“Two roads diverged in a wood, and I—
I took the one less traveled by,
And that has made all the difference.”
Robert Frost, The Road Not Taken
Since I established a 10% portfolio position in the ordinary shares of GEA in June at a price of €84.33, the share price has declined approx. 18%, precipitated by the release of Q3 FY14 results early last month. Q3 results indicated a very significant YoY drop in revenues both on a quarterly basis (-62% vs. Q3 2013) and a cumulative 9 months YoY basis (-45% for 9 months to 30 June 2014 vs. prior year period).
According to the management statement for Q3, the results reflect the slowdown in the pace of toll installation programmes in France, and difficulties with the roll-out of the Company’s international sales strategy. Management did not offer any detailed commentary in respect of either of these elements.
Upon release of the latest results, the share price initially declined by approx. 9%, followed by further falls to the current price of approx. €70 at the time of writing, giving a total decline to date of 18% since I invested. This has naturally prompted me to ask the following questions:
- What do the recent results mean for FY14 outturn performance, and what is the impact of this to valuation, versus the price I paid previously?
- Do the most recent results indicate that my previous analysis was flawed or incorrect? Did I miss something in my original appraisal of the business and its prospects prior to investing?
- Based on consideration of the above, was my investment thesis flawed and what is the consequent probability that I now face the risk of permanent capital impairment?
I will now address each of these questions in turn.
1. Q3 results and impact to valuation
The analysis below provides two scenarios for Q4 revenue and full year FY14 revenue outturn:
The above analysis arrives at a FY14 revenue range of €43.4m – €57.2m, based on the following assumptions:
- “Worst Case” FY14 revenue of €43.3m is arrived at by “grossing-up” the YTD revenue of €32.9m generated in the 9 months to June 2014, as per GEA’s Q3 results released by applying the historic % of total annual revenue for the 9 month period to June, which has averaged 76% over the previous three financial years; this calculation results in full year revenue of €43.4m, which implies Q4 FY14 revenue of €10.4m
- Full year revenue for FY14 or €43.4m implies a YoY revenue decline of 43%
- “Base Case” FY14 revenue of €57.2m is arrived at by applying the trailing average 5 year historic sales as a % of opening order book rate of 97%, and applying it to the total GEA order book value of €59m at the start of FY14, as per the 2013 annual report; this reults in full year revenue of €57.2m for FY14, and implies Q4 FY14 revenue of €24.2m
- Full year revenue of €57.2m would imply a YoY revenue decline of 24%, indicating a dramatic improvement for the year versus YTD trend
It is also necessary to consider the reasonableness of both the above Q4 revenue estimates in the context of Q4 revenue levels in prior years; while the Worst Case analysis indicates lower revenue for Q4 this year compared with Q4 in each of the previous three years, my Base Case indicates a significant uplift in revenues in Q4, ahead of 2013 and 2012, which were successive peak years for GEA. Does this suggest my Base Case for Q4 (and therefore the full year estimate) is optimistic or aggressive rather than conservative? I don’t believe so. It must be noted that GEA began 2014 with an order book of €59m, of which €32.9m (or 55%) has been recognised in revenue in the 9 months to June 2014, which suggests that a significant amount of revenue is still to be recognised. The following points are worth considering in this regard.
As highlighted in my previous note on GEA, given that GEA is a contracting business, subsequent years’ revenue is usually contracted and therefore GEA’s order book tends to serve as a reasonably reliable leading indicator of subsequent years’ revenue. To briefly recap on this point, the chart below plots the value of the order book at the beginning of each financial year against that years’ subsequently reported revenue, and the high level of correlation is clear:
While the present YoY decline does indicate a slowdown in activity (as denoted by the €59m order book at the start of FY14, versus a €75m order book at the start of both FY12 and FY13), it remains a fact that the Company’s order book is a reliable indicator of full year revenues. On this basis, I believe my Base Case estimate for Q4 revenue is not unreasonable.
Furthermore, as GEA is a contract revenue business, it has distinct no seasonality – revenue recognition is determined based on delivery of contract milestones or where the customer accepts invoicing once a stage of work is completed; this tends to fluctuate in accordance with completion stages of contracts, not a particular time of year, and therefore Q-o-Q comparisons are not all that meaningful.
Finally, as per management’s half-year update released at the end of Q2 (March 2014), the Company’s order book stood at €47m, which implies additional orders worth €19.3m were received by the Company during H1:
The €19.3m is arrived at after subtracting my estimate of the implied order book at the beginning of Q4 FY14 of€39.7m from the opening €59m order book value disclosed by management at the start of the year. This analysis does not reflect any additional orders received by the Company during H2. After taking account of Q3 revenues of €7.2m, the implied order book at the beginning of Q4 is €39.7m. On the basis of the above, my Base Case estimate of €24.3m for Q4 revenue is comfortably covered by the existing order book, and is therefore not unreasonable.
So what does the above revenue analysis imply for valuation based on likely current year performance, versus the price I paid for my shares in GEA? Moving from the above revenue analysis to a revised EBIT estimate for FY14, I outline Worst and Base Case EBIT scenarios below:
The above analysis indicates an estimated EBIT range for FY14 of between €4.5m – €10.6m based on current year Worst Case and Base Case revenue scenarios. This range is arrived at using the following assumptions:
- Gross margin of 62% achieved in H1 FY14; assumes full year margin of 59%, being the trailing three year average
- OpEx is broken down into two components, Payroll and Non-Payroll:
- Payroll for H1 FY14 is €7.3m, which is simply annualised for the full year outturn to €14.5m
- Non-payroll OpEx has average 14% of revenue historically, but increased to 15% in H1 FY14; this is assumed to remain at 15% of revenue for full year FY14 outturn
- Resulting EBIT margin under Worst and Base Cases is €4.5m and €10.6m respectively
The above EBIT scenarios imply an EV/EBIT valuation range of 2.2x – 5.2x based on the current share price at the time of writing as follows:
Both my scenarios indicate that undervaluation persists, significantly so under the Base Case, and more modestly under the Worst Case. The range of 2.2x – 5.2 EBIT compares to GEA’s historic (10 year) average of 3x EBIT, and present peer group average of approx. 11x. Considering GEA’s quality and consistent track record, the current valuation, even factoring in the Worst Case appears extremely low. Furthermore both the Worst and Base Cases are based on conservative assumptions for the remainder of the current year.
