Usually, I try to stay away from a “true” Merger Arbitrage as this is mostly a typical “shark tank” situation where as a small investor, the chances are pretty high to end up as shark food. However the situation when a first attempt fails and the price pulls back, it could be more interesting. In cases such as Rhoen Klinikum ,the interesting aspect is that suddenly the “true” value or “control price” of a business is revealed when a bid is made. With this information, one can more easily calculate the odds and expected returns.
The attempted take-over of R. Stahl by closely held German company Weidmüller was a special case anyway. In April 2014, German company Weidmüller made an “unfriendly” offer to all R. Stahl shareholders offering 47,50 EUR under the condition that 50% of shareholders accept the offer. Later, they increased the offer to 50 EUR, which was significantly higher than the “undisturbed” price of around 34 EUR.
The strange thing about the offer was the fact, that 51% of the company is held by the heirs of the founding family and further 10% is held by R. Stahl themselves. The families directly commented that they won’t sell and of course R. Stahl’s management was also not a big fan of this transaction, so the Treasury shares were out of question as well.
Not surprisingly, on July 4th, Weidmueller released that the offer has expired as only ~17% of shareholders have tendered their shares.
R. Stahl as a company
Let’s take a step back and look at R. Stahl as a company. In my opinion, R. Stahl is one of the typical “hidden Champions” of the German “Mittelstand”. They specialize in electrical installations within potential explosive environmenta (chemical plants, gas/oil etc.). The company is financed “rock solid” and has shown good growth in its core business for quite some time althoughresults did not fully trail rising sales.
I actually owned R. Stahl back in 2003 when it was a turn around case. I do have prove for this as I opened a discussion thread at “wallstret:online” back in 2003 when the stockprice was around 5 EUR per share and which is still active. I sold at 17 EUR and thought I was a genius and missing the next 100% in 2 years…
R Stahl does not look too expensive. Although P/E is around 19, EV/EBIT and EV/EBITDA look pretty cheap. EV/EBIT of 7,3 for instance is pretty cheap and is not even adjusted for the 10% treasury shares which should be deducted from EV. The latest quarter didn’t look that good as R. Stahl suffers to a certain extent from the lower Capex of its mein customers, oil and natural gas companies.
R. Stahl was actually on my watch list after the fell in the beginning of 2014 however the Weidmueller offer came before I could look more closely into the accounts.
Back to the failed Weidmueller offer
So the question is: Why did Weidmüller make this offer anyway? To be honest, I don’t know. I researched a little bit and it seems, according to some newspaper articles (for instance here), that Weidmüller had contacts to the family before and that maybe the families are not such a “solid block” at all. In this other article there is an interesting comment that chances were not so bad after all as family controlled companies are more open to sell to other family companies like Weidmüller. They also mention “Phoenix Contact” as another potential buyer.
The combination of Weidmueller and R. Stahl seems to make some sense as this interview with the Weidmüller CFO clearly shows. It was clearly not a cost cutting project but a growth project.
Interestingly, the stock price did not retreat to the “undisturbed” level, but is hovering around 41 EUR, clearly above the level before the offer.
Q1 numbers which were issued after the first Weidmüller offer did not look so good, so this is not an explanation for the still elevated stock price.
Is this interesting ?
A very simple way to look at this is making the following assumptions:
– something is happening within 1 year, either deal or ultimately no deal
– the “undisturbed” price is EUR 34.
– the control price is 50 EUR per share
– I want to make an expected return of 15% p.a.
Then I can solve for the implict required probability of a 50 EUR deal happening within 1 year:
41*1.15 = (Prob*50) + (1-Prob)*34 or (41*1.15-34)/16 = Prob
Based on those assumption, I would need to apply a 82% probability in order to have a 15% expected return on investment. I think this is much too high for my taste.
At the moment, I would assume that there is a 50/50 chance. With this assumption, I can calculate my required price level where the stock gets interesting.
This would be then the follwoing calculation:
0,5*34 + 0,5*50 = Price *1.15 = 36,52 EUR. So at 36,52 EUR per share I could get an expected return of 15% with odds at 50/50.
Now we can make another assumption: Let’s assume we are still at 50/50, but we assume that any acquirer has to pay more than 50 as the 50 were clearly not enough. So lets say 55 EUR. Then my target price would be around 38,69 EUR per share where I would be prepared to buy.
In reality, of course the outcome will not be so binary, but I think this framework is a good way to get a feeling for an intersting entry point. For me, the current price level of 41 EUR is a little bit to high, but I think this could be interesting around 38,50 EUR as a special “failed M&A” situation.
Activist angle
There is a further interesting angle. A smaller, but in expert circles well known investor (Scherzer) has released an “open letter” to the management and board during the offer period. There they critize that from the beginning Management and board were against the offer despite the fact that they are obliged to work for the benefit of all shareholders and not only the founding family. The letter contains some other interesting info, such as that the Head of the supervisory board had actually sold shares in the market before etc. etc.
The target of this letter is clearly to put pressure on the family in order to “Motivate” them making an offer to minority shareholders at the “eidmueller” price. I am not sure how the chances of success are here, but this could increase the odds towards an “event” as described above. I am not a lawyer, so I cannot fully judge if the potential legal issues mentioned in the letter with refusing the offer are enough to build a case against them but it clearly increases the leverage.
The question for me is: Does this move the “needle” far enough t justify an investment at the current price of 41 EUR ?
Summary:
Although the failed R. Stahl offer is clearly different from my succesful Rhoen investment, the situation itself is interesting. However for my taste, the current price of 41 EUR is a little bit to high compared to the undisturbed price of around 34 EUR in order to justify an investment. For me, this would get very interesting at a price of around 38-39 EUR at the curent stage. I will watch this one closely…..
In the last few days, the stock price dropped like a stone because they disclosed a 900 mn “investment” into the troubled Portuguese “Espirito Santo” Group
Reader benny_m post a very good comment on the old post, asking where to find in the balance sheet those 900 mn EUR.
1. Cash and Cash equivalents
2. Short term financial investments
Those are the respective amounts:
Q1 2014
2013
Cash
1.276
1.659
ST investments
1.071
914
So theoretically, the could be within either category. However two important caveats from my side:
– if they would book this under Cash and Cash equivalents, this would be scandalous and reminds me very much about the Royal Imtech fraud
– in the annual report, the comment to short term investments reads as follows:
24. SHORT – TERM INVESTMENTS
This caption consists of short-term financial applications which have terms and conditions previously agreed with financial institutions.
They disclose 750 mn of “debt securities” which are described as follows:
(i) This caption includes primarily debt securities issued by PT Finance and Portugal Telecom that had an average maturity of approximately 2 months and were settled in 2014 at nominal value plus accrued interest.
