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Steico – Investment Case

Published on October 19, 2014

As a market leader in terms of quantity and product diversity Steico is in a good position to continue prospering in its growing niche markets. Recently, the appearance of new capacities of competitors put pressure on margins. Therefore,the company is currently trading at a large discount to my estimate of replacement costs. However, the time has come that competitors are leaving the market or seem to be unwilling to grant further price reductions to customers. Therefore, I expect that the company will profit from an improvement in the industry’s demand supply situation. On top of that, an optimization of the capital structure and a reduction in growth capex after 2016 should gradually enhance return on equity and free cash flow.

Steico is a German building supplier of wood fiber insulation materials and wood based construction materials operating throughout Europe.

Steico is operating in different niche markets

According to the company, Steico is the European leader in the manufacture and sale of wood fibre insulation materials with a market share of 35%. This niche segment makes up only 4% to 5% of the whole insulation market based on estimates from The German “Institut für Wärmeschutz”.  The largest share is represented by organic foams (i.e. polystyrene rigid foam -Styropor) with around 40-45%, glass fibre insulation and stone wool (rock wool) insulation both have a share of around 25-30%.). Natural eco-friendly insulation products such as wood fibre are gaining popularity in the building sector and are more and more in consideration when it comes to renovation work on existing and new buildings. In Germany the awareness to understand wood fiber insulation as a conventional insulation material rose tremendously over the last couple of years. Here, the company has also a strong position in the market for loft conversions.  The sale of wood fiber insulation materials in Germany has increased rapidly from 0.1 million m3 in 1990 to 1.25 million in 2011. Over the long term the market share of wood fiber insulation is expected to increase to a level between 9% and 13%.

While Steico generates more than 60% of its revenues with wood fibre insulation, they are also producing wood based construction material. The company is the leading manufacturer of I-joists (Stegträger) in Europe. These are mostly exported to the UK with the country’s strong exposure to timber constructions. In the UK, housing starts are picking up resulting in strong momentum for segment sales in the current fiscal year. Based on the management’s information, they see increasing demand for this type of product not only in the UK but also in the rest of Europe. This segment is currently generating 11% of revenues.

The remaining revenue comes from lumber trade, specialty products, natural fibre boards and laminated veneer lumber (LVL; Furnierschichtholz).

Wide product range, efficient and integrated production and diversified revenue stream

Steico’s strategy focuses on being a system provider, offering a complete building solution for timber construction, which consists of I Joists, LVL, flooring products and different types of insulation materials. For instance, the good positioning in the sale of I-joists in the UK can be used as a door opener for the sale of insulation materials in this market. In addition, each of the company’s plants covers a large part of the total product range allowing merchants to order mixed deliveries to optimize their inventories. This presents an advantage compared to competitors as most of them have single product factories in place.

All Steico products are produced in three relatively new plants of which two are located in Poland (Czarna Woda and Czarnków) and one in France (Casteljaloux).  Raw material costs make up roughly 40% of revenue. Raw material is mostly consisting of wood. For the Polish plants the company uses pinewood and has a long term contract with the Polish forestry authority. Wood prices are fixed at the beginning of each year in an auction process. Based on the company’s information prices remained stable in 2014. In France the wood is purchased at the local lumber market.

From a geographical point of view, Germany (35% of revenue) is Steico’s largest market followed by the UK (14%), France (12%) and Poland (8%). Since 2007 most of the 63% growth in revenue has been generated in Germany and UK, while France, Poland and most of the other markets were flat or slightly declining.

Clients are trade intermediaries, construction companies and DIY chains. The largest client contributed 3.3% to revenues in 2013.

Long term catalyst for the industry

Over the long run, demand for Steico’s products should be supported by an EU directive urging member states to ensure that by 2020, all new buildings are nearly zero- energy buildings. In addition, buildings that undergo major renovation have to meet minimum energy performance requirements after renovation. As most new and existing homes are currently unable to meet the future requirements for energy consumption and thermal efficiency, the implementation of the EU directive in the member states might also lead to additional demand for Steico’s products as the year 2020 approaches. The recently completed new headquarters on the outskirts of Munich are already today in compliance with the zero-energy standard. During construction Steico’s construction and insulation products have been used. Hence, the building also provides a state of the art example of the company’s building solution to potential clients how to comply with the upcoming legislation.

Current investment programme targets margin enhancement and extension of product range

So far the company was not able to exploit the full growth potential in the I-joists segment as they faced problems in the supply of laminated veneered lumber (LVL) which is used to produce I-joists. As a consequence, management recently decided to build an in-house production facility for LVL until the end of 2015 to become independent of suppliers and increase margins in this segment. The production line will have a capacity of 80,000 m3 and is expected to break even at a 50% utilization rate. In addition, the company will be able to produce wider LVL’s than the current supplier is able to deliver. This project is the cornerstone of the company’s plan to invest up to EUR 60 m until 2016.

The other part of the investment programme comprises the production of very thin wood fiber insulation through eco-friendly wet process, where the company witnesses strong demand and low competition. Completion of the new insulation production line is expected for the end of 2014. This investment will potentially drive revenues and Steico will attain more flexibility on its capacities. Both investments represent extensions of the company’s existing plants.

The investment volume will come through a bank loan financing and operating cash flow. The company is currently very solidly financed. An optimization of the capital structure should have a positive effect on the return on equity and might therefore lead to more attention from financial market participants. In addition, the company can make use of the appealing current interest rate environment given its relatively high solvency.

Attractive access to capital, fierce competition and reverting returns on capital

The table below provides an overview of the key performance indicators since 2007:

In 2007, just at the right time, Steico went public at EUR 17.50 per share (current price EUR 5.50). The company raised roughly EUR 70 m from investors. Most of this capital was used to extend the two existing production sites in Poland and to acquire and modernize the production site Casteljaloux in France.

In 2008, Steico was hit by the crisis, but recovered quickly in 2009 and 2010. In 2011, massive pressure on Steico arose by the appearance of new capacities of competitors in the wood fibre insulation market. The expansion of many players in the market reflected the growing demand for wood fibre insulation in the years to come. As a consequence, though there has been plenty demand for Steico’s products, so far the company has not been able to return to 2009/10 profitability. For instance, the company’s production of insulation material increased by 17% from 158,934 tonnes in 2010 to 185,631 tonnes in 2013. During the same period, revenue per tonne decreased by roughly 7%.

Pricing pressure has been slightly reduced since 2013 as the consolidation process found its first victims. Finish Fibreboard closed a production site and the small competitors Smrecina Hofatex (Slovakia) and KZZP Koniecpol (Poland) both went bankrupt. Even more interesting, Swiss Pavatex, one of the strongest competitors of Steico, recently had to substantially reduce production at a one product plant in France which just had been finished in 2013. At the same time, Steico is producing at full capacity. Steico seems to profit from its large investments in efficiency, growing the product range, improving the distribution network and sales structures and to a certain extent from its larger scale being the European market leader.

