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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.


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.


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.


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.


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.


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.


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.


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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Lancashire Holdings (BMG5361W1047)

Published on August 1, 2014

To proclaim a competitive advantage for any member of the insurance industry is ambitious. Lancashire has outperformed its peers over an extended period of time and seems to be one of the few exceptions in the industry, where dependence on investment income is very low due to a very profitable underwriting. A soft insurance market and uncertainties with regard to both the recent departure of the long term CEO and a recent acquisition have been putting pressure on the share price. From my perspective, this provides an attractive investment opportunity in a high quality insurance company.   

Lancashire is a Bermuda based specialty insurer, providing insurance for the aviation, energy, marine, property and terrorism/political risk markets. The company was founded in 2005. The table below provides an overview of the most relevant performance measures:

Management’s focus is not on top line growth, but on underwriting profits in attractive niches of the insurance market and growth in book value. Management’s aim is to provide its shareholders with an ROE of 13% in excess of a risk-free rate over the insurance cycle.

With an average combined ratio of 59.2% since inception Lancashire has set itself apart from the normal insurance company as it is not selling a commodity product as most competitors do. Rather Lancashire is insuring risks that require extensive knowledge and experience to price policies and administer claims.  The company has experienced underwriters who are trusted by clients and brokers having long term relationships with them and who are able to be smart about risk selection. Given this skillset, Lancashire has been able to sustain a competitive advantage and thus high profitability.

As more than 85% of profits come from the insurance business, they do not have to rely on investment return as most competitors do. This is quite useful for the following reasons:

First, there is no need to increase the company’s float by writing as much business as regulators allow. Instead, Lancashire can focus on the relatively profitable contracts.

Second, there is no need to leverage the investment portfolio to generate adequate returns. Comparing return on assets with return on equity in the table above you can see that financial leverage is relatively low. In addition, debt makes only up roughly 10% of total assets.

Third, there is no need to take high investment risks. The company’s investment portfolio almost exclusively consists of highly rated fixed income. - Edit: However, they recently decided to establish a 3.7% portfolio position in different low volatility hedge funds. While they did not explicitly disclose what kind of strategies (e.g.market neutral) these funds follow, the allocation to these types of alternative assets seems to increase the investment risk and might have a negative effect on investment income in turbulent markets. -

Fourth, interest rate risk can be mitigated as there is no need to invest in long term bonds (with high interest rate sensitivity). As of December 31, 2013, the duration for the overall portfolio including the use of derivatives was only 0.8. In addition, they have established a 3.7% portfolio position in a number of hedge funds which are specialized in trading volatility.

Lancashire’s insurance operations

Lancashire primarily writes insurance with a focus on short-tail specialty risks where losses are usually known within, or shortly after, the policy period. This makes the process of reserve setting easier than in some complex casualty businesses where claims trends may be slow to materialise. The majority of the company’s business are excess of loss contracts. This means that  However, each policy has a defined limit of liability arising from one event. Once that limit has been reached, there is no further exposure to additional losses from that policy for the same event. In addition, the claims count on the types of insurance and reinsurance that Lancashire writes, which are low frequency and high severity in nature, is generally low.

The company’s four principal classes are property (49% of gross written premiums in 2013), energy (31%), marine (9%) and aviation (7%). Their insurance book is diversified over different regions and risks exposed to both natural and man-made catastrophes. In the property segment Lancashire insures mostly risks from natural catastrophes, political risks (e.g. confiscation, nationalisation) and risks from terrorism. The energy segment mostly covers the insurance of offshore drilling. The marine segment provides insurance for physical damage, loss of vessels from war, piracy or terrorist attack. The aviation segment provides coverage for third-party liability, excluding own passenger liability, resulting from acts of war or hijack of aircraft. In addition, the segment provides cover for satellite launches and satellites in-orbit.

The table below provides an overview of the development of Lancashire’s estimated insurance liabilities since inception:

Looking at the development of the estimates of ultimate liabilities indicates that management has been relatively conservative. For all periods (except for 2012) the estimates of ultimate liabilities had a tendency to decline in value over the years.

Setup of Kinesis Capital Management

Besides its direct insurance business, Lancashire is also a reinsurer. Approx. 40% of the business is made up of reinsurance. At the same time, Lancashire is both a buyer and seller of reinsurance. Increasing reinsurer capital levels and large supply of capital from alternative capital investors is pushing risk margins lower on reinsurance renewals in general. Based on this report, margins in some programs today stand at levels not seen for a generation. The current weak pricing in the market is therefore both an opportunity and an obstacle to Lancashire. On the one hand, the company has currently bought the biggest amount of reinsurance cover in its history to capitalize on the low pricing and to give part of the insurance risk to someone else. On the other hand, the company faces obstacles to increase its insurance book given the low margins achievable. However, Lancashire seems to have more pricing power than other insurance businesses given its niche lines of business which are less commodity like. In addition, to profit from the current supply of capital from alternative resources, the company recently set up a subsidiary to manage third capital. Kinesis will manage third-party capital on behalf of Lancashire, by leveraging its existing relationship network and underwriting knowledge in the property catastrophe and specialty lines. The business is capital light as there is no need for additional capital besides a 10% equity interest in the vehicle. As a consequence, return on capital for the whole company can be elevated relatively easily the more capital will be employed. Kinesis will receive a profit share and management fees from the investors. Based on the company’s information, there is no other meaningful seller of multi-class collateralised capacity in Lancashire’s area of expertise. The new business started at the beginning of 2014 and has so far deployed roughly USD 300 m.

Cathedral Acquisition

Lancashire acquired Cathedral in 2013 being the first acquisition since inception. Cathedral has two syndicates under management at Lloyd’s. Syndicate 2010 has 42.2 per cent of its capacity provided by third-party capital (Lloyd’s Names) who pay a fee, profit commission and their share of the costs. The remainder is underwritten on the Cathedral balance sheet. Syndicate 3010 is wholly underwritten for the Cathedral balance sheet, and provides the logical platform to build out additional business in future. The segments where Cathedral is active are similar to Lancashire’s. However, management regards the way that Cathedral underwrites its business as different, and therefore complementary, to Lancashire’s model of writing larger direct and reinsurance risks in the non-Lloyd’s environment. The Cathedral approach is based on greater populations of risk in portfolios of more modest individual line sizes. The rationale for the acquisition was that while Cathedral will continue to trade independently, Cathedral will profit from Lancashire’s more robust balance sheet (better opportunity to leverage exposure, should opportunities present themselves), the addition of proven underwriters, the geographic expansion in attractive markets where Lancashire is not doing business and the access to Lloyd’s worldwide licencing and rating. In addition, management expects to improve Cathedral’s capital structure and efficiency, making the acquisition accretive to ROE. Cathedral had gross premiums written of USD 288.2 m and a combined ratio of 77.3% in 2013.

Opportunistic management of capital

Management follows a shareholder friendly approach regarding the allocation of capital.

In a soft market as it is the case now, when there is no opportunity to reinvest excess cash to earn attractive returns, they return that cash to shareholders. Management has stated that they repurchase shares, when the share price is around 1.2x book value. If the share trades at a larger premium to book value the company will pay out special dividends. Over the last five years the average dividend yield has been more than 10%.

In a hard market management makes use of the option to raise equity or debt to profit from high underwriting margins.

