Monthly Archives: October 2014

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

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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.

Special situation: Citizens Financial Group (CFG) – Another interesting “forced IPO” ?

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Summary:
The recently IPOed US bank Citizens Financial Group looks like a typical “forced IPO” from a troubled regulated financial conglomerate, similar to Voya & NN Group /ING. The current valuation shortly after the IPO would imply a decent upside (~50%) even if Citizens only manages to become an “average” US regional bank.

Citizen Financial Group went public on September 24th . The story of the US-based lender is similar to the NN Group IPO in which I have already invested.

In this case, parent company Royal Bank of Scotland (RBS), which has been bailed out by the UK government following the financial crisis, is forced to concentrate on its UK business. RBS then decided to ged rid of its US business via an IPO instead of a direct sale to another buyer. It seems to be that there were quite some interested buyers.

Very similar to ING and NN Group, RBS has time until 2016 to sell down the whole stake. That this is not easy was clearly shown as RBS had to price the IPO at 21,50 USD per share, below the inital range of 23-25 USD.

Compared to other regional US banks, the valuation based on book value (and tangible book value) looks attractive:

Name Price/ Book Price/ Tangible Book ROE Current
CITIZENS FINANCIAL GROUP 0,65 1,00 -15,82
REGIONS FINANCIAL CORP 0,79 1,14 7,19
ZIONS BANCORPORATION 0,87 1,05 5,66
SUNTRUST BANKS INC 0,91 1,41 6,38
HUDSON CITY BANCORP INC 0,98 1,01 3,92
KEYCORP 1,07 1,21 8,87
COMERICA INC 1,08 1,19 7,56
FIFTH THIRD BANCORP 1,12 1,35 13,39
NEW YORK COMMUNITY BANCORP 1,17 2,02 8,35
BB&T CORP 1,20 1,82 8,00
HUNTINGTON BANCSHARES INC 1,29 1,44 10,92
M & T BANK CORP 1,37 2,02 10,76
FIRST REPUBLIC BANK/CA 1,73 1,84 13,66
CULLEN/FROST BANKERS INC 1,82 2,43 9,66
SVB FINANCIAL GROUP 1,98 1,98 11,37
SIGNATURE BANK 2,43 2,43 13,26
Average 1,28 1,58 7,70

If we just assume an average multiple, there would be a 50% upside based on tangible book and a 100% upside based on total book value. The problem is of course: in order to reach this multiple you have to earn the average return on equity.

Looking into the IPO filings, we can clearly see that things didn’t work that well in the past. “Normalized” earnings were around 650 mn USD in the past or ~2-3% ROE which clearly would not justify a valuation at book value. Due to the low-interest rate environment, revenues decreased and in 2013, most likely to prepare the IPO, they made a massive goodwill impairment of around 4 bn USD in 2013.

Banks as investments

As there is no shortage of material against banking and the associated risks and evil spirit, I want to outline instead what I do like about banking and this situation:

– Traditional banking in my opinion is a solid and good business if run conservatively and responsibly. Many value investors would never invest in a bank, but I have no problem with this (Mr. Buffet neither as we all know)
– Traditional banking (and Citizens is a traditional bank) profits from higher interest rates. It is easier to put margins on the loan if the nominal rate is higher. So owning a bank is quite a good interest rate hedge
– mid size banks used to have a disadvantage over the large banks, especially with regard to funding. With all the new regulation aimed at the mega banks, I think there is a much better “equal level” playing field. I like good & cheap mid-sized banks.
– I could imagine that being on its own feet, Citizen’s management can react better to local challenges and develop its business than being part of a nationalized UK banking group under constant pressure. The “spin-off effect” could be at work here. Many of the directors have purchased shares directly after the IPO. The CEO owns shares in the amount of 6 mn USD.
– Citizen does have scale on a regional level which in my opinion is quite important (see page 152 of the S1 document) in order to achieve good ROEs
– the region where they are active (North east, New England) had less issues with the housing bubble, so theoretically loan quality should be OK. Most of their business is by the way in so called “recourse states” which adds to the incentive of actually paying back personal loans

Stock overhang

RBS still owns ~66% after the IPO and a subsequent share repurchase. 2016 is not that far in the future and placing another 10 bn of shares will not be a walk in the park, but on the other hand a lot of this could be reflected already in the share price. For me it is always interesting to see when typically sell-side analysts apply a discount due to “stock overhang”. As an “intrinsic” value investor, those situations are one of the clearest situations for market inefficiencies as the intrinsic value of a company does not change because of this.

