Management / shareholder disconnect- E.ON SE edition

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Normally, I don’t care that much about quarterly results, but in the case of German utilities I sometimes make an exception simply because often they are too entertaining to miss.

Yesterday, for instance E.ON the German utility company reported Q3 figures. The press release reads pretty “upbeat”:

E.ON affirms 2014 forecast
11/12/14 | Posted in: Finance
Adjusted for portfolio and currency-translation effects, EDITDA above prior-year level
Renewables’ share of earnings rises to 17 percent
Economic net debt reduced by €1.2 billion
E.ON today reported nine-month earnings that were in line with its expectations. It therefore continues to anticipate full-year 2014 EBITDA of €8 to 8.6 billion and underlying net income of €1.5 to €1.9 billion. Nine-month EBITDA declined by seven percent year on year to €6.6 billion. The absence of earnings streams from divested companies and adverse currency-translation effects were the main factors. On a like-for-like basis—that is, adjusted for portfolio changes and currency-translation effects—E.ON’s EBITDA was above the prior-year level.

I would call this kind of disclosure “Level 1”: How the company wants to be seen

So with “adjustments” things look better than last year. However this time even a relatively “mainstream” German magazine remarked that the earnings disclosure of EON is relatively difficult to understand.

Level 2: P&L – Some kind of truth

In their quarterly report, EON has to use Accounting standards at some point. After 15 pages of useless “Management report” the first “real” accounting number shows up on page 16.

In fat type you can see the following:
Net income 255
 for YTD 2014, which is around 90% lower than 2014. Then in small print they show the following:

Attributable to shareholders of E.ON SE -14
Attributable to non-controlling interests 269

So under IFRS, EON actually lost 14 mn EUR in the first 9 months.But anyone who is reading this blog regularily knows that this is still only “half of the truth”:

Level 3: What really happened – Comprehensive income

Only on page 25 we see the comprehensive income statement of EON for the first 9 months. And this looks really ugly.

-1,7 bn losses from the increase in pension liability
-0,6 bn FX and hedging losses

then lead to a total loss of 2,2 bn EUR or -1,1 EUR per share for E.ON’s shareholders for the first 9 months.

If we look at the stock price, we see that the positive “spin” only lasted for around 20 minutes before the stock price started to drop.

Why are they doing this ?

Well, this is pretty easy and straight forward: This allows the Management to award them nice bonuses independent of what the total result for the shareholder looks like.

Total comp in 2013 according to the annual report for management was 18,5 mn, thereof around 13 mn “bonus”. And this in a year where the were only able to generate a comprehensive income o ~600 mn EUR or 2% ROE.

EON’s target achievement is measured the following way according to the annual report:

As under the old plan, the metric used for the operating-
earnings target is EBITDA. The EBITDA target for a particular
financial year is the plan figure approved by the Supervisory
Board. If E.ON’s actual EBITDA is equal to the EBITDA target,
this constitutes 100 percent attainment. If it is 30 percentage
points or more below the target, this constitutes zero percent
achievement. If it is 30 percentage points or more above the
target, this constitutes 200 percent attainment. Linear inter-
polation is used to translate intermediate EBITDA figures
into percentage

For a capital-intensive business like a utility, EBITDA in absolute is pretty useless. However it is pretty easy to achieve or beat for Management. As a shareholder you can be sure that your interests are not aligned well with those of the management. In my opinion, that whole mess at EON has a lot to do with this pretty obvious “detachment” between management and shareholders and only to a smaller extent with German energy policy.

Finally some other stuff

The most interesting item in the whole Q3 report for me was the fact that Electrical Power generation was actually 50% better (EBITDA) than in 2013 and more than 100% better on EBIT basis. The biggest drop yoy actually came from the natural gas business.

Summary:

EON’s Q3 report for me is a prime example for a badly managed company. The disconnect between management incentives and shareholders leads to nonsense reporting, mostly in order to avoid the hard truth of losses to shareholders. For instance anyone who wondered why they bought crappy assets in Brazil and Turkey instead of paying back debt should understand that this actually increased the bonuses of management irrespective of FX losses, write-offs etc. As an investor, one should stay as far away as possible from such companies, no matter how cheap they are because at some point in the future they will “hit the brick wall”.

