China Update: Equity market crash is just a tip of the iceberg

Summary: In recent months, the equity market crash in China has become a hot topic, but there are more serious problems and trends in the underlining economy that merit a closer look. In the near term, the declining interest rate difference, depreciation of the currency, and legacy overcapacity have started to squeeze the carry trades that provided a substantial part of the local monetary base. This will lead to a death spiral of shrinking money supply despite the central bank’s easing. But the fundamental problem that caused the recent turmoil is a shockingly low return on investments in China. In the long run, the inevitable rebalancing that the market is looking for is essentially a resetting of the rate. This will have a significant impact on the global market and the prices of exports from China.

Death spiral in action

In my previous Macro Comment in May 2015, I mentioned that there exists a large group of carry traders who borrow in U.S. dollars and invest in the wealth management products in China (implicitly guaranteed by the government). This has become a substantial part of the domestic money supply. At that time, the worry was that an easy monetary policy in China and a potential rate hike in the United States would squeeze this group of investors and create a death spiral. Looks like the process is now under way. The rate difference between USD and CNY continued to decline to around 2.5% from 4% in early 2015. Trade data discrepancies reported by China and Hong Kong have narrowed sharply, indicating that less money flew into China using fake trades. A one-time 3% depreciation in the CNY was a shock to the assumption of a stable currency, making it become harder to refinance, as more and more bad projects were exposed. All of these factors were pushing the carry traders to wind down their investments, which put additional pressure on the currency. As China prepares for more easing and the United States is getting closer to a rate hike, investors can expect the death spiral to reinforce itself and create more headlines from China.

Long-term implications from rebalancing

Although the recent short-term volatility in China may have had a negative impact on the global market, it is the shockingly low return on investments across all asset classes in China and their inevitable rebalancing that will have a larger long-term impact.

• Shockingly low returns across all asset classes

Analyzing China always seems to be difficult because of the data problems and government policies. But if you think of China as a “company” and its exports as products, then China will be much easier to understand. Since 2000, this “company” had been very successful because of its low cost advantage and high return on investment. Shareholders were attracted and put in more money. But as the “company” grew, it invested all its profits in new capacities and this resulted in a massive oversupply. In the meantime, cost had become a problem. Housing prices, labor costs, and an inefficient public sector were the biggest contributors to the cost increases.

The result was a disastrous return on investment of close to zero, if not negative. Housing prices have tripled since 2009, and the annual rental yield has declined to below 2%. Massive investments in infrastructure, partially supported by the carry trades, were made without profits or even cash flows in sight. Exporters, squeezed by the rising currency, labor costs, and hidden taxes, are now on life support from government subsidies and one-time asset transection gains. Part of the reason for money to leave China is that it is really hard to find investments with reasonable returns.

• Rebalancing is simple in theory but hard to execute

Just like the restructuring of a company in a similar situation, the solution is actually simple. The resetting of the return will involve cutting the capacities and costs and eventually raising the prices. But the execution is hard, especially in China. The labor cost is constantly rising because of the one-child policy, and this will be difficult to change, even in the long run. This leaves the burden of cutting on two entities: government and housing. Both are hard to cut and doing so will result in a direct hit to the banking system. Finally, there is another ugly way to reset the return, which is the depreciation of the currency to bring the prices back into line with the costs. The whole rebalancing seems to be an impossible mission, but it is inevitable as the current system cannot be sustained. And the recent market turmoil suggests that the tipping point is coming closer.

• Implications to the global economy and market

Although predictions of timing and paths involve many uncertainties, several things are very likely to happen. During the process, we should see a spike in the global markets’ volatility, especially in Asia. The commodity market should continue to be under enormous pressure because of China’s shift from unprofitable infrastructure investments. Then, if we imagine the world after this process when the return on investment is normalized, the export prices from China should increase due to shrinking capacities.

Conclusion

In the short term, the potential policies in China and the United States will reinforce the death spiral of tighter money supply and put pressure on asset prices in China. In the long term, however, the inevitable rebalancing process will result in higher market volatility, lower commodity prices, and eventually higher export prices from China.

Finally, for those investors who are interested in the Chinese A-share equity market, Figure 5 shows the one-year index performance. In my opinion, this is completely out of sync with the underlining economy because 1) a dot-com–like valuation and 2) the existence of controlling shareholders and very limited restrictions on them that has resulted in different agendas and a wild market.