Similar to ING, I think RBS did sell the first part cheaply in order to then (hopefully) sell into positive momentum. ING for instance managed to sell Voya down from over 60% to now 32% within 1 year and the stock still outperformed the indices.

My assumption is that RBS will not sell below tangible book value which is around the current stock price. If they sell below, they will lose available capital at RBS and therefore weaken their capital base and ratios. So a scenario where RBS sells down to very low levels far below the IPO price is in my opinion not realistic.

Valuation

I am clearly not in the position to judge if CFG is an “above average” bank. However, I think one can attach a high probability to the outcome that CFG will be an average bank. The nice thing about this is that there is significant upside already to the “average case”.

Therefore I would make the following, simplified case:

I assume that there is a 50% probability that within 3 years, CFG will be an “average” bank and trade at an average valuation. Conservatively I ignore goodwill and assume a target price of 1,6x current tangible book value in 3 years which would be ~ 40 USD per share.

To keep things simple, I further assume that there is a 25% chance that they will do really well and a 25% chance that they screw up. In the downside case, I will assume a 50% loss, in the upside case I will assume a valuation at 2x tangible book or around 50 USD.

So my “expected” value in 3 years time would be (0,5*40)+(0,25*11,5)+(0,25*50)= 35,4 USD. Based on the current price of around 22,80 USD, this gives me a potential annual return of ~15,4% which looks attractive to me for such a “special situation” investment.

Summary:

Citizens Financial “forced IPO” looks very similar to ING’s NN Group and Voya IPOs. I think this could be very attractive as even the assumption of Citizens becoming an “average ROE US regional bank” has significant upside. Despite or because of the assumed “stock overhang”, the mid-term risk/relationship looks attractive although, but similar to NN Group, one should not expect a quick win here.

I will therefore invest 2,5% of the portfolio into Citizens at current prices of around 22,80 USD.

P.S.: This will be my first US stock since a long time. I don’t have anything against US stocks, but often I do not find any kind of “edge”. In this case, I do have the feeling that banks are still highly unpopular as investments in general and that there is a good chance for some market inefficiency, even in the highly efficient US market.

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

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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.

Some links

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Damodaran tries to value Go Pro

David Merkel on the “interest rates must rise” mantra

Research Affiliates has a pretty cool new website where you can play around with expected returnas and volatilities of all major asset classes

Interesting post on the differences between Japanese and US stock valuations

A good summary of investment ideas presented from the “great investors” conference (GIBI) including Einhorn, Ackman, Price etc.

Recent ~40 minute interview with Warren Buffett

Special situation quick check: Rhoen Klinikum (ISIN DE0007042301) – “Listed transferable tender rights”

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Yesterday, Rhoen Klinikum released the details how they will buy back shares following the sale of most of their business to Fresenius (Rhoen was a very successful “busted M&A” special situation, previous posts can be found here)

They way they do it looks interesting and seems to be like a “reverse rights issue”. The instrument is called “Listed transferable tender right” and seems to work as follows:

– as of tomorrow, October 16th, each shareholder gets automatically one “tender right” per share
– those “tender rights” are traded separately at the stock exchange
– you need to have 21 tender rights in order to sell 10 shares
– the tender price is 25,18 per share
– the exercise period runs until November 12th, until then, the tender rights are traded
– already tendered shares will trade under a separate ISIN until November 14th
– the cash for tendered shares will be paid out on November 19th

As of today, the shares are trading at around 23,85 EUR. Following the logic of the subscription rights, one right should be worth

Edit: in the first version, I had the wrong formula. Thanks to a friendly reader, this is the correct formula:

(25,18-23,85)/((21/10)-1)= 1,21 EUR.

