NOTA DEL EDITOR:Este texto es obtenido de una carta trimestral a los inversores de Magallanes Value Investors.
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En el momento de escribir esta carta, asisto a un hecho trascendental: máximo histórico de la mayoría de las acciones tecnológicas integrantes del famoso acrónimo anglosajón FAANG, que designa, por sus siglas, las cinco compañías más populares y con mejor comportamiento bursátil de Estados Unidos, a saber, Facebook [FB], Apple [AAPL], Amazon [AMZN], Netflix [NFLX] y Google [GOOGL].
La capitalización de estas cinco empresas equivale a tres veces el tamaño de la economía española, solo Apple, con cerca de 1 trillón de dólares de valor bursátil, representa casi el valor de nuestra economía.
Me temo que, en este campo, hablar de valoraciones no tiene sentido. “Cambio estructural, ventajas competitivas, círculo virtuoso o nuevo paradigma”, son algunas de las expresiones más usadas que “justifican” dichas capitalizaciones y valoraciones exigentes.
Sin entrar en valorar dichas compañías, merece la pena pararse en dos puntos: la asimetría de rentabilidades entre índices y el estatus de invulnerabilidad presente en esta tipología de empresas. Continue reading »
Thomas Karlovits of Blackwall Capital Investment presented his in-depth investment thesis on Tomra (Norway: TOM) at European Investing Summit 2018.
Thesis Summary:
Tomra is the world leader in high-tech sensor-based collection (plastic bottles, 75% global market share) and sorting machines (food, recycling and mining; global market shares of 25%, 50% and 65%, respectively). The company is well-positioned to capitalize on several megatrends:
1) In collection, public outcry on plastic pollution is driving new laws and regulations to collect single-use bottles (e.g., EU target of 90+% collection by 2025).
2) Food safety and quality is increasingly driving consumer spending. Fast-growing online grocery shopping requires granular sorting of food.
3) Urbanization requires smart cities and the recycling of waste.
Tomra is a rare combination of a down-to-earth conservative, high-quality management with the ambition to create a circular economy for the betterment of the planet. High ROCE and double-digit growth rates, backed by a strong balance sheet and sensible allocation of FCF, provide a solid base for the short- to medium-term outlook. With billions of products sorted every day, Tomra leads in artificial intelligence, deep learning algorithms, and big data. This will allow for new business models in the long term. Although the valuation looks rather ambitious on 2018-2019 numbers, Thomas believes it is attractive based on the medium-term outlook and inexpensive on the long-term outlook.
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About the instructor:
Thomas Karlovits founded Blackwall Capital in 2014, having worked in the equity research sector for over 23 years. From 2003 to 2014, Thomas was at Kepler Cheuvreux (Kepler Capital Markets prior to the takeover of Cheuvreux). Thomas most recently held the role of Head of European Equity Research from 2013, and was Deputy Head from 2007. During this time, Thomas was also in charge of investment strategy for the wider group. Between 2005 and 2007 Thomas headed the European Telecom sector. Thomas studied Business Administration and Economics at the University in Vienna.
Alejandro Estebaranz of True Value presented his in-depth investment thesis on Taptica (UK: TAP) at European Investing Summit 2018.
Thesis Summary:
Taptica is one of the leading ad-tech companies. The company has 15% growth (organic plus M&A). It has a net cash balance sheet. The business is well run and the management has generated significant value since going public. The shares are cheap at 8x EV/FCF and 6x EV/EBITDA (2018E); and less than 7x EV/FCF and 5x EV/EBITDA (2019E). Insiders own ~20% of the shares and have a history of good capital allocation. The outlook for the sector is favorable, and comparable companies trade at much higher valuations. Private deals have also been consummated at high multiples. This GBP 200 million market cap company is cheap, likely because it is underfollowed and trades in the second segment of the London Stock Exchange.
The following transcript has been edited for space and clarity.
True Value is a five-star Morningstar fund that has grown from €3 million up to €210 million. Since the launch five years ago, we have generated a compounded annual growth rate of around 13%, net of fees and net for the client. We are focused primarily on small- and mid-caps, looking for good companies, high insider ownership, and low debt. We tend to favor growing businesses, and one of the most important features is that it should be trading at low prices. This is probably the main reason we have outperformed the S&P, the MSCI World, or the Euro Stoxx. We are very happy with our performance.
I’m the co-investment advisor. The other founding partner, José Luis Benito, is an economist who ran a family office before True Value. We are also an EFPA member.
My presentation focuses on Taptica, which we consider a highly compelling opportunity. This is an obscure small cap (around £300 million) operating in the advertising technology space. Taptica is in the right place: it does mobile, branding, and performance-based marketing for companies. It has excellent organic growth (about 15% to 20% per year), a robust net cash position, and returns on capital employed of around 60%. There is also good insider ownership (15% of the company), and Taptica expects to grow more than 25% over the next several years. There is also great capital allocation and a highly experienced team on M&A.
Since the company went public around 2013, revenues have grown from $20 million to almost $300 million. The share count has increased a little, but much less than revenue growth. EBITDA has been very good over the years, and free cash flow generation is up almost 10 times since the flotation.
There are a couple of things to note. In 2015, EBITDA declined, and sales went down almost 40% because the company transitioned the business into mobile. Originally, it was doing advertisement technology for display, or desktop, but the management saw the future is mobile advertisement and changed the business. That took one year, and in 2016, the performance was excellent. Taptica also has great capital allocation. When the share price went down during the turnaround period in 2015, it bought back almost 10% of total shares. But when the price recovered, it issued shares to buy other companies. The management understands that when shares are cheap, they should buy back, and when shares became expensive, they issue stock, mainly to do M&A.
