While the rules and regulations in the industry may not easily lend themselves to an online blog, I hope to keep the historical posts on Value Uncovered available as a sort of post-mortem on my journey as an investor.

After 100+ posts over the last several years, here are a few final reflections:

• Even though my belief in value investing never wavered, my approach to investing has improved dramatically over the last 5+ years. Investing requires continuous learning, even though the underlying concepts (buy-low-sell-high, margin of safety, etc.) never change.

• Investment write-ups were critical to my development, even though I cringe at some of the initial posts (What was I thinking?!). Narrowing down hundreds of pages of research into several concise bullet points forces clarity of thought. Committing to the reasons behind an investment also mitigates the potential for ‘thesis creep,’ while also serving as a time machine for analyzing past investment mistakes.

• Business school was worth it, but not from the perspective of ‘learning how to invest.’ School focuses on academic finance (CAPM, efficient frontier, Black-Scholes) and while these concepts are nice to understand, they do not help much in analyzing businesses or picking stocks. The relationships and networking opportunities were far more valuable, as was the built-in pathway – via stock pitch competitions and a summer internship – to gaining real-world investing experience.

• I’ve talked to many current and potential students who are interested in a similar career transition. My advice? The investing industry is ultra-competitive – everyone reads the Wall Street Journal and has an opinion on Apple. Passion for investing cannot be faked. Be different. Think originally.

• While I now have access to fancy tools and sell-side research, nothing compares to reading annual reports and thinking about business models. Primary source material is essential to the investment process.

• There is an incredible online community of investors around the world who are doing outstanding and thoughtful work. It is a valuable resource, and they have contributed heavily to my evolution as an investor – cheers to all of you!

If you would like to stay in touch, feel free to email me and I’ll pass along my updated contact information.

Finally, the Yacktman team discovered my work via Value Uncovered, and the website proved to be a far superior resume than any traditional paper copy. Although it’s too early to be sure, I think the decision to write here could end up as the best investment of my career.

Company Overview

Manutan (MAN.PA) was founded in 1966 by Andre & Jean-Pierre Guichard as the first French company specializing in catalogue selling of industrial equipment. The company is now the leading player in the European B2B mail order (or distance selling) market for office/industrial equipment and supplies – basically, the classic distributor model seen in office supplies, IT equipment, and many other industries.

The company operates in more than 20 countries, offering more than 200,000 products to 600,000 clients through both catalog (70%) and internet (30%) channels. The average order value is just €470.

Management Team

Record of Solid Long-Term Performance

The Guichard family continues to own 70% of shares and 77% of voting rights, and has expressed a desire that the company stays independent (so it’s unlikely that a competitor buyout will unlock value here). With that dynamic in mind, it’s important to look at the family’s track record.

Reading through the annual reports, phrases such as “steady growth rate” and “controlled expansion” and “long-term view” are mentioned numerous times. Here are the company’s results over longer time periods:

Over every time frame, MAN.PA has shown an ability to grow at rates higher than inflation through a combination of organic growth, new country expansion, and select acquisitions. Most importantly, this growth has been achieved while maintaining double-digit ROEs despite a large net cash position.

A high ROE without using leverage translates into average ROICs above 20%.

So why is this a good business?

– Low Supplier Power – Manutan sources products from almost 1,300 suppliers, with no single vendor accounting for more than 3% of purchases. Distributors like Manutan help manufacturers reach a broader customer base, as many do not have the right personnel or infrastructure to do it alone

– Low Buyer Power – Manutan serves more than 600,000 customers, with none more than 2% of turnover. Large accounts can negotiate product discounts due to volume, but these price concessions are mitigated by smaller customers purchasing at full price via online sales channels.

– Anti-Cyclical Cash Flows / Margins – Manutan benefits from anti-cyclical gross margins, as shown in the chart below from a competitor presentation:

This through-cycle margin profile is likely from suppliers trying to push inventory through the channel when sales stall (allowing MAN.PA to get better purchase prices), while at the same time allowing Manutan to hand out fewer volume discounts on the customer side.

As evidence, the company’s GM% increased +350bps from 2000-2002 and +30bps from 2007-2009.

In addition, these kind of distributors benefit from positive working capital cycles during recessionary periods, as inventory is worked down and receivables are collected. Manutan generated +€22.4m and +€24.5m in cash flow from working capital movements during the last two recessions.

– Product Breadth = Competitive Advantage – I spoke to a buyer in the procurement department of a large multi-national company. A big component of their procurement costs are the logistics of setting up purchase contracts and processing purchase orders across multiple vendors.

Working through a distributor not only provides better pricing, but allows these companies to place one purchase order for hundreds of items versus placing hundreds of POs with multiple vendors, cutting down on transaction costs.

So scale becomes a big advantage (MAN.PA is the European market leader), as customers look to rationalize all costs in the procurement process, not just the product price. This is illustrated in the graphic below:

Performance Stems from Long-Term Thinking

Another quote stuck out in the annual report (compare it to W.E.B.’s famous line):

“During the financial crisis, we made the strategic decision not to cut our marketing and commercial investments.” – Manutan AR

“A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful.” – Warren Buffett

True to their word, management was not shy about investing in the business during the recession, making large commitments in several key areas:

1) Continued investments in its European Centre, a €70m development project which will serve as a new headquarters, state-of-the-art logistics center/warehouse, and employee training & development center. The facility will be fully operational this year.

2) Company-wide IT overhaul to centralize the group’s warehouse management, content management, and e-business platforms within one system for all geographic areas. This sounds like a long overdue project, and MAN.PA has invested almost €40m in this project over the past five years.

3) Opportunistically acquiring 2 companies plus land/storage space during 2008 & 2009 (spending €35m), the first major acquisitions since 2000. Both added specialist niches, allowing the company to offer a wider array of projects and further expanding the value proposition (“one-stop shopping”).

These investments have consumed significant free cash flow, depressed margins and impacted ROIC over the last several years. Very few management teams are willing to make these decisions in the face of the inevitable pressure on their stock price – this long-term thinking is a major positive. These investments also setup the company for the core part of the thesis: reversion to the mean.

Margins – Reversion to the Mean

Manutan saw a sharp decrease in margins in 2009, with EBIT margins falling from north of 10% to just above 6%:

Why the decrease?

In March 2009, MAN.PA purchased Camif Collectivites, a distributor to the public (i.e. government) and education sector. The largest acquisition (on a revenue basis) in Manutan’s history, the purchase price was just $3.1m, as MAN.PA bought Camif after the bankruptcy of its parent company (not to mention during a terrible economic climate).

Check out the purchase multiples on the deal: 0.02x revenue, 1.1x operating profit and 0.55x BV.

While the deal was done at a very attractive price, margins in Camif are structurally lower, and the continued problems in Europe have caused even greater pressure. Camif was barely profitable in 2009 & 2010.

Management has taken steps to improve margins by:

– Adding several hundred higher margin products from the core business lines to Camif’s offerings

– Rationalizing the purchasing/sourcing process at Camif to lower cost of goods sold

– Expanding its scale within the public markets through additional acquisitions (see Valuation section below)

These steps have increased operating margins in the South region (where Camif is consolidated) by >100bps since 2009, with further improvements likely.

Management is targeting a 5% operating margin for Camif, almost double the current level. On $125m in run-rate sales, an improvement to 5% margins for Camif would boost EBIT by approx. €2.3m, raising overall profit margins by 50bps.

Several other geographic regions are currently reporting margins below long-term trends, with mean reversion potential there as well.

With continued improvements, a normalized operating profit margin around 7% is achievable (+70-100bps), which is only slightly below the long-term average.

Manutan is a good candidate for ‘reversion to the mean’ since the margin compression has occurred at the operating level – management has been able to maintain and even increase gross margins (both at Camif and in the core business), a good signal that the business has maintained its pricing power and competitive position.

Therefore, much of the margin reversion potential will come from rationalizing SG&A, technology, & marketing expenses – all of which are largely under management control.

Valuation

Comp. Valuation – Reversion to the Mean

TAKKT is Manutan’s closest competitor in the distributor space, and Manutan has historically traded at a discount to its larger competitor. Over the last five years, multiples have compressed sharply for both stocks.

However, the valuation gap between the two stocks has reached all-time highs:

The current EV/Revenues multiple is the highest recorded, while the gap in EV/EBIT multiples has only been this wide on 0.9% of days in the past ten years (23 days out of 2,575).

