Gener8 Maritime Inc. (GNRT:NYQ)

Gener8 Maritime Inc. is a leading U.S.-based provider of international seaborne crude oil transportation services. The company is a result of the merger between General Maritime Corporation and Navig8 Crude Tankers Inc. It IPO'd in June 2015 @ $14 a share. It has a fleet of 45 tankers, including 33 vessels currently on water & 12 more coming on stream over the next 9 months. Its current on the water fleet consists of 16 VLCCs, 11 Suezmax vessels, 4 Aframax vessels, and 2 Panamax vessels, with 12 new VLCC's to be delivered in the next 6-9 months.

Note – forecast P/E and forecast EV/EBITDA based on projected financials post stabilisation of full fleet towards end of FY17 / beginning of FY18.

Investment case

At current price, Gener8 Maritime is a buy. Although it is very difficult to predict intrinsic value due to the highly uncertain nature of the business – tanker spot rates, oil demand/supply equation, and new tanker order book are the 3 key variables which drive value & remain uncertain – at current price, I believe that the risk is largely priced in and offers a decent upside potential.

My buy thesis is built on the following narrative:

·         Come the end of 2017, post-delivery of all its new ECO VLCC’s, Gener8 will have a modern high quality fleet of crude tankers with an average age of 5 years and with significant growth potential in EBITDA, free cash flow and earnings. From 2017 onwards, the company is likely to initiate substantial return of capital to shareholders via dividends and share buybacks.

·         Oil supply equation will continue to remain favourable for the industry - the Saudis will continue current policy of defending market share as well as rapid Iraqi and Irani expansion will continue to ramp up exports from the Middle East. In general, increased supply is good for the crude transporters like Gener8.

·         The supply glut will continue to keep oil prices low – consensus forecast from all major institutions (World Bank, IMF, EIU) are for oil to trade at ~$60 per barrel to 2020, and continue to be at current levels of ~$50 per barrel in the medium term. In general, low prices are good for the crude transporters as they should support worldwide demand for oil.

·         I acknowledge that significant imports from the Chinese since the oilprice fall as part of their policy to increase their strategic petroleumreserves has been a massive boost to the oil tanker industry and Chinese demand is a big unknown. But at current and projected prices of ~$50 - ~$60 per barrel, based on my research, I believe that the Chinese will continue to buy. In addition, India has huge infrastructure spend plans and has recently entered buying agreements with Iran as it ramps up supply. Furthermore, the economic recovery in Europe is at early stages, and favourable outcomes from Brexit, Greek negotiations, Italian banking crisis, could provide an added fillip.

·         In addition to natural demand, congestion at key land based storage chokepoints continues the need for “forced” storage at discharge ports, adding to the length of voyages & revenue for super tankers. Further, oil price contango (current low spot prices compared to projected forward prices is increasing demand to buy and store) continues to promote demand for storage.

·         One area of risk is the tanker order book, and whether there is a risk of oversupply of tankers in the market, pushing down rates. Highly favourable conditions over the last few years – with new build prices falling due to fall in steel prices, sever distress and excess capacity in the shipbuilders – resulted in a flurry of orders to mid 2015. This was expected to continue given the current favourable trend for the crude carriers. However, surprisingly, the order book as a percentage of on-the-water fleet remains near all-time lows at 2.2% and 4.0% fleet growth for 2015 and 2016, respectively (data from Company presentation). New orders have more or less ceased in 2016 and the VLCC fleet is ageing, providing Gener8 with a considerable advantage owing to its young/modern fleet.

      Gener8’s investor group consists of Oaktree (16%), BlueMountain (10%), Avenue (9%), Aurora (8%) and Monarch (7%) all of who own over 5% of the company and are likely to ensure focus on return of capital via dividends/buy backs as soon as the new fleet has stabilized and revenue and cash flow has ramped up. In addition, Gener8 has a solid management team who are highly regarded, with substantial industry experience and with alignment of interest with shareholders.   

