Monthly Archives: May 2013

Some more thoughts on EGIS

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Following the first post two days ago, some more thoughts on EGIS:

Servier Group Diabetis drug scandal

One commentator mentioned, that Servier Group, the French parent is part of maybe the biggest pharmaceutical scandal in France ever. According to this article, at least 500 deaths are linked to a Diabetis drug of Servier.

Interestingly, already in 2011, EGIS denied having distributed or licensed this Drug from Servier. However they admitted, that they manufactured some of the ingredients and delivered them to Servier.

If Servier really gets fined heavily for this case, then in some aspect or another, EGIS will feel the impact. As we have seen, the internal business with Servier might be at risk.

Forinth/Hungarian interest rates

Standard CAPM tells you that you should use the risk free rate of the country a company is located as a basis to determine cost of capital. Although for EGIS this would clearly be a mistake as only 20% of their business is in Hungary. Nevertheless, I expect some tailwinds from the decrease of 10 year Hungarian Government yields from ~8.50% to 5% over the period of the last 12 months. This week, the Hungarian Central bank cut the short term rate for a 10th consecutive month.

If we compare for instance the performance of the Hungarian BUX Index for the last 12 months (+17%) against Italy (+34%), Spain (+34%), we can see that the Hungarian Index does not look extremely overvalued and with a level of 19000 would still have 50% upside to the ATH from 2007. So at some point in time there might be some kind of “catch up rally” for the Hungarian market as well.

Management/Reporting/Shareholder orientation

I cannot say anything about management so that’s neutral. Same for shareholder orientation. Ok, no buy backs or big dividends, but on the other side no negatives. Communciation is good. The annual reports. quarterly reports and analyst presentations are clear and easy to understand.

Other stuff

In March, EGIS and its US Partner Actavis settled a court case with AstraZeneca, which, according to some reports has a value of around 50 mn USD for EGIS starting in 2016.

Relative valuation

Lets look at the German generics company, Stada AG.

Stada Trades at the following multiples:

P/B 2.1
EV/EBITDA 10
P/E Trailing 19.5

ROE/ROCE have been a lot weaker in the past than EGIS, around 7% ROCE, and 8% ROE. Even if one considers that Stada is a potential take over target, I do not understand why Stada is trading roughly on 3 times the valuation of EGIS despite being less profitable over a long time period.

Looking at a more comprehensive list of generics companies, we can see that EGIS is by far the cheapest one. Only the Russian companies are at least comparable cheap. As EGIS does now a third of its business there, one should keep this in mind. Personally, I highly prefer to invest into a Non-Russian company doing in Russia than directly into a Russian company. C

Name Curr Adj Mkt Cap P/E Curr EV/T12M EBITDA Price/Sales FY2 P/FCF P/B
 
KRKA 1788.66 10.4 6.29 1.30 15.22 1.3
PHARMSTANDARD-CLS 1959.3 7.7 5.17 1.31 7.92 2.13
TEVA PHARMACEUTICAL IND LTD 25510.28 19.65 7.88 1.58 8.79 1.46
EGIS PHARMACEUTICALS PLC 562.52 7.82 3.75 1.04 8.23 0.85
HIKMA PHARMACEUTICALS PLC 2218.16 28.48 13.58 1.98 29.26 3.44
STADA ARZNEIMITTEL AG 2015.25 19.7 10.01 0.93 11.13 2.14
DEVA HOLDING AS 221.38 14.28 8.77   0 1.37
VEROPHARM 171.07 6.01 5.15 0.70 0 0.83

Absolute valuation

I think one doesn’t need to be to sophisticated here. A decent company like EGIS with a solid, non cyclical business should not trade at a P/E of 5 and P/B of 0.8. A fair price in my opinion, taking into account some issues from above should be a P/E of 10 or 1.5 times book, which would be still significantly below western peer companies.

Stock price

The stock price went up quite a bit since EGIS published quite positive 6m results a few days ago. Although one should mention that part of the positive development was driven by a positive FX result in the second quarter.

Summary:

EGIS combines some aspects which I personally find very attractive in “real” value stocks:

+ it is a very solid unspectacular business with solid returns over the cycle
+ the balance sheet is rock solid
+ valuation is extremely low both absolute and relative to peers
+ low valuation can be explained at least to a large extent by negative headline news which in EGIS case are not really justified

For me it looks a bit similar to Total Produce 2-3 years ago, where it was considered an Irish stock. If I have the choice, I actually prefer to invest in solid companies in troubled countries compared to more troubled companies in solid countries.

There is clealry some risks like

– Hungarian politics and tax risks
– court trial for Servier Group
– potentially bad/risky acquisitions

As a result, I will make EGIS a new HALF POSITION in the portfolio with 2.5% portfolio weight at a price of HUF 20.000 (*) per share..

DISCLAIMER: Please do your own research. The author might own the stock discussed already prior to posting it on the blog. Never follow blindly any tips, especially from internet sites. The information provided on this blog represents the subjective opinion of the author. Important issues might be interpreted wrong or even missing.

