Category Archives: Value Stocks

UK Banking – A look at IPO Aldermore Plc (ISIN GB00BQQMCJ47)

Within my Handelsbanken mini series (part 1, part 2, part 3), I have identified their UK business as one of the potential value drivers. So it was a luck and coincidence that a few days ago, Aldermore PLc, a “start-up” UK Bank went public.

Aldermore itself was founded only in 2009 by a then out-of-job former Barclay’s Banker called Philip Monks. They tried to go public already last year but had to pull the IPO in October.

As I have mentioned a couple of times, an IPO prospectus is always a good opportunity to learn about business models in general and about competitors and the specific sector as well.

There are some interesting parts from the prospectus on the UK banking market:

A high number of mergers and acquisitions in the sector has resulted in sector consolidation (Lloyds’acquisition of HBOS being the largest as well as a number of smaller building society takeovers such as Santander’s acquisition of Alliance & Leicester and Nationwide’s acquisitions of Cheshire, Derbyshire and Dunfermline Building Societies). This has resulted in the UK banking sector becoming one of the most concentrated and least competitive in Europe according to a Treasury Select Committee report published in 2011.

The report concluded that the top five UK banks controlled 75 per cent. of total gross new lending in total mortgages, 85 per cent. of the personal current account market and 62 per cent. of the savings account market.

For a potential shareholder in a UK banking business stock, “most concentrated and least competitive” sound not that bad as it implies some pricing power.

Handelsbanken is mentioned as one of the few foreign players:

Although there are exceptions (e.g. Handelsbanken), more generally, foreign banks have exited or reduced their presence in the UK market. For example, ING exited their mortgages and savings business and stopped writing new business in Asset Finance towards the end of 2012 and the UK business banking subsidiaries of Irish banks have restricted lending.
Furthermore, UK banks have been forced to carry out major cost-cutting exercises, including centralising credit selection functions; in some cases, ring-fencing retail operations; and spending significant amounts to improve the performance and security of their IT platforms.
UK banks have also been significantly impacted by legacy issues arising from, for example, the mis-selling of PPI and swaps and from legacy and underinvested infrastructure. Since 2011, the total bill for litigation,fines and customer redress has been £28.5 billion, equivalent to two-thirds of the cumulative profits of the top five banks over this period
 Customer dissatisfaction in the UK banking sector has also risen. One effect of this, as discussed in a recent Oliver Wyman report, is an increased propensity of customers to review and switch banking provider

Similar to my argument for Handelsbanken, UK customers seem to be fed up with UK banks and are open for new entrants like Handelsbanken and Aldermore.

As a result of these factors, there have been a number of new entrants to the UK banking market. They have adopted a variety of models targeting different credit segments (i.e. retail, SME, corporate) and adopted different distribution models (i.e. branches, intermediary, direct). These include retail-focused branch-based banks such as Metro Bank and Virgin Money and required disposals under State Aid such as Williams & Glyn (currently part of RBS) and TSB (majority owned by Lloyds Banking Group). In addition, these are specialist lenders such as Close Brothers, Shawbrook, Bibby and Paragon, challenging the share of the UK banking market controlled by the incumbents in targeted lending segments.

Aldermore however has a complete different set up than Handelsbanken. They don’t run any branches:

Aldermore does not have a traditional branch network and as such does not have the significant costs associated with running such a branch network.

Instead they run Online/Broker/intermediary based business model, claim to avoid unnecessary costs for branches.

The Directors believe that Aldermore’s branch-free distribution model is better suited to the digital era,with the regional offices representing the physical footprint that Aldermore requires to service its SME customers. The absence of a large, under-utilised branch network enables Aldermore to distribute products and service customers more cost effectively

Interestingly, their actual cost income ratio 2014 is  60% vs. 53% at Handelsbanken. This might have to do with size (Handelbanken is 2-3 times bigger). So it is clearly not a “no brainer” to run an online bank only.

What I didn’t like about Aldermore:

– Intermediary model is not that easy. They don’t have direct client contact, clients are “owned” by brokers
– How do they cope in a downturn test if work outs are necessary and they don’t have client contact ?
– large potential bonuses for management
– targets for management are only EPS and Share price

They do state an explicit ROE ambition:

The Directors are targeting a return on equity of approximately 20 per cent. by the end of the financial year ending 31 December 2016.

Targeting is great, but having it included in compensation would be even better.

Could Aldermore be the same story like Admiral 10-15 years ago ?

I think that Aldermore differs in a very important way from Admiraml: It is not structured at as capital-light model, Aldermore keeps the risk on its balance sheet and will at some point in time need additional capital if they grow like this, which then will dilute shareholders.