What is the price we have to pay today for this kind of company? It’s trading at only 8x free cash flow for 2018, but if we look one year forward, the multiple should be probably around 6x. If we look five years forward, this company will become very cheap.
Let’s explore the business in more detail. Performance-based marketing generates 50% of revenues, with Taptica getting paid only if a client completes a purchase, installs an app, completes a tutorial, registers in a particular database, or takes some other action specified by the brand. The other half of the business is what is called DSP, which is the future of online advertising. This is like a stock exchange for online advertisements where publishers and clients place their bids and offers, and the highest bid and volume for the offer wins the placement. The ad shows automatically in the platform of the publisher.
Taptica stepped into DSP performance marketing in 2017, when it bought Tremor Video, which was a great acquisition for several reasons. First, the price was low. It paid only $50 million, but this amount included $10 million to $20 million of positive working capital, so the net price is roughly $30 million, or around 3x EBITDA. Second, after some cost-cutting and cross-selling activities, this business is expected to generate around $11 million in EBITDA this year.
Taptica bought the business from a forced seller, publicly traded Telaria. This is the typical tech company generating almost no profit. It decided to exit a low-growth business, and the sale was also driven by the fact that Telaria is focused in the opposite side. The D in DSP is for the demand side, while Telaria was positioned in SSP, the supply side of the advertisement technology. It had a highly inefficient cost structure – for example, offices in the most expensive places, like New York, in the best buildings and the best areas. Taptica decided those costs where unnecessary, so it took them out. In the first half of 2018, Tremor Video was growing nicely, at around 10% to 12%.
It has also won some big clients recently, their largest now being Alibaba. Taptica has some other widely known brands as clients, and they are in the branding segment, which is like traditional advertising but on the internet. This is a more recurring business and higher-margin business, and Taptica wants to grow in this segment because it is huge.
M&A has played a major part in value creation over the last four or five years. This company was originally called Marimedia, and Taptica was its first acquisition since going public. It bought the business for around $15 million. Net income was negative at the time, but three years later, in 2017, the company was generating more than $100 million in sales and more than $20 million in EBITDA. If we took the purchase price after four years, it equals 1x EBITDA. One year later, it bought AreaOne, also for $15 million. This company was doing around $7.5 million revenues, but within three years, it was generating net revenues of almost $25 million and around $5 million in EBITDA. That equals 3x EBITDA for the business after synergies and some growth. In 2017, Taptica bought Adinnovation. This was a great platform to grow in Japan and Asia because it’s really difficult to do it from scratch in Japan due to the language barrier and the different culture. Since Taptica has a rather conservative approach to M&A, it decided to buy 57%, but it has a call option for the rest of the business at a P/E ratio of 8x. Adinnovation had 2017 sales of around $13 million and is performing really well since the acquisition.
Taptica is also doing business in a growing sector. Digital video advertising is expected to grow almost 70% over the four years to 2021, and Tremor Video is strongly positioned to capture some of this growth. The mobile advertising market is also expected to expand in the next two or three years. Desktop accounts for a tiny portion of revenues for Taptica now, only about 1%.
As value investors, we should ask ourselves what the reasons for this bargain are. Why is it trading so cheaply? One of the reasons is that we have an Israeli company trading on the London Stock Exchange, in fact, on its second segment, which is called AIM (Alternative Investment Market). This is a cheap place if you want to float a company, but the small investor base can sometimes create a bargain. The company also has low liquidity – around £800,000 a day. It is only covered by two small regional brokers, FinnCap and Berenberg, and those have a price target of around £6.
Another reason is the fear of the GDPR (General Data Protection Regulation) and all the internet regulation in Europe. However, only 13% of Taptica’s revenues come from Europe, and the first-half results published in September showed no impact at all. This is truly important, but Taptica’s small retail investors are weak hands – they sell fast and also come by fast when they feel the company should perform well. The GDPR affects only third-party data and has no effect on Taptica because it doesn’t rely on such data. There was also the Facebook scandal in the first half of 2018. All the small caps in the advertising space went down. People were afraid of new revelations and decided to sell their shares. The stock went down almost 40%, and while it has recovered a bit, it remains well off the highs.
We could add to the reasons the capital raise Taptica did in the beginning of 2018. The company issued some shares because it was planning to do a big acquisition. However, the management team told us they didn’t like what they saw during the due diligence process and decided to walk away. This is a good reason, but again, small retail investors were expecting the company to make a new acquisition. It didn’t happen, so the market decided not to buy its shares. In August, the management team told us they had a new potential big acquisition they expected to close in the second half of the year. Managers also sold some shares at peak levels in January, but since then, they have been active buyers in the open market at around £3.
There are some other reasons, like the fact that the company doesn’t hold quarterly conference calls, only a capital markets day one time a year. It doesn’t have investor presentations, and the investor relations (IR) section of its website is unfriendly, with very little information. It only features links to the London Stock Exchange, the annual reports, and the IR contact. The company doesn’t have an IR department; it wants to keep costs low and feels that it doesn’t need it. The IR person is actually the chief financial officer.
UK equities have been the most underweight asset class in recent months, which is another reason for this bargain. Also, the British pound has been hugely underweight over this period, and people have Brexit anxiety. It doesn’t matter for Taptica because it does most of its business outside the UK. The company reports in US dollars and trades in pounds, so if the pound goes down, you are going to suffer if you are a foreign investor, but Taptica’s profit will go up.
The first-half report for 2018 shows strong performance. Revenues more than doubled, with organic growth coming at around 15%. The share count was up only 10%, which is good, especially considering that EBITDA went up 65%. Cash flow generation was also up 65%, and the net cash position was equal to 15% of the total market cap. The company confirmed that Alibaba was its new top client and said it had won big clients in the US. The legacy business declined 66%, but it only represents $3 million in revenues against around $300 million for this year.
