value and opportunity

This is an idea I read recently on the beyondproxy blog/site.

As my first attempt at this post somehow disappeared, I will now just copy the introduction from the beyond proxy post:

CIR Group is a company whose story is an intricate all-Italian tale of family ownership, corruption and dirty politics. This unique combination of factors seems to be frightening investors away from the company thereby causing its shares to become substantially undervalued. Within the next two quarters however, the Italian courts will decide on a legal dispute that will put an end to the tale and, most likely, a higher valuation on the stock.

CIR is structured as a holding company. It owns controlling interest in four businesses (Sorgenia, Espresso, Sogefi and KOS) and has substantial investments in alternative assets such as hedge funds and other financial instruments. Its liabilities consist mainly of €300mm of publicly traded bonds and €564 million of legal reserves.

and this is the “kicker”:

CIR carries a €564 million liability that has been booked as “Borrowings”. In reality, this is not borrowed money – it is a legal reserve for an infamous legal proceeding that has been making headlines in Italy for the past twenty years: the so-called ‘Lodo Mondadori’.

The author (a Italian grad student by the way) then values the company with a simple sum of part model, using share prices for the listed subsidiaries (Espresso, SOGEFI) and NAVs (P/B=1) for the unlisted shares (utility Sorgenia, hospital KOS). As a result, the author sees an upside of at least 20% in any case or up to 135% in case of a positive outcome of the “Berlusconi situation”

I think this is a good starting point, but I would adjust the approach slightly:

1. add control premiums to the participations
2. adjust NAVs for unlisted participations if appropriate (and comparables are available)
3. deduct finally a control premium for the CIR share

One could ask: Why add control premiums and then deduct them again ? Well, clearly, being a minority shareholder in the middle of an Italian shareholding chain is not the best position to be in. The main effect of this approach is to deduct a control premium from the expected Berlusconi settlement. This should be done as one does not know what happens with the money. I assume it will not be paid out as a dividend.

Assumptions:

1. For a control premiums in both cases I assume 30%
2. For the unlisted utility, I will use a P/B valuation not at nAV but at 0.5 times NAV. This is in line with similar Italian utilities like Iren (0.58) and Enel (0.6). I use 0.5 because the others are even profitable, Sorgenia is not.

First step: Sum of parts ex “Berlusconi”

This rather simple table shows how i moved from the current “carrying values” in the HoldCo balance sheet of CIR Spa Holding to my mark-to-market valuation BEFORE applying the overall control discount. Remark: Using consolidated numbers for a company consisting of mostly 50% participations does not make a lot of sense.

Step 2: Berlusconi scenarios and control discount

Here you can see the base case (as is) and 4 potential scenarios for the payment, assuming that 150 mn before tax is the minimum. The upside is calculated based on a current share price of 0.95 EUR per CIR SpA share

We can see that after applying the -30% control discount on the sum of part, without the Berlsuconi settlement, the shares look rather expensive. The max. upside with around +28% is rather limited at this price.

So it looks like that some of the expected Berlusconi payments are already priced in. At that price, I don’t think CIR SpA is attractive if one applies a 30% control discount.

Legal disputes /court cases as special situationss

In general, legal disputes are often quite interesting special situations. This is a quote from the 1951 edition of Ben Graham’s 1951 edition of “security analysis” (via CS Investing):

Class D Litigated Matters.

There are fairly numerous cases in which the value of a security depends largely on the outcome of litigation. This may involve a damage or subordination suit (e.g., International Hydro Electric, Inland Gas Co.); disputed income tax liability (e.g., Gold and Stock Telegraph, Pittsburgh Incline Plane); an appeal from a reorganization plan wiping out stock issues (e.g., St Louis Southwestern Ry., New Haven R.R.). In general, the market undervalues a litigated claim as an asset and overvalues it as a liability. Hence the students of these situations often have an opportunity to buy into them at less than their true value, to realize attractive profits—on the average—when the litigation is disposed of.

What kind of holding company is CIR SpA ?

A few months ago, I had a post about how I distinguish Holding companies:

For myself, I distinguish between 3 forms of holding companies:

A) Value adding HoldCos
B) Value neutral HoldCos
C) Value destroying HoldCos

Back then, we saw that even for a “value neutral” holding like Pargesa, a 30% discount applied. So implicitly I assume CIR SpA is value neutral as well. At least the reporting is quite transparent. In the past, CIR was involved in many typical Italian Feuds like Olivetti and Mondadori, but I haven’t read anything that they try to screw minority shareholders of their own group.

