value and opportunity

Hans Einhell AG was part of the initial portfolio and is still there, however with 1.8% weight being the smallest position. Although the stock was mentioned briefly in some posts, I haven’t done an “in depth” analysis yet.

Company Profile:
Einhell sells a diverse range of gardening tools and other “do it yourself” tools mainly for “non professional” users. Production ist completely outsourced to China. 40 % of the products are sold in Germany, another 40% in the EU mostly through DIT chain stores like OBI, Hornbach or Praktiker.

The Einhell tools are sold cheaper than brands like Bosch or Black & Decker, however they are more expensive than no-name products. The company strategy as stated in this 2010 sell side research piece is “cheaper than the best, better than the rest”.

In an Investor presentaton from 2010 (only in German), Einhell defends its business model against a pure “importer”.

Stock & Simple Valuation metrics

The listed shares are preferred shares without any voting rights. In total, 1.68 mn preferred shares are outstanding plus 2.094 mn voting shares which are all privately held, most of them by the founding family.

At currently 35 EUR per share and assuming the same price for the voting shares, this would result in a market cap of 132 mn EUR.

Using “traditional” value metrics, the stock looks very cheap which was the main reason for putting it into the portfolio:

P/B	0.89
P/B Tangible	0.92
P/E 2010	8.26
P/E trail 12M	7.75
EV/EBITDA	6.71
EBIT/EV	13.02%
P/S	0.36
Div. Yield	2.29%

A quick glance to the earnings of the last 5 years shows relatively stable earnings with a small drop in 2009:

	2006	2007	2008	2009	2010	Avg
EPS	4.31	4.42	3.96	2.88	4.24	3.96

Based on those simple valuation metrics the stock looks relatively cheap, so let’s move on to a more detailed analysis.

Stage 1: Replacement Value

As a first step, I routinely eliminate any goodwill and minority interest. This results in the following “tangible” net equity:

	Per Share
NAV	39.43
– minorities	-0.63
– Intangibles	-2.38
Tangible NAV	36.42

Next are the “usual suspects” for direct adjustments, especially:

– pension liabilities: Einhell only has a very small amount of pension liabilities (1.2 mn EUR) with relatively conservative discount factors ( no adjustment necessary

– real estate: Einhell owns most of the real estate it uses. Gross purchase value of real estate (land and buildings) is 26 mn EUR, it has been written down to currently 10.5 mn EUR. As Einhell doesn’t produce any chemical or otherwise dangerous substances, one could assume that the current market value of these assets is a lot higher than current book value if sold. My conservative standard assumption would be that we can add back 50% of the writedowns or ~8 mn EUR

Other than that I could not locate any special items like “extra assets”, Einhell has a relatively simplye structure with holding only majority owned and therefore consolidated subsidiaries

Now let’s look at additional adjustments required for calculating a “replacement” value::

– R&D expenses: Einhell expenses around 90% of their R&D (~4 mn EUR per year). Although Einhell is not a producer, at least part of this R&D should be viewed as an investment, as a new competitor would need to spend some time and money to gain the same know how like Einhell with regard to this business. As a proxy, I would use 1.5 mn EUR per annum for the last 5 years as “capitalized” R&D

– marketing & branding: For a consumer product company one usually treats some of the marketing expenses as “invetsment”. Einhell however does not spend anything on advertising. Based on personal experience with Einhell tools I would not allocate any value on the Einhell brand.

So putting it all together, we get to the following result:

	Per Share
NAV	39.43
– minorities	-0.63
– Intangibles	-2.38
Tangible NAV	36.42
+ real estat adj	2.12
+ R&D cap	1.99
Replacement Value	40.53

All in all not bad, but at 35 EUR this results only in a very small discount to the Replacement Value of 40.53 EUR. So from a pure asset point of view, Einhell doesn’t look too exciting

Stage 2: Earnings Power Value (EPV)

Now we try to determine, how much cashflow to equity can Einhell generate on a “steady state” assumption. I have a slightly different way to do this. I start with reported operating cashflow and eliminate working capital movements before subtracting “maintenance” capex (as Einhell doesn’t state maintenance Capex, I use the regular depreciation as proxy). I do this to be able to compare cash generated with earnings booked.

