Quick check: Adidas AG (ISIN DE000A1EWWW0) – will this fallen angel rise again ?

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Adidas, the iconic German sportswear company, seems to be a big topic for value investors these days. A couple of my readers mentioned Adidas in the comments and also Geoff Gannon thinks it is cheap at least compared to Nike and Under Armour.

Over the past decade or so, Adidas was a great performer, riding mostly on the “Emerging Markets consumer” megatrend. This year however the share price is down ~-37% at the time of writing,:

Nevertheless, the Stock is still not really cheap on an individual basis:

P/E 19
P/B 2,2
P/S 0,9
EV/EBITDA ~10
Dividend yield 2,6%

Since a couple of weeks, there are constant rumours that some activist hedge fund will sooner or later appear and press for changes how the company is run.

Maybe in order to make it harder for activists or other potential “predators”, Adidas just announced a 1,5 bn share buy back over 3 years. According to the Reuters article this seems to be a rather quick change of mind:

Chief Executive Herbert Hainer said in August that Adidas had no plans for a share buyback.

Adidas also just launched a 1 bn EUR bond issue, most likely to fund some of the share repurchases. The bond issue however doesn’t seem to have been a smashing success.

Why did the share price go down so much ?

They had to issue a couple of profit warnings in the last few months. According to Adidas, two reasons are to blame: The issues in Russia, a core market for Adidas and the problems with the Golf business (Taylormade).

With the football World cup in Brazil, everyone thought that Adidas will have a record year, but as of 6m 2014, Profit declined by ~.27%. Adidas is the German company with the largest share of Russian sales in the DAX 30 index with around 7,5% of total sales. Doing badly in a year with a football Worldcup is not a good omen for the eventless next year.

What I don’t like at Adidas:

When I look at an expensive company like Adidas, I always look out for things I don’t like. After reading the 2012 & 2013 annual report, here are my “don’t like” point:

– management targets do not include capital profitability
– growth in recent years mostly from retail business
– Sales decreased already in 2013, 2014 just extends the negative trend
– they blame FX for most of their problems but that is part of the normal risk of doing business in Emerging Markets
– Adidas is doing Ok, but both Reebock and Taylormade are shrinking
– as with EVS, 2014 should have been a fantastic year (Brazil, Socchi). 2015, without any big events will most likely be even worse
– US as a strategic growth market does not make that much sense to me
– comprehensive income is lacking net income by a wide margin
– reporting overall is not very good, lots of “Marketing stuff”, critical figures like profitability per region are missing

What I like

– clearly iconic brand with growth potential especially in EM
– relatively conservative balance sheet
– management salaries are relatively low compared to total profit

Let’s look at some issues in more detail:

Retail business

If you look at their historical numbers, a large part of the recent growth comes from their “retail segment”. They started opening own stores some years ago and have expanded them fast. In 2013, the traditional business which they call “whole sale” already shrunk and only retail had some growth. However retail is lower margin business (Operating margins ~20% against 30+%). They expanded their stores much more aggresively than Nike, especially in Emerging Markets.

Also, retail business in my opinion is riskier than their core business. If you are in retail, you are also in Real Estate. With the threat of the internet (Zalando, Amazon), they are walking on a thin line.

Interestingly, despite paying ~600-700 mn rents p.a. they are only disclosing 1,7 bn of operating lease liabilities. I am not sure what to make of this, it looks like they are only renting short-term which might be OK if EM continue to be weak.

Currency Management:

According to the CEO’s letter in the 2013 annual report, Adidas doesn’t hedge FX risk in Emerging Markets as it is “too expensive”. Well, that’s complete nonsense in my opinion. Of course it is expensive, but for an EM based retail business, not hedging FX is almost suicide. A retailer in Russia is short the USD vs. Rubles twice: First, all the merchandise will be imported from China on a Dollar basis. Secondly, most of the rental contracts will be in USD as well. Sales will be made however in Rubles, so if the Ruble declines against the Dollar, all the nice margins just disappear.

Instead of hedging, the report “currency neutral” sales growth etc. In my opinion this is definitely a weakness especially if you compare Adidas to their major rival Nike. If you look into the annual report of Nike, you can see on page 77 & 78 that they have a pretty sophisticated hedging program in place, which creates a lot less volatility in stated net income AND comprehensive income.

