Passat engages in the video-assisted sales of products in department stores throughout France (71% of revenue), and parts of the US (19% of revenue) and Southern Europe (10% of revenue). The picture below shows a typical sales area in a department store.
Back in 2013, my investment thesis was based on a healthy return on investment and strong cash conversion, the company had shown for a prolonged time. In particular, Passat performed well during the years which followed the financial crisis. Therefore, I wrongly assumed that Passat had a sound business model. The numbers looked very appealing. Paying EUR 38 m for a company that has more than EUR 10 m in net cash and generates cash earnings of around EUR 5 m per annum on less than EUR 20 m of invested capital looked like a bargain to me.
However, as one fellow reader commented, shares of Passat looked more like a “value trap” to him. Rightfully so. In my analysis, I ignored a number of important aspects or came to the wrong conclusion.
Over the holding period, sales in France declined by 12% from EUR 34m in 2013 to EUR 30 m in 2016. I overestimated the resilience of impulse purchases during times of economic distress. Sales quickly recovered in the direct aftermath of the financial crisis, but since then the prolonged deflationary environment has weighted on consumer demand for Passat’s products.
In addition, I underestimated the threat from new entrants. Passat’s historic profitability was not sustainable given low barriers to entry in the industry. Customers do not care whether they buy from Passat or a competitor. Sales depend solely on the product and the perceived usefulness to the customer. As market leader in France, Passat might have advantages in product sourcing and procurement but as it turned out that was not enough to fight competition. Moreover, the transition from brick and mortar to e-commerce puts pressure on Passat’s business model as well.
Sales in the US declined by 33% from EUR 12m in 2013 to EUR 8 m in 2016. Until recently product sales depended to a large extent on a single product. When the exclusive distribution for this product was terminated, sales in North America eroded.
Moreover, the large cash balance might provide a safety net for the business but management was not inclined to invest in the business or distribute the cash to shareholders (which seems to be tax inefficient in France). Therefore, I have given to much weight to cash on hand in my assessment of this investment. I also overestimated the alignment between the owner operators holding 50% of the company and minority shareholders.
One month ago, the company released sales numbers for 2016 (The annual report will follow in April). While revenue declined by 10% y-o-y, management mentioned that operating profit was in line with 2015. Hence, shareholders can speculate on a stable dividend for 2016 providing a dividend yield of more than 8%. Hence, the announcement of the dividend payment might provide further positive momentum to the stock price.
The problem with a “value trap” is that it is always looking cheap and that shareholders are always hoping for better days to come. Of course, the potential introduction of a new “block buster” product or a sustained recovery in Southern Europe could give operations a short-term boost. However, going forward I expect the disruptive forces that have harmed the business over my holding period to prevail.
From a portfolio management perspective, with 0.7% of my portfolio invested in Passat the allocation to this investment is too small and does not justify the ongoing housekeeping any longer to keep on track with this investment. Moreover, shares are trading on very thin volume. Consequently, combined with the reasons mentioned above, I am not inclined to increase my position.
Therefore, I decided to use the current strength of the share price to sell my position. I assume that I started selling my position after the release of the 2016 sales figures on February 9, 2017. According to my trading rules, it took until March 10, 2017 to sell the entire position at a weighted average sales price of EUR 6.06 per share. I realized a total loss of 27.2% and an IRR of -7.9% over a 50 month holding period from this investment.
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