This makes no sense. “Issuing” a security means actually receiving money. They cannot own their own issued securities as those would have to be consolidated out. Also the second part of the sentence makes no sense at all. Those amounts were not “settled” as the total amount even increased in Q1 2014.
To add insult to injury, Portugal Telecom actually discloses “related party transactions” with Banco Espirito Santo (BES) on page 219 of its annual report as they are a significant shereholder, but there is no word of the loans to “Rioforte” another Espirito Santo group company.
Let’s look back at the “official” press release of PTC:
PT subscribed, through its former subsidiaries PT International Finance BV and PT Portugal SGPS, a total of Euro 897 million in commercial paper of Rioforte with an average annual remuneration of 3.6%. All treasury applications in commercial paper of Rioforte will mature on 15 and 17 July 2014 (Euro 847 million and Euro 50 million, respectively). Treasury operations are carried out in the context of analysis of various short-term investment options available in the market and taking into account the attractiveness of the remuneration offered and are monitored and approved by the Executive Committee.
Additionally, it is thus important to note that the subscription of commercial paper of Rioforte is based on the 14-year long adequate experience in treasury applications of Banco Espírito Santo (“BES”) and GES entities, in the context of the strategic partnership signed in April 2000 between both parties. This strategic partnership contemplated the cross shareholding between both entities as well as the designation of PT as a preferred supplier of telecommunications to BES Group and the designation of BES as preferred provider of financial services to PT.
Both sentences are in my opinion a clear prove of dishonesty of PTC management. No, lending 900 mn EUR to a troubled financial institution IS NOT part of normal treasury operations. And second, if you have a “strategic partnership” then you shoul disclose this under the relvant section in your annual report instead ogf hiding it behind nonsensical comments.
I have actually send some simple questions to PTC IR (where did they book it etc.) but received no answer.
Summary:
At this stage, I cannot say for sure if this is “only” dishonesty on part of PTCs management or if there is even fraudulent activity involved. In any case this looks really bad and as a result I will sell my PTC shares at current prices (2,18 EUR) and take the loss (~-27%. This is a company where you can’t trust management and even less their accounts/disclosures and this is an absolute “no go” for me.
In June, the portfolio gained 0,9% against -1,2% for the Benchmark (Eurostoxx50 (Perf.Ind) (25%), Eurostoxx small 200 (25%), DAX (30%), MDAX (20%)) an outperformance of +2,1%. YTD, the score is +10,2% against 4,1% for the Benchmark.
For June, positive contributers were IGE+XAO (+13,2%), Sistema (+7,5%), Admiral (+6,2%). Main loosers were Van Lanschott (-4,2%), KAS Bank (-4%,0%) and Energiedienst (-2,5%).
Interestingly enough, June was the fourth month in 2014 with negative BM performance and significant outperformance of the portfolio. This is how 2014 looks on a monthly basis:
Bench
Portfolio
Perf BM
Perf. Portf.
Portf-BM
Jan 14
8.849,21
181,48
-1,9%
3,7%
5,5%
Feb 14
9.306,80
186,34
5,2%
2,7%
-2,5%
Mrz 14
9.228,53
187,18
-0,8%
0,5%
1,3%
Apr 14
9.203,99
189,76
-0,3%
1,4%
1,6%
Mai 14
9.499,94
191,22
3,2%
0,8%
-2,4%
Jun 14
9.387,95
192,98
-1,2%
0,9%
2,1%
So whenever the market performs strongly, the portfolio underperforms significantly and when the market retreats it more then compensates. There is certainly some time lag involved here but I cannot completely explain what is happening here. At least it doesn’t look like a lot of beta 😉
Portfolio transactions
June was a very quiet month, the only transaction was to sell the remaining April SA stake. Although I introduced Admiral in June, I had invested already in April. The current portfolio as always can be seen here.
Including all the earned dividends, cash is now at ~11,8% plus the 5% in the Depfa LT2 which I consider very close to cash.
Currently, Portugal Telecom is “under review”. I bought a small position in order to keep my interest in the PTC/OI merger, the recent news about the undisclosed Rioforte investment caught me by surprise. I have sent an Email to PTC IR in order to clarify the accounting, but overall I think this is not a comapny to invest in after this incident.
As I have already written, in early July I already invested another 2,5% of the portfolio into NN Group, the Dutch IPO and insurance subsidiary of ING.
NN Group is the name of the soon to be just IPOed Insurance subsidiary of Dutch ING Group. NN Group sounds a little bit strange but is the “traditional” name of the Dutch Insurance company, “Nationale Nederlanden”.
As a value investor, normally, IPOs are an absolute “No go”. Benjamin Graham famously said that one should never touch an IPO because almost always, the stock price is overhyped and the risk return relationship is not good. Especially now with the market reaching new highs, buying IPOs doesn’t seem a good idea.
So why could this IPO be different ? In my opinion there are some good reasons:
1. ING is obliged to sell.
ING had to be rescued in 2008 by the Dutch Government under the condition that they dispose their full insurance activities. They cannot simply spin off the business because they need the money to pay back the Dutch Government and shore up the bank balance sheet.
This is form a recent Bloomberg article what they have done so far and what they committed to:
ING, the recipient of a 10 billion-euro bailout from the Netherlands in 2008, agreed with EU regulators to complete its disposal program by the end of 2016 and to sell more than half of NN by the end of next year. ING also still owns about 43 percent of Voya and a stake of about 10 percent in Sul America SA (SULA11) in Brazil.
The company is open to selling the Sul America stake, worth about 566 million reais ($253 million) based on the Rio de Janeiro-based insurer’s market value, in a block trade, Chief Executive Officer Ralph Hamers said in an interview in Sao Paulo yesterday.
2. The company is an “ugly duck” at first sight
The remaining insurance compqny is a strange combination of Netherlands, Eastern Europe and Japan with some Investment Management thrown in. In German, one would call the business mix a “Resterampe”, so the remains of what could not be sold directly. The majority of the business is Life insurance, which itself is clearly suffering from low interest rates.
The company shows more or less zero profits for 2013, however a couple of items could be considered true “One offs” in order to look better in the future, for instance the large charge against the closed Japanese VA business. Also Q1 2014 showed a loss, this time because of a charge in relation to pensions.
So now one can accuse ING of “dressing up the bride”, rather the opposite.
3. European Insurance is one of the sectors with the lowest valuations anyhow
The Stoxx 600 has currently a P/E of 24,8 and a P/B of 1,9. Compared to this, the Insurance sector trades at a trailing p/E of 12,4 and P/B of 1,21. This is even cheaper than banks and utilities. Within the insurance sector again, the Life Insurance sector is even cheaper. There are clearly many reasons for those low valuations, especially that interest rates are so low which makes it hard for life insurers to earn their guarantees and a spread on top if this.