Taptica doesn’t say it explicitly, but it has won WPP as a client. This is one of the biggest advertising agencies in the world, but it has a weak presence in the digital space. We think WPP could be a potential buyer of Taptica, and the management team and the insiders are open to selling the company. The CEO has said that if somebody offers a good or fair price, a sale would be considered.
This is also a highly cash-generative business. As value investors, we like to focus on high cash flow generation. One of the reasons this business generates a lot of free cash flow is because its capex levels are very low, typically around $2 million to $3 million a year. Cash taxes are also very low – Israel tech companies get special treatment in the federal tax code and only pay around 15%. There is also a tax shield due to amortization as a result of M&A activities. The second half of the year tends to be better in terms of cash flow generation, so we expect Taptica to conclude 2018 with around $40 million in free cash flow.
There is also high insider ownership, with around 20% of total shares held by insiders. The base salaries and bonuses for the management team are okay for a tech company with this kind of performance. The share-based compensation went up a bit in the first half of 2018 because the stock price performed really well in 2017. The CEO, Hagai Tal, bought over 120,000 shares between February and April 2018, which is positive for the company and the stock.
In addition, the sector is consolidating. There is a lot of M&A activity, and the space is trading at really high multiples. Sizmek bought Rocket Fuel for almost $300 million, including debt. This company had around $400 million revenue but no profit, unlike Taptica. Also, KKR invested in AppLovin early in 2018, paying around 4x sales. AppLovin is also not generating any kind of profit, so these companies usually get valued by sales. AT&T bought AppNexus in June in a deal valued at $2 billion. AppNexus had revenues of around $400 million, growing 20% a year.
Taptica is growing at almost the same rate, 15% to 20% a year, but it is trading at a valuation of $300 million, not $2 billion. There is a publicly traded company on the NASDAQ called Trade Desk. It is better than Taptica. It is the market leader and is growing at more than 40%, but it is trading at 40x EBITDA. If you exclude stock-based compensation, it is trading at around 80x price/free cash flow, which is an insane multiple. Taptica is still trading at around 5x EBITDA, 8x free cash flow, and 1x sales and has 50% organic growth, with no debt. Management has said that if the market doesn’t reward the stockholders, a sale of the company would be an option. We have asked the leadership team about potential buybacks, which they have done in the past, and they are open to the idea if no new M&A target emerges.
We have modeled three valuation scenarios. The bull case has the company growing by 15% organically plus another 15% inorganically due to M&A, and EBITDA margins stay at 19%. In the base case, we consider 10% organic and another 10% inorganic, with EBITDA margins a bit lower at 17%. In the bear case, we assume organic growth slows down to 5%, there are no M&A or buybacks, and EBITDA margins stay at today’s level, but the company generates a lot of cash over the next three to five years.
Regarding the bull case, Taptica has grown from $20 million to $200 million in the last year and expects to generate around $45 million to $50 million in EBITDA for 2018. We have modeled some dilution due to stock-based compensation. There are 10 million stock options, but the average strike price is around £2.5, so the real dilution after proceeds should be lower. We have used around 18x to 20x free cash flow. In our opinion, the most important metric in this business is EV/EBITDA and free cash flow. If the company continues to grow by more than 25% per year, which is likely given its past performance, the projected multiples are okay. If the company performs as we expect in this scenario and the market starts paying a fair multiple, the compounded annual growth rate would be huge. We are talking about more than 40% annually over the next three years, with the stock price tripling over this time.
For the base case, we have made projections with 20% growth, around 17% EBITDA margins, and some dilution in the future. We have used very conservative multiples, taking into account those for other public or private companies. Here, we also expect to make 3x our investment over the next three to four years. In this scenario, we assume Taptica can deploy $50 million to $60 million on average a year in M&A at 6x to 7x EBITDA after synergies. Net debt should stay at zero or close to zero because it can grow easily by 20% a year without using any kind of debt.
The bear case assumes only 5% growth and some dilution of the share count over the next years. In this scenario, as Taptica grows, the balance sheet gets more and more cash, so the net cash position grows over time, making the company a little cheaper year by year. We have used very low multiples here, around 9x to 13x EV/EBITDA. But even in this bad scenario, which we consider quite unlikely, the internal rate of return for the next three years is almost 20% annually. We’re pretty sure if M&A becomes expensive, the company can perform buybacks and generate a lot of value in this way.
There are some risks to this investment. As always with technology companies, there can be disruption. We don’t see it right now, but this can change over the years. Today, however, it is a low risk. M&A execution is another risk for this kind of company, but Taptica’s past performance in this space has been really good. Regulation has some impact, but this is also a low probability because Taptica doesn’t rely on third-party data to conduct its business. There is also some minor risk in the exchange rate between the US dollar and the British pound.
In summary, we have an excellent company in a growing sector that has high trading multiples. This a small, unknown business followed by only two small brokers. It has high insider ownership and great capital allocation skills. It is cheap for several reasons, but we think those reasons are outside of the business of the company.
The following are excerpts of the Q&A session with Alejandro Estebaranz:
John Mihaljevic: Could you comment a little more on the management’s incentives in terms of how compensation is determined on the cash side?
Estebaranz: The company has a great incentive scheme that is aligned with shareholders. It is based on EBITDA per share or total growth per share. It is true that the share-based compensation went up a bit during the first half of 2018, but the company has to keep middle management in place as it grows, so it needs to increase the share-based compensation to retain talent. On the other hand, the base salaries and bonuses at the top level are okay. They are not ultra-low, but they are okay.
Mihaljevic: What data points are you tracking to either validate or challenge your thesis over time?