So tomorrow, the Rhoen shares should open (all other things equal) -1,21 EUR lower and the rights should trade at 1,21 EUR. Let’s see if there is a chance to find a little arbitrage here and there.

One strategy could be to buy the stock at the open, hoping that the “discount” will be eliminated quickly. A second one could be an arbitrage between the rights and the stocks. Finally, it could be worthwhile to look at the tendered shares as well.

Don’t ask me why they are doing it that way. I think it most likely optimizes the tax position of the large shareholders, especially for the founder Eugen Muench, who wanted to cash in his remaining 10%.

A final comment for clarification: No, this does not mean that Rhoen shares should trade at 25,18. The price chosen by Rhoen is relatively “arbitrary”, they could have used any other price as well.

The Dutch Job: Royal Imtech (NL0006055329) Deeply discounted rights issue – The “short opportunity of the century”

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I had written about Royal Imtech, the troubled Dutch service company already a couple of times. The short story: Growth star encounters fraud and too much debt.

Somehow, I lost them from my radar screen until today. Already in August, they announced that they will do another rights issue, this time aiming for 600 mn EUR, after having raised 500 mn in 2013.

The funny thing is the way they actually do this which even puts my favourite “Italian Job” companies at shame:

Following the approval granted by the General Meeting on 7 October 2014, Royal Imtech N.V. (“Royal Imtech” or the “Company”) announces a 131 for 1 fully underwritten rights offering of 60,082,154,924 new ordinary shares with a nominal value of EUR 0.01 each (the “Offer Shares”) at an issue price of EUR 0.01 per Offer Share (the “Issue Price”). For this purpose, and subject to applicable securities laws and the terms of the prospectus dated 8 October 2014 (the “Prospectus”), existing holders of ordinary shares in the share capital of Royal Imtech (“Ordinary Shares”) as at 17:40 CEST on 8 October 2014 (the “Record Date”) are being granted transferable subscription rights (“Rights”) pro rata to their existing shareholdings (the “Rights Offering”, and together with the Rump Offering (as defined below) the “Offering”). No Rights will be granted to Royal Imtech as a holder of Ordinary Shares in its own capital. The Rights will entitle the holders thereof, provided they are Eligible Persons, to subscribe for 131 Offer Shares for every Right held at the Issue Price, subject to applicable securities laws and in accordance with the terms and subject to the conditions set out in the Prospectus. The Issue Price per Offer Share represents a discount of approximately 21.7% to the theoretical ex-rights price (“TERP”) based on the share price of EUR 0.3763 at Euronext in Amsterdam (“Euronext Amsterdam”) after close of business on 7 October 2014 and 458,642,404 shares issued and outstanding at the same date (thus excluding treasury shares

So before the rights issue, the market value of the company was around 0,38*458 mn shares= 175 mn EUR. Today is the first day where Royal Imtech trades “ex rights”. Just as a little refresher the formula for calculating the value of the right (to buy 131 shares at 0,01 EUR) before trading:

(0,3763-0,01)*131/132= 0,3635

So theoretically the price of Royal Imtech should be today: 0.3763-0.3635 = 0,0128 EUR. a little more than one cent.

Let’s look what the shareprice is doing today:

Imtech is trading at 0,09 EUR, around 800% higher where it should trade !!!!! On the other hand, the rights trade only at 0,17 EUR at the time of writing, a discount of 50% to the theoretical value (as of yesterday).

This leaves the question: Why are investors paying today 9 cents for the shares which they can buy via the rights at a little over 1 cents per share in 2 weeks time ? I have no answer. MAybe people (and computers) mixed up the decimals and think the new shares come at 0,10 EUR ?

Anyway, if anyone is able to short Royal Imtech at this level, this would be the short of the century. You can short something at 0,09 EUR today and buy back at 0,01 in a few days. Nothing more to say….

Edit: Might be a good example for any student who is confronted with the “Efficienty markets hypothesis”.

Quick check: Adidas AG (ISIN DE000A1EWWW0) – will this fallen angel rise again ?

