Category Archives: Anlage Philosophie

Special situation “Quickie”: Flughafen Wien AG (ISIN AT0000911805) partial Tender offer

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Just by chance I looked at Flughafen Wien these days where since a few weeks an interesting situation is playing out.

Although Flughafen Wien is owned 50% by the Government and cannot be taken over, an Australian based Infrastructure fund called IFM made a partial tender offer for up to 29,9% of the shares.

Initially, IFM offered 80 EUR per share with a minimum threshold of 20% acceptance.

A few days ago, after pressure from soem shareholders, IFM increased the offer to 82 EUR and waived the 20% minimum threshold.

If I understood correctly, the new final date to tender the shares is December 18th. The money then is being paid within 3 working days, so before year end according to the official offer.

IFM seems to have secured around 12% from 2 funds already (Silchester, Kairos).

IFM seems to be a “reputable” investor, there seems to be no relevant operational risks for the offer from a technical point of view as far as I can tell.

However, the stock doesn’t trade at 82 EUR but rather at around 79,20 EUR per share:

This implies that investors expect 2 things

a) that more than 29,9% will be offered
b) and that the share price will fall after the offer below the offer price

Now we can play around a little bit to see if this is something worth betting on. We could start for instance assuming that the stock directly drops to 70 EUR after the offer expires.

Then we can calculate at the current price of 79,2 EUR an implicit or “break even” acceptance ratio:

79,20 = X*82 + (1-x)*70 = 76,67%.

So if 76,67% of the offers get accepted, the remaining not accepted stocks can drop to 70 EUR before one is making a loss on the transaction.

If all tendered shares are accepted, the max. profit would be 2,8 EUR per share or +3,54% for a period of 2 weeks.

Worst case: All minority shareholders tender (The Austrian government will definitely not tender…), then the lowest possible acceptance rate is 29,9/50 = 59,8% and the price falls directly to the value before the ofer (~61,50 EUR). Then the maximum loss per share would be -5,44 EUR or -7,4%.. At a more realistic drop to 70 EUR, the downside would be 2,02 EUR or -2,6%. This would be a positive expected value if the assumption of 70 EUR as a post tender price is correct.

I do think that this is a nice liltle side bet, so I will invest 2,5% of the portfolio at 79,25% into this little “special situation” with a time horizon of 2 weeks

One important note here: There is clearly a downside here and I would not recommend this to anyone who doesn’t regularily do such things, as the “single bet” might be not super attractive. However if one runs such bets on a continous basis (as I do, like MAN, Sky etc.), over time one will make money even with a few loosing trades.

Electrica S.A. (ISIN US83367Y2072) – A deeply discounted infrastructure stock from Romania ?

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Again, this has turned out to be a long post. So a quick “executive summary” upfront:

Electrica S.A. looks like an interesting play on infrastructure in Romania. The stock is attractive as
– the current valuation is cheap compared to grid companies in Spain, Portugal and Italy
– the underlying business (electrical grid monopoly) looks structurally attractive due to high guaranteed returns on investment
– there is good visibility on growth for the next 5 years
Overall, based on relatively conservative assumptions, an investor could expect to earn 17-21% p.a. in local currency over the next 5 years.

There are clearly lots of risks (regulatory, politically) but overall the risk/return profile looks good and the risks are less correlated to overall market risks.

DISCLOSURE: This is not an investment advice. Do your own research !!! The author may have already invested in the stock prior to publsihing the post.

When analyzing Romgaz I said this:

Why Romgaz ? Well that one is easy: This is the only Romanian stock you are able to invest if you don’t have access to the Bukarest Stock Exchange. There are no ETFs on Romania either.

Well, that was wrong, because another formerly Government owned Romanian company IPOed in June this year on the LSE, the grid operator Electrica.

Electrica – the business

Electrica’s main business is owning and running the electrical grid in an area covering ~40% of Romania. Additionally, they are also an electricity supplier, however they do not generate any power. This graphic from the recent 9 month presentation shows how this looks on the map:

Electrica small

Similar to Romgaz, the IPO prospectus is a pretty interesting read, covering many aspects of the Romanian electricity market. Those were the major points that I extracted from reading the prospectus:

+ IPO proceeds went 100% to the company to fund future growth
+ significant potential for additional guaranteed investments
+ conservative balance sheet
+ efficiency gains possible (10% grid loss)
+ underlying growth potential
+ valuation ex cash VERY cheap for a grid company
+ potential M&A opportunities (ENEL assets)
+ EBRD as shareholder actively protecting minority rights
+ local regulation creates attractive “float”

– guaranteed return on regulated assets has been just lowered from 2014 peak (7,45% vs. 8,35% in 2014)
– business is partly electricity distribution, no pure “grid” play (no guarantees for distribution)
– limited experience with regulator (previous head of regulator convicted for bribery)
– some distressed subsidiaries (external grid maintenance)
– 22% minorities in all major subsidiaries

Electrical grid as a business

Building and maintaining an electrical grid is a very capital-intensive business. The electric grid is one of the most dominant monopolies available. There is competition on the generation and supply side, but there is always only one electric grid as this represents the archetypical network effect.