Valuation

As discussed at the very beginning, it is difficult to value this business due to the highly uncertain nature of the key variables – particularly tanker spot rates – which drive value. In addition, a number of additional assumptions need to be made such as fleet utilization (e.g. number of days in a year a tanker will operate), bunker fuel rates and operating costs. The difficulty of predicting revenues can be gauged by the fact that tanker spot rates spiked to over $100k towards end of 2015 and early 2016, before coming down to ~$60k a day towards latter part of Q1 2016.

For my base case valuation, I have made the following assumptions:

·         long-run 10 year industry average tanker rates for VLCC’s of $41.2k (which below recent spot rate trend), keeping Suezmaz, Aframax, and Panamax rates constant at of $37k, $27.5k, $22.5k respectively;

·         assuming all vessels, including new builds are delivered and deployed at spot rates (consistent with current trend); and

·         operating expenses based on Q1 2016 cost structure with a 1.5% growth in expenses annually (consistent with recent trends).

Based on the above assumptions, I get projected EBITDA for base case and optimistic case of $400m and $425m respective on the fully stabilised Fleet by end of FY17 / beginning of FY18. Assuming the company continues to trade at its current EV/EBITDA multiple of just over 6 (peers currently trade at ~7x), I get a forecast EV of $2.4bln - $2.6bln. My forecast net debt is just over $1.5bln ($1.7bln of total borrowings including additional borrowings on remaining instalments for new builds, and $200m of cash), giving an equity value of between $900m - $1bln, or per share value of $11 - $13 based on 83.68m of shares outstanding. At the current share price of $7.05, this equates to a return of 56% - 82%. 

If one assumes a multiple of 7x, the value per share goes up to ~$15 - ~$17.5 a share for a return of between 118% - 150%; I believe this to be too optimistic but not unlikely.

My forecast EPS on a fully stabilised fleet comes to $2.8 - $3 per share, equating to a forward P/E of just over 2. I expect the company to payout most of its earnings as dividends or for share buyback.

In addition, a good margin of safety is provided by the following factors –

·         book value per share of $17 (current share price equates to 60% discount to book) for modern fleet with an average age of 5 years; and,

·         based on conservative assumptions, I get a total value for the fleet of $2.47bln, equating to a net of debt value of $940m, or $11.4 per share.  

Other factors worth noting

·         The company’s new VLCC’s (21 of the 28 VLCC fleet) deliver substantial fuel savings compared to older/existing fleet. The savings per vessel per day could average $6,300, assuming a bunker fuel price of $350 per ton, and provide the company with a competitive edge compared to peers. In addition, large oil major customers are likely to favour quality vessels/safety which should give the company edge given global fleet age and mix.

·         Majority of tanker owners also own other offshore assets and dry bulk carriers and are currently experiencing difficult conditions in their other businesses due to the fall in oil price and distress in offshore assets. Therefore, they are unlikely place significant new orders or have the ability to find the financing to do so. Gener8 has no such issues as it has no other exposure, and financing for its new build is fully secured from existing facility.

·         Finally, the company has said that it may sell down some of its older Panamax and Aframax fleet if a suitable offer/price is available. Currently, the company sees no need to do so give the arbitrage between high tanker rates and relatively lower asset values. But any sell down could be a net positive for the net debt position with relatively low impact to earnings. Approximately $1.5 of my $11 per share value for my base case is backed by the Panamax and Aframax fleet. Majority of the upside comes from the VLCC fleet, followed by Suezmax.  

Restaurant Group PLC

What happens when a stock priced for growth stops growing? It tanks. And what happens when a stock priced for growth reverses trend and starts recording fall in revenues? It gets pummeled. Take a look at Restaurant Group Plc (RTN:LSE), the UK based restaurant operator with over 500 establishments and with principal trading brands including Frankie & Benny's, Chiquito and Coast to Coast. Its stock has lost over 51% of its value since the high of £7.24 in November 2015, wiping out £747m from its market cap in the process. It currently trades at £3.52, this after having fallen to £2.72 recently. The recent uptick is mostly on the back of rumors that a private-equity backed takeover may be coming.

I want to take a look at whether this fall offers a value opportunity. Has the market overreacted? Could the fall in sales simply be a hiccup, with no structural or fundamental reasons, offering a great opportunity to buy and wait for mean reversion? Let’s investigate.