(*) It took me some time to finish the blog posts about EGIS. When I made my decision, the share traded at 20.000 HUF.

EGIS Pharamaceuticals PLC (ISIN HU0000053947) – Why is the stock so dirt cheap ?

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Company description:

Egis Pharamaceuticals is a Hungarian based producer of Generic pharmaceuticals. Interestingly, according to their homepage, the company was founded in 1913 as a Swiss company. In 1993 it was privatised, in 1995 the majority was taken over by a French company Servier.

Valuation
Valuation based on traditional metrics looks cheap at a current price of ~ 20.000 HUfs

Market Cap ~540 mn EUR
P/B 0.8
P/E 7.5
P/S 1.0
Div. Yield: 1.3%

Taking into account ~5500 HUF net cash per share (~25% of market cap), the stock is ridiculously cheap:

EV/EBITDA: 3.0
EV/EBIT: 4.6
adj. P/E (trail 12 m): 5.5

Profitablity

On top of the cheap valuation, the company is consistently profitable, with double-digit margins:

NI margin ROE ROE cash adj
31.12.2002 9.2% 11.6% 12.7%
31.12.2003 7.0% 8.5% 8.7%
31.12.2004 8.1% 9.9% 10.2%
30.12.2005 11.9% 14.0% 14.0%
29.12.2006 15.2% 18.1% 18.5%
31.12.2007 6.5% 7.3% 7.9%
31.12.2008 11.0% 10.6% 11.6%
31.12.2009 11.8% 10.9% 12.2%
31.12.2010 14.1% 11.9% 12.5%
30.12.2011 10.5% 8.7% 9.7%
31.12.2012 14.0% 10.9% 13.6%
 
Avg 10.8% 11.1% 12.0%

Why is it so cheap ?

If a company looks so cheap, especially in today’s market environment, the first question is: Why ? So lets look at some obvious potential problems:

“Dictator discount”:
As a Hungarian company, one might think that a lot of investors are shunning Hungary because of the dictator like current government. In my portfolio, I experienced the unpredictability already once with Magyar Telekom. Although I managed to get out with a small profit, it was quite sobering to see how the company got punished by the Government via extra taxes, additional licences etc.

For Egis, this is clearly an issue. On top of price controls they are also subject to special taxes like Magyar Telekom. On the other hand they seem to be able to set off those special taxes against R&D expenses. This is from the last report:

Semi-annual drug price reductions, triggered by the price and reimbursement system that has been effective since October 2011 (the so-called blind bidding), strongly affected also this quarter, despite the fact that there was no further round at the beginning of the quarter. In addition to the blind bidding process, also the quarterly adjustment of reimbursement keys of medicines falling into the same INN category (so-called fixing) prevailed. However, price cuts focused on the blind bidding processes, consequently, the rate of price reductions effected on January 1, 2013 by Egis was negligible.
Payment obligation of drug producers on grounds of the reimbursements allocated to their drugs was raised to 20% from 12% as from July 1, 2011. In the second quarter, the total amount payable by the Company according to the turnover came to HUF 562mn. As from July 1, 2011 the rate of registration fee on medical representatives has been HUF 10mn/medrep/annum instead of HUF 5mn. On such grounds HUF 250mn payment obligation was accounted over the quarter.
In December 2012, the Parliament confirmed the R&D cost related deductibility option of payment obligations for an indefinite period of time. Accordingly, 90% of the payment obligations debiting the calendar year preceding the given year may be deducted, provided that the Company’s R&D expenses exceed 25% of reimbursement (proportionate to manufacturer’s price) paid on their products and that, within R&D spending, personnel
expenses remain above 3% of the same reimbursement amount. Pursuant to the rules of law lower rates of R&D expenses trigger lower deductions.
Entitlement to the deductibility option for the Company for the present financial year is judged on the basis of the R&D spending in the 2012/2013 financial year, consequently, the deduction allowance is accounted in the given business year while the financial settlement can be performed in the subsequent year. Taking into account the R&D expenses incurred in the second quarter of 2012/2013, 90% of the payment obligation, including also registration fee of medical representatives and surtax proportionate to reimbursement, occurring in the second quarter of the calendar year 2012, HUF 727mn were accounted as allowance.

That sounds complicated, but in the end, EGIS only paid an effective rate of 6% in the first 6 months. I am not sure how sustainable this is, the normal corporate tax rate in hungary would be 19%.

However, as a percentage of sales, Hungary doesn’t play such a big role anymore. In the current 6 month period, Sales in Hungary are 20% of total sales. In contrast, sales into Russia are now 1/3 of total sales and growing.

So to summarize the “dictator” discount theory: I don’t think this is justified. Rather it looks like that EGIS is benefiting from a very good treatment with regard to taxes at the moment, compared to companies like Magyar Telekom.

Cyclical business / easy to spot problems ahead:

For most pharmaceutical companies, patent expiry is the most obvious problems. If blockbusters expire their patents, then often profits fall off a cliff. With EGIS, this seems not a problem. As far as I understand, EGIS is mostly producing generics and not doing any R&D on own developments.