Comprehensive income

As this is often the case, the Comprehensive Income of Adidas is hidden deep within the annual report, in this case it is mentioned the first time on page 189. And, as it is not surprising, Comprehensive income is a lot lower than Net income as the table shows and also much more volatile compared to competitor Nike:

Adidas     Nike    
  EPS CI in % EPS CI in%
30.12.2009 1,25 -0,4 -33,0% 1,99 1,81 90,8%
30.12.2010 2,71 4,4 161,9% 2,22 2,12 95,6%
30.12.2011 2,93 4,0 137,2% 2,48 2,48 99,7%
28.12.2012 2,52 1,5 60,9% 2,65 2,81 106,2%
30.12.2013 3,76 2,2 59,4% 3,02 2,83 93,6%
Total 13,17 11,8 89,3% 12,36 12,04 97,4%

Most analysts would ignore this, as they would call this a “non cash” accounting effect. But especially currency movements in the comprehensive income in my opinion have enormous predictive value. Although its true that the initial currency movement (i.e. the decline of the NAV of foreign subsidiaries) does not impact the cashflow, a permanently lower value of the foreign currency will clearly lower the future profits of the company, especially if they don’t hedge.

Ignoring this effect is like looking at your stock portfolio and ignoring the currency movements if you calculate performance. You can do this, but it does not reflect the underlying value.

Strategy & Capital allocation

Adidas’ strategy to focus on Emerging markets has paid of, despite set backs like currently in Russia. What I don’t understand why the want to target the US. In the US, they have no advantage against Nike, rather the opposite. Nike is much bigger in the Us and clearly has economies of scale against Adidas in advertising expenses.

In my opinion, this is mostly due to the fact, that return on capital is not part of the targets for Adidas management. They have target like sales growth, operating margins and some nonsense stuff like EUR amounts for investments, but no return on investment or return on invested capital targets. Nike, th main competitor, reports ROIC

This leads more often than not to chasing growth for growth sake and not creating value. In my opinion, Adidas clearly has a strategy & incentive issue here.

Brand & Moat

There are different opinions on this topic, but for me , a brand is not a moat. It is a competitive advantage, especially as we have seen in “new markets” like the EM, but on the other hand, brands can easily loose their power if they are not well managed. A sports brand like Adidas in my opinion is even more difficult than a “luxury brand”. Sports brands define themselves via sports stars. Signing sports stars or teams gets more and more expensive and when you are unlucky, your expensive star turns out to be a sex maniac or drug abuser and all the money is for nothing.

A real strong brand allows you to make above average margins and returns on capital, which somehow Adidas fails to deliver compared to some of its competitors.

Valuation

At a 2014 PE of 19, Adidas is clearly not in value territory, based on Comprehensive income, the stock looks even more expensive. In order to justify an investment, one would either need to assume EPS growth or multiple expansion. Yes, Nike trades at a lot higher multiple, but it is also a lot better company than Adidas with much better earnings quality. I also have doubts, that Adidas will increase stated EPS in 2015. Without a major sports event and with Russia still critical, they should rather be happy to maintain current profits.

The share repurchase will maybe add to EPS, but overall, for me Adidas is not a buy at the moment. If you are an event-driven investor wanting to bet on a short-term bump by someone like Icahn, Loeb etc. it could be interesting.

Summary:

Adidas is a company with an iconic brand, however stand-alone it is already quite expensive and the company has at best average management. Earnings quality in my opinion is clearly lower than for competitor Nike. Some activist investors might indeed shake up things a little bit and bump up the share price in the short-term, but the company is clearly facing a very difficult year in 2015. “Turning around” Adidas and bring them to Nike’s level in my opinion is not just spinning off Reebock and Taylermade, but a real change in startegy and incentives.

Adidas is clearly a bet on the Emerging Market consumer, which might work out over the long-term but is somehow maybe difficult in the short and mid-term. There are also cheaper stocks available if one wants to bet on an EM revival. On top of that, I am clearly no expert on branded sports good so for me, this would only a buy if it would look cheap from an absolute point of view, which it doesn’t.

Performance review September 2014 – Comment “Stupid German money”

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Performance September

September was a pretty bad month for the portfolio, both in absolute and relative terms. The portfolio lost -2,2% against -0,2% for the Benchmark. YTD the portfolio is up +4,99% against 0,45% for the benchmark.

A significant part of this underperformance was driven by Sistema which I sold with a loss of 40%. The decision to sell quickly seemed to have been right as the share price has fallen a further 40% since then.

Other big losers were G. Perrier with -17,2%, Ashmore with -12,5%, Hornbach -7,6% and TGS with -6,0%. in contrast to Sistema, I do not see any structural issues with those companies. Clearly the fact that small caps are underperforming since a couple of months als plays a role here.

Portfolio transactions:

Additionally to Sistema, I sold my 0.9% position in Poujoulat. Overall, I am not happy with the way they allocated their capital and the result of the wood pellet segment is pretty bad so I decided to get out of this relatively small position. I sold at around 40 EUR, resulting in an overall gain of 23,5% including dividends.

Additionally I sold my Sky Deutschland shares at a small loss at 6,73 EUR. Unfortunately, they never moved up and the offer period is slowly approaching the end and I have no opinion about the value of Sky Deutschland without the “special situation” aspect.