First some key facts on the company. In the below table I look at cheapness (EV/EBIT) & quality (ROIC). I have also shown these ratios for before the fall in the stock (i.e., Nov15). 

As can be seen from the table above, the company’s EV/EBIT ratio has fallen from a high of 17.24x in Nov15 to 10.55x today. If one back’s out market’s implied growth & ROIC estimate for this fall, assuming a cost of capital of 8% and a tax rate of 15%, then this implies that the market has wiped out all or most of its growth & ROIC expectation from the stock. For example, the 17.24x multiple would imply that the market had priced the stock for a ~5% growth with a ~13.25% ROIC; and at 10.55x multiple, growth would be almost non-existent, with a fall in ROIC to ~10%. Note that my assumption of 8% cost of capital and 15% tax rate is based on my calculation of the company’s WACC and effective tax rate, and for completeness, I calculate my implied growth & ROIC percentages using the following formula for the multiple.

From ~5% implied growth and 13.25% ROIC to ~0% growth and >300bps fall in ROIC, has the market overreacted? Does one trading update from a company signalling poor trading conditions and a potential 2.5% to 5% fall in like for like sales merit such a pummeling?

This company has grown sales at a CAGR of over 7% over the last 5 years (FY11 – FY15); is extremely cash generative with a free cash flow from operations yielding ~9%; and it has a dividend yield of ~5%. Surely it is a buy, and it is only a question of waiting for mean reversion to take its natural course and revenue growth will come back, giving a handsome return for the value buyer? Not so fast. 

I dug up the last 5 year financials to piece together the pattern in sales growth, knowing that the company’s 7% CAGR growth in revenue has come from both like-for-like sales growth, and from new store openings. Take a look at the table below.

As the table above shows, LFL revenue growth has been falling, and was at its lowest level over the last 5 years in FY15, just a 1.5% LFL revenue growth. In particular, over the last 3 years, majority of the growth in sales have been coming from new restaurant openings, with 81% of the growth in sales for FY15 coming from new openings. This is at the heart of the challenges facing the company. Growing revenues by opening new restaurants is fine as long as your ROIC is greater than your cost of capital (which seems to be the case for the company at present, and as long as it stays that way, it should go on opening new restaurants); but LFL revenue growth is the better indicator of the company’s long term health. If LFL sales are faltering, then it is only a matter of time before it starts biting into new openings and on ROIC. So what’s the story here? The answer in one word – competition.

Michael Porter in his classic 1980 book - Competitive Strategy - described that the intensity of competition in an industry is determined by five forces: threat of new entry, pressure from substitute products, bargaining power of buyers, bargaining power of suppliers, and the degree of rivalry among existing competitors. As this recent FT article nicely sums up, UK restaurants are having to fight multiple battles at the same time:
with new entrants in the traditional eating out space (rivalry among existing & new competitors is intense); new rivals offering the online/delivery options are thriving and gaining ground (substitute products); more people are choosing the option of ordering at home more often and even when they eat out they have plenty more options to choose from (bargaining power of buyers); all of this makes the cost of leasing out space in the best locations more expensive (bargaining power of suppliers). Data from Euromonitor show that growth in home delivery and takeaway food has outpaced that of restaurants each year since the financial crisis. Between 2009 and 2014, the UK market for take away and delivery expanded 2.7 per cent to £6.5bn, while the value of food bought in restaurants fell 5 per cent to £17.1bn. Restaurant Group is heavily exposed to this trend as it does not deliver, and hardly has an online presence which could compete with rivals. In addition to the intense competition, the increase in national minimum wages from this year is going to eat into margins further (for Restaurant Group this will add at least £2m to its cost base this year). 

If an entire sector is in distress, then distressed companies within that sector could be good bets – as the sector recovers, those companies could bring great returns. But if a sector is thriving overall – overall revenues for the consumer/retail food sector is growing and people are spending more on food – and there are pockets of distress due to rapid changes in the industry, then it calls for caution when inspecting distressed stocks in that sector. There could well be a valid reason for the distress.