Short cuts: Sky Deutschland, Rhoen Klinikum, Bilfinger, Vossloh

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Sky Deutschland

A short quiz: Can you spot the day when the 6,75 EUR offer expired ?

My initial strategy obviously didn’t work out. Now however I am wondering why I didn’t short Sky Deutschland instead before the offer expired. It seems to be clear now that the price didn’t move above 6,75 EUR during the offer period, because most people attach a fundamental value of less than 6,75 EUR to the shares. That would have been second level thinking, but I missed it.

I read somewhere that you should only sell a stock from a portfolio if you are ready to short it. That would have been the best approach here.

Rhoen Klinikum

Looking at the chart, my decision to take a profit at 23,15 EUR looks stupid:

The mechanics of the current “listed transferable tender rights” are the following: The less people who want to actually sell there shares, the lower the price of the tender rights and the higher the share price. As for now, it seems that not so many people want to sell. I have to confess that I got nervous when the price of Rhoen dropped after I bought on the first day ex rights.

In the future, I think it makes sense to wait longer and see how these special situation plays out. I think I waisted some “intrinsic optionality” by taking the small profit much too early.

Bilfinger

In August I looked at Bilfinger for the first time. My arguments against an investment back then were the following:

– some of the many acquisitions could lead to further write downs, especially if a new CEO comes in and goes for the “kitchen sink” approach
– especially the energy business has some structural problems
– fundamentally the company is cheap but not super cheap
– often, when the bad news start to hit, the really bad news only comes out later like for instance Royal Imtech, which was in a very similar business. I don’t think that we will see actual fraud issues at Bilfinger, but who knows ?

Yesterday, Bilfinger released Q3 numbers.

For me, it was therefore no big surprise that they had to write down in total of ~230 mn EUR. The market however seems to have been expecting other things as the extreme drop in the share price shows:

I think Bilfinger is now approaching the “very cheap” area and I will look at them a little closer in the next weeks.

Vossloh

Vossloh, another potential “turn around” story also released Q3 numbers a few days ago. Similar to Bilfinger, investors seemed to have been spooked by the numbers.

In my opinion, two issues might have irritated investors:

– new orders in Q3 were very weak (new orders in the first 6 months were very strong)
– management basically said that a “full” recovery can only be expected for 2017

Interestingly, the whole press release had a very negative tone, they make no attempt to strip out the one offs etc. etc. Maybe it is coincidence, but if I would want to talk the stock down in order to maybe buy the company cheaply, I would do it exactly that way…..

This is what I said in September:

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.

So we are now very close to my potential entry point. I will watch this as closely as Bilfinger. Both for Bilfinger and Vossloh, Iit will be interesting to see if there will be some year end tax loss selling.

Performance review October 2014 – Comment “Stress testing”

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Performance October 2014

In October, the portfolio lost -0,8%. Compared to my benchmark (Eurostoxx50 (25%), Eurostoxx small 200 (25%), DAX (30%),MDAX (20%)) at -1,7%, this is an outperformance of +0,9%. YTD the score is +4,2% for the portfolio against -1,2% for the benchmark.

Positive contributors were Koc Holding (+9,7%), G. Perrier (+7,1%), Cranswick (+6,2%). Loosers were Draeger (-9,2%), Bouvet (-7,1%) and Miko (-5,8%).

Obviously, October was a relatively volatile month (more to that in the comment). However, in the worst days in mid October, the portfolio behaved as expected with a max. draw down of “only” 1/2 of the benchmark.

Portfolio transactions:

October was relatively quiet. Citizen’s Financial, my first US stock since a long time entered the portfolio as a “special situation”. In between I did a little “special situation” trade with Rhoen, netting me ~2% in the process.

The current portfolio can be seen at the usual place here.

Comment: “Stress testing”.

The first “Stress test” I want to refer to is the “comprehensive assesment of the financial health” of 120 major European banks by the ECB. The press feedback was quite predictable, mostly saying that it was only a first step and is not tough enough.