China Rate Cut: Unintended Consequence

Summary
China announced interest rate cut of 25 bases points during the weekend after recent disappointing macro-economic data. There is hope that the easy monetary policy can help China reverse the slowdown.  However, the rate cut may have unintended consequences. Since 2008, there has been a pattern of US dollar flowing into China through carry trade. This source represented an important part of the liquidity to the local market. But the whole carry trade is based on an unsustainable system. Further rate cuts in China and possible hikes in US later this year will risk pushing carry traders to disorderly wind down their positions.

Carry trade is an important part of liquidity in China
Since the financial crisis in 2008, China has increased its foreign exchange reserve by around USD2.5tn, among which trade surplus contributed USD1.8tn. There has been a lot of comments about the fake trade which helped investors move money into China. No one knows the exact number of the carry trade and some analysis even suggested that it may be over USD1tn. But at least two indicators can help put some light on this issue. Since 2010, accumulated difference between reported China export to HK and HK import from China has amounted to over USD400bn. Another indicator is Hong Kong banks’ total international claims which also increased by around USD300bn. Mainland companies can use off shore entities and complicated structures to bring trade finance into China. Although there is some double count here, the total amount can be easily above USD500bn and it has not counted any other source of money flow.

An unsustainable triangle
For the carry trade, when US dollar moved into China, the real dollar became currency reserve for central bank while RMB was issued for investors to buy wealth management products. Most of the money ultimately went into property and infrastructure projects. As long as there is liquidity, the products can always be refinanced:
Figure 3: Carry trade system

Source: Estimation

However, the system was based on three basic assumptions: interest rate difference, stable currency and return on (of) the projects. While the system has been running for five years, it becomes partly self-fulfilling. Wave after wave of incoming money, supplied by US central bank, guaranteed a rising currency and easy refinance of even the worst projects.

Interest rate difference: The rate to borrow the US dollar in Hong Kong was around 2.5% for companies in China and they can easily reinvest the money into wealth management products that yield 6% and the products were implicitly guaranteed by government. The rate difference has been constantly around 3% or higher which created a perfect environment for the carry trade.

Stable currency: Besides the self-fulfilling effect from more money coming in, investors also have some kind of belief that Chinese government will let the currency gradually rise in the foreseeable future. Because since 2005, the trend of ever rising currency has been the case. A lot of carry trade investors did not even bother to hedge the currency and enjoyed extra gains from the currency move.

Return or refinance of the projects: Nowadays, it was rare for a wealth management product to return cash when it is due because of the project had made money and cash flow. Almost all of the products were refinanced by another one. A lot of the money ultimately went into the property and infrastructure projects that may never make money. But the investors believed that they will not be the last one to hold the products or government will save them from any problems.

Rate cut and death spiral
The whole carry trade system was very attractive to investors because it did not require a lot of initial capital. It was like making money out of thin air. But it is completely wrong to think that the system can be sustainable. The Chinese rate cut and possible US rate hike may put enormous pressure on investors. The intention to ease the monetary policy is good but the combination of policies may quickly kill the carry trade investors. When everybody runs to cover the trade, currency will be under pressure, the bad projects will run out of money and the selling of assets by central bank will further squeeze the interest rate difference and currency.
Figure 4: Interest rate difference between 2 year Chinese government bond and US treasury
Source: Yahoo finance

Conclusion
The only thing that can prevent the breakdown is central bank’s USD3.8tn reserve and market believes that the worst consequence can be avoided. That may be the case but the whole system is still not sustainable in the long term. It is amazing how easy money and ‘implicitly-guaranteed-by-government’ assets can distort the market and lead people to invest in low return projects and ever rising properties. But the reverse of the process will be very painful. If central banks in China and US resume their course, we may see the crisis sooner than we thought.

IBM: Hidden value in underutilized industry knowledge

Summary
IBM has been in trouble for some time with declining revenue and market share. Comparing to ever more innovative products from cloud computing and mobile companies, IBM’s mainframe and traditional software never seem so obsolete. However, the belief that IBM is a technology company is fundamentally misplaced. Almost all of its profits are somehow related to consulting services. The main drive behind its profit, the deep knowledge of different industries, has not changed. Although IBM is late to the cloud and mobile, that is always the case for past several generations of technology. It is amazing for this company to constantly earn +$10bn when they do not get the technology right. Currently, you can buy this stock with 11x PE on the do-not-get-it profit. With the help of recent transformation to better integrate cloud computing, the true value and earnings power of its deep industry knowledge will be gradually reflected in the market price.

