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.

Valuation


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.

Risks
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.

Sources:
[1] https://www.barrons.com/articles/all-the-biggest-stocks-that-are-now-in-a-bear-market-in-one-chart-51545158981
[2] https://macroeconomicanalysis.com/macroeconomics-wikipedia/three-phases-quantitative-easing/
[3] https://www.forbes.com/sites/afontevecchia/2013/07/17/bernanke-to-congress-we-are-printing-money-just-not-literally/#1b4b3a63109b

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, www.leveragedloan.com

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 Web.com (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."