4. The IPO valuation looks cheap compared to the sector.
The company comes to the market at around 50% of book value. Considering that they don’t have a lot of Goodwill, this looks cheap even compared to the generally low valuations for life insurance companies. Dutch competitors Aegon and Delta Llyod trade at P/Bs of 0,7 and 1,3, the average for European Life insurers is ~1.4 including UK, and around 1 excluding UK.
5. The company looks like a target
Looking at this IPO, there seems to be a big sign on the company saying “split me up”. This strange combination of businesses is clearly not value enhancing. Splitting the company up for instance into a Dutch entity and selling down the rest could be a pretty easy exercise for an activist Hedge fund. I could also imagine that some Asian financial companies would be interested in acquiring a solid Dutch “brand”-.
6. The company is relatively solid
If one looks at the “usual suspects”, like Goodwill, pensions etc. there is not much to be found. The company had 6 bn of defined benifit liabilities in 2013 but actually got completely rid of them in early 2014 against an extra charge. I consider this as very positive and a good sign that they really cleaned up a lot of stuff befor doing this IPO. Additionally, another insurance specialty, so-called “DACs”, which are capitalized distribution costs only play a very minor role at NN compeared to other life players like AXA.
They do have some leverage but overall I would rate the balance sheet quality as “above average” for the sector.
7. The US IPO went relatively similar
There is a blue print for this transaction: Voya, the former ING US IPO. The US business was also supposed to be pretty ugly, so ING placed the first tranche very very cheap at below 0,4 times book value. Since then however the valuation seems to slowly approach those of other US life insurers and the stock almost doubled since IPO:
Other thoughts:
Management incentives
What I didn’t find out in the annual report or in the IPO prospectus was how the NN Group management is aligned with shareholders going forward.
In situations like this, a lot depends on Management, especially if they want to actually increase sahreholder value or if they want to maximise salaries which is easier in a bigger company and which would make reasonable spin-offs and disposals unlikely. So this is something to be watched.
Management has committed to a quite aggressive dividend payout ratio of 40-50%, starting with a large payout already this year in autumn. I am not a dividend investor, but this greatly reduces the risk of stupid acquisitions.
Distribution agreements with ING Bank
Life Insurance is mainly distributed via banks these days (often along with a mortgage loan). NN has an exclusive agreement with ING Bank according to the IPO porspectus until 2022. Although this is a limited time frame, this is very valuable as banks now charge high upfront fees in order to access their distribution channel.
Summary:
In my opinion this “IPO” of NN Group is much more similar to the classic “spin-off” than a “real” IPO. ING has to sell, the underlying business looks ugly at first sight and there is a lot of overall negative headline news for the sector and the specific business fields. As a result, other than with a normal IPO, the valuation is very cheap.
As I feel comfortable with the headline risks at this price level, I will invest a “half position” (2,5%) of the portfolio into NN Group at current prices (21,70 EUR). The short form investment thesis is that one gets an above average quality insurance business for a below average price.
Again, this is clearly not a “no brainer” and will need (lots of) patience, but over 2-3 years, the price of the shares could be easily 50% higher (including dividend distributions) if they reach average valuation ratios and the one-offs turn out to be real one-offs.
“Funny Money” is a rather “old” book, originally from 1984, covering the story of the Oklahoma Oil boom in the early 80ties and the subsequent bakruptcy of Penn Square Bank.
The most interesting thing about the book is that nothing is ever new in finance and history always repeats although not exactly but in similar fashion.
Penn Square Bank was a small Bank in Oklahoma City which was lending to local Oil and Gas companies. When a big well was found (the “Tomcat”), prices in that area exploded and a great boom started. Very similar to the real estate boom many years later, Penn Square was lending against market values, which in boom times looks always good.
Penn Square could do even more harm via “syndication”, in many cases they did pocket the arrangers fee but only kept 1% of the loan and “upstreamed” the other 99% to bigger banks. One of those banks, Continental Illinois, one of the largest commercial lenders in the US at that time went under 1 or 2 years after Penn Square and had to be bailed out by the US Government. Although the instrument is different, this is exactly what happened with all the CDO structures 25 years later in our socalled “Financial crisis”.
The book also offers a lot of insight into the Oil and Gas explorer industry which I think is still relevant today. MLPs for instance were very popular already back then, but as always, mostly only some of the promoters became rich.
Funnily, one of the most notourious promoters at that time, Robert A. Hefner IV, seems to be still around.
The author originally covered the events as a reporter for the “New Yorker” and then packaged the stories into a book. So its a pretty good “real time” description of a classic boom & bust cycle fulled by credit and credit derivatives. It is also proof that you don’t need to combine investment banks and commercial banks to screw up, commercial banks can do that on their own pretty well. Interestingly in the book, one senator gets quoted that “bank deregulation had gone too far” back then in the early 80ties. But this was a time what we would consider now as “tightly regulated”.
Another similarity to modern cases is the fact, that none of the “big guys” had to go to prison, only “lower level” guys got sentenced and one of them only because his employer needed to cash in the fraud insurance policy. Finally, the main players of the Oil Boom behaved very similar to Investment bankers in the 2000s and Internet entrepreneurs today. Private planes, helicopters, 1000 USD dinners etc. were already standard for the high rollers back then.
I think the main take-away from the book is that boom and busts will always occur and banks are inherently instable especially when there is a lot of credit growth. As an investor, it usually pays to stay out of such areas, unless you are very close to the promoters, otherwise the risk to get “fleeced” is very high.
Summary: I can highly recommend the book to anyone who is interested in the history of capital markets, especially boom and bust stories. This is one of the “classics”. As an add-on it gives some insight into the Oil and Gas explorer/drilling industry.
Disclosure: The author might have bought the stock well in advance of publishing the post. In this special case, the idea has been presented already some weeks ago to a group of value investors.
Introduction
Admiral is a UK based P&C insurance company. A brief look into Admiral’s multiples would single it out as a potential short candidate (~15 GBP/share):
P/B 8,0
P/S 4,5
P/E ~14,5
Div. yield 3,7%
Especially P/B and P/S look overvalued if compared to other P&C companies. The average multiple for European P&C companies is ~2,1 for P/B, 1,6 for P/S and 11,6 P/E. So the company looks wildly overvalued.
The pitch is relatively simple: Admiral is the UK version of GEICO, the famous low cost direct insurer owned by Warren Buffet. Just look at the cost ratios of Admiral compared to its 4 main competitors:
Cost ratio P&C 2013
Aviva
32,8%
RSA
32,6%
Direct Line
22,3%
Esure
23,8%
Admiral
19,9%
Clearly, the cost advantage against “traditional” companies like Aviva and RSA comes from the fact that they don’t have to pay insurance agents. But even compared to the direct competitors, Admiral seems to have a cost advantage. Among other things, Admiral is the only FTSE100 company located in Wales which implies quite “reasonable” salaries.