Estebaranz: First is organic growth, which should be above the market average. The online advertising space is growing at around 10% or 12% per year, and we like that the company achieves growth above that rate. The second point is M&A activity. We like it to pay low multiples for its acquisitions. We also focus on cash flow generation and capital allocation. If it doesn’t do any M&A, we’d want it to buy back shares. These are the four performance indicators.
Mihaljevic: Could you elaborate on the technology-related risks? In other words, could there be a superior technology that would quickly take market share and threaten this business?
Estebaranz: When Taptica was operating in the display advertising segment, it experienced low growth, so it decided to transition to mobile. We think it is now in the right space because mobile is the future of online advertising. Half of Taptica’s revenues come from the branding side of the business, and these tend to be very stable. This is like a traditional advertising agency but on the internet. You have to build a big agency on the internet to win important clients, and this is what Taptica is doing right now. It is aiming for a global presence because if a client like Guess, Whole Foods, Nike, or Electronic Arts wants to work with you, they want to have a global solution for all the areas they operate in. The management team believes that’s where the big money is, which is why the company is making these acquisitions in Asia and the United States. For the next acquisition, it wants to focus on Europe because its presence is the weakest there.
The second business segment is performance-based marketing, which relies on algorithms, among other things. This space could change in the future, but following our conversations with the company, independent analysts, and other sector players, we have come to believe Taptica’s position is quite good. It’s not as strong as Trade Desk’s on the DSP side, but it is solid. Still, you have to watch carefully for changes in the industry. Now, we don’t see any kind of disruption, but a new technology may appear in five years. Taptica has been great at adapting to new changes and trends.
According to the CEO, the real job is to look forward to the next big thing. He doesn’t want to run the company day to day. He’s focused on M&A, the next big thing, trying to anticipate changes in the sector, and maintaining the strong corporate culture of the company.
About the instructor:
Alejandro Estebaranz has served as the co-investment advisor of the True Value fund (ISIN: ES0180792006) since its inception. True Value, based in Spain, is a long-only equity fund founded in 2014. It focuses on underfollowed small- and mid-cap public companies, seeking good businesses with good management teams. Prior to True Value, Alejandro worked as an analyst for private investment partnerships. He holds a degree in mechanical engineering and a degree in industrial engineering.
Louis d’Arvieu of Amiral Gestion presented his in-depth investment thesis on John Wood Group (UK: WG) at European Investing Summit 2018.
Thesis Summary:
John Wood Group is a leading global engineering company in oil and gas (upstream and downstream) and industrial capex, from design and construction to operation and maintenance. Thanks to an asset-light and mostly de-risked model plus strong acquisition know-how, the company has been able to grow EPS at an annual compounding rate of ~10% across cycles. Management has an impeccable execution track record and good incentives linked to total shareholder returns, profits, as well as cash and safety. Based on Louis’ estimates, the shares recently traded at a recurring 10% FCF yield, with 5+% sustainable organic growth and a 3.5% dividend yield. The shares are cheap because the market appears to doubt they the company will succeed in integrating its most recent acquisition, Amec Foster Wheeler.
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About the instructor:
Louis d’Arvieu joined Amiral Gestion in 2005 and serves as a fund manager for the Sextant funds. Founded by Franois Badelon, Amiral is an independent asset management firm based in Paris. Amiral’s single goal is sustained performance with minimum risk based on the firm’s fundamental investing approach. Louis graduated from the HEC School of Management in Paris.
Adam Crocker of Logbook Investments presented his in-depth investment thesis on Safilo Group (Italy: SFL) at European Investing Summit 2018.
Thesis Summary:
Safilo is the world’s second-largest eyewear manufacturer, operating a portfolio of owned (25%) and licensed (75%) brands, generating nearly €1 billion in annual revenue. The company is poised for a turnaround under new leadership, whose operational skills are well-suited to the needs of the business. New management has identified €70 million in annual cost savings in a company with a recent €310 million enterprise value. On a normalized basis, Adam estimates that the business trades at less than 5x EV/EBIT and less than 3x EV/EBITDA. This compares favorably to competitors, which trade at 15-20x EBIT. Adam expects value to be realized as a pending recapitalization stabilizes the balance sheet and operational improvements are implemented.
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About the instructor:
Adam Crocker, CFA is Founder and Chief Investment Officer of Logbook Investments, a value fund with core positions based on insights from books. Logbook launched in 2016 and is seeded by his former employer. Prior to Logbook, Adam was a co-manager at Metropolitan Capital Advisors, a long/short equity fund founded in 1992. Before joining Metropolitan, he was an analyst at Morgan Stanley Investment Management conducting research on behalf of growth and value investment teams. He began his career in Leveraged Finance investment banking at JPMorgan. Adam is a 2005 graduate of the Value Investing Program at Columbia Business School and has an undergraduate degree in Economics from Columbia University.
Massimo Fuggetta of Bayes Investments presented his in-depth investment thesis on Landi Renzo Group (Italy: LR) at European Investing Summit 2018.
Thesis summary:
Landi Renzo Group is one of the two leading worldwide manufacturers of alternative fuel distribution systems for the automotive sector. This is done for the OEM market, where the company develops integrated systems for LPG (liquid petroleum gas), CNG and LNG (compressed and liquid natural gas), and sells them to car and truck manufacturers around the world. The company also serves the aftermarket with LPG and CNG conversion kits and related components.
While the megatrend in this automotive space is towards electrification, alternative fuels will continue to play a bridging role, as stricter regulation is increasingly imposed on fuel emissions, especially in emerging markets and for heavy-duty vehicles, on which the company is particularly focused. LR is also well positioned to benefit from a move toward hydrogen fuel cell engines, for which its products are easily adaptable.
