Wednesday, December 26, 2018

edding AG

Stock Price: 88EUR / Market Cap: 52.8M EUR / EV: 33.3M EUR
Business Overview
edding AG is well-known in Germany and Europe for its top quality products, namely its permanent markers. Specifically, it is a nano-cap company that develops, produces, and distributes markers & other writing utensils, and visual communication products in Germany and abroad. Its products are in the writing and marking division are used for creative and industrial applications such as for paints, textile, windows, and permanent and paper markers. Within its visual communications segment, the company provides office products like whiteboards and e-screens.

Writing & Marking Segment (73% of sales)
Produces markers and other writing utensils for commercial applications and private end users. Includes industry and office solutions, as well as creative product lines and household markers. Other product lines include those for printing and decorative cosmetics (namely nail polish, branded under edding L.A.Q.U.E). For the industrial markets, its markers are known for their excellent performance. Special aerospace markers have been approved for BAE use (British Aerospace). The company also makes porcelain markers, and metallic & calligraphic pens.

Visual Communications Segment 27% of sales)
This segment is exclusive to the B2B sector, and has end markets in schools and office conference rooms. It operates under the brand name Legamaster, which is responsible for the development of whiteboards and e-screens. Products include flip charts, whiteboards, and presentation boards. In Germany, sales were up double-digits YOY, 10.5%. In Europe. Sales were up 6.2%. Overseas, sales grew by a whopping 36.9%, most of which came from Argentina.

Revenue Recognition
Sales revenue is generated form independent distribution partners, commercial and private end users, traditional wholesale, retail trade, large-scale outlets (supermarkets, DIY stores), mail-order companies, and online distribution channels. Germany is the single biggest market for the company. 44% of the company’s sales come from Germany, and 66% from Europe and abroad.


edding AG is a cash-rich company. As such, it trades 5x FCF, 4x earnings (when excluding cash from market cap), 0.4x sales, and 1x book. Earnings yield 14%, and FCF 22%. The best way to value a company with a huge net cash position is through an earnings power valuation (EPV).

Next year’s revenue was projected by assuming a 2% growth rate, with 8% EBIT margins, normalized. Edding is a company in a declining industry, so we placed a 10x multiple on it, to assume little to no growth. The resultant EPV/share value was 127 EUR. Since the cash on the balance sheet has value (it could be used for future acquisitions or increased dividend payouts to shareholders), we decided to add it to EPV/share to get a total intrinsic value of 155 EUR/share. That number was then discounted to present value by assuming a cost of capital/return rate of 3% annually, and a time horizon of 3 years. Therefore, we expect to get to the target price within 3 years, which is the most Mr. Market would take to value edding AG fairly. This implies an upside of 76%.

Market Environment
The development of German paper, office, supplies, and stationary market has been hit by the progress of digitization. Despite this, edding has been successful at managing the digital transformation while being able to maintain its leading market position (and it shows in their top line, as discussed below). While markers are the mainstay of the business, edding has a division devoted to the development of e-screens and interactive whiteboards.

For being within a declining industry, edding’s top line has been rather resilient over the past 20 years. From 1999-2017, sales have growth 56%, and 36% in the last ten years. Each year has experienced very consistent growth, averaging 5% (with the exception of 2009). Within Germany, the writing and marking division has an average YOY sales growth of 4%. As a whole, the writing and marking division also has an average YOY sales growth of 4%. Its visual communication division within Germany has experienced YOY sales growth of 8%. As a whole, the visual communication division has experienced YOY sales growth of 6%.

In 2017, the German paper, office supplies, and stationary market stagnated, and is now 1% below its 2013 level. The German market experienced a 3.9% decline in the coloring segment, while the global market for interactive whiteboards and e-screens grew in 2017. As for Edding Group, the company sold more interactive displays than in past years, and sees a trend shifting away from interactive whiteboards (which accounts for under a third of units sold) to interactive flat panels.

Financial Analysis
In 2017, edding’s operating margin was 8%, comparable to previous years which ranged from 7-9%. Its net profit margin was 5%, on the lower end of recent years, which ranged from 5-7%. EPS has growth 30% over the past ten years.

In 2017, the company produced ROIC of 13%, ROE & ROA of 12%. 2017 ROIC was slightly lower than the ten-year average of 15%. ROE and ROA were roughly equal to their ten-year averages. For a company in a declining industry, edding is performing very much above average. It continues to be a market leader, and the name “edding” is comparable to “Expo” here in the States.

