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Gigaset (AQU) - Unsustainably Cheap Under Any Scenario

August 10, 2011
Above Average Odds

Above Average Odds

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The investment analysis below is our thirteenth in our ongoing series of guest posts which I am proud to say is brought to you by my friend and colleague, Thomas McGannon of Whetstone Capital Management. Thomas graduated Summa Cum Laude from Creighton University with concentrations in finance and theology, managed to complete his CFA at only 24, and amongst a laundry list of other impressive attributes also happens to be one of the most brilliant and insightful investment analyst(s) I know. It’s not a stretch to say that of all the wonderful friends/investors I’ve met over the years in this business (and through this blog) – and there have been many – I know of no one more passionate about investing or more capable of success than he and not a day goes by where I’m not reminded of how lucky I am to have such tremendous partners.

That said, I was finally able to cajole Thomas into putting a guest post together and in the process provide our readers with not only what we believe to be a tremendous low-risk, high-return investment opportunity, but more importantly, a first hand example of his uncanny ability to uncover and exploit value in the most unlikely of places. Enjoy!

Foreword

I began writing this thesis when Gigaset was trading at €3.75/share. I thought it was very cheap then. Thanks to the recent market turmoil and 25% increase in Gigaset’s free float, the stock is down 40%. I now believe it is insanely cheap. For those of you currently looking to find uncanny value in the wake of the recent sell off, I propose that you consider shares of Gigaset.

Investment Thesis

Gigaset (DE: AQU) is a leading designer and manufacturer of cordless phones. It is a good, but not great, business in a stable industry. At its current price of approximately €2.30/share, Gigaset is trading for<1x management’s guidance of run rate EBITDA and<2x ’12 free cash flow. Plainly stated, this is an unsustainably cheap valuation for a business with significant net cash and a dominant 33% market share in a stable industry. While I am no doubt concerned by the fact that the majority of operating income comes from Europe, I believe the core earnings power of the business is resilient. The EMU could break up and the world could be cast into a double dip recession, but people will still need phones to communicate. Furthermore, since only a very deep recession would permanently impair the value of the business, much of the European risk can be hedged out using a short of your choosing. I have paired this with a short of EZU, an EMU ETF (if anyone has a preferred macro hedge then I would love to hear it).

Conservatively (meaning cautious, not simply plausible as it is often used in such investment write ups as this), I believe this business is worth at least 5x my downward adjusted EBITDA (which expenses all R&D), implying a +150% return. With minimal debt, net cash and the potential combination of multiple expansion and improving margins, shares of Gigaset should provide asymmetric returns while incurring less than market risk, particularly when paired with a European macro hedge.

Why Does the Opportunity Exist

In my experience, developing a satisfactory level of conviction regarding the “why is it cheap” part of an investment thesis is one of the most challenging aspects of investing. With Gigaset, I believe the answer is quite obvious. I think I have a real edge when I buy shares of Gigaset. Here’s why:

  1. Gigaset operates in an industry that carries a stigma of being in terminal decline and is valued as though it is also in financial distress. The first point is debatably untrue, the second is certainly untrue.
  2. Gigaset is a restructure within a restructure. Both the operating business and parent holding company have undergone material changes over the past year. The current financial performance of the business is completely obscured by its former self.
  3. A recent conversion of convertible debt issued in November 2010 added 25% to the outstanding float. This release is at least partially responsible for the +40% sell off over the last two months.
  4. Gigaset is a microcap company based in Europe with less than a €120MM market cap. It’s probably not on any franchise broker’s “must own” list.
The presence of one or two of these factors would be enough to get me intrigued. The presence of all four makes me think that I have developed the ever elusive “edge” on this name. Following is some additional context and analysis of underlying factors.