The majority share holders, Servier Group in France itself is a pharmaceutical company which does the original research. EGIS is then licensing some of their products.

So in the case of EGIS, I don’t see patent expiries as a big problem, nor is the generic business very cyclical.

Nevertheless, we do see some volatility in margins, especially in 2007 and 2011. What happened there ?

2011: If we look at 2011 vs. 2010, we can see that 2 factors contributed to the significantly lower margins:

– losses in associated companies (~-1.5% net margin)
– contribution to the National Hungarian National health fund (~3% of net margin)

So without those non-operative charges, EGIS would have shown solid ~14% net margins for 2011 as well

2007:
This looks a little bit strange. from 2006 to 2007, “material type costs” jumped significantly. According to their 2007 investor presentation, this was a result of unfavourable exchange rates (the Forint gained significantly in that period), price cuts in Hungary and a different product mix.

The USD/HUF FX effect might have been the strongest effect and this most likely explains the improving margins once the Forint became weaker again. Today, EGIS hedges ~70% of their USD exposure which should prevent most of that volatility.

So in both cases I think the problem was not a underlying cyclicality of the business model but rather a result of unfavourable exchange rates and regulation.

Dependence from major shareholders – related company transactions

The majority shareholder with around a 51% stake is Servier Group, a privately owned french pharmaceutical group with around 4 bn EUR turnover.

If we look into the last annual report unde point 24. related party transactions, we can see that between 15.20% of sales go to other Servier companies. This is not insignificant, but so far I don’t see an indication that this is not done at arm’s length.

In contrary, having a subsidiary with only a tax rate of 2% or so, if there were no minorities, I would let this company earn as much as possible in intra group transactions.

Balance sheet quality (operating leases, pensions, guarantees)

No problems here. I didn’t find any disclosure of leases and they only have a tiny pension liability. Nothing about guarantees either.

Free Cashflow conversion / low dividend / acquisition

Over the last 10 years, EGIS only showed Free Cashflow of around 400 HUF per share on average, only in the last 2 years, this went up to around 1400 HUF per share. Historically, EGIS paid only a mini dividend of 120 HUFs, so less than 0.5% dividend yield. One factor for the low free cash flow has been the fact that in the past EGIS booked purchases of fixed income securities as “investments” even if they were actually short term cash like securities. They changed that in 2011.

This year at least, sitting on 5500 HUFs net cash per share they doubled their dividend, nevertheless the 1.20% dividend yield looks small compared to for instance Magyars 14% plus dividend yield.

I am sure that the historically low dividend yield is one of the reasons why many investors avoid that stock. However if we look into the past, the money that EGIS reinvested actually led to decent growth. Over 15 years, sales in local currency more than quadrupled in line with profit. ROEs and ROIC always remained around 10-12% which is not fantastic but very solid.

Personally, I can live very well with a company which reinvests at 10-12% ROCE and not paying dividends, especially when it is so cheap as EGIS. I think such low dividend paying solid stocks are in fact one of the few “pockets” in the market where the valuations are OK because the “yield hogs” are not interested in them.

In the last few months, EGIS announced several times that they plan to use their cash on an acquisition in Russia. This is of course a risk factor, but I I understand correctly, they are going for manufacturing capacity and not for expensive goodwill type acquisitions. This is clearly a risk, on the other hand, the company is already very active in Russia for a long time and should know the market quite well.

From a free cash flow reporting perspective, acquisitions of course look a lot nicer than building you own, although the result is the same.

Preliminary summary:

So far, one can see that there are some factors why the stock trades at such low multiples. Most of those factors however are not a problem for me, so it definitely makes sense to take an even closer look in a coming post.

Buzzi revisited – time to SELL

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Buzzi was part of our initial portfolio. In our initial investment thesis (German), the main reason was simple:

The stock, especially the Pref shares were significantly below book value, Buzzi had never made a loss in the past, “normalized” earnings and p/E ratios were low and it had a nice dividend yield.

We bought into the pref shares share at around 5,50 EUR

Additionally, the fact that Buzzi was only to a small extent an Italian company but rather a very international company due to the Dyckerhoff take over with large exposures in the US and Germany was maybe underappreciated.

Since then, a view things happened:

– Buzzi showed a loss twice, for 2010 and 2012 with only a mini profit in 2011
– when the price of the shares dropped in autumn 2011, I increased the position at 3.28 EUR per share
– the share price of the more expensive common shares performed a lot better than the cheap “Risparmo” shares. The difference since 01.01.2011 is a staggering 28% including dividends
– howver, both, the pref shares and the common shares outperformed the Italian stock index FTSEMIB by 17% resp. 45%

The more interesting question is: How did Buzzi perform against our initial expectations ?

In different posts I came up with different “reversion” to the mean approaches, among others

Reversion to the mean net income/PE
Initially: average P/E for the pref shares of 6. net margin of 9.6% (12 year average)
Now: After 15 years, average net margin decreased to 7.11%. Based on current sales of ~14 EUR per share results in 1 EUR per share normalized profit, so with an average PE of 6, the pref shares are fairly valued. I would argue to common shares are even overvalued.