As a result, the direct cash percentage went up to 13,2%, the economic cash position is close to 20% (including MAN and Depfa LT2 which I consider “close to” cash). Another side effect of my sell transactions is the fact that with 25 positions the portfolio is in my personal “Sweet spot” with regard to the number of positions.

The current portfolio, as always can be seen on the “Current Portfolio” page.

Comment: “Stupid German Money”

September was high time for German Corporations to announce large acquisitions in the US. In a short period of time, transactions were announced from Siemens, Merck Kgaa, SAP and privately held ZF group.

This is a quick overview of the four deals:

Target EV USD bn Buyer P/E Target P/E Buyer Buyer/seller multiple
TRW 12,4 ZF 13,0 not listed  
Dresser Rand 7,3 Siemens 32,0 15,2 211%
Sigma Aldrich 15,7 Merck Kgaa 31,1 16,0 194%
Concur 7,1 SAP 208,0 16,6 1253%

We can easily see that the multiples paid by the 3 listed entities are significantly higher than their own multiples. Large acquisitions are a big risk in any case, but in the case of German – US acquisitions the track record is particularly bad. Daimler/Chrysler is clearly the worst German-US deal ever, but there are loads of other value distracting US deals like Dresdner/Wasserstein, Siemens/Dade-Behring, RWE/American Water etc. There are a few good deals as well, but in my opinion the success rate is definitely below 50%.

Why is this the case ? In my opinion, there are 3 major reasons for this:

1. German companies are normally very risk averse. So in “difficult” times, they keep their cash and wait until times get better. At some point in time when the good times are rolling (as they are now) they feel the urgent need to catch up with their international competitors and then buy into the boom which creates a very procyclical behaviour.

2. German companies often underestimate the cultural differences between Germany/Europe and the US. Many top managers might have been on vacation in the US or even studied there, but running an US company is very different from running a German company. Financial incentives are much more important in the US and often don’t fit with the rules here in Germany. So it is often almost impossible to keep the best people of a recently acquired company and without them, the business often deteriorates quickly.

3. In general. especially large German companies are just not good capital allocators. Buying back own shares is more often than not a no go and considered to be a sign of weakness. Equity is often thought as “Management’s equity” then “Shareholder’s Equity”. The term “shareholder’s equity” actually doesn’t exist in German language, “Eigenkapital” translates into “own funds” and I think most German managers consider it as their own funds and not the shareholder’s.

As a result, the acquisition behaviour of German companies is almost always super procyclical and then looking back mostly looks pretty stupid and is value destroying for the German shareholders.

As a private shareholder, my advice would be: Watch out !!

– You don’t want to own the stock of a German company which acquires a big US company. Chances are high that they will regret it in a few years time
– You don’t want to own the sector longer term they are investing in. This sector might be at or close to a cyclical peak
– although I am not a market timer, you might be very cautious in general despite M&A induced further increasing share prices

Exotic securities: Gabriel Finance 2% 2016 Evonik Exchangeable (ISIN DE000A1HTR04)- Free options anyone ?

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Background / Evonik

Evonik is a German specialty chemical company with a total market cap of ~12 bn EUR. The company went public in 2013, however the majority is still Government owned via RAG (“Ruhrkohle AG”), the German coal mining “run off” company.

Private Equity shop CVC bought a 25% stake in Evonik in 2008. At the end of 2013, CVC issued a 350 mn “exchangeable” bond which exchanges into EVONIK shares if certain thresholds are hit.

The “exchangeable”

Just for clarification: An “exchangeable” bond is a “convertible” bond which is NOT issued by the company of the underlying shares but by someone else. But let’s look at the bonds:

Volume: 350 mn EUR
Maturity: 26.11.2016
Coupon: 2% (semi-annual)
Denomination: 100 K EUR (so not for retail investors…)
Exchange ratio (Nominal/number of share): 2.821,8774 shares per 100 k
Strike price/break even: 35,437 EUR
Stock price “cap”: 130% (Gabriel can call the bond if the share price hits 130% of the exercise price)

So far the structure is fairly typical for a normal “convertible/exchangeable” bond:

– as long as the stock stays below the “strike” one will get back the nominal amount (plus coupons)
– if the stock rises above the strike, one can exchange the bond into the shares and realize the upside which equals a call option on Evonik
– however the upside is “capped” at around 130% of the strike which is similar to a “short call” option on top of the long call

Technically, the bond can now be evaluated by calculating the value of the long call option minus the value of the short call and add this to the “Pure” bond value, which is the nominal plus the coupons discounted back at the “risk adjusted” rate.

The NPV of the long option is around 2,6% of the bond nominal, the short call is worth around -0,5% under standard settings. So this would add almost 100 bps p.a. in option value to the bond. As the bond itself trades around 98%, together with the 2% coupon it looks like that the buyer gets a juicy 3% yield plus a free option on Evonik, so almost a “no brainer” trade in the current interest rate enironment (2 year swaps are at 0,25% p.a.).