The Business

Gigaset is the largest retail phone (fixed-line and VoIP) manufacturer/vendor in Europe, and second largest worldwide (Panasonic is number one). By region, two-thirds of sales come from Europe. The remainder is mostly from South America and China. By product, sales are comprised of 80% cordless products and 20% corded products (sell side pegs it at a higher percentage of cordless). In cordless phones, Gigaset holds a 33% market share in Europe and over a 50% market share in Germany (its largest market; ~30% of total sales). Furthermore, Gigaset holds a stunning 90% market share in the European high-end cordless phone market (ASPs of €100 and up). From my research and conversation with individuals familiar with the space, it appears that Panasonic and Philips have largely ceded the high-end market to Gigaset. Using an admittedly non-scientific approach of searching for cordless phones on Google Germany, I estimate that ~75% of units sold in Europe that are priced €100 and up are made by Gigaset. The user reviews and “Best Of” lists I have read almost unanimously peg Gigaset phones as the highest quality phones in the market, often referring to them as the “Mercedes Benz of cordless phones.”

I accept that any mention of a dependence on fixed-line voice communications raises everyone’s secular decline/melting ice cube flags. However, I think these concerns are misplaced. Fundamentally, I think that: a) the lack and prohibitive cost of “all you can eat” mobile plans in regions around the world, particularly Europe, creates a durable place in the market for fixed-line products (this is crucial to my variant view on the operations), b) people prefer the quality of fixed-line/VoIP voice to mobile and c) there are innumerable practical reasons why it makes sense to have a fixed-line phone in households and businesses (I know this is not really a point in and of itself, but hopefully you get the picture. Landlines still make sense for most people, either at home or in the office, particularly for Europeans.).

Fortunately, there is real data to back this up. Each year the European Commission completes an E-Communications survey, analyzing household use of phone and internet connections. In the most recent report, findings indicate that fixed-line phone utilization across Europe was 71%. This was a 2% decrease from 2009 levels, but is slightly above the 70% utilization in 2007. While the percentage of households who use mobile-only increased from 24% to 27% from 2007 to 2011, this shift is largely attributable to the 6% increase in mobile penetration, rather than outright cord cutting. Furthermore, in respect to Gigaset’s primary markets, the underlying dynamics for landline use appear relatively stable. In Germany, where Gigaset generates +30% of its sales and +40% of operating income, fixed-line access increased 7% from 81% to 88% between 2007 and 2011. France, Gigaset’s second largest market, experienced a similar 7% increase in fixed-line access over the four year period. The report and supplementary information can be found here: http://ec. europa. eu/information_society/policy/ecomm/doc/library/ext_studies/household_10/report_en. pdf.

While there are a number of ways to look at the fixed-line market, my view is that it is largely stable. This is a variant view. Furthermore, I would contend that the lack of perceived market growth will dissuade new entrants from attempting to steal market share, thereby giving Gigaset a better-than-average chance at holding its current position. If anything, competition is decreasing and likely to continue to decrease. The top three cordless phone manufacturers in Europe (Gigaset, Panasonic and Philips) combine for 67% of the market. Second-tier producers find it very difficult to compete given the high fixed costs and importance of brand identity. Even within the top three, Gigaset is competitively advantaged. Whereas Panasonic and Philips have several lines of business to occupy their attention, Gigaset is solely focused on consumer phones. And this isn’t just lip service; Gigaset has grown market share +300 bps over the past two years and Philips decided to pull out of the UK market because it was no longer profitable. By comparison, Gigaset generates +40% gross margins and +12% EBITDA margins in the UK.

Restructure #1: The Parent

Prior to December 2010, Gigaset operated as Arques Industries, a publicly traded private equity firm focused on acquiring and monetizing control investments in turnaround businesses. Arques was founded in 2002 by Dr. Peter Loew. Dr. Loew led the business from 2002 to 2007 before “withdrawing to the private life” as it was stated in the release announcing his departure. Essentially, he sold his €53MM position in the company and took some time to enjoy it. Following his departure, however, business became a lot more difficult at Arques. Long story short, in 2009 Arques Industries found itself with over ten unrelated and unprofitable business groups ranging from electronics to steel manufacturing to candy makers. Perhaps the only thing that these businesses had in common was that they all were crushed in the recession and, collectively, forced their parent to recognize impairments which exceeded €230 million or over one third of the book value of assets.