From my perspective, management made use of extremely attractive access to equity markets in 2007. In contrast to Francotyp Postalia (one of my other investments), management did not burn the cash proceeds from the IPO by undertaking overpriced acquisitions. To the contrary, management allocated the capital to extend production capacities in order to react to higher demand for wood fibre products and to reinforce the company’s position in its industry.

So far these investments have not produced an attractive return on capital. Nevertheless, the company has been able to weather the overcapacity in its industry relatively well. Once the consolidation process will come to an end, I expect Steico to earn a substantially higher return on assets.

In addition, in spite of the large capital expenditures over the last years, the company’s financial position is very solid. With an equity ratio of 63% and a debt-to-equity ratio of 0.2x, banks are willing to finance the ongoing EUR 60 m investment programme at a relatively low cost of capital. Compare this to one of Steico’s competitors, Homann Holzwerkstoffe. They are currently paying a 7% coupon on their EUR 100 m five year bond which was issued in 2013.

As already mentioned, return on capital is relatively low. It remains to be seen, if Steico can translate the top line growth into an improvement on the margin side. Assuming that the European construction market will remain stable, wood fibre insulation will continue to gain market share from the conventional insulation market and that overcapacity will be reduced, I think that return on assets should easily approach 4% again. Going one step further and assuming that the current investment programme will increase total assets by EUR 40 m to EUR 200 m until 2016, potential net profit can reach EUR 8 m per annum or EUR 0.63 per share. Taking into account an improvement of the capital structure targeting a financial leverage ratio of 2 times, return on equity could reach 8%.

For 2014 management’s guidance is a 10% year on year increase in EBITDA and EBIT to EUR 23.5 m and EUR 10.2 m combined with a slightly lower growth rate in revenues.

Why market participants might hesitate to buy Steico shares

First, Steico is an owner-managed company. Udo Schramek is holding 67.2% of the share capital. This leaves only a small free float of 4.2 m shares or roughly EUR 23 m.

Second, Mr. Schramek’s wife has a board seat. Moreover, members of the board seem to be replaced infrequently.

Third, Steico prepares their consolidated financial statements under German GAAP (HGB) and investor relation material is only available in German.

In addition, the company is listed on the Entry Standard, where the reporting requirements are very low. This is aggravated by the fact, that the Entry Standard is forming a reservoir of potential delisting candidates in Germany. Due to the current legislation an investment in a potential delisting candidate presents a risk to minority shareholders.

Apart from that, in 2013 the company completed its new headquarter. Investors might ask whether there are better opportunities to allocate capital.

Most importantly, the company faces the risk of entering a period of recession while at the same time adding substantial capacity to the market once the investment programme will be finished.

What does that mean to me?

Generally, I like owner operators and the alignment of interests with minority shareholders. In this case minority shareholders could get screwed for instance by a delisting of the company. However, during my research it became obvious to me that the company pursues a transparent reporting and continuously tries to attract the attention from potential investors. This year the company held presentations at five different financial market conferences. In addition, the company exceeds the reporting requirements of the Entry Standard by releasing quarterly reports. According to the company, one of the reasons why Steico does not upgrade its listing to a higher segment of the stock exchange is the resulting requirement to change the reporting standards from German GAAP to IFRS. From the management perspective this would not be worth the effort.

Of course, a downturn in the construction market would hit the company. However, a diversified product range, broad geographic positioning and very solid financials should ensure that Steico can weather another recession relatively well. Over the long run Steico seems to be part of a growing industry.

Valuation

First I will focus on what a new entrant will have to spend to reproduce a similar company like Steico:

From my perspective in Steico’s case reported asset values on the balance sheet provide a good proxy for an estimate of reproduction costs for a new entrant.

I know that management has invested roughly EUR 150 m in fixed assets since 2004 to get the company where it stands today (from company reports and the IPO prospectus). Before 2004 they had roughly 30% of today’s production capacity in place. So one could assume that the reproduction of the fixed assets costs EUR 215 m ignoring depreciation. However, net fixed assets on the balance sheet total only EUR 100 m comprising of land and buildings (37%) and machinery and equipment (63%). From my perspective it is questionable, whether the company’s production facilities have already lost EUR 115 m in value since completion. So I feel very comfortable to make the assumption that the reproduction of fixed assets costs at an absolute minimum EUR 100 m.

On top of that, to estimate hidden assets not shown on the balance sheet like the distribution network, customer relationships, IT systems and R&D expenses, I consider the annual expenses in the P&L which are used to create these assets. In 2013, the company spent roughly EUR 5 m on distribution, advertising, IT and R&D/patents. I make the assumption that hidden assets add two times worth of these costs or EUR 10 m to the total reproduction costs. Again a conservative estimate.

Current assets consist of inventory, accounts receivables and other current assets. Days of inventory showed low volatility over the last years and prices for finished goods have been stabilized recently. So I assume that the reproduction cost of inventory is in line with the reported numbers. The cost of reproducing an existing’s firm accounts receivables should be more than the book amount as some customers do not pay their bills. In the footnotes I could not figure out the amount of allowances contained in receivables. So I decided to be conservative and use the book value of receivables. Other current assets are cash or will be due in short term, so book value should be appropriate here as well.

On the liability side we have current liabilities consisting of accounts payable to suppliers and other short term liabilities. I assume that this equals the amount a new entrant would have to pay to duplicate what Steico has.

In conclusion, I come up with the following estimation of reproduction costs for Steico’s operations:

Steico has a market cap of EUR 70 m and net debt is EUR 25 m. So a potential buyer could pay a 69% premium on the current stock price and would still be indifferent between reproducing the business on his own and taking Steico private.

However, obviously the question is whether a potential entrant in the market would be interested to invest that much capital either by reproducing the assets or by acquiring Steico. Based on the current guidance for 2014, Steico would be valued with an EBITDA multiple of 5.9x and an EBIT multiple of 13.6x when using reproduction costs as a proxy for enterprise value. This appears pretty rich for a company currently earning a mid-single digit return on invested capital.

Currently, the market is valuing the company with a price-to-tangible book ratio of only 0.7x, a P/E of 13.1x and an EV/EBITDA of 4.0x. So it seems, that the market is giving the company no credit for its high solvency and asset quality which I expect to be converted in higher earnings and cash flow going forward.

Conclusion

In conclusion, for a potential competitor it is currently not attractive to enter the industry. At the same time there is a number of still existing small players who will potentially leave the industry due to competitive disadvantages in terms of economies of scale, product diversity and dependency on local markets. Steico could profit from this trend in the upcoming years. Combined with a more efficient capital structure and a reduction in growth capex, this should result in a higher return on equity and cash flow yields which should close the gap between market value and reproduction costs over the next three years.

In one of my last posts, I announced that I will start to accumulate a position in Steico. Based on the assumption that I trade one third of the daily volume, my target is to accumulate a 2% position for the virtual portfolio with a stock price limit of EUR 5.70 starting from October 13th, 2014.

Disclaimer

The content contained on this site represents only the opinions of its author(s). I may hold a position in securities mentioned on this site. In no way should anything on this website be considered investment advice and should never be relied on in making an investment decision. As always please do your own research!