However there is a big difference compared to GEICO:
GEICO’s business model as we all know, combines low cost / direct with investing the “float” Buffet style, so every premium dollar earned is kept and invested as profitable as possible, preferably in stocks. In principle, this is the strategy of all insurance companies, but very few are able to get “Buffet like” returns.
So I have compiled 3 statistics which show that Admiral “ticks” differently:
2013
Ratio Financial income /total profit
Net retained premium
“Other” in % of profit
RSA
116,4%
93,6%
0,0%
Aviva
72,9%
88,2%
0,0%
Direct Line
35,2%
101,6%
36,3%
Esure
11,3%
91,4%
40,1%
Admiral
3,3%
25,0%
85,0%
A quick explanation of those ratios: The net profit of an Insurance company is the result of 3 major components:
a) Underwriting result
b) investment result
c) “other” stuff
The first column in the table above shows what percentage of the total result in 2013 can be attributed to the investment result. RSA for instance actually makes a loss in insurance, so more than 100% of their profit comes from the investment portfolio. Admiral, on the other end, attributes only 3% of the total profit to investments. So what’s going on here ? Do they manage their investments so badly ?
The second column explains this “conundrum”: All the other players keep more or less all the insurance premiums they are collecting. Admiral, on the other hand only keeps 25% of incoming insurance premiums, the other 75% get “ceded” to Reinsurers.
Finally, the third column shows, that Admira is actually earning most of its money with “other” stuff whatever that means. To solve the puzzle, one has to look back into history of Admiral: Admiral was founded by a Lloyds syndicate to act as a kind of “Underwriting agency” in order to generate premium for the syndicate. So from the start, Admiral had a very lean structure, selling only direct etc. At some point in time they decided that the syndicate was too expensive and that they actually want to issue the policies themselves. Nevertheless, they kept their lean set up and lined up reinsurers to shoulder the majority of the risk.
Most people familiar with Insurance would say that the concept of Admiral doesn’t make sense. Why should you give up profits both, on the insureance side as well as in investments by passing 75% ? The answer is relatively simple: Capital efficency. Most insurance companies are notouriously capital inefficient. Long term ROEs for most major players are below 10% p.a. despite often significant leverage through subordinated debt. The main reason for this is the fact, that in many jurisdictions, the “GEICO” model requires to hold a large amount of capital to buffer capital market movements. Unless you are Warren Buffet, the returns on those investments are often below average so as a result, ROEs are bad. Plus the fact that growth often requires a lot of upfront capital as well.
For Admiral, the big structural problem of course is the following: If I pass most of my premiums and cash to reinsurers, how do I then earn money ? This is where the “other” column from my table above comes into play. Due to this business model, Admrial very early concentrated on making additional money by selling “ancillary” stuff.
This is what Admiral writes in its latest annual report (by the way: all annual reports since 2003 are highly recommended for clarity and insight !!!):
Other Revenue
Admiral generates Other revenue from a portfolio of insurance products that complement the core car insurance product, and also fees generated over the life of the policy. The most material contributors to net
Other revenue are:
> Profit earned from motor policy upgrade products underwritten by Admiral, including breakdown, car hire and personal injury covers
> Profit from other insurance products, not underwritten by Admiral
> Vehicle Commission (see page 25)
> Fees – a dministration fees and referral income (see page 25)
> Instalment income – interest charged to customers paying for cover in instalments
This additional income is extremely high margin with almost no capital requirement and drives the profitability of the company.
The result
This low capital requirement leads to ROE’s which are compared to its peers “from outer space”:
Name
ROE FY
ROE 5Y
Average
16%
17%
ADMIRAL GROUP PLC
59%
59%
TOPDANMARK A/S
26%
31%
TRYG A/S
19%
21%
LANCASHIRE HOLDINGS LTD
15%
17%
BEAZLEY PLC
21%
16%
GJENSIDIGE FORSIKRING ASA
16%
15%
SAMPO OYJ-A SHS
14%
14%
GRUPO CATALANA OCCIDENTE SA
13%
14%
EULER HERMES SA
13%
13%
ZURICH INSURANCE GROUP AG
12%
12%
ALLIANZ SE-REG
11%
12%
AMLIN PLC
19%
10%
MAPFRE SA
9%
9%
XL GROUP PLC
9%
9%
RSA INSURANCE GROUP PLC
-11%
5%
Other unique aspects of Admiral’s business model
Comparison sites
Admiral runs in addition to its insurance operation, its own insurance comparison sites (e.g. Confused.com in the UK). Although those comparison sites themselves only contribute less then 10% of total profit, it gives Admiral a strategic advantage: Via their comparison site they can monitor in real time what competitors are doing and how they are pricing stuff. Other comparison sites also sell this kind of data but usually with a significant time delay. So running its own comparison site is clearly an advantage against a “normal” onilne insurer.
Capital allocation
With regard to capital allocation, again look at this statement from the 2013 annual report:
Admiral believes that having excess cash in a company can lead to poor decision-making. So we are committed to returning surplus capital to shareholders. We believe that keeping management hungry for cash keeps them focused on the most important aspects of the business. We do not starve our businesses but neither do we allow them the luxury of trying to decide what to do with excess capital.
Charly Munger would say at this point “I Have nothing more to add”. This is how it should be done but rarely found especially in the Insurance industry.
Managment & Shareholders:
The current CEO, Henry Engelhardt founded the company on behalf of the Lloyds Syndicate in 1991. He still holds ~12,8% of the company.
Co-founder David Stevens owns around 3,8%. Both founders only pay themselves ~400 k GBP per year salaries and no bonuses. The only exception is the CFO, who is relatively new. He earns around 1 mn GBP including a bonus and doesn’t have a lot of shares. There are quite some interviews available on Youtube with the CEO, among them this one is especially interesting:
Largest outside shareholder is MunichRe with 10%, who is also providing the majority of the reinsurance capacity. Other noteworthy shareholders are PowerCorp from Canada and Odey, the UK Hedge fund with a -0.79% short position. All Admiral employees are shareholders and there is a program for employes to purchase shares.
Stock price
Since going public, Admiral has performed very well:
Including dividends, Admiral returned 25,5% p.a. since their IPO against ~8% p.a. for the FTSE 100. Since 2004, EPS trippled and dividends per share increased by a factor of five. Interestingly, Admiral never traded at a level which one would asociate normally with such a growth stock, at the peak, the share had a P/E of 22 in 2006. I think this has to do with the general discomfort that many investors have with financial stocks.
Challenges for Admiral
Some of the additonal income sources for Admiral are clearly under regulatory thread. Referral fees, bundling etc. are currently investigated by UK regulators (see here and here) but especially Admiral seems to be quite creative on how to find different ways to earn fees.
Another and maybe the biggest strategic issue is that in theory comparison sites could start to sell additional products as well as we can see in the car rental market. However Admiral has the big advantage as they cover both, the comparison area and the insurance “sales funnel”.