Reversion to the mean EV/EBITDA
Initially: Assumption EV/EBITDA of 5.5 and EBITDA Margin of 26% (12 year average)
Now: 14 year EBITDA Margin is 24.8%. With current debt, the fair value of a Buzzi share would be around 13 EUR. This means the common shares are fairly valued, the upside in the pref shares without any other catalyst would be that the relative underperformance would be compensated at some point in time.

Free cash flow:
I had assumed free cash flow to equity of 200 mn EUR as “normal” level based on a 7 year history. “Adjusted” free cashflow both in 2011 and 2012 are more like 100 mn EUR, bringing down the average to 175 mn EUR. If I use this as a basis and the same discount rates I used back then (12-18% for a cyclical pref share), I end up with a fair value range of something like 4.75 EUR – 7.11 EUR per share. So the current share price would be rather in the higher part of the range.

Overall issues with mean reversion

Those three examples show a problem with “Mean” reversion plays: What is the mean ? In the Buzzi case, the mean now goes down every year, reducing the fair value for the mean reversion valuation.

Clearly, the current down cycle is a very severe one, but maybe the previous up cycles used for the mean were above the mean ?

What to do now ?

For me this is a typical situation where one should sell. Initial expectations have not been met, fair value has gone down and share price has gone up. Of course one could argue that the “mean” will go up and the sentiment is getting better with recent buy ratings among others from Deutsche bank.

In recent times, some US funds actually built up meaningful positions like Marketfield Asset Mgt. with ~2.9% of the common shares, and another, Mackay Shields with around 2.1%.

Nevertheless, I don’t think that at current levels and based on the current situation that there is a lot of “margin of safety” left in Buzzi. I will therefore sell the complete position at today’s VWAP. At the time of wirting, this would be a total gain of ~36%, mainly attributed to the second purchase at 3.28 EUR in late 2011.

Some more thoughts on IVG & “ESUG” special

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DISCLAIMER
As always do your own research. Don’t follow tips blindly. In this specific case I would not recommend any private investor to invest in this security as the situation is very complex and more bad news should be expected.

Just a remark at the beginning:

Some people asked me why I post so much on such a crappy company like IVG and do not post more about “great value stocks” like IGE & XAO. The answer is quite simple: First, I don’t find that many attractively priced value stocks any more. Secondly, the blog was always meant to be a value AND opportunity blog. Opportunities in my definition are one-off situations where the payout is relatively independent from overall market movements. Additionally I think the IVG case is so interesting, that it would be a crime not to look at this in detail. Complicated capital structure, new German insolvency law, US hedge funds, real estate exposure etc. There is so much to learn here.

Back to IVG:

Lets start with a question from the comments:

Now regarding the convertible I have some questions
1) Going concern scenario:
a)How likely is it in your view that they keep as a going concern in 2014 (ie are able to refinance the convertible)
b) At what value will IVG refinance the convertible
c) How are they going to do it (sell property, give equity …)
3) Bankruptcy
a) How much will be the recovery value
b) How long does to realize the recovery value
c) Is the IRR worth it?

Well, the answer is: I don’t know. But we can start with a very easy guess (and of course everyone can criticize and make it better):

1) Start with 50/50: That would be the base assumption if you don’t know better with every binary “option”.

At the current price of ~60% we can work back the recovery quite easily (very simplified:

60% = (0,5*100 %) + (0.5*x%) with x being the recovery.

So the implicit recovery would be (60%-50%)/0.5= 20%.

But attention: those 20% would represent the market value of the then defaulted security. If we assume that the workout period is 3-5 years in a real “messy insolvency”, and buyers of defaulted securities charge at least 20% p.a., then this implies a current recovery value between 20% * (1.2)^3 = 35% and 20% * (1.2)^5 = 49%.

So to make this clear: If the current ultimate recovery is 50% and they need 5 years to distribute the liquidation proceeds, the current price of the convertible is a fair price !!! It would be a very big mistake to calculate the current value of the underlying assets and not take into account the time delay. (This is by the way one of the lessons from Zeke Ashtons presentaton to which I linked in the last post).

As I mentioned before, in my opinion, the current asset value is more like 80%, so I would expect (immediately after insolvency) a price range of 32%- 46%. Based on a 50/50 percentage, this would move the current fair value to a range of 62-73% of nominal, slightly above the current value of 60%.

Based on this binary scenario alone, I guess the convertible bond would not merit an investment at the moment, as the downside is quite significant.

However as most things in live, also the IVG situation is not binary. As it was discussed in the blog already quite a few times, some hedge funds are looking into “restructuring” the company without a liquidation in the end.

Logic behind the restructuring idea – REIT & Taxes

In my opinion, the restructuring idea does have some logic and might even create value. Why so ?

As far as I understand, the Hedgefunds want to lower debt in order to be able to transform IVG or a part of it into a REIT and in that process sell down/spin-off the other stuff like the asset management and the Caverns.