The “exotic” feature: The “short put”

But not so fast. CVC has built in something which makes this bond “exotic”: The issuing entity, Gabriel Finance has no additional support from CVC. The issuing entity owns the shares and the shares are pledged to the bondholders, so far so good. But what happens if the stock of Evonik falls below the assumed exchange ratio ? For this case, they have allocated an additional amount of shares to the bond holders, in this case the same amount of shares as are actually the underlying of the bond.

However, even this additional amount of shares might be insufficient if the shares would fall further. We can easily calculate the share price at which the original shares and the additional shares are not sufficient anymore to cover the principal:

“break even” = 350 mn / (original shares + additional shares) = 17,70 EUR er Evonik share.

So what happens if the share price drops below 17,70 EUR ? Well, the bondholders will not get the principal back but whatever the pledged shares are worth at that point in time. (Remark: I did not find out is there is the risk of an insolvency procedure or not)

With a normal exchangeable, the issuing entity would have to make up the shortfall with any other asset they own but in this case, there is none. It is maybe easier to understand if we look at the final payout of the bond in relation to the then prevailing Evonik share price which I graphed using Excel:

gabriel payoff

In order to correctly value the whole “option package”, we will therefore need to

+ add the value of the long call
– subtract the value of the short call
– subtract the value of the put option.

Beware of the Skew

Valueing long dated stock options is a tricky thing. The major input clearly is the volatility of the underlying stock which has a major impact on the value of the option. The volatility to use depends on a couple of things, among others how far the option is out-of-the money.

In our case, the following effect is important: If you have both, a put and a call option for the same stock with the same “distance” to the current price, the put option is usually more expensive than a similar call which means you have to pay a higher volatility. Nobody knows really why this is so but it is a fact and is called the “Volatility skew”.

Finally, another “exotic feature” needs attention: The mechanics explained above mean, that in th positive case, you are long around 2821 shares per bond in th upside case. However, once you hit the downside trigger at 17,70, you are suddenly short 2×2821 shares.

So you need to buy twice as many puts at 17,70 EUR than you could sell calls on the upper end (that’s also the reason why in the Excel graph above, the slope in the downside case is much steeper than in the upside case).

Valueing the whole “package”

So in order to find out how attractive this bond is we need to calculate the “option adjusted” yield of the bond by adding/subtracting the option values to the purchase price and then calculate the yield with the 2% coupon (implied volatility for short call and short puts +6% vs. long call):

EUR In % of Nominal
Purchase price 98000,00 98,0%
minus long call -2624,35 -2,6%
Plus short call 1608,47 1,6%
Plus short put (2x) 5643,76 5,6%
“Option adjusted” Purchase price 102627,88 102,6%

Based on the adjusted purchase price of ~102,6%, this results in an annualized yield of ~0,78% p.a., which is ~0,5% above swap but hardly super attractive.

Summary:

Unfortunately, the Gabriel/Evonik exchangeable is not the nice 2% carry plus free option trade I was hoping for in the beginning. Depending on the assumptions with regard to volatility, the bond actually looks like fairly and efficiently priced. For a pure bond fund who can invest into the bond on a fully hedged basis, this still has some spread left, but if you want to achieve “stock like” returns, then the risk/return profile is not overly attractive.

Clearly my assumptions with regard to volatility are debatable and you could price the short options cheaper, but with options I prefer to make mistakes by being too conservative on the short side. On top of that, as I have mentioned a couple of times, I am not comfortable with German law for bonds and unfortunately this one is issued under German law which makes it relatively easy to change important features of the bond such as coupons and maturities.

Even if one is really bullish on Evonik, buying the underlying stock would be the better choice in my opinion, so for the time being the Gabriel/Evonik exchangeable is not interesting for me, especially as I don’t like the “Black Swan” exposure via the short put.

Emerging market risks, Turkey & Koc Holding

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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.

Sistema update & general thoughts on Russian stocks

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The News

Today, Sistema dropped by some 40% because the boss of Sistema, Vladimir Yevtushenkov was put under “House arrest” following money laundering charges in connection with the Bashneft acquisition.

Going back to my initial Sistema posts (part 1, part 2), let’s look back at the original investment thesis. One fundamental assumption for me was the following:

Is a Russian stock really “investible”

This is a big question for me. A couple of months ago, I wrote a post why I would not invest in Greek stocks (mistake !) or German-Chinese companies (score).

Honestly, a Russian stock is clearly in general much more a “speculation” than a German or French one. Compared to Italian stocks however, I am not so sure anymore, as the EMAK and ASTM example clearly showed that Corporate Governance for instance in Italy is not that much developed.

The two most relevant questions in my opinion are:

a) Are the managers fraudsters or thieves ?
b) Can someone else easily interfere and take away assets etc. ?

