Garfisa (GFA): Homebuilding in Brazil

By Ian Wyatt, editor Top Stock Insights

Brazil is a great growth story and one that is attracting the attention of investors.

With its economy expected to grow at twice the speed of the United States, investors can expect more profits in 2010. This background leads to our recommendation for Gafisa (NYSE: GFA) -- one of the largest homebuilders in Brazil.

Garfisa has been operating in Rio de Janeiro and Sao Paulo since 1954. The company has expanded at a rapid pace the last four years, branching out from exposure in just 10 states and 16 cities to 21 states and 100 cities.

The company builds homes for all income segments. Its namesake brand focuses on residential developments for the luxury and the medium income segment, but the 2008 acquisition of Construtora Tenda moved Gafisa into the affordable housing segment.

With over 980 successfully completed projects, Gafisa has an edge in the Brazilian real estate market, a market that stands to benefit from favorable demographics, political incentive programs, and a healthy domestic economy.

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These programs are aimed at lifting poverty levels and boosting employment and have resulted in over 8 million new jobs and a 46% rise in minimum wage since 2003.

This policy has given Brazil's population discretionary income to spend, which has fueled demand for real estate and consumer goods. While most investors are focusing on Brazilian resource stocks, savvy investors will invest in areas poised to benefit from Brazil's growing middle class.

Brazil is quickly gaining attention from international investors. U.S. born billionaire and real estate entrepreneur Sam Zell is just one such capitalist who sees upside in Brazil, specifically in the real estate market.

Last March, Zell put his money where his mouth was, and raised his stake in Gafisa to 18.8%. Zell sees a big opportunity from the 190 million people in Brazil and the expansion of the middle class, growth that is accelerating due to government programs.

With a population approaching 190 million, Brazil is the 5th most populated country in the world and growing by almost one percent each year.

This rise of the middle class has fueled spending on goods, more specifically houses, and the rising standard of living will continue to fuel real estate development in the future. In fact,one of the biggest opportunities for growth in 2010 is Brazil's low income market.

Recent estimates from the Ministry of Cities (MOC) expect Brazil to spawn 1.6 million new families each year for the next decade, of which 80% will be low income families.

Thus, in the next ten years, Brazil will need to construct 16 million new home units. Add in the 8 million unit current shortfall and this means 24 million new units of demand for the next decade.

Gafisa will be quick to profit from the government's recent stimulus. After 40 years of developing units for the middle to high end real estate market, Gafisa entered the affordable housing market in late 2008 by acquiring competitor Tenda.

This strategic move will shift Gafisa's focus from the luxury market, which represented 80% of sales in 2006, and balance the company's revenue stream. In 2008, middle and luxury sales were 55% of total revenues while affordable housing jumped to 28% of total sales, and should expand further through this year.

I expect 2010 revenues of $2.25 billion, which represents 50% annual growth from my $1.5 billion 2009 sales estimate. Home prices should also continue to increase resulting in higher operating margins, which have been increasing each year from 6% in 2005 to 11% in 2008.

Given the income growth, widening margins and industry comparable data, shares are attractively valued using a 10 times earnings multiple. I expect operating margins to average 11.5% next year, pushing diluted EPS to $4.08. Using my 10 times forward multiple yields a $47 target price on shares.

Overall, many Brazilians are now looking to 'trade up' from their old rural house into a new home in a bigger city.

Unlike in the U.S. where employment is evaporating and incomes are falling, real estate prices in Brazil should continue to benefit as incomes expand and cities are built up in preparation for the 2014 World Cup and 2016 Olympic games.

With an abundance of natural resources and a government that encourages domestic growth, the Brazilian economy and real estate market are set to prosper for many years to come. Investors in Gafisa will have an opportunity to benefit alongside the Brazilian people as this company grows to meet demand.

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