TAKKT has grown faster out of the recession, due primarily to its wider geographic focus (40% of its business is in the U.S.). In addition, the gap in profitability has also increased due to Manutan’s (temporary) margin challenges. TAKKT arguably deserves to trade at a premium, but the current one seems far too wide.

However, in the long-term, this valuation disparity should close, as operating performance normalizes at MAN.PA. Here’s how Manutan would stack up if the market prices the stock at its historical discount to TAKKT (somewhere between the midpoint of the 5 and 10 year average discount):

The EV/EBIT implied value is lower given the current depressed state of operating margins. At a 7.25% normalized margin, Manutan would have EBIT of €41.3m on TTM sales, or a €50 stock price at the implied multiple.

Valuation – 2015 Forecast

However, it will likely take 2-3 years before Manutan’s margins normalize, as the 2013 outlook for Europe remains murky and the Camif turnaround is still ongoing.

In addition, Manutan acquired Casal Sport in Oct. 2012, a leading distributor of sporting goods to educational institutions. Casal offers complimentary products to Camif, providing synergy opportunities and increasing scale in the public market segment.

With revenues of €48m, the acquisition will push FY’13 revenues near €600m, but contribute initially at 5% margins (lower than the group average).

Here’s how the business could look by FY’15 under several scenarios:

The bear case provides only marginal downside (-14%), as the market seems to be pricing in in flat sales, continued margin compression, and multiple contraction to near ’09 lows – essentially a perfect storm of bearishness.

A more reasonable base case is that margins improve 50bps to 7% (still below historical averages) and the multiple improves slightly to 12.5x. This estimate provides €4/share in earnings power and a €50 stock price.

With 60% upside in a conservative base case vs. just 14% downside, MAN.PA offers an attractive risk vs. reward.

Valuation – Forward Return

One last way of looking at the stock is on the basis of its forward FCF yield, after adjusting for the company’s normalized earnings power:

With normalized EBITDA margins of 9.4% and maintenance capex at 2% of sales, Manutan would produce after-tax FCF of €30m, offering 13% forward yield (or 16% FCF yield to EV).

Why Is the Stock Cheap?

1) Margins pressure / poor short-term returns – TTM ROIC is 13.1% compared to the LT average around 20%, as the fall in margins has been compounded by a dramatic increase in invested capital – the HQ/distribution project has added €70m in net PP&E to the balance sheet over the last 4 years despite not being operational (and therefore not contributing to returns).

Going forward, margins are expected to improve and IC should grow at a much slower rate (or even shrink), driving returns closer to the long-run average.

2) European troubles – MAN.PA’s financial results and stock price are highly correlated to the economy, especially the European PMI index:

Unlike TAKKT, Manutan has continued to focus exclusively on the EU, choosing to concentrate its leadership position despite the poor economic climate. While a return above 50 for the PMI (signaling expansion) is probably unlikely in 2013, the eventual recovery will provide a boost to results.

3) Family-control / illiquidity – The stock only trades 2000 shares a day (~$65k in ADV), too small for most institutional investors. In addition, many investors view family-control as a negative, a viewpoint I do not share (assuming the family has a long history of prudent capital allocation, see my investments in TES.PA, COM.PA, IBAL and others).

Conclusion

Manutan is a rather boring stock with a solid business model and long-term track record. Based on a multi-decade history, the company is capable of growing at 3-6% while reinvesting capital at returns approaching 20%.

At current prices, investors are paying <10x depressed earnings for an above-average, growing business, headed by a management team which has demonstrated an affinity for planning (and investing) for the future even at the expense of short-term profits.

With excessively bearish forecasts already baked into the stock and several areas of potential reversion to long-run averages (margins, ROIC, comp. valuations, etc.), now is a good time (in fact, one of the best times in the stock’s history) to partner with the Guichard family.

Disclosure

Long MAN.PA & other stocks mentioned

The major details from the press release are included below (emphasis is mine):

“Core expects the new business to generate annual revenues of approximately $26-$30 million and anticipates revenues beginning late in the second quarter and ramping up by the fourth quarter of 2013. Planning and staffing activities are underway as the Company is evaluating facilities to produce these heavy duty truck hoods, roofs and other molded parts for Volvo. This new business is expected to employ up to 140 additional people. Core plans to make an additional capital investment of approximately $12.5 million throughout 2013 and 2014 for equipment and infrastructure to support this and other business.”

The market responded positively, sending the stock price up more than 20% over the past two days. With $168m in TTM sales, $28m in incremental revenue (at the midpoint of the expected range) represents a 16.7% increase. The new business will reach full production by the end of the fiscal year.

While specific profitability information is not provided, estimates can be made based on CMT’s long-term business metrics:

Looking at the increase in hiring, $28m in incremental revenue with 140 new workers translates into sales/employee of $200k for this new business vs. $110k sales/employee for the company as a whole. This makes sense (few if any admin personnel will be need to be hired at HQ for example), and should provide some leverage on the SG&A line.

However, the biggest risk is that management sacrificed pricing in order to win such a significant award, which would impact gross margins. A sensitivity analysis is included below:

If the long-tern economics hold true, it seems reasonable to assume that the new business will add $0.15-$0.19 EPS. At a 10x multiple on the mid-point, this Volvo award is worth $1.66/share in value to CMT, close to the $1.59/share added to the stock price in the last two days.

On the investment side, the company is planning to spend $12.5m in capex to “support this and other business.” If 90% of the planned capex is for Volvo, it would equal capex/share of $1.52 and an acceptable ROI of 11.3%.

Other Thoughts

Prior to this announcement, the stock had struggled since May (hitting a low of $6.35 in January).

One part of the original thesis was that record backlog would boost the top line. While Q1 and Q2 sales were up 54% and 26% YoY respectively, sales growth stalled in the second half of the year (Q3 was flat).

Most important, profitability did not follow the sales growth – gross margin fell materially due to a combination of production inefficiencies, change in product mix to lower margin products, increased tooling sales, and start-up costs for the Kentucky subsidiary:

A major contributor to the margin compression was costs for the Kentucky subsidiary, a short-lived and disappointing initiative. The facility was created in July 2011 to diversify away from trucking-related subsidiaries, with an expectation of $5-8m in annual revenue at full production.

However, the facility’s major customer reversed course suddenly, terminating the relationship in June 2012. The facility was closed in October 2012. This failed project impacted margins throughout the year, in addition to consuming $1.2m in leasehold improvements.

With the facility now closed, this drag on earnings and management attention will go away and gross margins should revert to the long-term average (pending pricing terms on the Volvo deal of course).

Conclusion

Ultimately, the Volvo business helps mitigate one of the biggest risks associated with CMT: customer concentration. Sales to Navistar and PACCAR represented 80% of sales in 2011, especially troubling considering the difficulties at Navistar.

Therefore, the addition of a 3rd major customer is great news for the long-term stability of the business.

The trucking cycle continues to improve (225k units in 2012, up from 197k in 2011; 210-240k expected for 2013), as the age of the fleet remains near all-time highs.

Despite the operational missteps, CMT will likely report record results in 2012 and is still priced like a no-growth business despite long-run evidence to the contrary.

Disclosure

Long CMT

The total number of positions in the portfolio has crept upwards, with 29 stocks at year-end. The majority of trading activity occurred in existing holdings, with just 6 new additions. Two stocks (APNC, NOOF) were acquired during the year.

As mentioned in my last review, 2011 was the first time I branched out into international stocks and it has been a major point of emphasis over the last twelve months. Today, 47% of my portfolio is now outside of the U.S., and I continue to look for opportunities overseas.

With a hat-tip to the blog at the red corner for the idea of mimicking Buffett’s ‘look-through earnings’, here is how the portfolio would stack up as a mini-conglomerate (on a weighted average basis):

A few comments on these numbers:

– 5% sales CAGR. This definitely won’t be mistaken for a growth portfolio. However, the majority of holdings are trading below a conservative ‘no-growth’ value, so anything beyond inflation is upside. I rarely have confidence in forecasting future growth, so I try to avoid paying for it.

– 9% trailing earnings yield. Since companies within the portfolio are generally net cash positive (in the case of the net-nets, in a rather extreme way), this trailing figure is actually understated as the yield to enterprise value would be much higher.

– 85% FCF conversion. Over the last ten years, the holdings have converted 85% of earnings into free cash flow. Little reinvestment is required to support growth, so FCF is available for share repurchases or dividends.

