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

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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.

Some links

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Damodaran tries to value Go Pro

David Merkel on the “interest rates must rise” mantra

Research Affiliates has a pretty cool new website where you can play around with expected returnas and volatilities of all major asset classes

Interesting post on the differences between Japanese and US stock valuations

A good summary of investment ideas presented from the “great investors” conference (GIBI) including Einhorn, Ackman, Price etc.

Recent ~40 minute interview with Warren Buffett

Special situation quick check: Rhoen Klinikum (ISIN DE0007042301) – “Listed transferable tender rights”

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Yesterday, Rhoen Klinikum released the details how they will buy back shares following the sale of most of their business to Fresenius (Rhoen was a very successful “busted M&A” special situation, previous posts can be found here)

They way they do it looks interesting and seems to be like a “reverse rights issue”. The instrument is called “Listed transferable tender right” and seems to work as follows:

– as of tomorrow, October 16th, each shareholder gets automatically one “tender right” per share
– those “tender rights” are traded separately at the stock exchange
– you need to have 21 tender rights in order to sell 10 shares
– the tender price is 25,18 per share
– the exercise period runs until November 12th, until then, the tender rights are traded
– already tendered shares will trade under a separate ISIN until November 14th
– the cash for tendered shares will be paid out on November 19th

As of today, the shares are trading at around 23,85 EUR. Following the logic of the subscription rights, one right should be worth

Edit: in the first version, I had the wrong formula. Thanks to a friendly reader, this is the correct formula:

(25,18-23,85)/((21/10)-1)= 1,21 EUR.

So tomorrow, the Rhoen shares should open (all other things equal) -1,21 EUR lower and the rights should trade at 1,21 EUR. Let’s see if there is a chance to find a little arbitrage here and there.

One strategy could be to buy the stock at the open, hoping that the “discount” will be eliminated quickly. A second one could be an arbitrage between the rights and the stocks. Finally, it could be worthwhile to look at the tendered shares as well.

Don’t ask me why they are doing it that way. I think it most likely optimizes the tax position of the large shareholders, especially for the founder Eugen Muench, who wanted to cash in his remaining 10%.

A final comment for clarification: No, this does not mean that Rhoen shares should trade at 25,18. The price chosen by Rhoen is relatively “arbitrary”, they could have used any other price as well.

The Dutch Job: Royal Imtech (NL0006055329) Deeply discounted rights issue – The “short opportunity of the century”

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I had written about Royal Imtech, the troubled Dutch service company already a couple of times. The short story: Growth star encounters fraud and too much debt.

Somehow, I lost them from my radar screen until today. Already in August, they announced that they will do another rights issue, this time aiming for 600 mn EUR, after having raised 500 mn in 2013.

The funny thing is the way they actually do this which even puts my favourite “Italian Job” companies at shame:

Following the approval granted by the General Meeting on 7 October 2014, Royal Imtech N.V. (“Royal Imtech” or the “Company”) announces a 131 for 1 fully underwritten rights offering of 60,082,154,924 new ordinary shares with a nominal value of EUR 0.01 each (the “Offer Shares”) at an issue price of EUR 0.01 per Offer Share (the “Issue Price”). For this purpose, and subject to applicable securities laws and the terms of the prospectus dated 8 October 2014 (the “Prospectus”), existing holders of ordinary shares in the share capital of Royal Imtech (“Ordinary Shares”) as at 17:40 CEST on 8 October 2014 (the “Record Date”) are being granted transferable subscription rights (“Rights”) pro rata to their existing shareholdings (the “Rights Offering”, and together with the Rump Offering (as defined below) the “Offering”). No Rights will be granted to Royal Imtech as a holder of Ordinary Shares in its own capital. The Rights will entitle the holders thereof, provided they are Eligible Persons, to subscribe for 131 Offer Shares for every Right held at the Issue Price, subject to applicable securities laws and in accordance with the terms and subject to the conditions set out in the Prospectus. The Issue Price per Offer Share represents a discount of approximately 21.7% to the theoretical ex-rights price (“TERP”) based on the share price of EUR 0.3763 at Euronext in Amsterdam (“Euronext Amsterdam”) after close of business on 7 October 2014 and 458,642,404 shares issued and outstanding at the same date (thus excluding treasury shares

So before the rights issue, the market value of the company was around 0,38*458 mn shares= 175 mn EUR. Today is the first day where Royal Imtech trades “ex rights”. Just as a little refresher the formula for calculating the value of the right (to buy 131 shares at 0,01 EUR) before trading:

(0,3763-0,01)*131/132= 0,3635

So theoretically the price of Royal Imtech should be today: 0.3763-0.3635 = 0,0128 EUR. a little more than one cent.

Let’s look what the shareprice is doing today:

Imtech is trading at 0,09 EUR, around 800% higher where it should trade !!!!! On the other hand, the rights trade only at 0,17 EUR at the time of writing, a discount of 50% to the theoretical value (as of yesterday).

This leaves the question: Why are investors paying today 9 cents for the shares which they can buy via the rights at a little over 1 cents per share in 2 weeks time ? I have no answer. MAybe people (and computers) mixed up the decimals and think the new shares come at 0,10 EUR ?

Anyway, if anyone is able to short Royal Imtech at this level, this would be the short of the century. You can short something at 0,09 EUR today and buy back at 0,01 in a few days. Nothing more to say….

Edit: Might be a good example for any student who is confronted with the “Efficienty markets hypothesis”.

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.

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