Homex: Where the Growth Is

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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.

Analyst Leon follows telecommunications stocks for Standard & Poor's Equity Research Services .