There is just no reason to build a second electrical grid and unlike as for instance telephone landlines, there is a pretty low risk that electricity could be distributed via an alternative way. This is one of the reasons that grids are almost always heavily regulated as the potential power to abuse this monopoly would be pretty high.

One additional features is the fact in many countries the grid was not designed to cope with locally generated renewable energy, so there is clearly a need for massive additional investments. Normally, a sector with large investment requirements is not that attractive, but if you combine this with stable yields and leverage potential, things can suddenly become very interesting in a low growth environment.

I had written 2 years ago that even Warren Buffett thinks utilities can be attractive, if the earnings are stable or even guaranteed, especially if you then can leverage up accordingly. Also the announced E.On spin-off ties to move grid and end-user supply into the good ship

Although there is always a risk that regulators run amok, at least for electrical grids the seem to be on the soft side as they know that a lot of capital is required to cope with the renewable energy revolution. As a consequence, the valuation of listed grid operators are the highest among the overall utility sector.

Let’s look at the valuations of 4 listed electric grid companies in Europe:

Name Mkt Cap (EUR) BEst P/E:2FY P/B ROE ROA Debt/capital
             
REDES ENERGETICAS NACIONAIS 1.352 12,2 1,2 11% 2,4% 70%
RED ELECTRICA CORPORACION SA 9.922 16,5 4,2 24% 5,8% 60%
TERNA SPA 7.811 14,6 2,5 17% 3,7% 71%
ELIA SYSTEM OPERATOR SA/NV 2.442 16,1 1,1 9% 3,3% 55%

It is interesting to see that despite being located in the more critical countries of the Eurozone (Portugal, Spain, Italy and Belgium) those companies enjoy quite rich valuations. ROAs are low single digits but due to the monopoly character of the business, it can easily be leveraged up between 50-70% of the total capital (and several times equity).

Romanian electricity market

This is an interesting quote from the IPO prospectus:

The average electricity consumption per capita in Romania is still significantly lower than the average electricity consumption in the 28 EU member states. In 2012, Romanian electricity consumption per capita was 2.3 MWh, whilst the average electricity consumption per capita in all the EU countries was 6.0 MWh and in the selected Central and Eastern European countries (excluding Romania) in the table above it was 4.3 MWh.
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So assuming that Romania will catch up to a certain extent with the Eurozone, underlying growth in the electricity market should be strong. Romania has separated grid and power generation, however, at least in the case of Electrica, supply to end users is still part of the package.

The power market for end users is still highly regulated to a large degree but will be liberalized going forward. For Electrica’s grid business, this is irrelevant, but the supply business could be affected.

Electrica has a 25 year concession to operate the grid with an option to extend another 25 year. They can charge a fee to customers which guarantees them a certain pretax rate of return on assets if the meet minimum requirements set by the regulator. The base rate which they can charge is currently 7,45% for the next 4 years, higher rates seem to apply for “smart grid” investments.

One interesting specialty of the Romanian market is the existence of the “connection fee”. This is what they say in the IPO prospectus:

According to the law, the value of new connections to the electricity network is charged to the final users as a connection fee. The new connections to the electricity network are the property of the Group. The Group recognises the connection fee received as deferred revenue in the consolidated statement of financial position and subsequently records it as revenues on a systematic basis over the useful life of the asset.

The total amount they show as deferred revenue is 1,4 bn RON which is quite significant. For them, this is a very attractive “float” as it doesn’t carry interest and no covenants are attached. I assume that this also explains why they don’t use external debt as the investments are basically financed by the clients.

Valuation – simple version

Electrica has a market cap of 4 bn RON. Including IPO proceeds, the sit on 2,8 bn liquid assets, so the core business is valued at 1,2bn RON. With a run rate of 250 mn Earnings, this equals P/E of 4,8 ex cash. Assuming that a unlevered grid company in Romania could be worth 10 times earnings (still cheap compared to a highly levered Portuguese grid company at 11x earnings), the upside for the stock would be at least 30% based on current earnings.

Valuation including growth

Now comes the interesting part. Normally as a value investor I would assume zero growth. But in Electra’s case I would make a difference. Why ? Well, because:

1. They can invest (“compound”) at a guaranteed rate
2. The have already raised the money
3. The guaranteed rate can be charged irrespective of power prices or volume
4. There is no competition

The “only” risk that remains is the regulator. In order to model the profit growth, I have built a very simple model for the next 5 years using the information form the IPO prospectus:

I made the following (conservative) assumptions:

– supply business remains more or less constant despite significant growth yoy 2014
– I assume the losses from the “distressed” service subs will be phased out over 3 years
– they will distribute 85% of earnings as dividends
– they will invest according to plan at a blended guaranteed rate of 7,7%

Based on those assumptions, the profit after tax and minorities should double within 5 years. Assuming 8%% dividend payout (all of which can be funded by existing cash on operating cashflow), one can expect a return of 17-21% p.a. assuming an exit P/E multiple of 11-15.