– 26% normalized ROIC. Outside of 1 or 2 exceptions (a net-net and a turnaround or two), all of the businesses are earning acceptable returns. As a group, normalized ROIC is substantially higher than the cost of capital, indicating that many positions have some sort of a competitive advantage or at least a leadership position in a niche market.

– 38% RONIC. Incremental returns on capital are higher than current returns, so growth is adding to shareholder value.

Final Thoughts

As some of you might have noticed, I took a hiatus from the blog for several months, as I continue to pursue investing as a full-time career. My prospects are shaping up even better than I could have hoped, but it has taken time away from posting on the blog.

But the main reason for the lack of posts is the strong market in 2012 (followed by another ~5% upswing in January alone), which has pushed up valuations on many stocks outside of my comfort zone, especially in the U.S. Viewing the market on a bottoms-up basis, stocks within my circle of competence look expensive – basically, not much looks interesting right now.

Therefore, I have been spending time reexamining each position within the existing portfolio, while building a watch list of high-quality businesses. While sitting on cash and showing patience does not make for very good blog reading, it will hopefully be rewarded on the inevitable pullback.

“Owner-operator companies are those controlled by a significant, typically the largest, shareholder. This is a person with a great deal, perhaps most, of their personal capital at risk in that business…Businesses managed by their founders and/or largest shareholders tend to have much more liquid balance sheets, are more opportunistic, and exhibit remarkably higher long-term results.” – Murray Stahl, Chairman of FRMO Corp

Tessi (TES.PA) is a family-owned firm with a leading market position for high volume document processing in France.

Essentially, Tessi allows large companies to outsource the manual and often tedious task of handling and processing large volumes of physical documents. Through an acquisition, the company is also the leading wholesaler of gold and currency in France.

Operations are broken out into three business segments:

Document Processing – #1 market share leader in France for check processing and document digitization (converting physical checks or other documents to electronic form). While check processing is a declining business, the transition from physical-to-digital documents is a growth area. The company handles hundreds of millions of documents per year.

Core advantages: established customer relationships (why switch outsourcers in the middle of a 100 million document conversion?), available manpower, scale/efficiency

Marketing Services Operation – handles marketing functions such as redeeming rebates/coupons, processing customer gift fulfillments, executing mail campaign, and staffing call centers.

Core advantages: None really, lots of competition. Breakeven business but with a small “float” (see below)

CPoR Devises – acquired in 2005, CPoR is a broker of foreign currency and gold reserves, serving as the principal supplier in France. TES collects revenues from banks for holding reserves in its vaults, along with taking a fee for transactions between third parties.

Core advantages: sole supplier in France for these transactions, blessed by the French government, fixed investments in security/vaults, regulatory hurdles, reputation

Historical Track Record

Through a combination of acquisitions and organic growth, Tessi has turned in an enviable long-term track record under the current management team.

Since 2002, management has compounded revenues, operating income, and book value at 13%, 22% and 18% respectively.

Much of the growth associated with Tessi’s document/marketing businesses is due to acquisitions, as the company has taken out smaller competitors (scale is important in this business) and branched out into ancillary services.

These acquisitions are usually the ‘bolt-on’ variety, most often between €1-20 million in sales, a size capable of being easily integrated into Tessi’s infrastructure.

High Quality Business

Tessi’s businesses are attractive in two major ways:

1) The “float” from the marketing division – While Tessi has no competitive advantage in this space (as evidenced by the breakeven result), the marketing operation is setup so that customers prepay for campaigns, but consumer redemptions often occur weeks or months later.

Assuming TES signs on new customers, this cash advance reduces the need for external financing (effectively, Tessi can self-finance part of operations) – this marketing “float” has averaged roughly €20 million per year.

2) Asset-light business, especially in CPoR – Tessi supports €262 million in sales with just €22 million in net fixed assets.

Documents/marketing (the core business) is service-based. For CPoR, once the infrastructure/vaults/security is in place, there is little additional investment requirements as Tessi’s “product” in CPoR is essentially currency and/or gold – therefore, the cost of handling incremental transactions is negligible.

Combine these factors together and Tessi is generating ROIC north of 50%:

CPoR Acquisition = Game Changer

“Admittedly, when people a century from now are fearful, it’s likely many will still rush to gold.” – Warren Buffett, Berkshire Hathaway

“The world seems more uncertain today than at any other time in my life.”– Howard Marks, Oaktree Capital

In 2005, TES paid €41 million for 80% of CPoR Billets (now CPoR Devises) in a break from its traditional document/marketing focus. The remaining 20% ownership is held by Crédit Agricole, which plans to eventually divest its stake.

CPoR supplies gold and foreign currency to all of France’s banking and financial institutions, with a market shares of 90% in forex and 95% in gold.

Dominant market share + little capital requirements = high margins/returns

In 2011, Tessi’s CPoR segment generated €27.4 million in operating profit at 43.6% margins from just €16.5 million in assets, for an ROA of 166%. As a broker, CPoR is leveraged to both price and volume of gold transactions, so in times of crises, results are boosted doubly.

With investor’s traditional view of gold as a safe haven, CPoR serves as a natural hedge during market crashes. As evidence, CPoR grew right through the recession, with margins increasing 1300bps in the last five years: 

Gold investment statistics also show the demand increase since 2008:

This increased demand has driven up gold prices:

Here is the revenue breakdown of the CPoR division through 2006 (TES does not break out profit-level details between gold and forex):

Margins have improved dramatically as gold has become a greater percentage of CPoR’s overall results.

Critically, the market is pricing in a decline in this business, as analysts are forecasting negative 5-7% annual growth in CPoR revenues from 2012-2014.

In order for revenues to fall by this amount, CPoR would have to see a decline in either gold volume or gold prices that was not counterbalanced by an increase in the other component.

Here’s how the company is doing on those two fronts:

Gold Prices

While prices have moderated in the last several months, average gold prices are still 17.5% above 2011 levels.

Gold Volumes

Tessi handled 15 million tonnes of gold in 2010. While volume was not disclosed in 2011, CPoR revenues grew by 36%.

In 2011, average gold prices were up 22%, which would imply an 11.7% increase in volume (this analysis is overly simplistic, but should be directionally correct):

Considering the YoY increase in gold prices for 2012, volumes would have to decreases markedly (by around 15%) for gold revenues to stay flat – and fall even further to justify analysts’ poor outlook.

Through the first six months of 2012, CPoR revenues were up 5.6% YoY, only to fall behind with the Q3 report. It is unclear whether this was due to gold or forex.

However, there are other factors that could mitigate this trend in Q4 and into 2013, lending credence to the possibility that analysts are being overly conservative:

The roll-out of more affordable gold ingots: CPoR released a series of very popular 50-500g ingots in 2011, which generated 2.4 million tonnes of new business in their first year. Last month, the company released a 5g, 10g and 20g version. With prices now starting as low as €225, these new ingots are within reach of many more people and volumes should improve (possibly dramatically) in Q4 and beyond.

The improving tax environment for gold: Historically, sales of physical gold in France were taxed at a flat-rate of 8% regardless of whether the sale generated a gain or loss, which limited demand. In September 2012, a law was passed which modified the tax treatment for gold, increasing the attractiveness for new investors by offering a:

• Choice of the most advantageous taxation system (either the 8% flat-tax or a 34.5% capital gain), depending on the gain obtained and the holding period
• Total tax exemption after a period of 12 years
• No tax due in the event of a capital loss, irrespective of the holding period

Since 2011 was such a record-breaking year for CPoR, similar growth is unlikely – at the same time, annual revenue declines of 5-7% and margin contraction of 500-700bps (what the Street is forecasting) seems too pessimistic as well.

Valuation

Here are relevant comps for the marketing/document (core) side of Tessi:

Assuming the core business grows at 3% with 10% margins, the fair market value of this segment alone would be €133 million versus Tessi’s market cap of €200 million:

Therefore, a buyer in Tessi gets a stake in CPoR – a business that enjoys 40%+ margins, 50%+ ROIC and a monopoly position in its niche market – for €67 million, or less than 4x earnings.

Here is how the valuation of CPoR might break down:

If current earnings continue, CPoR is worth €160-252 million (midpoint of €206), or 4-6x its implied price.

