Category Archives: Bilanzanalyse

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

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

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

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

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

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

1. Significant growth potential in UK and Netherlands

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

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

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

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

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

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

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

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

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

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

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

Netherlands:

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

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

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

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

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

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

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

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

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

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

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

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

Valuation exercise

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

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

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

The following table translates this into a simple IRR calculation:

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

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

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

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

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

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

Summary:

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

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

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

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

Svenska Handelsbanken vs. Deutsche Bank – what to look for when investing in banks

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Many value investors are of the opinion that banks are not investable. Either because they say the business is too complex or because they think banks are doomed anyway. Maybe due to the overall low valuations of banks, I get regularly requests on writing about how to value bank,s so at least some people seem to be interested. The greatest value investor of all obviously has no problems with investing into banks. Wells Fargo is the biggest position of Buffett at around 26 bn USD and he holds various other bank assets like the Bank of America Warrants.

A few days ago, a good friend recommended me to look at Handelsbanken from Sweden as an example how a well run bank should look like.
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When dividends matter (Hint: Mostly not at all)

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Today I read an article in one of the major German Newspapers, Frankfurter Allgemeine, about the merits of investing in stocks.

I know that the year is still young, but this article (in German) might be easily the worst article of the year on stock investing.

They offer 3 “compelling” reasons why stocks are attractive:

– dividends are increasing
– stocks are still below all time high if you look at a pure price index (the old FAZ index)
– the dividend yield according to them is 2,9% and higher than 10 year Bunds (0,5%) or BBB bonds (1,5%)

They even recommend to buy stocks just before the dividend payment to collect the dividend and then sell. They finally show a calendar with all dividend dates of the major German stocks in order for the readers to be prepared.


Technicalities:

For some reason, the author doesn’t seem to know the existence of an “Ex-dividend” adjustment for stocks. I guess this guy also buys bonds the day before they pay the coupon or so. Including taxes and execution costs, I am pretty sure this kind of “dividend hopping” has negative expected value.

Anchoring bias

Secondly, it is interesting that you see such a nice example of an “anchoring bias” in a major newspaper. For investing in stocks it doesn’t matter if the stocks trade at an all time high or all time low. All that matters is if stocks are valued adequately in relation to their intrinsic value which in turn is determined by future profits and cash flows. With a “strategy” like that one mentioned, you will miss most bull markets and happily buy into bear markets. Congratulations !!!

Where is the problem with dividend yields ?

Well, before I further insult the writer of this article, the problem is that many people seem starting to think that somehow dividends are like “coupons”. This is clearly the side effect of the current low-interest rate environment.

There are also many statistics which point out that over a very long period of time, dividends have been a significant part of stock market returns.

However just buying stocks with high dividend yields is actually a loosing strategy as Dreman, O’Shaugnessey and others have shown. For me, the problem is two fold:

1. High current dividend yield stocks are often value traps

When companies get in fundamental trouble, they often try to preserve their “sacred” dividend until the bitter end. For some reason, canceling a dividend is been seen as the ultimate ratio before the real troubles begin. So it is quite common, especially in capital-intensive industries that struggling companies keep up their dividend despite an eroding business, as it could be seen with E.on, RWE or the banks. Sometimes you even see companies paying dividends and issuing dilutive shares at the same time just to keep up the illusion of a constant, “coupon like” dividend like Santander just recently.

Those long term returns mentioned above are actually much more the result of high growth, low dividend yield stocks which over a long-term grow so much that after 20 years or more, the dividend in relation to the original purchase price is then huge.

Especially these days, dividend yield is a very imperfect measure for shareholder returns anyway. Including share buy backs and looking at total shareholder return is the much superior strategy as for instance Mebane Faber has shown in his book.

2. Psychology: Yield hogs get slaughtered

A “yield hog” is someone who only looks at coupons or yields and not on total returns. If you buy a bond and the issuer does not go bankrupt, you get the coupon and the principal back. If you buy a stock, you might get your dividends (or not), but you never get your principal back. In contrast to a bond, you have to sell the stock to someone else in order to get your principal back. However there is clearly no guarantee that you will your principal back as “mr. market” might disagree on the value he wants to give you.