Major risks and uncertainties

In April 2014 the founder and CEO of Lancashire left the company and sold all his shares. It is pretty unclear why he made this decision. Given the development in 2013 with Kenesis and the Cathedral acquisition there might have been some disagreements regarding the future strategy. However, in this interview the new CEO Alex Maloney made clear that there will not be any changes in the company’s business model and management style. I think it is positive that Alex Maloney and a large part of the management team have been with the company for a long time. Nevertheless, this remains an uncertainty and might be one of the reasons for the weak performance of the share price over the last couple of months.

The integration of Cathedral is a major task for the company given that it will increase Lancashire’s premium level by 40% to 50% and that it has been the first acquisition since the company’s inception. Reading through the latest annual report it also seems that Cathedral’s solvency is lower than Lancashire’s. Though there is a risk with every acquisition, management did a good job in explaining the advantages of Cathedral’s addition to the group, which I think will lead to additional value for shareholders over time.

At the moment Lancashire is facing a very soft insurance market. Management states the following about the market condition in the report for the first half of 2014:

“There can be no doubt that the additional capital in our industry, not just new capital but also the undistributed retained earnings of many of our peers, is driving competition on pricing, terms and conditions. Most of this competition is still responsible and leaves acceptable underwriting margins and volumes for those underwriters like Lancashire, Cathedral and Kinesis who have the ability, experience and track-record that clients and brokers rely on to lead and structure policies. However there are areas of the market where there are instances of indiscipline, and Lancashire is always prepared to let underpriced business go. There have been some industry loss developments from prior years and events, but the first half of 2014 itself has been relatively quiet in terms of major loss events, so there is no catalyst for pricing to move upward.

Lancashire’s strategy since day one has always been to write the most exposure in a hard market and the least in a soft one. There are now abundant reinsurance and retrocession opportunities that allow us to maintain our core insurance and reinsurance portfolios, whilst significantly reducing net exposures. From our peak exposures in April 2012, when losses had driven substantial market hardening, we have reduced exposures across the board. We will stick to our strategy in the knowledge that when an event comes, we are well prepared through all three of our platforms to take advantage of subsequent opportunity.

There is some discussion about whether pricing has reached a floor, and there have been signs of over-ambitiously priced programmes being rejected. But on the whole we think there is still pressure on pricing and, with business more scarce in the second half of the year, we wouldn’t be surprised to see some aggressive renewal targets. But we can mitigate the effects of up-front pricing impacts with very substantial savings on our own reinsurance and retrocession purchases, and for LICL and LUK we’ve also bought substantially more limit this year for both risk and cat covers. Cathedral has always been a buyer of extensive reinsurance but has also managed to improve retentions, breadth of cover and costs.”

There is a risk that a prolonged continuation of this soft market environment will lead to a lower premium level given Lancashire’s disciplined underwriting approach which might ultimately lead to lower earnings.

Catalysts for a hard market are a reduced supply of capital currently entering the insurance market or events leading to losses and therefore margin increases for contract renewals. The former could happen, when there are more attractive investment opportunities for alternative sources of capital than the insurance market (e.g. triggered by a rise in interest rates).The latter will happen at some point in time. This seems to be already the case in the aviation segment after the recent tragic events in Eastern Ukraine with MH17 and Libya.

There is always a risk, that a large event will wipe-out a substantial part of Lancashire’s shareholder equity. Management provides an estimate of the exposures to certain peak zone elemental losses, as a percentage of tangible capital, including long-term debt. As of June 30, 2014, these modelled assumptions for peak zone elemental losses have been reduced substantially compared to the end of 2013 due to the purchase of reinsurance:


Shares of Lancashire are currently trading with a P/B of 1.3x and a P/E of 8.6x based on 2013 earnings. The first half of 2014 was affected by the retirement package for the former CEO. Excluding this impact, net profit would have been roughly 20% higher for this period leading to a ROE of 7.6%. It is difficult to come up with an estimate for the whole year of 2014, but an ROE of 13% to 15% should be achievable in the absence of significant losses. Additional upside for earnings could appear over the next couple of years from the following sources:

- Increase in Kinesis assets under management

- Leveraging Cathedral’s business supported by Lancashire’s higher solvency

- A hard insurance market

- An increase in interest rates

From my perspective, the market is not giving any credit to a potential upside in earnings from recent corporate activities and a potential midterm improvement of the insurance market. If the market does not recover, Lancashire will continue to return cash to shareholders and to write premiums in selected market segments where opportunities exist. Therefore, I think that the downside is limited provided that Lancashire sticks to the disciplined underwriting approach.

Due to Lancashire’s highly profitable business model which includes a relatively solid balance sheet, the company’s share price should trade with a premium to book value. At the same time with an earnings yield of 11.5% Lancashire seems to be very attractively priced.


Lancashire offers a differentiated product in a commodity like industry. Management seems to be very capable of manoeuvring through the cycle. There are a number of catalysts for the stock price to appreciate, which the market seems to ignore. For instance, a rise in interest rates will not damage the investment portfolio significantly given its low duration. To the contrary, management could shift the portfolio in higher yielding securities. In addition, higher interest yields could translate into less supply of capital in the insurance market. From a portfolio perspective, the addition of Lancashire also provides some kind of hedge against a rising interest environment.

For the portfolio, I will establish a 3% position at the current price level.


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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Eredene Capital (GB00B064S565)

Published on July 13, 2014

The following investment case concerns a security which is very thinly traded and where only limited information is available. The author owns the security.

This private equity investor is currently in the process of liquidating its Indian investment portfolio. Despite an improved sentiment in the course of the Indian elections in May, the stock trended downwards, currently offering a 44% discount to NAV. Based on current NAV and  assuming that the company will be liquidated until September 2017, an investment offers an 18% IRR and a 1.6x equity multiple over a 40 months holding period.

Eredene Capital is a private equity investor in Indian infrastructure operating companies. Private equity in India has been one of the worst performing asset classes. The aggregate dollars invested in India based on private equity funds from 2000 to 2009 have produced an IRR of less than 4%. The situation is even worse for investors, who piled into the country in 2007 and 2008, when the economy was expanding at 9% to 10%. Since then, growth has fallen, sliding to 5% to 6% mostly due to a slowdown in both public and private sector investment. Many investments made 6 to 7 years ago are now down 30% to 40%.

One of the major reasons is the fall of the Indian rupee, which has lost roughly 51% against the USD dollar since September 2007. This was caused by rising interest rates and inflation coupled with a reduction in foreign direct investments.

Apart from that, corporate governance standards and quality of management for many investments falls well short of the minimum standards required. In some instances, promoters acted fraudulent. At the same time legal proceedings against these promoters are complicated due to an inefficient court system. Moreover, land accumulation (for real estate and infrastructure investments) is very time consuming. A high level of bureaucracy, inefficient taxation policies and corruption complete the picture.

Based on this paper from the beginning of 2014, negative investment sentiment is expected to lead to a continued decline in allocation of funds to India in the near term as a result of slowing growth and increased competition from the next wave of emerging economies like sub-Saharan Africa and Southeast Asia. In addition, high entry valuations and a difficult exit environment are currently major deterrents to investing in India.

However, there are indications that investor sentiment has improved after the recent elections in May and that fund raising for new funds is accelerating. For the first time in 30 years, a single political party won a clear mandate from Indian voters for a five year mandate. The new administration headed by Narendra Modi, stands for a new government approach with streamlined decision making and improvement of accountability. As Chief Minister of Gujarat, Mr. Modi was already quite successful in implementing reforms and generating relatively high levels of growth. The question will be whether the new government can implement their approach for the benefit of the whole country and whether they can continue and improve the former government’s attempt to contain the current account deficit, support the currency, and better regulate the banking sector. On thursday, the new government released its budget plans.  They plan to reduce the budget deficit from 4.1% for this year to 3% for 2016/17. In terms of tax reform, the implementation of a goods and service tax was highlighted. They also announced a programme to boost infrastructure investments.