At that point in time, my opinion was that:

It looks like that Sistema is at least on neutral to good terms with Putin. In the case of the Indian Mobile subsidiary for instance, Putin put the problems of Sistema on the table when he visited India in 2012.

and

This sounds like a guy who knows how to maneuver (so far) within the harsh Russian political and business climate. So the risk should be a lot lower than for instance for Pharmstandard, but clearly, a dispute with government (see Rosneft/Bashneft) or a more powerful oligarch could change this real quickly.


Well, it looks like that the core foundation of my thesis is not valid anymore. Putting someone under house arrest to me looks already like a significant escalation. To add insult to injury, one of my readers alerted my already end of July:

Seb
26. July 2014 10:26 (Edit)

Hi,
there is something brewing with regards to Sistema’s shareholding in Bashneft. The chairman, Vladimir Evtushenkov had to appear in front of the Investigative Committee in relation to the “the theft of shares of oil and energy companies in Bashkortostan”. Sistema’s Shares in Ufaorgsintez and Bashneft are now restricted from being traded.

I guess, the Bashneft SPO which was planned later this year, will not go ahead. There is even a chance that Sistema could be forced to give up their shares in Bashneft. I feel that the political risk for the company has increased a lot so that I decided to sell my Sistema stock at a nice profit. What’s your opinion on that situation?

I personally thought at that time that they will somehow sort this out but it doesn’t seem to go away easily. Rosneft (and Putin) seem to want Bashneft (and the dollar cash flows) badly and what Putin wants, he gets at some point in time.

What to do now ?

For me the answer is clear: My core assumption has turned out wrong. I do not feel comfortable to price the political risk in this scenario and the only consequence for me is to sell first and ask questions later. Speculating on a rebound would be the other possibility, but this is too much speculation for my taste. In my experience, selling fast is often better in those cases.

Additional remarks on Russian stocks /Sberbank

As some readers might rmemember, I still have a postition in Sberbank and I used to own Pharmstandard for a short time. For now the score is 2 down, one still open for my Russian investments. Not a very good one which shows clearly that both, there is a lot to learn and that the market itself could be rigged against outside investors.

For the time being, I will keep my Sberbank shares but I need to think hard if I can justify investing into Russian stocks with such a personal track record.

I have also underestimated the escalation in Ukraine, where I thought that this will be settled without huge noise at some point in time. Doesn’t look like that and Sberbank could be one of the casualties along the way if the sanctions escalate.

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.

Some links

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WertArt Capital with a potential German liquidation case UMS AG

Charlie Munger is still in great form at the age of 90 as Jason Zweig’s interview notes clearly show. He doesn’t like Benjamin Graham though……

Great FT Alphaville post why one should be careful with “high dividend paying” securities.

A collection of notes from the recent New York Value Investing congress

Good presentation from Carson Block (Muddy Waters) on activist short selling

Self driving cars: Tesla joins the hype, Google’s real world experience still seems to have room for improvement

Vossloh (DE0007667107) – another potentially interesting “Fallen Angel” with an activist angle ?

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Vossloh AG is a mid-sized German company and calls itself “a leader in the rail infrastructure and rail technology”.

Looking at the stock chart we can clearly see that not everything is going well there:

Vossloh lost almost 50% from their peak 3 years ago. If we look at some profitability measures of the past 10 years we see an interesting pattern:

EPS Profit Margin ROE
30.12.2004 3,91 6,2% 18,5%
30.12.2005 3,08 4,8% 13,3%
29.12.2006 2,98 2,0% 5,7%
28.12.2007 4,26 7,0% 18,2%
30.12.2008 6,30 11,5% 31,1%
30.12.2009 6,57 7,5% 18,5%
30.12.2010 7,32 7,2% 19,0%
30.12.2011 4,32 4,7% 11,0%
28.12.2012 4,15 4,8% 12,4%
30.12.2013 1,00 1,1% 3,1%

Vossloh showed only little impact during the financial crisis but then results deteriorated. They showed a small profit for 2013, but for the first half-year 2014, they shocked everyone with an “Accounting Bloodbath”, showing a loss of ~12,20 EUR per share, wiping out all profits for the last 3 years and some more.

So what happened ?

This is a quote from the CEO letter of the 2010 annual report:

For the years ahead, we intend to accelerate our growth while sustaining the rate of profitability. It is especially in the international markets that we will be amplifying our presence and we will be scoring in particular with the new products. For 2011, we are targeting group sales of €1.4 billion and an EBIT above €160 million.

