Category Archives: Emerging Markets

BMPS update & Quick look at Turkey (Koc Holding, Depfa TRY Zero bond)

BMPS

Today I sold my BMPS “special situation” position at 1,80 EUR per share, a small loss compared to my 1,80 EUR entry price when I factor in transaction costs. The subscription rights stopped trading already yesterday. Overall, the case did not work out very well. The stock was volatile only the very first day and didn’t do a lot ever since as the chart shows:

bmps 11 close

It seems to be that the regulator has been quite succesful this time to warn market participants against any kind of option based short squeezes. So no “Italian Job” this time. As I have mentioned in the comments of the last post, I do not consider BMPS as a longer term investment. I do think the risk/reward profile of this special situation was good but it just didn’t work out. For the record, I consider the whole transaction as one trade so I still have one potential transaction open or June 😉

Quick look at Turkey

The Turkish Lira and the stock market got hit hard this week as the ruling party did not get the majority of votes.

Politically, one might say that this was actually good news because it clearly enforced democracy in Turkey. Or how the linked Reuters article said:

Erdogan loses his chance to become Turkey’s Vladimir Putin

Financial markets in the short-term however seem to prefer potential dictators to democracy. Although I really like the FT guys, this video shows clearly the opinion of many “pundits”. Especially the currency got clobbered and is almost back (in EUR levels) to early last year’s levels:

In the long run I do believe that a functioning democracy is positive, both for the country and business despite “uncertainties” due to elections. Especially as a public shareholder it is very important that the institutions in a country are properly working. With Erdogan gaining more and more power, I did have my doubts. I don’t know that many positive examples that stock markets with dictators in charge do really well.

Koc

My Turkish stock investment Koc Holding is still doing well. In EUR Term, I am still up around +50%. This is mostly due to a quite lucky entry point back in February last year. I still could not motivate myself to increase the position as Q1 results haven been operationally good but net income was lower yoy because of one-offs.

For Koc, a weaker Erdogan/AKP should be clearly positive in the long run as it reduces risk.

Depfa “Kebap bond”

My second “Turkish” investment is the 2020 Depfa TRY Zerobond which I bought almost exactly one year ago. Again I was lucky with the purchase timing. Although I bought at a more expensive exchange rate (2,85 TRY/EUR), I made some money on the bond price so that I am only slightly down.

The interesting thing is the following: Relatively speaking, the bond has become more attractive. This is what I wrote back then:

At a current yield of ~13% p.a., the bond trades around 4% p.a. wider than a 2 year longer EIB Zero bond and around 3% wider than similar Turkish Government (coupon) bonds.

Well, one year later, the bond actually trades 4,2% wider than Turkish Govies and 4,3% wider than the EIB bond. I still believe that there is very little credit risk in a senior Depfa Bond and that at around 50% and a yield of 13,8%, the bond is good value at an Exchange rate of 3,10 TRY/EUR. I might increase the position slightly in the next few days.

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

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

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

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

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

When analyzing Romgaz I said this:

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

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

Electrica – the business

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

Electrica small

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

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

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

Electrical grid as a business

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

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

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

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

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

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

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

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

Romanian electricity market

This is an interesting quote from the IPO prospectus:

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

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

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

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

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

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

Valuation – simple version

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

Valuation including growth

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

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

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

I made the following (conservative) assumptions:

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

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

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

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

Other considerations

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

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

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

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

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

The Romanian government still owns 49%.

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

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

Summary:

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

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

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

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

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

SNGR Romgaz (ISIN US83367U2050) – A chance to participate in a Romanian revival at a large discount ?

As this turned out to be a quite long post, a quick summary upfront:

Romgaz, the recently privatized Romanian Natural gas producer looks like a pretty cheap play on the success of privatisation in Romania. Additional tail winds could come from the recently elected ethnic German President who wants to fight corruption and intends to repeat the business friendly and succesful model of his hometown Sibiu where he was mayor for 14 years.

Depending on the underlying value of the natural gas resources, the stock could have a potential upside between +50% in a pesimistic case and 200% in an otimistic one.

Disclosure & Risk: The stock presented is clearly risky and quite illiquid. The author might have bought shares before publishing this. Please do your own research !!!

On Romania

Romania is part of the European union, however it is the second poorest member, only trailed by neighbouring Bulgaria. The country never really recovered from the financial crisis and many Romanians left the country to work all over Europe.