 
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Renk (DE0007850000)

Published on October 16, 2014

From today on, I start buying Renk shares targeting a 2% position for the virtual portfolio with a stock price limit of EUR 75.

A write-up of my investment case for Renk will follow asap.

Edit 10/17/2014: I increase the stockprice limit to EUR 78.

Disclaimer

The content contained on this site represents only the opinions of its author(s). I may hold a position in securities mentioned on this site. In no way should anything on this website be considered investment advice and should never be relied on in making an investment decision. As always please do your own research!

 
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Telefonica Deutschland Holding (DE000A1J5RX9)

Published on October 16, 2014

From today on, I start buying Telefonica Deutschland shares targeting a 3% position for the virtual portfolio with a stock price limit of EUR 3.55.

A write-up of my investment case for Telefonica Deutschland will follow asap.

Disclaimer

The content contained on this site represents only the opinions of its author(s). I may hold a position in securities mentioned on this site. In no way should anything on this website be considered investment advice and should never be relied on in making an investment decision. As always please do your own research!

 
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Steico (DE000A0LR936)

Published on October 13, 2014

From today on, I start buying Steico shares targeting a 2% position for the virtual portfolio with a stock price limit of EUR 5.40.

A write-up of my investment case for Steico will follow this week.

Edit 10/17/2014: I increase the stock price limit to EUR 5.70.

Disclaimer

The content contained on this site represents only the opinions of its author(s). I may hold a position in securities mentioned on this site. In no way should anything on this website be considered investment advice and should never be relied on in making an investment decision. As always please do your own research!

 
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UMS – Add to exisiting position

Published on October 6, 2014

Since my initial write up the extraordinary general meeting held on September 25th 2014 has approved the disposition of UMS (DE). Over the last couple of days the share price trended downwards. At the same time trading volume has been relatively high.

There have not been any significant changes to my investment thesis (at least as far as I am aware of). On a positive note, management expects a higher total payout to shareholders of EUR 11.1 per share compared to my estimate of EUR 10.9. However, the second expected payment to shareholders of roughly EUR 3.6 per share might be postponed to July 2017 in case the pending court trial and the liquidation of an Italian affiliate take longer than originally anticipated. Taking these two factors into consideration the expected IRR decreases by 80 bps compared to my initial analysis (IRR:10.7%).

However, the lower share price (currently at EUR 9.3) further increases the attractivness of this investment adding 320 bps to the originally expexted IRR. Therefore, I will add to my existing position starting from today until reaching a 3.5% portfolio share with a share price limit of EUR 9.40. I am currently holding a 2.5% portfolio position which I purchased at a volume weighted average price of EUR 9.63.

Disclaimer

The content contained on this site represents only the opinions of its author(s). I may hold a position in securities mentioned on this site. In no way should anything on this website be considered investment advice and should never be relied on in making an investment decision. As always please do your own research!

 
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Q3 2014 Performance & Portfolio Update

Published on October 2, 2014

Below you can find an overview of the current portfolio as of September 30, 2014:

# Investment

Currency

Purchase Price

Current Price

Gain/Loss1

Portfolio Share

1 Passat

EUR

9.69

6.50

-27.8%

1.3%

2 RHJI

EUR

3.86

3.90

1.1%

2.9%

3 Fairfax Financial

CAD

441

500

14.9%

5.3%

4 Real Dolmen

EUR

17.2

20.4

18.8%

2.2%

5 Lectra

EUR

6.49

8.10

28.2%

2.4%

6 Retail Holdings

USD

18.5

20.4

19.1%

3.4%

7 Broedrene A&O

DKK

1,342

1,203

-10.2%

2.5%

8 City of London

GBP

2.41

3.15

43.4%

5.3%

9 Olympic Entert.

EUR

1.90

2.04

12.5%

3.0%

10 Miba

EUR

348

411

20.2%

2.2%

11 Dundee Corp.

CAD

16.9

16.9

8.1%

4.1%

12 TMW Weltfonds

EUR

15.9

12.4

9.4%

2.1%

13 Lenzing

EUR

45.5

48.9

7.6%

3.1%

14 AGCO

USD

56.5

46.5

-11.0%

3.5%

15 Eredene Capital

GBP

0.055

0.054

2.1%

2.5%

16 Lancashire

GBP

6.05

6.40

7.6%

3.2%

17 Francotyp

EUR

4.14

4.12

-0.5%

3.0%

18 UMS

EUR

9.70

9.72

0.2%

1.0%

Portfolio

53.0%

Cash

47.0%

Total

 

 

 

5.7%

100.0%

1) incl dividends/interest and fx movements

The portfolio gained 1.1% during the quarter. Foreign exchange movements had a positive effect of 110 bps. Hence, excluding fx movements the portfolio performance for the quarter would have been +0%. During the same period the benchmark decreased by 3.2%. Over the last three months the top contributors to portfolio performance were City of London (+0.5%) and Retail Holdings (+0.5%). The detractors were AGCO (-0.4%) and Passat (-0.3%). During the quarter there have been four additions to the portfolio with Eredene Capital, Lancashire Holdings, Francotyp-Postalia and UMS. No dispositions were made.

Investment Update

In July, I invested in Eredene Capital. Since then they have made two dispositions. They sold a 23% share in their best performing asset Sattva CFS for GBP 1.9 m. At the same time they managed to sell their worst performing asset Matheran Realty for GBP 3.0 m. On top of that, subject to the future profitability of Matheran, they can receive another INR 200 m in September 2017. That is encouraging as I did not assume any value for this investment in my original analysis. Cash at hand is now GBP 5.4 m and management indicated that they plan to make a distribution to shareholders.

In August, the second largest shareholder Ruffer sold its 25.4% stake to the Chairman of Ocean Dial (asset manager of Eredene) for a price of 3.0 pence per share. That represents a discount of 43% to the public market price at that time and a 70% discount to my original estimate of NAV. There is definitely a lack of interest for this type of illiquid and exotic asset, but I doubt that there would not have been another investor willing to pay a higher price. For instance, Miton Group has been aggressively purchasing shares of Eredene Capital over the last months. Apart from that, it is important to note that the buyer is not a third party investor, but the asset manager. As a consequence, Ocean Dial’s interests become even more aligned with shareholder interests which I think is very positive.

Management also indicated that at some point in time they plan to delist Eredene from the AIM segment. Normally, this would be worrisome for me. However, in this case, I believe that most stakeholders are interested in a fast wind down of the company. In addition, as I plan to hold the shares until the completion of the liquidation and given the illiquidity of the listed shares the usefulness of a listing for me is limited to the reporting requirements of an AIM listed company. If Eredene was to delist there will no longer be any requirements to report interim results or announce any transactions. The only necessity would be to publish annual accounts. However, in this case I believe that this is not a game changer with regard to my initial investment case.