Facing the real possibility of bankruptcy and a total loss of capital for equity holders, Arques began liquidating its portfolio of businesses in early 2010 at a rapid clip. However, as management began to empty the company’s bathwater, founder Peter Loew returned to the scene and gasped: “Wait! There’s a baby in there! Its name is Gigaset!” Recognizing that there was significant value in Arques if one could isolate Gigaset, Loew returned to persuade the board not to sell it (he also purchased 4.5% of the business). While I do not have the specifics of Mr. Loew’s return and the events that followed, a simple news search will outline the following:

  • August 23, 2010: Arques reports that it is in negotiations to sell Gigaset.
  • August 26, 2010: Dr. Peter Loew is announced as head of the Supervisory Board.
  • August 27, 2010: Arques reveals that its CEO is resigning. Effective August 31st.
  • September 14, 2010: Arques announces that it is issuing 13.2 million shares to existing shareholders, raising €14. 5 million. While it is not spelled out, the capital from this raise is being used to purchase Siemens’ remaining 18% interest in Gigaset.
Over the following six months, Arques resolved outstanding Gigaset-related issues with Siemens, liquidated the majority of its PE portfolio and paid down over €65MM in debt. Perhaps more significantly, Arques formally changed its name to Gigaset and announced that going forward it would focus exclusively on the telecommunications industry. The difference in the financial picture between then and now is night and day. As of March 31 the company had a net cash position of around €25 million (the convertibles converted June 30 and should therefore be viewed as equity), which is likely ~€5-10 million higher at present due to positive Q2 operating cash generation and the sale of the final legacy business, van Netten, a candy manufacturer which did €49MM in revenue and €3.6MM in EBITDA in 2010.

Restructure #2: The Operations

The operating business is the former “Home and Office Communications” unit of Siemens. It was sold to Arques Industries in 2008 after Peter Loescher took over as Siemens’ CEO to construct a turnaround following a near fatal blow dealt by bribery scandals and rampant “conglomerate-itis” (a condition typified by disparate businesses operating under a bloated corporate overhead). At the time of the sale, the unit generated over €700 million in revenues selling a wide portfolio of phones, media products and broadband devices. The division employed over 2,100 people and generated negative EBITDA. The total purchase price was approximately €45 million. Based on conversations I have had, Siemens was simply motivated to stop the cash drain. Upon purchase by Arques, the new owners quickly shut down the unprofitable media and broadband product lines, where Gigaset did not have a market leadership position, and trimmed headcount by +20%. What was left was a business that in 2010 did over €500 in sales, achieved a 12% EBITDA margin and expanded its European cordless phone market share to 33%.

Guidance and Growth

Management is guiding €540 million in sales for 2011. Net of discontinued operations, this will come out to around a 1.5% increase from 2010 levels. While not particularly exciting, considering that Q1 revenues were down 5% (Q1 ‘10 was a strong quarter and weakness was apparent in southern Europe), I believe that this guidance reflects confidence in their existing product refresh for the year and some expectation of sales from growth initiatives. Whether this is the reason or not, the new management team has been notably conservative when framing the market’s expectations over the last year and I am willing to take their guidance at (or at least near) face value, even under current tumultuous conditions. Management estimates that they can produce €65-70MM in EBITDA with flat sales, implying a 12-14% EBITDA margin. Given the fact that Q1 EBITDA margins were just over 14%, I think this is reasonable if not a bit conservative. It is worth noting that even on lower sales, margins expanded +60 bps from Q1 2010.

Using this guidance and applying a 33% German corporate tax rate, I estimate Gigaset’s NTM NOPAT to be in the neighborhood of €25MM. Looking at March 31 financials, I calculate invested capital for the business at around €63MM (€310MM assets – €20MM excess cash – €227MM current liabilities). This comes out to around a 40% ROIC, which I believe supports the claim that this is a decent business and offers some hope for value creating growth opportunities.