The company has recently emerged from a long downtrend, under the leadership of new CEO who has driven a deep restructuring of the balance sheet and operations. The stock price reflects past difficulties and is cheap relative to future prospects.
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About the instructor:
Massimo Fuggetta started his career in 1988 with JP Morgan Investment Management in London, where he was an equity portfolio manager and then the head of global balanced portfolios. In 1999 he moved to Milan, where he was CIO and then CEO of Sanpaolo IMI Asset Management. In 2004 he founded Horatius, an asset management company which he ran until 2011. In 2012 he moved back to London, where in 2014 he founded Bayes Investments, which since May 2016 has been the investment advisor to the Made in Italy Fund, a Luxembourg mutual fund dedicated to Italian Small caps. Massimo graduated in Economics at LUISS in Rome, has a D.Phil. and an M.Phil. in Economics from the University of Oxford and has taught Behavioural Finance at Bocconi University in Milan. He is a member of the CFA Institute and has served on the Editorial Board of the Financial Analysts Journal. In 2012 he started the popular Bayes blog, where he writes, among other things, about investing and probabilities.
José Antonio Larraz of Equam Capital presented his in-depth investment thesis on Ti Fluid Systems (UK: TIFS) at European Investing Summit 2018.
Thesis summary:
Ti Fluid Systems is a leading supplier of fluid systems to automotive OEMs. It is the number-one global supplier of brake and fuel lines and number-three supplier of plastic fuel tank systems. The company operates in a global, niche business with strong market share and high barriers to entry, which are reflected in the company’s high profitability (14% EBITDA margin) and return on capital employed (above 20%). Management has extensive industry experience, with the CEO having worked in the automotive industry for more than forty years. TIFS shares recently traded at a large discount to comparable auto suppliers (4.5x EV/EBITDA and 10+% FCF yield) due to a potential share overhang from the majority shareholder and the risk of transition to electric vehicles. However, electric vehicles are likely an opportunity rather than a threat as the company’s addressable market could be significant higher in the coming years.
The following transcript has been edited for space and clarity.
Allow me to start with a brief introduction to Equam Capital. It is a management firm focused on investing in European companies, mainly with a very long-term approach. We leverage our past experience of investing in unquoted companies, where we collaborated closely with the management teams through being members of the board and helping the companies execute their strategic plans.
We invested in those companies for five to seven years, so we are used to being long-term investors. We really understand that in order to create value, you need to be patient. We took all of the experience from our private equity period and put it into this fund. Right now, we are trying to take advantage of what we believe is, on many occasions, the short-term view of the market. We are patient and look for companies we believe to be trading at low valuations for various reasons.
The companies we like have four main characteristics. First of all, they have good businesses, suggesting there is a barrier to entry. At the same time, we like businesses which are not growing too much because they would otherwise attract new competitors into the market. We don’t like businesses which are not doing well or have structural problems. Mainly, we look for what we call boring businesses, but ones with a competitive advantage. The second main characteristic is that we don’t like to invest in companies that have too much leverage. Second, we avid companies with too much leverage. Since we are patient investors and need time, too much leverage can, in some situations, play against us. The third characteristic we look for is a management aligned with the rest of the shareholders. We traditionally like family-owned companies run by managers who own stakes in the business. Finally, we look for companies trading at attractive valuations. To get companies at attractive valuations, you need to buy when people are selling, to be contrarian, or to buy companies that are well-known to the market but, for whatever reason, people are not thinking about that investment.
The focus of my presentation is a company we believe to have these characteristics. Of course, it’s difficult to find a company that matches all criteria, but we need to find situations where there is a good equilibrium among these four traits. TI Automotive (TI Fluid Systems) is a UK company based in Oxford, with a market cap of around €1.1 billion. It is a leading supplier of fluid systems to automotive manufacturers. TI has 118 manufacturing plants in 28 countries and 28,000 employees, with a presence in all the major automotive markets. The company had revenues of €3.5 billion and EBITDA of around €491 million EBITDA in 2017.
TI has two main divisions. One focuses on manufacturing and supplying brake and fuel lines. The company is a clear leader in this segment with a market share of 35%. The second division deals in fuel tank and delivery systems, where the company is among the top three players globally, with a 15% market share. With almost 100 years of history, present-day TI is the result of the merger of Tube Group and Smith Industries in 2000.
In recent years, the company has been in the hands of several private equity players. One of them acquired it in the early 2000s, but it put too much leverage in the company, so when the crisis came, TI found itself in a really difficult financial situation. Bain Capital bought the company in 2007 and decided to IPO it at the end of 2017, opting for a capital increase that raised around €360 million. The money was mostly used to reduce the company’s debt. Bain Capital is still the major shareholder. It had over 60% after the IPO, but it sold another stake in the summer of 2018 and currently owns 54% of the company.
At present, the fluid carrying systems division represents 59% of TI’s business, and 41% of the revenues come from fuel tank and delivery systems. In terms of market segments, the company is mainly focused on light vehicles, with 88% of revenues coming from there. It also has a small share in heavy trucks and aftermarket.
One important characteristic of TI Automotive is its strong diversification in terms of geographies. The company is more or less evenly split between Europe, North America, and Asia, with Europe having a slight lead with 37%. North America accounts for 27%, and Asia contributes 28% of the revenues, with China being an especially important market and one where the company has been present for many years. There is also strong diversification in terms of customers.
The fluid carrying systems is a market worth around €6 billion. TI is the clear leader, the other two big players being US-based Cooper Standard and Japan’s Sanoh. The rest of the market is split among many smaller regional players. In this division, TI makes three main products: brake and fuel lines (the connectors and tubes related to brakes), thermal products (those used in vehicle air conditioning and heating systems), and powertrain products (gasoline and diesel lines, and cooling and lubricant fluid systems). Historically this division has delivered organic growth consistently well above market levels, as well as strong and consistent profitability over the 2014-2017 period.