Given the intensity of competition in the sector, and the difficult / uncertain trading conditions faced by Restaurant Group, the approach to determining its intrinsic value needs to take account of the many possible outcomes. I have used a scenario based approach, with intrinsic value being the expected payoff taking account of the various outcomes. I have analysed intrinsic value under 5 scenarios which combine various assumptions for revenue growth  & decline and for development capex (determined by the number of new openings or closures). My analysis concludes that the intrinsic value per share for Restaurant Group Plc is in the range of £3.5 - £4. Given the current share price of £3.52, I don't believe that the stock offers adequate margin of safety for a value investor.

You can see a table with my summary of probability weighted intrinsic value, including detailed DCF calculations for each scenario, in the tables at the end the end of this write-up. My sources and reference material have mostly been the company’s last 5 years financial statements (FY11 – FY15).

Finally, my thoughts on the recent news of a private equity takeover of the group. Any takeover of a public company would have to be at a premium of at least 20% - 30% to current the share price, giving a target price of at least £4.23 to £4.58 a share based on closing share price of £3.52 on 20 May 2016. Given that a private equity buyer will have a return (IRR) expectation of at least in the mid-teens, I find it difficult to see that level of return for at current price. I am not ruling a bid out, or the fact that a buyer with an edge and detailed knowledge of the portfolio on a restaurant by restaurant basis may well know how to generate that return. But any buyer will need to get their hands very dirty with the operational aspects and I suspect will also need to place a lot of faith in growth reverting.

This stock could yet be a value buy. There could well be a sell-off - e.g. if market's recent expectations of a private equity buyout in the near future does not materialize. Secondly, it is worth watching closely the outcome of the strategic review being carried out by the management, the results of which are to be announced in August. This situation merits monitoring on an ongoing basis. 

Probability weighted intrinsic value per share under various scenarios

DCF valuation for Scenario 1 - LFL sales continues to be a struggle; development capex continues, but at a lower rate, with restaurant numbers growing. 

DCF valuation for Scenario 2 - LFL sales continues to be a struggle; development capex is discontinued from FY17, with restaurant numbers falling.

DCF valuation for Scenario 3 - LFL sales fall is arrested & mean reverts; development capex continues, but at a lower rate, with restaurant numbers growing. 

DCF valuation for Scenario 4 - LFL sales fall is arrested & mean reverts; development capex is discontinued from FY17, with restaurant numbers falling.

What’s ailing Utilitywise Plc?

The shares in Utilitywise Plc (UTW:LSE), a company that helps small businesses find the cheapest energy and water supply contracts and takes a cut from suppliers, have fallen 30% over the last year. Its shares currently trade at a low P/E of 9.4 and EV/EBITA of 8.3. For a company that is growing revenue at 36%, with healthy gross and EBITA margins of 40% and 20% respectively, the stock looks cheap. Quality, which I measure as Return on Invested Capital (ROIC), is not bad at all at 26%. The market it caters to is huge and largely untapped – there are over 4.5m small businesses in the UK and many more in Europe where the company has just started operations. My Discounted Cash Flow valuation for various scenarios comes up with an intrinsic value per share of £2.6 - £2.8, implying a potential 60% to 75% upside on the current price of £1.60 per share.

So why this sell-off? Shouldn’t this stock be a screaming buy?

Two major concerns merit market’s skepticism. The first is to do with revenue recognition and risk of future write-downs, and the second is a lack of moat and increasing competition which seems to be eating into margins and putting the sustainability of growth and returns at risk.

Revenue recognition

Utilitywise earns a significant chunk of its income as commission from energy suppliers; a fair amount of this commission is paid over the life of the contract (typically 5 years) that the end consumer signs with the energy supplier. The commission paid by energy supplier is based on actual energy consumed by the end consumer over the life of the contract. However, the group recognises revenue on the entire contract at the point when the contract goes live; using a fair value method, the group applies a 15% variance discount (for variance in projected consumption) & present values the projected cash flows using a 3% discount rate. There are obvious risks associated with such an approach – a) the end consumers are small businesses and the risk of a default will be high; the 3% discount rate that the company uses is based on the credit rating of the energy suppliers not the small businesses, and b) it cannot be easy to project energy consumption over the life of long contract period with any degree of certainty; any variance in consumption could have a material impact on prior year revenue already booked.