On the balance sheet, edding’s cash conversion cycle has been steadily increasing. Its DIO is primarily responsible for an increasing CCC. Days inventory outstanding increased by 18 days from 2016-2017. The longest increase took place from 2011-2012, marked by 30 days. Days sales outstanding has also been increasing but by a far less magnitude with 4-5 day increases each year. DPO, on the other hand, has been consistently decreasing. The company pays its supplier much faster than it collects receivables and turns inventory. Inventory turnover is the slowest, about 2x a year. Receivables are collected about 7x a year and payables paid about 13x a year. This shows that the company is too small to take part in factoring agreements, and doesn’t have much power to negotiate with suppliers on terms despite its very liquid balance sheet.

Inventories decreased by 7% in 2017. The company did not give its reasons. However, because there was an equal decrease in raw materials and finished goods (6% each), the company may be preparing to trim production, and reduce exposure to obsolete inventory.

Debt is practically nonexistent at edding. Its gearing ratio nears zero, and its debt to equity is 0.12. Cash covers total debt about 3.5x. The company has deleveraged substantially from 2008, and has been in a net cash position for several years. It decreased gearing ratio from 0.35 and debt/equity from 0.51. In 2008, cash used to cover only half of total debt.

In 2017, EBIT covered interest approximately 30x over. Operating cash flows and FCF covered interest 35x and 29x over, respectively.

On the cash flow statement, depreciation has trailed capital expenditures from 2012-2016, meaning a five-year period of underinvestment. In 2017, depreciation roughly equaled capital expenditures. For reference, 2017 capital expenditures levels are at two-third’s of 2007 cap ex levels. Investment growth has averaged 5% despite several years of negative growth (that below -11%). Edding is not a capital intensive company, but it is underutilizing its manufacturing capacities. What little it invests is maintenance-related, and doesn't appear to be targeting growth.

2017 FCF was approximately 12M EUR, and has tripled since 2007. 20% of FCF goes toward dividend payments for shareholders, and 5% goes towards LT debt repayment. Dividend payments as a proportion of FCF have decreased from 38% in 2007. Edding’s dividend yield is currently 4.3%, but dividends payments still have a lot of room to grow, so the yield is far from being unsustainable. I believe edding’s shares are undervalued, so a 6% buyback would also be a good use of free cash flow.

Is the business susceptible to a cyclical event?
No, edding’s financials are somewhat resilient to a black swan event, such as a global recession. Looking as 2009 as a yardstick, sales fell by 15% and earnings by 44%. Edding had far greater debt levels then, and was able to cover its interest by EBIT approximately 9x. Now, edding is in a very substantial net cash position, and has far better interest coverage as explained in the preceding paragraphs. Even if sales and earnings fell by the same proportion, history has shown that the rebound will be strong (9% growth in sales in 2010, and 83% growth in earnings).

Is the business being disrupted? How are people and culture changing that might effect the business?
As the edding CEO remarked in 2014, “We will be selling the classic edding 3000 20 years from now. But the number we sell will decrease.” While the company does not give a sales break-down by product, edding’s resilience over the past 20 years even with numerous tech disruptions and the rise of tech giants such as Amazon, shows that the company will continue to be around for future decades. The company does not mention Amazon as a threat, even though the company does not currently sell its markers on the website. It will continue to sell its markers through retail channels, and because of its leadership position in Germany and Europe, it is unlikely that the “edding” brand will fade away. As mentioned before, for Europeans, “edding” is synonymous with “Expo.

 While there has been a rise of digital office media, schools and business conference rooms have continued to use traditional whiteboards. In addition to being used for industrial purposes, edding markers are also used for household use and creative applications. The edding marker has been made so that its use isn’t confined to one use. The edding Group is also exploring new channels, such as nail polish. Online reviews based off numerous blogs have cited edding nail polish for its quality and durability, comparable, or even better than Essie on those two characteristics. The only disadvantage they cited was its price.