A consulting rather than technology company
In the Enterprise IT space, there are many ways to make money but most can be categorized into three segments. The first two are providers of hardware or software as a function. The third is a consulting firm that helps customers integrate and create business value. The general perception is that IBM makes money from technology products. However, a detailed look will reveal that IBM is more like a consulting company rather than a technology provider. Considering that part of IBM’s software sales were also a result of the consulting projects, a big part of IBM’s profit depended on consulting and integration.

Figure 1: Industry breakdown

Source: Company data

IBM makes money from its industry knowledge
The business model change in IBM can be traced back into 1990s’. The strategy to create value as an integrator rather than a provider was set during the time of Louis Gerstner. In his book, he mentioned:

“Sure, there are supply chains, and there are enterprises at various points in the chain that offer only one piece of a finished product: steelmakers in the auto industry; component makers in consumer electronics; or providers of a marketing or tax application in financial services. But before the components reach the consumer, somebody has to sit at the end of the line and bring it all together in a way that creates value. In effect, he or she takes responsibility for translating the pieces into value. I believed that if IBM was uniquely positioned to do or to be anything, it was to be that company.”

Unlike software or hardware companies who just provide functions to the customers, IBM developed most of its solution with the biggest companies in the world. During this process, it accumulated the knowledge of how the actual business works. This knowledge does not show up in any financial statements, but it is the real building block for the whole company. I would argue that customers pick IBM not because the products are better, but because IBM knows how business works with technology. Among system integrators, IBM has the biggest market share covering almost all industries.

Why IBM is not growing
The main reason that IBM makes money in the past is because it knows how to integrate, not only its own products but also others’. The rapid growth in the cloud computing market is definitely a shock to IBM’s traditional business model. The small and medium size companies now purchase individual software functions like CRM or HR from cloud computing providers at a very low cost, creating a boom in the market where IBM is not presented yet.

Figure 4: Business model difference

Source: Company data

IBM was never supposed to directly compete with those software providers. But as an integrator, IBM was not able to leverage its vast industry knowledge base to create integration solutions for smaller companies. There are several factors that contributed to this: 1) IBM’s mind set of creating complete solution to big customers. Its old business model was not able to incorporate the new cloud computing platform; 2) IBM’s organization that was slow to adopt new technology. This is not the first time when new technology forced IBM to change; 3) Smaller customers that are more focused on gaining access to IT infrastructure that they cannot afford previously rather than building a strategy around IT.

Market misconception about IBM
Despite lagging in the cloud computing, IBM’s most important competitive advantage, the deep knowledge of industry, has not been weakened. It enjoyed margin expansion as an integrator because of a lower input cost (software and hardware). While market thinks that IBM is only for big customers, the industry knowledge can be applied to smaller companies. But acquisitions are not the way for IBM to figure out how to serve smaller customers. The buyback was actually a better reinvestment at current stage.

• Declined price in software/hardware lowered IBM’s cost

If you think of IBM as an integrator, the current cloud computing products become part of its input. The rapid price decline of software and hardware is a big contributor to the margin expansion in recent years. Moreover, the fast growing earnings (or may be just revenue) in software industry can be delusive because of the intense competition and price decline. But it is much harder for competitors to accumulate the knowledge about industries.

Figure 5: IBM service revenue vs. margin

Source: Company data

• Potential growth from serving smaller companies

Thanks to the fast growth in low cost cloud computing services, smaller companies had the chance to use more sophisticated software functions. Some companies are using Salesforce.com for CRM, Workday for HR and some online database for transactional data. Each service is easy and cheap enough on standalone basis, but the customers can definitely get more from an integrated point of view with those existing systems. The fragmented services and a large customer base have created a perfect environment for future integration and business value creation. The growth rate of IBM’s Strategic Imperatives will be an initial sign of whether IBM can get it right.