This approach means:

1. A significant chunk of the revenue is sat as trade receivables and accrued revenue on balance sheet and takes a fair amount of time before converting to cash; and,

2. There is constant downward pressure on this prior year revenue both due to variance in projected versus actual consumption and due to risk of default by the end consumer.

The group has already taken significant write-downs against its FY14 and FY13 receivables and accrued income claiming that its initially projected consumption variance was lower than actual. To put this into context, the group in its FY15 accounts wrote off a total of £6.35m of accrued revenue and trade receivables booked in FY14 and FY13 (net of tax). Adjusting the group’s operating profit in FY14 and FY13 for these write-downs would result in operating profit after tax falling by 42% for FY14 and by 52% for FY13. This is significant and throws into question any DCF valuation based on group’s revenue numbers in the accounts (out of the window goes my intrinsic value estimate of £2.6 to £2.8 per share when such uncertainty exists in revenue recognition). Furthermore, the FY15 financial statements say that no adjustments have been made for years prior to FY13, not because none exist, but because it would be difficult to estimate due to lack of information.

Competition, moat, and falling profitability

When a sector offers juicy margins, a large & untapped market, and low barriers to entry (Third party intermediaries are currently unregulated), one can bet top dollar that competition will come. This is evident in the company’s results - operating margins have fallen from a peak of 31% in FY11 to 20% now, and arresting the fall will be difficult. The company also seems to be facing significant difficulty in retaining sales staff – the high staff attrition rates are a clear sign of high competition  in the sector. The company looks to be trying to counter competition by diversifying (it has made some technology acquisitions – i.e., enabling energy consumption tracking, providing energy consulting services etc.) and expanding into new markets (it has recently commenced operations in Europe). It has also recently put new management team in place to counter the challenges. But given the low barriers to entry, it is difficult to see how the current high margins and ROIC can be sustained.

In conclusion

If one were investing simply based on attributes – cheapness (low P/E & low EV/EBITA) & quality (high ROIC) – Utilitywise Plc would be a buy. But as Michael Mauboussin has repeatedly said in his writings circumstances trump attributes when it comes to investing success. To paraphrase a quote of Michael’s – “Sometimes our nostrums work, but more often they fail us. The reason usually boils down to the simple reality that the theories guiding our decisions are based on attributes, not circumstances.”

I highly recommend buying Michael Mauboussin’s two books - More Than You Know and Think Twice; both are great investment in time for a value investor, but I would pass on Utilistywise Plc’s stock for the time being. 

Using multiples – why? which ones? & what does it mean?

Why use multiples?

There is no doubt that discounted cash flow technique is the fundamental valuation measure. But multiples are a useful tool in an investor’s tool kit. They help you:

-          cross check your DCF forecast by comparing it to market’s forecast (e.g. by backing out implicit growth rate forecast by the market based on the multiple at which the company currently trades);

-          compare between peers – multiples are a great way to compare peers and get a feel which companies the market believes have better prospects & which ones the market things are likely to suffer); and,

-          are a great way to search for bargains. I use multiples as a useful starting point for bargain hunting. However, it is very important to recognise that a high multiple does not necessarily mean overvalued stock; and a low multiple does not mean there is a definite bargain to be had. There can be real economic reasons for why a stock trades at a low or a high multiple, and searching for those reasons are what lead to investment decisions.

Which ones?

There are three widely used multiples for investors:

-          Price to Earnings (P/E)

-          Enterprise Value / Earnings before interest, tax, depreciation and amortisation (EV / EBITDA)

-          Enterprise Value / Earnings before interest and tax (EV / EBIT)

P/E is a widely used measure in stock valuation and there are many research reports supporting low P/E as a good measure of value. On average, low P/E stocks have returned more in the long term than high P/E stocks. However, I don’t like to make buy decisions simply based on low P/E; I only use low P/E as a good starting point for further investigating a stock. P/E has its drawbacks, the main ones being:

-          Firstly, P/E is distorted by GAAP & non-operating items such as one off gains & losses, write-offs, amortisations etc. This can cause significant distortions and be difficult to wrap your head around if you want to make the adjustments to get to a comparable P/E;

-          Secondly, P/E distorts the picture by mixing the capital structure with the operating performance. For example, two similar business will show very different P/E ratios if one is highly geared and the other has nil or negligible debt. It’s better to use a multiple which is a good gauge of operating performance and is not distorted by the capital structure.