This is from the 2011 CEO letter, where profits already declined:

Dear Stockholders:
Following a series of very successful fiscal years marked by above-average growth rates Vossloh suffered setbacks in 2011. Contrary to our expectations, Group sales and earnings declined. The chief influencing factors were the slowdown in the progress of Chinese rail projects, which only became evident as the year proceeded, the suspension of shipments for a major project in Libya and, from the summer onward, weak demand in key European rail markets. Under these circumstances, the Rail Infrastructure division’s sales, which at around 65 percent of the Group’s continued to contribute the lion’s share of revenue, dropped for the first time in years, by some 13 percent. The sales shortfall at Vossloh Fastening Systems was especially severe at the Chinese location and could not be offset by business elsewhere. The Switch Systems unit also performed below expectations due to the military conflict in Libya, which prevented the planned extensive shipments to that country in 2011. In addition, in several European countries demand slackened and price pressure stepped up.

In 2012, the outlook for 2013 was not that good but still “solid”:

However again, they disappointed, as stated in the 2013 annual report:

There were two significant reasons for the downward development in 2013: For one, we were confronted with extensive non-recurring charges that were due to expenses for the final out-of-court settlement of a dispute in the Transportation division in an amount and extent that was not to be expected. For another, there were additional expenses in this division in connection with the processing of several projects, which entailed additional and unexpected losses of earnings. In contrast, the Rail Infrastructure division performed significantly better than expected, and revenues as well as the result increased significantly. The Fastening Systems business unit primarily contributed to this positive development.

Not too surprisingly, both, the CEO and COO stepped down in February making way for a new management. Normally, CEO hate to step down even after management disasters so what happened ?

The activist angle:

Vossloh had been more or less controlled by the founding Vossloh family for more than 100 years although they only owned around 34%. Since 2011 though, another strong shareholder emerged: Hermann Thiele, the owner of German unlisted company Knorr Bremse who had built up a stake of close to 30 % from 2011 to 2013.

Although Thiele is not widely known and keeps a low profile, he is one of the most succesful German entrepreneurs of the last 30 years. He bought Knorr Bremse in 1985 as one would call it a “leveraged management buyout” and then grew the company by a factor of 15-20 times over the last 30 years. Despite being a non-listed company, Knorr Bremse issues a relatively good annual report where onr can see that the company is spectacularly profitable. Net margins of 8-9% and cash adjusted ROICs of more than 30% are clearly an indicator that this guy seems to know what he is doing. Besides that, depending on how you value Knorr Bremse, he is also one of the richest persons in Germany.

A little side story: World famous BMW AG once was the engine subdivision of Knorr Bremse until 1922 when it was sold to an investor as they didn’t find the engine business interesting enough……

In 2013, he finally succeeded in being elected as boss of the supervisory board against the explicit wish of the founding family. The founding family finally sold most of their shares in late 2013. It was him who kicked out the old management and brought in 2 new guys, among them the new CEO Hans Schabert who used to run the rail operations of Siemens.

In one of Thiele’s rare interviews in 2013 he stated that Vossloh is his private investment. Although he likes the business, he doesn’t want to take full control and leave Vossloh listed.

As a supplier to the rail industry, he knows the sector pretty well. I could imagine that long-term this might help Vossloh to get back on track. However I do not believe that he will remain a minority shareholder for ever. I do think that sooner or later he will try to take control. There would be clearly synergies between Knorr Bremse and Vossloh as both have the same clients and Knorr is even a supplier to Vossloh’s locomotive unit.

The 6 months 2014 “accounting massacre”

If you ever want to see a “how book as many losses as possible” financial report then look at the recent 6 month report from Vossloh. The new management wasted no time and did not even wait until year-end in order to write down everything they could.

Even in the investor presentation, they don’t make the slightest attempt to normalize the result.

Digging deeper into the report, you will find among others:

– goodwill write offs
– inventory write downs
– extra provisions against “risks”
– and even a charge because they did an early retirement of a higher coupon debt facility, which is clearly earnings accretive in the future.

In their outlook the state that one can expect some more losses in 2014 but from 2015 on Vossloh will be profitable again. But they did not specifc how profitable. Operationally they made already some significant changes. So overall this looks a little bit similar to the Van Lanschot story. The new CEO (with the support of the Supervisory Board) has written off whatever he could in order to show increasing profits going forward.

However there could also be a problem here. At some point in time, Thiele could decide that he doesn’t want to share the upside of a turn-around with the other shareholders and try to take Vossloh private as cheaply as possible. Other than Cevian at Bilfinger, Thiel has no track record with capital markets and many “old school” German business tycoons do not care very much about minority shareholders. This is clearly a risk to be considered

What could be a “turned around” Vossloh be worth ?

This is an overview of average margins (10/15 Years) of Vossloh and its 3 listed European “pure play” competitors:

Avg NI Margin  
  10 Y 15 Y
Vossloh 5,67% 5,19%
CAF 5,40% 6,46%
Faiveley 6,50% 5,00%
Ansaldo 5,98% n.a.