Figure 6: Growth from IBM’s Strategic Imperatives

Source: Company data

• Buy back is the appropriate choice for now

Buying one cloud computing provider to enter the market cannot help IBM release its underutilized industry knowledge. It is up to IBM itself to figure out a profitable way to provide integration to those small and medium size companies. So when it is still trying internally, buyback is an ideal way to compound return. It is true that IBM needs to invest more on the business, but small acquisitions they made in recent years should be enough to help understand the economics and customers behind the new technology.

Figure 7: IBM’s use of cash vs. EPS

Source: Company data

Conclusion
If you just look at the current earnings and growth trajectory, IBM will never seem to be an attractive investment. But if you think of it as the biggest technology consulting company and an integrator, its accumulated industry knowledge is clearly underutilized and undervalued. The potential market size can be huge considering the fast expansion of fragmented cloud computing services among smaller customers. Current valuation of 11x PE on below-normal earnings can be very attractive to the investors in the long term.

Figure 8: Comps within IT consulting and outsourcing segment:

Source: Company data

Distressed Valuation Not Justified – Penn West Petroleum (PWE)

Summary
PWE is one of the largest conventional oil and natural gas producers in Canada. For years, its previous manager increased debt to pursue high production growth without cost in mind. New management took control in mid-2013 and started the plan to bring down debt and improve efficiency. But share price declined 80% in the past year as oil price and legacy problems hurt the company during the change. However, strong management with focus on low-cost oil assets will help PWE survive the oil downturn and current distressed valuation is not justified.

Investment Thesis

• Strong Management and well turn around execution
  The new managements took control in mid-2013. Since then, they have achieved all of their stated targets in operation improvement. Non-core assets of over CAD1bn were disposed to bring down debt from CAD3.2bn to ~CAD2bn. Annual cash cost decreased CAD400m. Previous practice of expensive acquisition immediately stopped. They cut 25% of the workforce and turned the company to focus on efficiency. Management voluntarily disclosed an accounting issue in mid-2014 and finished a full review by Oct 2014.

• Misunderstanding about true earnings power of the company
  Due to previous management’s expensive acquisition, current non-cash cost was inflated and did not reflect the long term cost structure of the company. Management’s decision since 2013 to focus on 3 conventional oil assets prepared the company for the low oil price. Unlike shale oil companies, which need to constantly drill new wells to keep production, conventional players can rely on old wells for more years. PWE has a total reserve of 487MM boe with current annual production of ~10% reserve. The long term total cost will gradually decline to around $30/bbl and ensure the survival during the downturn.

• Debt problem exaggerated, equity and bond valuation mismatch
  Debt is the main concern in the market for PWE. Net debt/EBITDA may temporarily breach the debt covenant. However, management has reached an agreement with bondholder to relax covenant in next 2 years. Considering the 30% Net debt/Equity ratio, strong reserve base and further cost structure improvement, the company has enough room to cover the debt. Moreover, Pennwest’s bonds are traded above par at a healthy yield while equity is at a distressed level.

Valuation
PWE is currently trading at distressed level with EV/Reserve at $5.3/bbl, significantly lower than $15/bbl finding cost and its historical average of $18/bbl. Price target of $3.5 is based on $9/bbl EV/Reserve exit downturn in 2 years with 20% of reserve decline. However, it is very likely for EV/Reserve to eventually reverse back to above cost of finding in the long term.

Company Overview

Penn West Petroleum (Pennwest) is one of the largest conventional oil and gas producer in Canada. The company was founded in 1979 with headquarter in Calgary, Alberta. In 2005, Pennwest, along with many other Canadian oil and gas producers, transformed itself into a Canadian Royalty Trust which distributed all income to avoid federal income tax. However, in 2011, Pennwest eventually converted back into normal company after government regulation.

Pennwest mainly operated in three conventional oil & gas field in Cardium, Viking and Slave Point with an annual production of around 100k BOE/d. At the end of 2014, Pennwest’s net proven and probable reserve totaled at 487m BOE.

Why this is a good company
Because the oil price cannot be set by any individual company, the E&P business is generally a price taker and the success is based on low unit cost. The combination of low-cost-to-produce asset and a strong management that focus on efficiency is the formula to long term value creation.