The fuel tank and delivery systems unit has two main products: fuel tank systems (TI does the plastic variety) and pump and module systems. The company has a strong market position in this segment as well, but not as strong as in the other division because there are two bigger players here, Inergy and Kautex. This division has benefited greatly in recent years by a shift from steel to plastic fuel tanks. Since TI produces plastic fuel tanks, the change has allowed the company to grow significantly. Also, because of operational leverage, it has been able to improve the profitability as it gained more business. However, we need to be aware that around 28% of the market is still using steel fuel tanks, so there is ample room for further growth, even above-market growth.
One of the worries in relation with this company is what will happen to it amid the ongoing transition to hybrid and electric vehicles. After our due diligence, we strongly believe it will benefit from this trend. Today, the estimated content per internal combustion engine vehicle is €200 on average, of which around €100 corresponds to fluid systems and €100 to fuel tank products.
With hybrid cars, the content per vehicle for TI Fluids will increase significantly because these cars have the same combustion system as traditional vehicles plus battery-related components which will bring additional products for the company. On the combustion part of the hybrid vehicle, the additional content will come from the need to have higher value-added, specialized fuel tanks to protect all the electric parts of the car. In the electrical car, you also need additional cooling and heating systems for the batteries.
As regards electric vehicles, the company will obviously lose business related to the fuel tank products. But at the same time, we believe there will be additional thermal products to compensate for this loss. TI estimates it would have around 2x the content it has now per a combustion vehicle. With hybrids, we are talking up to 3.5x more content compared to traditional vehicles.
What does this mean for the future development and the potential market of TI Fluids? According to IHS, the well-known consulting firm for the automotive sector, the addressable market for TI Fluids will go from around €18 billion at present (€8 billion corresponding to fluid systems and €10 billion to fuel tanks) to around €31 billion. The reason is that the content of the hybrid vehicle, which is the faster-growing market, is much higher than the current content, and this increases the addressable market. Even if we go with 25% less hybrid or electric vehicle penetration or scenarios where electric vehicles develop much quicker than expected, the addressable market will be far larger than the current market. Therefore, the electric and hybrid vehicle transition should be a big opportunity for a company like TI Automotive.
The global automotive market is a cyclical one. If we look at historical trends, it has constantly been growing, but the fact remains that it is cyclical. We believe there are several trends with a positive effect for TI. The first one is the increase in regulatory requirements to reduce emissions and increase fuel economy. The second big trend is the constant increase of global platform standardization and the move of OEMs away from regional platforms. This is a trend that favors companies with a global footprint, such as TI Automotive. Because of it, they can gain market share at the expense of more regional supplies. Finally, while it’s true the market is cyclical, when you have a global presence, you can compensate for the maturity of certain markets through growth in other parts of the world. Besides, we need to consider that there is huge growth potential in emerging markets, where the number of vehicles per 1,000 inhabitants is much lower than in the mature occidental markets. TI has a solid presence in those segments and should benefit from the strong growth potential of Asia.
What do we like about this company and why do we believe this is a good investment opportunity? First, we are talking about a company with market-leading positions in niche markets. These small niche markets have significant barriers to entry. There are products critical for good vehicle performance and compliance with the recent regulatory requirements. There are not many players able to supply these kinds of products.
Second, TI’s current management team has been in place for 10 years. These managers came in when the company was hit with financial problems in 2007. It’s the management that did the initial restructuring and has achieved the strong performance of recent years.
Moreover, we see the electric and hybrid vehicle transition as an opportunity rather than a threat, and the addressable market will grow over time because of this.
We also have a company with a long-established presence in China and one truly unique characteristic – 100% ownership of the subsidiary in China. Traditionally, China doesn’t allow it and always requires of foreign companies to have a local partner. However, TI Automotive has been in the country for many years, long before this department was in place, and it now has a 100% subsidiary in China and 18 manufacturing plants. Since it also works for Chinese manufacturers, it gets access to the local market.
Besides its global footprint and good relations with most OEMs, TI has high profitability, with margins well above those of other auto component suppliers. We believe it also has a quite flexible cost structure because first, 67% of its employees are located in low-cost countries, and second, it has high cost flexibility in terms of labor, with many temporary workers. Moreover, we see quite a strong pricing power because the products it makes have high value added and are critical components for automobiles.
Another notable thing is the strong cash flow generation capacity of the company. Its capex needs are relatively small – we are talking about 4% of revenues and quite consistent over time. The networking capital needs of the business are also quite modest because the company has 118 manufacturing plants, which puts it very close to its customers and keeps inventory levels low. Working capital is around 8% of revenue versus 15% or so for other auto component manufacturers. All of this means that 1) the free cash flow generation of the company is really strong, and 2) the return on capital employed is significant, consistently above 20% through the years. Another important thing related to the free cash flow generation is that the company deleveraged sharply after the IPO in December 2017, so it has greatly reduced its interest expenses, which should improve the free cash flow generation capacity in the years ahead.
This is a company with a strong financial performance, consistently delivering organic growth due to three factors: the rise in content per vehicle, the increased use of global platforms by automotive manufacturers, and a strong presence in emerging markets. In addition to growing revenues organically, the company has been significantly improving its operating profitability. This is the result of operational leverage and a strong production efficiency program the current management put in place after the restructuring process in 2008 and 2009.