Although Benedetti Junior looks a little bit like someone who enjoys doing shady deals 😉

According to the last annual report, Benedetti Senior has ceded control of CIR SpA to his sons.

Summary:

Although I like the unique aspect of this special situation, the potential upside is NOT attractive enough to justify an investment at current prices.

I will keep this on the radar but I would not invest above ~0.70 EUR. I would need 50% upside in order to justify the risk of the underlying companies which are clearly struggling.

This is “research” directly from Bloomberg:

KPN NA: 2.74 TARGET: 2.20-2.40
April 25, 2013
We recommend shorting KPN on the share issue announcement. The equilibrium price is Eur 2.04/share and the stock price should trend toward this level in the near future.
Equilibrium Price = (price pre-cap raising announcement x # shares + price cap raising x # shares) / total # shares.
The shares were trading at around 4.0 pre-announcement and there were 1.431 bn shares outs.
The company is issuing 2.84bn shares at 1.06. This works out 2.04/share. Let’s imagine that thanks to the cap raising the
fundamentals are slightly better now than they were before, and we set our target at 2.20-2.40, or 10-20% lower than the current price. The stock should be sold/shorted.

Let’s look at their “formula”:

Equilibrium Price = (price pre-cap raising announcement x # shares + price cap raising x # shares) / total # shares

“Wow, they are professionals and have a formula, this must be right” was my first thought and I briefly thought that I have made a mistake. Although I had a nagging feeling that the formula (or the application of it) was not right.

Enter readers JM and Martin in the comments of the last KPN post:

26. April 2013 um 09:57 | #8 Antwort | Zitat | Bearbeiten
ok…I join the game. When the capital increase was announced the share price was Euro 3,1…so 3,1+1,06+1,06/3 = 1,74. If the dust settles this share price is my personal target…more I do not expect .

memyselfandi007
26. April 2013 um 10:35 | #9 Antwort | Zitat | Bearbeiten
The day BEFORE the capital increase was announced, the stock price was 4.10 EUR.

Martin
26. April 2013 um 10:55 | #10 Zitat | Bearbeiten
(4.10+1.06+1.06)/3=2,073
price today 1,56
discount 24,7%
As there were cost for KPN real economic discount is somewhat lower.

Martin and JM (by the way, thank you for your many helpful comments) are using the very same formula, however with one big difference: They compare the result with the stock price AFTER the rights have been split of.

So the question is: Who is right ? The “professional” reasearch on Bloomberg or the comments on my amateur blog ?

Well, if you are a KPN shareholder before and KPN would sell the new shares directly to new shareholders at 1.03 EUR per share, then of course the old shareholders would be massively diluted.

In reality however, no one is able to by the shares directly at 1.03. You can only access those cheap new shares by buying the subscription rights which have been giving to the old shareholders as compensation for the dilution.

So the big mistake made by the “professional” analyst was that he somehow forgot to account for the subscription right. as the subscription right was worth 1 EUR pr share, suddenly an overvalued share according to the “professional” is an undervalued share.

How can a “professional” be so stupid ?

My guess is that the “analyst” mixed u a rights issue with an issue of shares without rights. Companies usually can issue a certain amount of shares (usually max. 10%) directly to new shareholders without any rights to old shareholders.

In those cases, the announcement is usually made shortly before the trading day starts and then the formula above is applied to the price the day before and the price for the new shares.

Nevertheless it is really embarrassing for any institution that such a mistake slipped through and this report gets actually published on Bloomberg

Applying the formula to a rights issue

The “formula” rests on 3 critical assumptions:

1) The price of the shares on the day before the announcement is exactly the right (and efficient) price. There was no information out there before about the capital increase

2) Nothing happened in between

3) the additional capital will not create any additional value

I think all three assumptions are quite difficult to hold for the KPN rights issue. Talk about the issue started already in September last year, so at the time of the announcement (Feb. 5th), the stock price reflected already a part of that.

Also, the time period between announcement and pricing of the issue is quite long with 6-7 weeks.

Summary:

It is amazing, how bad some of the “professional” research actually is. In that case the analyst used a formula without accounting for the subscription rights. However this also shows that in those situations, the price discovery might be not fully efficient.

I wouldn’t put too much faith into the “formula”, as the application towards rights issues really stretches the implied assumptions.