I also think that for the comparison sites, it is not that easy to sell additional insurance products. Insurance policies are less standardized than rental cars, with very individual pricing so it is harder for a comparison site to actually close the deal intead of passing the client on to the insurer for a fee. Clearly comparison sites will try to get into this game as well but again, Admiral is the best positioned insurer.
Finally, the UK car insurance business shows almost a “brutal” cyclicality, for instance in 2013 premiums for the whole market dropped ~20%. Nevertheless, Admiral has shown that they are profitable over the cycle.
Opportunities
Admiral is currently trying to expand its business model into 4 other countries: Spain, France, Italy and the US. An earlier attempt in Germany failed a couple of years ago, mainly because the German market renews policies only once a year and Admiral was not able to really use its strengths (dynamic offers and pricing) on that basis.
If they succeed in any one of those markets similar to the UK, then there would be significant upside in the stock. If they suceed in 2 or more, Admiral could become a multibagger. If they don’t succeed at all, one could imagine that they might take additional market share in the UL, but then the upside is limited.
Although the subs are growing strongly, they still made a loss in 2013. Car insurance is however to a certain extent a scale business. You need a certain scale to become profitable. Clearly, just buying a competitor (and paying a lot of goodwill) would look better in the short term. Building up your own operations takes longer, but if you do it right, the value generation is significantly better than via M&A.
SUMMARY: Bringing it all together
Personally, I think Admiral has a very unique “outsider” business model. Reinsuring most of their business allows them to focus on the core product, car insurance underwriting and ancilliary services. They don’t have the complexity of traditional insurers with complex investments, expensive investment management and “asset liability management” departments etc. etc.
This keeps structural complexity low, lowers cost and allows them to scale up business much quicker than any “traditional” model and with very low capital intensity. Traditional insurance companies have always the option to realize investment profits in order to make results look good in the short term. In the long term, this often leads to a detoriation of the core business. Admiral doesn’t have this luxury. Additionally it insulates Admiral mostly from capital market volatility and enables them to move aggresively if other insurers are nursing their investment losses. Additionally, they don’t need to sell complicated subordinated debt etc.
Overall, I think the likelihood that someone succesfully copies Admirals business model is low, because for any Insurance executive, it is extremely counterintuitive to give premium away. Any insurance CEO would rather sell his grandmother than increase the reinsurance share and give away investment money. GEICO for instance in my opinion is not a “real” outsider company. It is a traditional insurer with a focused direct sales force. Admiral is really a very different animal.
Clearly, the thread of Google & Co is real, but on the other hand, Google & Co hesitate to to move into regulated areas. However if they would want to seriously move into this business, I would think that Admiral could be an interesting acquisition target for cash rich Google & Co.
Against the traditional competition, in my opinion Admiral has a 10 year headstart in understanding how to sell insurence and especially “others” over the internet. I think they will chuckle when they read how for instance AXA tries to become “digital” as they were already selling 70% of their policies over the internet in 2003.
I would go so far as calling the combined business model a “moat”. Yes, it is maybe not that difficult to start an online insurer and does not fit into the classical moat categories, but to scale up quickly and get the whole package right, this is another story and in my opinion very very unlikely. Even the direct clones like Esure only go “Half way” by keeping all the premiums and exposing themselves to capital market volatility.
I also think that this is still a “value investment” despite the optically expensive multiples. In my opinion, the value lies in the business model plus the headstart in online insurance. To put it into s short thesis: This is a high quality company at a “Normal company price tag” and an “above average” growth opportunity due to the cost advanatges.
For the portfolio, I had bought already a “half position” in April at 13,80 GBP per share as I have briefly mentioned in the April post. I know this is a little unfair but I just didn’t have time to finish the write up.
P.S. There will be an extra post for this, but I have sold the rest of my April SA position in order to keep the exposure to the financial sector (~20% of the protfolio including the bonds) constant
Following Mr. Draghi’s speach on Thursday, the German Stock Index DAX hit the 10.000 mark for the first time in history soon thereafter. Many major publications directly came out with headlines along the line “DAX 10000 – what’s next” and speculated where the DAX might go.
In contrast to that and only for reasons of personal entertainment, I want to take a look back into the DAX history. The DAX was introduced 26 years ago in July 1988 by the German Stock Exchange in order to introduce a modern, performance based stock index. The linked Wikipedia site gives a great overview on the history of the DAX and the change in constituents. Mathematically, the DAX times series was based on 31.12.1987 with a starting value of 1.000 although there exist some “Virtual” time series going back much further.
Just a few interesting facts about the DAX:
– only 15 of the original constituents are still in the DAX
– 3 (or 10% of the original 30) actually went bankrupt
– the best years since 1987 have been 1993 with +46,71% and 1997 with +47,11%
– the worst year were 2002 with -43,94% and 2008 with -40,37%
– the biggest cummulative loss was the 2001-2003 period with a cumulative loss -58,9%
– the Dax rarely ends up pruducing single digit returns over a full calender year. Only 5 out of the last 26 years produced “single digit” returns. So yes, long term stock returns might be single digits but short term single digit returns are an exception
Neverthess, the 10.000 level represents an annual return of ~9,02% over 26,5 years (from December 1987 until May 2014). This compares with around 10,1% for the S&P 500 (in EUR).
For me personally, the implementation of the Dax coincidently equals almost exactly when I bought my first stock. The first Stock I bought was a company called Hoesch in September 1987. I remember this so well because just a few weeks later, the “Black october of 1987” hit me with full force. I had used half of my earnings from a vacation job. As I wanted to increase my position after the crash, the people at the bank refused to take my order because they said that stocks are only for gamblers. As I was not yet of legal age back then, I had to come again with written permission of my parents to buy stocks.
This leads to another question:
Was this huge 26 year rally predictable or not ?
3 years ago I had reviewed the original “Market Wizards” from Jack Schwager which contains interviews with many then famous traders and hedge fund managers. Overall, one year after th 1987 crash, the sentiment was very very negative.
As I did not find historical P/Es for the Dax in 1987/1988, let’s look at this table of historic P/Es for the S&P 500:
P/E
31.12.1973
12,3
31.12.1974
7,3
31.12.1975
11,7
31.12.1976
11,0
30.12.1977
8,8
29.12.1978
8,3
31.12.1979
7,4
31.12.1980
9,1
31.12.1981
8,1
31.12.1982
10,2
30.12.1983
12,4
31.12.1984
9,9
31.12.1985
13,5
31.12.1986
16,3
31.12.1987
15,6
avg
10,8
Someone like John Hussmann might have said that stocks have nowhere to go as the P/E even after the 1987 crash was ~50% higher than the preceeding 15 year average. At the and of 1987, 10 30 year US Treasuries were yielding around 9%, another argument why stocks didn’t look that “apetizing” at that point in time. Why bother with stocks if you can earn double digits with corporate bonds any time ?