In my opinion, two important aspects have not been highlighted very often. First, I think the major achievement of this is to make all the different bank models comparable. In my opinion, this is a result which should not be underestimated. Everytime when some kind of international standard is released, all the local governments try to lobby as hard as they can for exceptions for their own players. The result then is basically a general standard with very few “teeth” and no one is able to compare the results. In this case, the ECB has been quite succesful to make the results comparable and even get the approval of all the regulators which I find is quite an achievement.

Additionally, for me it was quite surprising that some banks actually failed. I would have expected more like “ok, they failed based on 2013, but have restored their capital already” outcomes. So I was quite surprised that especially for some Italian banks, the situation became quite difficult (esp., BMPS and Banca Carige). In my opinion this indicates that the ECB will not be a “lame duck” regulator, which in the long run is good news for the Euro zone despite more short-term issues. Plus, as Draghi is alway accused of helping the “Club Med” countries, this outcome shows that this is not the case.

Overall, despite all the negative opinion about the Eurozone, my opinion this is a very important and constructive step to get the “financial plumbing” right within the Euro zone. If and when this leads to a revival is another question but personally I think that the public opinion is underestimating what is actually being achieved here.

The second but more personal stress test was clearly the sudden drop in equity markets in mid October. Especially for the US market, this was the biggest drop since 3 years or so. I guess for many investors this was quite “spooky” as there was no apparent reason. In my opinion, a potential reason for this kind of volatility is the fact that many people who are owning stocks now shouldn’t own stocks. Buying stocks because the dividend yield is higher than the yields on deposits sounds good at first, unless your shares suddenly drop 10% or more. Often such investors are called “weak hands” because they sell just because of a drop in the share. After the financial crisis, many “weak hands” stayed out of the market for quite some time but are now returning mostly because of the low-interest rates.

Normally I don’t give general investment advise, but here I make an exception. Two points of advise to investors:

1. Don’t buy stocks because of the dividend yield
2. Stress test yourself: If October made you nervous, or you can’t afford your stocks dropping 10%,20%,30% or more, then you maybe shouldn’t be in stocks at all

I have clearly no divine insight where the stock market will go in the future, however we should expect the ride to be quite bumpy.

Some links

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Sohn conference SF 2014 notes with summaries of all the pitches plus Notes from the Sohn Canada conference with even more ideas

Great write up on C.H. Robinson from the Punchcard blog.

Some great bloggers “on air”: Nate from Oddball and David Merkel, Aleph

Damodaran on the HP break up and Amazon’s field of dream

Fall 2014 issue of Graham & Doddsville, featuring Wally Weitz

David Einhorn’s presentation for Sun Edison

Wertart Blog likes Steico, the German insulation manufacturer and Valueinvesting France is back with a post on Akka and SII

Tesco Plc (ISIN GB0008847096) – Potential value investment or turnaround gamble ?

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For a very long time, Tesco, the UK supermarekt chain could do no wrong. They grew nicely year after year and margins, returns on capital etc. were in a league on its own compared to other supermarket chains.

In the 20 years leading up to 2007 for instance, the Tesco share price increased 15 fold, resulting in an annual gain of ~ 16,3% vs. ~7,0% for the FTSE 100.

In the last few years however, Tesco’s star faded. Profit warning was followed by profit warning. In 2013, after exiting the US business and the China venture, many thought that the worst was behind them. But now in 2014, the problems seem to have just begun with further sales declines in the UK markets and lately with an accounting scandal forcing the Chairman stepping down

Over the last few years I looked from time to time into Tesco. I usually don’t like retailers that much, but with Tesco the simple reason was always “Buffett is owning it”. I have to admit that for me the fact that Buffett is owning something creates an urgent need to look at those companies.

Anyway,
Warren Buffett admitted defeat and sold out a few weeks ago, after buying a large stake as late as in 2012, calling the whole episode as a “great mistake”.

Nevertheless, such a rapidly falling stock price of a “blue chip” company still lures many value investors. Among others, Vitaly Katsenelson came out with a “pro Tesco” article just a few days ago.