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Adidas, the iconic German sportswear company, seems to be a big topic for value investors these days. A couple of my readers mentioned Adidas in the comments and also Geoff Gannon thinks it is cheap at least compared to Nike and Under Armour.

Over the past decade or so, Adidas was a great performer, riding mostly on the “Emerging Markets consumer” megatrend. This year however the share price is down ~-37% at the time of writing,:

Nevertheless, the Stock is still not really cheap on an individual basis:

P/E 19
P/B 2,2
P/S 0,9
EV/EBITDA ~10
Dividend yield 2,6%

Since a couple of weeks, there are constant rumours that some activist hedge fund will sooner or later appear and press for changes how the company is run.

Maybe in order to make it harder for activists or other potential “predators”, Adidas just announced a 1,5 bn share buy back over 3 years. According to the Reuters article this seems to be a rather quick change of mind:

Chief Executive Herbert Hainer said in August that Adidas had no plans for a share buyback.

Adidas also just launched a 1 bn EUR bond issue, most likely to fund some of the share repurchases. The bond issue however doesn’t seem to have been a smashing success.

Why did the share price go down so much ?

They had to issue a couple of profit warnings in the last few months. According to Adidas, two reasons are to blame: The issues in Russia, a core market for Adidas and the problems with the Golf business (Taylormade).

With the football World cup in Brazil, everyone thought that Adidas will have a record year, but as of 6m 2014, Profit declined by ~.27%. Adidas is the German company with the largest share of Russian sales in the DAX 30 index with around 7,5% of total sales. Doing badly in a year with a football Worldcup is not a good omen for the eventless next year.

What I don’t like at Adidas:

When I look at an expensive company like Adidas, I always look out for things I don’t like. After reading the 2012 & 2013 annual report, here are my “don’t like” point:

– management targets do not include capital profitability
– growth in recent years mostly from retail business
– Sales decreased already in 2013, 2014 just extends the negative trend
– they blame FX for most of their problems but that is part of the normal risk of doing business in Emerging Markets
– Adidas is doing Ok, but both Reebock and Taylormade are shrinking
– as with EVS, 2014 should have been a fantastic year (Brazil, Socchi). 2015, without any big events will most likely be even worse
– US as a strategic growth market does not make that much sense to me
– comprehensive income is lacking net income by a wide margin
– reporting overall is not very good, lots of “Marketing stuff”, critical figures like profitability per region are missing

What I like

– clearly iconic brand with growth potential especially in EM
– relatively conservative balance sheet
– management salaries are relatively low compared to total profit

Let’s look at some issues in more detail:

Retail business

If you look at their historical numbers, a large part of the recent growth comes from their “retail segment”. They started opening own stores some years ago and have expanded them fast. In 2013, the traditional business which they call “whole sale” already shrunk and only retail had some growth. However retail is lower margin business (Operating margins ~20% against 30+%). They expanded their stores much more aggresively than Nike, especially in Emerging Markets.

Also, retail business in my opinion is riskier than their core business. If you are in retail, you are also in Real Estate. With the threat of the internet (Zalando, Amazon), they are walking on a thin line.

Interestingly, despite paying ~600-700 mn rents p.a. they are only disclosing 1,7 bn of operating lease liabilities. I am not sure what to make of this, it looks like they are only renting short-term which might be OK if EM continue to be weak.

Currency Management:

According to the CEO’s letter in the 2013 annual report, Adidas doesn’t hedge FX risk in Emerging Markets as it is “too expensive”. Well, that’s complete nonsense in my opinion. Of course it is expensive, but for an EM based retail business, not hedging FX is almost suicide. A retailer in Russia is short the USD vs. Rubles twice: First, all the merchandise will be imported from China on a Dollar basis. Secondly, most of the rental contracts will be in USD as well. Sales will be made however in Rubles, so if the Ruble declines against the Dollar, all the nice margins just disappear.

Instead of hedging, the report “currency neutral” sales growth etc. In my opinion this is definitely a weakness especially if you compare Adidas to their major rival Nike. If you look into the annual report of Nike, you can see on page 77 & 78 that they have a pretty sophisticated hedging program in place, which creates a lot less volatility in stated net income AND comprehensive income.