Even if I’m wrong and both gold demand and prices drop sharply – i.e. margins/NOPAT fall to pre-crisis levels – CPoR is still worth at least 150% more.

Here is a sum-of-the-parts valuation:

As a sanity check, Tessi has been able to convert an average of 131% of earnings into FCF over the past ten years.

With ’12 earnings estimated in the €30-31 million range, Tessi should generate close to €40 million in FCF, for a yield of 20.1%.

Add in inflation (2%) and organic growth (3-5%), and Tessi’s forward FCF yield is north of 25%.

Conclusion

“What I’m telling you is that the bulk of the return of the indices—and not just in the United States, but in all nations, the bulk of the return was earned by these owner-operators.” – Murray Stahl, Chairman of FRMO Corp.

Marc Rebouah is the Chairman and CEO of Tessi, controlling just over 50% of shares outstanding. Tessi is a classic owner-operator (Rebouah has been in charge since he purchased Tessi in 1979), and demonstrates how much value can be created by a smart management team combined with a long-term view.

Rebouah is now 68 years old, and according to company bylaws, he has to step down as Chairman in January 2014. A sale of the company is a possibility, but I’m hopeful that current management will remain involved in strategic decisions at some level.

If the next ten years are even half as good as the prior, an investment in TES should work out quite satisfactory…

Disclosure

Long Tessi (TES)

Company Overview

UMS United Medical (ETR:UMS) is a medical equipment service provider, focused on mobile service solutions – think “medical equipment on wheels”. Customers include hospitals, ambulatory service centers and physicians’ offices.

The company is broken out into three business segments, focused on different service areas: Urology (kidney stones), Gynecology (breast biopsy), and Other (namely Radiology services)

The most important division is Urology, which accounts for approx. 70% of revenues and 80% of operating profit:

Medical Technology Overview

The Urology segment primarily focuses on a technology called extracorporeal shock wave lithotripsy (ESWL), a non-invasive treatment of kidney stones using an acoustic pulse.

The technology has been around for almost 30 years and is considered a standard of care for treatable kidney stones.

However, ESWL isn’t a high-growth industry (at least in UMS’ niche), with the number of UMS patients growing each year roughly in line with inflation:

UMS targets medical services where the capital expense for the technology (which can range into the millions of dollars) cannot be justified by the volume of expected patients.

Corporate Structure

UMS International is a German-based company, but the majority of operations occur in the U.S via wholly and partially owned subsidiary companies.

A crucial part of the business model is the formation of partnerships with physicians, creating a shared ownership around the success of the mobile initiative and an economic incentive for both parties to maximize utilization of UMS’ machines.

UMS has over twenty of these partnerships spread across the country, with most rolling up into the U.S. subsidiary.

UMS usually takes a 10-25% ownership stake in these partnerships but retains management control, and therefore consolidates the subsidiaries on its own financial statements.

The portion of earnings attributable to the physicians (paid out as dividends) is included on the financials as non-controlling interests (NCI), which represents a significant portion of the overall balance sheet.

However, the parent company is the entity that purchases the machines, pays for gas to transport them to each location, accounts for the depreciation, etc.

This means that each partnership on its own right is extremely profitable relative to capital invested, since its costs are essentially just management/rental fees back to UMS.

Approximately 60-70% of UMS’ total earnings go towards paying out NCI.

Ownership

Board members and management hold 39% of shares, up quite a bit from the IPO due to share repurchases over the last several years.

In 2011,  less than €300k was spent on compensation for the management and supervisory boards, a number which is dwarfed by their ownership stake in the company (worth tens of millions).

Therefore, management should be incentivized to allocate capital in the most effective way for all shareholders. The presence of two investment funds, Union Investment and Capiton Value, should also ensure that management continues to grow shareholder value.

Investment Thesis

1. UMS is a ‘broken IPO,’ as losses from a failed international expansion led to frustrated selling, obscuring the value created over the past five years

UMS went public back in July 2000 for almost €25 per share, but fell to only €1/share by early 2003, a loss of 95%:

In the first four years as a public security, UMS reported net losses of €16.7M, €2.5M, €2.1M and €9.7M.

While most of the losses occurred below the operating line – consisting of restructuring charges, asset writedowns, and goodwill impairments – it was not exactly the best start to its public company life, likely scarring its original shareholder base.

During this time, UMS attempted to expand business operations across Europe, making heavy investments in new technologies (such as PET scans) and new offices in foreign countries.

Unfortunately, the company ran into challenges due to the “non-reform of “encrusted” state-run healthcare systems & lack of insurance coverage.”

By 2007, UMS had sold off its European operations and divested non-core business segments, and subsequently started focusing exclusively on the U.S.

While revenues were cut almost in half by the divestitures, profitability improved:

And the balance sheet was strengthened dramatically:

While the share price is up significantly over the past year, the market still seems to be ignoring the cash generation ability of the refocused business.

2. Economics of transportable medical procedures business model is attractive for patients, physicians, hospitals and UMS shareholders

These medical machines are expensive, and major hospitals often cannot justify the capital expenditure based on the projected patient volume – the usual alternative is to send the patient to another facility.

UMS transportable model allows hospitals to ‘rent’ the medical device for a daily rate (say on every 3rd Thursday), providing the needed services to patients in a cost-effective way.

UMS receives management and equipment fees from the hospital and its physician partnerships. Since UMS’ mobile units are able to serve multiple sites, the company is able to drive up the overall asset utilization of the machines.

Everyone benefits:

• Hospitals avoid major capital expenditures
• Patients receive required treatment at lower cost/procedure and without traveling to another location
• Physicians create a new revenue stream by offering additional services
• Shareholders participate in the earnings stability afforded by long-term contracts and steady patient volume

According to the company’s research, the economics of the mobile units are attractive, providing services at a fraction of the cost over a five year period:

In the last five years, UMS has shifted its capital allocation policy from ill-fated growth initiatives to a strategy of returning cash flow to shareholders via aggressive stock buybacks and dividends

From 2002-2006, the company spent an average of €5.9M per year on acquisitions in attempt to expand around the world. After years of losses, UMS curtailed the acquisition-fueled growth strategy to focus instead on returning cash to shareholders, with small tuck-in acquisitions along the way.

This shift is represented in management’s new capital allocation record – the company spent €0.9M/yr on acquisitions in the past five years, with the bulk of the remaining FCF being returned to shareholders.

This represents a marked shift from ‘empire building’ to a focus on shareholder returns.

The change in policy coincides with Union Investment Funds (a large European asset management firm with €180B+ in AUM) taking a 5% stake in the stock in 2007/2008.

Since that time, UMS has aggressively bought back shares via open market repurchases and tender offers. Total shares outstanding have fallen from 6M to 4.8M, or more than 20%.

UMS paid its first dividend to shareholders in 2010, offering an average dividend yield of over 6% – if share repurchases are included, total cash returned to shareholders yields greater than 10%.

Valuation

Looking at the company’s ten year financial track record, there is a clear delineation pre and post-2006, representing the shift in business strategy.

Even after adjusting for the payments due to NCI, the core business is solid, with sustainable ROIC in the mid-teens.

Looking at the past five years, the business becomes even more attractive on a cash ROIC basis, as D&A is higher than maintenance capex:

And over that time, the company has provided a double-digit FCF yield, with a significant (and increasing) portion of that cash returned to shareholders:

So why is the company trading at an EV/EBITDA < 3x? (Added: See comments below)

Lack of growth. (Added: And due to the fact that the majority of the EBITDA goes towards NCI)

The company has struggled to grow its business organically (or at least grow faster than the rate of inflation). 2011 sales of €38.3M were up only 11% from the 2004 number – that’s just 1.3% per year.

Due to a recent acquisition and stronger organic growth, 2012 sales should reach the €42-43M range, but this is definitely not a fast-growing business, so let’s value it as a ‘no-growth’ stock:

Despite a share price that is up 33% in the past year, UMS is still trading at a 28% discount to its EPV valuation.

Not only does this provide a margin of safety, but any growth (if it ever materializes) is free.

Conclusion

UMS has carved out a niche for itself within this mobile medical services space.

If the recent run-up in share price is any indication, maybe some investors are starting to take notice of the new shareholder-friendly strategy, as the stock continues to offer a steady double-digit yield (not bad in today’s rate environment).

The company is not exciting, and many investors seem to pass over such steady cash flow generating stocks in a pursuit of growth. However, as evidenced by UMS’ past, growth – if done for growth’s sake – can destroy value.