IVG in its current form does not make a lot of sense for investors. If you invest int IVG because of the real estate, the profit gets taxed 2 times, once on the corporate level and then again on investor level. A real estate investment via a REIT gets taxed only at the investor level, there are (almost) no taxes on the corporate level. If we assume 30% taxes, a fully equity financed real estate portfolio would be 30% more valuable in a REIT than in a normal company. Adding debt reduces the difference but even with debt at the level of IVG, there is still a tax disadvantage of maybe 15% or so of the current IVG vs.a REIT.

Another point which might make a restructuring event much more likely than a liquidation are taxes. On the one side I assume that the DTA will stay in a restructuring event, therefore greatly enhancing the overall value, secondly, there is no need to sell the real estate and pay property transfer taxes (up to 5% in Germany). So the restructuring alternative sounds like a no brainer compared to the liquidation scenario for almost every party involved in this.

How would/should the restructuring work (“ESUG”) ?

Well, this is the hard part and I do not have a lot of experience with that in detail. Plus we have a relatively new insolvency law in Germany (“ESUG”) which has not yet been tested in such a big case.

Let us look into the “ESUG” (“Gesetz zur Erleichterung der Unternehmenssanierung”) a little bit more closely. ESUG is meant to bring the concept of the American chapter 11 to Germany. Up until now, it was very difficult under German bankruptcy law to really restructure a company. The new “ESUG” which came into effect in MArch 2012 should change this.

However, until now there are not that many succesful restructuring stories in Germany.

If one googles “ESUG” one can find a lot of issues with the new law, for instance here at WiWo or here at Handelsblatt.

The best overview about the current status of the ESUG that I found was this study from Roland Berger. A very good document how the debt/equity swaps works can be found here.

To summarize what I have learned from this:

– there seems to be a big issue currently for holders of subordinated bonds, as they are not represented separately within the ESUG process. Another reason to avoid the IVG HYbrid.
– so far, there is no precedent for a debt/equity swap. Unchartered territory so to say, especially for senior unsecured holders
– However, there seems to be checks and balances in place that unsecured holders receive shares etc. according to the “fair value” of the claims.
– Decisions are taken by simple majorities. I guess this is done by debtor group. So “hold-outs” do not really matter in the restructuring scenario anymore

What does that mean for IVG ?

In my opinion, the restructuring case via ESUG is the most likely one. Thinking it through, it is even for the convertible holders most likely a lot better than liquidation. The DTA could remain in place (and have value), one doesn’t have to pay property transfer tax etc. The question is clearly how much of that value will be shared by the “super senior” creditors.

One the one hand, IVG will be “THE” test case for the new law and people involved (advisors etc.) will make sure that senior holders will be treated fairly to a certain extent so that this kind of restructuring will happen more often (and create fat fees for advisors….). On the other hand, the Distressed debt players with a lot of restructuring experience could try to use this to make a absolute “killing” on the back of the unsecured holders. As the Jackpot is quite high with 4 bn plus, this is a real concern.

So after this preliminary ESUG analysis, I think now that the restructuring event is very likely.

Back to the calculation

So finally back to a calculation of a fair value. Staying with simple 50/50 rules I assume the following:

1) There is a 50% chance for a proceeding according to ESUG. Within the ESUG process, I assume with 25% propability that the unsecured holders get screwed (25% recovery), and a 25% probability that the unsecured holders get a fair share (75% recovery)
2) for the remaining 50% probability I will again divide into 25% for the payback at par and the liquidation scenario.

So my current fair value for the convertible looks like:

0.25 x 75% + + 0.25 * 25% + 0.25 x 100% + 0.25 x 40% = 60%

Of course, this calculation is highly subjective and any of the assumptions can change pretty quickly and will not remain stable over the course of time.

So under this asumption, the convertible is fairly priced, no big upside from an intrinsic value point of view.

What now ?

To be honest, I am not so sure anymore. Do we see something like a short bounce if they come up with some sort of rescue attemptlike at Prakiker ?there I got out too early, howver now the bond is already back to deeply distressed levels:

I would argue that this is less likely for IVG as the small investors will not touch this due to the high nominal value and the “pros” are a little bit more cautious here.

On the other hand it could be an interesting situation once the “ESUG” restructuring is running or even as restructtured equity play.

Summary:

Looking a little bit deeper into the different possible outcomes, for me a few important take aways remain:

– the likelihood of IVG “surviving” long term in my opinion is very small or even zero. So equity and hybrid should be avoided
– the restructuring scenario (ESUG) might not be so bad for the senior bonds as many fear although it is unknown territory
– there is still the possibility that IVG manages to repay the convertible at par, but it is not very likely as for most secured creditors, a ESUG style reorg would not hurt that much
– buying inot the secured loans at 80% looks like a lot better value, however I can’t do this as private investor

Overall, for the portfolio I would for the time being sell down the position at current rates and eat the loss. I am pretty sure that I am too early but as I know that I am a rather bad short term speculator, I want to play this safe.

To Do: Read more about ESUG. Any tips for a good book are highly appreciated !!!

DISCLAIMER
As always do your own research. Don’t follow tips blindly In this specific case I would not recommend any private investor to invest in this security as the situation is very complex and more bad news should be expected.