Last week, something quite interesting happened in Romania: An ethnic German was elected as new President of Romania.

Klaus Johannis became major in Sibiu, a mid size town in Romania in 2000 despite representing only 1% remaining ethnic Germans who live there since the 12th century. He was reelected 3 times and managed to attract a lot of German companies to his hometown Sibiu. As a consequence, Sibiu is the Romanian city with one of the lowest unemployment rates and the highest standards of living. By the way it is a really beautiful city very close to the Carpathian Mountains. In my opinion a very attractive yet undiscovered travel destination:

In Romania, the President has a lot more power and influence than for instance in Germany, I think one can compare it to France. Clearly, this election alone will no be enough, as for instance his opponent for the President’s job is still prime minister. nevertheless the vote should be a huge plus for Romania going forward, both as the new president seems to be trustworthy and anti-corruption as well a pro business and economy.

So how did the Romanian stock market react ? Ummm, if we look at the BET index, it didn’t react at all. Actually Romanian stocks are down since the election, so no “Modi Mania” for Romania it seems. One can speculate why this is the case, but in my opinion the Romanian Stock market is too small and so off-the-beaten-track that just no one bothered with it. And Romanians themselves do not really invest in stocks.

Romgaz

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

Romgaz is a Natural Gas producer (“upstream”) with around 50% market share in Romania. Romania produces most of its own natural gas. In contrast to OMV-Petrom, its domestic rival, Romgaz only does “on shore” production,.

Romgaz has been IPOed one year ago and placed shares on the Bukarest stock exchange as well as on the LSE in the form of GDRs. Since then when the stock was sold at 30 Lei per share, not much happened with the stock price:

The great thing about a recent IPO is, that one usually gets the best information about the company and the sector through the IPO prospectus, which is normally much more comprehensive than any annual report.

The Romgaz IPO prospectus is actually very good and comprehensive

This is a summary of my pro’s and con’s after reading the prospectus

+ no debt, significant net cash
+ only one share class
+ further scheduled price increases due to deregulation, mostly independent of market prices
+ many additional assets like gas storage (90% of total storage capacity), smaller distribution networks, power plant etc.
+ dividend payout ratio ~90%, resulting in a current dividend yield of ~8% (withholding tax “only” 16%)
+ High quality reporting (English)
+ privatised Government company with modern management -> lots of potential to be more efficient

– windfall tax applied in 2013 & 2014
– “royalty payments” on natural resources to Government which could increase (Nat gas & storage)
– “donations” to Government in the past
– government clients defaulted on receivables (that’s how they became owner of a power plant in 2013)
– government influence remains with 70% share
– proven reserves for only 10 years at current production rate
– reserve replacement rate very weak in the past (better in 2012/2013)

This is on the reserves from the IPO prospectus:

Owing predominantly to the re-evaluation of existing reserves, Romgaz has recorded an increasing replacement ratio, reaching 298% in 2012 (2011: 152%, 2010: 92%, 2009: 49%, 2008: 57%), with proved reserves being 71% of its total reserves. Romgaz believes that further increases of Romgaz’s reserves base can be achieved by improving its recovery rates through utilisation of well-established technologies. Romgaz’s size, longevity and market position has also helped it to enter into partnerships with major international natural gas companies including Lukoil, ExxonMobil and Schlumberger to develop other opportunities to increase reserves both inside Romania and internationally

On the upside, until 2012, Romgaz had to deliver their natural gas at “far below market” prices to their customers. Following the deregulation, prices can be adjusted to reach the market price in some years. Again from the prospectus:

Price Liberalisation
In addition, Romania has undertaken to fully liberalise the gas price for domestic production as well as the end-customer prices. In February 2013, the Romanian government started to implement a plan to deregulate natural gas prices by raising gas prices by 5% for non-household customers. It has planned to achieve the
complete price deregulation by 1 October 2014 for regulated customers and by 1 October 2018 for non-regulated customers. For non-household customers, the price of domestic gas is to increase from 49 RON/MWh, as of 1 February 2013 to 119 RON/MWh, by 1 October 2014, and for household customers, the price is to increase from 45.7 RON/MWh, in 31 December 2012 to 119 RON/MWh, by 1 October 2018.