Let’s turn to the valuation because this is one of the reasons we decided to invest in this company. We consider TI Automotive a quality player and much better than many automotive components manufacturers. However, it is trading at a significantly lower valuation than other players. We have compared it to two similar companies. Norma also has returns on capital employed significantly higher than the rest of its peers because, like TI Fluids, it manufactures critical components, which gives it pricing power and generates higher margins. In the case of Norma, we are talking about margins of 19%, even higher than what we see with TI Fluids. Nevertheless, the return on capital employed is lower for Norma because TI Fluids has low working capital needs. Norma is trading at almost 10x EBITDA versus less than 5x EBITDA for TI Fluids. Cooper Standard is one of the competitors in the fluid systems segment. This company has lower profitability and much lower return on capital employed, the main reason being that it has other divisions with products less profitable than fluid systems products. Cooper’s EBITDA margin is around 11% versus 14% for TI Fluids, and the return on capital employed is half what TI Fluids achieves. Despite this, it is also trading at significantly higher multiples than TI Fluids.
TI Fluids is greatly undervalued, in our opinion. We did a simple evaluation exercise, taking the average free cash flow generated by the company in the last four years (around €150 million) and excluding the working capital because TI had some additional working capital needs as it was growing. We also went with a 7% free cash flow yield, which is reasonable for a company like this given the cyclicality of the business. Thus, we reached a valuation of around €4.25 per share, whereas the company is currently trading at €2.2 to €2.3. This means we have an upside of around 92%. The implied valuation, also taking the average EBITDA in the last four years, would be 7.5x EV/EBITDA. If we take the numbers for 2018, the valuation we get is much higher, but we believe it’s more conservative to use the average for four years since this is quite a cyclical business.
The big question is why this company is trading at a discount to peers even though it is of good quality. There are some good reasons justifying this. First, this is a recently IPO-ed company, so there isn’t much public quoting history. Also, it was IPO-ed mainly by US brokers but is traded in the UK (therefore, in pounds) while reporting in euros. The headquarters are in Oxford, but all the management and the corporate office are in the US, in Michigan. It’s the kind of complex situation that could justify the current low multiples.
Another reason the company is cheap is concern in the investment community over the electric and hybrid vehicle transition. To us, this is not a good reason, and our due diligence points to the transition being more of an opportunity for the company than a threat.
Finally, investors might be uncomfortable with Bain Capital still owning more than half of the company. It will probably continue to sell in the future, so some investors seem to be worried about an overhang in the stock. We are never worried about this; our concern is the value of the company. If somebody sells and the stock goes down, we will buy more.
As for the investment risks, we could start by noting the cyclicality of the business. Regardless, we think certain trends in the industry are playing in favor of TI Fluids – global platforms, presence in emerging markets, and the critical products it supplies are very important in the context of stricter regulations on emissions. The risk of lower-than-expected content in electrical vehicles is not on our list because we see this as an opportunity, but it still needs to be proved in the future. The company has started getting certain programs and contracts in the hybrid and electric vehicles space, and as it gets more, the investor community will become more comfortable. Regulatory risk is always present in the automotive sector. As for raw material prices, the company is using mostly steel, aluminum, and some resins. It has been consistently able to pass that to its customers, but there is always some time delay, so in the short term, it could suffer a huge and rapid increase in raw material costs. Finally, there is the foreign exchange risk, but we should take into account the good match between revenues and costs because the company has 118 manufacturing plants.
In summary, this company fits into our investment criteria for several reasons. First, it flies under the radar and has low coverage and a complex situation. We believe this is a sound business operating in a niche market with a high market share, making products which are critical for automotive manufacturers. Regarding leverage, the company is at 1.8 x net debt to EBITDA, which is not too high but is still higher compared to other peers. There are two important things to note here. Frist, the company has no financial covenants on its existing debt facilities, which helps. Second, it has impressive free cash flow generation capacity. This is a company which traditionally has not done any M&A, so it doesn’t do inorganic development. In the last 10 years, it has made only one acquisition, buying a US business for €125 million, which is not significant. M&A is not on the management’s agenda – the leadership is dedicating the entire free cash flow to reducing the leverage. It should come down closer to 1x between this year and next year.
With regard to this being an owner-occupied business, it’s true that the largest stockholder, Bain, is selling. But it’s also true that management has been with the company for 10 years and has a 2.5% stake in the company, which is not insignificant for a €1 billion enterprise. This provides certain comfort about the alignment of the management team with the rest of the shareholders.
In terms of valuation, the company is trading at about 10% free cash flow yield, much lower than the rest of its peers despite its better quality.
The following are excerpts of the Q&A session with Jose Antonio Larraz:
Q: Capital allocation is always a topic of importance to value investors. Would you like to see the company bring down leverage or would you rather it prioritized other things to do with the cash flow?
A: My management and I agree that the current priority should be to reduce leverage. We are not particularly worried with 1.8x, but given the cyclicality of the business, the company should be utilizing most of the free cash flow to reduce leverage. M&A is not part of its strategy, and it can continue to grow organically above the market without acquisitions. In terms of capex, it has a lot of regional capacity, so it doesn’t need to make extraordinary capital investments to cope with future growth. we believe the company will and should be using the cash flow generated to reduce debt.
Q: Can you elaborate a bit more on the competitive landscape for automotive fluid systems and the specific competitive advantages of TI Automotive?
A: There are three top players in each of the segments where the company operates. In fluid carrying systems, TI is the clear market leaders with a 35% share of the market, and there are two other big players. The rest are regional operators which have and will consistently lose market share because automotive manufacturers are looking for companies that can supply them on their global platforms. For that, you need to be on all continents, which is hard to achieve for a regional player. In the case of fuel tank and delivery systems, the situation is similar although it’s true there is a little more competition and some other players apart from the top three. That, of course, affects the margins.
Q: For someone who would like to track this idea over time, what would be the key data points to keep an eye on?
