Broedrene A & O Johansen (AO) is a Denmark-based wholesaler of technical installation materials and supplies to the construction industry. It is engaged in the supply of electrical equipment, as well as plumbing, heating and sanitary products. The Group has more than 20,000 customers who are offered a stock of approx. 50,000 different items. AO is active in Denmark, Sweden and Estonia. However, international revenue is only 10% of the company’s total revenue.
AO’s product range serves two main markets:
First, the professional market for technical installation materials includes sanitary products, plumbing, electrical equipment, drainage products, water-supply systems and tools. This segment is highly fragmented, with many small customers. Its customers are professional tradesmen, construction companies, municipalities, utilities and public institutions. Demand is coming from new building work and repair and maintenance.
The market for repair and maintenance work is relatively stable, as it is characterised by many small assignments. The assignments are difficult to plan, and the need for materials in connection with each individual assignment can therefore not be predicted. This fits into AO’s decentral strategy with stores that are close to the customer. In addition, the stores are offering a “one-stop shopping” solution where the customers get a complete product range as part of a collection and delivery system, which is supported by an online trading systems.
New construction work varies from year to year and is very sensitive to the economic environment. Overall, AO’s product range represents approx. 50% of the total material cost of a new building project.
AO’s revenue from the professional market is generated via three sales channels:
- 48 stores in Denmark, 5 stores in Sweden and 1 store in Estonia
- A call centre accepting orders and giving advice to customers
- Online trading (e.g. using apps for smartphones)
Second, the do-it-yourself (DIY) market, operated through SEKO, includes sanitary products, as well as electrical equipment. Only business-to-business sales are made, and primary customer groups of the section are DIY centres, specialised stores and other retailers. This market has relatively few, large customers.
The company makes no statement about the revenue and profit split for these two segments, but states that the focus of its activities is on the professional market.
The Danish Housing Market
AO’s operating performance depends on the business trends in the Danish building sector and in particular on the local housing market. Residential property prices rose by 66.3% between 2003 and 2007. From its peak property prices are down by 20% now. The decline in housing prices is comparable to the UK and Spain:
While Danish government debt is less than half the euro-area average, private debt is 239% of GDP. In Germany this ratio is only 116%. Based on a this handbook from Danske Bank total Danish residential mortgage debt to GDP was 101% at the end of 2011 compared to 45% in Germany. Average residential mortgage debt per capita was EUR 43,000 compared to EUR 14,000 in Germany.
Nevertheless, despite the significant fall in house prices and the high level of indebtedness, the level of repossessed dwellings and loans in arrears has been low so far (see table below). This seems to be due to the low unemployment rate in Denmark, the strong mortgage legislation and the flexibility for borrowers to adjust their mortgages to different interest environments.
However, currently the mortgage industry faces another challenge: In 2003, banks started to give borrowers the option of deferring amortization for as long as a decade. This type of mortgage became very popular and has since grown to about 56% of all outstanding housing loans in the country. Now, more than 100,000 borrowers have to renegotiate their repayment terms if they are to meet their loan obligations, according to the University of Southern Denmark. To prevent a wave of foreclosures, the mortgage industry has been negotiating with the government to soften repayment terms on interest-only mortgage loans.
Overall, the fall in house prices is reflected in the decreasing number of completed buildings. The table below provides an overview of building completion in sqm for the three major housing categories:
Though there has been a rebound in the apartment sector, the overall construction in the three major housing segments is down by 58% compared to its peak in 2007.
AO’s operating performance
So the question is how AO weathered the crisis so far:
|Year||Revenue in DKK million||Gross margin in %||EBIT Margin||Profit Margin||ROA||ROE||BV/share||EPS|
AO’s business shows cyclical sensitivity, but it seems to be relatively resilient during downturns. From 2007 to 2009 revenue decreased by 31.5%. Despite this substantial decline in turnover the company was able to remain profitable except for 2008. Though revenue was 15.9% lower in 2012 than in 2006, EPS have recovered to its pre-crisis level again.
