Ferronordic Machines: Russia, P/E 5 and 30% growth

Background

Ferronordic Machines is the official Volvo Construction Equipment dealer in Russia. End of 2014 it had 75 dealership all over the country, from St. Petersburg over Siberia all the way up to Vladivostok.

It’s simple razor and blades business. First sell the machine and then spare parts and service to that machine. Equipment sales are cyclical but spare parts provide stability and covers operating costs. It’s good business with 20%+ ROIC.

ROIC%
2013: 27%
2014: 20%
2015E: 24%

To refinance bond Ferronordic issued 500 MSEK worth of preference shares in 2013 with 10% initial dividend yield and conversion privilege to common stock.

Since then Russian economy and ruble have collapsed and the preference share price with them. Currently whole issue is trading at 215 MSEK, 43% from par and implied 24% dividend yield (~P/E 4).

What makes the preference share interesting, apart from the low P/E, is the conversion claim to common stock in IPO, which is not valued at the 500 MSEK par value but with higher 650 MSEK value (conversion claim of the preference share increases each month the IPO is delayed up to 650 MSEK).

Essentially number of common stock received in conversion is determined by formula:

Number of stocks received=650 MSEK/IPO Price

So basically by paying 215 MSEK, in addition to getting right to 50 MSEK annual dividend, preference shareholders in aggregate get up to 650 MSEK claim to Ferronordic total equity value if there is IPO.

I think the preference share as if paying 215 MSEK to get 650 MSEK worth of currency to shop around in IPO. And assuming the IPO price is fair, by definition therefore, buying price will be below fair value.

The conversion claim is conditional on IPO which was planed for 2014 but has been delayed because of the developments in Russia. Although IPO is not guaranteed management’s statement is that it happens when the situation clears.

Opportunity

Currently IPO window for anything Russia related is closed, but if it could be done say in three years, and if the preference dividend could be paid as promised, the cash inflows for preference shareholders would be:

2016: 50 MSEK, dividend
2017: 50 MSEK, dividend
2018: 50 MSEK, dividend
2018: 650 MSEK, conversion to common stock and sell @ IPO price

So that,

Total cash inflows 800 MSEK
Paid market price 215 MSEK
Profit 585
UPSIDE 272%
CAGR 55%

Payoffs will be realized if there is enough earnings to cover the 50 MSEK dividend and if there is at least 650 MSEK equity value available in 2018, factors that are partly function of underlying earnings power in RUB and partly function of SEK/RUB exchange rate.

Earnings power:

Adjusted earnings (MRUB, assumed 20% tax rate)
2013: 210
2014: 310
2015E: 360
%Change 71%
CAGR: 31% (vs. 15% inflation)

So RUB earnings have grown 31% p.a, double the inflation rate, despite mayhem in Russia. This year growth seems be slowing down to inflation rate, which implies stable earnings in real terms.

Growth and stability despite mayhem is sign of a good business and a good company and typical characteristic of dealership business (look at the car dealership performance during the financial crisis for example, scarce any reported any losses).

But the preference shares are payable in SEK, not RUB, so what is the value of earnings in SEK?

Earnings (MSEK, SEK/RUB=8)
2013:26
2014: 39
2015E: 45

So with current exchange rate Ferronordic’s SEK earnings don’t cover the 50 MSEK dividend. Clearly this is not safe bond with ample “interest coverage”.

But while the promised 50 MSEK dividend is not covered, yet the price relative to earnings available for preference share holders, i.e. all earnings below 50 MSEK, seems reasonable. For whole preference share issue is selling at 215 MSEK which implies 4.8 P/E on the 45 MSEK available 2015E earnings.

More over, if full amount of dividend is not paid, the difference accrues to “outstanding amount” to be paid later or to be used as additional currency in IPO, so the question really is how much equity value Ferronordic will have by the time of IPO.

Equity value estimate:
EBIT’15E 660 MRUB
Multiple 8
EV 5280 MRUB
Avg Net debt 510 MRUB
Equity value 4770 MRUB
SEK/RUB 8
Equity value ~600 MSEK

(Note that the net debt is last 12m average net debt, but as result of inventory finance it fluctuates a lot. Currently Ferronordic actually has 320 MRUB net cash position but which I consider temporary.)

So as it currently stands the 600 MSEK rough equity value estimate would not be enough to cover the full 650 MSEK preference issue’s conversion claim (and essentially that the common equity is worthless).

How ever, following developments would increase the value of equity considerably higher so that the conversion claim could be fully settled:

1. Strengthening of ruble just a little
2. Some normalization of economic activity from current mayhem level
3. Continuation of organic growth of the business

But let’s assume current earnings and RUB/SEK for the 2016-2018 period (i.e. the 45 MSEK annual earnings).

Let’s also assume that all available earnings are paid to preference shareholders and that the conversion claim is settled up to the point where there is available equity value in the company (i.e. instead of the official full 650 MSEK claim value there will be only the previously estimated 600 MSEK equity value available for the preference shareholders).

Then payoffs would be as follows:

2016: 45 MSEK, dividend
2017: 45 MSEK, dividend
2018: 45 MSEK, dividend
2018: 600 MSEK, conversion to common stock and sell @ IPO price

So that,

Total cash inflows 735 MSEK
Paid market price 215 MSEK
Profit 520
UPSIDE 242%
CAGR 51%

So summary of the situation.