IGE + XAO SA (ISIN FR0000030827) – another hidden French champion ?

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DISCLAIMER: The stock discussed in the following post is a very illiquid French small cap. The author might own the stock. Please do your own research. Do not blindly follow recommendations neither on this blog nor anywhere else.

Sometimes investment ideas are created from quite random events. I was looking into my database for interesting French stocks (as always). Out of interest, I thought that I want to tackle a French software stock next.

Among the few software stocks I just picked randomly the company called “IGE + XAO SA” because of its strange name. And guess what ? This company is creating CAD software for electrical installations with Gerard Perrier, my last stock pick as one of the major clients.

So despite the rather expensive valuation numbers, I decided to dig a little bit deeper.

“Tradition” Valuation metrics:

P/E Trailing 14.2
P/B 2,9
P/S 2.6
EV/EBITDA 5.1
Dividend yield 1.8%
Market cap EUR 61 mn

Not so exciting at first. However, when I ran IGE through my checklist, it scored very high (20 out of 27), at par for instance with Vetropack and AS Creation mostly due to the following facts:

– great free cashflow generation (FCF on average 1.2x Earnings !!!)
– rock solid balance sheet with ~15 EUR net cash per share
– Management owns 20%+ of company, CEO & founder still on board
– company started to significantly repurchase shares again in 2012 (Sharecount decreased by 20% since 2008)

If I would take into account net cash and the share repurchases, IGE would even met my P/E and dividend criteria, scoring 22 out of 27, equal with Tonnelerie.

So the result from the checklist is clear: Dig deeper !!!!

Business model / “Scuttlebutt”:

The company is mainly a Software company which, according to their Webpage offers the following products:

The Electrical CAD Software Specialist and you….
For over 26 years, the IGE+XAO Group has been a software publisher designing, producing, selling and ensuring the maintenance of a range of Computer Aided Design software (called “CAD”). These CAD software products have been designed to help manufacturers in the design and maintenance of the electrical part of production processes. This type of CAD is called “Electrical CAD”. IGE+XAO has built a range of Electrical CAD software designed for all the manufacturers, which functions either with an independent computer or with a company network.

So this is a very specialized “niche”. If I search for the German “Elektro CAD” in Google, it is already clear that IGE is not the only one offering this kind of Software.

The first question I would ask myself: “General” CAD Software is used everywhere, so can’t just the general CAD packages take over this job ? Well, according to this site ( a competitor) , this doesn’t seem to be so easy.

There seems to be also some competing products, for instance I found this German discussion board where different E-CAD or CAE systems are discussed. One of their main products, CADdy seems to be based on a old German DOS program and has been developed further by IGE.

Overall, I think that with specialised software like this, one should see quite significant network effects, i.e. if one product gains dominance, than this will be self-sustaining as there is little incentive to use different programs of that complexity for instance when you switch firms. I browsed a little bit in CAD forums and this has been confirmed quite often, for instance here. So once a program in this area is used and people are educated on this program, they will want to use it further on. What I found interesting is the fact that in this forum, A German IGE +XAO employee actively moderates everything which has to do with their products.

I think this is also the reason why they have 70% market share in France according to their 2011/2012 investor presentation. Which, of course, makes gaining market shares in other countries quite difficult.

This 70% market share might also explain the nice margins the company is enjoying. 20.9% Operating margin and 18.4% net margin are clearly not something one finds easily, not even with software companies.

ROE looks OK with 20%, however we should not forget, that basically all the equity is basically net cash and only a small part of that is really needed.

Those margins are on par or even better as heavyweight software champions like SAP or Dassault or CAD expert Nemetschek. Teh only difference is that those companies are much more expensive

As it looks for now, their business isn’t subject to the overall slow down in the French economy. In their latest half year report from the beginning of April, they still show solid growth rates of 5%. Net income didn’t grow due to higher tax expenses, but that should be a one time effect.

Net profit margin development

One thing that puzzled me, was the development of net margins. We can see that with one exception (a jump in 2008), Net margins increased steadily from 7.4% in 2002 to a fantastic 18.4% in 2012.

NI margin
31.12.2002 7.4%
31.12.2003 7.6%
31.12.2004 8.3%
30.12.2005 8.5%
29.12.2006 10.4%
31.12.2007 11.8%
31.12.2008 15.3%
31.12.2009 12.6%
31.12.2010 14.1%
30.12.2011 16.2%
31.12.2012 18.4%

In my opinion, this creates a series of questions:

– how did they achieve this ?
– are those margins stable ?
– do we have to expect reversion to the mean at some point in time ?
– what would be the “Mean” for margins ?