In spite of P/E’s drawbacks, I would suggest using it in screening for value stocks, but don’t buy simply based on low P/Es as it is likely that low P/E is for a reason, and that reason could be a blow up coming soon.

EV/EBITDA is a widely used multiple by practitioners. In my experience this multiple is used commonly in the private equity and M&A world – for example, it is common to see new releases by buying & selling companies where they talk about the EV/EBITA multiple at which a business is being bought or sold.  It is also common to see a sector or industry EV/EBITDA multiple. However, a major drawback of this measure is that it ignores depreciation – which is the accounting equivalent of capex required in the future to sustain the business. If a true measure of value is the free cash flow, it is dangerous to ignore depreciation as it will come out of cash flows at some point. Followers of Buffett will note that he hates this measure for the same reason. However, this can still be a useful measure in industries with very little maintenance capex requirements (e.g. some new technology or social media companies).

EV/EBIT solves for the depreciation issue inherent in EV/EBITDA by accounting for accounting depreciation. However, EV/EBIT too has its drawbacks:

-          Firstly, EBIT accounts for amortisation expense which tends to be a accounting only measure – e.g. if a company has made acquisitions at a premium and recognised intangibles to account for the premium, it would amortise the intangible. This will distort its multiple compared to a similar business which has grown organically (organically generated intangibles don’t need to be recognised or amortised for accounting purposes).

-          Secondly, two companies may have very different depreciation based on the market value they paid for their assets being depreciated.

-          Thirdly, there may be a big difference between accounting depreciation and the actual cash required for maintenance capex.

In summary, the best multiple to use depends on the specific circumstances of the company being investigated. I would personally start off with EBIT and make necessary adjustments as follows:

-          Compare accounting depreciation to real cash required for maintenance capex and use the latter if it significantly differs to the accounting depreciation – i.e., EBIT + accounting depreciation – maintenance capex. The cash flow statement is usually a good place to check for capex; try to estimate the average capex to sales ratio over the years and use this to predict capex needs based on your forecast sales.

-          Secondly, I would also add back amortisation expense to EBIT for my multiple measure.

The Mckinsey book on Valuation has a very good chapter on how to use multiples to triangulate results. It recommends using a EV/EBITA measure which his similar to the above.

What does it mean?

It is important to never forget the fact that the value of an asset is equal to the present value of its future cash flows. A multiple based valuation measure is only of use if it links in with the fundamental valuation measure based on cash flows. In order to make sense of multiples, I love the explanation in the Mckinsey book on valuation and I have had good success in being able to use this method in practice to make sense of multiples between peers which is rare for most theoretical measures.

If you accept that free cash flow is the fundamental driver of value, then value can be expressed by the following formula:

NOPLAT is basically your estimate of free cash flow (e.g. EBITA). Using your estimated EBITA, the fundamental value driver formula translates to:

Note that T is the effective tax rate, which most companies will report. The (g/ROIC) determines the amount the company needs to keep re-investing in order to grow at the projected rate. ROIC can be estimated based on growth in sales over growth in capital employed, alternatively you could simply use the return on capital employed achieved by the business; as for growth rate, this should be the same as the forecast you have used for your DCF. WACC too should be your estimate for the cost of capital – cost of debt is easy to calculate, whereas cost of equity will depend on your assumption for the premium you demand as an investor.Now the next step takes you to the key formula which relates the multiple to the free cash flow formula. Simply divide both sides by EBITA:

The above is what a multiple tells you about value. In particular, the multiple is a function of the following variables – tax rate, growth rate, Return on Invested Capital achieved by the business, and its cost of capital. Always remember this when using multiples.

Variables	Impact on multiple
Tax rate	Higher (lower) the tax rate, lower (higher) the multiple
Growth rate	Higher (lower) the growth rate, higher (lower) the multiple
ROIC	Higher (lower) the ROIC, higher (lower) the multiple. However, is very important to note that if ROIC is < WACC then higher growth actually wipes out value. ROIC always must be greater than WACC for growth to add value
WACC	Higher (lower) the WACC, lower (higher) the multiple

As you will know, the above variables are key in calculating a DCF value. And by knowing how they link in with a multiple based value, it is possible to test your DCF assumptions with what the market is saying, and also a useful measure of comparing between peers.

