This article is authored by MOI Global instructor Samuel Weber, founder and portfolio manager at Samuel S. Weber Vermögensverwaltung, based in Switzerland.
Samuel is an instructor at the upcoming European Investing Summit 2022, to be held fully online from October 11-13. Members enjoy complimentary and exclusive access.
The world is constantly changing, and my human brain has an extraordinary ability to create stories and explanations in hindsight that often bear little resemblance to what was actually happening in real-time. Therefore, one of my primary objectives for presenting my favourite European investing ideas on MOI Global is to have a well-documented account of my own thinking at the time of making some of the most important decisions of my investing career.
As I currently have no new investment to present to the MOI community, I decided to update my previous ones. Since presenting Deutsche Bank in 2017, the world has faced a global pandemic, the outbreak of a war in Europe, and the resurgence of inflation, among other things. These are highly significant events in global history that are reshuffling the cards for many investors. It is therefore of prime importance for me personally to see how my investment theses are holding up in this new environment.
I will not repeat what I said in the past on this platform. Enough has changed to focus on providing relevant, timely and new information. For readers interested in hearing my past presentations, they can be found on moiglobal.com. Also, this short article gives a preview of what will be a more detailed presentation next month. I will start with my most recent idea, first reviewing the investment case for Lanxess that I presented last year, then Swatch Group (2020), Holcim (2018) and finally, Deutsche Bank (2017).
Since presenting Lanxess last October, the economic environment has taken a dramatic turn for the worse. As a diversified chemicals group with a significant industrial footprint in Germany, the company is heavily affected by the war in Ukraine. It needs a lot of natural gas to fuel its operations and suffers from the commodity’s high price and possible lack of supply. More generally, inflation imposes significant working capital needs that lower operating cash flows, increase capital invested and decrease the returns on that capital.
Despite facing this tremendously disadvantageous operating environment, the company performs reasonably well. During the first half of 2022, it was able to fully pass on material and energy costs to its customers and increase operating profits by more than 20%. It has published an analysis of the potential costs of factory shutdowns due to a lack of gas, showing that even this adverse and so far hypothetical scenario could be managed with limited profit impact, because the most gas intensive plants are also the least profitable ones. Also, when it comes to gas supply, Germany is divided into two parts, with the East being supplied mainly by Russia, and the West (where Lanxess is located) by LNG from global markets and pipelines from the Netherlands.
Most importantly, the company – under the supervision of a superb management team – continues to deliver on its transformation towards a specialty chemicals company. While there has been some sobering news about Standard Lithium, Lanxess recently announced a joint venture with Advent, allowing it to partly monetize one of its four segments (the weakest one, in my opinion) within the next 12 months and fully monetize it within the next 4 years at attractive valuations, allowing it to deleverage its balance sheet and refocus on more profitable segments. Furthermore, it closed two sizeable acquisitions in its Consumer Protection business, catapulting it into the world leader in biocides and a strong global player in flavour and fragrances.
The valuation of Lanxess is dirt cheap. The company is currently valued at less than EUR 3 billion. After fully monetizing its joint venture and given the current level of leverage, assuming no further acquisitions, the company should be debt free in a few years. On a projected EBITDA of around EUR 1.2 billion, it would then trade on an EV/EBITDA ratio of 2.5 times. The ultimate valuation depends on the competitive strength of the group, i.e., how sustainable its pricing power is and how much free cash flow it will generate. As far as I can tell, an EV/EBITDA ratio of 10 times seems achievable, indicating significant upside.
When I presented Swatch Group in 2020, two years ago, it was suffering from the effects of the global pandemic and, more importantly, from government-imposed lockdowns. Since then, the company has increased its revenues and profitability significantly. Even during the pandemic, it achieved a healthy level of operating cash flow by selling down inventories, releasing accumulated working capital.
In my presentation, I identified the company’s capital allocation as a material weakness, and this has not changed. Indeed, it got worse. A few years ago, the company engaged in a share buyback to avoid paying negative interest rates on cash assets, giving me hope that, besides statements to the contrary, the CEO, who is a significant shareholder, has a rational eye towards capital allocation. However, today, I am much less optimistic.