Additionally, they are not active in the comparison space. I do think that in the long run will bite into their profitability as the comparison siteswill be able to charge them significant comissions for referals. In the insurance space, referral fees in many cases are already as expensive as sales commissions for agents.

A good reminder that not every new and online based financial company is “the next Admiral” is for instance Vardia, the Norwegian direct insurance newcomer. After explosive growth, out of the blue they had to announce a recapitalization recently. The stock price of course got hammered.

Summary:

Aldermore is clearly riding the wave of disgruntled UK bank clients, but I would not invest there. I don’t see a real competitive advantage,at least not for now.
Valuation wise, the company trades at around 2,5x book value and 15 times earnings which is OK but not cheap. The biggest risk in my opinion is that with their aggressive growth, the might attract a lot of bad risks. Their long-term underwriting abilities will be tested in the next down turn for sure. Anyway, the Aldermore IPO clearly shows that there is room for smaller players in the UK and that there is a good chance for Handelsbanken to grow for quite some time.

Additionally i would argue that the UK banking sector still looks attractive compared to other countries. In Germany for instance retail and commercial banking is dominated by Government backed banks (Sparkassen) which have a built-in advantage of extremely low funding cost. The local UK market in comparison looks much better, especially as interest rates are still positive…..

Short cuts: AS Creation, Fortum, KAS Bank annual report

AS Creation

As Creation is a stock I owned in the past. Last November I had quickly updated the case and written the following:

In any case, I don’t think AS Creation is interesting at the current level of 30 EUR. At a 2014 P/E of 15-20 (before any extra write-offs on Russia) there seems to be quite some turn around fantasy being priced in.

Just a few days ago, AS Creation came out with an anouncement. There will be no dividend and the loss for the year 2014 is 9,3 mn EUR, at the upper end of the communicated range. In parallel, the CFO left the company. The loss seems triggered by a 10 mn EUR FX loss and a 5 mn EUR fine in France. They did not give further details but one can assume that the German business wasn’t that great either.

In any case a good reminder that despite cheap fundamentals, not every “value stock” is good value.

Fortum

Fortum is also a stock which I owned in the past. I sold them in autumn 2012 because I was not really convinced by the idea anymore.

Looking at the chart, we can see that Fortum has done OK since then, especially compared to like German utilities like RWE, which looked a lot cheaper back then:

Again a reminder that cheap doesn’t mean good. The even more interesting aspect is that a few days ago, Fortum finalised the sale of the Swedish power distribution grid to a consortium of pension plans and insurers for 4.4 bn EUR.

According to Reuters, the multiples were quite “Juicy” for the seller:

The deal values the network at around 16.6 times earnings before interest, taxes, depreciation and amortization (EBITDA), the same as for Fortum’s Finnish grid sale in 2013.

16,6 times EBITDA for a business which is quite comparable to my portfolio stock Electrica is an interesting price point. Clearly, you need to take some kind of discount for a recently privatized Romanian company, but I think it clearly shows what kind of prices especially pension and insurance companies are ready to pay. This makes me feel even better about the prospects of Electrica than before.

KAS Bank annual report

When I looked first at KAS Bank 2 and a half years ago, i was drawn in mostly by a very low valuation and the solid business model with a good “mean reversion” potential. that’s what I wrote back then:

Summary:

KAS Bank for me looks like a very interesting opportunity within the banking sector due to the following reasons:

+ attractive specialist business model (custodian)
+ cheap valuation even based on current “bottom of the cycle” earnings
+ valuation depressed because of overall hostility against banks
+ low or no analyst coverage
+ reversion to the mean speculation a lot less risky than with normal banks as virtually no risk of dilution (even Basel III standards are met by a wide margin)
+ potential upside ~100% over the next 3-5 years plus dividends+ low correlation / beta good portfolio diversifier

The upside has realized much quicker than i thought. As of now, including dividends, the stock return +75%. So good analysis, great return ? Well not really. Actually, if I am honest, this was mostly luck as I made a big mistake or omission when i analyzed the stock: I did not look at the pension liability. And this despite the fact that I have written and warned quite often about pensions.

In Kas Bank’s case I have ignored that because the plan was funded. That was a mistake and I will show you why.

Looking into the 2014 annual report of KAS Bank, we can see that they made a nice 24 mn EUR profit this year, which includes the one time effect of the canceled German JV. However, total equity DEcreased from 213 to 194 mn EUR. As the 2014 dividend is around 10 mn EUR, the question is clearly: Where did the other 35 mn EUR equity go ?