Thursday, December 20, 2018

Cheat Sheet for Bear Markets

Source: The Bear Book by John Rothchild

Money Illusions Begin to Unearth in Bear Markets

"But in the end, alchemy, whether it is metallurgical or financial, fails. A base business cannot be transformed into a golden business by tricks of accounting or capital structure. The man claiming to be a financial alchemist may become rich. But gullible investors rather than business achievements will usually be the source of his wealth."
-Warren Buffett

"Only when the tide goes out do you discover who's been swimming naked."
-Warren Buffett

A "Dow Theory" indicator, the Dow Transports index is finally in a bear market, down 20% from its September high. As other indexes, including DJIA, continue to hemorrhage (down 13% from October high), uncertainty fills the air. Many individual stocks were already in bear markets, as a Barron's article, reported earlier today [1] . The S&P darlings are stumbling: Netflix, down 38%; Facebook, down 36%; Apple, down 30%; Amazon, down 26%. The S&P's worst decliners include Mohawk Industries, down a whopping 59%, and GE down even more so, 63%!

As an Austrian, one can't help wonder: were these gains ever real to begin with?

Let's rewind for a second, and go back to when QE1, 2, and 3 first happened. The Fed bought MBS, Treasuries, and other securities in bulk primarily to "stabilize" the financial sector in November of 2008 [2]. In November of 2010, three months after the first QE ended, it started up again, with time with a focus on the Fed just buying Treasuries to add to its already bloated balance sheet.

Then, in September of 2012, the Fed introduced the third bout of quantitative easing. The difference between QE3 and previous QE programs was that the Fed chose to have a monthly approach for purchases instead of buying it in bulk.

Bernanke stated once that this Fed policy was primarily to inject liquidity into the equity markets. By late 2012, the DJIA had already recovered to pre-crisis levels, but after QE3, it took off. It's not far-fetched to assume that any gains from the start of 2013 and are just as real as the money Bernanke printed to reflate the stock market bubble [3].

Remember, each program has some lag associated with it. You don't know the extent until some time has passed, and introducing three rounds of QE within a short amount of time doesn't leave much up to the imagination of what follows next, and how big the effects will be. Mises once stated that financial assets are the primary beneficiaries of a central bank's interventions in assets. As we've seen since its peak in 2007, the S&P has almost doubled, a trend unlike past cycles.

Look at stock charts of individual companies within the DJIA, and the S&P. Asset inflation is very clearly evident there. Wherever you see a tide rising, or rising sharply after 2013, look elsewhere for opportunities.

Inflation not only has effects in inflating asset prices, but also has effects in the real economy. Price increases ultimately boost corporate earnings. Which sectors can this been seen? Look in consumer discretionary, industrials, and health care. That should tell you to stay away from companies that rely on price increases to bolster their earnings. Those that come to mind are Apple, Samsung, Mohawk, industrials (airlines), and health care. Why stay away? Selling prices will eventually revert to the mean. When it does, those earnings will collapse.

More importantly, we've seen the build-up of leverage at unprecedented levels at the federal and corporate levels, not to mention bubbles in housing, credit cars, student loans, auto loans, you name it. As the equities are the first to pop (FANGs were among the first to be in a bear market), it won't be long until the "everything bubble" will come crashing down.


Tuesday, December 4, 2018

"More Money Has Been Lost Chasing Yield Than At the Point of a Gun"

“Buyout returns have slowly trended downward. The PE industry has matured and become more competitive, with many more participants and massive amounts of capital competing for a limited set of deals. To be sure, superabundant capital has diluted returns across asset classes, not just private equity. Everyone is chasing yield, and where investors spot a sliver of extra yield, they pile in and bid down returns. Outsized returns that GPs could earn on once-common undervalued assets are harder to find today.”

-Bain Report, Global Private Equity Report 2017

What Hath Private Equity Wrought?

Source: LCD,

After the last financial crisis, the Federal Reserve warned banks that most companies should not carry debt levels above 6x EBITDA. Unfortunately, that hasn't stopped the mania in private equity.

Today, private equity companies buy companies at 10-11x EBITDA. From the second quarter 2018 press release for (pictured above), its net debt to EBITDA was approximately 12x. Deals like Refinitiv ($17B buyout), and Akzo Nobel ($11.7B), otherwise known as "jumbo LBO's," have contributed to the increasing size of US LBO's, now nearing pre-crisis peaks. The third quarter of 2018 saw an average size of approximately $1.75 billion in US LBO's, somewhat comparable to the $2.1 billion peak in 2017.