Psychologically, “Yield hogs” often cannot stand draw downs on the stock price and then get “slaughtered” when the panic sell in a bear market (often after doubling up on the way down). In some areas like insurance or pension funds, where you need to show a current yield, this “yield hog mentality” is basically baked into the business model and can be observed cycle by cycle.

So when do dividends add or indicate value ?

In my opinion, the only case where dividend yields are important if you invest in “deep value” cheap non-growing companies with a lot of cash flow and questionable capital allocation skills or dangerous environments. In such cases, having a paybacks via high dividends lowers the “risk duration” of an investment significantly.

In my portfolio for instance, Installux, Romgaz and Electrica are such candidates where I would not invest if they would just accumulate earnings. but be careful: i ti snot the dividend which makes them good investment but the undervalued nature of the stock. Admiral for instance, a company I really admire, would do much better fo its shareholders if they would buy back stock instead of paying 6-7% dividends. The long term compounded return would be much better without the tax on the dividend income.

As always, Warren Buffett has summarized it nicely several times why dividends are actually stupid for good companies.

Quick summary:

Investing in stocks because of the dividend yield is an extremely stupid way to invest. Either you will end up holding a lot of value traps and/or you will lose your nerves in the inevitable downturns.

Dividends should only been considered in context with the underlying business model and in combination with the capital allocation (reinvestment, share buy backs, debt levels), but never ever as a stand-alone investment criteria.

Dividends ARE NOT COUPONS and stocks are not “yield replacements” for bonds !!

FBD Holdings (ISIN IE0003290289) – A local Irish Insurance champion for sale ?

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Again this turned out to be a quite long post as I am digging a little bit deeper into the balance sheet. Therefore a quick summary:

Although FBD Holdings, the Irish P&C company looks interesting, I will not invest. The company has a very impressive track record, but in my opinion the business model is not scalable as it doesn’t have any structural competitive advantages besides a loyal client base. Additionally, the company severely screwed up their asset allocation and will be faced with ultra low investment returns going forward unless they are increasing their investment risk significantly.

At current stock prices, the company is in my opinion pretty well priced, with only a relatively small upside in a good case and equally large downside in a more negative case.

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Short Cuts: Flughafen Wien, Alstom, Trilogiq, Sberbank

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Flughafen Wien

A quick update on my “Christmas-special situation” investment Flughafen Wien:

82,2% of the tendered shares have been accepted at the offer price of 82 EUR. With the current share price of ~ 77,5 EUR, the overall return results (pre costs and taxes) are :

(0,822*(82-79,25) + 0,178*(77,50-79,25))/79,25= +2,46% For the portfolio I assume that I would be able to close the position (sell the rest) at 77,50 EUR. Privately my broker DAB was not yet able to “release” the tendered shares.

Alstom

Back in August this year, I looked at Alstom as a potential “sum of parts” play following the GE deal announcement. One open point was the issue of pending corruption charges. I had written the following:

A second big issue is that at the moment no one knows exactly how much of the liabilities will get transferred to GE. Especially with regard to operating leases (nominal ~830 mn EUR), litigation liabilities (528 mn EUR) and pension liabilites (gross 5,2 bn) there is no definitive answer how much will be transferred to GE and what remains at Alstom. In a sum of part calculation, any of those remaining liabilities will have to be deducted from the extra assets as they are economically equivalent to debt.

I had some discussion and the consensus was that litigation liabilities would be transferred to GE, although I was sceptical. It turned out that I was right in this case. Alstom pleaded guilty and agreed to pay 772 mn USD fine. For the valuation, the most important sentence is this one:

In June, Alstom agreed to sell most of its energy business to General Electric. The French company said it would not be able to transfer its fine over bribery allegations to G.E.