The Indian stock market has reacted very positively with the BSE SESEX increasing by 20% and the BSE Small Cap Index increasing more than 40% since the beginning of 2014:

As a consequence, overall expectations are quite high now. At the same time, Eredene’s stock price has trended downwards since the beginning of the year losing more than 30% of its value and was not positively affected by the improved sentiment. During that time GBP/INR has been more or less flat. Reasons for the underperformance might be Eredene’s listing on the AIM in London and its small market cap leading to less attention from investors.

Description of Eredene Capital

Over the last years infrastructure investments in particular have been negatively affected due to a delay in project approvals and failures to accumulate land combined with increasing interest rates. As a consequence, the number of non-performing assets increased and banks became more reluctant to provide financing. However, this has not reduced the overall need for high quality infrastructure which is one of the most important requirements for the Indian economy to make use of its growth potential on a consistent basis. Based on my information, most of Eredene’s investments provide for relatively high quality infrastructure assets with some of them meeting Western standards.

Between 2006 and 2011 Eredene Capital raised roughly GBP 90 m. After withdrawing from the Ennore Container Terminal project in 2012 and the disposition of the fund’s share in Ocean Sparkle in 2013 the company returned so far GBP 35.4 m to shareholders. The current portfolio consists of investments made in 2007 and 2008. Eredene will release its annual accounts as of March 31, 2014, at the end of July. My estimation of current NAV is GBP 24.4 m leading to a discount to NAV of 44% compared to the current market cap.

Eredene Capital is registered in the UK. Its investments are held through holding companies (SPVs) in Mauritius, which has a double tax agreement with India. Each investment is made through a dedicated pair of SPVs in Mauritius, giving flexible realisation options by allowing the sale of the lower tier Mauritian company rather than selling the investment directly. The company believes that proceeds of such sales held in Mauritius will not be subject to tax and, if remitted to the UK, may not be subject to tax there.

Eredene’s investment portfolio

MJ Logistic Services (MJL) operates a logistics center in Palwal on the Delhi-Agra Highway. The high-tech warehouse at Palwal provides both cold and ambient storage over 200,000 square feet. MJL also operates leased warehouses, and including Palwal it has a total warehouse capacity in North India of 800,000 square feet. The major ambient customer is Tata Motors. Cold chain customers include Domino’sPizza, Subway Du Pont Danisco and Unilever. MJL is dependent on two customers with one customer representing 36% of revenue and the other 33% of revenue. The company owns additional land around its current site to be developed for capacity expansion.

MJL, posted revenue of GBP 4.2m for the financial year ended March 31, 2013, a 23% increase over the previous year in Indian Rupee terms, and generated positive EBITDA.

Eredene is holding an 86% share in the company. The remainder is held by the management. Eredene’s equity injection of GBP 10.9 m in 2008 secured an initial 90% of the company, which can be diluted to 74% due to the conversion of preference shares into ordinary shares by the MJL management team following the achievement of performance milestones.

There is an interesting interview with the promoter Anil Arora available, where he explains why the company is increasing its cold storage capacity and how the company will profit from an implementation of a GST tax and increased infrastructure spending. Based on my research the promoter seems to know what he is doing.

Contrans Logistic CFS services bulk cargo and containers through the Maersk operated port of Pipavav in Gujarat. Major customers include shippers Maersk India, Hapag-Lloyd and J.M. Baxi & Co, global chemical and textile company GHCL and logistics providers Shreenathji Worldwide and Gudwin Logistics. The CFS is currently using 23 acres of its 79-acre site and has an annual throughput capacity of 0.1 m TEUs (twenty foot equivalent units, the length of a standard container). A CFS is an off-dock facility close to a port, helping to de-congest the port by shifting cargo and customs related activities outside the port itself.

The CFS is located 700m from the Pipavav port gates. Pipavav is the first privately owned port in India having begun cargo handling operations in 1996. The port’s operating company is listed on the stock exchange. Based on this press release, France’s CMA CGM Group is going to partner with one of Pipavav’s rivals to build a new container port leading to more competition. Based on this presentation, the Pipavav port grew revenues by 135% from 2009 to 2013 to INR 5.2 bn. In 2013 they generated a profit margin of 37% and a ROCE of 13%. At the same time, debt has been steadily reduced and is 20% of equity as of 2013. It is planned to increase the container handling capacity from 0.85 m TEUs to 1.35 m TEUs. In addition, Maersk took measures to increase traffic at Pipavav port by adding Pipavav to its India-Middle East-East Coast service, thereby connecting its customers in Gujarat and the North India hinterland to the US market.

Based on this document, the Indian rating agency ICRA assigned a BB- rating to Contrans Logistic in 2012. They had debt outstanding of INR 170 m. Based on the current valuation, this translates into a gearing ratio of 0.1x.  The business generated revenues of INR 133 m for fiscal year 2012 and a small profit. I could not find any information about 2013, despite Eredene reporting that revenues fell due to a decline in volume. The promoters have several years of experience in the industry and have been operating a CFS at the Port of Mundra in the North of Gujarat State since 2003. In addition, there seems to be limited competition for Contrans Logistic CFS.

Contrans Logistics’ second project is a 128-acre site at Baroda in central Gujarat which has planning permission to develop a road and rail Inland Container Depot on the busy Delhi-Mumbai freight corridor. Based on Eredene’s information, the market value of the site is at a significant premium to the original purchase price. Currently, the company is trying to sell the site.

Eredene invested GBP 5.7 m for a 44% stake in the two projects. The current valuation of Eredene’s share is GBP 6.0 m. Most of the value seems to be attributable to the land held by the company.

Although relatively small, the most successful investment to date has been Sattva Vichoor in Tamil Nadu, which is profitable and dividend paying. Eredene invested GBP 0.7 m and is holding 39% of the operating company. It operates on a 26-acre site and handles containers from Chennai Port and also provides facilities for on-site assembly of imported machinery. Customers include South Korean machinery manufacturer Doosan, NYK Line and Maersk. The container freight station handled 75,300 TEUs in 2012-13, compared to 68,000 TEUs in the previous year, an 11% increase. The business posted annual revenue of GBP 3.7 m, a year-on-year increase of 5% in Indian Rupee terms. A new 10,000 square feet export warehouse is under construction which will take the total warehousing capacity on the 26-acre site to 97,500 square feet.

Sattva Vichoor Container Freight Station is one of two joint investments with the Sattva Business Group. Sattva Business acquired a 10% stake of the investment from Eredene at the beginning of 2012. Hence, chances are good that the remainder will also be sold to Sattva. Based on this analyst report from 2008, the project was financed with debt of INR 282 m. Based on the current valuation the gearing ratio is 0.3x. Eredene’s share in the business is valued at GBP 3.8 m.

After this successful joint venture with with Sattva Business Group, Eredene invested another GBP 3.8 m for an 83% share in Sattwa Conware also located in Tamil Nadu. This Container freight station on a 60-acre site is located within reach of both Ennore and Chennai ports and the newly opened Kattupalli container terminal and has a total warehousing capacity of 74,000 square feet. However, so far the business was unable to launch its export-import container business due to a lack of the necessary Government-allocated customs staff. At the moment, the container freight station is only handling empty container boxes from Wan Hai and NYK shipping lines and domestic cargo for Ford India.