The primary focus areas for organic growth include: VoIP, small business phone systems and international expansion. The first two are interesting. I could do without the third, but since they aren’t spending money on it I am indifferent and won’t even discuss it. Gigaset is spending €8-12MM in capitalized R&D and cap ex on VoIP. The opportunity is straightforward: depending on the destination of a call, using VoIP is incrementally free to users. I am not a telecommunications expert but my intuition tells me that, in time, people will increasingly adopt VoIP and buy compatible phones. If you refer back to the communications study discussed above, you will find that 65% of those surveyed said they limit mobile calls because of the cost. Gigaset already offers several VoIP compatible phones and I believe their place as market leader in the high-end space will translate well. While I don’t have much insight into how significant of a growth driver VoIP might be (especially considering that some level of sales will be cannibalized from the traditional business) I think some simple math suggests that this is a decent use of capital. While I generally trust market studies about as far as I can throw them, researchers predict the global VoIP phone market will be around 40 million units per year in 2015. Presuming that Gigaset will capture a 10% market share (its current global cordless market share is 12%) and estimating ASPs at €50, this would be a €200MM revenue stream for Gigaset. While management does not break down existing VoIP sales as a percent of total revenues, so it is difficult to determine how much of this would be new sales, I think it stands to reason that spending €8-12MM per year for a €200 million revenue opportunity with +40% gross margins is worthwhile. The end market could be cut by 75% and it would still be a good use of capital.

The other area for growth is in the small business and home office space, which is referred to as SOHO. Currently, Gigaset phones are often used in many business phone systems as part of an integrated platform. The plan is to move horizontally into offering the full phone system package. Management estimates that they can generate €15 million in new sales in 2012 from this business and is spending around €20 million in capitalized R&D and cap ex to ramp up the initiative. While estimating an expected return from this unit is also an exercise in approximation, I think one can take a reasonable walk to decide whether this is a worthwhile use of capital. Gigaset’s existing gross margin is around 40%, with management targeting 50% once the restructure is fully complete. Assuming that gross margins will be near existing levels and that Gigaset will have to add bit in overhead for SOHO, I think that pre-tax contribution margins should come out around 35%. On €15MM in sales, this would look like a 26% ROIC. While this is nothing extraordinary (especially considering that the current free cash flow to equity is +50%), it at least gives me comfort that management is not wasting cash here.

Non-Economic Selling Pressure

As part of the recapitalization, Gigaset raised €23.8MM in the form of 9% convertible debt in November 2010 that was convertible at management’s discretion after June 30, 2011 at €2.30 per share. As expected, management converted the issue as soon as they could. This resulted in an additional 25% to the existing shares outstanding (10MM shares; 29x average daily volume). The holders of these shares were no doubt very eager to get liquidity and cash out on their +60% seven month gain. I believe that the recent weakness (-35% since 6/30 vs -15% for the DAX) is largely attributable to this conversion.

Micro-Cap + Europe = Pass

Gigaset’s market cap is around €120MM and it is traded on the DAX. Almost all of its operations are based in Europe. While I am as skittish about the current scenario in the EMU as anyone, I also believe that the world is not going to end. Europeans are still going to buy phones. In 2009 total cordless phone purchases declined only 3.4%. While Gigaset sales declined 5%, this was the result of non-core product trimming. Despite being known as a high-end producer, they were able to grow market share during the last recession. Given the fact that Gigaset has significant net cash and derives a majority of its operating income from Germany and France, I feel this business is capable of managing through turmoil.

All in, Gigaset runs a fairly durable business with a recently improved cost structure. It is almost certainly going to be around in ten years and it’s priced as though it won’t be here in two. Even so, if Europe scares you as much as it does me then I might recommend pairing this with a European short of your choosing (again, recommendations for your favorite hedge are welcomed).

Valuation

Management is guiding for €510MM in 2011 revenues from continuing operations (discontinued operations contributed €31.6MM in revenues). Based on my conversations with management, I believe the business can generate €65-70MM in EBITDA on flat revenues. I take the mid-point of €67.5MM in EBITDA, implying a 13.2% EBITDA margin. EBITDA margins in Q1 were just over 14%, so I view this as a reasonable input.