In order to understand better the increase in margins, I compared 2002 with 2007 and 2012 in the following table:

2012 in % of sales 2007 in % of sales 2002 in % of sales
Total sales 24.2   20.7   15.7  
             
external costs -5.4 -22.1% -5.5 -26.5% -5.4 -34.6%
salaries -12.3 -51.0% -10.7 -51.7% -7.1 -45.4%
other cost -0.6 -2.6% -0.5 -2.4% -0.5 -3.1%
Depr. -0.5 -2.1% -0.7 -3.5% -0.8 -5.1%
             
Operating result 5.4 22.2% 3.3 15.8% 1.9 11.8%
             
Net interest reslt 0.3 1.4% 0.3 1.4% 0.0 0.2%
             
EBT 5.7 23.7% 3.6 17.3% 1.9 12.0%
             
Tax -1.5 -6.1% -1.2 -5.7% -0.7 -4.5%
             
Net result 4.3 17.6% 2.4 11.6% 1.2 7.5%

The interesting thing here is that the improvement in the margin can almost be fully attributed to the decrease in percentage points to the decrease of external purchases / services. To me this looks like the typical “economies of scale” at a software companies. Once you have written the code, selling additional licenses increases the margin.

Competition

I found an interesting interview in French from 2009 where the CEO has been asked the question. His answer was (my translation):

– in everything related to aerospace etc., there are only Japanese and American competitors which do not seem to cross borders
– for industrial installations, there seem to be local competitors in each country
– in everything which is related to buildings, Autodesk is considered the main competitor

I think there competitive position is quite good. Their current niche is still to small to really interest a large player to enter on a “green field approach”.

Stock price

Looking at the stock price alone makes me ask myself why I didn’t discover the stock already last year when it was really really cheap. On the other hand, the more important point will be: What is the intrinsic value now ? Is there still enough upside ?

Management

As a hobby investor, I do not have access to management, However i watched on Youtube some interviews with the CEO (for instance here. The general impression was quite good. The only thing that I noticed is that the CEO is also active as the head of the local commercial chamber as well as some function at the local airport. This might lead to additional business contacts on one side but maybe distract him from the companies at other times.

Picture of the CEO:

Renumeration for the CEO was 250 k in total for 2012, that is quite OK for such a succesful year. Compared to the value of his shares (~7 mn EUR), I think the interest is quite well aligned with shareholders.

Shareholder structure:

A few words here because for a small French company, the shareholder structure is rather unusual. There is no majority shareholder.

The 2 top shareholders

Irdi Midi Partners 14.1%
Odysee Ventures 12.3%

are French private equity companies which ahve reduced their stakes lately. On the other hand, Amiral, the well known French value investment firm has recently increased their stake from ~3% to 9%.

That means howver that in theory the company would be “available” for a competitor to buy. Maybe this explains the quite shareholder friendly policy of the company which is ussual for France.

Edit: Longer term shareholders seem have double votes, so the Management plus IRDI might still have the majority, but how long ?

Valuation

Comparables: Just for fun, lets look at some other Software companies. I picked out 5 others:

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Name Rev – 1 Yr Gr OPM EBITDA Mrgn 3Yr Avg ROE R&D/Net Sales:Y EV/EBITDA T12M EV/T12M EBIT
               
IGE + XAO 4.8% 22.9% 23.9% 18.2% 25.0% 6.8 7.1
PSI AG 6.7% 6.3% 8.6% 11.4% 9.6% 14.0 18.7
NEMETSCHEK AG 6.8% 16.8% 23.0% 20.2% 25.1% 10.0 14.3
DASSAULT SYSTEMES SA 13.8% 24.7% 29.3% 14.6% 18.1% 16.8 20.0
AUTODESK INC 4.4% 15.1% 20.7% 14.2% 25.9% 14.7 20.0
SAP AG 14.0% 25.5% 30.8% 23.8% 13.9% 16.7 20.5

Although its maybe not really fair to compare them, people pay for the same kind of profitablity aroound twice or three time as much for the larger companies.

This could be clearly also a function of better growth prospects, on the other hand it could also indicate what a potential buyer could be willing to pay.

Risks
As a French company, IGE is clearly subject to a worsening of the situation in France. With 73% of sales in France, there will be clearly problems if France goes into a real deep depression.

Another risk as with all cash rich companies could be that they use their cash for expensive acquisitions. So far, they haven’t done it but one never knows.

Summary

Overall, I think IGE + XAO makes a compelling investment case:

+ high margins and return on capital, rock solid balance sheet
+ capital light software company with good local competitive postion
+ for a French company surprisingly share holder friendly
+ potential target for buy out or take over

The major risk is of course the overall developement of the French economy. Nevertheless this is also the reason why one can buy this excellent company at a very attractive price.

I will therefore add IGE & XAO to my portfolio. I assume that I could have purchaes ~300 k EUR of shares over the last 6 weeks since I follow the company at ~42.50 EUR per share, making it a 2% position in my virtual portfolio.

Final remark on sizing /portfolio risk

The 2% portfolio weight might look a little bit small compared to the enthusiasm of my review. On the other side, my total French exposure now has hit 20% gross (~18.5% net of hedge). This is of course a quite conncentrated bet on France not going down the drain. So I try to limit my exposure within this concentrated bet on France by having a kind of “basket” approach and spread to different companies. Let’s see how this one works out…

IFRS 19 pensions “Voodoo accounting” – ThyssenKrupp edition

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ThyssenKrupp issued their quarterly earnings today. Together with Lufthansa, Thyssen has one of the largest “pension holes” in the DAX index.