The solution to this question can be found on page 52, in the Comprehensive Income statement: KAS Bank lost 52,6 mn EUR pre tax) because of the increase in its pension liability. 2014 has been a brutal year for pensions. The discount rate has been reduced significantly. In 2013 I didn’t pay attention, but KAS Bank used 3,9% which was on the very high-end of permitted rates for EUR. In 2014 they had to slash this to 2,2% (page 80). It gets even crazier if we look at the gross numbers on page 81. The gross DBO increase 105 mn EUR from 182 mn to 287 mn. Luckily, some of that increase could be countered by asset increases. From an overfunding of 40 mn EUR, the plan went to break even. What really surprised me is the duration of the plan with around 22 years. The problem for me is the following: Despite the current funded status, there is a significant amount of risk in the plan. The gross size of the plan is 1,5 times the equity of KAS Bank. The run a significant equity allocation (85 mn EUR or ~ 45% of KAS Banks Equity). So in a scenario with a stock market crash with continuing low-interest rates, KAS Bank would pretty quickly be forced to do a capital increase.

Additionally, the current environment is clearly not helping KAS Bank in its core business. A custody bank is always deposit rich which is a problem now. Another second level problem is mentioned on page 18:

Treasury income, mainly securities lending, decreased by 20% to EUR 11.4 million (2013: EUR 14.3 million). The lower income from securities lending was primarily due to a market wide liquidity surplus which decreased
the prices for securities lending services.

This decrease happened even before the ECB started pumping liquidity into the markets.

So overall, I have been very lucky so far. I didn’t take into account the pension liability in my first analysis and fundamentals got worse for the business itself. Nevertheless I made good money because i bought cheap enough. Optically, the stock still looks priced oK at P/B 1, trailing P/E of 7 and 5,6% dividend yield, but fundamentally, especially looking at ultra low interest rates for quite some time, KAS Bank is in my view now at fair value.

However, I didn’t want to stretch my luck too far and therefore I sold the whole position at around 11,50 EUR per share.

Handelsbanken (part 3) – where is the upside & valuation

As this turned out to be again a pretty long post, a quick “management summary” in the beginning:

1. I do think that Handelsbanken’s UK business represents a significant opportunity for long-term growth
2. Additionally, I think that well run banks are a good opportunity as banks are in general disliked and overall risks in banking have been greatly reduced
3. However, at current valuation levels, Handelsbanken is too expensive. I would be a buyer at around 350 SEK per share or ~-15% below current prices

After trying to “kill” the Handelsbanken investment case last week, now in my third post I will look at the potential upside.

From my side, there are 2 potential “catalysts” which COULD imply future upside, which are:

1. Significant growth potential in UK and Netherlands
2. (Relative) revaluation of the banking sector in the medium term

1. Significant growth potential in UK and Netherlands

If you read the Handelsbanken annual reports over the last few years, it is not exactly a secret that they have great success in the UK. This is a table I compiled from the annual reports which shows the development of the UK branches:

Branches Operating profit Total OP UK/total
2009 62 177 13727 1.29%
2010 83 417 14770 2.82%
2011 104 639 16563 3.86%
2012 133 1006 17108 5.88%
2013 161 1173 18088 6.48%
2014 178 1652 19212 8.60%

Since the end of the financial crisis in 200, Handelsbanken managed to increase operating profit in the UK 10 times and the UK business reached almost 9% of total operating profits in 2014.

Despite a higher cost/income ratio in the UK (~55%) vs the home market in Sweden (~33%), profitability as measured by ROE is already at the same level. Opening bank branches is clearly a cost factor, so one should expect cost income ratios to even go down in the UK over time.

Gross margins in the UK are clearly higher than in Sweden. In my opinion, this has two possible explanations: First, overall interest rates are higher in the UK which makes it easier to charge more. Secondly, most of the competitors (Barclay’s, HSBC, Lloyd’s, TSB) have large legacy portfolios and need to earn margins on new business.

The big question is: can Handelsbanken continue to grow and how big could this become ? One clear driver of the growth is that UK customers are fed up with their local banks. Most of them needed bail outs (RBS, Lloyds, TSB), damaged their reputation by aggressively selling questionable products and/or tax evasion etc. (HSBC’s Gulliver with his Swiss bank account as a last example).

Handelsbanken’s market share in UK so far is tiny. I tried to collect some numbers. In this 2011 report for instance, Handelsbanken didn’t even show up. This is how market shares for instance looked for personal account:

Normally, as in many industries, size does have advantages also in retail banking. Advertising for instance are expenses which scale well. In the UK however banks with large market shares face strong headwinds as outlined in this article. Interestingly, Lloyd’s with its leading market share has a cost-income-ratio of currently around 67% and this number has improved a lot over the last year. So it’s quite interesting to see that the “dwarf” Handelsbanken is already much more efficient than the big guys.