Due to the strong dollar, in EUR the fine is actually 100 mn USD higher han the reserves. Overall, for anyone assuming GE taking over those liabilities, this reduced the value of Alstom by 2 EUR per share.. It will be interesting to see how the transport business is actually doing once Alstom publishes annual results. So far, I do not see any reason to buy the stock from a fundamental point of view.

Trilogiq

A few days before Christmas, Trilogiq reported 6m figures (30.09.2014). For some reason, the report is not on Trilogiq’s homepage, so one has to look at secondary sources like this one. Sales were slightly lower, gross margins more or less equal to last year. Net income was significantly lower but still positive.

They attribute the lower result to special marketing expenses and new hires:

la hausse de 13% des autres achats et charges externes, notamment du fait de la multiplication des actions marketing destinées à faire connaitre la nouvelle gamme GRAPHiT à travers le monde, l’augmentation de 12% des charges de personnel qui ont été grevées par d’importantes indemnités de départ et par de nouveaux recrutements

Cash is till around 22 mn EUR or 6 EUR per share. If Trilogiq manages to return at leat to 2/3 of the old profitability, (earnings were between 1,45 EUR per share and 1,75 EUR from 2008 to 2013), the stock would be priced at 6-8 times earnings. It remains to be seen if the temporary effects are in fact temporary. A friend forwarded me this equity research piece on Trilogiq where they expect 1 EUR EPS in 2016/2017 which to me looks quite conservative. Nevertheless, I think the further fundemental downside for Trilogiq at the current stock price is rather limited.

Sberbank

Over the holidays, I decided that I will exit my Sberbank position still within the old year at today’s prices. In the private account this also leads to “tax loss harvesting”. For the portfolio it became clear to me that my investment decision now has been invalidated 2 times. First, I estimated that the Ukraine conflict would be over quickly which was clearly wrong. Secondly, I did not account for the drop in oil prices and the ruble. I have honestly no idea how exposed Sberbank is directly or indirectly to oil and the ruble, but the prudent decision is to sell now and look at the stock (and the Russian market) again next year.

It might look very pro-cyclical selling near the low, on the other hand, if an investment case has deteriorated as much as in this case one should better exit before “behavioural biasis” such as “breaking even” etc. kick in.

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.

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”.

EVS Broadcast Equipment (BE0003820371) – A super profitable market leader at a bargain price ?

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The company:

EVS Broadcast Equipment SA is a Belgian company developing and selling state-o-the art equipment mostly to broadcasters and TV production companies, enabling them to store, edit and broadcast live camera images on a fully digitalised basis. They are especially strong in the area of live sporting events.

Growth and profitability

Looking at the current valuation multiples:

P/E (2013) 13,0
EV/EBIT 14,0
P/B 5,2
Dividend yield 7,0%

we can see that EVS is not super cheap. However if we look at past profitability and growth numbers numbers, we can see that EVS is still “super profitable” at levels which only can be explained by significant competitive advantages:

5 y avg 10 y avg
Profit Margin 30,8% 36,5%
ROE 55,2% 63,5%
Sales growth 3,30% 12,70%
EPS growth -5,40% 22,30%

However, if one looks at the growth figures we can clearly see that the “High growth” phase seems to be clearly over, but they are still incredibly profitable.

Why are they so profitable?

This is a quote from the 1999 annual report (which is by the way a very good report):

The EVS Group sells its equipment to radio and television channels as well as to people providing services to these channels. This is a professional market where quality and technical performance of the equipment is often more important than its price.

Plus another quote from the 2002 annual report:

Investments

Production of the equipment manufatured and marketed by ECS and NETIA does not require important tangible investment. Nor does R&D require any considerable investments, since engineers and programmers work directly on the machines to be sold or on PC type equipment for the sftware developement.”

So building “mission critical” equiment with low price sensitivity combined with low to no physical capital needs sounds like a pretty good business case. But how do you get into such a desirable position ?