Eredene has two logistic parks in East India with investment partner Apeejay Surrendra Group, a Kolkata-based conglomerate. The two facilities are operated in a 50/50 joint venture.

The Apeejay Infra logistics park in Haldia operates on a 90-acre site close to the port of Haldia, a petrochemical hub at the mouth of the Hooghly River and the major gateway to Kolkata. It has a warehouse capacity of 140,000 square feet and a container yard of 300,000 square feet. Haldia Port has recently seen a reduction in container volumes and Apeejay’s logistics park has been impacted by a restriction on containers being handled by external CFS imposed by Haldia Port Trust. Eredene has written down the value of its investment in Apeejay Infralogistics as a result of the reduced prospects for the Haldia logistics park.

Apeejay Infra-Logistics’ second logistics park at Kalinganagar is the first purpose-built transport and warehouse facility in Orissa State and has been set up to service the local steel and metallurgical industry. The 30-acre facility has a warehouse capacity of 84,000 square feet and a container yard of 185,000 square feet. The domestic warehouse and a substantial area of the open yard are leased to logistics services provider Tata TKM.

Based on Eredene’s notes in the financial report, the SPV for this investment has entered into two deeds of undertaking with the financing bank. Under the terms of those undertakings, the SPV has agreed to provide additional funds to Apeejay Infra-Logistics in the event that there is a shortfall in the Apeejay Infra-Logistics Group’s ability to service its debt. The debt facilities provided by the bank total to INR 778.3m (GBP 7.6 m) and the undertaking is provided on a joint and several basis by the SPV and its joint venture partner. Assuming that the whole facility has been drawn, this would translate into a gearing ratio of 1.65x based on the latest valuation. However, in this article  the chairman of Apeejay Surendra states that total investment for the two projects was INR 2.5 bn (GBP 24.7 m). So it is likely, that there is more debt outstanding up to a gearing ratio of 4.4x.

Nevertheless, Eredene’s joint venture partner seems to be pretty solvent. Apeejay Surendra, is a privately held conglomerate. They own a hotel chain, have one of India’s largest privately held shipping lines and are the third largest Indian tea producer. Based on Indian credit agency ICRA, their other businesses are all graded with A grade ratings as can be seen here, here, and here. Apart from that, their hotel chain raised USD 55 m from one of Credit Suisse’s real estate funds in 2007 for a 15% stake in the company.

Eredene invested GBP 2.9 m for a 50% stake in the two logistics parks. Eredene’s share is valued at GBP 2.3 m.

Eredene is also holding a majority stake in a low-cost housing real estate project, Matheran Realty, near Mumbai. Eredene invested GBP 15.3 m. They have been trying to sell the project for quite some time, but have not been successful so far. As of September 2013, the potential sales price was GBP 3 m and Eredene wrote the realisable value down to that price in the accounts. They also reported, that if a sale is not achieved then it would be the company’s intention to work with Matheran to complete the first phase of the affordable housing development prior to any subsequent sale. This may require further funding from the company.

New Investment Manager and liquidation of the company

After withdrawing from the Ennore Project in September 2012, Eredene decided to make no further investments in new projects in India and in 2013 decided to liquidate the company. After an independent financial and legal review of the principal investments the company reported it may take until September 2016 to sell all investments and to return the sales proceeds to shareholders.

In addition to that, Eredene transferred the investment management to Ocean Dial Asset Management in September 2013. The investment management agreement is for a 24 month period and thereafter can be terminated with three months’ notice. The transfer leads to a significant cost reduction. Eredene is saying that holding costs will be reduced from GBP 1.8 m p.a. to GBP 0.85 m p.a. Ocean Dial used to be wholly owned by Caledonia Investments, a 21% shareholder in Eredene. In May 2013, Caledonia disposed of its entire shareholding in Ocean Dial to the Ocean Dial management team. The team on the ground in India is led by Raju Shukla, a former country head of Barclays Capital India. Apart from the Eredene mandate, Ocean Dial is managing to Indian public equity funds with combined AUM of roughly USD 190 m. Ocean Dial receives a capped performance fee on the sale of each investment, of 0.4% to 0.6% of the sales proceeds per investment. Should a sale of Matheran Realty not occur, Ocean Dial will manage the assets and will receive a capped performance fee which varies from 0.67% to a maximum of 5.0% of proceeds depending on the sales value achieved.

Ocean Dial is supported by Ranveer Sharma and his team to identify and execute the sale of the investments. Mr. Sharma has already worked alongside the former investment manager since the setup of Eredene Capital. The above mentioned holding costs of GBP 0.85 m p.a. include his work for the company.


Below you can find my estimations of the current NAVs, gearing and gross values for the single investments and the company:

The investments Sattva Vichoor, Contrans and Apeejay are held in the accounts at fair value and that fair value was determined by Grant Thornton India. The appraisers used a 19% discount factor for Apeejay and 16% discount factors for the other two investments. In addition, they used a terminal growth rate of 4% and a marketability discount of 15%.

I do not believe in a sale of Matheran Realty, as management has already made an announcement in this regard two years ago. So I assume that the current liquidation value of this investment is zero, but that any future injections into the project will flow back to Eredene.

The two direct majority stakes in MJ Logistic and Sattva Conwave are consolidated on the balance sheet. For the NAV computation I have used book value including goodwill arising from the original acquisition of MJ Logistic which is subject to impairment. In the notes of the latest annual report management states regarding the value of goodwill that:

“Sensitivity analysis has determined that no reasonably possible change in the key assumptions used will result in significant impairment and that there is sufficient headroom in all of the key assumptions before the carrying value becomes impaired.”

From my perspective, this is an indication that book value might be a conservative estimate of intrinsic value for MJ Logistic.

Apart from that, I have reduced the cash balance by GBP 0.6 m compared to September 30, 2013 to account for holding costs from October 2013 to June 2014.

Management has set the target to liquidate the company until September 2016. I think it makes sense to be more conservative here. I assume that half of the NAV will be returned to shareholders until September 2016 and the other half until September 2017. For the period from July 2014 to September 2017, I include holding costs of GBP 2.8 m in my calculation and I assume that Ocean Dial will receive a performance fee of 0.6% of sales proceeds in September 2017. Based on these assumptions an investment in Eredene returns an 18% IRR and an equity multiple of 1.6x.

The following sensitivity analysis shows the total returns under different scenarios based on changes in gross values of the investment portfolio and foreign exchange fluctuation (INR/GBP).

First, for the internal rate of return:

Second, for the equity multiple:


The liquidation of Eredene’s portfolio will take time. Further setbacks are likely given the difficulties to conduct business in India and the country’s current economic weakness. Expectations on the new government seem to be very high. At the same time, there is a general view that it can’t get worse after the former government. The announcements made regarding an investment programme and the implementation of a GST tax are a first step into the right direction for India’s infrastructure sector.

From my perspective, the decision to liquidate the company and to change the investment manager shows the strong influence of the two largest shareholders. Both Ruffer and Caledonia are each holding more than 20% of the shares outstanding. The decision to transfer the investment management to Ocean Dial, a former affiliate of Caledonia, is a positive not only from a cost perspective. Ocean Dial is a small owner operated investment boutique and the Eredene mandate gives them the opportunity to prove their abilities in the management of private equity investments. If successful, they should be able to attract further mandates and to grow assets under management. Apart from that, the quality of the promoters seems to be relatively good. In addition, the stock price has not reacted to the improved sentiment in India and the large discount to NAV provides a healthy margin of safety.