Other important points to bear in mind when using multiples

Enterprise Value

When using Enterprise Value based multiples, it is important to calculate the Enterprise Value correctly. Note that Enterprise Value is the price a buyer of the company will need to pay when taking over the whole thing. Therefore, it not only includes the value of equity (market capitalisation), but also the debt, minority interest, preferred shares, pensions liabilities, and any other fixed obligations (e.g. capitalised leases), and from this you will need to deduct cash & cash equivalents and the value of any non-operating assets (e.g. investments not used in the operations) held by the company. Although most online tools give you a number for the Enterprise Value, I would highly recommend that you work through the company’s balance sheet and detailed notes in arriving at this number. There can be a lot of useful details on fixed obligations hidden in the notes which some of the freely available tools ignore. Broadly, use the following as a guide to calculate Enterprise Value:

Enterprise Value = Market Cap + Debt (both short-term & long term) + minority interest + preferred shares + lease obligations + any pensions deficit + other fixed obligations (e.g. litigation expenditures) – cash & cash equivalents – non-operating assets or other long-term investments

Using the right measure

When using multiples for valuation ensure that you are using the denominator consistently across comparables – e.g. if you are using EBIT and adjusting it for amortisation and maintenance capex, ensure you do the same across comparables.

Using the right peers

If using multiples as a relative value measure, it is important to use the right peers (i.e., companies within the same sector and with similar operational characteristics).

In conclusion - If you use multiples correctly, you will be able to see the differences between peers, reasons for them, and be able to compare your assumptions with those of the market. It is a great way to identify mispricing and form a thesis. The other opportunity is where you have a conglomerate with discrete businesses where you can compare the component parts with listed peers and identify value add if/where that component part is being spun-off by the conglomerate. 

Metro AG’s proposed demerger should unlock significant value

·         Metro AG, the large German conglomerate, last week announced its intention to demerge its wholesale foods division (Metro) and its consumer electronics division (Media Saturn); the demerger is scheduled to complete by mid-2017.

·         The demerger makes perfect operational sense – both divisions have very little overlaps and hardly any synergies; a demerger should bring more focus and better execution in a highly competitive sector.

·         The demerger also makes sense for the shareholders – the current conglomerate is a hotchpotch of businesses trading at a discount to peers. The demerger, by creating two distinct pure-play sector leaders, should unlock significant value by removing the conglomerate discount inherent in price.

·         In my opinion the demerger should unlock significant value for the shareholders generating between 50% - 60% return in the next 12-15 months with little downside.

After significant fall in sales between 2012 and 2014, the group has managed to arrest the decline, with like-for-like sales recording a 1.5% growth in FY14/15. Media Saturn, is growing at just over 3%, with the whole sale foods division (Metro) growing at a negligible 0.1%. EBITDA margins have been consistent at around 4% for Metro and 3% for Media Saturn. Management have been upbeat and have shown confidence that the sales decline has been arrested and the positive trend in like-for-like sales should continue.

Consensus forecasts from the 35 analysts covering Metro indicate a conservative forecast with median FY16/17 sales for Metro showing negligible change and Metro Saturn sales showing a 3% growth. The conservative forecast is understandable given the shock analysts would have received when sales fell by 30% in 2013, and as is usual, it will likely take a while before they start correcting for the like-for-like trend. For my valuation purposes, I have used the conservative forecasts. 

Structure post demerger

The demerger is to be implemented by way of a spin-off of Metro, the whole sale food division, from Metro AG. Post the demerger, Metro AG will be left with the consumer electronics division, Media Saturn.

 Source: Metro AG

The demerger should create two distinct pure-play sector leaders – with Metro and Media Saturn. 

Below are select wholesale & foodservice sector players by sales. 

Below are select consumer electronics sector players by sales.