Despite a windfall tax applied by the government, this development has been clearly positive for Romgaz with a 40% profit increase so far in 2014 against the prior year.

Valuation:

Valuing commodity producers by “standard” metrics like P/E or P/B often misses the point. The main value of a commodity producer is clealy “the stuff in the ground” minus the costs to get it out. However normally it is quite difficult to value the “stuff in the ground”. In the Romgaz case however we are again quite lucky. Part of the IPO information package was an independent “resources report” carried out by a large and well known US specialist company.

In this report, they calculate future “net revenue” including all costs taxes etc. and then come up with an NPV. In the Romgaz case, they actually created 3 scenarios: A base case, a low case and a high case. Addionally they provide NPVs for different discount rates, ranging from 8-15% p.a.

So in order to fully value Romgaz we can do a relatively simple asset-based valuation: Using the value of the reserves from the report plus any “extra assets” like the storage facilities and the power plant.

This is what I came up with for Romgaz:

Some comments:

– for the net cash I used the most recent quarterly report 09/2014
– I assumed a valuation of 6x EBITDA for the gas storage in all cases (one could argue for a much higher valuation as “infrastructure asset”)
– I assumed the original “purchase price” of the power plant form early 2013 as the market price
– for the “resources worst case”, I used the lowest value from the report (low case, only proven reserves, 15% discount)
– for the mid case I used base case, proved plus provable resources discounted at 12%

I think it is important to mention that this valuation does not give any credit to a potential exploration of new reserves, this is pure “run-off” only.

In any case, even in the worst case, the stock would have a 50% upside to “fair” value, although the fair value would still imply that you make ~15% p.a. after this value has been achieved. In the more optimistic cases, the current stock price seems to represent an even higher upside. Clearly, there is no guarantee that this value will be realized within a short time frame, but it clearly should limit the downside and create a relatively attractive risk/return relationship.

Why is the stock cheap ?

To me, this could be the combination of different factors, Mostly in my opinion:

– natural resource companies/commodities are out of favour anyway
– Emerging Markets and especially Eastern Europe are unpopular and Romania is even further away from the “Beaten track”
– there is no local shareholder base for Romanian stocks

A few words on Russian companies (Lukoil, Gazprom)

P/E wise, Russian natural resource companies look a lot cheaper and I expect some readers to comment that I should rather buy Gazprom at a P/E of 2 or so instead of Romgaz at 10. For me, despite the higher multiple, Romgaz looks more attractive to me because:

1. there is less uncertainty with regard to property right etc. in Romania. Despite obvious issues with corruption, Romania has proven that Democracy works and it is full member of the European union. This should significantly lower the risk of any “Sistema scenario”.
2. Due to the privatization story, Romgaz is less exposed in the next years to overall market price fluctuations.
3. Despite the low P/Es shown, you never know what actually happens with all those Russian profits. Dividend payout ratios are very low and the companies issue debt like crazy. Romgaz in comparison pays out a large amount of earnings and runs a big cash surplus

Summary:

In my opinion, Romgaz offers a compelling combination between a recently privatized company at a large discount to its underlying value and a potential “macro trigger” for Romania following the surprise election of an ethnic German as new President.

As Romania is so “off the beaten track” for stocks, it might take some time to realize this value, but in between one is paid quite handsomely with a 7-8% dividend yield.

As a result, I will enter into a 2,5% position as part of my “Emerging Markets” bucket at current prices (34 RON / 7,60 EUR per share).

Overall, I expect to make ~100% over a 3-5 year horizon. 30-40% should come through dividends, the rest with price appreciation, mostly based on increased earnings. Downside factors to watch are clearly any government interventions (additional taxes, royalties), further upside could be realized if reserve replacement ratios develop better than expected.

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

After a “Near death” experience with Sistema, I am nevertheless still interested in companies with significant Russian exposure as a “counter-cyclical” EM play, however preferably with less “Oligarch” risk. A very interesting company with a significant Russia exposure is ITE Plc, the UK-based company. According to Bloomberg

ITE Group Plc is an international organizer of exhibitions and conferences. The Company provides
its services to customers in a variety of commercial and industrial sectors, including travel and
tourism, construction, motor, oil and gas, food, security, transport, telecommunications, and
sports and leisure.