Overall, I would say a 5,5% net profit margin on average is not unrealistic. Based on 2013 1.325 mn sales and assuming no growth, this could mean that Vossloh at some point in the future makes ~ 73 mn EUR profit or ~5,5 EUR per share If we assume a 12-15 P/E range, this would mean that a target share price of 66-82 EUR would be realistic.

Based on today’s price of ~49 EUR this would mean a potential upside of 35-68%. However one should assume that this turn-around needs at least 3 years. For a turn around, I personally would require a higher return than for a normal “boring” value stock as there is clearly a risk that the turnaround does not work out as planned.

If I assume a target return of 20% p.a., i would need to be sure that the price of Vossloh is in 3 years at around 85 EUR. This is clearly at the very upper end of my target range. So I would either need to have more aggressive assumptions or I would need a lower entry price. As a value investor, I would not want to bet on growth or on a shorter time frame for the turn around, so the only alternative is to wait for a lower entry price.

Taking the midpoint of my range from above at 74, I would be a buyer at ~42 EUR per share but not before.

How does this compare to the Bilfinger case ?

A few weeks ago, I was looking at a similar case, Bilfinger. Similar to Vossloh, an activist investor (Cevian) managed to get rid of the CEO and tries to turn around the company after mutliple earnings disappointments.

At a high level comparison I like Vossloh’s underlying business better. Bilfinger clearly has some structural issues especially with its power business where the underlying market (electrictiy) is undergoing a big fundamental change whereas the railway business to me seems fundamentally intact. On the other hand, Cevian as “activist” has a very good reputation and is easier to “handicap”. They will most likely treat minority shareholders fairly and do some kind of spin off etc. So the risk of getting screwed by the activist is lower.

In a dirct comparison however I would prefer the “activist risk” at Vossloh against the fundamental issues at Bilfinger. Additionally, the real “accounting bloodbath” at Bilfinger hasn’t happened yet.

Summary:

In general I think Vossloh could be an interesting turn around story, especially considering the involvement of German self-made billionaire Hermann Thiele. I do like the industry better than for instance Bilfinger. It is clearly cyclical but I don’t see any structural issues. On the other hand, the current price is too high with regard what I would expect for such a relatively high risk “turn around” investment. The “Mean reversion potential” at the current price is not high enough, I would need a ~20% lower share price to justify an investment.

Looking at the chart, this might not be unrealistic as the stock price is still in free fall and any “technical” support levels would be somewhere around 39 EUR per share if one would be into chart analysis. In any of those “falling knife” cases, patience is essential anyway.

Vossloh will therefore be “only” on my watch list with a limit of 42 EUR where I would start to buy if no adverse developments arise. Additionally I will need to check Vossloh against Alstom once

Short cuts: KAS Bank & Van Lanschot

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Both Dutch Banks in my Portfolio, Van Lanschot and KAS Bank reported 6 month numbers last week.

Van Lanschot

Van Lanschot’s 6 month numbers were relatively solid in my opinion. 6 months EPS were 1,14 EUR per share, however this includes certain one-offs from asset sales. The underlying wealth manangement business seems to have stabilized. Net interest income is slightly going down but this is the result of shrinking their loan portfolios and was expected. The stock price reacted quite positively on those numbers:

What I didn’t like at all was the fact that within the comprehensive income, they burried a large increase in their pension reserves of around -82 mn before tax. This is around 10% of gross pension liabilities and wiped out all the profit of Van Lanschot in the first 6 months (comprehensive income was actually negative). Unfortunately, there is no explanation given. I Have sent an Email to IR in order to understadn this better.

KAS Bank

Similar to Van Lanschot, KAS Bank presented very solid 6M numbers including a big one time effect. They received 20 mn EUR as compensation for letting German dwpbank out of an outsourcing contract. Underlying profit without this one off increased nicely, although mostly due to cost savings than higher revenues.

Compared to Van Lanschot, the stock price did very little:

Maybe this has to to with a somehow muted outlook and the decission to fully reinvest the dwpbank payment. Nevrteheless, for me KAS Bank seems to be on a very good way and is rather a buy on weak days. I still think that KAS Bank should trade at least at book value which is around 14,50 EUR per share.

KAS Bank in my opinion is also a very good and cheap interest rate hedge. If short term rates rise, this will directly benefit KAS Bank’s result within a very short time frame. I do not have an active opinion on interest rates, but it is a nice “add on” to the investment case.

Performance review August 2014 – Comment “Patient enough ?”

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Performance August:

In August, the Benchmark (Eurostoxx50 (Perf.Ind) (25%), Eurostoxx small 200 (25), DAX (30%), MDAX (20%)) recovered from last month’s loss to a certain extent and gained +1,1%. The portfolio could not keep up with that and was almost unchanged. YTD, the score is +7,6% for the portfolio against +0,3% for the BM.

Winners were Installux (+6,9%), Van Lanschot (+5,9%) and Cranswick (+5,1%). Losers were Admiral (-8,4%), Sistema (-8,3%) and Kas Bank (-3,2%).