I would summarize his arguments as follows:

It is a good time to buy Tesco NOW because:
– the news is all negative
– there is an natural upper limit of discounter market share in the UK close to the level where it is today in the UK (~7%)
– Tesco is still twice as large as the nearest competitor and 10 times bigger as Aldi and Lidl
– US grocers have countered Walmart in the US succesfully, so will Tesco in the UK
– Tesco sits on a lot of prime real estate
– Tesco has a 50% market share in online groceries in UK
– the discovered accounting issue is not so bad, as part of if happened in past years
– there is a lot of hidden value in Tesco’s real estate
– Tesco has subsidiaries (loyalty cards, Asia) which are valuable, it could be a sum of parts play
– the 7,5 bn GBP debt load is not an issue because the company is “asset rich”
– at an assumed “fair”operating margin of 5%, Tesco would be a “steal” at 6x P/E

Overall, the pitch is well written and seems to be quite convincing.

However at a second look, the Tesco story seems less convincing. Regarding Katsenelson himself, I wonder why he didn’t explictly mention his article from 1 year ago, where he recommended to buy Tesco right back then, at a price of around 3,60 GBP with virtually the same arguments. Since then, the stock lost a -54% if you followed his advice.

But let’s look at some of his arguments:

There is an natural upper limit of discounter market share

Katsenelson claims that the current discounter market share of around 7% is a “natural limit”. He doesn’t link to any proof and only mentions the limited success some US chains to support this. However if you look at the “Motherland” of hard discounting, Germany, you can see that this argument is pure nonsense. Although German shoppers might be a little special, a market share of 44% for diacounters in 2014 clearly shows that there is a lot of room for discounters in the UK, even if the never get to German levels.

Tesco is still twice as large as the nearest competitor and 10 times bigger as Aldi and Lidl

Well, that’s true for the UK but not for the Europe. Lidl had total sales of 75 bn EUR in Europe, only slightly less than Tesco’s total sales. Aldi doesn’t issue consolidated sales figures but is only slightly smaller than Lidl. What Kastenelson however completely misses is the following: Aldi and Lidl offer only a very limited choice, usually several hundred products compared to 10.000 or more in a large supermarket. So you don’t have the choice of 10 different sorts of orange juice, there is only one and the same goes for other categories-

The result of this limited choice is a a massive scale effect. Even with less total sales, sales per single product at Aldi & Lidl might be already higher in the UK than at Tesco. And sales per single products are essential because this gives negotiation power with the suplier.

There is a lot of value in Tesco’s real estate

This is the same argument one hears all the time for struggling retail companies. They just need to sell their precious reals estate and everything will be OK. The problem with this kind of approach is that real estate for a retailer is not some kind of “extra asset” which comes on top, but real estate is an essential production factor. Selling real estate for a retailer normally means a “sale-and-lease” back and is nothing more than taking on more debt.

I have written about one case, Praktiker in Germany, where the sale-and-.lease-back finally killed the company, the same happened with Karstadt/Arcandor. Tesco by the way, seems to have been quite active in more or less intransparent sale-and-lease back transactions in the past, as this FT Alphaville article outlines. There is also a pretty good post at Motley Fool with regard to the assumed “real estate treasure” and the following quote nails it down:

The supermarkets’ race-for-space is over. Forget the news that Tesco is planning to build houses on some of its now unneeded landbank — that’s it’s a sideshow in the grand scheme of things.

The real story to focus on is those aircraft-hangar-like Extra stores that Tesco is currently padding out with Giraffe restaurants, gyms, children’s play areas and suchlike. This seems little more than a holding strategy, while the company decides what to do with the stores in the new consumer-is-the-destination world, where ‘destination stores’ already seem so last decade.

Analysts at Cazenove have painted a grim — but I think realistic — picture of the way Tesco’s UK property valuation is heading:

“The gap between the performance of large out-of-town stores and convenience stores continues to widen … This has direct and strong implications for the property valuation of the Extra stores (45% of the UK space). The company says that its UK real estate is worth £20bn based on the extrapolation of past sale and lease-back transactions to the entire estate. We believe it is likely worth less than half that value — the book value of UK land and buildings is £9.3bn and the alternative use value towards which several out of town stores are converging is a fraction of the book value”.