During the crisis management has been able to reduce costs, to increase efficiency and to enhance customer services. In their annual reports management provides some interesting examples how they are improving business processes. For instance, they implemented an automated sorting system in their logistics/distribution centres leading to more accuracy and faster delivery. In addition, packaging was changed from cardboard to plastic boxes. These boxes are reused again and again in connection with supplies from AO’s central warehouse to all stores. Moreover, the investment in a stationary cardboard compactor with a capacity of 7 tons has reduced the transport costs related to the disposal of cardboard waste by 75%.
AO’s position in its industry
AO is part of an international collaboration through WIM (Wholesalers of Installation Materials), a network of European wholesalers all active in the fields of sanitary ware, climate control and installation materials. They have a combined revenue of EUR 3.1 bn and are therefore able to purchase goods at competitive prices from their suppliers. As AO is offering a stock of approx. 50,000 different items and products, it would be difficult for any supplier to cut out AO as the intermediate distributor.
In the professional segment they have more than 20,000 customers. AO is providing a substantial benefit to these customers with their “one-stop shopping” solution which enables the company to extract relatively high margins in this segment. However, this is not the case in the DIY segment. There are only a couple of DIY chains in Denmark. The company does not provide detailed information about this segment, but based on Seko’s homepage, most of the Danish DIY chains are resellers of Seko’s products. However, at least the major DIY chains like XL-BYG and Silvan also have their own purchasing companies and do not seem to depend on Seko’s services.
Based on AO’s information the total market for goods distributed via wholesalers in Denmark is estimated at DKK 12.0 bn (EUR 1.6 bn). AO is holding a market share of approx. 19%. Overall, there are four nation-wide large wholesalers with a combined market share of more than 80%. Apart from that, DIY chains like XL-BIG and Silvan are not only servicing private handymen, but are also active in the professional market. Silvan is owned by Wolseley, the world’s largest distributor of heating and plumbing products to the professional market.
One of AO’s major competitors is J-F. Lemvigh-Müller (LM). The company is privately owned. At the end of 2007 LM announced the acquisition of AO for DKK 2,500 per share. At that point in time, LM was approx. 2.5 times larger than AO. However, the Danish antitrust authorities barred the merger between LM and AO in 2009. One of the major reasons was stated as follows:
“The entry barriers are already, before the merger, high. This makes it difficult for new competitors to enter the market. It is, inter alia, caused by high customer demand of service level, geographical coverage, and to the breadth and depth of the product range. The barriers is exemplified by the fact that new wholesalers have not been able to take significant market shares during the last 5-10 years unless it happened as part of a merger with already existing wholesalers. The concentration would further raise entry barriers because an interesting subject for a take over from a new entrant would disappear.”
Hence, there seem to be barriers to entry for new entrants in this industry. However, financially powerful groups such as Wolseley, Saint-Gobain or Grafton should be able to easily gain market share in the Danish market. However, I believe that for potential entrants there are currently more attractive markets in the world with a better growth outlook and larger sales volumes. In addition, these companies have been hit hard by the recent downturn in the construction industry. As a consequence, I do not believe that their current focus is on expanding in a highly competitive small market like Denmark.
I could not find a lot of information about LM itself, but current revenue is approx. DKK 5.1 bn compared to approx. DKK 7.0 bn in 2006 leading to a decline of 27.1%. In the same period of time, AO’s revenue declined by only 15.8%.
Fortunately, there is another competitor which is a listed company. Sanistaal generated approx. DKK 1.9 bn of revenue with their wholesale supplies construction industry division (44% of total revenue). They are active in Denmark and to a smaller degree in the Baltics. Interestingly, they also tried to acquire AO in 2007 and bought 39.1% of AO’s share capital. However, they then decided to sell their shares to LM. As the merger between LM and AO failed, they were not able to dispose their shares to LM. So far they did not find another buyer.
Let’s have a look at Sanitaal’s performance since 2007:
|Year||Revenue in DKK million||Gross margin in %||EBIT Margin||Profit Margin||ROA||ROE||BV/share||EPS|
1) Excluding non-recurring profit from property sale
Besides the construction division, Sanistaal has also an industry division (56% of revenue), where they are wholesaling steel and other metal and Technical Products to the manufacturing industry in Denmark, Eastern Europe and Germany.
