value and opportunity

I already wrote a lot of posts about Praktiker in the past.

My previous summary was something like this : I don’t understand the motivation behind the recent events especially asking senior bond holders for a cut first before shareholders contribute , why they didn’t do any capital increase when the stock price was higher etc. etc.

After thinking about this the most likely possibility in my opinion is the following thesis:

Current Management doesn’t work in the interest of the current shareholders and bondholders but in the interest of potential future investors.

The result of this is relatively clear: It would be suicide to invest into the shares, as you can take a massive dilution at some point in time for granted. However, a new investor might prefer a “non-bancrupt” company, so for the bond things might look better from a risk/return perspective.

With this in mind, I think one can now try to analyse the different possible scenarios for bondholders, which in my opinion are

1) No bankruptcy – (unrealistic) best case: Take over within 1-2 year and early full pay out of bond
2) No bankruptcy – normal case: Bond pays out as scheduled
3) No bankruptcy – bad case: coupon gets reduced in second round of bondholders vote
4) bancruptcy – normal case: bond gets “fair” share of liquidation value 40% in 2016
5) bancruptcy – bad case: “DIP” financing reduces liquidation value significantly , value 10% in 201

Then we have to do 4 more steps:

First, assign probabilities to each scenario and the second, “model” cashflows.In a third steps we then can calculate “weighted” total cashflow and then calculate an internal rate of return based on current market prices.

In the following table, I have made a first try:

	Bankrupt	Prob. in %	2013	2014	2015	2016
Best Case	No	5.00%	5.88	105.88	0.00	0.00
Normal Case	No	60.00%	5.88	5.88	5.88	105.88
bad case	No	10.00%	1.00	1.00	1.00	101.00
Normal Case	Yes	12.50%	0.00	0.00	0.00	40.00
bad case	Yes	12.50%	0.00	0.00	0.00	10.00
Weighted CF		100%	3.91875	8.91875	3.625	79.875

This scenario would give the bond at the current price of 40% an implicit IRR of 28%, which would be attractive. If we would change for instance the “normal non bancruptcy” probability to 35% and increase the two bancrupty scenarios to 25% each, we would end upwith a 17.6% IRR.

	Bankrupt	Prob. in %	2013	2014	2015	2016
Best Case	No	5.00%	5.88	105.88	0.00	0.00
Normal Case	No	35.00%	5.88	5.88	5.88	105.88
bad case	No	10.00%	1.00	1.00	1.00	101.00
Normal Case	Yes	25.00%	0.00	0.00	0.00	40.00
bad case	Yes	25.00%	0.00	0.00	0.00	10.00
Weighted CF		100%	2.45	7.45	2.16	59.66

An analysis like this can help to understand better the sensitivities of such a rather complicated special situation investment.

Of coure, the probability of bankruptcy is the single most important driver, so let’s discuss this shortly:

On the positive side we have the fact that Praktiker survived the year end and the restocking of inventory for the spring 2012 season. Further, I think at the moment no one has a real advantage if Praktiker goes bankrupt. The biggest problem, the leases for the real estate, could be better reduced if Praktiker would be bancrupt but on the other hand they might have much more problems getting merchandise delivered even if bankruptcy would only be short term.

Additionally, I think the “year end accounting blood bath” makes more sense on a going concern basis than if one would prepare a “prepackaged” bancruptcy.

Potential Catalyst:

In my opinion, something with regard to financing has to happen this year. So there might be a good chance that the bond reacts positively within a limited time frame if the refinancing package is hopefully finalized.

Stand alone risk / return and portfolio view

If I compare Praktiker with the sucessful WestLB Genußschein investment, the Praktiker bond looks more risky, both from the potential downside and time horizon. However, also the potential upside is a lot higher at current levels.

However, on a portfolio level, things look differently. With special situations, I try to make “bets” as long as they are company specific and not directly correlate with each other or “normal” portfolio companies.

With Praktiker, we have the interesting situation that the bond ecoonomically is even negatively correlated with one of my core holdings, Hornbach.

This is something we can clearly see in current company news. In 2011, the German DIY segment showed around 3% growth, Praktiker lost almost 10% in slaes whereas Hornbach and OBI gained significantly above the market growth with 5-6% growth each.

If Praktiker really goes bancrupt, Hornbach among other will profit even more, either through taking over some of the better locations or just gaining more customers. On the other hand, if Praktiker manages the turn around or even gets a startegic shareholder, they might win back a lot of customers from the competition and hurt them significantly.

So one could argue (and I know this sounds a little crazy) that the Praktiker bond combined with the Hornbach shares creates a kind of “hedged” position.

Just for fun I loked at correlations between the Praktiker share, the Praktiker bond and the Hornbach Baumarkt Aktie. And, surprisingly we see the following based on 12 months and daily observations:

Over the last 12 months, the Praktiker share was slightly positively correlated with the Hornbach share (+0.03) whereas the bond was slightly negatively correlated with -.002. Not much but. nevertheless interesting. Again, for instance the last 4 months shows a small positive correlation between the shares (0.05) and a slightly negative correlation (-0.02) between Bond and Hornbach. So maybe not that crazy after all….

Summary:

On a stand alone basis, at current level, the Praktiker Bond is no “sure thing”, but a relatively risky speculation however with a relatively attractive risk/return ratio. In combination with the Hornbach share in my opinion, the combined position has a very intersting risk/return relationship which can greatly increase the expected return of the portfolio by actually reducing risk on an overall level.

I will therefore add a half position (2.5%) of Praktiker 2016 bonds to the portfolio at current prices (limit 41% of nominal value).