Whatever the final outcome will be, but buying a highly indebted retailer because of the assumed value of the real estate has never really worked. If Tesco doesn’t earn enough on the real estate they occupy, who else will do this ? From my experience, when a retailer’s main attraction is the value of its real estate, then you should better run.

US grocers have countered Walmart in the US succesfully, so will Tesco in the UK

Again, Katsenelson looks at the US and compares Aldi & Lidl to Walmart in the US. I think this is a big mistake. If we look again to Germany, one can see that traditional grocers and supermarkets NEVER recovered fully from the attack of the discounters. Just a few weeks ago, one of the German supermarket pioneers, Tengelmann, sold its remaining “classical” super markets to rival Edeka. Operating margins for normal supermarkets, even for the really big ones are more in the 2-3% area maybe half of that what UK supermarkets like Tesco still achieve. Aldi and Lidl are privately owned long term players who clearly are prepared to sacrifice profit for a long time in order to gain market share.

Summary:

It could easily be that we see a mighty rebound in Tesco, maybe even after I post this and I will look like an idiot. However in the medium and long term, I think many of the popular arguments for Tesco as a value investment (real estate etc.) are pretty useless and some of the arguments (i.e. “natural maximum market share” of discounters) are just plain wrong.

If you define a value investment as an investment where the probability of a loss is very small, than clearly Tesco with its highly leveraged balance sheet is not a value investment. On balance debt, off balance debt, a big pension deficit adds to Tesco’s pretty weak balance sheet. Just recently, Tesco was downgraded to BBB- from S&P. Below this level, refinancing will be difficult and much more expensive and subjct to capital market problems.

As an investor you will only make money with Tesco in the long run if they manage a real turn-around. How likely is that ? I have no idea and so I will better stay away from Tesco. In my opinion this is much more a turn-around gamble than a potential value investment.

Special situation: Citizens Financial Group (CFG) – Another interesting “forced IPO” ?

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Summary:
The recently IPOed US bank Citizens Financial Group looks like a typical “forced IPO” from a troubled regulated financial conglomerate, similar to Voya & NN Group /ING. The current valuation shortly after the IPO would imply a decent upside (~50%) even if Citizens only manages to become an “average” US regional bank.

Citizen Financial Group went public on September 24th . The story of the US-based lender is similar to the NN Group IPO in which I have already invested.

In this case, parent company Royal Bank of Scotland (RBS), which has been bailed out by the UK government following the financial crisis, is forced to concentrate on its UK business. RBS then decided to ged rid of its US business via an IPO instead of a direct sale to another buyer. It seems to be that there were quite some interested buyers.

Very similar to ING and NN Group, RBS has time until 2016 to sell down the whole stake. That this is not easy was clearly shown as RBS had to price the IPO at 21,50 USD per share, below the inital range of 23-25 USD.

Compared to other regional US banks, the valuation based on book value (and tangible book value) looks attractive:

Name Price/ Book Price/ Tangible Book ROE Current
CITIZENS FINANCIAL GROUP 0,65 1,00 -15,82
REGIONS FINANCIAL CORP 0,79 1,14 7,19
ZIONS BANCORPORATION 0,87 1,05 5,66
SUNTRUST BANKS INC 0,91 1,41 6,38
HUDSON CITY BANCORP INC 0,98 1,01 3,92
KEYCORP 1,07 1,21 8,87
COMERICA INC 1,08 1,19 7,56
FIFTH THIRD BANCORP 1,12 1,35 13,39
NEW YORK COMMUNITY BANCORP 1,17 2,02 8,35
BB&T CORP 1,20 1,82 8,00
HUNTINGTON BANCSHARES INC 1,29 1,44 10,92
M & T BANK CORP 1,37 2,02 10,76
FIRST REPUBLIC BANK/CA 1,73 1,84 13,66
CULLEN/FROST BANKERS INC 1,82 2,43 9,66
SVB FINANCIAL GROUP 1,98 1,98 11,37
SIGNATURE BANK 2,43 2,43 13,26
Average 1,28 1,58 7,70

If we just assume an average multiple, there would be a 50% upside based on tangible book and a 100% upside based on total book value. The problem is of course: in order to reach this multiple you have to earn the average return on equity.