In my last quarterly report, I mentioned that I will write an update on Broedrene A&O Johansen (AO). The company reported half year numbers at the end of August. As already indicated at the beginning of the year revenues and profits are under pressure due to a declining market in general and increased competition. In particular, this was the case in the sanitary segment, where the third largest market participant, Sanistaal, tried to gain market share by aggressively cutting prices. Dhal which is an affiliate of Saint Gobain and the number one in this market reacted and a downward spiral started, which has not been stopped yet.

Since a debt restructuring in 2011, 72% of Sanistaal shares have been held by a consortium of banks (Danske Bank, Nordea and Jyske). It seems likely, that in the foreseeable future the consortium will try to sell Sanistaal to a third party. AO might be one of the potential buyers. Against the background that Sanistaal is holding 39% of AO’s capital, a merger of the two companies could be a potential solution for the current complex shareholding structure. Apart from that, AO’s management reported that they have been in talks with Sanistaal to acquire Sanistaal’s share in AO. However, they have not been able to agree on a price yet. Given that one of their major competitors is holding a large share of AO’s capital, no dividend payments were made for a couple of years. Management indicated that after a solution with respect to the shareholding structure, the company plans to reinitiate the payment of a dividend.

Management expects EBT to be in a range of DKK 75 m to DKK 100 m for 2014 (38% to 17% below 2013). Based on the company’s information, this year the overall market might decline by 4% to 5% and is expected to stabilize in 2015. At the end of 2014 the company will reach the end of an investment cycle and expects capex to go down to DKK 25 m for the upcoming years. At the same time D&A will be roughly DKK 45 m p.a. Assuming that the low end of the management’s target range for profit will be achievable in the upcoming years and subtracting taxes, the company is currently trading for a free cash flow multiple of 8.4x. At the same time book value per share grew by 10.4% p.a. since 2009 and the share is trading at a P/B of 0.8x.

Nevertheless, it is important to reiterate that Mr. Johansen (CEO and Chairman), though he is only holding 10.2% of the share capital, owns 52.4% of the votes. As a consequence, he cannot be overruled and this is definitely a risk for minority shareholders. Apart from that, the Danish housing market is facing a difficult environment due to the enormous amount of outstanding mortgage debt. That’s the reason why some hedge funds have been/are short the Danish krone, Danish sovereign debt and bought credit default swaps on Danish banks. So a sudden drop in investor confidence and/or a prolonged recession in the Danish housing market will affect AO. However, the company has done remarkably well after the financial crisis compared to its peers, it is relatively well positioned in the market, it has a very sound balance sheet and the valuation is very modest. Therefore, I hold the position and might increase it when the stock price comes down.

AGCO reported weak Q2 2014 numbers and lowered its guidance for the rest of the year. The market reacted disappointed sending the shares down by 18% during the quarter. Interestingly, the activist hedge fund Blue Harbour recently disclosed a 0.9% share in AGCO. In addition, AGCO’s Indian JV partner TAFE, the third-largest tractor manufacturer in the world and second-largest in India increased its shareholding in AGCO to 9.1% of shares outstanding. In September AGCO and TAFE  reached an agreement that TAFE may not increase the stake to more than 12.5% by acquiring shares in the market. However, the agreement allows TAFE to make a non-public offer to acquire all or a part of AGCO or propose another similar strategic transaction that would result in a change of control of the Issuer. Apart from that, the agreement gives TAFE a right of first refusal in case AGCO sells its global Fendt/Massey Ferguson franchise. So that’s an interesting development to watch given that at the same time AGCO is holding a 23.8% interest in TAFE.

RHJI presented operational progress with the release of the first half 2014 results. While BHF Bank and Kleinwort Benson Investors are both generating operating profits, Kleinwort Benson Wealth Management is still loss making.

Apart from that, management has reached an agreement with the co-investors in the BHF-BANK transaction to convert their ownership of 35.13% in KBG into RHJI shares. In exchange for the co-investors’ share in KBG, 41.2 m new shares of RHJI were issued, bringing the total number of issued and outstanding shares from 91.0 m to 132.2 m. As the co-investors originally injected a total of EUR 179.4 m in KBG, they actually paid EUR 4.35 per RHJI share representing a premium of 12% to the current share price. The co-investor’s shares have a lock up period until 2017. The conversion further reduces holding costs through the elimination of KBG. RHJI plans to rename to Kleinwort Benson-BHF Holdings. Though there is still a long way to go, the results and the fast implementation of the ownership conversion send a positive signal and seem to be another step in the right direction.

Portfolio Transactions in Q3 2014

Just for your information below you can find the quarterly portfolio transactions for the virtual portfolio:

Item Date

Amount in EUR

Beginning Cash Balance 7/1/2014

5,849,214

Eredene Capital 4/2/2014 to 8/14/2014

-262,500

Miba dividend 7/4/2014

4,592

TMW dividend 7/9/2014

87,717

Passat dividend 7/15/2014

10,317

Lancashire 8/1/2014

-315,000

Francotyp 8/28/2014 to 9/2/2014

-315,000

UMS 9/8/2014

-107,719

Interest on cash 7/1/2014 to 9/30/2014

13,501

Correct interest Eredene 4/2/2014 to 6/30/2014

-275

Current Cash Balance 6/30/2014

4,964,847

Disclaimer

The content contained on this site represents only the opinions of its author(s). I may hold a position in securities mentioned on this site. In no way should anything on this website be considered investment advice and should never be relied on in making an investment decision. As always please do your own research!

 
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UMS United Medical Systems – Investment Case

Published on September 10, 2014

This company is currently in the process of selling its operating business. Management announced that it plans to liquidate the company in case the disposition is successful. So far, the stock price has not reacted due to a number of uncertainties. While I think that the downside risk is limited, I expect this investment to deliver an IRR of 10.7% over a holding period of 22 months.

UMS United Medical Systems International AG (UMS AG or company) is a German holding company. The company’s assets are almost entirely held by its 100% owned affiliate UMS (DE) Inc., which is incorporated in the US (more specifically in Delaware). The operational business is conducted in various affiliates of UMS (DE) in the US, Canada and South America.

On August 14, 2014, the company announced that it has entered in an SPA (Sales Purchase Agreement) to dispose UMS (DE) for a sales price of EUR 56.4 m. The current market cap of UMS AG is EUR 46.4 m based on a share price of EUR 9.75. Shareholders need to approve the disposal at an extraordinary general meeting to be held on September 25, 2014.

Provided that the deal will be completed, the company’s assets will almost exclusively be limited to the cash inflow from the sale of UMS (DE). Therefore, at the extraordinary general meeting, management also proposes to change the company’s purpose in the articles of associations. In case the transaction is successful, the sole purpose of the company will be the management of cash. In addition, management announced that with the following annual general meeting to be held in June 2015 a significant part of the profit portion from the sale of UMS (DE) will be distributed to shareholders. Thereafter, the company will be liquidated and the remaining cash will be distributed to shareholders.