Comprehensive income

As this is often the case, the Comprehensive Income of Adidas is hidden deep within the annual report, in this case it is mentioned the first time on page 189. And, as it is not surprising, Comprehensive income is a lot lower than Net income as the table shows and also much more volatile compared to competitor Nike:

Adidas     Nike    
  EPS CI in % EPS CI in%
30.12.2009 1,25 -0,4 -33,0% 1,99 1,81 90,8%
30.12.2010 2,71 4,4 161,9% 2,22 2,12 95,6%
30.12.2011 2,93 4,0 137,2% 2,48 2,48 99,7%
28.12.2012 2,52 1,5 60,9% 2,65 2,81 106,2%
30.12.2013 3,76 2,2 59,4% 3,02 2,83 93,6%
Total 13,17 11,8 89,3% 12,36 12,04 97,4%

Most analysts would ignore this, as they would call this a “non cash” accounting effect. But especially currency movements in the comprehensive income in my opinion have enormous predictive value. Although its true that the initial currency movement (i.e. the decline of the NAV of foreign subsidiaries) does not impact the cashflow, a permanently lower value of the foreign currency will clearly lower the future profits of the company, especially if they don’t hedge.

Ignoring this effect is like looking at your stock portfolio and ignoring the currency movements if you calculate performance. You can do this, but it does not reflect the underlying value.

Strategy & Capital allocation

Adidas’ strategy to focus on Emerging markets has paid of, despite set backs like currently in Russia. What I don’t understand why the want to target the US. In the US, they have no advantage against Nike, rather the opposite. Nike is much bigger in the Us and clearly has economies of scale against Adidas in advertising expenses.

In my opinion, this is mostly due to the fact, that return on capital is not part of the targets for Adidas management. They have target like sales growth, operating margins and some nonsense stuff like EUR amounts for investments, but no return on investment or return on invested capital targets. Nike, th main competitor, reports ROIC

This leads more often than not to chasing growth for growth sake and not creating value. In my opinion, Adidas clearly has a strategy & incentive issue here.

Brand & Moat

There are different opinions on this topic, but for me , a brand is not a moat. It is a competitive advantage, especially as we have seen in “new markets” like the EM, but on the other hand, brands can easily loose their power if they are not well managed. A sports brand like Adidas in my opinion is even more difficult than a “luxury brand”. Sports brands define themselves via sports stars. Signing sports stars or teams gets more and more expensive and when you are unlucky, your expensive star turns out to be a sex maniac or drug abuser and all the money is for nothing.

A real strong brand allows you to make above average margins and returns on capital, which somehow Adidas fails to deliver compared to some of its competitors.

Valuation

At a 2014 PE of 19, Adidas is clearly not in value territory, based on Comprehensive income, the stock looks even more expensive. In order to justify an investment, one would either need to assume EPS growth or multiple expansion. Yes, Nike trades at a lot higher multiple, but it is also a lot better company than Adidas with much better earnings quality. I also have doubts, that Adidas will increase stated EPS in 2015. Without a major sports event and with Russia still critical, they should rather be happy to maintain current profits.

The share repurchase will maybe add to EPS, but overall, for me Adidas is not a buy at the moment. If you are an event-driven investor wanting to bet on a short-term bump by someone like Icahn, Loeb etc. it could be interesting.

Summary:

Adidas is a company with an iconic brand, however stand-alone it is already quite expensive and the company has at best average management. Earnings quality in my opinion is clearly lower than for competitor Nike. Some activist investors might indeed shake up things a little bit and bump up the share price in the short-term, but the company is clearly facing a very difficult year in 2015. “Turning around” Adidas and bring them to Nike’s level in my opinion is not just spinning off Reebock and Taylermade, but a real change in startegy and incentives.

Adidas is clearly a bet on the Emerging Market consumer, which might work out over the long-term but is somehow maybe difficult in the short and mid-term. There are also cheaper stocks available if one wants to bet on an EM revival. On top of that, I am clearly no expert on branded sports good so for me, this would only a buy if it would look cheap from an absolute point of view, which it doesn’t.