Overall, without having examined the UK market in more detail, I do think there is room for Handelsbanken to expand and reinvest capital at attractive rates for some time.

Personally, I like the organic growth of Handelsbanken a lot. In general I find that especially in the early stages, organic growth is often undervalued. Stock investors prefer often fast growth via acquisitions. You can book a lot of accounting special effects etc. and increase EPS per share much quicker. As we have seen often however, the risk of M&A deals is a lot higher and more often than not, those deals backfire and sometimes even sink the acquirer.

In the UK for instance, recently spun-off TSB has already been approached by Spanish Bank Sabadell for a potential take over a few days ago. This is of course a quick way to add a lot of branches but also a much more risky one.

Netherlands:

Netherlands for Handelsbanken is a comparable small market. with currently 20 branches (up from 18 in 2013), the business grew by ~17%. In principle, I think the situation could be similar to the UK. a lot of the dutch banks have big legacy issues and need to earn margins. However at the moment I would look at the Netherlands as an option and not as something to actually take into account when valuing Handelsbanken.

2. (Relative) revaluation of the banking sector in the medium term

I have quickly touched this topic in the two other posts already. Banks are generally considered as “bad investments” by most participants in the stock market. This is clearly justified if we look back the last 10 years or even longer. Whereas a company like Nestle is considered a safe and promising investment at a P/E of around 23, banks are considered a pure gamble even when the trade at fractions of those multiples.

For me, this is both, a lesson in how to look at historical data and a potentially big structural investment opportunity. Let me explain why.

The main arguments against banks is that they are highly leveraged and too risky. The risk is both individual and systemic (Lehman scenario). In my opinion, the systemic risk component has been greatly reduced by what happened since the financial crisis. A lot of mechanisms have been created to prevent a second event like the run that happened in 2008/2009. For me the most important are:

– collateralization of derivatives
– bank resolution systems both national (e.g. SOFFIN) and on international level
– clear commitment and mandates of central banks
– significant increase in capital requirements internationally

For current shareholders of large legacy banks, this is not very funny at the moment. Whereas most non-banks pay dividends and buy back shares like crazy, banks have to raise capital and postpone dividends in order to shore up their capital. And clearly, in many of the mega-banks, there is plenty of toxic waste on the balance sheet to justify low valuations.

On the other hand, this creates in my opinion great opportunities for players like Handelsbanken which have little toxic waste on their balance sheet and are run efficiently. The systemic risk for those players has become a lot smaller as a potential bankruptcy of one of the old mega-banks will most likely have only little effects on other banks in the future.

The individual risk of a classic and disciplined lending bank in my opinion is relatively limited if it is run by the right people. I do not think that a conservatively run bank is riskier than any other business. I know this is a somehow controversial standpoint but to me, a standard banking business model looks a lot less complex than for instance a multi national branded consumer goods company. For me this kind of blind distrust in the banking business model creates a very interesting opportunity.

Yes, banking in general will be much more dull in the future, but als a lot safer.

The second issue I want to touch quickly is the issue of historical data. Yes, historically, banks look like terrible investments because many of them have been wiped out in the financial crisis. I cannot prove it statistically, but I think banks are also the reason why suddenly low P/E and low P/B strategies seemed to have stopped working. The now favored metric by many “data miners”, the EV has the advantage that it automatically filters out any financial company. But looking into the rear view mirror is not always the best way to make investment decisions. If you would have been a stock investor after WW II, you might not have ever invested into German or Japanese shares because they have been wiped out. But a World War luckily does not happen every 5-10 years and neither does a full-blown financial crisis.

I think that there is a good chance that due to the pressure of capital markets, in the future, returns for banks could be relatively a lot better than they have in the past, assuming that the basic banking model is here to stay. The market will squeeze banks so much that those who remain will earn good ROEs again at some point in the future. And good banks will earn very good ROEs.

Valuation exercise

There are many ways to evaluate companies. I prefer simple ones. For banks, I consider ROE and P/B as the most important factors which drive long-term returns, so a valuation model should focus on those metrics.