Again, the best explanation is given in the 1999 annual report:

In 1994, most recorders used by television channels were tape recorders, although hard disks already had replaced tapes for recording purposes in the
computer area. Three factors have since then influenced the use of hard disks rather than tapes for professional video recording :
• the increased capacity and higher performance of hard disks,
• their lower cost,
• considerable progress has also been made in compression : for example, the JPEG system allows an average compression ratio as low as 5:1 in the memory space required to record a picture.

EVS strategy on the huge professional recorder market has been to pinpoint those applications for which hard disks would offer the user a substantial competitive advantage over tapes. By the end of 1996, the number of professional recorders installed throughout the world was estimated at about 352 000 units, for 60 000 users.
Among these, tape recorders accounted for about 340 000 units, compared to 12 000 disk recorders.

So what EVS did in the mid/late 90ties was a classical “disruption”: At that time, most broadcasts were recorded on physical tapes which had a lot of disadvantages. In sports for instance if you wanted to show a replay, the recording had to be stopped, rewinded and replayed. In between, no recording could be done,so often the consequent action on the field was unrecorded. EVS as one of the first companies offered a digital solution, which allowed continuous recording and easy access to slow motion etc.

The second boost came in the mid 2000s with the introduction of full HD and HDTV which sped up the change from tape to digital and required new generation of servers.

EVS became the defacto industry standard for most of the digitalised live TV production around the world, especially for sports. Somewhere I read that they claim a 95% market share in certain areas. With all the money pouring into professional sports these days, it still looks like a pretty good place to be a “niche market leader”.

Will EVS stay so profitable ?

This is a much harder question to answer compared to “why are they so profitable”. The question boils down to: Are the obvious competitive advantages sustainable ?

According to theory, two potential competitive advantages could e relevant for EVS: Size advantages and the network effect.

Network effect:

As far as I know, EVS did use mostly open source and industry standards, so in theory it should be relatively easy to replace EVS’s equipment. It seems however that the software implies a certain way to do things that doesn’t make it that easy to simply copy the stuff. EVS equipment seems to define work processes and many people in the field might prefer a known, working process to a new one even if its cheaper. The technicians are trained on the gear and might prefer this to any other gear. Nevertheless I would argue that there is no strong network effect at work here but maybe a “soft” one.

Size advantage

Although EVS is still a relatively small company, within its niche, it is huge. They had a big headstart into the current technology and have built up significant technical knowledge which is not easy to copy. Any small competitor who wants to compete with based on the same technology will have a big issue. Even if they would be able produce slightly better gear, they would still need to build up a sales and service organizition and spend a lot of money on getting access to all those potential clients. This would be different if a competitor would be coming into the market “vertically”, for instance guys like Sony who produce the cameras etc. but for some reason that didn’t happened. Maybe the niche overall is too small to justify a big investment by a “vertical” competitor.

For me, the biggest issue might be that once again the technology will change and allow another disruptor into the business. A small hint could be seen in a interesting research report from media technolgy research company Devoncroft (report is free but registration required).

For EVS, one of the most “dangerous” developments could be what is described on page 36: The move from specialised IT gear for real time processing to “generic” gear. EVS delivers “spezialised” gear and software. This is how a typical EVS “box” looks like:

I am not sure how solid their business would be if the “Boxes” were seperated from the software and this would clearly open the door for disruptors.

Limits to Armchair Investing

At this stage, there are clearly limits to Armchair Investing. With the time available for me, it is impossible to judge for me if EVS will be able to keep its high margins or not. If margins “normalize”, then the current price for the stock might be still high. If margins remain high and the market still grows then the stock would be a “high quality” bargain. However I do not feel comofrtable to make any judgement here.

Some other observations

– Founders sold down early, only one remaining (CTO)
In 1999, the three founders and their families owned around 57% of the company. Since then, 2 of the three left and the remaining one has reduced his ownership to ~6%. It seems that they were not fully convinced about the long term prospects of EVS.

– they are currently building crazy expensive heaquarters in Belgium.