A: The big question is how the company is developing and what contracts it is getting for hybrid and electric vehicle products. In 2018, it announced its participation in two important programs for hybrid and electric vehicles, but we need to see more of that to determine with certainty that the transition is an opportunity for the company. We strongly believe this is the case, but it still needs to be proved. The more contracts the company wins, the better the visibility will be.
Q: Could you shed a little more light on the management’s incentives and how comfortable you are with them?
A: Since the management owns a 2.5% stake, this gives us some comfort because it’s not small money. Second, the company has a long-term incentive plan aligned to the performance of the stock and certain key performance indicators such as the cash flow and EBITDA. Although we know companies with a stronger alignment, this is sufficient for us in this case.
Q: Could we do a bit of a postmortem? Let’s say we meet again in two or three years, and the idea has not worked as expected. What would you think might be the culprit?
A: The main risk for the next two or three years is a big downturn in the automotive sector dynamics. If there is a sharp drop in automobile production in the coming years, the company is going to suffer. But even then, we believe it will continue to generate good cash flow, and the current low valuation will give us a certain margin of safety, allowing us to go through that period. Our experience shows that in a down automotive cycle, companies with a clear market position come out reinforced from these situations, while the smaller players with lower-quality products are the ones that suffer. In such a scenario, we need to be more patient – instead of being three or four years in the company, we might need to hold it for five or six years.
About the instructor:
José Antonio Larraz is a founding partner of Equam Capital. Jose has 12 years of experience as a partner in Capital Alianza Private Equity, investing in Spanish private companies in the middle market. He has investment experience in chemical, food, retail, outsourcing and telecommunications sectors, having participated in the board of directors of six different companies. Jose has 4 years of experience in financial advisory, corporate finance and M&A at Lehman Brothers in London and New York and He is a Professor at Instituto de Empresa since 2008. Jose holds a degree in Law and Business Administration from ICADE University and MBA from Insead.
Jean-Pascal Rolandez of The L.T. Funds presented his in-depth investment thesis on Korian (France: KORI) at European Investing Summit 2018.
Thesis summary:
Korian (France: KORI) is one of two European leaders in retirement homes (the other being Orpea). Since its inception in 2003, Korian has amalgamated retirement home and rehabilitation centers companies in a fragmented market — first regional French, then national, and now continental European businesses, resulting in Korian becoming the number-one player in Germany, France, Belgium, and the number-two player in Italy. Sales exceed €3.3 billion, with close to 50,000 employees in 750 establishments. The market capitalization is ~€2.5 billion, with a float of 60%. The sector is growing organically at 3% annually. This rate is likely to accelerate after 2025 as baby boomers pass the age of 80 years. The private sector (~50%) is consolidating and benefiting from the public sector not coping with demand. Over the last four years, Korian has been integrating a heavy acquisition program that started five years ago, hence a stagnant share price. However, with this operational risk largely behind the company, Korian’s profitability should benefit from leveraging operationally and deleveraging financially. Excluding property portfolios, Korian trades at a ~33% discount to Orpea and only 7.6x 2019E EBITDA for a business growing internally at ~6% per annum and deleveraging by ~3% of equity value.
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About the instructor:
Jean-Pascal Rolandez is the manager of The L.T. Funds, a Geneva-based investment firm focused on a buy and hold strategy based on a limited number of European stocks with a 5+ year investment horizon. Jean-Pascal has more than 25 years of equity investment experience and has founded the first investment club at the leading French business school ESSEC. Prior to establishing The L.T. Funds, Jean-Pascal held various executive positions at BNP Paribas for 22 years, including as Paribas’ French equity strategist.
This article by MOI Global instructor Soumil Zaveri is excerpted from a letter of DMZ Partners Investment Management, based in Mumbai, India.
In thinking about our purpose and approach in managing our families’ capital over the past few months we’ve come to appreciate a phrase that would be well suited as a motto for us – Buying irreplicable assets with irreplaceable capital [*]. To provide some context, we like this phrase as it retains focus on two key points.
1) Own the right stuff – own companies that operate assets/ brands/ processes/ technologies/ cultures that are irreplicable (very difficult/ nearing on impossible to replicate by competitors) – such companies are usually capable of compounding our capital at compelling rates of return over very long periods of time. This retains our focus on the quality of businesses we own and the qualities of people we partner with.
2) The money we manage is finite – unlike many large asset managers, in our case the investor base is clearly defined and largely static – this makes the capital we manage irreplaceable. If I were to permanently lose say 30% of a family member’s capital due to poor investing decisions – this will likely have possibly-permanent and decision-altering consequences for that family. In doing so, we will have also meaningfully shrunk the capital that we manage as we do not have or want an endless supply of clients and capital that an army of relationship managers can keep generating.
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This article is authored by Alirio Sendrea, head of research at Invexcel, based in Madrid. Alirio focuses on bottom-up analysis of European small and mid-caps.
When I travel abroad I find the views from overseas on Spain are rather interesting. For many, Spain means fun, sun, paella, tapas, Rioja wines, and La Liga; while others focus on the more sober side, and ask about our odd politicians, unstable legal framework, longstanding economic crisis, high unemployment… and everybody, without exception, thinks that an essential part of our daily life is the siesta.
Let’s agree that there’s a little bit of truth in both views. However, there are some caveats here and there. Sun-chasers should bear in mind that some regions can be freezing in the winter (don’t laugh, but some tourists have ended up in the hospital with pneumonia); and in very touristic spots, some Rioja wines and paellas are not that great… Essentially, while some sleep their siesta, the owners and managers of great companies are wide awake.
Invexcel has chosen to invest in those great companies, from the Spanish small- & mid-cap landscape, that are delivering great value to their shareholders. So, let’s get down to business, and share a few snapshots on compelling investment ideas.
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