Performance review September 2014 – Comment “Stupid German money”

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Performance September

September was a pretty bad month for the portfolio, both in absolute and relative terms. The portfolio lost -2,2% against -0,2% for the Benchmark. YTD the portfolio is up +4,99% against 0,45% for the benchmark.

A significant part of this underperformance was driven by Sistema which I sold with a loss of 40%. The decision to sell quickly seemed to have been right as the share price has fallen a further 40% since then.

Other big losers were G. Perrier with -17,2%, Ashmore with -12,5%, Hornbach -7,6% and TGS with -6,0%. in contrast to Sistema, I do not see any structural issues with those companies. Clearly the fact that small caps are underperforming since a couple of months als plays a role here.

Portfolio transactions:

Additionally to Sistema, I sold my 0.9% position in Poujoulat. Overall, I am not happy with the way they allocated their capital and the result of the wood pellet segment is pretty bad so I decided to get out of this relatively small position. I sold at around 40 EUR, resulting in an overall gain of 23,5% including dividends.

Additionally I sold my Sky Deutschland shares at a small loss at 6,73 EUR. Unfortunately, they never moved up and the offer period is slowly approaching the end and I have no opinion about the value of Sky Deutschland without the “special situation” aspect.

As a result, the direct cash percentage went up to 13,2%, the economic cash position is close to 20% (including MAN and Depfa LT2 which I consider “close to” cash). Another side effect of my sell transactions is the fact that with 25 positions the portfolio is in my personal “Sweet spot” with regard to the number of positions.

The current portfolio, as always can be seen on the “Current Portfolio” page.

Comment: “Stupid German Money”

September was high time for German Corporations to announce large acquisitions in the US. In a short period of time, transactions were announced from Siemens, Merck Kgaa, SAP and privately held ZF group.

This is a quick overview of the four deals:

Target EV USD bn Buyer P/E Target P/E Buyer Buyer/seller multiple
TRW 12,4 ZF 13,0 not listed  
Dresser Rand 7,3 Siemens 32,0 15,2 211%
Sigma Aldrich 15,7 Merck Kgaa 31,1 16,0 194%
Concur 7,1 SAP 208,0 16,6 1253%

We can easily see that the multiples paid by the 3 listed entities are significantly higher than their own multiples. Large acquisitions are a big risk in any case, but in the case of German – US acquisitions the track record is particularly bad. Daimler/Chrysler is clearly the worst German-US deal ever, but there are loads of other value distracting US deals like Dresdner/Wasserstein, Siemens/Dade-Behring, RWE/American Water etc. There are a few good deals as well, but in my opinion the success rate is definitely below 50%.

Why is this the case ? In my opinion, there are 3 major reasons for this:

1. German companies are normally very risk averse. So in “difficult” times, they keep their cash and wait until times get better. At some point in time when the good times are rolling (as they are now) they feel the urgent need to catch up with their international competitors and then buy into the boom which creates a very procyclical behaviour.

2. German companies often underestimate the cultural differences between Germany/Europe and the US. Many top managers might have been on vacation in the US or even studied there, but running an US company is very different from running a German company. Financial incentives are much more important in the US and often don’t fit with the rules here in Germany. So it is often almost impossible to keep the best people of a recently acquired company and without them, the business often deteriorates quickly.

3. In general. especially large German companies are just not good capital allocators. Buying back own shares is more often than not a no go and considered to be a sign of weakness. Equity is often thought as “Management’s equity” then “Shareholder’s Equity”. The term “shareholder’s equity” actually doesn’t exist in German language, “Eigenkapital” translates into “own funds” and I think most German managers consider it as their own funds and not the shareholder’s.

As a result, the acquisition behaviour of German companies is almost always super procyclical and then looking back mostly looks pretty stupid and is value destroying for the German shareholders.

As a private shareholder, my advice would be: Watch out !!

– You don’t want to own the stock of a German company which acquires a big US company. Chances are high that they will regret it in a few years time
– You don’t want to own the sector longer term they are investing in. This sector might be at or close to a cyclical peak
– although I am not a market timer, you might be very cautious in general despite M&A induced further increasing share prices