Latin America Equity Research Industrials – Mexico July 2012

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Industrials – Mexico Industrials – Mexico Juan Carlos Mateos,* CFA Head of Equity Research, Mexico HSBC Mexico, S.A. +5255 5721 3607 [email protected] Ivan Enriquez* Analyst HSBC Mexico, S.A. +5255 5721 2397

[email protected]

*Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations

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2 Latin America Equity Research Industrials – Mexico July 2012

Sector structure Mexican Industrials

Diversified/Multi-industry Conglomerates

Chemicals

Alfa

Mexichem

ICH

Grupo Carso

Alpek

Simec

Grupo KUO

Cydsa

Grupo Industrial Saltillo

Pochteca

Steel

Source: HSBC

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Latin America Equity Research Industrials – Mexico July 2012

Mexican Industrial Conglomerates: Cumulative total return(%), 2007-June 2012

400% 350% 300% 250% 200% 150% 100% 50% 0% Jun -0 7

D ec -07

Ju n-08

D ec -08

Jun-09

D ec -09

Jun -1 0

D ec -10

Ju n-11

D ec -11

-50% -100%

A lfa

K UO

Mexichem

Me xbol

3

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Source: Bloomberg, HSBC

Ca rso

4

16 15 14 13

Latin America Equity Research Industrials – Mexico July 2012

Mexican Industrial Conglomerates: Historical EV/EBITDA, 2008–June 2012

12 11 10 9 8 7 6 5 4 3 2 J un-08

D ec -0 8

Jun-0 9

Source: Bloomberg, HSBC

Alfa Avg A lfa

Jun-1 0

D ec-10 C arso A vg C arso

Jun-11

D ec-1 1 K UO A vg K UO

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Me xic hem A vg Me xic hem

D e c-09

Latin America Equity Research Industrials – Mexico July 2012

Sector description Mexican industrial conglomerates have undergone an overhaul since the 2001-2002 global economic downturn, when many were weakened by high exposure to cyclical industries, such as steel and auto parts. Over the past decade, the conglomerates have emerged as leaner, more efficient, less leveraged, and more focused industrial companies. They have shifted away from cyclical industries and commodities, resulting in lower earnings volatility. Operations have become more concentrated in fewer industries and with fewer subsidiaries. Some Mexican companies have made acquisitions abroad in search of growth opportunities. Capital goods companies, some of which are still industrial conglomerates and some of which are now more narrowly focused capital goods companies, represented a market capitalization of around USD72bn in June 2012, or 8% of the Mexican stock market’s value. The biggest companies are Alfa, Alpek, Carso and ICH, and they range from multi-industry groups to those in the chemicals and steel sectors.

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Juan Carlos Mateos,* CFA Head of Equity Research, Mexico HSBC Mexico, S.A. +52 55 5721 3607 [email protected] *Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/ qualified pursuant to FINRA regulations

Reshaping and reinventing Divestitures, changes in JVs, acquisitions: Following the 2001-2002 economic downturn, the business portfolios of Mexican industrial companies changed. Some moved away from commodities, such as Alfa, which now participates in fewer, less cyclical industries. In 2003 it sold Hylsamex, its steel division. It expanded its high-tech, non-commodity auto parts business (aluminum engine blocks and heads) to different parts of the globe and is now the world’s largest producer of these components. It has also grown abroad in petrochemicals (US and Argentina) and the refrigerated food business (Central America, Caribbean, and US). In petrochemicals, Alfa, through its listed Alpek division, has limited exposure to cyclical commodities given that the majority of its revenues come directly or indirectly from consumer-related products such as plastic bottles and containers, and wrapping film, among others. KUO restructured its portfolio; it lowered exposure to auto parts and only kept operations where it had extensive experience and owned the required technology (mainly, manual transmissions). It also strengthened its consumer business, mainly in the food segment, where it has established a joint venture with Herdez, one of Mexico’s largest branded foods manufacturer. Carso, controlled by Carlos Slim and his family, has become a leaner conglomerate after a series of divestitures and spin-offs. Over the past 15 years, it has sold the ceramic tile, bakeries, paper manufacturing, chemicals, plastics, cigarettes, some auto parts, and aluminium businesses, among others. In addition, it spun off the mining and real estate business, which now trade separately in the Mexican Stock Exchange. It has expanded into oil platforms and other infrastructure-related activities. Grupo Sanborns, the retailing division, is now Carso’s most important business. Mexichem’s cable division was sold in 2005 as management decided to focus on the chemicals and petrochemicals industries. Mexichem is now a group of chemicals and petrochemicals. The company is the largest producer of PVC resins and pipes in Latin America, and the only integrated PVC pipes producer in the region. Mexichem is also the only fully integrated hydrofluoric acid and refrigerants producer in the Americas. An aggressive expansion strategy has resulted in leading market positions in