Finally, I think it’s important to point out the mission of Capiton Value, which continues to hold a sizable stake in the business:

“[Capiton Value’s] objective is to purchase significant shares in noticeably undervalued medium-sized enterprises as well as offering when suitable the respective management support for the implementation of value-creating measures…CVM combines capital market know how of many years with sound private equity expertise”

“CVM can offer support ranging from e.g. enhancement of capital market communication up to divestments (sometimes combined with a cash out) or Buy & Build strategies as far as assistance during a Going Private”

It remains to be seen whether CVM’s involvement could be an eventual route towards closing this value gap for minority equity holders…

Disclosure

Long UMS

However, the cost of attending these conferences is usually prohibitive (at least for those of us who are still full-time students), even before the travel arrangements and other costs.

The new European Investment Summit 2012, scheduled for October 9 and 10, promises to change all of that.

Put together by the folks behind The Manual of Ideas, the European Investment Summit is a fully online conference, meaning no plane flights or costly entry fees.

The conference has managed to attract an amazing group of speakers and will focus on investment ideas in Europe – an area of focus lately given the economic turmoil in that region.

As a teaser for the conference, the organizers are offering an interview with legendary investor Howard Marks, with the 27-page transcript available as a bonus immediately after registration.

A few quotes from the Marks’ interview (emphasis mine):

“What the investor has to do is weigh out on the one hand price and on the other hand reality. Everybody thinks very dire thoughts about Europe and the Euro, and I would be the last person in the world to argue against that position. Then the next question is, European assets are lower in price because of the macro conditions, but are the macro conditions being viewed too pessimistically?”

“Tenet number three of our investment philosophy says we are active in less efficient markets only. We probably wouldn’t do a hedge fund forlarge-cap New York Stock Exchange firms because the tendencies are that those would be more efficient than others. But emerging markets, yes. Japan, yes.”

“[U.S. Treasuries] are a safe investment in the sense that the outcome is known and not really subject to variation. I think they are not a good investment because the known outcome is an unattractive one. Today you can buy the ten-year [Treasury] and with no risk, lock up the certainty of 1.9% return for ten years. Is that really a good thing to lock up?”

The early-bid registration price of $297 (50% off) expires this Friday – registration also includes two weeks of access to the conference materials after the conclusion of the event.

Check out the registration page or click on the banner below to learn more.

Disclosure: I receive a referral fee if you register for the conference through Value Uncovered. The cost is the same either way.

Spin-off Details

Lotto24 AG (LO24) began trading on July 3, 2012, as a spin-off of Tipp24.

According to Tipp24’s CEO,

“we believe that a complete legal separation is the best option to provide Lotto24 AG with a starting position in the German market which is not burdened by legal disputes.”

Two board members from Tipp24, Petra von Strombeck and Magnus von Zitzewitz would join the new executive board of Lotto24 AG, with von Strombeck as CEO.

Priced at €2.50 per share, the spin-off jumped to the mid to high 3’s on the first day of trading before falling to a low of €2.78 only a month later.

Specific details of the spin-off included:

• Treated as a dividend in kind from Tipp24’s capital reserves
• Offered an additional 5,988,816 ordinary shares via a rights offering
• Total proceeds of approx. €13.87 million after-fees

Lotto24’s goal is to re-establish lottery brokerage services within Germany as soon as possible, essentially resuming Tipp24’s domestic business which was halted by the 2008 German State Treaty on Games of Chance (“GlüStV 2008”).

Q2 Financial Report

Lotto24 just released its first quarterly report as a public company, and it provided some detail about the company’s current state and future plans. Another quick history lesson on the German legal situation:

• Jan 1 2009: The GlüStV 2008 is passed, banning online gambling including lottery advertising and ticket brokerage over the internet

• Sept 2010: European Court of Justice (ECJ) declares that key elements of the GlüStV 2008 contravene EU law

• Dec 2011: Based on the ECJ’s opinion, the German States draft a new treaty

• Jan 2012: Schleswig-Holstein, one of the 16 German States, moves forward with its own law making online gaming legal and allowing LO24 to restart operations for SH residents

• March 2012: A revised treaty, the First State Treaty to Revise the State Treaty on Games of Chance (“GlüÄndStV”), is given to the ECJ for positive approval, but the ECJ does not approve or comment on it, casting doubt on whether it complies with EU law either

• July 1 2012: The GlüÄndStV treaty is ratified by the German States anyway

• July 2012: Schleswig-Holstein reverses its original course and now plans to join the other states in ratifying the GlüÄndStV this fall

So what does this all mean for online lottery brokerage in Germany? The short answer is that it’s still unclear.

The longer answer is that

“although the approval process [for nationwide rollout of online lottery brokerage] has been initiated, the permit criteria, Internet requirements, and advertising guidelines have not been finally decided yet.”

In addition, Lotto24 still believes that the new treaty’s validity as it relates to the ECJ ruling is still questionable:

“All in all, it is uncertain under such circumstances whether or not the GlüÄndStV can be legally applied.”

What the company does know is that the internet and TV advertising permits are handled by the German State of North-Rhine Westphalia, and will not be finalized until after their state elections – sometime in November 2012.

Although the GlüÄndStV might need to be revised even further to pass the ECJ (ultimately ending up in an even better situation for LO24 in all likelihood), the state of online gambling seems to be moving forward (albeit slowly and with a ton of uncertainty), and the company expects to be operating its lottery brokerage nationwide within the next twelve months.

On the financial side, LO24 has total equity of €32.6million, with the vast majority made up of cash (€14.7mil) and goodwill (€18.9mil). The goodwill is a result of the contribution in kind from Tipp24 for the “business opportunity for the resumption of online lottery brokerage in Germany.”

Unlike other start-ups, Lotto24 does not have to re-invest much back into operations or R&D – the software is developed already and can sit on the shelf without incurring holding costs, and the majority of expenses (like marketing) are discretionary and can be ramped up when the internet ban is lifted.

Operating expenses through the first six months of the year were €1.6 million. However, €960 thousand of that expense was due to one-time IPO costs.

After removing these non-recurring items and annualizing this figure for the entire year, LO24’s has a steady-state cash burn rate of €1.25 million per year.

With almost €15 million in cash, that’s a long runway…

Lotto24 Positives

Brand recognition:

With more than 2.5 million customers prior to the internet ban, German lottery players are familiar with the Lotto24 brand – it seems reasonable to assume that they will return to a familiar and trustworthy service. Lotto24 should benefit from a sharp initial jump in customers when the online lottery market resumes.

Negative working capital:

Lotto24 benefits from advanced customer payments and a slight lag in payouts, leading to “steadily increasing negative working capital” balance. With limited reinvestment requirements, FCF will be higher than net income[1. For reference, from 2003-2007, Tipp24 had cumulative FCF that was 2x of total earnings.]. This is very similar to insurance float, and allows LO24 to grow basically for free.

Stable investor base:

Gunther Holdings, a large shareholder in Tipp24, increased its stake even further (to 33%) via the rights offering, signaling confidence in the stock’s prospects. Gunther has been involved in the Germany gambling industry for decades, and will likely be a stabilizing shareholder through any delays in starting up operations.

Broadband penetration:

More internet users = a greater number of people who can gamble online. Over the past five years, Germany’s broadband penetration rate grew by 76.8% to 32 users per 100 inhabitants. This is faster than any Western European country save Ireland, and Germany now ranks 5th overall in broadband penetration out of the entire European Union. Basically, the pool of potential customers has almost doubled since 2007.

Growing lottery market:

See below.

Lottery Market

The gaming gambling, at least when looking at global numbers, is largely immune from economic downturns, growing at 4.9% per year from 1999-2011 without a single down year (2009 was flat):

As the second largest market (only slightly behind North America), Europe is expected to grow from $122.9 billion in 2010 to $171.5 billion by 2015, or 5.7% CAGR, slightly faster than the global rate:

The largest gambling product worldwide?

Lotteries, with 29.1% market share.

German Lottery

While it has been four years since the GlüStV 2008 was passed, a relaxation of the law seemed inevitable.

First, as shown by the above charts, people love to gamble and have done so via lotteries for hundreds of years – moving that business online seems logical.

Second, the ECJ was strongly critical of the original treaty and will likely continue to apply pressure to the German states until a compliant law is passed.