Current Portfolio & transactions:

In August, I added Bouvet ASA as a new position to the portfolio and increased Gronlandsbanken to a half (2,5%) position. This reduced the outright cash level to 9,0%. Together with 3 special situations (Depfa LT2, MAN AG, Sky Deutschland) which I consider “close to cash”, the portfolio is still very conservatively positioned.

The detailed portfolio can be seen as always under the portfolio page.

Comment: “Patient enough ?”

In my blog, I have often written about the virtues of patience for an investor, for example in my January 2013 comment. This is what I wrote some 19 months ago:

However another potentially big mistake should also not be underestimated: Taking profits too early. Most investors (including myself) get nervous if their stocks climb quickly 20-30%. What you then often hear is something like “It never hurts taking a profit” or “No one ever got bankrupt by taking a profit” or something similar.

The truth is: In order to generate above average returns, taking profits too early hurts badly. Statistically, the vast majority of investment ideas will be rather average, some will be bad, but some of them and usually only a small amount will be really really succesful.

So if I look at the January 2013 portfolio, I can already identify a couple of positions which I have sold far too early, among them Total Produce, WMF, Dart Group, Bouygues which I sold far too early despite my smart talks in the comment. So obviously, I am still not patient enough, especially with my winning shares. So how can I trick myself into more patience ?

In my current portfolio overview I added a column called “Holding period”. This is simply the calculated time since I bought the first part of the position. Interestingly, both for the “core value” part as well as for the special situations, the average holding period is around 1,5-1,6 years.

Name Weight Perf. Incl. Div Holding period
CORE VALUE      
Hornbach Baumarkt 4,3% 35,7% 3,7
Miko 3,9% 10,7% 1,0
Tonnellerie Frere Paris 5,7% 117,3% 3,7
Installux 3,5% 82,1% 2,3
Poujoulat 0,8% 26,5% 2,3
Cranswick 5,8% 72,4% 2,2
Gronlandsbanken 2,5% 25,7% 1,8
G. Perrier 4,5% 102,5% 1,5
IGE & XAO 2,2% 57,3% 1,3
Thermador 3,0% 41,3% 1,2
Trilogiq 1,7% -14,5% 0,9
Van Lanschot 2,6% 9,7% 0,8
TGS Nopec 4,9% 12,3% 0,8
Koc Holding 3,6% 46,3% 0,5
Ashmore 2,9% 17,8% 0,5
Sistema 1,1% 4,4% 0,5
Sberbank 1,1% 6,7% 0,3
Admiral 2,7% 3,3% 0,2
Bouvet 2,7% -0,3% 0,0
       
OPPORTUNITY      
KAS Bank NV 4,3% 49,8% 3,7
Drägerwerk Genüsse D 4,8% 143,5% 2,9
DEPFA LT2 2015 5,0% 30,3% 3,7
HT1 Funding 4,3% 86,5% 0,8
MAN AG 2,3% 4,8% 0,5
Energiedienst 2,6% 10,6% 0,3
Depfa 0% 2022 TRY 3,0% 16,5% 0,2
NN Group 2,6% 2,5% 0,1
Sky Deutschland 2,5% -0,8% 0,0
       
Cash 9,0%    
       
Core Value 59,5%   1,6
Opportunity 31,5%   1,5
Short+ Hedges 0,0%    
Cash 9,0%    
  100,0%   100,0%

Most of my “core value” investments are usually meant to take 3-5 years in order to work out as planned. Of course, sometimes events out of my control impact the holding period such as buy- outs (EGIS, AIRE KGAA) or maturities in the case of bonds. But especially for the “core value”, the current 1,6 year holding period looks short on average. Clearly, there is some effect due to the fact that I started the blog 3,7 years ago and in my private portfolio some of the initial positions are there for a much longer time. Nevertheless, in the future I will focus more on the average holding period.

If i would invest consequently along my stated goals I would expect an average holding period of at least 2-3 years for my “core value” part. The “special situation” part is naturally a little bit shorter.

Now the good news: I don’t have to do anything to increase the holding period. I just have to sit around, wait and do nothing and the holding period will increase each day…..

I don’t want to give myself any “hard restrictions” on the average holding period as I strongly believe that most external restrictions on investment portfolios are negative for performance in the long run. One of the biggest advantages of any private investor is that he/she doesn’t need to have any restrictions. If you look at any institutional portfolio, it is crazy how many regulatory and other restrictions exist. Many portfolio managers spend most of their time steering through those restrictions instead of looking for good investments.

For that reason I will not create any artificial minimum but rather look at this as a continuous process and as a “qualitative factor”. In practice for instance I will check any new idea against the alternative to increase an existing position and report the holding period in my monthly updates. Of course this does not prevent too early selling, but I think it helps to implement more patience into my portfolio management process.

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