Assuming exit multiples is of course already quite aggressive, on the other hand, if the price wouldn’t move, the assumed dividend yield of Electrica would be more than 10% in 2019. So some multiple expansion would not be unrealistic.

Addtitional (significant) upside could come via profit increases in the supply sector or opportunistic M&A as the ENEL grid seems to be for sale. My required rate for such an investment would be 10-15%, so at the current price Electrica looks attractive.

Other considerations

Stock price: In local currency, the stock price is only slightly above the IPO price of 11 RON:

Analysts: According to Bloomberg, a surprising number (8!) of analysts cover the stock. Their price target on average is around 14,6 RON, a potential upside of 30%.

Shareholders: During the IPO, the EBRD (European Developement Bank) acquired 8,6% of the shares. According to this article they are actively working to protect/ensure minority shareholder rights:

“Our participation demonstrates the EBRD’s commitment to supporting the government’s plans for increased privatisation of the energy sector,” Nandita Parshad, Power and Energy Director at the EBRD, said in a statement.

Parshad said the EBRD will work with Electrica to align its corporate governance with international standards: “This will provide additional comfort and confidence to potential future investors.”

The Romanian government still owns 49%.

Management: There is unfortunately not a lot of information on management. The CEO is an “Old timer”, joining the company in 1991. there seems to be some variable component in their companesation package but it is not clear how this looks like.

“Frontier” market: Despite being an EU member, Romanian stocks including Electra are considered “Frontier” stocks by MSCI, not even “Emerging”. That might make it more difficult for “established” funds to invest.

Summary:

As I have written in the Romgaz post, I find Romania fan interesting market in general especially with the lection of the new President. Electra is similar to Romgaz a privatization story. What I like about Electra is the fact that there is good visibility on growth.

The major risks are from the regulatory side, although I am quite optimistic that with the new president there will be even more of a “pro business” and “pro growth agenda”. Plus, the risks in this case in my opinion are relatively uncorrelated to other issues within my portfolio, so I think this could be a good diversifier.

With relative conservative assumptions and the guaranteed part of Electrica alone, one should expect between 17-21% return per annum over 5 years. If the non-guaranteed supply business improves or they are able to get other parts of the Romanian grid then the upside could be even higher.

I am pretty sure that not many investors will be interested in the stock as it seems to be both, too exotic and a strange mixture between “deep value” and growth, but for me it is the perfect stock as I don’t have to track any indices.

For the portfolio, I will buy a 2,5% position at current prices. This increases my “Romania bet” to 5% and total EM exposure to 13%. Time horizon is 5 years.

E.ON Spin off plan – The final “Hail Mary” pass ?

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According to Wikipedia, a “Hail Mary pass” is described as following

Originally meaning any sort of desperation play, a “Hail Mary” gradually came to denote a long, low-probability pass attempted at the end of a half when a team is too far from the end zone to execute a more conventional play, and that it took divine intervention for it to happen.

I have covered E.ON already a couple of times in the blog, with a first analysis, followed by a deeper look into their Nuclear decommissioning liabilites.

Finally, just a few weeks ago when the “spun” their Q3 results, I commented that E.ON is one of the prime examples of Management/Shareholder “disconnect”.

Now on Sunday, out of the blue, E.on came forward with an announcement to split themselves up into 2 parts, a “Renewable energy & Grid part” and a “Conventional part” including oil upstream nuclear power etc.

This was big news in Germany with a lot of press coverage and let to a nice “Bounce” in the share price on Monday:

Before I make some comments on the proposal, I found it quite interesting that another part of the press release had been pretty much ignored:

Fourth-quarter impairment charges of about €4.5 billion anticipated due to altered market environment
Outlook for 2014 EBITDA and underlying net income confirmed

Further down the “explain” it the following way:

Altered market environment necessitates in impairment charges

As part of the process of preparing the annual financial statements and the new medium-term plan, the E.ON Board of Management recently tested the Group’s assets for impairment. Beyond the roughly €700 million in impairment charges already disclosed in the first three-quarters, E.ON expects to record additional impairment charges of about €4.5 billion in 2014, primarily on its operations in Southern Europe and on generation assets. Although not cash-effective, the impairment charges will result in E.ON reporting substantial negative net income. However, E.ON expressly reaffirmed its forecast for full-year 2014 EBITDA and underlying net income.

Once again, EBITDA, which is relevant for the CEO bonus looks great, unfortunately shareholder’s equity will be further reduced by a cool 4,5 bn EUR, but the capital market either seemed to have not noticed this “small detail” or they are so enthusiastic about the spin-off.

The “Spin-off”

Spin-offs are generally considered interesting “special situation” investments. The underlying theory is the following: Many times, the capital markets seem not be able to price companies correctly, if the company either runs very different business lines or some of the business lines are performing badly. “Spinning off” underperforming divisions to shareholders then can unlock value because the capital market will value each part correctly and in sum this should be higher than the conglomerate. A secondary effect of spin offs is often that previously underperforming divisions freed from their previous owners often develop a unexpected positive dynamic, especially if the incentives for the management of the spin-off are correctly aligned.