Uncertainties reflected in the share price

The company has currently roughly 4.76 m shares outstanding. Based on a sales price of EUR 56.4 m for UMS (DE), this corresponds to EUR 11.85 per share of UMS AG. As far as I know, the company has no substantial liabilities. So why is the company’s share currently trading with a 17.7% discount compared to the sales price of UMS (DE)?

First, 75% of shareholders present at the general meeting need to approve the transaction. The board and management is holding 37.4% of the shares. At the last annual assembly roughly 50% attended the meeting. Shareholder attendance might be higher this time. While I believe the chances to be low, there is a risk that a group of shareholders representing at least 25% of the votes will break the deal at the meeting.

Second, financing for the deal is not in place yet. The investment firm New State Capital Partners committed to capitalize the buyer with equity in an amount of USD 23.37 m. The rest of the purchase price is planned to be financed with debt. Based on my knowledge, there has not been an announcement made that debt financing is in place. Based on the PSA, the deal has to close until November 22, 2014.

Third, the preferred transaction structure for minority shareholders would have been an offer for UMS AG instead of UMS (DE). However, based on information from the management, the company has been in negotiations with different parties regarding a disposition since 2006. One of the obstacles was to sell the German AG which is basically only holding a US entity. Given that it can be quite difficult for a buyer to gain a 100% share in a listed German entity, potential buyers refused to make a bid for UMS AG. So the structure of the transaction provides for complexity.

Fourth, the deal is not fully transparent. It is not clear, who is behind the acquiring entity. The official statement is that New State Capital is “advising” the buyer and provides equity financing. In addition, the company said that the current management of UMS AG plans to participate in the acquisition of UMS (DE). So it is not clear, whether there are conflicts of interest.

Fifth, the time frame of the liquidation is uncertain. As a consequence of the intransparency mentioned above, shareholders might take legal actions against the company. For instance, supposed that shareholders will approve the deal at the meeting, a shareholder could file a law suit against the resolution. Based on the SPA, this can be resolved with a legal opinion from the advising law firm and the transaction can be completed. Nevertheless, a pending law suit could delay the following liquidation of the company and therefore distributions to shareholders.

Sixth, after deal completion management could change their mind or the shareholder structure could change. As a consequence, a liquidation of the company might no longer be pursued.

Seventh, mutual funds have been reducing their shareholding over the last months, which weighs on the stock price. BayernInvest has reduced its holding from 5% to below 4% and Universal Investment from above 3% to below 3%. Perhaps they know more than I do. On the other hand it could just be position trimming due to expected lower trading volume as a consequence of the upcoming liquidation.

Apart from that, there will be substantial cash outflows including deal related costs, disposition taxes, operating costs and costs for liquidating the company.

Based on the SPA, the seller shall be responsible for all transaction expenses and costs incurred by UMS AG and UMS (DE) in connection with the consummation of the transaction. I think that it is conservative to estimate deal related costs for UMS AG to be 3.5% of the sales price. This is EUR 2.0 m or EUR 0.41 per share.

I am not a tax expert, but the way I am calculating disposition taxes to be paid by UMS AG is the following:

After deducting transaction costs and book value (I take the book value from the holding company) from the sales price, the estimated profit is EUR 35.5 m. Based on § 8b Abs. 2 KStG and § 8b Abs. 3 Satz 1 KStG, 95% of the profit is tax free. Hence, the taxable income is EUR 1.8 m (=5% x EUR 35.5 m).

In the latest annual report, management makes the following statement regarding accumulated tax losses:

“UMS AG has income tax losses of € 11.8 million (previous year: 11.6 million) and € 10.5 million in trade tax losses (previous year: € 10.3 million) that are available indefinitely for offset against the UMS AG’s future taxable profits, within the limits of § 10d (2) EStG and § 10a GewStG. No deferred tax assets have been recognized in respect of these losses as they cannot be used to offset taxable profits elsewhere in the group. As the holding company is not likely to generate future taxable profits, no deferred taxes have been recognized for timing differences for UMS AG.”

Therefore, it might be possible to further reduce the taxable profit by using accumulated income tax losses. As I am not sure, whether that is doable, I leave them out of the equation.

UMS AG has to pay corporate tax, solidarity surcharge and trade tax. Hence, I estimate the tax payment to be EUR 0.6 m (= (15% x (1+ 5.5%) + 16.4%) x EUR 1.8 m) or EUR 0.12 per share.

UMS AG receives an annual management fee of EUR 0.4 m from UMS (DE) and has annual holding costs of roughly EUR 0.5 m (excluding exceptional items). Expected closing date is November 22, 2014. So I assume that annualized operating costs will be EUR 0.5 m or EUR 0.11 per share from December 2014 until liquidation of the company.

In addition, there is a brief story to be mentioned. Recently, the company sued its tax advisor as management is of the opinion that it was wrongly advised. The background is the following: concerning the dividend distribution for the fiscal years 2009 and 2010, on the advice of its tax advisors, the company withheld taxes for their shareholder (which is the common way) and remitted them to the tax office. As it turned out, however, the company determined that the distributions would have been tax-exempt because these distributions could have been made from the contribution account for tax purposes. Based on my understanding, the company had to bear accumulated costs related to this issue of roughly EUR 0.8 m until the end of 2013. Legal proceedings against the tax advisor started in 2014. Management expects the chance to succeed as “very good”. Let’s keep it simple and assume that they will reach a settlement and that any inflow from the tax advisers will be offset by outflows to the company’s lawyers.

Apart from that, I assume that the costs of the liquidation (e.g. consulting fees, costs of lease termination) will be EUR 1.0 m or EUR 0.21 per share.

Estimated time frame of the liquidation and targeted return

My base case scenario for this investment is an orderly proceeding of the liquidation. In that case, after deal completion shareholders will decide about the dissolution of the company and the distribution of the profit share after tax payments and deal related costs (EUR 34.6 m or EUR 7.27 per share) at the general meeting in 2015. Thereafter, there will be a twelve month period, where creditors can demand outstanding liabilities from the company. Then, the company can be liquidated and the remaining cash (assuming that there are no unknown outstanding liabilities) of EUR 17.3 m or EUR 3.65 per share can be distributed to shareholders.

The calculation of the estimated liquidation value can be found in the following table:

I assume that the next general meeting after completion of the transaction will take place in June 2015 combined with a distribution of EUR 7.20 per share. An additional distribution of EUR 3.72 could then be made 13 months later in July 2016. Based on these assumptions an investment offers a total return of 12.0% and an IRR of 10.7% for a holding period of 22 months.

Consequences of a broken deal

If the deal fails, I will hold a company which is generating a steady and relatively predictable income stream of roughly EUR 2.5 m per annum. The stock has a dividend yield of 5.6%, which is tax free. I think there is a large number of market participants who are looking for this type of income generating stock. In addition, the market reaction to the announcement of the deal was rather negative. So disappointment in case the deal falls apart should be limited. Apart from that, there is still the possibility that another buyer turns up. So I believe that the downside risk is relatively limited here.

