As I pointed out in this issue’smain feature article, the Latin American homebuilding market has huge potential for profits in the coming years, even if there have been and likely will be more challenges in the future.

Gafisa Group (NYSE: GFA), one of Brazil’s largest homebuilders, is coming off a troubled run over the past couple of years after hitting some challenges of its own. But now it faces brighter prospects ahead.

The company caters to the full spectrum of home buyers. Gafisa develops and builds homes for middle income buyers; its Alphaville division focuses on the high-end luxury market, while its Tenda division targets low-income buyers.

Acquired by Gafisa in 2008, Tenda has been the source of most of the company’s problems.

Most low-income home buyers receive substantial government support in Brazil, which in 2009 launched a program known as “Minha Casa Minha Vida,” a massive low-income housing building program. Initially funded to the tune of BRL34 billion with a goal of building one million low-cost housing units, in 2011 its budget was more than doubled to BRL72 billion and its goal was increased to two million units.

On its face, that should have been a huge opportunity for Tenda. But the Brazilian government is no model of efficiency and the program quickly became plagued by delays and cost overruns.

As a result Tenda, and its parent Gafisa Group, were hit by build cancelations which added to its already high debt load. At the same time, profitability per project dropped to almost nil as the cost of many projects shot up by as much 50 percent.

The problems became so severe that the company swung to a BRL945 million, or BRL4.38 per share, loss in 2011 even as revenues were growing rapidly.

In an effort to right the ship, Gafisa ultimately ended up cancelling a number of projects, reevaluated its building methods and processes and has been on a campaign to reduce debt and improve its free cash flow.

Last year, Tenda began using an aluminum mold construction method which, while not quite prefabricated can almost be described as assembled building blocks. This method has shaved nearly five months off of construction times and can be built using fewer skilled laborers, drastically reducing costs.



Gafisa has also begun timing projects across all three of its divisions, whereby new builds are essentially prepaid by sales of homes already under construction. Consequently, cash flows are much smoother and the company actually generated BRL536 million in free cash flow last year, the first time since 2004.

The company has been applying that cash flow to reducing debt, paying down about BRL300 million in 2012 as it works to deleverage its balance sheet.

Gafisa has said that it plans to pull in its horns on its rapid geographic expansion of years past, another key element in its cash flow troubles, to focus on the Rio de Janeiro and Sao Paulo markets which have, historically, been extremely profitable for the company.

Rio represents a particularly attractive opportunity since the World Cup is scheduled to be played there in 2014 and the Olympics will follow in 2016. While the Brazilian government has been working to address the issue of slums and substandard housing countrywide, right now it is focusing its efforts heavily on Rio to put its best face on for the world.

Investors have been slow to reward Gafisa for the impressive turnaround it has made over the past year alone, with shares trading at a 30 percent discount to book value. Part of the issue there is that the few analysts that cover the company have generally taken a fairly pessimistic view of the company.

Over the past three months two firms have upgraded their rating of the company, though few investors seem to have noticed.

While Gafisa is a somewhat risky turnaround play, management’s efforts to right the ship have been paying off thus far. At the same time it stands to benefit from the government’s redevelopment efforts. It is estimated that the government will spend about BRL70 billion on new, affordable housing in the Rio region by next year.

Gafisa is better positioned to cope with the government’s vagaries and also has expertise in high-rise construction, which the government is said to favor at the moment. Gafisa Group is the newest addition to our Long-Term Portfolio and is a buy up to 5.