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Latin America Equity Research Industrials – Mexico July 2012

most Latin American markets where it participates. More than 10 acquisitions in the last three years have expanded Mexichem’s operations to more than 30 countries including the US, Canada, UK, and Japan.

Key themes Avoiding over-diversification: Staying within the few industries where Mexican industrial companies now have a competitive advantage will be important, since many of these companies have been involved in the past in multiple businesses, ranging from making TV sets to hotels to steel. In many cases, barriers to entry are high. For example, large investments and scale are required to compete efficiently, and most sectors in which these companies are active are highly concentrated with few players participating. International expansion: There are attractive growth opportunities beyond Mexico, and most of the conglomerates have been successful in their business ventures abroad (US, Latin America and Europe). Some have small ventures in Asia. Succeeding there will be the challenge because of their smaller scale and less familiarity with those new markets. As a result of their international expansion, Mexican companies now must compete with a much wider range of competitors in the global markets. Keeping leverage under control: In the early 2000s some Mexican conglomerates had high leverage ratios, with several above 4x net debt to EBITDA. The peak was in 2002; by mid-2012 it had fallen to c2x on average. Companies will need to focus on continuing to finance growth with their own resources and moderating levels of indebtedness.

Sector drivers US and Mexican auto sales Alfa, Carso, and KUO have auto parts businesses. Auto sales in the US and Mexico are closely related given that c85% of the total autos produced in Mexico target the export market. Of the Mexican autos exported, c65% went to the US in the January-April 2012 period. Mexican auto production and auto production for exports has reached record-high levels. In April 2012, 206,389 autos were produced in Mexico for a cumulative figure of 2,678,675 units in LTM; auto exports reached 174,631 units in April 2012, for cumulative figure of 2,248,418 units exported in LTM. We believe that the gradual upward trend of domestic auto sales will continue based on various economic developments in Mexico, such as easier availability of credit to consumers from banking institutions.

Commodity prices For a typical commodity chemical producer, c80% of the cash cost of production is linked to the price of feedstock – in most cases crude oil, the price of which tends to be highly volatile. In the case of Alpek, its main raw material is paraxylene, a benzene derivative obtained as a by-product of oil refining process. MEG is an important raw material for Alpek. For KUO, the main raw material is butadiene which is used for the manufacturing of synthetic rubber. For Mexichem, its main raw material is VCM which is used for the production of PVC resins and pipes. The petrochemicals and chemicals industry structure in Mexico is unique given that Petroleos Mexicanos (Pemex), the state-owned oil company, is exclusively mandated by the Mexican constitution to perform such activities as oil exploitation and production, and oil refining, as well as the manufacture of basic

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Latin America Equity Research Industrials – Mexico July 2012

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petrochemicals. In many cases, this has created high market concentrations with some markets in Mexico effectively being monopolies for major resins such as PET and PVC.

Currency volatility A stronger peso could depress conglomerates’ operating margins. A high percentage (c60%, on average) of the group’s revenues is USD-linked. In addition, with a large component of peso-denominated costs, these could grow at a faster pace than USD-linked revenues when the latter are converted into pesos. A stronger peso would hurt operating profit but boost net income through lower interest expense and foreign exchange losses given that, on average, 65% of the conglomerates’ debt is denominated in USD. In contrast, a weak Mexican peso favors the group’s performance since USD-linked revenues translate into more local currency units.

