterprise value of about R$3.4 billion.

For the GFA ADR, the above numbers would need to adjusted based on a 2:1 ADR to Shares ratio and an assumed exchange rate. So basically, the numbers are: 63 million ADR’s outstanding and about US$375 million in debt (assuming 1.60 exchange rate), for an EV of about $US 2.1 billion.

Interestingly, from the above numbers, one can easily see how important a role currency exchange rate assumptions can play when investing in GFA or any other foreign company. Basically, if the REAL weakened to 2 to $1 vs. the US dollar (nothing out of the ordinary, since it traded at 1 to US$2.5 only two years ago), Gafisa’s Brazilian Local shares could still theoretically trade at the same price, while the ADR’s would decline by over 18%. Should the Brazilian local shares fall under this scenario, the ADR’s would really get clocked. At the same time, if the REAL strengthened vs. the dollar, the holders of the ADR could benefit even if the local shares decline.

Getting back to the valuation, the enterprise value of R$3.4 billion is matched against R$3.4 billion in receivables. While it’s difficult to say, how much of these receivables will actually turn into cash, given the fact that some of the receivable cash will need to go to ongoing construction costs and other expenses, it’s interesting to note that Gafisa has about R$600 million in current payables for land purchases and materials. This implies to me that a significant portion of the construction costs have already been paid for and that a large majority of the R$3.4 billion in receivables will turn into cash-flow over the next few years.

Subtracting the above payables balance from the receivables balance leaves about R$2.8 billion in receivables that can be turned into cash. To be conservative, one chop these receivables in half to about R$1.5 billion and then just assume that the R$1.5 billion will turn into cash over the next five years. Making another overly-simplified assumption and dividing R$1.5 billion equally over five years, assumes about R$300 million in annual operating cash-flow over the next five years, without any growth (interestingly this number about equals the annualized EBITDA of the company given 2Q 2008 numbers). This number also assumes that future down payments on new properties, and other revenue streams, will at least cover ongoing expenses, so that the R$1.5 billion in additional payments from past projects, can basically flow to the bottom line. I do not think such an assumption is unrealistic. Basically, the above cash-flow number would imply that the company is trading at about 11X EV/OCF.

The key question of course, assuming the numbers above have validity (which they certainly may not) is whether this valuation is cheap. This is of course, not an easy question to answer, given the many variables involved, but I do think that paying 11X OCF for a company that can double in the size in a few years is surely not unreasonable. This, of course, once again assumes a stable and strong currency in Brazil relative to the US dollar.

Conclusion
In conclusion, GFA’s solid receivables balance and potential for continued significant residential unit growth, suggest that the stock is quite reasonable at current prices. In addition, the favorable mortgage market in Brazil both from a financing and securitization perspective, suggest a strong macroeconomic environment for the Brazilian housing market, which would benefit GFA.

Key risks for GFA would be a slowdown in the mortgage market in Brazil and/or a significant economic slowdown in Brazil, which would make it more difficult for the average person to afford residential property.

Interesting Facts:

Some interesting facts about Real Estate in Brazil from Gafisa’s 20-F. These points are interesting when you compare the real estate prices to those currently available in the US, even after the real estate bust in the US. Note how affordable Brazilian real estate still is, especially from an income standpoint.

Luxury buildings are a high margin niche. Units usually have over 180 square meters of private area, at least four bedrooms and three parking spaces. Typically, this product is fitted with modern, top-quality materials designed by brand-name manufacturers. The development usually includes swimming pools, gyms, visitor parking, and other amenities. Average price per square meter generally is higher than R$3,600 (US$2,033). Luxury building developments are targeted to families with monthly household incomes in excess of R$20,000 (US$11,293).

Buildings targeted at middle-income customers account for the majority of our sales since our inception. Units usually have between 90 and 180 square meters of private area, three or four bedrooms and two to three underground parking spaces. Buildings are usually developed in large tracts of land as part of multi-building developments and, to a lesser extent, in smaller lots in attractive neighborhoods. Average price per square meter ranges from R$2,000 to R$3,600 (US$1,129 to US$2,033). Developments in Rio de Janeiro tend to be larger due to the large tracts of land available in Barra da Tijuca. Middle-income building developments are tailored to customers with monthly household incomes between R$5,000 and R$20,000 (US$2,823 and US$11,293).

Lower income housing developments. In Rio de Janeiro, our first project intended for lower income development was “Colinas de Campo Grande”, launched in 2000 in the neighborhood of Campo Grande, with an average sale value of R$38,000 (US$21,457). Affordable entry-level housing consists of building and house units. Units usually have between 42 to 60 square meters of indoor private area and two to three bedrooms. Average price per square meter ranges from R$1,500 to R$2,000 (US$847 to US$1,130). Affordable entry-level housing developments are tailored to families with monthly household incomes between R$1,600 and R$5,000 (approximately US$903 and US$2,823)

Note: One square meter is equal to approximately 10.76 square feet.