To have a starting point, I make the following assumptions:

– ROE will improve to 15% over 5 years (from currently 12,4%) and will stay there (15 year average is 16,5%)
– P/B will remain constant at 2,1 (15 year average is 1,7)
– Divdend payout will be 25% and handelsbanken will be able to reinvest at the above assumed ROEs

The following table translates this into a simple IRR calculation:

Current Price book 2,1                    
ROE 15%                    
                       
ROI 7,1%                    
                       
                       
                       
    1 2 3 4 5 6 7 8 9 10
Book Value 200 218,8 240,1 264,4 292,1 323,9 360,4 400,9 446,0 496,2 552,0
ROE 12,5% 13% 13,50% 14% 14,50% 15% 15% 15% 15% 15% 15%
EPS 25 28,44 32,41 37,01 42,36 48,59 54,05 60,13 66,90 74,43 82,80
Implicit P/E 16,8 16,2 15,6 15,0 14,5 14,0 14,0 14,0 14,0 14,0 14,0
Retention ratio 75% 0,75 0,75 0,75 0,75 0,75 0,75 0,75 0,75 0,75 0,75 0,75
Dividend   7,1 8,1 9,3 10,6 12,1 13,5 15,0 16,7 18,6 20,7
Target Price   459,4 504,2 555,2 613,5 680,2 756,8 841,9 936,6 1.042,0 1.159,2
                       
NPV CFs -409 7,1 8,1 9,3 10,6 12,1 13,5 15,0 16,7 18,6 1.179,9
                       
IRR 12,9%                  

Under those assumptions, Handelsbanken would be trading at 1.160 in 10 years time and returning me 12,9% p.a.

Now comes the interesting part: If I would want to see my 15% p.a. which I normally require, I would need to change assumptions. First I could move the purchase price down from 409 SEK. In my model, I could pay 342 SEks per share and get my 15% annual return. I could also increase my P/B multiple to 2,6 to get my 15% or I could increase the ROE to 21% after year 6 to get 15%. To be honest, both, the multiple expansion and the ROE increase seem much to aggressive to me.

So the question clearly is: Is 12,9% potential return enough or should I insist on 15% ? With the 10 year government rate in Sweden at 1%, the 12,9% would indicate a potential equity premium of 11,9% which is far more than one would normally expect from the market. On the other hand, no one knows what long-term interest rates will be in 10 years time, so betting fully on today’s low rates is also not the best solution.

This return is also driven by the assumption that Handelsbanken can continue to reinvest 75% of their profits at attractive ROEs. In Handelsbanken’s case, I don’t think that this is unrealistic. However if they could for instance only reinvest 60% and pay out the rest in dividends, then the expected return would drop to 10,7% p.a.

Anyway, for now, I would not feel comfortable investing at the current stock price level.

Summary:

At the end of this mini-series, it has become relatively clear to me that Svenska Handelsbanken is really a great company, a true “Outsider” in regard to its business model and culture. Additionally, I do think that they have good growth opportunities in UK, which allows them to reinvest capital for some time to come attractive ROE’s.

In general, I believe than well run banks are one of the few potential bargains left in the market as investors hate them and do not see the greatly improved fundamentals of the financial “plumbing”.

Nevertheless, I do think that Handelsbanken does not fulfill my return requirements as the current price seems to have priced in some of this growth already. Unfortunately i was very slow in discovering Handelsbanken., as I could have bought them at an attractive only a few months ago. Nevertheless, I will keep them as my prime candidate on my watch list. I would love to add this “Outsider company” to my long-term value portfolio.

But again, patience is important. another positive aspect of this exercise is that I know now much better than before what I am looking for when I analyze a bank.

Tesco Plc (ISIN GB0008847096) – Potential value investment or turnaround gamble ?

For a very long time, Tesco, the UK supermarekt chain could do no wrong. They grew nicely year after year and margins, returns on capital etc. were in a league on its own compared to other supermarket chains.

In the 20 years leading up to 2007 for instance, the Tesco share price increased 15 fold, resulting in an annual gain of ~ 16,3% vs. ~7,0% for the FTSE 100.

In the last few years however, Tesco’s star faded. Profit warning was followed by profit warning. In 2013, after exiting the US business and the China venture, many thought that the worst was behind them. But now in 2014, the problems seem to have just begun with further sales declines in the UK markets and lately with an accounting scandal forcing the Chairman stepping down

Over the last few years I looked from time to time into Tesco. I usually don’t like retailers that much, but with Tesco the simple reason was always “Buffett is owning it”. I have to admit that for me the fact that Buffett is owning something creates an urgent need to look at those companies.

Anyway,
Warren Buffett admitted defeat and sold out a few weeks ago, after buying a large stake as late as in 2012, calling the whole episode as a “great mistake”.

Nevertheless, such a rapidly falling stock price of a “blue chip” company still lures many value investors. Among others, Vitaly Katsenelson came out with a “pro Tesco” article just a few days ago.