Finally and most importantly, money from the state lotteries goes towards the sports, environment, youth projects, and state budgets.

To put this in perspective, the German lottery had total receipts of €6.66 billion in 2011. Due in part to the treaty, this number is down more than €3 billion from the average levels from 2004-2007 – a pretty staggering drop – and no doubt forcing some unpopular budget cuts.

With a restart of online lottery brokerage, Lotto24 is planning for an immediate jump in lottery receipts to €8 billion, with the overall lottery market in Germany growing to €12 billion by 2020.

The company is also projecting a rapid increase in online ticket sales, growing to €6 billion by 2020, or 50% of total lottery sales.

While this growth rate seems optimistic, it is not crazy outlandish. Two thoughts:

1. Already, some countries (such as the UK) have more than 20% of gambling done via online/mobile channels – 50% in the next eight years seems within the realm of possibility:

2. While lotteries are still the most popular form of gambling, they lag other products in online sales, so there is even a larger runway for internet growth:

In summary, there is a ton of potential for LO24 once the company’s marketing machine can crank up again.

Historical Business Model

Lotto24’s plan is to sell tickets online for the State Lottery and take a small percentage commission. This is the same model that Tipp24 employed from 2003-2007, before the German gambling ban forced the management team to focus on secondary lotteries abroad.

Tipp24 was the dominant player in German lottery brokerage, reaching 60% market share of online ticket sales by 2007.

Check out this growth rate:

Roughly 25-30% customers were ‘active’ (completing at least one transaction per month), but Tipp24 earned almost €600 in billings per active customer[2. Active customers play a lot, and show almost no churn after the first year].

In the brokerage model, Tipp24 generated revenue from three sources:

• 10% distribution fee on traditional lottery ticket sales
• 20-30% markup fees for premium lottery products like scratch cards
• 15-20% margins on ‘white label’ business services (Tipp24’s technology powered the back-end on other lottery broker websites)

Therefore, blended gross margins – revenues / gross lottery receipts – were historically around 13%.

Here are the biggest operating expenses as a percentage of revenue:

Both marketing and other expenses were skewed higher in 2006-2007, as the company spent money on legal/consulting fees while also dealing with slowing customer growth due to the uncertainty surrounding the impending internet ban – Tipp24’s management was targeting marketing expenses at 30% of revenue.

As shown by the cost breakdown, the key part of the brokerage business model is marketing, as money spent to attract new customers is the largest expense by a wide margin. Customer acquisition costs averaged roughly €20 per new registered customer.

As the business matures however, these costs should fall as the rate of sign-ups slows and the company moves towards maintenance marketing.

This is a highly scalable business model, in that ‘other’ expenses (such as personnel, rent, etc.) will fall dramatically as a percentage of revenues as the number of customers grows.

Once the infrastructure is in place, the marginal cost of selling another lottery ticket is basically zero.

This should lead to future margin expansion, with a steady-state ceiling well above the 20% EBIT margins shown by Tipp24 historically, assuming the growth materializes and management executes successfully.

Lotto24 Forecasts / Valuation

So what is LO24 worth?

LO24 is essentially a start-up right now – with only a few thousand existing customers and negligible revenue – facing a still uncertain legal situation.

There are a ton of variables to consider:

• what year (and if) the ban is reversed
• legal restrictions in the new permitting process
• growth rate of the lottery market overall
• % of lottery market share taken by online tickets
• growth trajectory of LO24’s market share
• new customer acquisition cost curve
• and the list goes on…

However, with five years of Tipp24 financial history, there are some historical benchmarks to guide the exercise.

Here are key metrics for Tipp24 from 2007, the last year before its business was disrupted by the GlüStV 2008:

These metrics can be used as a baseline to forecast possible growth scenarios, in order to value Lotto24 based on its expected future cash flows through 2020, discounted back to the present.

First, some core assumptions which apply across each scenario:

• Activity rate starts out at 30% but falls as the market matures
• Billings per active customer gets an initial boost when the ban is lifted (i.e. the most die-hard lottery players sign up first) but stabilizes around €580 per active customer
• Gross margins start out at 8% and rise to 12% as premium lottery products and business services are phased in
• The company burns cash until the ban is lifted, but once legalized, operating margins rise steadily due to the scalability in the business model (i.e. falling marketing expenditures & other operating costs as a percentage of revenue)
• Capex and depreciation cancel each other out (reinvestment is negligible)
• Business model benefits from negative working capital, and FCF outpaces net income (consistent with Tipp24’s track record of cash flow generation)

Finding a precise value is not the goal[3. Whew!], but the exercise can demonstrate a range of scenarios.

Here is how Lotto24 might look in 2020:

Bull Case

This assumes that the online market is fully legalized by 2013, and grows – both overall and online – to meet management’s forecasts of €12 billion and €6 billion respectively. It also models sustainable EBIT margins of 30%[4. Analysts were predicting 5-year margins closer to 40% for Tipp24 back in 2005-2006, so 30% seems achievable].

Even with a peak market share well below the company’s past history, if this plays out, LO24 would be an absolute home-run investment.

Base Case

This projects a more realistic growth trajectory for lottery sales (5% CAGR), with online transactions making up 15% of the total (still a €1.5 billion market).

It also assumes that the internet ban isn’t lifted until 2014, even though LO24’s management is predicting full resumption of activities within 12 months.

Even so, this scenario still results in over 100% upside.

Bear Case

In the bear case, Lotto24 burns money for three years before finally winning the legal argument and starting up in 2015.

The total lottery market does get an ‘internet spike’ in 2015 (20% growth, back to pre-internet levels), but barely grows above the rate of inflation overall, with online sales reaching only 10% of the total.

Active customers fall to 20%, as LO24’s customers get bored and move to new forms of gambling , and economies of scale never kick in to boost EBIT margins north of 20%.

The market thinks the bear case is likely (i.e. Lotto24 is fairly valued).

Ultra-Bear Case

The stock goes to zero, a possibility for any start-up.

In this world view, the German government never allows internet brokering of lottery tickets and/or centralizes that function within the state lottery itself.

LO24 burns through its cash fighting legal battles and eventually goes bankrupt.

While this seems unlikely, there are still lots of uncertainties, and management will have to prove that they can navigate the legal and regulatory situation while executing on the company’s growth potential once the opportunity arises.

Growth Comparison

Here is a simple chart that shows the growth in registered customers under the various scenarios:

Conclusion

Putting it all together, LO24 is more of a special situations investment, where investors are weighing the probabilities of several scenarios and not necessarily coming up with a specific intrinsic value.

Using this range of outcomes, here is the expected value of making the investment:

This assumes a reasonable chance that Lotto24 is a success, while giving some weight to the extreme outliers on both the positive and negative side. With these probabilities, investing in the stock seems to be a very +EV decision.

Inverting the argument, here is what the market is currently forecasting:

In order for the stock to be fairly valued, the market is assigning zero probability for the bull case, and a 30% chance of the stock going bankrupt (even though a full bankruptcy is unlikely, given that LO24’s cash pile is almost 12x the current cash burn rate).

In fact, because the bullish outcome has such a high reward, the chances of the bull case playing out only needs to be 7.6% for an +EV outcome, even if the rest of the probability (92.4%) is assigned to a the stock going bankrupt.

In poker, maximizing positive expected value decisions is one of the keys to making money over the long term. Unlike poker – where hands can be analyzed – the exact probability weightings are unknown in Lotto24’s circumstances, but it appears that the odds are heavily in favor of some sort of positive outcome.

With a poker background, passing up +EV situations is against my nature – with the odds on Lotto24, I’ll stay in the hand and see how the river plays out…

Disclosure

Long LO24, TIM

P.S. – If anyone has updated lottery statistics from LaFluer’s 2012 World Lottery Almanac, please contact me.

Company History

Founded in 1999, Tipp24 SE (TIM) was an early pioneer of online lotteries in Germany and other European countries. The original business model had Tipp24 serving as an online broker to the German state lottery, essentially funneling lottery ticket sales through an online interface and keeping a 10% markup fee.

From 2002-2008, the number of subscribers grew from 0.4mil to 2.5mil (28% CAGR), as Tipp24’s market share rose to 60%.