Before moving into more details, let’s look once again in the original press release of EON:

The first step of the spinoff will involve E.ON transferring a majority of New Company’s capital stock to its shareholders, with the result that New Company will be deconsolidated. E.ON intends—over the medium term and in a way that puts minimum pressure on the stock price—to sell the shares of its remaining minority. This will enhance E.ON’s financial flexibility for future growth investments.

Why does EON only spin-off part of the “bad ship” ? Well, I guess the reason is simply that “E.On new” does not have enough capital to grow the renewable business on its own. It need the proceeds from the retained part in order to fund future investment.

In my opinion, this already lowers my enthusiasm for the deal, as the two parts are clearly not able to exist independently without an external capital injection. Economically, the sale of the remaining part is equivalent to a “backdoor capital injection”. This will clearly not be beneficial for the valuation of the “bad ship” part after the spin-off und limit the upside potential for some time.

Let’s look at the proposed structure of the spin-off next:

I didn’t listen to the Concall, but the slides for the new strategy can be found here. Before jumping into the presentation, let’s look what I have written almost 2 years ago:

– Nuclear is not coming back, that was more than 1 bn of EBIT which is missing going forward
– 60% of sales are actually energy trading revenues. The results of this “sector” look quite volatile
– they show huge swings in the net results of financial derivatives. In 2010 for instance, E.on showed a net gain of 2.5 bn against a 2011 loss of -1 bn .
– E.on has around 17 bn liabilities for nuclear waste etc. This liability is hard to analyse and could be grossly over-/understated. In the notes they state that the discount rate they use is 5.2%. I think this is a rather high rate. Combined with the long duration of those liabilities, there could lurk a potential multi billion hole there as well as in the 14 bn pension liabilities
– another “whopper” are the 325 bn EUR (yes that’s three hundred twenty five billion) of outstanding fossil fuel purchase commitments. Disclosure is rather limited here but I guess this is one of the big problem areas where they have locked in Russian NatGas purchases at too high rates

This is the plan from page 3 of the presentation:

E.on:
+ Renewables
+ Distribution/grid Germany / EU
+ “customer solutions” (whatever that means)
+ Turkey

NewCo (Bad ship):
– Generation (fossil, Nuclear)
– Hydro (why is this not renewable ?)
– E&P
– Global commodities
– Russia
– Brazil

So comparing my “problem list” from back then clearly shows, that ALL PROBLEMATIC areas would go to New Co.

Does this create value ?

I think some smart investment bankers have compiled valuations of utilities across Europe. This is a quickly compiled list of some utility and “utility like” companies across Western Europe:

Name Mkt Cap (EUR) EV/TTM EBITDA
     
ELIA SYSTEM OPERATOR SA/NV 2.443 12,3
RED ELECTRICA CORPORACION SA 9.973 11,5
NATIONAL GRID PLC 44.385 11,1
EDP RENOVAVEIS SA 4.726 10,7
SNAM SPA 14.196 9,9
EDP-ENERGIAS DE PORTUGAL SA 12.754 9,7
ENEL GREEN POWER SPA 9.135 9,6
A2A SPA 2.672 9,5
RWE AG 17.672 8,3
IREN SPA 1.221 8,0
GAS NATURAL SDG SA 22.771 7,8
E.ON SE 30.405 7,8
ACEA SPA 1.876 7,7
ENDESA SA 16.760 7,6
IBERDROLA SA 37.017 7,0
ENEL SPA 36.372 6,7
ACCIONA SA 3.427 6,3
EDF 45.477 4,9
GDF SUEZ 48.498 4,0

It is pretty easy to see that anything which sounds like “renewable” and/or “grid” trades at double-digit EV/EBITDAs whereas all the “integrated players” trade at medium to low single digit EV/EBITDA multiples.

So the idea behind this the proposed split seems to be clearly driven by the hope that the grid/renewable part will be valued at double-digit EV/EBITDA and the rest remain in the “integrated” valuation range.

The problem is of course, if the “bad ship” will actually trade at an integrated utility” multiple or not. My guess is: In the beginning, it will most likely not. I could also hardly imagine that the government will let the “bad ship” pay high dividends for a longer time because they will know that this is money which should be held for the nuclear liabilities.

Other considerations:

Looking into the past, E.ON has been spectacularly bad at reacting to changes and timing its strategic investment decision. They bought into Brazil right before their partner Batista went bankrupt, they missed the first 10 years of renewables etc etc.

If history is any guide, then the timing of the proposed split could indicate that maybe we have seen the worst and better times for conventional power generation lie ahead

It is also interesting that they said nothing about who will be running the two companies. Will the old guys remain at E.On ? This would be clearly negative

There could be some roadblocks on the way. The current German energy minister Gabriel seems to like the transaction (or doesn’ understand it) but there could be more resistance building up if people understand that the nuclear liabilities are dramatically under reserved. Also the pensioners of the “bad ship” could try to block the deal as having claims against the bad ship is clearly les valuable than for “E.On new”.