Source: TM Capital, Leveraged Lending Market Report October 2017

At present, US loan funds have an AUM of almost $185 billion, which is a 68% increase since June of 2016. Despite this, growth has plateaued in recent months. The recent outflows of equity capital from leveraged loan funds could mark an inflection point. They are occurring at a time when leveraged loan issuance is at its highest, which could signal that a liquidity dry-up is eventual. Investors have pulled nearly $1.74 billion from loan funds, which marks the second biggest outflow in the past four weeks. This follows the $1.5 billion outflow in mid-October.

What does this mean from an Austrian standpoint? There are two morals: first, everything comes at a price, and second, everything has consequences. There is only so high a price that private equity firms can pay when taking another company over. And there is only so much leverage that can be placed on a company. The LBO graveyard is littered with examples from past corporate debt bubbles: RJR Nabisco, United Airlines, Texas Power (Energy Future), et cetera. The consequences, no matter how far they can be postponed, always catch up. Mises once commented that the second class of recipients of inflation are the investor-class, who receive it in the form of asset inflation in stocks and real estate. LBO deals are no exception, and despite their "success" from the credit-fueled binge, their end will be met. We're already seeing reflexivity assert itself. As Stein's Law states, "If something cannot go on forever, it will stop."

Wednesday, November 14, 2018

A Tale of Two Hotels

"Though my bottom line is black, I am flat upon my back,
My cash flows out and customers pay slow.
The growth of my receivables is almost unbelievable;
The result is certain – unremitting woe!
And I hear the banker utter an ominous low mutter,
‘Watch cash flow’.”
            -Herbert S. Baily, Jr.

“Money often costs too much.”
            -Ralph Waldo Emerson

Part I: A Brief History & Overview
In 2013, Hilton Worldwide went public after having been under private ownership by Blackstone since the late 2007. Earlier this year, Blackstone exited their position in Hilton Worldwide completely. Bloomberg is calling it “the best leveraged buyout ever.” Back in 2007, Hilton Hotels Corp CEO, Stephen Bollenbach, said that the decision to have Hilton bought out by Blackstone would be the best opportunity to “maximize shareholder value.” Of course, history has told us that a leveraged buyout is never done because a business is doing well, so “maximizing shareholder value” was merely a guise for something more ominous.

Hilton’s last annual before the buyout, 2007, shed some light. While operating cash flows on the surface appeared to be very positive and growing ($548M, $486M, and $652M in 2004, 2005, and 2006 respectively), it was line items in investing and financing activities that gave cause for concern. Proceeds from asset dispositions were providing unsustainable cash flows ($1B in 2005, $1.45B in 2006), and borrowings, while they didn’t play much of a role before 2006, were ramped up to $2.6B during 2006. There was also a $1.5B increase in revolving loans.
But there was one item in particular that was waving a red flag: an enormous $5.46B outflow of cash in investing activities from an acquisition. Let me say that again: five and a half billion dollars. That’s nothing to sneeze at.

In the footnotes, Hilton’s management warns us in one line: “We are more highly levered as a result of the HI acquisition.” During 2006, Hilton Hotels Corp (what Hilton Worldwide was called back then) acquired Hilton International. Farther back into the footnotes, we find that because of the HI acquisitions, Hilton Hotels entered into new senior credit facilities, from $1B to $5.75B like the drop of a hat. A 2007 news article further mentions that Hilton’s indebtedness was financed with $20.6B of mortgage and mezzanine debt financing.

This acquisition was the hay barrel that broke the camel’s back. Not soon after, Blackstone started showing some interest in Hilton, and the rest is history.

It was Mark Twain who once said, “history doesn’t repeat, but it does rhyme.” This time around, the demise will be more subtle as debt payments begin to creep up in the coming years. Unless of course, Hilton Worldwide decides to do just one more “diworseification.”

Before I get into the details, just upon first glance, we already see comparisons to Hilton Hotels in 2006/7. Earnings to fixed charges in 2004-2006 were 2.2x, 3.1x, and 2.3x respectively. In 2018, EBIT covers interest a measly 3x, roughly the same as it was before. In most respects, the Hilton situation is a replica of 2007 Hilton, with a little more cash on the balance sheet. But what’s $500M really when you’re up against billions in debt?

Part II: Cash Flow Analysis – Past & Present
I’ll be analyzing Hilton’s cash flow in two ways: the first through a multiple-year excess cash margin, and the second through a detailed multiple-year FCF worksheet.

An excess cash margin analysis compares the growth rates in earnings and operating cash flow. ECM declines when operating earnings grow more quickly or decline more slowly than operating cash flow.