I would summarize his arguments as follows:

It is a good time to buy Tesco NOW because:
– the news is all negative
– there is an natural upper limit of discounter market share in the UK close to the level where it is today in the UK (~7%)
– Tesco is still twice as large as the nearest competitor and 10 times bigger as Aldi and Lidl
– US grocers have countered Walmart in the US succesfully, so will Tesco in the UK
– Tesco sits on a lot of prime real estate
– Tesco has a 50% market share in online groceries in UK
– the discovered accounting issue is not so bad, as part of if happened in past years
– there is a lot of hidden value in Tesco’s real estate
– Tesco has subsidiaries (loyalty cards, Asia) which are valuable, it could be a sum of parts play
– the 7,5 bn GBP debt load is not an issue because the company is “asset rich”
– at an assumed “fair”operating margin of 5%, Tesco would be a “steal” at 6x P/E

Overall, the pitch is well written and seems to be quite convincing.

However at a second look, the Tesco story seems less convincing. Regarding Katsenelson himself, I wonder why he didn’t explictly mention his article from 1 year ago, where he recommended to buy Tesco right back then, at a price of around 3,60 GBP with virtually the same arguments. Since then, the stock lost a -54% if you followed his advice.

But let’s look at some of his arguments:

There is an natural upper limit of discounter market share

Katsenelson claims that the current discounter market share of around 7% is a “natural limit”. He doesn’t link to any proof and only mentions the limited success some US chains to support this. However if you look at the “Motherland” of hard discounting, Germany, you can see that this argument is pure nonsense. Although German shoppers might be a little special, a market share of 44% for diacounters in 2014 clearly shows that there is a lot of room for discounters in the UK, even if the never get to German levels.

Tesco is still twice as large as the nearest competitor and 10 times bigger as Aldi and Lidl

Well, that’s true for the UK but not for the Europe. Lidl had total sales of 75 bn EUR in Europe, only slightly less than Tesco’s total sales. Aldi doesn’t issue consolidated sales figures but is only slightly smaller than Lidl. What Kastenelson however completely misses is the following: Aldi and Lidl offer only a very limited choice, usually several hundred products compared to 10.000 or more in a large supermarket. So you don’t have the choice of 10 different sorts of orange juice, there is only one and the same goes for other categories-

The result of this limited choice is a a massive scale effect. Even with less total sales, sales per single product at Aldi & Lidl might be already higher in the UK than at Tesco. And sales per single products are essential because this gives negotiation power with the suplier.

There is a lot of value in Tesco’s real estate

This is the same argument one hears all the time for struggling retail companies. They just need to sell their precious reals estate and everything will be OK. The problem with this kind of approach is that real estate for a retailer is not some kind of “extra asset” which comes on top, but real estate is an essential production factor. Selling real estate for a retailer normally means a “sale-and-lease” back and is nothing more than taking on more debt.

I have written about one case, Praktiker in Germany, where the sale-and-.lease-back finally killed the company, the same happened with Karstadt/Arcandor. Tesco by the way, seems to have been quite active in more or less intransparent sale-and-lease back transactions in the past, as this FT Alphaville article outlines. There is also a pretty good post at Motley Fool with regard to the assumed “real estate treasure” and the following quote nails it down:

The supermarkets’ race-for-space is over. Forget the news that Tesco is planning to build houses on some of its now unneeded landbank — that’s it’s a sideshow in the grand scheme of things.

The real story to focus on is those aircraft-hangar-like Extra stores that Tesco is currently padding out with Giraffe restaurants, gyms, children’s play areas and suchlike. This seems little more than a holding strategy, while the company decides what to do with the stores in the new consumer-is-the-destination world, where ‘destination stores’ already seem so last decade.

Analysts at Cazenove have painted a grim — but I think realistic — picture of the way Tesco’s UK property valuation is heading:

“The gap between the performance of large out-of-town stores and convenience stores continues to widen … This has direct and strong implications for the property valuation of the Extra stores (45% of the UK space). The company says that its UK real estate is worth £20bn based on the extrapolation of past sale and lease-back transactions to the entire estate. We believe it is likely worth less than half that value — the book value of UK land and buildings is £9.3bn and the alternative use value towards which several out of town stores are converging is a fraction of the book value”.

Whatever the final outcome will be, but buying a highly indebted retailer because of the assumed value of the real estate has never really worked. If Tesco doesn’t earn enough on the real estate they occupy, who else will do this ? From my experience, when a retailer’s main attraction is the value of its real estate, then you should better run.

US grocers have countered Walmart in the US succesfully, so will Tesco in the UK

Again, Katsenelson looks at the US and compares Aldi & Lidl to Walmart in the US. I think this is a big mistake. If we look again to Germany, one can see that traditional grocers and supermarkets NEVER recovered fully from the attack of the discounters. Just a few weeks ago, one of the German supermarket pioneers, Tengelmann, sold its remaining “classical” super markets to rival Edeka. Operating margins for normal supermarkets, even for the really big ones are more in the 2-3% area maybe half of that what UK supermarkets like Tesco still achieve. Aldi and Lidl are privately owned long term players who clearly are prepared to sacrifice profit for a long time in order to gain market share.