Summary & evaluation

The proposed split/spin-off of E.On was clearly a surprise. So far, the spin has worked and the stock market has liked this move. E.ON has outperformed the DAX and RWE by 7% since the announcement, which is a lot considering that they announced an unexpected 4,5 bn loss at the same time.

For me, E.On currently is clearly not a buy. On one hand, there is the risk that the spin-off does not work. Secondly, it is no real spin-off and depends on people actually buying the minority stake. Thirdly, just splitting the company in my opinion will not increase the value. If the same guys remain who made all the past mistakes, why should they suddenly be able to turn things around ?

On the positive side, the grid/renewable part could clearly be a take-over target, the bad ship however looks pretty toxic. For me, E.ON is still too much of a black box and without management change and better incentives, I could not see that much more upside. Still, I will keep them on my watch list as the prospoctus for the “Bad ship” IPO could be really interesting.

Coming back to the beginning of the post: Yes, E.ON has just thrown their final “Hail Mary” pass, but at the moment there is no way to tell if the ball even makes it to the end zone….

Harvesting the archives (1): AS Creation, Medtronic, Netflix

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Introduction:

Keeping track of all the companies one has ever looked at is pretty hard. It is pretty easy to update the companies which are in the current portfolio, but in my case, I often forget about the companies which I have looked a couple of years ago but didn’t buy for one reason or another or sold them. One of the great things of blogging is that you can easily look at everything you have ever written. Especially in the current environment, where good value investing ideas are pretty hard to find, it might make sense to look back at companies one has researched sometimes ago and either sold or not bought. Maybe they have become interesting again ? For me it is a lot easier to update myself on a stock I have looked 3-4 years ago compared to looking (and digging) into a completely new stock.

So in this new series, I will look into stocks I have written about and either sold or rejected and try to find out if something has changed or if some lessons could be learned.

AS Creation

AS Creation was the first detailed stock analysis on the blog in December 2010 (in German). The company back then looked cheap: Single Digit P/E, historically a single digit p.a. grower, 30% market share in Germany and the potential upside of a Russian JV (Russia was supposed to be a growth market back then). After some quite significant ups and downs, the stock was sold in August 2013 because the margins didn’t mean revert and the Russian JV was already in some trouble under “non crisis” conditions.

Looking back, the decision to sell in June 2013 at ~34 EUR looks smart if we consider the chart although in between the stock went up to 40 EUR again:

Operationally, AS Creation was hit by several negative events: First, the bankruptcy of Praktiker impacted them in the German core business, secondly, their French subsidiaries suffered and finally, the Russian JV which had to suffer from delays has been clearly hit by by the current crisis. With regard to the German business I have the impression that they never really rebounded to their historical average, maybe they did profit from some kind of anticompetition arrangements, for which they were fined. An interesting detail: They were convicted to pay 10,5 mn EUR in 2014, but they seem to have appealed the decision. To my knowledge, no appeal was ever succesful.

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.

From my side there were 2 important lessons:
1. Mean reversion on single stock basis is nit guaranteed
2. If you buy cheap enough, you don’t lose much if things go wrong.

Medtronic

Medtronic was introduced (in German) on December 31st 2010 and then kicked out in August 2011 because I didn’t feel comfortable with a large cap US stock.

Looking back, this clearly doesn’t look like the smartest decision I ever made. Back then, I sold Medtronic at a loss of around -19%. Since then, the stock showed a total return of 167% in EUR. One of the interesting things about Medtronic is that a lot of the performance came from multiple expansion.

When I sold the stock at around 32 USD, the stock was trading around 10 times trailing earnings (3,27 USD per share 2010). 4 years later, reported earnings 2013/2014 have been ~20% higher per share at 3,80 USD, but Medtronic is now trading at around 18,5 times trailing earnings.

What is even more interesting than that is the fact that in absolute terms, 2013/14 earnings are at exactly the same levels as 2010/2011. Profit margins are even lower than back then. What happened ? Well, as in many cases for US stocks, the company bought back shares aggressively. Still, both ROE and ROIC declined but shareholders don’t seem to bother.

So despite the big run up of the share price, I don’t think that selling the shares has been a mistake. From a fundamental view the company looks worse than back then, however investors seem to be so happy about buyback driven EPS gains that they are willing to pay a pretty high valuation for this.

You could have speculated on such an outcome but as a fundamental investor, this would not have been in line with my investment philosophy. And clearly, You cannot increase the value of the company forever just by reducing the share count.

Stand-alone I would argue that Medtronic is clearly overvalued, based on the stagnating profit and deteriorating profitability. However with the current Healthcare “merger mania” I would not want to short the stock either.

Netflix

I briefly considered to skip the whole Netflix episode but then decided against it. Looking back, this clearly shows that one can do stupid things and still make money….