The stock went public in 2005, and has turned in a remarkable run since, with revenues and EBIT rising nearly every single year (a small EBIT dip in 2008 as the sole exception):

Legal Environment

But in 2008, the German government ratified the State Treaty on Gaming (GIStv), which banned all online lottery brokering and advertising. This basically eliminated Tipp24’s core business, and management had to scramble to come up with a new strategy. The company ended up applying for a gambling license to begin operating secondary lotteries via a UK subsidiary.

In September 2010, the European Union proclaimed that the GIStv violated European law, and that Germany would need to submit a revised treaty.

Then in 2011, one of the German states, Schleswig-Holstein, broke off from the others and ratified its own state treaty to allow online lotteries starting in 2012 – meanwhile, the new GIStv is still making its way through the court system for the rest of the country.

While the lottery ban seems unlikely to stand forever, it has cost Tipp24 millions of euros in legal fees and lost business.

The legal situation remains complicated in Germany, but fortunately Tipp24’s management team finally decided to spin-off the old brokerage segment into a new company, Lotto24 AG (ticker: LO24), which began trading on July 3, 2012.

This action separates the legal fight in Germany from the UK operation, and it’s the UK business which will be the focus of the investment thesis. Despite all of the controversy and legal battles in the home country, the UK operation has thrived.

(To try to avoid confusion, the use of “Tipp24” and “company” references the new standalone UK business)

UK Business Overview

Tipp24’s UK subsidiary, MyLotto24 Ltd. (not to be confused with Lotto24, the new spin-off), operates a secondary or “virtual” lottery, allowing players to participate in lotteries such as the EuroMillions and German “6/49” lotteries.

Essentially, customers are “betting” on the traditional state lottery – keeping the same odds of winning the possible jackpot, but without having to physically go to the store and purchase a ticket. Tipp24 bears the risk if the jackpot is hit, but crucially, only pays if one of their customers is the winner.

The payout ratio is set at 50%, so Tipp24 keeps the difference between the price it charges for the lottery ticket and the expected payout, and then subtracts out a 15% UK gambling tax and any hedging costs to produce its overall profit.

Investment Thesis

#1) Attractive business model with high margins and free cash flow with little reinvestment requirements

Tipp24’s product offering is entirely online, and this asset-light business model is reflected in 2011 gross and net margins of 57.6% and 27.5% respectively.

Historically, the old brokerage model operated with negative invested capital.

In order to start-up the UK operation from scratch, management invested ~€30mil over the last four years, mostly in software upgrades. Total capital expenditures, including software and PP&E, were €36.5mil or roughly €9mil per year.

Even with this start-up investment, Tipp24 generated €54.3mil of EBIT (€38m after-tax) with only €31.7mil in invested capital. ROIC is more than 100% – this is a phenomenally profitable business:

Management is forecasting total capex (including software) of only €3-5mil in both 2012 and 2013. Since software assets are amortized over four years and make up the majority of Tipp24’s non-cash invested capital, amortization will likely exceed reinvestment needs and ROIC should improve.

Limited capital requirements also mean that the company has significant free cash flow available for share repurchases or dividends:

Even with the start-up costs, FCF has averaged €20.7mil over the last three years for a FCF yield of 7.3%, or 11.8% using estimated maintenance capex.

#2) Spin-off of German operations eliminates most of legal headaches, creating a catalyst (likely a large special dividend) within the next 12-18 months

Due to the legal situation, Tipp24 was forced to transfer control over its UK subsidiary, MyLotto24 Ltd. In effect, the company was trying to segregate the UK operations – running successfully since 2007 without political pressure – from the legal situation in Germany.

To accomplish the split, 60% of the preference shares in MyLotto24 Ltd. were sold to a Swiss foundation, as a way to show independence to German regulators. Importantly, Tipp24 retained a call option to repurchase the shares of Mylotto24 Ltd. from the Swiss foundation for £30k, and therefore can regain full control over the UK subsidiary at any time.

Once the corporate structure is simplified, the parent company would then have access to the subsidiary’s cash balance of €133.5mil, 47% of the stock’s current market cap.

A substantial amount of that cash would be excess, even considering the requirement to keep cash on hand to pay the deductible, so a large special dividend is likely in the next 12-18 months.

The company did pay a €0.50 per share dividend back in 2008/2009, equivalent to roughly 65% of EPS – that same payout percentage would result in a dividend per share of around €3.00 (an 8.5% dividend yield).

#3) New hedging mechanism improves cost structure, leading to potential margin improvements

Historically, Tipp24 hedged its jackpot exposure in two different ways:

– Via an insurance contract for the German “6/49” lottery, which kicked in for any jackpot payouts over €10mil

– Via “native hedging” on the EuroMillions and other lotteries, which meant buying a ticket with the same numbers and earning a profit through markup and distribution fees

In September 2011, the company announced a new hedging mechanism with the issuance of a three year €70.5mil catastrophe bond (CAT bond). This bond transfers the payment obligation to a third party while having Tipp24 retain the first €22.5mil in jackpot payments (i.e. its annual ‘deductible’).

Essentially, the new bond allows Tipp24 to eliminate native hedging whenever the EuroMillions jackpot is less than €50mil – before, the company had to hedge every ticket sold regardless of the jackpot size. These hedging costs were significant, running around 10-11% of UK revenues:

Through Q1 2012, hedging costs have fallen 49%, from €5.0mil to €2.6mil – annualizing this figure results in a FY cost of €10.24mil, for a savings of €6.3mil.

This new strategy could boost EBIT by €5-6mil in 2012, without any growth in the number of players or popularity of the EuroMillions product, which seems conservative.

To make the benefits clear, here is an estimate of the economics of the EuroMillions lottery ticket, under the new strategy (i.e. no natural hedging required):

While not representative of true margins (there are other direct expenses, and the company will have to hedge tickets anytime the jackpot is over €50mil), it does showcase the benefits of this new strategy.

Valuation

Due to the legal uncertainty, the Germany segment posted €26.5mil in operating losses over the past three years, which must be removed for the new standalone company.

In addition, statistical fluctuations should be excluded to get a better picture of the UK’s earnings power, assuming the “average or expected” result:

Management is forecasting revenues of at least €130mil and EBIT of €35mil for 2012.

However, this EBIT forecast builds in a €10mil buffer for statistical fluctuations, so the true EBIT forecast is €45mil. Even this number seems conservative considering:

a) the potential cost savings from the new hedging strategy

b) the spin-off of the costly Germany segment

c) any growth from re-focused operations and management attention

2011 earnings were skewed upwards by an insurance payment, counterbalanced by charges for the C-bond issuance, costs related to the spin-off, management changes, etc.

Let’s say that normalized earnings are €50mil per year – or €35mil after-tax.

With limited reinvestment needs, net operating profit after tax (NOPAT) matches up almost exactly with free cash flow.

Capitalizing the €35mil number at a 10% discount rate yields a no-growth value for the operating business of €43.83/share, or 24% upside from the current stock price. This valuation is giving no credit for all of the excess cash on the balance sheet, plus any additional growth opportunities.

Here are the upside scenarios at varying discount rates and estimates of excess cash:

Put another way, the base valuation of €53.85/share (52% upside) is consistent with 9.5x P/E, plus the ~€85mil in excess cash – a rather conservative multiple for such a profitable business model.

Risks

Regulated operating environment – Gambling and lotteries are heavily scrutinized activities, and Tipp24 runs the risk of legal or political changes which could negatively affect the business model.

Negative statistical fluctuations – Even with the new hedging strategy, the company is still on the hook to pay jackpots up to €22.5mil, and lottery results could run below expectation for an extended period of time. Unlike other business models, poor results can occur purely by chance.

Management turnover – The size of both the executive and supervisory boards have been changed several times – for example, Marcus Geiss was added in April 2011, but left prematurely in April 2012. The current CEO and co-founder, Dr. Hans Cornehl, has been involved with the company since 2002, although the other co-founder left in 2009. Current management holds less than 1% of shares.

Conclusion

Essentially, Tipp24’s business model is rather simple:

In exchange for €25mil in invested capital (basically cash that is set aside in the case of a jackpot payout), Tipp24 takes a cut of potential payoffs (50% ‘rake’ on each ticket, less the cost of hedging), for running a secondary lottery – which just so happens to be more convenient to play than the real thing.

This €25mil in cash sits in the bank and generates €30-35mil in after-tax proceeds each year. Not a bad return, and better than a savings account.

To some degree, this is still a ‘wager’ on Tipp24’s part (essentially betting that two large jackpots won’t be hit back-to-back for example), but the jackpot odds are so small that the risk/reward is skewed heavily to the positive side.