Summary:

It could easily be that we see a mighty rebound in Tesco, maybe even after I post this and I will look like an idiot. However in the medium and long term, I think many of the popular arguments for Tesco as a value investment (real estate etc.) are pretty useless and some of the arguments (i.e. “natural maximum market share” of discounters) are just plain wrong.

If you define a value investment as an investment where the probability of a loss is very small, than clearly Tesco with its highly leveraged balance sheet is not a value investment. On balance debt, off balance debt, a big pension deficit adds to Tesco’s pretty weak balance sheet. Just recently, Tesco was downgraded to BBB- from S&P. Below this level, refinancing will be difficult and much more expensive and subjct to capital market problems.

As an investor you will only make money with Tesco in the long run if they manage a real turn-around. How likely is that ? I have no idea and so I will better stay away from Tesco. In my opinion this is much more a turn-around gamble than a potential value investment.

ITE PLC (ISIN GB0002520509) – Super profitable market leader in Russia at a bargain price ?

After a “Near death” experience with Sistema, I am nevertheless still interested in companies with significant Russian exposure as a “counter-cyclical” EM play, however preferably with less “Oligarch” risk. A very interesting company with a significant Russia exposure is ITE Plc, the UK-based company. According to Bloomberg

ITE Group Plc is an international organizer of exhibitions and conferences. The Company provides
its services to customers in a variety of commercial and industrial sectors, including travel and
tourism, construction, motor, oil and gas, food, security, transport, telecommunications, and
sports and leisure.

The good thing with UK companies is that usually some blogger has covered the stock already. WIth ITE, this is the case as well. Among others, there is a very good Seeking Alpha post, from the Portfolio 14 blog and als the Interactive Investor covers the stock.

I agree with all posts. Organizing exhibitions is good business:

+ you don’t need a lot of capital (negative working capital due to prepayments)
+ once an exhibition is established, it creates a network effect which is relatively difficult to duplicate
+ although the business fluctuates with the cycle, costs are to a certain extent variable
+ it’s a nice b2b business, connecting a large number of exhibitors of with a large number of interested visitors
+ despite or because of e-commerce, personal contact in the form of trade fairs etc. seems to become even more important
+ the company has no debt

The “catch” is of course that most of their exhibitions take place in Russia and the former GUS. Clearly, not the easiest part of the world to be at the moment.Looking at the past 16 years since their “reverse IPO” in 1999, we can see that the business has suffered in downturns such as the Russian default but always recovered. However, mostly due to the weak ruble, comprehensive income in the last few years was mostly lower than stated income:

Year EPS Compr. Income In% of EPS
29.12.2000 0,03    
31.12.2001 -0,13    
31.12.2002 -0,01    
31.12.2003 0,03    
31.12.2004 0,04    
30.12.2005 0,07    
29.12.2006 0,07 0,07 99%
31.12.2007 0,09 #N/A N/A #WERT!
31.12.2008 0,09 0,09 97%
31.12.2009 0,13 0,11 86%
31.12.2010 0,10 0,12 121%
30.12.2011 0,13 0,10 82%
31.12.2012 0,13 0,13 98%
31.12.2013 0,14 0,09 64%

The valuation looks quite cheap, especially the EV/EBIT and EV/EBITDA ratios for such a business with high (historical) growth rates:

P/E ~9
EV/EBITDA 5,9
EV/EBIT 7,0
P/B 4,4
Div. Yield 5,0%

After reading some of the reports, I found a couple of things I didn’t like:

– focus on “headline” profits, excluding amortizations and “restructuring charges”
– Management fully incentiviced on “Headline profits”, not ROIC or ROE etc..
– Falling knife Stock chart
– one of the biggest “rainmakers”, Edward Strachan retired a few months ago.
– trade fares and exhibitions often have a time lag of 6-12 months to the general economy. So the worst in Russia for ITE might come only in the next few quarters.

Peer Group

There aren’t that many “pure play” trade fare /exhibition companies listed but I tried to compile a list to the best of my knowledge. Two of the companies listed below (Kingsmen & Pico) are actually more supliers to exhibitions than promoters/organizers:

Name Mkt Cap (GBP) EV/EBITDA EV/EBIT P/E P/S
ITE GROUP PLC 434,5 5,3 7,0 9,9 2,2
TARSUS GROUP PLC 198,7 7,7 12,0 16,4 2,6
UBM PLC 1267,5 9,6 14,4 9,9 1,7
MCH GROUP AG 237,8 7,2 13,9 11,9 0,8
FIERA MILANO SPA 182,0 156,0 #N/A N/A #N/A N/A 0,9
KINGSMEN CREATIVE LTD 87,1 5,9 6,4 10,9 0,6
PICO FAR EAST HOLDINGS LTD. 182,6 6,7 9,6 11,2 0,7

If we look at P/Es, most of the companies trade relativelly cheap at around 9-11 times earnings, but long term ROE and margins at ITE are clearly a class of its own. The big question is: Can they sustain those margins in the long run ? Many of the listed peers as well as the unlisted ones like Deutsche Messe tried (at least before the crisis) to get into the Russian market.