I shorted Netflix in January 2011 after a short thesis from Whitney Tilson. Luckily I was able to cover the short with a gain in September 2011.

Looking at the chart, we can see that despite extreme volatility, Netflix is now trading 3 times higher than when I covered the position:

The lessons here were pretty simple:

1. Don’t short “hot stocks” based on fundamentals. It is too volatile and just not worth it-
2. Stay away from whatever Whitney Tilson is recommending

Fundamentally, Netflix is on my “too hard” pile. I do think streaming is a big thing and will be even bigger in the future. However I have no idea how much money Netflix will actually be able to make.

Book review: “Built to Last: Successful Habits of Visionary Companies” – Jim Collins

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“Built to last” is a managment literature classic, first published in 1994. It has been reviewed and critized many times already,so I just want to provide a very short summary:

The author analyzes 18 companies which were succesfull for a very long time and compares them to less succesful companies in order to find out what set them apart. The most important point seems to be that the company is a “visionary company”, meaning that the company has a clear mission which is not only earning as much money as possible but somthing in the way of “We want to make people happy” (Disney). Combined with “core values” and “really big goals”, this, according to the author is the secret sauce for a long term succesfull organization.

Looking at those 18 companies clearly shows that since the book was written, not all the companies were great successes for their shareholders. Citigroup, Ford, Motorola were clearly not performance stars, on the other hand, a couple of o the companies (AMEX, Wal-Mart, IBM) are long-term successes and core holding of our value investing Hero Warren Buffett.

Is the book relevant for investing and if yes how ?

I think the answer is clearly “YES” and those are the 3 major points in my opinion:

1. Many current CEOs have read this book (and many future CEOs will read it) and try to act accordingly

For instance the “3G story” of the Brazilians who now run Ambev, Heinz and Burger King seem to have clearly taken this book as blueprint for their strategy. “Dream Big”, core values such as meritocracy, honesty etc. were clearly inspired by this. Edit: And yes, Jim Collins has actually written the foreword to “dream Big” and he seems to have worked with “mastermind” Leman for a long time.

Interestingly, in the book it is clearly said that just writing down those statements is clearly not enough, you have to live them every day which is not easy to achieve. So just when you see something like this written on an annual report, you know that they have read the book but you cannot be sure if a company actually follows those vision and values.

2. A strong vision and core values compared with a good alignment of management and investors might result in great shareholder returns

Many critics use the failed companies of the book as a proof, that success is more depending on luck than on any vision and core values. I would argue that they are missing one point: In many of the failed cases, there happened a serious disconnect between shareholders and management. The most obvious case is Citigroup, which at least since the 2000s was run to the benefits of the employees rather than for all stakeholders. The same could be said of Ford, where the Ford family did not really exercise the owner’s influence as it would have been necessary.

I think it is not random, that especially the companies which were held for instance by Berkshire (Amex, Procter) or where the founder / founding family has a strong tie to the business (Wal-Mart) did well. Both, the influence of a significant investor or a founder with a large ownership can ensure that a visionary company can be also a big success for shareholders. It is clearly not a 100% “hit ratio” but I think the chances for long-term success are clearly above 50%.

For me, Google for instance is a fantastic “visionary company”, but in Google’s case I am not fully convinced that their goals are fully aligned with me as potential minority shareholder.

3. Non-visionary companies can be very good investments as well but it might be harder to sustain success in the long run

The prime example for a non-visionary company in my opinion is Berkshire Hathaway. Buffett’s target has always been to compound shareholder’s wealth. That the company did this for so long and so successful in my opinion is clearly the result of Warren’s and Charlie’s genius and their long and healthy lives. Interestingly, now close to the end of their careers, they seem to be on the “Vision” and “core value” track. At least that is how I interpret the rebranding of many subsidiaries as “Berkshire Energy” and Buffett’s speeches about Berkshire core values which at least to my knowledge were not so prominent years ago.

I think it has become clear to Buffett, that a conglomerate formed by two geniuses might be hard to sustain when those two are not around anymore.Additionally it will be interesting to see how the interests of a future Berkshire CEO who will not own half of the company, will be aligned with the shareholders.

Summary:

Despite having some lengths, I think the book is a good and relevant read for investors who want to look a little bit outside typical investment literature. Some people might say that the book is too old to be relevant, but I personally think that the content of the book is pretty timeless.

Management / shareholder disconnect- E.ON SE edition

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Normally, I don’t care that much about quarterly results, but in the case of German utilities I sometimes make an exception simply because often they are too entertaining to miss.

Yesterday, for instance E.ON the German utility company reported Q3 figures. The press release reads pretty “upbeat”:

E.ON affirms 2014 forecast
11/12/14 | Posted in: Finance
Adjusted for portfolio and currency-translation effects, EDITDA above prior-year level
Renewables’ share of earnings rises to 17 percent
Economic net debt reduced by €1.2 billion
E.ON today reported nine-month earnings that were in line with its expectations. It therefore continues to anticipate full-year 2014 EBITDA of €8 to 8.6 billion and underlying net income of €1.5 to €1.9 billion. Nine-month EBITDA declined by seven percent year on year to €6.6 billion. The absence of earnings streams from divested companies and adverse currency-translation effects were the main factors. On a like-for-like basis—that is, adjusted for portfolio changes and currency-translation effects—E.ON’s EBITDA was above the prior-year level.