• New management team with a strong track record
  The current management team took control in mid-2013. It has a very strong track record of creating long term value for shareholder and is well-known for its efficiency orientation. Since 2013, underlining operating performance has improved significantly. Cash run rate has been coming down dramatically, drilling time has been cut in 3 major plays and most importantly uneconomic production has been shut down. The management has adopted a shrink-improve-expand process and further improvement is likely to be realized in the coming years. Core management team member include:
  Chairman – Richard George: Previously CEO of Suncor Energy from 1991 to 2012. He built the company from a small regional producer into Canadian’s largest energy company with over $50bn market cap. During his 21 year period, company generated a compound annual return of above 20%.
  CEO – David Roberts: Previously COO of Marathon Oil from 2008 to 2013. He was in charge of the E&P business of Marathon Oil and was good at improve efficiency. Under his management, Marathon oil recorded improving operating matrix constantly from 2008.

• Low cost to produce conventional oil assets
  Conventional crude oil in Canada competed with both US shale oil producers from Bakken and Cushing. The growing supply in US shale oil production has made the Alberta crude to trade at significant discount to WTI. However, even with the price discount and larger transportation fees, the conventional producer from Canada still has advantages over its US shale competitors: 1) Cost to produce for conventional oil can be as low as under $30/bbl while shale producers usually has a higher than $50/bbl cost; 2) Conventional oil producers does not need to continuously drill new wells to keep production relatively stable while shale players face a much faster production decline; 3) As more light crude oil can move to new refinery capacities from the Gulf area, the competition will gradually ease and the discount is likely to shrink. As an of the largest conventional producer, Pennwest is set to be more competitive in a low oil price.
  

Why it is undervalued
Pennwest stock price has declined over 80% in the past year due to market perception of it as a high-cost producer, concern of its debt level, and a self-revealed accounting issue. However, a detailed look at the fundamentals shows the concerns resulted from market misunderstanding and exaggeration. The company’s distressed level valuation is not justified.

• Market perception of it as a high-cost producer
  Although Pennwest sits on top of an attractive conventional oil & gas assets, previous management did a poor job by overpaying on the acquisitions to grow production without cost in mind. New management took control in mid-2013 and immediately stop the bad practice. The disposition of non-core assets and 25% reduction in work force set the stage for Pennwest to convert to a low cost producer. However, the previous expensive acquisition (Finding & Development cost which is capitalized) and the short term decline in production masked the true long term earnings power of the company. Furthermore, the decline in oil price has exaggerated the market misunderstanding. The new focus on self-developed reserve in low-cost area will result in total cost per barrel to decline to around $30/bbl. This will give Pennwest a significant advantage over its main competitors, the US shale oil producer.

• Concerns of the debt level
  Another negative impact from previous poor management is the debt used to support growth. Under current market situation, market is correct to worry about the debt of the company. However, there is a huge mismatch emerging from the debt and equity market for Pennwest. The stock price is clearly trading at distressed level and indicate a high probability of default while all company’s debts are trading above par and at a healthy yield.

After taking control in mid-2013, the new management started debt reduction through selling non-core and high-cost assets. Net debt level has declined $1bn in the past year. Absolute debt/equity level is not high at 30% but the concern is on debt to EBITDA level. The ratio is likely to temporarily breach the covenant of 3x due to oil price decline. But company has already reached an agreement with the banks to waive the requirement in the short-term. And for the long-term, the cost saving method combined with $1.7bn unused credit line can help company go through the downturn.

• Accounting problem
  In Q214, management voluntarily disclosed a minor accounting problem. Some expenses were misallocated to CAPEX/royalties for 2012/13 period and management team initiated a full scale internal accounting practice review. The review has been completed in Sep 2014 with operating cash flows of 2012/13 restated lower by 5%/7%. But reserves and other major balance sheet items were reaffirmed by a third party. It ensured the company a clean start under the new management. However, the damage has been done just before the oil price decline and this is also a contributor to current lower valuation.

Valuation & Comps

Normally, it costs around $15/bbl to find new Proven and Probable reserves especially for light crude oil. Pennwest used to be traded in the past decade at an average valuation of $18/bbl EV/Reserve which reflect reasonable return above finding cost. Currently, the stock is trading at only $5.3/bbl EV/Reserve which in the long-term is not sustainable. The base case price target of $3.5 is derived assuming $9/bbl EV/Reserve exit downturn in 2 years with 20% of reserve decline during the period. The bear case PT of $1.6 assumes 30% decline in reserve before oil market stabilize. And the Bull case assume 10% reserve decline but a reverse back to $15 finding cost for EV/Reserve.   