Run-rate D&A is around €30MM. The corporate tax rate in Germany is 33%, so the normalized tax burden should be around €12.4MM. Gigaset has +€60MM in NOLs. Because these NOLs provide real, but short-lived, economic value to Gigaset I apply a full tax burden and value the NOLs as an asset which reduces the enterprise value. I value the NOLs by calculating the NPV of NOL utilization at the current level of profitability using a 25% discount rate. I use an outsized discount rate because the timing and nature of NOL utilization is uncertain.

Going forward, I expect that capitalized R&D and cap ex will be in the neighborhood of €35MM. Despite the fact that +80% of this spend is going toward growth initiatives, I acknowledge that Gigaset will have to innovate and add new business lines to keep the top line stable. As such, I assume that €20MM of the total cap ex budget is maintenance cap ex. Given the fact that I expect +€5MM in operating income contribution from SOHO (and that’s the less attractive growth effort), I think this is fairly conservative.

Fully Converted Shares50.02
Current Price€ 2.30
Market Cap€ 115.05
Excess Cash-€ 25.00
NPV of NOLs (See below)-€ 32.69
Enterprise Value€ 57.35
Sales€ 510.00
EBITDA Margin13.25%
EBITDA Est.€ 67.58
EV/ EBITDA0.85x
D&A-€ 30.00
EBIT€ 37.58
EV/ EBIT1.53x
Taxes (33%)-€ 12.40
Net Income€ 25.18
EV/ Net Income2.28x
D&A€ 30.00
Maintenance Cap Ex-€ 20.00
Free Cash Flow€ 35.18
Free Cash Flow Yield61.33%
Target Price

As I stated in the beginning, I am not certain what this business is worth. Comps are tough to apply directly since there aren’t really any consumer phone pure-plays, but I think names such as VTech, Nokia, Bang & Olufsen and Motorola can be looked at to a degree. Generally these businesses trade for 5x to 10x EBITDA. At a minimum, Gigaset is trading at a +50% discount to what one may reasonably call comps. Because I support selling investments when I no longer feel I have a margin of safety, I would probably place a target of 5-6x adjusted EBITDA of €51MM, which backs out capitalized R&D (€68MM EBITDA less €17MM capitalized R&D). From a free cash flow perspective, this approach would value the business at 7-9x free cash flow, which I believe is fair for a stable, possibly declining, cash generating business. A valuation in this neighborhood would result in a share price of €6.20 – €7.20, implying +170% upside. From a downside protection standpoint, I believe that if I am wrong about the business and it is indeed in terminal decline at 5% a year then the shares are still worth +€4.50 using a 15% run-off discount rate.

Catalysts

This business has a +30% market share in a local market where it generates two-thirds of its sales and an even larger share of its operating profit. It trades at<1.15x adjusted EBITDA. I think the price disconnect is enough to consider value as its own catalyst. Even so, I think there are some concrete internal catalysts here (it is, after all, a re-org). Most notably, I think posting “clean” results for the stand-alone Gigaset operations, realization of cash from the remaining business sale and the removal of the overhang from the conversion of the convertible bonds will provide opportunities for a revaluation. It would also help if people would realize that Europe is not going back to the Middle Ages.

Risks

Having addressed concerns regarding secular decline and the European meltdown, the biggest risk associated with an investment in Gigaset is whether or not management will properly allocate cash. According to the CFO, management expects to use free cash to invest in the business through both internally developed initiatives and acquisitions. While I have tried to express to management that a share repurchase is very likely their best use of capital, they maintain that they feel the best decision is to build out the business. I am sure that there is likely plenty of low hanging fruit for management to go after now that they are finally able to focus on the actual operations which leads me to conclude that such a strategy would be unlikely to destroy shareholder value. Furthermore, I take comfort in the fact that Peter Loew, who is active in the business and chairs the Supervisory Board, was a very good capital allocator when he ran Arques (he grew tangible book value per share at an astounding rate, even considering the favorable environment). Dr. Loew owns 4.5% of the business and he makes money only when shareholders make money. Still, it is always disheartening to see management waste an opportunity to buy their shares at a price that they will likely never see again. The unwillingness to repurchase shares is frequently my biggest problem with investing outside the US. An unwillingness to repurchase shares at this price is enough to give me a heart attack.

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