Conclusion

I think it is likely that shareholders will approve the deal. However, from the risks and uncertainties mentioned above, I suppose that a prolonged liquidation due to legal proceedings from minority shareholders against the company poses the biggest threat to my base case scenario (a liquidation of the company returning an IRR of 11%). On the other hand, I believe that management and the board representing a shareholder group holding 37.4% of the company are highly incentivized to cash out and to speed up the liquidation. There are a number of assumptions I have made. However, I think that the risk to lose money in this investment is relatively limited.

In my last post, I announced that I will start to accumulate a position in UMS AG. Based on the assumption that I trade one third of the daily volume, my target is to accumulate a 2.5% position for the virtual portfolio with a stock price limit of EUR 9.75 starting from September 8, 2014.

Disclaimer

The content contained on this site represents only the opinions of its author(s). I may hold a position in securities mentioned on this site. In no way should anything on this website be considered investment advice and should never be relied on in making an investment decision. As always please do your own research!

 
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UMS United Medical Systems (DE0005493654)

Published on September 8, 2014

I start building up a 2.5% position for the virtual portfolio with a stock price limit of EUR 9.75 from today on.

A write-up of my investment case for UMS United Medical Systems will follow asap.

Disclaimer

The content contained on this site represents only the opinions of its author(s). I may hold a position in securities mentioned on this site. In no way should anything on this website be considered investment advice and should never be relied on in making an investment decision. As always please do your own research!

 
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Francotyp-Postalia Holding – Investment case

Published on September 5, 2014

This company is currently in the final stage of a restructuring. The core segment is declining, but increasing profitability and a large share of recurring revenues makes high free cash flow generation for an extended period highly likely. Based on my assumptions, the market is valuing the company with a price to free cash flow multiple of 10x. In addition, the company invested in new segments which are currently not generating a profit. However, this might change in the future. Hence, an investor is getting the optionality of additional cash flow generation from these entities for free.

The core segment of Francotyp-Postalia (FP) contains the development, production and distribution of franking and inserting machines for the processing of physical letters. The majority of the revenue is generated with franking machines. Franking machines enable letters to be franked automatically. All franking machines need to be certified by the local postal authorities as they can be topped up with credit for the necessary postage. For instance, in the US, the largest market for franking machines, there are only five authorised suppliers by the US Postal Service. The even more interesting part of FP’s business model begins after leasing or selling the franking machines. The after-sales business with its recurring revenue streams generates a high share of the company’s total turnover. This includes the teleporto business (charge for topping up the machines with credit), the sale of consumables (tape or ink cartridges and customer-specific printing plates), the creation of printing plates, maintenance services and software solutions for cost centre management.

The market for franking machines is dominated by three competitors. Pitney Bowes is the world leader, Neopost has a leading position in Europe and FP is the leader in Germany and Austria with a market share of more than 40% in these two countries. Worldwide FP has provided 10% to a total installed base of 2.7 m franking machines.

Physical mail volume in secular decline

Until the late 90’s physical mail volume growth was linked to GDP growth. However, due to the rise of the internet and the resulting digitalisation of communication the physical letter seems now to be obsolescent in the worst case or to become a complimentary media to online in the best case.

Nevertheless, it is worth noting that worldwide business letter volume (excl C2C/C2B) has actually been pretty stable. Based on FP’s information, the volume of classical business mail has only declined by roughly 10% since 2004. Even more revealing is the situation in Germany. Total letter volume up to one kilo (incl C2C/C2B) has been fluctuating around 16 bn pieces per year since 1998. Reason for that seem to be the less severe recession in Germany after 2008 compared to other countries and the continued widespread use of business mail by the German Mittelstand and government authorities. However, the situation is quite different in the US were the recent recession accelerated the decline in physical mail volume. In this report, BCG expects total mail volume in France, Germany, UK, Italy and Spain (which are basically FP’s major markets) to decline by 3% per annum going forward. However, another recession in these markets could again accelerate the decline.

Large ongoing investments in the franking/inserting segment

Despite the negative outlook for the physical mail volume and the resulting implications for FP’s industry, the company is heavily investing in its distribution network and the installed base.

In Germany management is implementing a new sales channel besides its own distribution force by targeting associations. They have already won Büroring (350 independent dealers), WinWin Office Network (30 mid-sized dealers) as well as regional partners with a close contact to SMEs.

Due to an ongoing decertification process by the US Postal Service, FP is currently replacing 35,000 franking machines in the US which were installed in the early 90’s. This equals to 13% of all FP machines currently in use. The US is the most important foreign market for the company. Decertifications are performed by postal companies when older franking systems are to be replaced by a technologically new standard. The recent decertification is expected to run until the end of 2015.

Given that the US is a pure leasing market, the company needs to pre-finance these machines leading to a temporary increase in capital expenditures. An advantage of the leasing model is, that the company stays in close contact to their customers and can quickly react to additional/changing needs.

In addition, FP recently entered the French and Italian market. In Italy the company makes good progress with its leasing business. France is Europe’s largest market for franking machines and like the US a pure leasing market. FP is endeavouring to achieve a market share of 10% here in the medium term or roughly 26,000 franking machines. Neopost has a stronghold position in this market, which French La Poste would like to change. As a consequence, La Poste more or less invited FP to join the French market. FP is currently only marketing the small franking machine MyMail, but expects to receive certification in France for their successful product PostBase at the end of this year.

PostBase is an industry leading franking system which can be operated with a touchscreen or can be directly controlled via a PC and was introduced in 2012. It has already been certified in Germany, the US, Canada, Italy and the UK. PostBase is also part of the so called A-segment including small franking machines for the SME sector with a daily mail volume below 200 letters. This segment seems to be the most robust in the franking machine industry and it is also the most important for FP. So far Pitney Bowes and Neopost have not introduced a similar product like PostBase to the market.

Apart from broadening its footprint in traditional markets and constantly investing in new products, FP is simultaneously taking its first steps in markets such as Russia, Malaysia and India. These countries are still at the first stages of mail communication professionalization, meaning that the revenue and earnings effects will remain limited for the time being. In addition, the company faces challenges in setting up a distribution network and getting the necessary certifications in these markets. However, FP has taken timely possession of markets here, which could unfold considerable growth potential in the years to come. Last year they were quite successful in selling franking machines with a value of EUR 2 m to Russia.

Below you can find an overview how the different revenue components in the franking/inserting segment have developed over time:

The sales revenue of machines declined sharply during the recession and did not recover afterwards. This is in line with the statement I made above, that with each recession the decline rate in mail volume accelerates. In addition, the increase of smaller machines as percentage of unit sales and a larger number of machines leased are also reasons for the decline in sales revenue. At the same time, the company is generating roughly EUR 80 m of recurring revenue each year and this number has been more or less flat since 2007.

The relatively high profitability of the after sales business and the predictability of cash inflows makes this part of the business highly attractive despite the industry’s overall negative growth rate.

Transformation of the business model started in 2006

FP’s former management started to react to the liberalisation of the German postal market and to the shift of mail communication towards digital forms of mail processing shortly before FP’s IPO in 2006 with the acquisition of freesort (100%) and iab (51%).