Besides the low EV/Reserve vs. historical average, Pennwest has the lowest multiple among major Canadian E&P companies, even lower than those companies with worse balance sheet and less light crude reserve.

Table 2: Comps of valuation, operating and financials among Canadian oil E&P

 

Conclusion
Pennwest, with its strong management and conventional oil assets, is severely mispriced because of misunderstanding of its true cost structure and exaggerated concern over debt problem. The oil price decline, management strategy to shrink operations with unhedged oil and legacy accounting problem also helped create this distressed level valuation. In the long run the EV/Reserve is very likely to reverse to underlying finding cost. On top of the misprice, Pennwest also has the potential to turnaround and become a long term winner in a low oil price environment.

Long Term Value Creation from Stable Business – TAKKT AG

Summary
TAKKT AG is a Germany-based B2B direct marketing retailer. It helps business customers to purchase specialized equipment for plants, warehouses, offices and food chains from over 1,000 suppliers. It facilitates the purchases by providing catalogs, online marketing, logistics, procurement and advice. Since its IPO in 1999, the stock has consistently outperformed the index and its peers’ because of efficient capital allocation and carefully maintained economic moat. Current valuation of 14x 2014 P/E provided an attractive entry point for investors to enjoy long term value creation.

Investment Thesis

• 15 years’ track record of efficient capital allocation; ROE stable at ~20%
  Since 1999, TAKKT has engaged in 6 acquisitions, 3 divestments and 1 stock buyback. Management followed a strict rule in the acquisitions targeting above 20% equity return under conservative assumptions. It also treated buyback as an investment decision under the same rules. In Feb 2009, company conducted a tender offer to buy back 10% of total shares at a very attractive price. Moreover, TAKKT made 3 divestment to shed low return businesses, and a cumulative dividend has amounted to above 80% of IPO price.

• Strong economic moat with high margin
  TAKKT operated at a higher margin than its competitors and the margin difference was widening after the financial crisis in 2008. That was mainly caused by: (1) Economic of scale and diversification that provided cost advantage; (2) High value proposition to customers from recommendation to customers using accumulated knowledge; (3) Focus on building a portfolio of leaders in niche market. Moreover, TAKKT also enjoyed an extremely fragmented suppliers and customers. Considering the high initial investment to build logistics and acquire suppliers/customers, the high margin is well protected.
• Market priced different earnings and management quality at same multiple
  Takkt and its major competitor Manutan is trading at a similar level of 14x 2014 PE. While there is no discount on multiple, the earnings quality of Takkt is much better because they were derived from high margin business with protection from economic moat. And the management team in Takkt showed superior ability in capital allocation to create value for the past 15 years. Market failed to reflect the long term predictability of earnings by focusing too much on short-term performance.
• Valuation
  In past 15 years, TAKKT stock generated a CAGR of 10% without multiple expansion. A stable management with its strict focus on return is likely to maintain a 20% ROE. Current valuation of 14x 2014 PE is attractive for investors to enjoy the long term compound return from efficient capital allocation and an improved business portfolio. Potential return can be in a range of 10%-18% CAGR in 5-10 years.
  
  

Company Overview
TAKKT AG is a Germany-based B2B direct marketing retailer. The company is operated under decentralized corporate structure with Group Company making capital allocation decision and regional company with its own brand making operating decision.

Chart 1: Company structure
Source: Company data

TAKKT built its business portfolio in diversified sectors across US and Europe. Revenue from Europe accounted for just above 50% of total revenue while profit from Europe stood at 70%.

Chart 2: Diversification of regions and product ranges
Source: Company data

In terms of the management, Takkt had a very stable team and well managed transition history. From 1999 to 2009, Georg Gayer was the CEO of the company and Felix A. Zimmermann was CFO. They made most of the capital allocation decisions during that period. Felix A. Zimmermann, now 47, became CEO in 2009 after Georg Gayer’s retirement. Since then, there was no change the way the company made capital allocation. In the company’s Board, most of the members came from Takkt’s controlling shareholder Franz Haniel & Cie. GmbH (50.2% of total shares).

15 years’ outperform without multiple expansion
Since Takkt’s IPO from 1999, it has achieved CAGR of 10% in the past 15 years. The stock return was slightly better than DAX and S&P500 while significantly outperformed its peers in the industry both from US and Europe. Moreover, it is currently trading at 14x PE, same as it was in 1999. The consistent outperform was not a coincidence or deviation from mean but rather a result from carefully managed economic moat and disciplined capital allocation.