Since April 2, 2014 there have been no news and the stock traded in a range between 5.3 pence and 6.0 pence. Due to the stock’s low liquidity I assume that I have traded one third of the volume since then at a VWAP of 5.6 pence. This leads to a current portfolio position of 1.6%. I will add to this position until reaching a 2.5% position with a limit of 5.8 pence.


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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Q2 2014 Performance & Portfolio Update

Published on July 2, 2014

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

# Investment


Purchase Price

Current Price


Portfolio Share

1 Passat












3 Fairfax Financial






4 Real Dolmen






5 Lectra






6 Retail Holdings






7 Broedrene A&O






8 City of London






9 Olympic Entert.






10 Miba






11 Dundee Corp.






12 TMW Weltfonds






13 Lenzing






















1)      Performance in EUR inc. dividends/interest

The portfolio gained 2.3% during the quarter. During the same period the benchmark increased by 1.9%.  Over the last three months the top contributors to portfolio performance were City of London (+0.8%), Fairfax Financial (+0.5%), Dundee (+0.5%), RealDolmen (+0.3%), Equal Energy (+0.3%; sold) and Miba (+0.3%). The detractors were Broedrene A&O (-0.3%), Magix (-0.2%; sold) and Passat ( -0.2%).

Corporate risk reduction and stock market volatility

Since the last considerable market woes in mid-2012, volatility has remained at low levels in the Western markets. During the same time indices like the S&P 500, EURO STOXX 50 and DAX steadily increased and are now 50% higher. Back in 2012, when fears again peaked over Europe’s debt crisis the German blue chip index DAX lost roughly 15% from mid-March to the end of May. During the same period the volatility index VDAX spiked from 17.8 to 31.2. Since then, the VDAX decreased to a low of 11.5 in October 2013 and currently stands at 12.5. Generally, periods of low volatility are good for momentum guys, but not for value investors, as more and more investment opportunities tend to exceed their intrinsic value. In addition, many mistakes will be excused by the market during these periods (just want to mention my recent experience with Magix where I got off lightly).

Recently I read this very interesting paper from Horizon Kinetics. They state that increasing cash levels and therefore reduced balance sheet risks of the major S&P 500 components (e.g. Apple, Google, Microsoft, Johnson&Johnson, etc.) have led and will lead to low volatility of the S&P 500. Based on their paper, for the 12 largest nonfinancial companies in the S&P 500 cash as a percent of total corporate assets is 23.3% on average.

They conclude that,

“Companies like these have come to dominate the S&P 500 in recent years. With such liquid balance sheets, their stocks are necessarily much less volatile than the stocks of market leaders of the previous generation. For example, companies in a prior era, like Ford, U.S. Steel and General Motors, did not maintain anything close to this level of liquidity. Their earnings were much more volatile than those of the companies that lead the S&P 500 today. What we might be looking at is an equity market that is less volatile than the historical average.”

They add that,

“For many of these companies, the priority placed on liquidity comes at the expense of investment. Along with other headwinds discussed in past commentaries, the unwillingness to deploy cash reserves seems likely to adversely impact earnings for the largest companies and indexes going forward, such that the companies and sectors with the most attractive predictive attributes will be found outside of the major stock indexes.”

While I perfectly agree with the statements in the second paragraph, I am wondering whether high cash levels are in general predicting low stock market volatility (as mentioned in the first paragraph). So, let’s get back to the German DAX. As you can see from the chart below, volatility for the DAX (VDAX) and for the S&P 500 (VIX) have highly correlated over the last three years.

I have prepared a similar overview for the DAX as Horizon Kinetics did for the S&P 500. The table below shows cash and short term investments as a percentage of total assets for the largest 10 DAX components. In addition, I am comparing the cash levels in 2013 with 2009.

First, the ten largest DAX companies did not increase their cash level over the last four years. Second, the overall cash level stands at roughly 8% of total assets, which seems to be prudent and in line with historic levels. At the same time the DAX and the S&P 500 highly correlated in terms of volatility.

As a result, there seems to be no correlation between cash levels on corporate balance sheets of the DAX components and stock market volatility. Consequently, it seems that an increase in cash levels does not cause lower volatility. I believe that the same applies to the S&P 500 and that other factors like yield hunting due to the low interest rate environment are more important. So is it different this time? Not at all! I believe that periods of low volatility can continue for quite some time. However, the longer this period lasts, the more volatile it gets afterwards.

Investment Update

RealDolmen reported good numbers for the year ended March 2014. They also sold their French subsidiary to a French rival. Given the weak market position, the company had in France, this seems to be the right step.

TMW Weltfonds sold its trophy asset in Hamburg. However, the sales price was quite disappointing. Their largest asset in the remaining portfolio, Eastview in Paris, is now fully leased for a 12 year period. The other assets in the Netherlands face problems due to market conditions in general. They also sold one of the four Dutch properties for a gross yield of roughly 12% which is better than my estimation in my original write up. I think that a liquidation value of EUR 19.3 per share is still achievable. However, it might take longer than originally expected. At the current price, I see limited downside risk. The major problem is, that the people in charge are not really incentivised to liquidate the portfolio at the best price.

Broedrene A&O Johansen reported weak Q1 2014 numbers and lowered its annual pre-tax profit guidance from DKK 125 m to DKK 75 m “due to increased competition and uncertain market forecasts.” I plan to come up with an update on this investment.

Passat reported a revenue decline of 19.6% for the first three months. Revenue in France (82 of total) declined by 14.5%. Up to now, France used to be the company’s stronghold, so this is quite alarming. The company expects to stabilize sales with new product releases in the coming months.

In a rather opaque presentation, RHJI’s management presented the goal to achieve a EUR 60 m pre-tax profit within the next two years. This would translate into a pre-tax return on equity of roughly 8%. This seems to be at the low end of achievable returns in the private banking business under normal circumstances. In terms of valuation, this translates into a 5.3 times pre-tax profit multiple. So despite the issues the company has (as already outlined in former posts), valuation is attractive based on a moderate profit expectation.

Portfolio Transactions in Q2 2014

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

Item Date Amount in EUR
Beginning Balance 4/1/2014 6,481,937
Miba 4/1/2014 to 5/22/2014 -95,850
Equal Energy 4/14/2014 -204,652
Lectra Dividend 5/7/2014 6,779
Olympic Entert. Div. 5/13/2014 15,766
Magix 5/20/2014 110,607
Lenzing 5/26/2014 -306,855
Equal Energy Div. 5/28/2014 2,197
Equal Energy 6/13/2014 237,736
AGCO 6/27/2014 -413,846
Interest on cash 4/1/2014 to 6/30/2014 15,395
Current Balance 6/30/2014 5,849,214


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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Published on June 27, 2014

This farm equipment manufacturer has a strong presence around the world and is therefore very well positioned to profit from growth in farming in the developing world. Increasing world population and a reduction in the number of farmworkers provides accelerating demand for efficient farming equipment. The company’s diversified revenue stream does also help to reduce weather related risks which play a major role in the farming industry. In addition, a wide range of products are helping the company to differentiate itself from its competitors. Apart from that, management makes substantial progress in improving profitability. On top of that, the company is currently in the process of repurchasing 10% of shares outstanding and seems to be focused on increasing shareholder value. Currently, the market seems to be afraid of a softer demand in the US and Brazil ignoring the progress in profitability and the long term growth potential for this company.