Mn EUR	2006	2007	2008	2009	2010
Op. CF	6.585	0.455	13.907	51.111	-7.661
Working capital	-13.613	-20.06	-8.031	41.029	-28.508
Op CF w/o WC	20.198	20.515	21.938	10.082	20.847
Capex	-4.736	-4.532	-3.612	-3.425	-3.282
Free CF to Equity	15.462	15.983	18.326	6.657	17.565
per share	4.10	4.24	4.86	1.76	4.65

So ingoring working capital, free cash flow to equity is with the exception of 2009 equal or even higher than stated earnings, which could be a good sign.

The average free Cash flow to equity has been 3.92 EUR for those last 5 years. Discounted by an average 10%, this would also imply an intrinsic value somewhere near 40 EUR. I don’t see any reasons here to use a lower discount rate as history shows that there is significant volatility in Einhells cashflows.

But coming back to the Working Capital issue:

Over those 5 years, Einhell has produced 74 mn EUR free cashflow to equity. Over this 5 years, the cash has been used as follows.

– 13.3 Mn EUR as dividends to shareholdes
– Accumulated cash 20 mn EUR
– 30 mn increase in working capital
– the rest (10 mn EUR) went into smaller acquisitions

So only less than 20% of the free cash flow has been distributed to shareholders, whereas 40% went into the build up of working capital. Management has also indicated that 20% of net profit is their goal for dividends, so even with 5 EUR EPS one would only get 1 EUR or less than 3% in divídends.

If we look into the 2011 half year report, we can see that during the year the situation is even worse, the cash position has shrinked from 44 mn EUR at year end to only 6 mn at June 30th. This clearly shows that working capital requirements during the year are higher than at year end and therefore year end cash balances should not be deducted from any valuation efforts.

Net working capital at half year amounts an astonishing 175 mn EUR, 10% less than sales in the first half year.

This cash conversion cycle of ~6 months is described in the before mentioned research report:

Einhell usually converts inventory into cash in approx. 200 days. After having received orders for a number of different products from the subsidiaries or by clients directly. Einhell’s trading company in Hong Kong bundles orders and passes these on to the factories in China.
Depending on the product and batch size, manufacturing usually takes between six to eight weeks. After receiving the products for shipment Einhell pays its creditors i.e. factories in approx. 20 days. Including shipping time of 3-4 weeks the average inventory turnover is approx. 4 or 90-100 days. With DSO being ca. 65 days this means that inventories are recycled to cash in approx.
six to seven months.

So the big problem for Einhell is the fact that it has to pay its producers within 20 days, but receives the cash much later. With this business modell, every Euro growth in sales increases capital requirement by 50 cents.

As Einhell doesn’t want to or can’t use operational leverage (trade financing etc.), depending on the realised margins (4-5% net) and capital cost, any growth in Einhell could actually destroy value for the shareholder.

Unfortunately, there seems to be no catalyst for any change in the financing structure.

So summarizing the whole case in a couple of bullets we get the following result:
– Replacement Value and EBV are both around 40 EUR, shares are only slightly undervalued
– current business model with high working capital requirements financed mostly through equity does not create value after cost of capital
– free cash flow to equity has to be used mostly to finance increasing working capital requirements, a significant increase in dividends seems highly unlikely
– due to minority status of preferred shareholders, no catalyst (take over, activist etc.) is on the horizon

In my opinion, despite the cheap valuation from a “traditional” pont of view, Einhell does not offer a sufficient Margin of Safety. The risk of ending up with a typical “Value Trap” is not remote. The remaining position will be sold.