Sustainable economic moat
B2B marketing for equipment is a very competitive market with several big listed companies but more regional small private players. However, Takkt has consistently achieved the highest margin and ROE in the industry.

• Value proposition & competitive advantage

Consistent higher margin is obviously a good thing for the company. But a more important question is where is the higher margin coming from and whether it will be sustainable. In Takkt’s case, the difference in margin can be explained mainly by gross margin difference which reflected higher value proposition to customers. Higher customer value comes from several areas: (1) A wide range of products to choose from, (2) Recommendation from Takkt on the quality of product from past experience, (3) Customized solutions to meet customers’ unique demand, (4) Longer warranty periods, and (5) Faster and flexible delivery. All those advantages were supported by some kind of moat that protect competitors from competing away high margins.

Because Takkt is the biggest operator in all its subsectors, it can provide a one-stop shop for certain industries. With the accumulation of past user experience, Takkt is in the best position to help customers on purchasing. The shared logistic services and IT systems further enhance the competitive advantage because Takkt as a whole is the biggest company in the industry. (3-times the size of the second company by market cap).

• Sustainable moat with high margin

Although the direct marketing business is a very competitive industry, Takkt’s management and strategy has done a great job of keeping its advantage for a long time. Part of the reason is it is hard for companies in different subsectors to compete out of their original businesses. The initial investment to build relationship with fragmented suppliers and customers was very high. And considering Takkt’s deliberately picking of industries with ~5% organic growth, it is not attractive for new companies to enter the market.

Another critical part to protect the moat is management’s philosophy on capital allocation. Company has strictly followed the rules to acquire successful operators in the niche market. And it targets to get different knowledge on customers or industry from the acquisitions. Through this, Takkt is consistently looking to widen its moat and ensure that it can earn an excess margin and return.

Capital allocation
Since 1999, TAKKT has engaged in 6 acquisitions, 3 divestments and 1 stock buyback. Management followed a strict rule in the acquisitions targeting above 20% equity return under conservative assumptions.

Table 2. Historical capital allocation decisions      

• Acquisition; TAKKT’s acquisitions usually included below terms: (1) Successful leader in a niche market; (2) Previous owners continued to run the department independently while infrastructures like logistics and order systems were consolidated; (3) Additional knowledge of new market or leading ways of marketing can be learned and applied to more groups; (4) Valuation of ~10x P/E with high EBITDA margin

• Divestment; All 3 divestments from Takkt in the past decade were to sell its legacy businesses that have a permanently lower margin prospect and growth potential. During the divestment process, resources were freed for management to make additional acquisition. But the resulted slow revenue growth masked true growth potential of the company.

• Buyback; Takkt treated buyback activity correctly as a reinvestment decision. Rather than making open-ended buyback commitment, Takkt preferred to use tender offer to buyback stocks at attractive price. In Feb 2009, the company bought 10% of shares using tender offer at the price of EUR7.9. The decision also contributed to long term outperform comparing to competitors’ buying not-that-good businesses to support revenue at the same period.

• Dividend; Takkt also promptly returned cash to shareholder when there were no attractive investment opportunities in 2007, 2008 and 2011. The management showed a strong track record of capital allocation. Investment in Takkt can be partly seen as a delegation of investing decisions in the direct marketing area targeting 20% ROE. Management is very predictable and this provided solid protection for the downside.

• Outlook; Management will continue to execute similar strategies in the future. With all divestments of legacy businesses finished in 2015, organic growth of 5% can be expected in the long run. Further growth can be realized from acquisitions. Considering the natural of the industry where a lot of small successful family owned companies dominated individual niche markets, there will be ample opportunities for Takkt to invest.

Valuation & Comps
In the past 15 years, TAKKT stock generated a CAGR of 10%, in line with book value growth. Current valuation of 14x 2014 PE is attractive for investors to enjoy the long term compound return from efficient capital allocation and an improved business portfolio. Possible CAGR can be at least 10% in the next 5 to 10 years.

Table 3. Expected return

In addition, below is a DCF valuation table based on 8.3% WACC and 2% terminal growth rate for reference.         

Table 4. DCF
                
Source: Company data