AGCO manufactures tractors (60% of revenue), hay tools and forage equipment (9%), grain storage systems and protein product equipment (7%), combines (6%), and application equipment (5%). In addition to sales of new equipment, the replacement parts business (13%) provides a less cyclical higher profitable revenue stream for the company. Since most of their products can be economically maintained with parts and service for a period of 10 to 20 years, each product that enters the marketplace provides them with a potential long-term revenue stream.

The company has established a distribution network of 3,100 independent dealers and distributors in more than 140 countries.

AGCO Finance provides retail financing (83% of total) and wholesale financing (17%) to Agco’s dealers. AGCO Finance is a joint ventures owned 49% by AGCO and 51% by Dutch Rabobank. The majority of the assets of the retail finance joint ventures represents finance receivables. The majority of the liabilities represents notes payable and accrued interest. Rabobank provides financing to the joint venture. So AGCO does not guarantee the debt obligations of the joint ventures (except from a small amount). The wholesale receivables are either sold directly to AGCO Finance without recourse from AGCO or AGCO Finance provides the financing directly to the dealers. The total finance portfolio in the joint venture was approx. USD 9.4 bn (88% of revenues) as of December 31, 2013. AGCO Finance’s assets are not consolidated on AGCO’s balance sheet and earnings of the retail finance joint venture are only included in “Equity in net earnings of affiliates” in the P&L. In 2013 the joint venture contributed USD 48.8 m to AGCO’s net income (8% of total net income).

Geographical Diversification

The company generates 51% of revenues in the EMEA region (Europe, Middle East, Africa). Europe in general is a mature market dominated by replacement revenue where growth potential comes from new technologies. However, the management sees attractive growth opportunities in Eastern Europe due to underinvestment in the past and low productivity. The company has extended its dealer network to profit from a potential increase in investment activity in this region. Apart from that, the company is also planning to expand its operations in the African markets.

North America contributes 26% to revenues. An increase in farm income over the last couple of years has led to a strong market for farm equipment. In addition, given the low interest environment, farmers have been refreshing their fleet to lower the lease rate and renew warranties. For the coming years, the company forecasts a softer demand. This might be also due to an expiration of a tax break concerning the accelerated depreciation of equipment purchases. The company has a good position in the middle sized horse power segment. Nevertheless, going forward management wants to grab a higher share in the more profitable market for high horse power tractors. They have been working on improving and consolidating their dealership mainly due to a collaboration with the Caterpillar dealer network. In addition, they plan to import low horse power tractors from their plant in China to offer a low priced alternative to small farmers.

19% of revenues come from South America. AGCO has a very strong presence in Brazil with a market share of 40% in the tractor segment. AGCO lost market share to Deere over the last couple of years, as the world largest tractor manufacturer grabbed market share with a low price strategy. Over the long run, Brazil is expected to add 2% to 3% of new production capacity per annum. In addition, given AGCO’s large product range, the company also profits from a shift from standard products to special products. Farm income has been quite strong as Brazilian farmers profit from the weak currency and input costs in USD make up only 40% of total input costs. However, Brazil is currently suffering from a lack in financing due to a delay in the Government financing programmes and rising borrowing costs. This leads to softer demand in 2014. From January to May 2014 AGCO’ tractor sales declined by 16% year over year combined to 20% for the whole market. The decline has been lower for AGCO during the first two months of the second quarter while the market continued its weak performance (9% for AGCO vs. 18% for the market)

Currently, Asia plays a minor as the company generates only 4% of revenues in this region. In China, the company is still in the start-up phase. They have a new production site with a capacity of 30,000 tractors per annum located in Changzhou (close to Shanghai) exporting tractors mainly to the US and other developed markets. This is expected change as management wants to participate in the urbanization trend in China. As more and more farm workers move to the cities China needs higher efficiency production and agricultural machinery to develop their arable land. In India the, the largest market for low horse power tractors, the company participates through license payments from third party manufacturers.

Continuous extension of product range and product differentiation

AGCO is now focusing on internal product development and integration of existing brands. Historically, the company has grown through acquisitions. Acquisitions include Massey Ferguson in 1994, Fendt in 1997, Challenger in 2002, and Valtra in 2004. The recent acquisition of GSI in 2011 led to an attractive extension of the company’s product range as AGCO entered the market for grain storage and protein product equipment. In this segment, management sees ample room for growth for the following reasons:

GSI is a relatively high margin business and management is looking to shift revenues from GSI’s home market in the US to its European, South American and Asian markets. In terms of cross selling products, it also helps to differentiate its product range from larger competitors like Deere and CNH.

With regard to grain storage a relatively large share of grain harvest is wasted due to insufficient storage capacity in the emerging world. With increasing demand for food, this problem can be solved with improved food storage equipment. In addition, farmers are incentivized to invest more in food storage due to the increasing volatility of crop prices. Having the opportunity to store the harvest, enables them to wait for the right time to sell their crops to the market.

In general, an increasing demand for animal protein products in the emerging world is good for GSI. In addition, this segment is somehow countercyclical as lower grain prices increase profit margins for stock farmers which should lead to increased demand for protein product equipment stabilizing the overall business.

Operating Performance and margin enhancement

Over the last couple of years AGCO has been able to enhance profitability. Management targets a 10% operating margin within the next two to three years (2013: 8.4%). The progress in margin improvement is due to the following reasons:

Material costs make up a large portion of total costs. The company is in the process of converting from a regional purchasing organization to a globalized organization. As a result, better buying power is a key driver to reduce input costs and improve profitability.

In addition, management has been heavily investing in existing plants to achieve productivity gains. AGCO is a multi-brand company comparable to Volkswagen or GM in the automotive industry. To become more profitable, they are currently working on a platform solution (as Volkswagen did some years ago) to streamline production. Capital expenditures should reach its peak in 2014. This should translate into higher free cash flow margins starting from 2015.

On top of that, management focuses on the sale of higher horse power equipment to professional farmers in the developed markets to achieve margin enhancement.

Risks and Red Flags

In terms of working capital management, the company experienced a spike in its inventory levels in Q1 2014. The below table shows, that days sales in inventory jumped 25 days both quarter over quarter and year over year:

During the Q1 2014 conference call, management stated that they are “dissatisfied” with the current situation. They target an inventory level for the end of the year 2014 which is below the Q4 2013 level (DSI of 98). At least, comparing finished goods and replacement parts with raw materials and work in process there is no negative component divergence, as the increase in days sales in finished goods/replacement parts is in line with the combined increase in days sales in raw materials/work in process. This means that finished goods do not pile up in excess of raw materials and work in process which would be an indicator for future inventory write downs. Nevertheless, the run up in inventory is a concern and I will monitor this closely over the next quarters.

Apart from that and a potential economic downturn in AGCO’s markets, I see the following risks:

AGCO’s business model heavily depends on the availability of affordable financing and the credit quality of the finance portfolio. An increase in interest rates and/or a lack of financing provided by the company’s joint venture partner Rabobank could harm AGCO’s business. In addition, given the size of the portfolio relative to the joint ventures’ level of equity, a significant adverse change in the joint ventures’ performance would have a material impact on the company’s operating results.

Though the company is highly cash generative a significant portion of the operations are held through foreign holding companies. As a result, it is difficult from a tax perspective (as for most other US multinational companies) to repatriate cash back to the US. This hinders the potential of the company to return capital to shareholders.

In addition, in many markets demand for the company’s product depend on Government schemes and subsidies. Moreover, the company is currently profiting from low steel prices, which could change when excess capacity in the steel industry is reduced.