In their annual report they only provide information about revenue and EBITDA for their two segments. EBITDA in the construction division was DKK 59.5 m in 2012 (33% of total EBITDA) leading to an EBITDA margin for this segment of 3.1%. In comparison, on a consolidated basis AO achieved an EBITDA margin of 7.3% in 2012. Sanistaal struggled during the financial crisis and the company is currently focused on improving its capital structure as its solvency ratio stands at only 25.3%. AO’s solvency ratio is currently at 59.6%.
In conclusion, AO has been able to perform substantially better than Sanistaal’s construction division since the beginning of the financial crisis.
Share capital and shareholders
In 1963, AO was introduced on the Copenhagen Stock Exchange with an ownership structure consisting of a combination of ordinary shares and preference shares. This owner structure, which among other things means that the Company only can be taken over if the takeover has been accepted by the holders of ordinary shares, has been maintained since then. The ordinary shares cannot be negotiated without the approval of the Board and are not listed, whereas preference shares are freely negotiable and listed on Nasdaq OMX. The Company’s nominal share capital is DKK 57 million. Of this, DKK 5,640,000 are in the form of ordinary shares and DKK 51,360,000 are in the form of preference shares. Each ordinary share of DKK 1,000 carries 100 votes, whereas each preference share of DKK 100 carries one vote.
Niels A. Johansen, who is the company’s CEO, owns all the ordinary shares and 0.4% of the preference shares. As a consequence, though he is only holding 10.2% of the share capital, he owns 52.4% of the votes. To the contrary, though Sanistaal is holding 39.1% of the capital, they own only 20.7% of the votes. The same applies for LM which is still holding 12.5% of the capital, but only 6.6% of the votes. Given that two of their major competitors are holding a substantial share in AO, the company has not paid out a dividend for the last couple of years. It will be interesting to watch how this problem will be solved as neither Sanistaal/LM nor AO might be very happy with this situation. From my perspective, over the long run Sanistaal/LM will sell their shares to a third party which could also result in an offer for the remaining shareholders including Mr. Johansen.
There is a private market valuation for AO from 2007, when LM was willing to pay DKK 2,500 per share. Obviously, times have changed since then. Even if LM would be allowed to acquire AO now, I doubt that they would be able to pay the same price given the effect the market downturn might have had on their financial flexibility.
Below you can find a comparison of AO with companies active in the same sector:
|Company||Market Cap in EUR millions||Debt to Equity||ROE||P/E||P/B||EV/EBITDA||EV/EBIT||EV/Sales|
From an equity value perspective AO and Sanistaal are more or less equally valued. However, the market seems to ignore the tremendous debt Sanistaal is carrying on its balance sheet. Given that Sanistaal’s debt level is ten times larger than AO’s, they should not trade at the same price-to-book ratio.
The other three companies are all large distributors of construction products. All of them have been hit hard by the downturn in the construction market in Europe. The stock market is currently valuing these companies with relatively high multiples hoping that operating performance will return to its pre-crisis level. AO has already returned to its pre-crisis profitability. However, from my perspective this is not reflected in the company’s current valuation.
Let’s use another approach: Over the last 16 years AO generated an average return on assets of 4.3%. Using the company’s current financial leverage ratio of 1.9x this leads to an average return on equity of 8.2% (current ROE is 13.1%). From my perspective, buying this business below book value offers an attractive opportunity.
AO is operating in a difficult market environment. The outlook for the Danish construction industry is definitely not good. However, compared to its competitors the company was able to weather the crisis very well so far. Therefore, I believe that AO’s position in the market has strengthened during the crisis. In addition, the company has a strong position in the relatively high margin professional market segment. Apart from that, there seem to be barriers to entry making it difficult for other companies to enter the market. From my perspective AO’s good operating performance is not reflected in the current valuation. Reason for that could be the uncommon ownership structure and the low trading volume on Nasdaq OMX. In addition, there is uncertainty about the future shareholder structure as both LM and Sanistaal might want to sell their stake in AO.
I will establish a 2% position for the portfolio with a share price limit of DKK 1,350. Liquidity is very low and it might take approx. 28 trading days to build the position assuming Wertart Capital trades one third of daily volume. Please click here for more information on WertArt Capital and the virtual portfolio.
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