Out of total balance sheet assets of CHF 14 billion, inventories account for CHF 7 billion and cash & equivalents for over CHF 2.5 billion, amounting to a total net working capital of CHF 9 billion. Theoretically, the company could monetize its gold and jewellery assets, and, together with its cash assets, buy back more than a third of its outstanding shares, dramatically increasing its earnings per share, return on equity and shareholder value. On a recent earnings call, however, the management team showed no willingness to do such a thing.
Given the size of the amounts involved and the unsatisfactory level of profitability during the past 5 years (which is mainly related to the company’s capital intensity, much of it unnecessary for operational purposes, in my opinion), I can’t defend this observed unwillingness to engage in rational capital allocation any longer. The company’s financial performance could still be bailed out by strongly growing revenues. But relying on such growth to generate reasonable returns isn’t a responsible strategy, least of all considering that first-half-year revenues haven’t grown during the past 10 years!
A lot of economic crimes have been committed in the name of capital efficiency. And I support a reasonable safety buffer. But no amount of safety buffer can provide operational safety in the long-term. Only watch-loving and -buying customers can do that, and no amount of assets on the balance sheet will compensate for a lack thereof. Meanwhile, the seriously depressed capital returns destroy shareholder value with no concomitant benefit.
When I presented Holcim in 2018, Jan Jenisch, its CEO, was in the process of significantly transforming the company. He joined in 2017, and today, has accomplished much of what he set out to do. Holcim achieved all its 2022 targets one year in advance. It reset its profitability, doubling free cash flow to over CHF 3 billion, deleveraged its balance sheet and laid the basis for the fourth segment, Solutions & Products, to become a significant profit centre.
The company recently announced the sale of its India subsidiary to Adani Group at twice its own valuation, meaning that it will receive more than 20% of its current market cap in cash while selling only around 10% of its earnings power (and even less of its free cash flow). The proceeds will mainly be used for further acquisitions in the Solutions & Products segment. This divestment is particularly attractive given the significant hurdles the Indian government imposes on repatriating cash from India and the current CO2-related discount that Holcim suffers from in the stock market due to its cement activities (the Indian subsidiary accounts for more than 20% of Holcim’s total cement grinding capacity).
I expect Holcim to continue executing on its transformation, significantly outperforming its 2025 plan, and to generate significant and growing free cash flows in the future based on its hundreds of local monopolies. Jan Jenisch has a proven track record in capital allocation and a massive firepower to finance acquisition, so the majority of Holcim’s activities will soon consist of products and solutions unrelated to cement. Importantly, I also view its cement activities as highly valuable. Not only do they provide the company with significant cash flows that fuel its transformation, they also enable Holcim to get into contact with its customers very early in the life cycle of a building / an infrastructure, allowing it to cross-sell other products & solutions. The valuation of less than 10 times free cash flow and 8 times owner earnings is highly attractive, compounded by a tax free dividend yield of around 5%.
Of all my investment ideas, Deutsche Bank was by far the most controversial. How could I possibly consider investing in a European, unprofitable and criminal bank? Didn’t I know that this company is already insolvent, the value of its assets significantly overstated, its risk management broken and its business inherently unprofitable?
While predictions of an imminent downfall can’t be falsified, I am happy to report that five years after my analysis, I turned out to be mostly correct. In the first half of 2022, Deutsche Bank achieved its targeted level of profitability with a return on equity of 8% and net profit of more than EUR 2 billion, despite absorbing significant costs from its capital-release unit and facing a global pandemic and the recent outbreak of a war in Ukraine. The company is benefitting from a sustainable recovery in trading revenues, the quality of its asset base, rising interest rates and improving efficiency across all business units.
There are still a lot of doubts about Deutsche Bank’s ability to keep up and further build on its recent performance. Europe’s financial industry resembles a construction site, and its banks suffer from material competitive disadvantages (mainly related to their size) compared to internationally active U.S. banks. Many European banks are significant holders of sovereign debt from their home countries that are much less credit-worthy than Germany. And some banks on the continent are in a seemingly never-ending restructuring with no clear solutions in sight.
Despite that, I feel very well about the Deutsche Bank’s prospects, having observed closely its management team, risk management and operational progress during the past 5 years. The return on equity may soon surpass 10%, powered by its sizeable deposits franchise, leading to a yearly net profit of around EUR 6 billion. On this basis, the bank is currently trading at a price-earnings-ratio of 3 times. Furthermore, it will pay out significant dividends and engage in meaningful share repurchases during the next few years, which will further enhance shareholder value.
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