No wonder lotteries have been around for hundreds of years…

Disclosure

Long TIM, LO24

Company Overview

Mitani Group (8066:TYO) is a Japanese conglomerate that operates in segments from concrete to semiconductors and from bowling alleys to nursing homes. With roots going back to 1914, the company now manages almost 100 subsidiaries – an overview of the group structure is included on the website.

Many of these subsidiaries have operations that are hard to categorize, but the company is broadly organized into three main segments:

Information Systems – includes CATV, software development, and outsourced IT services

Energy / Life Support – includes housing equipment, gas stations, and wind power generation

Construction Materials – includes building materials, concrete products, and aluminum sales

Of the three, the Construction Materials segment is the most important, accounting for almost 70% of sales and total profits:

With a market cap of ¥26,134mm (~$330mm), Mitani is quite a bit larger than other Japanese net-nets like Maruka Machinery and Fuji Oozx.

Financial Overview

For the 2012 fiscal year, Mitani reported sales of ¥403,336mm, an 11% increase over the prior year and up 24% from recession lows. All three major business segments had positive growth, led by a 12% increase in the Energy & Life Support division.

Both operating and net income rose even faster, up 18% and 30% respectively, with EPS reaching a record of ¥232.

Over the past decade, revenues have grown 4.8%/year while SG&A costs climbed only 3.1%/year – these costs now consume 6% of revenue versus 8% ten years ago.

Unlike many other Japanese net-nets, Mitani does have some short and long-term debt on the balance sheet, totaling ¥9,919m, plus another ¥2,065m in retirement obligations.

However, this debt is offset by ¥45,136mm in cash and a very manageable debt-to-equity ratio of 16%.

Although Mitani has spent over ¥7,800mm on acquisitions over the past ten years, total goodwill and intangibles of ¥1,468mm is negligible when compared to ¥177,576mm in total assets.

FCF has averaged just over ¥5,000mm over the past ten years, for a FCF yield of almost 20%.

Investment Positives

Conglomerate structure helps dampen swings in economic cycle, which translates into smoother top and bottom line growth

Although Construction Materials makes up a significant portion of revenues and profits, the varied business lines among the operating subsidiaries insulate the company from economic swings.

Here are YoY revenue growth rates for each business over the past five years:

Every business struggled in FY2010, but historically, drawdowns in one segment (such as in FY09) can be compensated by growth in other areas.

Compare Mitani’s negative swings to several other Japanese net-nets:

This consistency has translated into 4.8% annual revenue growth over the past ten years, a solid result considering the economic environment in Japan.

Due to operating margin increases and share repurchases, EPS grew at 27% annually over that same time period.

Positive industry dynamics will translate into continued demand for construction materials over the next 2-3 years, boosted by domestic rebuilding after the Japanese earthquake

Many construction materials and supply companies saw a sharp jump in stock price after the March 2011 Japanese earthquake on anticipations of a massive rebuilding effort.

Mitani’s stock price hit ¥1,405 per share in early May, up 67% in fewer than 30 days post-quake – other construction stocks showed similar increases.

However, the price jump reversed itself quickly, and Mitani’s stock price returned to pre-quake levels only six months later.

While the initial thesis was straightforward – earthquake/tsunami damage leads to greater requirements for building products like cement and concrete – investors seemed to misjudge how long the process would take.

The fact remains that the rebuilding in many of the hardest hit areas has only just begun, as this USNews report shows: “Before and After: One Year After the Japan Earthquake.”

This is backed by cement shipments to those tsunami-affected prefectures (with cement demand being a good enough proxy for rebuilding efforts): 

Notice how the demand spike did not occur until the first two quarters of 2012, almost a year after the quake.

Analysts are expecting total cement demand to peak at 45b tons in FY2013 , with reconstruction demand providing a 3b ton boost:

While growth in the cement industry has been modest, it reverses a two-decade trend of declining demand:

(Looking at the chart, FY2010 was a rough year: cement demand was half of the 1990 peak. That same year, total Japanese construction investment hit a low not seen since the late 1960s – truly staggering)

Mitani’s Construction Materials segment showed a 10% sales increase in FY2012, growth which should accelerate over the next 1-2 years.

History of conservative guidance softens impact of poor outlook in latest annual report

Despite the seemingly positive macro trends (at least in the construction industry), the FY2012 financial report provided a very conservative outlook for the coming year: sales up only 0.4%, operating income down 9.8%, and net income down 9.4%.

In the 30 days after the May 9th release of the annual report, the stock fell 18%.

However, Mitani’s management has a history of conservative forecasts:

In each of the past three years, management has revised both the revenue and profit figures upwards – with the final result ending up even higher than the revised forecast.

While past history is no guarantee of future performance, the cautious outlook for FY2013 does not appear to be a major concern.

Availability of English-language financial statements

Not to be overlooked. While the raw financial numbers can be found in CapIQ or Bloomberg, Mitani publishes translated financial statements online.

This prevents translations mistakes (Google Translate struggles with Japanese. Trust me, I’ve spent hours trying to make sense of reports), and provides important information.

For example, Mitani clearly shows that ¥5,110mm of its long-term investments are Investment Securities.

While Mitani’s translated reports do not include financial notes or management commentary, even the provided info is lacking in many other Japanese microcaps.

Investment Negatives

Conglomerate structure – reduces chances of acquisition by competing firm, which is a key source of unlocking value in many microcaps.

Conglomerate discount – Markets often price conglomerates at discount to comparable pure-play companies (although discounting to zero seems a bit extreme).

Domestic-based – Mitani is highly dependent on the economic and political environment in Japan. Much has been written about the Japanese situation, with passionate arguments on either side. Readers can make their own judgments on the macro risks.

Currency risk – Many investors are betting on a weakening of the Japanese yen, which would reduce the holding period return when closing out a position and converting proceeds back to USD. Even with possible currency losses, the margin of safety with Japanese net-nets is huge – here are some interesting views on the yen and currency hedging (here and here).

Valuation

As with the other Japanese stocks I’ve invested in, Mitani is a traditional Graham net-net stock selling for less than NCAV:

The company’s enterprise value is negative -¥1,222m, meaning that the market thinks that Mitani’s collection of 100+ subsidiaries is worth less than zero.

However, the Information Systems and Construction Materials segments are actually good businesses, with double digit pre-tax return on assets[1. Pretax ROA calculated as segment operating profit ÷ total segment assets, without adjustment for inter-segment sales or corporate-level assets.].

Even the Energy & Life Support segment has shown steady improvement:

Over the past decade, Mitani’s ROE has averaged 8.4%. Since FY2008 (right through a global recession) average ROE actually improved to 8.7% – nothing spectacular, but very good compared to the majority of Japanese net-nets.

At 0.39x of book value, investors are getting a stock that has compounded BV/share by 9.3% annually for 10 years, in addition to offering a 2-3% dividend yield since 2009.

Mitani’s P/B multiple has averaged 0.52x over that time period, with a trough of 0.21x during the depths of the crisis.

Here are a range of IRR scenarios using BV growth and P/B multiples, starting with the 3/31/12 BV/share of ¥2,429 and forecasting through FY2015:

If the stock trades back up near its historical P/B range of 0.5x and continues growing BV/share at 9% per year, the resulting IRR would be 20% per year (or roughly 22.5% with dividends included).

On a P/E basis, Mitani’s multiple has averaged 7.4x over the past decade vs. a current TTM P/E of 4.1x, so a return to long-run averages would imply a price target of ¥1,719, or 81% upside.

Conclusion

Several recent articles have highlighted the potential in Japanese small-caps:

Managers see big profits in Japan’s smaller-caps

Ex-Goldman Trader Run-Symphony Seeks Money for Hedge Funds

This renewed investor interest could lead to more activism in this unloved space.

To conclude, it might be helpful to provide a quick illustration of the potential with many of these Japanese net-nets. Consider:

1. If these activists and hedge fund managers can shake up the situation in Japan (a big if)

2. And market valuations return to more rational levels (probably a bigger if)

…then a growing, consistently profitable business like Mitani should never sell for less than net cash.

So what might someone bid for the entire company in a private transaction?

Getting bought out at a “fair” price is wishful thinking given the Japanese environment right now, especially in the small-cap space, but even a return to NCAV within the next few years could offer double digit annual returns.

Disclosure

Long Mitani