Firstly,

1. There is not enough SEK earnings to pay the originally promised annual preference dividend (50 MSEK)
2. There is not enough available equity value to settle the full conversion claim (650 MSEK) in the preference share

And secondly,

1. Current earnings support 45 MSEK dividends, 5 MSEK less than the original promise
2. Preference shares conversion claim can be settled only up to 600 MSEK, 50 MSEK less than what was originally promised.

And because of current preference share price is 215 MSEK the second option offers opportunity for very good potential returns, though not as good as the original promise suggests.

Threats

Ruble. Putin. In Russia there is no long term. End of commodity cycle. End of investment cycle. Ruble. Macro stuff, mainly. But the problem is now on the table, which is good because then it can be dealt with.

And Ferronordic is dealing with it remarkably well (business growing/stable on real terms). Quality of the brand name dealership business, especially the aftermarket business, is the main source of safety. 

If Russia fails then this investment will fail.

Management

Main owners and top management are Swedish background and old managers from Volvo. They own 53% of  Ferronordic.

They left their jobs and bought the dealership licence in 2010 when Volvo decided to outsource their dealership business to 3rd party. And now their Russian adventure seems to be backfiring.

For if my earlier valuation resembles true value of Ferronordic, then it seems that management’s common stock is worthless as all earnings and value of is going to preference shareholders.

Main reason for this unfortunate situation for manager-owners is collapse of the ruble (as said, underlying operations have performed remarkably well).

Only way for managers to recover their big investments is strengthening of ruble or alternatively increase in the underlying business value.

They are hoping for the first, I presume, and working hard for the latter, I would expect. In my view incentives with minorities are aligned with the top management, as both want to increase the value of the underlying business.

Summary

In short the opportunity is to indirectly through preference shares buy number one brand name construction equipment dealership in Russia with under 5 times mayhem earnings.

Game plan would be to buy the preference shares for 215 MSEK, collect 150 MSEK in dividends while waiting 2018 (?) for IPO, convert the preference share to 650 MSEK worth of common stock and sell them after lock-up.

Current earnings don’t quite support the optimal payoffs but little less. Still, the payoffs could be quite respectable if ruble holds its value and the business continues to perform well in difficult environment (as presented earlier, current earnings would support 135 MSEK on dividends and 600 MSEK equity value in conversion).

In local currency growth has been impressive 30% p.a. despite mayhem, double the inflation rate. Pace seem to be slowing down to inflation rate this year (15%), which means that at least Ferronordic is not losing earnings power in real terms.

Especially interesting is the current and potential stable payment flows from existing Volvo equipment fleet in Russia, that help support the dividend payments.

There is 10 000 Volvo construction machines and 100 000 Volvo trucks in Russia, which need to be serviced every year. Ferronordic’s service segment has already won big enough market share from the potential market so that gross profit already covers all operating expenses, which provides safety.

Interesting part is how ever the growth.

Service segment is the most profitable part and has been the growth driver of Ferronordic Machines over last three years (up 40% from 2013).

There is further opportunity increase those earnings.

To get some idea of the numbers, if each of the some 100 000 Volvo trucks and construction equipment uses about 20 000 SEK (2000 EUR) to maintenance, which is about tenth of western equivalents, then that’s a 2 BSEK market. That’s about 800 MSEK in terms of gross profits (40% gross margin).

Even 10% share of that would triple Ferrnordic’s profits. And the share could and should be even higher (at least in car dealership market franchise dealerships have about 20% of the after market sales, which I venture should be higher with complex and expensive commercial trucks and machines).

Due to the growth in recurring service business Ferronordic could not only easily support full dividend payments but also the be very valuable asset in the future.

Additionally.

On macro level Russia is in desperate need of new roads and infrastructure. Construction equipment fleets are being modernized and the market westernized, which plays in to brand name dealerships hands. Long term potential to modernize Russian construction equipment/truck service market is huge, according to management.

Construction equipment market is -70% from pre Ukraine/high oil prices so there is obvious “turnaround case” made to be here.

Turnaround is not necessary to successful investment, though, as Ferronordic is profitable even in current mayhem and P/E is about 5.

Ruble could strengthen, which increases the SEK value immediately.

Dealership business is not in politically sensitive industry.

At least temporarily there is net debt free balance sheet.

Manager-owners are working under pressure to save their fortunes.

Disclosure: No position (life situation such that cannot increase currency/equity risk. I’m dreaming about some  5% position later).

Notes on figures used:

Ruble figures in this post I have done by myself using approximate average exchange rates. I have rounded the ruble figures to closest 10 million. These numbers are not provided by the company. I did the calculations on paper while visiting mom, so there is bigger than usual risk that there is some errors. So check the figures if considering buying/selling.

Earnings figures are adjusted for goodwill and franchise agreement depreciation.

In 2015E only Q4 figures are estimated, where I have just extrapolated trend and assumed 10% gross margin for equipment sales and 40% for aftermarket sales, pretty standard figures in USA equivalent comps and car dealership.

Edit 30.12.2015: Changed few expression errors for sake of clarity. Original message unchanged.