Source: Metro AG

Not only will Metro and Media Saturn offer pure-play in their respective sectors, they will also be sector leaders becoming the second largest players globally in whole sale foodservices and consumer electronics sector.

Valuation

Metro AG currently trades at just under 6 time enterprise value (EV) to earnings before interest, tax, depreciation and amortisation (EBITDA).

Metro trades a multiple which is significantly below its peers. A look at the multiples for the sector peers shows that the whole sale food services peers trade at a EV/EBITDA multiple of~12 and consumer electronics peers trade at a EV/EBITDA multiple of ~8.

A crude valuation for Metro which assumes that the demerged businesses will trade at EV/EBITDA multiple comparable to peers would should a share price for the combined divisions of €73, generating a 174% (2.74x) between now and post the demerger. See below.  

However, such a crude valuation would completely miss the point. Multiples cannot be compared in isolation of individual business fundamentals and key variables such as growth rate, return on invested capital (ROCE), cost of capital, and tax rate need to be factored in. Peers are a good starting point, but there are valid reasons why peers don’t always trade at the same multiples. Take the example of Sysco, the largest player in the wholesale foods services sector. It trades at EV/EBITDA multiple of over 12, and its business is fairly similar to Metro. But there are valid reasons why Metro shouldn’t trade at the same multiple as Sysco – Sysco has a higher growth rate, higher ROCE, and lower cost of capital compared to Metro. If enterprise value is a function of free cash flow discounted at cost of capital, then multiple should be consistent with this. In short, multiple should be a function of the following formula:

Using the above, we can see the difference between Sysco’s multiple and Metro’s multiple.

Using this methodology, I have calculate a multiple for Metro AG’s wholesale food services division of ~7.9 and for the consumer electronics division of ~8.1.

It is worth noting that the multiple for Media Saturn is similar to Darty, a peer with very similar characteristics as Media Saturn (i.e., both trade in similar markets and have a similar profile).

Using the above derived multiples to value the separate divisions gives a value per share of €43.2, a return of 62% based on current share price. 

Below, I have modeled share price and returns sensitivity to multiples.

As can be seen, there is very little downside, and significant upside. Metro AG already trades at a very low multiple, and with the improving trend in sales and the proposed demerger, upside is more likely than downside.

Risks

As with every thesis, there are risks involved. I have briefly discussed the key risks below.

Governance - Erich Kellerhals, the founder of Media Saturn who still owns 22 per cent of Media-Saturn, has had several run-ins with Metro in recent years. The main reason for the demerger to be structured by way of a spin-off of the wholesale foodservices business is to isolate that business from the legacy structure with Media Saturn in it. However, there is a risk that the Media Saturn business may continue to face problems with Erich Kellerhals. This was raised in Metro’s call with analysts last week when the demerger was announced. Metro’s management strongly believe that the new structure will not give rise to any governance issues (apparently Erich Kellerhals’ stake will be restricted to the subsidiary of Metro AG, and Metro AG will have full flexibility in running the Media Saturn business – e.g. make new acquisition, expansion etc. – without any hindrance. Management went on to state that in spite of media reports re issues with Eirch Kellarhals, the Media Saturn business has performed very well in recent years and management have full flexibility to run the operations. It is worth noting that a spokesman for Mr Kellerhals’ investment vehicle, Convergenta Invest, has said they did not see any issues with the proposed demerger. Even assuming that the market discounts 10% of value for this governance risk, I get a share price of €38.9 or a 46% return.

Tax, legal, commercial, and execution risks – Management have confirmed that they have undertaken detailed preliminary analysis of the key risks and no red flags or showstoppers were identified. In particular, indications are that the demerger should not be a taxable transaction.

Assignment of assets and liabilities between the divisions – Management have not yet made it clear as to how the assets and liabilities will be split between the two divisions. In particular the split of debt. This will be made clear as they work out the details – most likely in Q2 earnings call. That said, my valuation estimates should not materially be impacted by the chosen split.

Conclusion

Metro AG’s proposed demerger of the two divisions which have limited synergies is a great move and should be able to achieve management’s stated objective of creating two distinct pure-play sector leaders in the wholesale foodservices sector and consumer electronics sector. The move should also reward shareholders by unwinding the conglomerate discount.