Overall cost is expected to be around 60 mn EUR. This is from the 6 month report:

At the end of 2011, EVS started the construction of a new integrated building in the proximity of its current location in Liège, in order to gather all employees of EVS headquarters, split today in 6 different buildings. EUR 39.4 million have been invested by the end of June 2014 (less EUR 5.2 million of subsidies booked at the same date). The total budget for the project (including some higher investments in future-proof equipment) is estimated between EUR 55 and EUR 60 million.

EVS has in total 500 employees, with at least 1/3 outside Belgium. So spending ~200k EUR per employee for a new headquarter is absolutely insane in my opinion.

– current CEO is a “manager”, no ownership

The current CEO came from outside and has no stock ownership. He does have stock options and I have not seen a single share purchase of management ever.

– potential “diworsification”

The new strategy is to diversify “verticaly” into post production technology as the core sports area seems to be somehow saturated. EVS tried to diversify early on, but both attempts failed (digital radio, digital cinema). Maybe vertical diversification works better but if the high margins can be retained ?

– weak first half of 2014 indicates increasing pressure on margins

Normally, EVS always performs strongest in years with large sports events. 2014 with the Winter olympics in Sochi and the Football Worldcup in Brazil should have beenn a great year for them. However, despite rising sales, profit went actually down compared to the “non event year” 2013. 2015 with no events willbe even harder for them. So the trend clearly is negative at the

The stock price also shows that the market does not look that favourable at EVS’s prospects following the 6 month numbers:

Summary:

EVS is an interesting company. As a clear niche market leader with fantastic historic profitability , it could be a great investment especially if the diversification strategy would work. On the other hand, there are several qualitative factors which i found distrubing, especially with rgeard to the new HQ and the lack of “ownership” within management and employees. On top of this, 2015 will be a tough year for them anyway so it might be the wrong time to invest in any case. So for me it is just a stock for the watch list with the next review in Q3 2015.

AGEAS (ISIN BE0974264930) – Potential litigation play ?

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The company:

Ageas is a Belgium based insurance company and formerly known as “Fortis”, one of the biggest Eurpoean casualties of the financial crisis. Fortis, together with RBS and Santander tried to take over ABN Amro but especially Fortis then failed spectacularily and was saved by the Belgian Government and finally sliced and diced into Insurance and Banking, of which the banking part was sold to BNP Paribas.

Ageas itself is an interesting case, similar to NN Group, it is a strange collection of Belgium, UK, and Asian insurance companies plus some weird stuff at corporate level, resulting from the quite ugly split of a combined group into two separate businesses. However, a lot of the ugly stuff has already been cleared over the last few years and Ageas was looking like an almost “Normal” insurance company

The litigation

A few weeks ago, a Dutch court decided that Ageas is liable for misinforming Fortis shareholders in 2008:

The Amsterdam Appeals Court ruled that Fortis is liable for misleading investors by saying the firm was “financially stronger than ever” after a government bailout on Sept. 28, 2008, only to be replaced by a break-up plan five days later.

and further down:

Ageas should be able to meet a worst-case liability of 2.5 billion euros before taxes possibly stemming from the ruling, Matthias De Wit, a Brussels-based analyst at KBC, said in a note today. Still, potential indirect effects shouldn’t be ignored, he said.

Looking at the stockprice, we can estimate that the stock lost ~ 5 EUR per share:

With about 230 mn shares outstanding, the market seems to have implied ~ 1,1 bn EUR loss after tax. Ageas itself has provisioned around 130 mn EUR against this case.

Is this interesting ?

At the moment, it is hard to say. Ageas trades at ~0,62 times book value, which is relatively cheap. They are very active in repurchasing shares (sharecount decreased by -115 since 2011). I do like the insurance sector at the moment because its cheap and the problems (low interest rates etc.) are well known.

Insurance companies do have traditionally very good lawyers on their payroll and litigation is part of their business, so one can assume that they handle this very professionally. On the other hand, other than the CIR Spa case, there is no direct catalyst as the law suit can linger on quite some time.