With eight sorting centres throughout Germany, freesort is one of the leading independent consolidators of outbound business mail on the German market. Their mail consolidation services include collecting letters from clients, sorting them by postcode and delivering them in batches to a sorting office of Deutsche Post. Depending on the amount of letters consolidated, Deutsche Post is obliged to provide a discount on the postage of up to 36% to freesort. Over the last years revenues have continuously increased to EUR 43 m in 2013. However, competition in this market is extremely fierce. Though the company is not breaking out the freesort numbers individually, looking at the income statement it becomes obvious that material costs are increasing in line with revenue. Increases in revenue over the last years were mostly generated by freesort. So it seems that freesort has to pass on most of the discounts to the customers and is hardly able to generate profits at the moment.

iab is providing software solutions and services for the processing of hybrid mail. Hybrid mail refers to a blend of electronic and physical mail. The sender dispatches the letter digitally. The recipient gets a normal letter. iab takes on the entire production process in between, from printing out, franking and inserting to handover of the letter to a mail delivery company. Since the letter is sent digitally, customers are saved the expense of paper, envelope and printer, and also the costs of travelling to the post office or letterbox. The benefits of traditional letters are nevertheless still there. Revenues in this segment have grown steadily and reached EUR 13 m in 2013. Based on the company’s information, this segment is profitable.

Restructuring and turnaround after the recession

In 2006/2007, the former management paid an acquisition price of EUR 19.6 m for freesort and EUR 7.1 m for iab. As things turned out this was much too high and substantial write offs followed in the years afterwards. In addition, a period of sluggish operating performance in the core segment and relatively high fluctuation in management followed until the end of 2010, when the current CEO, Hans Szymanski, took over. A brief interview (in German) with Mr. Szymanski can be found here. Since then, the management focused on cost cutting, increasing efficiency and new product development. At the beginning of 2012, the company issued 1.46 m shares for EUR 2.66 each to the private investor Klaus Röhrig. Since then he has been the largest shareholder, holding 10.3% of the company and he became chairman of the board in April 2013. In addition to that, another eleven investors hold 43% of the company including Scherzer & Co. AG which is holding roughly 3.0% of the shares outstanding.

The most recent acquisition followed in 2011 with Mentana-Claimsoft GmbH (since 2014 FP is holding a 100% share) for roughly EUR 2 m. The company specialises in electronic signatures and, in addition to products for long-term archiving, also offers products for securing electronic documents and aiding legally binding communication.

Apart from that, Mentana-Claimsoft is one out of three accredited De-Mail providers in Germany. This fully electronic solution enables customers to send their letters securely and confidentially. What makes De-Mail binding is that both sender and recipient must identify themselves on first registering before they can use the technology. Confidentiality is guaranteed thanks to powerful encryption. The German De-Mail Act defines the security requirements, establishing the legal basis to ensure that the De-Mail has the same legal effect as a standard letter. It also places a stronger obligation on authorities to enable electronic communication with citizens. Essentially, the act governs aspects including the administration’s duty to open an electronic channel and the Federal Administration’s duty to open up access to De-Mail.

The two other accredited providers are United Internet and T-Systems (a subsidiary of Deutsche Telekom). While they focus on private customers, Mentana-Claimsoft is targeting corporate clients (e.g. government entities and insurance companies). For instance, Mentana-Claimsoft has won a mandate to implement the gateways and to operate the De-Mail system for Deutsche Rentenversicherung. However, it turns out that it will take quite some time until De-Mail will work as a substitute for physical mails for these type of large governmental institutions:

First, it seems to be quite difficult to change processes and IT. Second, currently Deutsche Rentenversicherung (German governmental pension fund) is not allowed to send mail via De-Mail. Hence, legislators have to adapt legislation.

At the moment Mentana-Claimsoft is not generating substantial revenues. Management is expecting that in three to five years, some 10% of De-Mail-capable mail potential in Germany will be sent via De-Mail. This corresponds to a quantity of around 540 million consignments. The company targets a market share of 10% of the De-Mail market, that is to say around 50 m consignments per year. This again could lead to a revenue contribution of EUR 15 m to EUR 20 m. Based on the latest annual report, strongly increasing margins are expected. EBITDA in percentage from revenue is expected to range between 16.2% and 42.5%.

FP positioned as multi-channel mail service company

The central element of the company’s strategy in Germany is the dovetailing of the different business segments. For instance, FP can approach existing freesort customers about the possibilities of using De-Mail and therefore open up a broader potential market for these solutions.

Another example is the new product PostBase Gateway Multi, which helps to overcome the time lag in the transformation to De-Mail. The system enables clients to use one type of software for De-Mail and hybrid mail. If the communication partner has a De-Mail address, the message is sent via De-Mail (Mentana-Claimsoft). If the communication partner does not have a De-Mail address yet, the message is sent via the hybrid channel (iab).

As a consequence, FP offers the entire letter post distribution chain today from franking and inserting physical letters through mail consolidation to hybrid and fully electronic mail dispatch via De-Mail.

Financial Analysis

In 2005 the former management and Quadriga Capital bought FP from Röchling Group. As a consequence of the leveraged buyout, the company had to take on a substantial debt load and pension liabilities relating to FP.

At the end of 2006, FP went public at an IPO price of EUR 19.0. The net proceeds from a capital increase were used to finance the acquisitions of freesort and iab and to repay part of the loans. In the following years the amortisation of intangibles and the impairment of goodwill weighted heavily on the income statement. Free cash flow was almost entirely used to repay debt. The recession following the financial crisis revealed weaknesses of FP’s operations and the new management had to undertake significant restructurings and cost cuttings afterwards.

For instance, the assembling of all machines was shifted and centralized in a new plant in Wittenberge (Eastern Germany). As a consequence, personnel expenses slightly declined (only 10% of the workforce are employed in production), but more importantly efficiency in production increased substantially. In addition, FP cancelled the membership in the Employers’ Association of the Metal and Electronic Industry. This gives more flexibility for future negotiations regarding salary increases. Management was also quite successful in reducing working capital needs.

Apart from the completion of the necessary restructurings in 2012, a new long term financing led by Deutsche Postbank was agreed on in 2013 at improved terms compared to the former financing. The financing facility has a maturity of up to 5 years and a total volume of EUR 45 m. In accordance with the loan contract FP must adhere to the following covenants:

The interest coverage ratio or the EBITDA divided by the financing cost must be at least 2.5 (10.7x YE2013). In addition, net debt to EBITDA must not be above 2.25 (1.77x YE 2013, but substantially improved in 2014). It is also not permitted to fall short of time-staggered, adjusted equity and equity ratios (no details stated in the annual report).

Despite the achievements mentioned, the balance sheet is still looking weak. The current equity ratio stands at 18.3%. Even worse, a large part of equity is still made up of goodwill and intangibles. In addition, though the company has no defined benefit plans in place, it is carrying a legacy liability in the form of pension liabilities in an amount of EUR 14.1 m. Due to a reassessment of former restricted cash in UK relating to the teleporto business net debt was reduced to EUR 11.0 m in 2014. Management already announced that a large part of the total available liquidity of EUR 31.3 m will be used to reduce the outstanding bank debt.