Valuation The main metric used when valuing Mexican industrial companies is EV/EBITDA. Analysts and investors have traditionally preferred to use this methodology over PE given that during several decades Mexico used inflation accounting, under which net income was a less meaningful measure. Specifically, companies posted monetary gains or losses depending on whether they had a net debt or net cash position. This item caused a distortion, as well as foreign-exchange losses or gains, which are non-cash items. Most of these companies have traditionally had large levels of debt, usually in USD. Therefore monetary and FX gains or losses had a larger impact on them than on other Mexican sectors. Mexico has stopped using inflation accounting. As a result, net income has become a more meaningful measure so more market participants are beginning to consider PE as a relevant metric. However, we believe that most analysts and investors prefer to keep using EV/EBITDA as the main valuation metric. Sum of the parts, another alternative. Another way to come up with a valuation of the multi-industry companies is by calculating an estimated value for each of its business units and then adding those values. In our experience it is a more complex task since not all of the components are publicly traded. In any case, in general, the market value of the conglomerates tends to trade at a discount to the sum of its parts. According to our calculations, this discount has ranged from 15% to 50% over the past 14 years. As of June 2012, the group was trading at 6.1x EV/EBITDA multiple for 2012e, below the Mexican Bolsa’s IPC index’s 8.0x and below the industrial group’s 7.2x five-year average. The Mexican industrials sector’s EBITDA and net income posted growth rates of 25.0% and 20.7%, respectively, in 2011. The consensus forecasts for 2012e are 36.5% and 37.3%, respectively. The sector has typically traded at a 7.6x EV/EBITDA and 15.9x PE. Please note that the EV/EBITDA multiple for Mexican industrials may be higher than the EV/EBITDA multiple of other international comparables given that Mexican conglomerates have operations in high-multiple businesses such as retail and food.

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Latin America Equity Research Industrials – Mexico July 2012

Sector snapshot Historical fwd EV/EBITDA multiple

Key sector stats Industrials

5.27% of MSCI EM Latam

Trading data ADTV (5 Year) (USD mn) Free flow market cap(USD bn) Performance since 1 Jul 2002* Absolute Relative to MSCI EM Latam 3 largest stocks Correlations (5-year) with MSCI EM Latam

128.78 39.97

16 14 12 10 8

343.12% -36.46% CCRO3.SA, LFL, COPEC 0.88

6 4 2 J un -0 7

D ec -0 7

Ju n08

D ec -0 8

Ju n09 Alfa

*Performance includes dividends Source: HSBC, Thomson Reuters Datastream, MSCI, I/B/E/S, At June 30, 2012

D ec -0 9 Gcarso

Ju n10

D ec -1 0

Ju n11

D ec -1 1

Mexchem

Source: Bloomberg, HSBC

Top 10 stocks

Industrial production in the US and Mexico

Stock rank

Stocks

1 2 3 4 5 6 7 8 9 10

CCR RODOVIAS ON LATAM AIRLINES GROUP COPEC ALFA 'A' EMBRAER ON LOCALIZA ON ALL AMER LAT ON GCARSO 'A1' ECORODOVIAS ON NM GAP 'B'

Index weight 0.96% 0.91% 0.89% 0.58% 0.50% 0.27% 0.26% 0.25% 0.18% 0.16%

125

101 99 97 95 93 91 89 87 85 83

120 115 110 105 100 95 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 United States (left axis)

Source: HSBC, Thomson Reuters Datastream, MSCI, I/B/E/S, At June 30, 2012

Mexico (right axis)

Source: Bloomberg, HSBC

Country breakdown Country

Weights (%)

CHILE MEXICO BRAZIL COLOMBIA PERU Source: HSBC, Thomson Reuters Datastream, MSCI, I/B/E/S, At June 30, 2012

20.78 4.29 4.06 0.00 0.00

Retail sales 126 124 122 x)e 120 d In ( 118 116 114 112 110 2006

2007

2008

2009 SA

Source: HSBC estimates, ANTAC

8

2010 Trend

2011

2012