Valuation wise, Ageas look similar to NN Group, actually, I could easily see those two Groups merging at some point in the future. My guess is that someone is maybe already working on the idea to form a strong Benelux players out of the available mid size companies (Delta lloyd, NN Group, Ageas, SNS).

Nevertheless, I do not think that AGEAS is a “Litigation play” at the moment, as I don’t have a good idea on the time line of the law suit. However it it looks like a pretty cheap insruance company with some upside potential, so I will keep it on my watchlist.

MIFA Bond (ISIN DE000A1X25B5) – Distressed debt & Restructuring “German Style”

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I had covered the case of MIFA several times in the last few months (part 1, part 2, update, update 2).

Over the week-end, finally some news emerged with details about the restructuring.

If I understood the filing correctly, the following will happen:

1. Existing shareholders will be diluted 1:100
2. Bondholders will accept a “haircut” of 60% plus the coupon will be reduced to 1% (from 7,5%) and the maturity will be extended to 2021 (from 2018)
3. Hero cycles will inject (up to) 15mn EUR via a capital increase
4. Bondholders will get 10% of the new company for the 15 mn haircut and a subscription right for additional shares

Interestingly, the advisor nominated by the bondholders also made a press release. Some additional info from this release:

– the advisor estimated a recovery rate of only 15% for bondholders in the case of bankruptcy
– technically, bondholders will own 91% of MIFA equity before Hero cycle invests
– bondholders get subscriptions right and could, if they want to invest new money, own up to 30% of MIFA including those shares they get via the debt equity swap

As some details are still missing (price of new shares) etc., it is hard to correctly say how much the bonds are worth and if bondholders were treated fairly compared to Hero. However current prices at ~38% seem to imply most of the upside.

My 5 cents on this

For me, the following aspects of this whole episode are interesting:

– How can be the recovery rate of bond issued twelve months ago only be 15% ? Where did the 21,5 mn EUR disappear ? In my opinion, MIFA was a fraudulent company for quite some time and was already insolvent when they issued the bonds.

– Will there be any law suits by bondholders ? Why did Hero take the risk and didn’t wait for insolvency ? Are there any special provisions for Hero to back out if law suits come up ?

– “Senior bonds” under German law should not be treated and priced as senior bonds. As this example shows, one can “haircut” bond holders under German law (“Schuldverschreibungsgesetz”) without even going into bankruptcy procedures. German Bonds are much more similar to potentially perpetual, deeply subordinated bonds or “Genußschein” than a senior bond under international law. Any covenants written into the prospectus are worth nothing as it is so simple to just restructure the bonds.

– such a restructuring can be decided with only a small percentage of the bondholders. Only 28% of the MIFA bondholders were present when the advisor, who can commit to binding changes, was elected. So in theory, 14% of the bondholders can decide what happens to the remaining 86% of the bondholders with very little chance for any “hold outs”. Maybe Greece and Argentina should issue their future bonds simply under German law. Tha would make life much easier for them.

. why does the MIFA share (1% of the future company) trade at 80 cents or 6 mn EUR market cap ? Do shareholders think that the company is worth 600 mn EUR ? This is a clear “short zo zero” situation if one could actually borrow the shares

– one could argue that the restructuring makes sense because MIFA will be able to continue to operate and now jobs are lost. However I think it would be naive to believe that Hero will operate MIFA they way they worked before. Hero wants the brands and the distribution, not the production. I am pretty sure that they will not guarantee a lot of jobs.

– but at least, the order that existing equity gets wiped out before the senior bonds still holds, even under German law. I had some serious doubts about this.

The most important lesson: As I have written before, new corporate bonds under German law should be avoided at all cost. Especially the “Mittelstandsanleihen” are in principal similar 20 EUR bills issued at 100 EUR with a tiny little option to receive 100 EUR. The “lipstick on this pig” is the high coupon. But German investors seem to buy anything with a high coupon these days anyway. No surprise maybe if you have to pay for holding 2 year treasuries at the time of writing.

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