The problem could easily be that ITE is too profitable. Past average net margins of 20%-25% are far higher than any of the competitors. Deutsche Messe for instance, which aggressively expands into EM earned a net margin of 3% in 2013. Clearly, It is not so easy to kick out ITE, but if the difference in margins is so big, at some point in time competition will begin to bite. although it’s not easy to establish a succesful trade fair or exhibition, it is relatively easy to start one. So yes, there is a network effect but the barriers to entry are still relatively low. A good example for this can be seen currently at TESCO in the UK. For quite some time it looked that they are protected by their dominant position and had margins 2 or 3 times higher than their continental peers. But once the competitors like Aldi and Lidl, who could only dream of such margins in other markets, were big enough, margins for the leader deteriorated pretty quickly.

Valuation

Based on what I described above, I would make the following assumptions:

– going forward, net margins will be lower than in the past. In the past they achieved margins of 20-25%, I will calculate with 18% (thats what they made in 2012 and 2013)
– in order to reflect the additional risk in Russia, I will require more return. My normal requirement would be 15%, here i need 5% more or 20% p.a.

So if I assume that in 3 years time, ITE will again do the same amount of sales as in the FY 2013, this would be 0,80 GBP per share. At 18% Net margin, they would then earn around 14,4 pence per share. A “fair” P/E for such a company could be around 15. So the 3 year target price would be 14,4*15= 2,16 GBP.

However, in order to earn my 20% p.a. , I need to discount my target: 2,16/ (1,2)^3 = 1,25 GBP. This is however a lot lower than the current price of 1,70 GBP

So for me, under those assumptions, LTE is not a buy, I would buy once the price is at or below 1,25 GBP per share.

Summary:

It really took me some time with ITE Plc. I really like the business model of trade fair /exhibitions. Although cyclical, it seems to be good business with a certain protection. For ITE however, I fear the worst is yet to come. With the oil price plunging and the “Russian situation” unchanged, including more potential trade sanctions etc., the next year will be even harder than the last for ITE.

I would stil buy them if they are cheap enough, which, at the moment they are not. They would need to drop a further 30% in my opinion to make them really intersting and compensate me for the additional risk. I will however try to look at some other similar companies going forward. Especially Pico Far East and Kingsmen looked interesting at first sight.

It could easily be that I am too cautious due to my losses with Sistema (“Recency bias” ?), but at the moment I rather make the mistake of being too conservative.

Short cuts: KAS Bank & Van Lanschot

Both Dutch Banks in my Portfolio, Van Lanschot and KAS Bank reported 6 month numbers last week.

Van Lanschot

Van Lanschot’s 6 month numbers were relatively solid in my opinion. 6 months EPS were 1,14 EUR per share, however this includes certain one-offs from asset sales. The underlying wealth manangement business seems to have stabilized. Net interest income is slightly going down but this is the result of shrinking their loan portfolios and was expected. The stock price reacted quite positively on those numbers:

What I didn’t like at all was the fact that within the comprehensive income, they burried a large increase in their pension reserves of around -82 mn before tax. This is around 10% of gross pension liabilities and wiped out all the profit of Van Lanschot in the first 6 months (comprehensive income was actually negative). Unfortunately, there is no explanation given. I Have sent an Email to IR in order to understadn this better.

KAS Bank

Similar to Van Lanschot, KAS Bank presented very solid 6M numbers including a big one time effect. They received 20 mn EUR as compensation for letting German dwpbank out of an outsourcing contract. Underlying profit without this one off increased nicely, although mostly due to cost savings than higher revenues.

Compared to Van Lanschot, the stock price did very little:

Maybe this has to to with a somehow muted outlook and the decission to fully reinvest the dwpbank payment. Nevrteheless, for me KAS Bank seems to be on a very good way and is rather a buy on weak days. I still think that KAS Bank should trade at least at book value which is around 14,50 EUR per share.

KAS Bank in my opinion is also a very good and cheap interest rate hedge. If short term rates rise, this will directly benefit KAS Bank’s result within a very short time frame. I do not have an active opinion on interest rates, but it is a nice “add on” to the investment case.

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