Valuation and competition

AGCO competes primarily with Deere and CNH. Deere is also involved in the forestry and construction businesses, while CNH derives part of its sales from construction and transportation. AGCO is the only major pure play on agriculture equipment. Below you can find a comparison of the three companies:

It is important to note that Deere and CNH consolidate their financing division in the financials, whereas AGCO does not. To compare the three companies, I excluded the financial division’s obligations to receive adjusted numbers for total debt (incl. pension liabilities and operating leases) and enterprise value. In addition, I adjusted EBIT and EBITDA for finance income and interest payments relating to the finance division. As a result, income from the finance division is only included on the net income level (P/E, ROE) as it is the case in AGCO’s P&L.

Deere seems to be more efficient than AGCO from an operational perspective. However, it becomes also clear that Deere’s high return on equity depends to a large extend on the company’s finance division. The same applies to a lesser extend to CNH. On the other hand, AGCO’s finance division seems to have a much smaller impact on net income.

Overall, Deere might have a better market position and advantages in terms of scale and distribution. However, I regard AGCO as less risky with regard to their balance sheet. AGCO will be affected by a deterioration of the finance portfolio, but the company is not liable for the portfolio. In addition, they carry less debt than Deere or CNH on their balance sheet. Compared to the two larger competitors, I view AGCO’s valuation as attractive given that further margin improvement might get AGCO closer to Deere’s level of profitability (ignoring income from the finance division).

Free cash flow approach: If we assume that AGCO is currently able to generate roughly USD 800 m of operating cash and that capex will go down to USD 300 m, then the company is currently trading with a price to free cash flow multiple of approx. 12x. From my perspective, this is an attractive multiple given the current market environment and the existing growth opportunities for the company.


AGCO’s sales depend on agricultural spending which is mostly driven by farm income. Farm income in the U.S. and Brazil has grown strongly over the last years.  A slowdown of investment activity in these regions over the medium term is likely.  However, AGCO has a strong global presence and should be able to profit from recovering demand in Europe and growth in other developing countries. In addition, margin improvement should help to compensate for lower top line growth. A solid balance sheet combined with strong cash flow generation, an attractive valuation and management’s commitment to return excess capital to shareholders completes the investment case.

Over the long run, an increase in protein diet per capita, a larger world population, less affordable labour available for farming and the need to increase crop yields due to a limited amount of arable land should provide for rising demand of AGCO’s products. From my perspective, AGCO is very well positioned to benefit from this scenario.

For the portfolio I purchase a 4% portfolio position at today’s VWAP.


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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Equal Energy – Sell

Published on June 13, 2014

You can find my initial investment thesis here.

Yesterday, EQU’s management filed the definitive  proxy statement with respect to EQU being acquired by Petroflow.

Under the Arrangement, Petroflow Sub will acquire all of the outstanding common shares of Equal for USD 5.43 per share, payable in cash. Upon completion of the Arrangement, Equal Shareholders will also receive a cash dividend of  USD 0.05 per share. A USD 0.05 dividend per share was already paid to investors in May being part of an increased offer to shareholders due to a delay in the acquisition process. Hence, since my initial write-up Petroflow’s offer to shareholder’s increased by USD 0.1 per share.

A shareholder meeting will be held on July 8, 2014. At least 66  2 3 % of the votes must be voted in favour of the transaction. In addition, the transaction is subject to a minority approval. Lawndale Capital Management, holding roughly 4.8% of EQU’s shares, has already indicated that they will vote against the transaction. So despite the efforts made by EQU’s management to get the deal done, I believe it is still likely that the deal falls apart.

With the share price currently trading at the offer price of USD 5.43, I will skip the additional USD 0.05 per share dividend to be paid after deal completion. I will start to sell my position from today with a limit of USD 5.40. This implies a total return incl. dividends of roughly 15% over a two months holding period.

Lessons learned

Not only me, but also the market underestimated EQU’s management’s willingness to get the deal done, as they are highly incentivized. In my original scenario analysis I estimated a 25% probability that the deal will be completed. In hindsight this was far too low. (Though the deal has not been commpleted yet)

Given that I saw a 75% probability that the deal falls apart, I planned to increase my initial 2% portfolio position after a drop in the share price (triggered by the unsuccesful transaction). Nevertheless, based on the original scenario analysis, all the potential outcomes led to a higher share price. So it might have been a better strategy to establish a larger position right at the beginning given this high conviction investment.

Edit 6/15/2014: Position sold on 6/13/2014 for an VWAP of USD 5.41. Realized gain of 17.2%.


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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Lenzing (AT0000644505)

Published on May 24, 2014

Lenzing is the world leader in terms of production and technology of man-made cellulose fibers (MMCFs). MMCFs are used in the textile industry (women’s outerwear, sportswear, home textiles) and the nonwovens industry (hygiene products, cosmetics). The company holds a market share of 20% in its industry. Currently, an increase in capacity coming mostly from China is harming the industry’s profitability. After a consolidation of the industry and a reversion of prices for MMFCs from their low level, I expect Lenzing to profit from ongoing cost reductions and product mix improvements. From my perspective, the current share price is not reflecting the potential upside in Lenzing’s profitability coming from a structural demand growth for MMCFs and a decline in the growth rate of capacity expansion.

The raw material for Lenzing’s fibers is wood, which is the basis for producing dissolving wood pulp subsequently processed into cellulose fibers. Wood Pulp is the main input factor with a 31% share of total costs. 52% of the wood pulp supply are secured through own production and 40% over long term supply contracts linked to the paper pulp index and not the spot price. The vertical integration of the company’s wood pulp supply leads to cost advantages of 20% compared to the current spot price for wood pulp.

Lenzing has seven production sites located in Austria, Indonesia, Czech Republic (pulp production), UK, US and China. The company’s total fiber production increased from 334,000 tonnes in 2000 to 891,000 tonnes in 2013 with revenues increasing from EUR 599 m to EUR 1,909 m.

Over the last years the company shifted its product mix towards higher quality specialty fibers. For the company’s trademarks Tencel and Modal customers pay premiums of up to 50% compared to the standard viscose fiber prices. Specialty fibers make up 35% of revenue and the company has a market share of more than 80% in this segment. With the new Tencel production line in Austria to be completed in 2014, the company meets the growing demand from spinning mills. Lenzing specialty fibers have comparable characteristics to cotton and are more sustainable from an environmental perspective. The environmental impact from cellulose fibers is 17.5x lower than from cotton. Lenzing is not only producing a product which is more sustainable than its substitutes, but is also the leader in terms of sustainability within its industry. Companies like Marks & Spencer, H&M, Ikea and Inditex are aware of the positive effects for their brands, if they make use of sustainable materials in their products. Given Lenzing’s position in its industry this offers substantial growth potential for the company. Recently, H&M started a large sustainability campaign called “H&M Consciuos Fashion”. Lenzing’s Tencel fiber is one of the materials used in H&M’s Conscious Fashion line.