What I’ve done above is adjust reported operating cash flow and operating earnings for non-recurring and non-operating items. By subtracting the two, and dividing by revenue, I can see how it trends. It’s not about it being negative as much as it is about how negative it gets. By 2006, ECM declined had declined from -4% to -7%, which is almost double in three years. What this means is that earnings were growing much faster than operating cash flow. We can see similar trends happening today. By 2017, ECM was -9% from -5% in 2015. Looking at adjust OCF, it almost halved between 2016 and 2017, while adjusted earnings increased slightly. The takeaway from this is that it tells us that we should look further. There’s probably a cash flow problem somewhere.

To pinpoint where, we look at FCF detailed over the three years.

In this version of deriving operations cash flow from 2004-2006, we see an almost identical trend to reported operating cash flows: positive and increasing. Cash flow after debt service doesn’t look much different either, except for 2006. The highlighted LT debt line shows a sudden $1.3B cash outflow, which causes 2006 cash flow to venture into negative territory where it stays before external financing. Now here’s the kicker. After external financing, cash flow is suddenly out of the hole and a positive $2.3B, all thanks to LT debt financing (a.k.a. increased senior credit facilities). Despite the artificial financing, the HI acquisition knocks cash flow back into the hole, $3.1B deep. So, the trend we see in the end is positive and growing, up until 2006, when the pendulum swings and breaks from the acquisition, which can’t be covered, even by financing.

The past is the past, but how similar is it to now? Below the spreadsheet shows operations cash flow from 2015-2017. The trend is flipped, from negative in 2015 and 2016, to positive in 2017, which different from what is reported on the cash flow statement. As you can see, LT debt payments are substantially bigger each year than they were in the mid 2000s period. Cash operating expenses, of which half consists of other expenses from franchises and managed properties, is 4x what it was in 2004-2006. It appears that cash flows are substantially more negative this time around, dragged down by LT debt payments: -$1.6B in 2015, -$4.4B in 2016, and -$1.9B in 2017. External financing did little to help in all years. The acquisition in 2015 (related to Park Hotels spin-off) shows just how dire the situation can get with cash after acquisitions -$3.4B. Hilton Worldwide appears to be teetering on the brink of solvency according to this model, and it’s only a matter of time until the credit markets dry up and leave little room to fund existing debt with new debt.

Part III: The Marriott Dis-analogy
Upon re-reading You Can Be a Stock Market Genius, it became very apparent that Hilton Worldwide since 2015 may be the complete opposite of Marriott back in 1993. Marriott International spun-off Host Marriott towards the beginning of what would become a 10-year expansion. Hilton Worldwide spun-off Park Hotels and Hilton Grand Vacation at what may be the end of a 10-year expansion.

In 1993, Host Marriott received all of Marriott International's debt and the headache of hotel properties while Marriott International got the lucrative management fees with very little debt (most of which was structured so that it was convertible into common equity).

Despite being left with consistent revenue streams from management & franchise contracts, the parent, Hilton Worldwide has still managed to burn through half its cash on the balance sheet within a year, and is loaded with long-term debt (roughly 7.7B as of the most recent quarter).

What was the most surprising about Hilton’s spin-off deal was the management didn’t completely palm off their debt to the spinoffs. The company still has tremendous leverage. On the other hand, Marriott made the smarter decision back in 1993 by transferring most, if not all, of their debt onto Host Marriott.

Part IV: Macro Implications
There has been a noticeable weakening of loan covenant quality since after the credit crisis of 2008. Most characteristic is the issuance of covenant-lite levered loans. In 2010, these loans represented less than 20% of the loan market. In the midst of the boom (2006 and 2007), they were 25%. In 2018, covenant-lite loans make up approximately 77.6% of the loan market.

Demand for floating-rate leveraged loans will lead to more defaults and lower recovery rates in the next economic downturn. The prevalence of senior loan-only structures, like we see, for example, with Hilton Worldwide, is that it lacks the cushion of junior debt. Moody’s has even hypothesized that this could produce an extended default cycle. $891B of US leveraged loans were issued as of mid-August, 2018. This was higher than last year’s record of $833.7B during the same period. In addition, B-rated loan volumes totaled $39.1B through mid-August, up 90.7% from 2017. Hilton is among them, having their senior notes rated Ba1 by Moody’s.