What followed
Looking back, it is easy to point out some of the events which led to this remarkable run especially for the DAX over the last 26 years:
– Communism broke down (“Peace dividend”)
– the Eurozone was created, stimulating cross border trading, increasing competition
– technology change (PC, Internet, Mobile)
– Corporate taxes in Germany went down form >50% to ~30%
– interest rates declined for now 25 years in a row
– old crossholding structure (“Deutschland AG”) dissolved, more professional management, foreign investors
– the BRIC story unfolded, further possibilities to export “core competency” goods like machinery and cars
In 1987/1988, few market pundits did even predict a single one of those factors. That’s why I think that just looking into the rearview (valuation) mirror should not be the only tool in the investing toolbox. Past P/Es will not predict future seismic shifts. On the other hand, one should not rely on such evcents happening over and over again and boosting share prices further. Clearly, interest rates and taxes will not fall that much lower and the effect of the end of Communism will not repeat itself.
For me the major conclusion is the following: Do not rely on any one system which tries to predict the future and/or future returns. Keep an open eye on everything, from valuations to macro economic factors and political shifts. Be prepared for surprises. Inthe long term, many surprises turned out to be positive for the economy and stock return.
Some musings on the Dax constituents
Just for fun, I created a table with the long term performance of the 15 “surviving” Dax constituents. Unfortunately I only got performance numbers back to 1992, but the p.a. Performance of the DAX was quite similar. lets look at those 15:
1987
Still in DAX
Comment
LT Perf (08/1992)
p.a.
DAX
545,14%
8,95%
Allianz *
1
177,55%
4,80%
BASF *
1
3650,23%
18,12%
Bayer *
1
1598,15%
13,90%
BMW *
1
1723,82%
14,28%
Commerzbank *
1
-70,14%
-5,40%
Continental
1
1962,28%
14,92%
Daimler-Benz (*)
1
90,50%
4,22%
Deutsche Bank *
1
89,57%
2,98%
Deutsche Lufthansa *
1
615,84%
9,47%
Henkel *
1
1200,08%
12,51%
Linde *
1
699,66%
10,03%
RWE *
1
308,71%
6,68%
Siemens *
1
742,92%
10,29%
Thyssen (*)
1
89,98%
4,32%
Volkswagen *
1
1690,10%
14,18%
Not surprisingly, financial stocks do not look good here. Overall, companies which are considered “well managed” did quite well such as Henkel, Bayer, BMW, Linde. Surprising for me is the fact that Lufthansa actually outperformed the DAX as well as Siemens.
Now let’s take a quick look at the new stocks. If I didn’t have returns from 1992, I made a comment:
Total
p.a.
Perf. Since
Adidas
1
896,84%
13,23%
1995
Beiersdorf
1
1658,99%
14,09%
Deutsche Börse
1
335,79%
11,74%
2001
Deutsche Post
1
103,80%
5,41%
2000
Deutsche Telekom
1
62,22%
2,80%
1996
EON
1
485,63%
8,46%
Fresenius
1
4651,42%
19,42%
Fresenius Medical Care
1
174,05%
5,90%
1996
HeidelCement
1
242,80%
5,83%
Infineon
1
-80,66%
-10,95%
2000
K&S
1
3084,30%
17,24%
Lanxess
1
302,98%
16,11%
Merck
1
555,53%
10,64%
1995
Munich Re
1
300,42%
7,24%
1994
SAP
1
3502,32%
19,98%
Not surprisingly, the best “newcomers” also lead the total Dax performance. Smaller companies which grow big are always the best investments, although it is often hard to identify them before.
Finally one other table. Let’s look at some of the best performers and their historical P/Es:
FRE
SAP
HEN3
BEI
BAS
31.12.1992
28,6
24,4
19,6
18,9
11,4
31.12.1993
35,2
25,8
25,7
22,8
28,0
30.12.1994
19,4
36,7
15,0
20,6
14,6
29.12.1995
33,0
55,2
18,4
18,9
7,8
31.12.1996
64,4
52,1
25,9
28,7
14,4
30.12.1997
49,2
61,1
29,5
46,8
12,0
30.12.1998
30,8
71,5
32,8
30,4
11,8
30.12.1999
27,1
83,7
26,2
32,5
25,3
29.12.2000
37,7
60,0
21,7
41,9
23,6
28.12.2001
183,3
78,5
18,3
38,1
20,7
30.12.2002
10,8
46,3
20,0
31,3
13,9
30.12.2003
23,0
38,1
17,1
27,3
27,5
30.12.2004
18,2
30,9
5,3
21,9
14,5
30.12.2005
20,1
31,5
16,2
23,7
11,3
29.12.2006
23,5
26,2
18,9
16,7
11,6
28.12.2007
21,5
22,3
18,1
27,2
12,1
30.12.2008
21,2
15,5
54,7
16,8
8,9
30.12.2009
14,2
22,3
26,4
27,8
28,2
30.12.2010
16,3
24,9
18,1
29,7
12,0
30.12.2011
16,9
14,0
16,7
39,8
8,0
28.12.2012
16,3
25,8
18,3
31,6
13,6
30.12.2013
19,7
22,3
23,1
31,3
14,7
We can easily see that quality and growth NEVER is cheap. I am not sure if that Henkel 2004 P/E of 5 is incorrect data, but the solid “quality stocks” always traded “richly” and nevertheless delivered outstanding long term performance. Only BASF, as a “quality cyclical” company has been available at single digit P/Es at some years.
So after all, this is wat Warren B. likes to tell us: In the long term, quality does seem to beat anything else, especially if you factor in taxes, trading costs etc.
Summary:
So what does this all tell us ? I am afraid that I cannot come up with some “Magic Formula” to identify future winners. Nevertheless, I think the look back emphasizes three of Warren Buffet’s main points:
1) over the long term, stocks have been a unbeatable compounding machine. A return 10 times the original inevstment in 26 years despite several devasting crashes speaks for itself
2) over such a long time horizon, it seems that “quality buy and hold” seems to be at an advantage at least for large caps. Yes, introducing a backtested system (market timing, EV/anything) could generate fantastic returns as well, but just buying and holding well managed companies did produce spectacular returns
3) Just buying the index and sitting on one’s ass would have beaten almost all active strategies. To be fair although, the first DAX index funds were available mid/end 90ties…..
P.S.: To finish the story: What happend to my first stock, Hoesch AG ? Hoesch was taken over by steel company Krupp which itself merged with Thyssen. If I would held it all the time, it would have been a pretty weak investment……
Via my “home forum”, someone brought up the Latvian Pharma company Grindeks AS. The company looks similar form the business model to Hungarian company EGIS and Croatian Krka which I covered some months ago
Valuation wise, the stock looks like a clear “no brainer”:
ROIC, ROE, net margins all solid “double digit” numbers. My own, mechanical “Boss Score” would indictae a fair value of at least 3 times the current market cap.