Current Obstacles

After a record year in 2011, the company faced a steady decrease in the price for viscose fibers from a high of EUR 2.40/kg in Q2 2011 to a low of EUR 1.56/kg in Q1 2014. There are two major reasons for this development:

1) Overcapacity in the industry

Despite growing demand for MMCFs, increasing capacity in the industry puts continuous pressure on pricing. Since 2011 world production capacity has increased by 23%. In the latest conference call, management reported that capacity increases have come down to single digit growth numbers and that many Chinese fiber producers face liquidity constrains at the current price level. As a consequence, Lenzing is operating in a cash driven industry. The company’s Chinese competitors are currently producing at 85% of total capacity to generate cash serving their large debt burdens. Further credit tightening in China is limiting their financial flexibility. Consequently, they have no ability at the moment to decrease utilisation rates and influence prices upwards, although price agreements between these companies seem to be common. The following table provides an industry overview:

1)      Private company

As you can see from the table above, Lenzing has the second lowest production costs for viscose fibers despite the company’s focus on sustainable production. Financial information is not available for Grasim and Fulida, but solvency ratios for the other companies look stressed compared to Lenzing.

2) The price for cotton

Cotton is the major substitute for men-made cellulose fibers. After a price spike in 2011, the price for cotton has trended downwards. Prices for Lenzing products generally have a high correlation with the cotton price. The U.S. Department of Agriculture’s (USDA) world 2014/15 cotton projections anticipate that cotton production will exceed consumption for the fifth consecutive season. This is mostly due to overproduction in China.

China, the world’s largest cotton producer, implemented a price floor for cotton in 2011 that exceeds world prices and a stock-building policy to support local farmers.  Consequently, world stocks more than doubled between 2009/10 and 2013/14. China’s stocks are now 146% of 2013/14 domestic consumption, surpassing the previous stocks-to-use record set in 1998/99. The USDA expects the Chinese state reserve to purchase 85 % of the total 2013/14 Chinese crop to maintain internal prices substantially above world price levels. As a consequence, the Chinese textile industry currently substitutes cheaper man-made fiber in finished goods, which is positive for Lenzing but has so far not led to price increases for fiber viscose.

There are signs that the Chinese government is now reducing incentives to cotton farmers outside of the Xinjiang province (where half of China’s cotton is produced and quality reaches world standards) and that a growing number of farmers is diverting from cotton into food crops. The Government is now also trying to actively reduce its stock pile. However, it is important to note that most of the cotton produced in China is of secondary quality and that local mills prefer imported fibers. Due to the market distortion in China the correlation between world cotton prices and man-made fibers decreased over the last years. Without the Chinese intervention the world cotton price should be much lower.

The situation is different in the rest of the world. Here the stock-to-use ratio is only 54% which is rather at the lower end of the range from a historic perspective. Overall, the market for cotton is highly distorted which makes it even more difficult to forecast the price development over the short term.

Operating Performance

From the table below you can see, that the company witnessed strong top line growth until 2011:

Despite a 30% price decline since 2011, revenues have been relatively stable mainly due to an increase in sales volumes from 713,000 tonnes in 2011 to 891,000 tonnes in 2013 and an improved product mix. It is also noteworthy that the company sold its plastics segment concluded in the middle of 2013 leading to a revenue reduction of roughly EUR 65 m in 2013. The company will reach a production capacity of close to one million tonnes in 2014 (17% of world capacity). Management expects that the company’s production lines will remain fully booked in 2014.

With surplus production capacities for viscose fibers and Chinese manufacturers keeping capacity utilization as high as possible in order to generate cash, profitability came further under pressure in 2013. This development was supported by the partially lower prices for wood pulp, the most important raw material used in manufacturing viscose. Lower prices combined with high capacity utilization led to market share gains on the part of Chinese producers.

As a consequence, the company started a cost savings initiative in 2013 in order to achieve a declared objective of generating annual cost savings of EUR 120 m p.a. Management estimates that the programme will already positively impact earnings to the amount of up to EUR 80 m in the course of 2014. In addition, the company decided to postpone any capacity expansion projects with the exception of the new Tencel plant in Lenzing, Austria.

Returns on capital are now under pressure. However, with decreasing capacity expansion in the industry and continuing demand growth for MMCFs a reversion to higher profitability over the next two years seems to be a likely outcome. So let me point out to you the general reasons for an investment in the next paragraph.

The long term investment thesis

First, over the long term it seems to be pretty clear that the demand for fibers will rise due to population growth and an overall increase of GDP per capita. In addition, there are structural limitations in cotton production due to a lack of arable land and water supply, a potential peak in cotton yields and caprious weather. So there is reason to believe that the proportion of MMCFs as a percentage of total cellulose fiber production will continue to grow disproportionately.

Second, Lenzing is the technological leader in its industry. The company owns approx. 1,400 patent applications and patents in 63 countries mainly for its Tencel products where it has been active for more than 20 years. The production of Tencel is quite complicated and Lenzing’s competitors are still trying to get an edge in this segment.

Third, Lenzing enjoys cost advantages on the basis of pulp integration, and benefits from economies of scale. The integration of pulp production and long-term pulp delivery contracts for its most important raw material give the company a competitive edge. Lenzing also profits from its size. Lenzing operates the largest and second largest production plants for man-made cellulose fibers.

Fourth, Lenzing sets the highest environmental standards in the industry. The required raw material wood is derived from ecologically sound forests and a large portion of energy consumption comes from renewable resources. In addition, the integrated wood pulp production reduces the need for drying, packaging and transportation of pulp. With the improving sustainability awareness among end-users Lenzing provides an almost perfect product to the textile and nonwoven industry.

However, I don’t want to be too enthusiastic here. Needless to say, there are also a number of risks:

Lenzing is operating a commodity business where barriers to entry are low as can be seen from the recent entry of new competitors after the high price levels for MMCFs in 2010 and 2011. In addition, Lenzing’s strategy of product differentiation will only work as long as it keeps its technological leadership. Moreover, price agreements between Lenzing’s Chinese competitors seem to be standard and provide a structural disadvantage to the company. Though I do not believe that China will also start to subsidise its MMCFs industry, market intervention from the Government is also a potential risk.


First, I try to model the company’s profitability with regard to the average realized price for Lenzing’s products. Based on the company’s information a EUR 0.01 change in the fiber price per kg is equal to a EUR 10 m change in EBITDA.

In 2013, Lenzing realized an average price of EUR 1.70/kg at an utilisation rate of 97% (Total capacity 921,000 tonnes) leading to a revenue in the fiber segment of EUR 1,512 m. The company will add another 67,000 tonnes of Tencel production to its capacity in 2014. Assuming that the new production line will have the same utilisation rate, but ignoring any price premiums for Tencel this will add another EUR 110 m of revenue.

I also assume that other revenues from the engineering segment and the sale of raw materials will stay flat.

In addition, I imply a EUR 100 m cost reduction which is EUR 20 m below the management’s target.

Based on these assumptions, I come up with an estimation of EBITDA for different price levels. To get to the EBIT number I use an annual depreciation of EUR 130 m.

This is only an approximation of the actual profitability potential, but it shows the upside potential of the share price should the fiber price recover from its currently low level.

Second, with an equity ratio of 45%, no goodwill and intangibles making up only 3.6% of total assets, the balance sheet looks solid. The average ROCE is 13.0% and the average ROE is 16.0% over the last ten years. At the same time the company is only trading with a price-to-book ratio of 1.1x.


An investment in Lenzing is a bet on the company’s ability to keep its strong market position and that prices for MMCFs will revert from their low levels. As outlined above, I think there is reason to believe that demand for MMCFs will grow further in the future. The price increases in 2010/11 led to enormous capacity expansion. The current overcapacity puts pressure on the return on capital of all industry participants. So it should take some time for the oversupply to be reduced ultimately leading to higher pricing levels. At the end of this process Lenzing could be in an even stronger position than before given a more effective cost structure and a more diversified product range.

I will establish a 3% portfolio position with a share price limit of EUR 47.


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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