I would call this kind of disclosure “Level 1”: How the company wants to be seen

So with “adjustments” things look better than last year. However this time even a relatively “mainstream” German magazine remarked that the earnings disclosure of EON is relatively difficult to understand.

Level 2: P&L – Some kind of truth

In their quarterly report, EON has to use Accounting standards at some point. After 15 pages of useless “Management report” the first “real” accounting number shows up on page 16.

In fat type you can see the following:
Net income 255
 for YTD 2014, which is around 90% lower than 2014. Then in small print they show the following:

Attributable to shareholders of E.ON SE -14
Attributable to non-controlling interests 269

So under IFRS, EON actually lost 14 mn EUR in the first 9 months.But anyone who is reading this blog regularily knows that this is still only “half of the truth”:

Level 3: What really happened – Comprehensive income

Only on page 25 we see the comprehensive income statement of EON for the first 9 months. And this looks really ugly.

-1,7 bn losses from the increase in pension liability
-0,6 bn FX and hedging losses

then lead to a total loss of 2,2 bn EUR or -1,1 EUR per share for E.ON’s shareholders for the first 9 months.

If we look at the stock price, we see that the positive “spin” only lasted for around 20 minutes before the stock price started to drop.

Why are they doing this ?

Well, this is pretty easy and straight forward: This allows the Management to award them nice bonuses independent of what the total result for the shareholder looks like.

Total comp in 2013 according to the annual report for management was 18,5 mn, thereof around 13 mn “bonus”. And this in a year where the were only able to generate a comprehensive income o ~600 mn EUR or 2% ROE.

EON’s target achievement is measured the following way according to the annual report:

As under the old plan, the metric used for the operating-
earnings target is EBITDA. The EBITDA target for a particular
financial year is the plan figure approved by the Supervisory
Board. If E.ON’s actual EBITDA is equal to the EBITDA target,
this constitutes 100 percent attainment. If it is 30 percentage
points or more below the target, this constitutes zero percent
achievement. If it is 30 percentage points or more above the
target, this constitutes 200 percent attainment. Linear inter-
polation is used to translate intermediate EBITDA figures
into percentage

For a capital-intensive business like a utility, EBITDA in absolute is pretty useless. However it is pretty easy to achieve or beat for Management. As a shareholder you can be sure that your interests are not aligned well with those of the management. In my opinion, that whole mess at EON has a lot to do with this pretty obvious “detachment” between management and shareholders and only to a smaller extent with German energy policy.

Finally some other stuff

The most interesting item in the whole Q3 report for me was the fact that Electrical Power generation was actually 50% better (EBITDA) than in 2013 and more than 100% better on EBIT basis. The biggest drop yoy actually came from the natural gas business.

Summary:

EON’s Q3 report for me is a prime example for a badly managed company. The disconnect between management incentives and shareholders leads to nonsense reporting, mostly in order to avoid the hard truth of losses to shareholders. For instance anyone who wondered why they bought crappy assets in Brazil and Turkey instead of paying back debt should understand that this actually increased the bonuses of management irrespective of FX losses, write-offs etc. As an investor, one should stay as far away as possible from such companies, no matter how cheap they are because at some point in the future they will “hit the brick wall”.

Short cuts: Sky Deutschland, Rhoen Klinikum, Bilfinger, Vossloh

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Sky Deutschland

A short quiz: Can you spot the day when the 6,75 EUR offer expired ?

My initial strategy obviously didn’t work out. Now however I am wondering why I didn’t short Sky Deutschland instead before the offer expired. It seems to be clear now that the price didn’t move above 6,75 EUR during the offer period, because most people attach a fundamental value of less than 6,75 EUR to the shares. That would have been second level thinking, but I missed it.

I read somewhere that you should only sell a stock from a portfolio if you are ready to short it. That would have been the best approach here.

Rhoen Klinikum

Looking at the chart, my decision to take a profit at 23,15 EUR looks stupid:

The mechanics of the current “listed transferable tender rights” are the following: The less people who want to actually sell there shares, the lower the price of the tender rights and the higher the share price. As for now, it seems that not so many people want to sell. I have to confess that I got nervous when the price of Rhoen dropped after I bought on the first day ex rights.

In the future, I think it makes sense to wait longer and see how these special situation plays out. I think I waisted some “intrinsic optionality” by taking the small profit much too early.

Bilfinger

In August I looked at Bilfinger for the first time. My arguments against an investment back then were the following:

– some of the many acquisitions could lead to further write downs, especially if a new CEO comes in and goes for the “kitchen sink” approach
– especially the energy business has some structural problems
– fundamentally the company is cheap but not super cheap
– often, when the bad news start to hit, the really bad news only comes out later like for instance Royal Imtech, which was in a very similar business. I don’t think that we will see actual fraud issues at Bilfinger, but who knows ?