The good thing with UK companies is that usually some blogger has covered the stock already. WIth ITE, this is the case as well. Among others, there is a very good Seeking Alpha post, from the Portfolio 14 blog and als the Interactive Investor covers the stock.

I agree with all posts. Organizing exhibitions is good business:

+ you don’t need a lot of capital (negative working capital due to prepayments)
+ once an exhibition is established, it creates a network effect which is relatively difficult to duplicate
+ although the business fluctuates with the cycle, costs are to a certain extent variable
+ it’s a nice b2b business, connecting a large number of exhibitors of with a large number of interested visitors
+ despite or because of e-commerce, personal contact in the form of trade fairs etc. seems to become even more important
+ the company has no debt

The “catch” is of course that most of their exhibitions take place in Russia and the former GUS. Clearly, not the easiest part of the world to be at the moment.Looking at the past 16 years since their “reverse IPO” in 1999, we can see that the business has suffered in downturns such as the Russian default but always recovered. However, mostly due to the weak ruble, comprehensive income in the last few years was mostly lower than stated income:

Year EPS Compr. Income In% of EPS
29.12.2000 0,03    
31.12.2001 -0,13    
31.12.2002 -0,01    
31.12.2003 0,03    
31.12.2004 0,04    
30.12.2005 0,07    
29.12.2006 0,07 0,07 99%
31.12.2007 0,09 #N/A N/A #WERT!
31.12.2008 0,09 0,09 97%
31.12.2009 0,13 0,11 86%
31.12.2010 0,10 0,12 121%
30.12.2011 0,13 0,10 82%
31.12.2012 0,13 0,13 98%
31.12.2013 0,14 0,09 64%

The valuation looks quite cheap, especially the EV/EBIT and EV/EBITDA ratios for such a business with high (historical) growth rates:

P/E ~9
EV/EBITDA 5,9
EV/EBIT 7,0
P/B 4,4
Div. Yield 5,0%

After reading some of the reports, I found a couple of things I didn’t like:

– focus on “headline” profits, excluding amortizations and “restructuring charges”
– Management fully incentiviced on “Headline profits”, not ROIC or ROE etc..
– Falling knife Stock chart
– one of the biggest “rainmakers”, Edward Strachan retired a few months ago.
– trade fares and exhibitions often have a time lag of 6-12 months to the general economy. So the worst in Russia for ITE might come only in the next few quarters.

Peer Group

There aren’t that many “pure play” trade fare /exhibition companies listed but I tried to compile a list to the best of my knowledge. Two of the companies listed below (Kingsmen & Pico) are actually more supliers to exhibitions than promoters/organizers:

Name Mkt Cap (GBP) EV/EBITDA EV/EBIT P/E P/S
ITE GROUP PLC 434,5 5,3 7,0 9,9 2,2
TARSUS GROUP PLC 198,7 7,7 12,0 16,4 2,6
UBM PLC 1267,5 9,6 14,4 9,9 1,7
MCH GROUP AG 237,8 7,2 13,9 11,9 0,8
FIERA MILANO SPA 182,0 156,0 #N/A N/A #N/A N/A 0,9
KINGSMEN CREATIVE LTD 87,1 5,9 6,4 10,9 0,6
PICO FAR EAST HOLDINGS LTD. 182,6 6,7 9,6 11,2 0,7

If we look at P/Es, most of the companies trade relativelly cheap at around 9-11 times earnings, but long term ROE and margins at ITE are clearly a class of its own. The big question is: Can they sustain those margins in the long run ? Many of the listed peers as well as the unlisted ones like Deutsche Messe tried (at least before the crisis) to get into the Russian market.

The problem could easily be that ITE is too profitable. Past average net margins of 20%-25% are far higher than any of the competitors. Deutsche Messe for instance, which aggressively expands into EM earned a net margin of 3% in 2013. Clearly, It is not so easy to kick out ITE, but if the difference in margins is so big, at some point in time competition will begin to bite. although it’s not easy to establish a succesful trade fair or exhibition, it is relatively easy to start one. So yes, there is a network effect but the barriers to entry are still relatively low. A good example for this can be seen currently at TESCO in the UK. For quite some time it looked that they are protected by their dominant position and had margins 2 or 3 times higher than their continental peers. But once the competitors like Aldi and Lidl, who could only dream of such margins in other markets, were big enough, margins for the leader deteriorated pretty quickly.