As already noted, for FP leasing is becoming more important compared to the sale of machines. In Austria the company is using finance leases to rent their machines. However, overall operating leases play a major role, which are used in the international business predominantly in the US. This mixed use of operating and finance leases provides for complexity in analysing the financials (in particular the income statement). The following table tries to overcome these difficulties by focusing on the cash conversion of FP’s business:

As already mentioned above, revenues in the franking/inserting segment are falling mostly due to the retreating sales business. freesort and iab show accelerated top line growth. However, there are two isues to be pointed out:

First, the large revenue increases in 2010/2011 for freesort and 2011 for iab are mostly due to changes in revenue recognition. Second, gross profit was not positively affected by freesort’s and iab’s revenue growth indicating that these two business entities together combined with Mentana-Claimsoft have not earned money for the company yet.

On the way from EBIT to operating cash flow, we can see the huge impairments from 2006 until 2010 (resulting from the two acquisitions and the leveraged buyout). Income taxes paid declined and the company has quite substantial loss carry forwards to be used in the future. Apart from that, I have included an additional line called “Inflow from finance leases”. The company reports this cash flow stream in the financing section of the cash flow statement. From an analytical perspective it makes more sense to add these cash streams to the operating section. Operating cash flow is very stable with the exception of 2011, when restructuring expenses spiked.

FP is capitalizing part of the R&D expenses. That’s not good, because it distorts the income statement. The company is constantly investing in new product development. Currently it focuses on a successor of the small franking machine MyMail and the De-Email technology. Investments in leases are currently at an elevated level due to the ongoing replacement process in the US which will last until 2015. New leasing business is and will be generated in France and Italy, which should lead to growing cash inflow from recurring revenues in the future. However, overall investment in leases are expected to fall after 2015. Free cash flow to the firm (FCFF) will be negative in 2014. Alongside the high investment activity, the relocation of headquarter to Berlin in autumn 2014 and the integration of the distribution departments in the Netherlands and Belgium causes the high cash outflow. Management estimates the positive effect of the relocation and the optimization of the international operations to be EUR 1.5 m per annum. Overall, as can be seen from the past there is vast potential for cash flow generation once investment outflow will revert.

In the past free cash flow was used to repay debt. Given that net debt has come down substantially it can be expected that equity holders will participate to a larger extent in the cash flow generation in the future (e.g. free cash flow to equity holders (FCFE) should increase). In addition, as a large part of the freed up cash might be used to further reduce the debt outstanding, interest paid on bank debt should fall in the coming years.

Valuation

The current number of shares outstanding is 15.8 m. Based on a current share price of EUR 4.0 the equity value is EUR 63.2 m. Add to this net debt of EUR 11.0 m and pension liabilities of EUR 14.1 m and we get an enterprise value of EUR 88.3 m. Management is targeting an EBIT of EUR 12 m for 2014 and EUR 14 m for 2015. This translates into a modest valuation with an EV/EBIT multiple of 7.4x for 2014 and 6.3x for 2015.

What kind of cash flows can equity holders expect? The company should be able to generate EUR 21 m of normalized operating cash flow going forward. Stable recurring revenues, ongoing cost cuttings and new leasing revenue from France and Italy should help to hold this level for an extended period of time. Regarding investment activity, I assume that investment cash outflows will revert to historic averages after 2014 due to the reasons mentioned above. This translates in an annual investment activity of EUR 13 m. Assuming that management makes use of the large cash pile to reduce debt, interest payments will further decrease. Let’s suppose that they will use EUR 15.0 m or 48% of the current cash balance. As a result, debt outstanding will be down by 36% to EUR 27.2 m. Based on the numbers for the first six months of 2014 we can extrapolate interest payments and make the assumption that interest payments at the current debt level sum up to EUR 2.5 m. Reducing the interest payments by 36% leads to EUR 1.6 per annum.

Putting this all together, I believe that free cash flow to equity holders will approach EUR 6.4 m after 2014. Based on this assumption, the company is currently valued with a P/FCFE of 9.9x or a free cash flow yield of 10.1%.

In my analysis I came to the conclusion that freesort, iab and Mentana-Claimsoft are currently hardly breaking even if viewed as a combined entity. This implies two consequences:

First, my valuation does only concern FP’s franking/inserting business. Given that the industry is in secular decline, the estimated free cash flow yield is going to be reduced by a negative growth rate. If we assume that free cash flow declines by 2% per annum, we will still get an attractive 8% yield.

Second, I have not given any value to freesort, iab and Mentana-Claimsoft. In its annual report the company is performing a detailed impairment test for the three companies by estimating the fair value less cost to sell. The valuation is derived from a DCF-Model. freesort is valued with EUR 21.9 m (WACC:10.2%; growth rate: 2%), iab based on a 51% share with EUR 3.9 m (11.5%, 2%) and Mentana-Claimsoft with EUR 16.0 m (16.3%, 2%). This sums up to an additional value of EUR 41.8 m for the group.

Of course, this is just a rough indication and based on the subjective estimates of management. However, from my perspective an investor is currently not paying for a future contribution to cash flows from these entities. At the same time, I expect the core business to generate ample free cashflow in the upcoming years.

Conclusion

FP’s management seems to make a good job to enhance profitability of the franking/inserting segment. Though this segment is positioned in a declining industry, good cash flow generation and a high share of recurring revenues make the business quite stable. A low quality balance sheet, high historic losses on the income statement and uncertainty regarding the decline rate of the old business and the potential profit generation of the new business seem to hold down the company’s market value at the moment. However, I expect profitability and free cash flow generation to improve substantially over the next three years. With this expectation, today I am only paying for the old business and get the optionality for the new business for free. Apart from that, a broad range of financial investor’s is holding the equity component. In addition, the company is listed at the “Prime Standard” of Deutsche Börse. Hence, I regard the delisting risk with its negative consequences for minority holders based on German law to be low.

In my last post, I announced that I will start to accumulate a position in FP. Based on the assumption that I trade one third of the daily volume, I bought a 3% position for the virtual portfolio at a VWAP of EUR 4.14 from August 28th to September 2nd.

Disclaimer

The content contained on this site represents only the opinions of its author(s). I may hold a position in securities mentioned on this site. In no way should anything on this website be considered investment advice and should never be relied on in making an investment decision. As always please do your own research!

 
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Francotyp-Postalia (DE000FPH9000)

Published on August 28, 2014

Today, Francotyp-Postalia released its first half financial report 2014. As a consequence, the trading volume is relatively high and I start building a 3% position for the virtual portfolio with a stock price limit of EUR 4.40 from today on.

A write-up of my investment case for Francotyp-Postalia will follow asap.

Disclaimer

The content contained on this site represents only the opinions of its author(s). I may hold a position in securities mentioned on this site. In no way should anything on this website be considered investment advice and should never be relied on in making an investment decision. As always please do your own research!

 
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