As we all know, from 2013, IFRS 19 requires to fully reflect pension liabilities “on balance”. Interestingly, in their Investor presentation, IFRS equity is not mentioned at all.

So one really has to go into the interim report to look what happened.

And again, at a first glance it doesn’t look so spectacular:

Shareholders Equity end of March is around 2.8 bn EUR, 0.77 bn less than stated for September 2012, in line with the losses. However when we look into the developement of the equity position of page 32 of the report, we can see that closing shareholders equity has actually been 7.6 bn in September 2012.

In contrast to Lufthansa, they hide their restatement in an “insignificant drop” of retained earning from March 2012 to September 2012 in an amount of ~4.2 bn EUR. Lufthansa had spread their restatement over 2 years. So there seems to be quite some leeway how to do this.

So to sum it up: Thyssen Krupp has lost ~ 4.8 bn of equity or -63% and management doesn’t even bother to disclose this to shareholders in their presentation. Well, who cares about equity anyway ?

One final remark: Thyssenkrupp uses 3,6% to discount the liabilities, which is quite high. Many other companies use 3.2% for EUR or less. As a proxy, one would multiply the difference times 15-20 in order to see what to add in percentage points to the pension liabilities.

So to scale this, we would for instance multiply 0.4%*15= 6%. With total pension liabilities of 8 bn EUR, we would need to deduct a further 500 mn EUR from equity in order to compare them with more conservative companies.

In any case, I think Thyssen will need to raise some equity capital pretty soon.

IVG – JPM Research on property values

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A friendly reader forwarded me a current equity research report from JPM about IVG.

Not surprisingly, they estimate the value of the share as zero:

Our EVA based European
Valuation Model implies zero value for IVG ordinary equity as a going concern, while a DCF driven revaluation implies zero equity value on the existing balance sheet. We therefore lower our Mar-14 EVM based price target from €2.22 to €0.01, and await the announcement of restructuring plans over summer 2013.

Although one might wonder, why they had a 2.22 EUR price target before. Much more interesting is that they actaully come up with an asset value for the IVG portfolio which looks as follows:

ivg jpm valuation

Although they use slightly different adjustements, thei asset value is very similar to what I calculated a couple of weeks ago:

2011 Adj. Val 2012 Adj.Val Comment
Intangibles 251 0 253 0 100% write off
Inv. Property 3,964 3,398 3,654 2,920 scaled to 7% yield
PPE 157 118 190 143 25% discount
Financial Assets 189 142 174 131 25% discount
equity part 95 71 84 63 25% discount
DTA 404 0 336 0 100% write off
Receivables 60 45     25% discount
   
Inventory 1,025 513 996 498 50% discount
Receivables 179 134 190 143 25% discount
Cash 238 238 142 142 0% discount
   
AFS 341 256 58 44 25% discount
Asset Management 275   318 1.5% of AUM
Marekt value caverns 163   140 50% of disclosed adj.
         
Total 6,903 5,351   4,540

Additionally, they calculate “Bull” and “bear case” scenarios:

ivg bear case

The bear case scenario clearly would not leave a lot for convertible holders.This clearly shows the risk of the implicit “leverage” of the secured loans via the convertible.

Summary:

Although the JPM research looks a little bit superficial especially with regard to the liability structure, it is definitely worth to look at in order to get a better feeling for the underlying property values.

Their base case would imply even “full recovery” for the convertible and hybrid, although I think they haven’t modeled the liability structure correctly.

In general, their asset valuation does not look to different from mine,so for the time being I don’t see a reason to sell the convertible at current levels. Also there seems to be no reason to approve any debt for equity swaps.

However both, equity and hybrid capital seem to be clearly out of the money in most scenarios if one takes into account the full liabaility structure.

Quick update KPN – Sold rights & stock

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Today I sold, both the KPN Shares and the rights .

All in all, I got around 2,91 EUR (1.68 for the shares, 1.23 EUR for the rights) which results in a gain of ~ 11.5% before trading cost. Quite a nice outperformance against the AEX with ~ 3.5% in the same time period.

Nevertheless, this was clearly a “bumpy ride” as the chart for the rights shows:

The optimal timing would have been to buy on the second day of the trading period. I guess this was the result of the very short time period between announcement of the terms and the start of trading.

I heard that for instance US investors were completely taken by suprise and couldn’t actively trade the rights.

Main reason for selling was that I was not sure if I want to exercise the rights and I have some other, in my opinion better ideas in the pipeline. Also I am not really optimistic about KPN in the long term.

In general, those “deeply discounted rights issues” are interesting special situations for a short term trade but have to be handled with a lot of care and patience …

Edit:
Someone asked me why I don’t show annualized returns for my single portfolio stocks. In my opinion, annualized returns for single stocks are pretty meaningless. The KPN Trade would have been an annualised 280% but what does such a number say ? As my investment strategy includes a lot of “sleeping” stocks, I think that showing annualized returns on single stock level do not provide any benefit at least not for me. Much more interesting than an annualized return per stock is the potential gap between the current price and intrinsic value.

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