Looking into the IPO filings, we can clearly see that things didn’t work that well in the past. “Normalized” earnings were around 650 mn USD in the past or ~2-3% ROE which clearly would not justify a valuation at book value. Due to the low-interest rate environment, revenues decreased and in 2013, most likely to prepare the IPO, they made a massive goodwill impairment of around 4 bn USD in 2013.

Banks as investments

As there is no shortage of material against banking and the associated risks and evil spirit, I want to outline instead what I do like about banking and this situation:

– Traditional banking in my opinion is a solid and good business if run conservatively and responsibly. Many value investors would never invest in a bank, but I have no problem with this (Mr. Buffet neither as we all know)
– Traditional banking (and Citizens is a traditional bank) profits from higher interest rates. It is easier to put margins on the loan if the nominal rate is higher. So owning a bank is quite a good interest rate hedge
– mid size banks used to have a disadvantage over the large banks, especially with regard to funding. With all the new regulation aimed at the mega banks, I think there is a much better “equal level” playing field. I like good & cheap mid-sized banks.
– I could imagine that being on its own feet, Citizen’s management can react better to local challenges and develop its business than being part of a nationalized UK banking group under constant pressure. The “spin-off effect” could be at work here. Many of the directors have purchased shares directly after the IPO. The CEO owns shares in the amount of 6 mn USD.
– Citizen does have scale on a regional level which in my opinion is quite important (see page 152 of the S1 document) in order to achieve good ROEs
– the region where they are active (North east, New England) had less issues with the housing bubble, so theoretically loan quality should be OK. Most of their business is by the way in so called “recourse states” which adds to the incentive of actually paying back personal loans

Stock overhang

RBS still owns ~66% after the IPO and a subsequent share repurchase. 2016 is not that far in the future and placing another 10 bn of shares will not be a walk in the park, but on the other hand a lot of this could be reflected already in the share price. For me it is always interesting to see when typically sell-side analysts apply a discount due to “stock overhang”. As an “intrinsic” value investor, those situations are one of the clearest situations for market inefficiencies as the intrinsic value of a company does not change because of this.

Similar to ING, I think RBS did sell the first part cheaply in order to then (hopefully) sell into positive momentum. ING for instance managed to sell Voya down from over 60% to now 32% within 1 year and the stock still outperformed the indices.

My assumption is that RBS will not sell below tangible book value which is around the current stock price. If they sell below, they will lose available capital at RBS and therefore weaken their capital base and ratios. So a scenario where RBS sells down to very low levels far below the IPO price is in my opinion not realistic.

Valuation

I am clearly not in the position to judge if CFG is an “above average” bank. However, I think one can attach a high probability to the outcome that CFG will be an average bank. The nice thing about this is that there is significant upside already to the “average case”.

Therefore I would make the following, simplified case:

I assume that there is a 50% probability that within 3 years, CFG will be an “average” bank and trade at an average valuation. Conservatively I ignore goodwill and assume a target price of 1,6x current tangible book value in 3 years which would be ~ 40 USD per share.

To keep things simple, I further assume that there is a 25% chance that they will do really well and a 25% chance that they screw up. In the downside case, I will assume a 50% loss, in the upside case I will assume a valuation at 2x tangible book or around 50 USD.

So my “expected” value in 3 years time would be (0,5*40)+(0,25*11,5)+(0,25*50)= 35,4 USD. Based on the current price of around 22,80 USD, this gives me a potential annual return of ~15,4% which looks attractive to me for such a “special situation” investment.

Summary:

Citizens Financial “forced IPO” looks very similar to ING’s NN Group and Voya IPOs. I think this could be very attractive as even the assumption of Citizens becoming an “average ROE US regional bank” has significant upside. Despite or because of the assumed “stock overhang”, the mid-term risk/relationship looks attractive although, but similar to NN Group, one should not expect a quick win here.

I will therefore invest 2,5% of the portfolio into Citizens at current prices of around 22,80 USD.

P.S.: This will be my first US stock since a long time. I don’t have anything against US stocks, but often I do not find any kind of “edge”. In this case, I do have the feeling that banks are still highly unpopular as investments in general and that there is a good chance for some market inefficiency, even in the highly efficient US market.

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”.

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