Valuation

Based on what I described above, I would make the following assumptions:

– going forward, net margins will be lower than in the past. In the past they achieved margins of 20-25%, I will calculate with 18% (thats what they made in 2012 and 2013)
– in order to reflect the additional risk in Russia, I will require more return. My normal requirement would be 15%, here i need 5% more or 20% p.a.

So if I assume that in 3 years time, ITE will again do the same amount of sales as in the FY 2013, this would be 0,80 GBP per share. At 18% Net margin, they would then earn around 14,4 pence per share. A “fair” P/E for such a company could be around 15. So the 3 year target price would be 14,4*15= 2,16 GBP.

However, in order to earn my 20% p.a. , I need to discount my target: 2,16/ (1,2)^3 = 1,25 GBP. This is however a lot lower than the current price of 1,70 GBP

So for me, under those assumptions, LTE is not a buy, I would buy once the price is at or below 1,25 GBP per share.

Summary:

It really took me some time with ITE Plc. I really like the business model of trade fair /exhibitions. Although cyclical, it seems to be good business with a certain protection. For ITE however, I fear the worst is yet to come. With the oil price plunging and the “Russian situation” unchanged, including more potential trade sanctions etc., the next year will be even harder than the last for ITE.

I would stil buy them if they are cheap enough, which, at the moment they are not. They would need to drop a further 30% in my opinion to make them really intersting and compensate me for the additional risk. I will however try to look at some other similar companies going forward. Especially Pico Far East and Kingsmen looked interesting at first sight.

It could easily be that I am too cautious due to my losses with Sistema (“Recency bias” ?), but at the moment I rather make the mistake of being too conservative.

Emerging market risks, Turkey & Koc Holding

Emerging markets stocks are risky. This is not a very original insight but a pretty well-known fact. Among the obvious risks compared to most “developed” countries are:

– general legal risks (listing, disclosure, property rights)
– volatility of economy
– currency
– general political instability

Following the Sistema story, I would add another significant risk for any Emerging market based company:

– personal disputes between a controlling shareholder and the current government

That this risk is real can be seen very well in Turkey at the moment at Asya Bank. Asya Bank is supposed to be owned or influenced by the major Erdogan enemy, the Gulen movement. What is happening in Turkey, at least from my perspective is pretty unique: The Government is more or less actively trying to bankrupt a private bank because the owner of the bank is opposing the current government:

Investors have dumped stocks and bonds of Istanbul-based Bank Asya as the lender was dragged into a feud between President Recep Tayyip Erdogan and Fethullah Gulen, the Pennsylvania-based Islamic cleric who Erdogan blames for a graft probe that implicated his government in December. The president this week called for Turkey’s banking regulator to take action on Bank Asya, citing deteriorating finances.

It seems to be that Erdogan has become much bolder since he won the election a few weeks ago and seems to care less about any negative short-term impacts on the economy.

Honestly, that made me pretty nervous with regard to my largest EM based investment, Koc Holding. I am not completely sure if everything is well now between Erdogan and the Koc family. There were already several probes against Koc companies, the latest I found was against subsidiary Turpas in July 2014.

The big question is always: Am I getting paid for the risk I am taking ? In Koc’s case, especially after the nice run up in the share price, I am not so sure anymore.

Koc is now trading at around 11 times 2014 profits, which is in line with the overall Turkish stock index. Although I believe that Koc is a far above average quality Turkish company, the individual political risk is much higher than for the general Turkish market.

In my initial post, I wrote the following:

I am clearly no expert here, but the fact that the Koc family, among others, survived 3 military coups, the second world war and hyperinflation, the probability is maybe relatively high that they survive the current episode, but risks are clearly there.

Following the Asya story however, I got much more cautious and in EUR terms, Koc is almost 40% more expensive since I bought them. It could easily be that I am too cautious here, but I am not sure if I get actually paid for this Koc related “relationship” risk when I hold Koc stocks at the current level, especially with a portfolio weight of around 3,5%. If I compare this for instance with MIKO or Hornbach, I can still invest in a nice “Boring” stock at the same level without the very specific and real risks of Koc in Turkey.

As a consequence, I will reduce my stake by more than 2/3 to a 1% level which for the future will be my maximum exposure per position to any single Emerging market based company.

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