Graña y Montero SAA's (NYSE:GRAM), a Peru-based construction and engineering company, has performed well this year, but the stock may have reached its high for 2016.
While Peru appears to have one of the stronger economies in Latin America, with GDP growth of around 4% expected this year, the country still faces some challenges. Inflation is low compared to Argentina and Brazil, but is still above target. The Central Reserve Bank of Peru expects inflation to come in at 3.4% for 2016, which is higher than the 1-3% target range.
Low commodity prices have hurt Peru, the world's third-largest copper producer, as the country's mineral exports decreased and investments slipped in 2014. Since commodities may no longer be a tailwind for the economy, creating a healthy level of internal consumption is important.
Expanding the domestic market should be a focus of the incoming administration.
Recently, Peru elected Pedro Pablo Kuczynski as its next president. It was a very close race, but Kuczynski and his opponent, Keiko Fujimori, were both viewed as friendly for the markets.
This view stemmed from the belief that monetary policy would remain independent and focused on containing inflation and reducing volatility, and economic growth would be boosted via an increase in infrastructure spending, regardless of which candidate was elected.
Armed with this information, investors bid up Peru's stocks, causing the iShares MSCI All Peru Capped Index Fund (NYSEARCA:EPU) to rise over 50% this year. The expected increase in infrastructure spending is what some investors may be focusing on when it comes to Graña y Montero. With the ADR shares up 123% ytd, it has outperformed EPU, and optimism about the company's prospects appears high.
But I believe the stock may have climbed too quickly, and fundamentals don't seem to warrant such a valuation.
According to the Q1 2016 earnings call Transcript, Graña y Montero is reducing the size of the company in Chile and Colombia. And while Peru accounted for about 73% of sales in 2015, Chile and Colombia accounted for most of the rest.
What's more, Engineering and Construction (E&C) margins have contracted during the first quarter of 2016. Decreased activities in Chile and Colombia can be partially blamed for this contraction, evidence that Graña y Montero's operations in the two countries are meaningful.
Unless there is a quick turnaround in the company's Chilean or Colombian operations, cash flows may not increase much over the next one or two years, and markets may be overly-optimistic in relation to how Peru's fiscal policy will benefit Graña y Montero.
Ultimately, investors may be overestimating how quickly infrastructure spending in Peru will add to the company's bottom line, and growth in consolidated earnings could come in lower than expected if sales fail to increase in other regions.
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