The only issue coming up is the fact that the company never paid a dividend.
There is also a quite obvious reason why the stock is cheap: The majority of sales goes to neighbouring Russia, which clearly is not very popular with investors these days. As I do not have an issue with this “Headline risk” as long as I get compensated accordingly, I looked into the annual report 2013 in order to find out more.
As with Australian Vintage, I scan the report for unusual or problematic things first.
In Grindeks case, I was puzzled by a quite unusual balance sheet position called “Advance payments for financial investments “ something which I haven’t seen before. The explanation in the notes says the following:
In 2012 the Company has signed purchase agreement with Dashdirect Limited regarding purchase of the controlling interest in the equity of HBM Pharma (Slovakia). As of the date of signing these financial statements the agreement is partly completed. The main activity of the HBM Pharma is production of the medical substances. As of December 31, 2013 the Company’s and Group statement of financial position contains advance payments related to the before mentioned purchase agreement in the amount of EUR 11,670,000. The Group management is certain that this deal is going to be finalized during 2014.
In my experience, it is not uncommon to take over M&A targets in several steps, but it is quite uncommon to pay money first and get nothing in return. A few days ago, Grindeks issued another news item which covered this strange transaction.
The numbers look OK, Grineks seem to pay only 6 times P/E of the target company. However another sentence looked strange:
Orders of JSC «Grindeks» make up about 30% of the total “HBM Pharma” s.r.o. turnover
So they are buying a company where they are the biggest customer anyway, also strange. So I decided to google a little bit and found this:
On July 8, 2010 Lithuanian-domiciled Central and Eastern European (CEE) specialty pharmaceutical company Sanitas, AB sold its 100% shareholding in subsidiary HBM Pharma s.r.o in Slovakia to Latvian company Liplats 2000, SIA. HBM Pharma was primarily engaged in toll manufacturing activities and the entity has been sold with all of its existing toll manufacturing contracts. As previously announced, sales, marketing and regulatory divisions in Slovakia and the Czech Republic were separated from HBM Pharma and retained in Sanitas Group prior to the divestment.
Sanitas acquired HBM Pharma (previously named Hoechst Biotika) from Sanofi Aventis in July 2005.
So a Latvian company called Liplats 2000 bought HBM in 2010. Googling further, I found this document on HBM’s website, describing a cross border merger between Liplats 2000 and HBM. The most interesting part of this document ist the last line in the final page: From Liplats side, a guy called Kirovs Lipman signed.
Now Kirovs Lipmans happens to be the majority shareholder of Grindeks. So effectively, Grindeks is buying this M&A target from theit majority shareholder (and former CEO). This is from Grindeks annual report:
Kirovs Lipmans – Chairman of the Council Born in 1940. Kirovs Lipmans has been the Chairman of the Council of “Grindeks” since 2003. Simultaneously K.Lipmans is also the President of the Latvian Hockey Fede
ration, the Member of the Executive Committee of the Latvian Olympic Committee, the Chairman of the Board of “Liplats 2000” Ltd. and JSC “Grindeks” Foundation „For the Support of Science and Education”, the Chairman of the Council of JSC “Kalceks” and JSC “Tallinn pharmaceutical plant”, also the Member of the Council of JSC “Liepajas Metalurgs”. Graduated from the Leningrad Institute of Railway and Transport
So to summarize it at this point: Grindeks never paid any dividends but makes a major acquisition and pays money upfront to a company controlled by the majority shareholder, without any disclosure of this potential conflict of interest.
Of course, theoretically, this could have been an “arm’s length” deal with no disadvantages for Grindeks, but the probability that something is “fishy” is quite high, combined with the fact that they never paid dividends.
Maybe I am too cautious here, but an undisclosed significant “related party” transaction is a big red flag for me.
Just to be clear: A “red flag” doesn’t need to be the ultimate “value driver”. Reply SpA is a good example. Since my “red flag” alert, the stock made a whopping 276% return.
Summary:
For me, Grindeks is, depsite the attractive valuation, an absolute no -go. Undisclosed related party transactions combined with a lack of dividend makes this a speculation rather than a value investment. I don’t know if there are Corporate activists in the baltics, but this would be a good target. Additionally, they seem to have some specific operating issues as well, so no buy, watch only.
May was a strong month for the Benchmark (Eurostoxx50 (Perf.Ind) (25%), Eurostoxx small 200 (25%), DAX (30%), MDAX (20%)) with a gain of 3,2%. The Portfolio made 0,8%, an underperformance of -2.4% in May. YTD, the portfolio is up 9,2% against 5,3% for the benchmark. Interestingly, the portfolio was up every single month this year whereas the benchmark only was positive in February and May.
Best performer in May were the 2 Russian stocks (Sberbank +21,2%, Sistem +20,4%), Koc Holding (+8,6%) and Cranswick (+5,6%), loosers were Portugal Telecom (-12% without dividend), IGE & XAO (-5,4%) and TGS Nopec (-5%).
Portfolio transactions May
Major transactions in May were:
– Sale of second half of the Sias Position at 8,75 EUR (and missing the 5% rally in the last 2 days…..)
– Purchase of TRY 2020 Depfa Zerobond
– Increase of LT2 Depfa 2015
Cash is now at ~10% plus the 5% in the LT2 Depfa 2015 which I consider “cash equivalent”. The portfolio as of May 31st can be seen as always under the “Current Portfolio” page.
Comment: “Leave the driver in the bag”
Anyone who plays golf (yes, I play as well but badly….) likes to swing with the biggest club, the driver. If you hit the ball right, you hear a satisfying sound like “Ziiiinggg” and the ball goes really far. The problem ist the following: For most golfers it is quite difficult to control the direction. On the other hand, especially for players with high (bad..) Handicaps, you need the distance in order to have a fair chance for a good score.
More often than not, especially if you play on older golf courses, you are faced with a similar view from the tee-off:
Trees to the left, trees to the right and only a very narrow fairway and you cannot see the flag. If you hit the ball into the trees, you might not be able to find it and you get a penalty, destroying your chances on a decent score. Or you find the ball, but you need several strokes to get out of the trees again.
The much more reasonable strategy for an average golf player is to use a shorter club where the distance is much shorter but you have better control on the direction. Yes, if you hit the driver straight, you will be much better off than with the iron, but ane iron gives you a much higher probability to stay on the fairway. For professional players, this is a quite common problem. Especially if you play tournaments over 4 days where every stroke counts, one bad hole (out of 72) can kill the whole tournament. So professional golf players have to be pretty good in probablilities. They have to assess constantly what club gives them the overalll probability to get the best total score from any situation.