Yesterday, Bilfinger released Q3 numbers.

For me, it was therefore no big surprise that they had to write down in total of ~230 mn EUR. The market however seems to have been expecting other things as the extreme drop in the share price shows:

I think Bilfinger is now approaching the “very cheap” area and I will look at them a little closer in the next weeks.

Vossloh

Vossloh, another potential “turn around” story also released Q3 numbers a few days ago. Similar to Bilfinger, investors seemed to have been spooked by the numbers.

In my opinion, two issues might have irritated investors:

– new orders in Q3 were very weak (new orders in the first 6 months were very strong)
– management basically said that a “full” recovery can only be expected for 2017

Interestingly, the whole press release had a very negative tone, they make no attempt to strip out the one offs etc. etc. Maybe it is coincidence, but if I would want to talk the stock down in order to maybe buy the company cheaply, I would do it exactly that way…..

This is what I said in September:

Looking at the chart, this might not be unrealistic as the stock price is still in free fall and any “technical” support levels would be somewhere around 39 EUR per share if one would be into chart analysis. In any of those “falling knife” cases, patience is essential anyway.

Vossloh will therefore be “only” on my watch list with a limit of 42 EUR where I would start to buy if no adverse developments arise.

So we are now very close to my potential entry point. I will watch this as closely as Bilfinger. Both for Bilfinger and Vossloh, Iit will be interesting to see if there will be some year end tax loss selling.

Performance review October 2014 – Comment “Stress testing”

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Performance October 2014

In October, the portfolio lost -0,8%. Compared to my benchmark (Eurostoxx50 (25%), Eurostoxx small 200 (25%), DAX (30%),MDAX (20%)) at -1,7%, this is an outperformance of +0,9%. YTD the score is +4,2% for the portfolio against -1,2% for the benchmark.

Positive contributors were Koc Holding (+9,7%), G. Perrier (+7,1%), Cranswick (+6,2%). Loosers were Draeger (-9,2%), Bouvet (-7,1%) and Miko (-5,8%).

Obviously, October was a relatively volatile month (more to that in the comment). However, in the worst days in mid October, the portfolio behaved as expected with a max. draw down of “only” 1/2 of the benchmark.

Portfolio transactions:

October was relatively quiet. Citizen’s Financial, my first US stock since a long time entered the portfolio as a “special situation”. In between I did a little “special situation” trade with Rhoen, netting me ~2% in the process.

The current portfolio can be seen at the usual place here.

Comment: “Stress testing”.

The first “Stress test” I want to refer to is the “comprehensive assesment of the financial health” of 120 major European banks by the ECB. The press feedback was quite predictable, mostly saying that it was only a first step and is not tough enough.

In my opinion, two important aspects have not been highlighted very often. First, I think the major achievement of this is to make all the different bank models comparable. In my opinion, this is a result which should not be underestimated. Everytime when some kind of international standard is released, all the local governments try to lobby as hard as they can for exceptions for their own players. The result then is basically a general standard with very few “teeth” and no one is able to compare the results. In this case, the ECB has been quite succesful to make the results comparable and even get the approval of all the regulators which I find is quite an achievement.

Additionally, for me it was quite surprising that some banks actually failed. I would have expected more like “ok, they failed based on 2013, but have restored their capital already” outcomes. So I was quite surprised that especially for some Italian banks, the situation became quite difficult (esp., BMPS and Banca Carige). In my opinion this indicates that the ECB will not be a “lame duck” regulator, which in the long run is good news for the Euro zone despite more short-term issues. Plus, as Draghi is alway accused of helping the “Club Med” countries, this outcome shows that this is not the case.

Overall, despite all the negative opinion about the Eurozone, my opinion this is a very important and constructive step to get the “financial plumbing” right within the Euro zone. If and when this leads to a revival is another question but personally I think that the public opinion is underestimating what is actually being achieved here.

The second but more personal stress test was clearly the sudden drop in equity markets in mid October. Especially for the US market, this was the biggest drop since 3 years or so. I guess for many investors this was quite “spooky” as there was no apparent reason. In my opinion, a potential reason for this kind of volatility is the fact that many people who are owning stocks now shouldn’t own stocks. Buying stocks because the dividend yield is higher than the yields on deposits sounds good at first, unless your shares suddenly drop 10% or more. Often such investors are called “weak hands” because they sell just because of a drop in the share. After the financial crisis, many “weak hands” stayed out of the market for quite some time but are now returning mostly because of the low-interest rates.

Normally I don’t give general investment advise, but here I make an exception. Two points of advise to investors:

1. Don’t buy stocks because of the dividend yield
2. Stress test yourself: If October made you nervous, or you can’t afford your stocks dropping 10%,20%,30% or more, then you maybe shouldn’t be in stocks at all

I have clearly no divine insight where the stock market will go in the future, however we should expect the ride to be quite bumpy.

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.

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.

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