So why do I tell this “golf stories” ? The answer is easy, an investor is facing the almost same problems than a professional golf players. You can make really risky investments, like for instance a concentrated position in an expensive growth stock which would be the stock equivalent of a driver. Or a super cheap “deep value stock” with management problems and a high debtload. Great upside potential but also big risk the end up in the “trees”. As in golf, the investment environment plays a big role in deciding what amount of risk to take. When markets are cheap in general, then taking risk makes more sense as you are facing a nice and wide fairway.
If valuations are high and a lot of strange things are going on, you might want to leave your driver in the bag and use the investment equivalents of short woods or irons, like smaller positions and more defensive stocks.
The current market environment, especially in the “developed” markets with low yields to me looks very similar to the narrow fairway from above. Relatively high valuations, experiments from central bankers etc etc. in my opinion is faced best with a more “controlled” game, like smaller position more diversification, a prudent cash position and uncorrelated risks. Otherwise the risk of permanent loss of capital and missing the “Cut” is real.
What we actually see in the markets is currently the opposite. Especially pension funds, insurance companies and sovereign wealth funds are “taking out the big clubs” by increasing the risk of their portfolios to compensate for low yields. Suddenly real estate, private equity, high yield corporate bonds and illiquid infrastructure loans are considered perfect investments for conservative pension funds and life insurance companies. Those investors are betting fully on being able to “Control the driver” whereas in reality they might not even had a practice swing before. In my opinion there is a high risk that many or most of those investors will find themselves “in the trees” at some point in the future and cursing themselves for not being prudent before.
So my advice for anyone would be: Now is not the time to “swing for the fences”. Try to stay in the middle of the investment fairway with controlled (and known) risk taking. Don’t take badly priced illiquidity risk and/or credit risk. Don’t buy badly managed companies or troubled business models with concentrated position. On the other hand, don’t stop “the game” completely but play patiently and wait for the “wide fairways” i.e. low valuation environments in order to bring out the driver again.
A very persistent commentator asked me about my opinion on Australian Vintage, an Australian Wine producer. In between, Nate from Oddball covered the stock and seemed to like it as an asset play .
Optically, the company looks dirt cheap (Bloomberg):
P/E 7
P/B 0,3
P/S 0,3
Dividend yield 10,5%
When I look at such “cheap” companies, I start reading the only annual report and concentrate only on problems. I tend to avoid company presentations as they usually only show the positive stuff. A 30 minutes “speed” read of the 2013 annual report shows already some issues:
– goodwill, brand values and DTAs make up ~100 mn AUD of the book value plus another 50 mn AUD or so for biological assets and water rights
– the 2013 profit includes a significant “one-off” reserve release. without that, 2013 profit would have been some 40% lower or the P/E well into “double digits”
– the company carries significant debt and lease obligations, overall around 240 mn AUD in the 2013 annual report
– the directors salary is at ~ 3 mn AUD a significant portion of the profit
– on the other hand, directors own only insignificant amounts of shares (AUD amount of shares ~20% of total annual salary)
– operating cashflow has been negative in 2013, so the dividend has not been “earned”
– Depreciation is around 7 mn AUD per year, investments only 4-5 mn in 2012, 2013. This looks like “underinvestment”.
– most “hard” assets (inventory, property etc.) are pledged for the loans
– all subsidiaries are explicitly guaranteed by the Holdco, so all loans are fully recourse against any asset
– bank loan covenants exist, but are not clearly reported:
The Group is also subject to bank covenants with its primary financier as follows:
– Equity must be above $210 million.
– Gross profit and earnings before interest and tax must exceed pre-defined levels
– the bank loan facilites mature in 2015 and will have to be renegotiated
– there are “related party dealings” with companies of the CEO (purchase of grapes etc.)
In October / November 2013, they did a massive capital increase (42 mn AUD) in order to pay back debt. Some might argue this is a good thing, but paying large dividends and in parallel doing large capital increases is a very bad sign and very bad capital management (among others, they had to pay around 5% fees on the raised capital).
One observation with regard to the capital increase proespectus: On page 35 they show that the capital increase will increase earnings per share due to lower interest rate expenses. However they use a pretty obvious “trick” here: they use an “average amount” of outstanding shares, not the relevant final amount of shares. With the full amount of shares (232 mn) instead of the “average”, the capital increase would of course be “dilutive”.
The first 6 months of fiscal 2014 looked better on the bottom line, but again includes a big reserve release. Operationally, the first 6 months of 2014 were a lot worse than the year before, especially the US turned from an operating profit to a loss.
Some additional thoughts:
– As an Australian asset play, the Australian Dollar plays a big role. As a non Australian investor, I might have a operational upside if the AUD goes lower, but asset value as a EUR investor will be lower as well
– the UK supermarkets who are the major non Australian clients, are under a lot of preassure themselves. They will squeeze their suppliers as hard as they can and will demand lower prices if the AUD becomes weaker
– return on assets is very low. If the 10 Year treasuries yield 3.7% and Return on assets is far below that than the value of the assets ist most likely overstated by a large margin
– moving “upscale” is not easy. This needs even more capital (oak barrels, longer ageing = higher inventory etc.) and time.
– from the main brand “McGuigan”, you can buy in Germany only the Shiraz which is currently on sale (4,95 EUR vs. 5,99 EUR) and a “Sparkling Shiraz” at 12,95 EUR. To upgrade from that level will be hard…..
– finally, the Australian wine industry seems to be one of the clearest victims of climate change. Water will become much more expensive and many grapes might not grow so well in the future. This could for instance seveely reduce the value both, of the land and teh biological assets. This study for instance shows that Australie is hit hardest globally. If this will realize, everything, land, machinery and “Biological assets” would loose most of their value.
Overall I think the main issue is that the interests of the Management and shareholders are not really aligned in this case. Especially the CEO, whose max target bonus has by the way doubled for next year, seems to be far more interested in his salary than the shares and it looks like that the majority of his own investments seem to be outside the listed companies. Combined with the relatively risky financial profile, this is clearly a “deep value” case with a significant risk especially close to the 2015 maturity of the loans.
Opposite to Nate, I can see a lot of things that could go wrong here and either trigger another massive capital increase or even a bankruptcy. As I do not know a lot about the Australian Wine industry either, I think I would pass on this investment as it is extremely difficult for me to handicap the probabilities and would therefore be a quite “risky turn around gamble”. As I don’t have any experience with Australian liquidation rules, I would also be really careful to expect meaningful recovery rates for shareholders in case of a bankruptcy / restructuring. If for instance the loans would get into the hand of aggressive “vultures” like Oaktree, I would bet that stated book values would not be worth a lot.
However for “deep value” specialists, this could be interesting if they are able to estimate the “survival probability” to a certain extent.
A side note: “Moving up the value chain” in wine usually means oak barrels. So despite the much higher valuation, I still think that Tonnelerie Francois Freres is the better (and safer) long term investment in the wine industry.
value and opportunity 