This brings us to the next key question – are these revised EBIT estimates for FY14 representative of GEA’s normalised earnings power? If so, this indicates my previous analysis was flawed, which casts significant doubt over my original investment thesis. If not, and a case can be made for GEA’s normalised earnings power exceeding the revised current year estimates, then the recent share price decline may offer an attractive buying opportunity.
2. Was my previous analysis flawed?
With the benefit of knowing how GEA is currently performing, it is worth considering how my previous analysis stacks up against the above revised analysis following the Q3 update.
The Worst Case scenario in my original note indicated EBIT of €12.4m, which significantly exceeds my Worst Case above by €7.8m(!), and even exceeds my Base Case estimate – so where did I go wrong in estimating FY14 EBIT previously? And does this imply that I overpaid for GEA common stock based on an overly optimistic estimate of future earnings?
My potential miscalculation is attributable to two elements:
- Revenue trajectory
- Operating leverage and EBIT margin
With regard to revenue, my previous analysis assumed FY14 revenue of €57m (in line the above Base Case), based on the order book of €59m and simple extrapolation of H1 FY14 revenue being 25% behind H1 FY13 revenue. My new Worst Case scenario assumes FY14 revenue of just €43.4m, €13.6m or 24% less revenue than the order book would suggest based on historic order book/revenue conversion rates. If FY14 revenue were to finish at €43.4m for the year this would imply either:
- Orders included in the opening €59m order book value were subsequently cancelled; or
- Due to contract milestones or invoicing timelines, this revenue is still contracted in the pipeline, but cannot be recognised yet, suggesting that this revenue (and any subsequent profits) are pushed out into a future period
Based on the order book analysis and the historical correlation between the order book and subsequent revenues as outlined above and in my original note, I do not believe that FY14 revenue will be significantly lower due to orders being cancelled or lost; if recognised revenue in FY14 does turn out to be lower than previously expected, this will most likely be attributable to contract and invoice timing, meaning that future earnings will have deferred, not lost.
However, even if these revenues are deferred, this will obviously still impact current year EBIT, due to a factor which I had not fully considered in my previous analysis: operating leverage. GEA is a contracting business and so carries a significant amount of fixed overhead, particularly with regard to staff payroll, which has averaged 22% of revenue over the previous three years. As outlined above, this is likely to increase to 25% – 34% of estimated FY14 revenue under the Base and Worst Case scenarios respectively (assuming payroll of €14.5m). I believe it is highly unlikely that payroll costs and will be reduced by management if revenues fall to the levels estimated above. Approx. 95% of staff are employed across production, engineering and R&D and so these staff are unlikely to be let go as a result of one year’s results. Staff will need to be retained for R&D purposes as new technologies are developed for the next generation of electronic toll equipment in future deployment cycles, while engineering staff will continue to be required to service GEA’s extensive, existing installed base of toll equipment.
In my previous Worst Case analysis, the €10.4m in EBIT assumed a normalised EBIT margin of 21.8%, based on the trailing four years prior to 2013 (2013 was an exceptional year with one-off contracts driving a significantly higher than normal EBIT margin). This was perhaps an overly simplistic analysis, which did not account for a reversal in the trajectory of revenues and the consequent impact of operating leverage on EBIT. The revised Worst Case above shows a significant contraction in EBIT margin to 11%, which illustrates the clear impact of operating leverage to this business. Under the Base Case above, the EBIT margin contracts to 19%, on the basis that FY14 revenues approximate the opening order book value of €59m.
In light of the above analysis, it appears my original Worst Case scenario for FY14 was overly optimistic on the basis that I did not consider the effects of operating leverage. My original Base Case EBIT of €12.4m was also on the optimistic side by €1.7m or 16% compared to my revised Base Case above. This leads back to the critical question of whether these revised FY14 estimates for EBIT approximate the normalised earning power for GEA going forward, in the context of the slowdown in revenues that management have reported so far this year?
To answer this question, a brief examination of what is presently happening in the motorway construction and tolling sectors is required, together with a revisiting of where GEA sits in the within competitive landscape.
GEA’s management have reported that a significant factor driving the current year decline in revenue is the slowdown in electronic toll installation in the French market, after a period of solid growth from 2009 – 2013. This period saw significant projects undertaken by key customers including Vinci, Eiffage and Sanef contracting GEA to provide equipment and software to specific projects, for example the Exotaxe initiative to tax heavy goods vehicles on French motorways. After a number of years of robust activity, 2014 appears to mark a downturn in motorway toll development. The are two key questions in this regard then are (1) is this slowdown a permanent one or simply a natural cyclical trough, and (2) what the consequences for GEA’s future earnings power?
At a macro-level, the French economy continues to face significant challenges and is lagging behind other Eurozone economies such as Germany, Britain and more recently even Ireland – key industrial sectors are at 20-year lows in terms of activity, and unemployment exceeds 10 percent. These conditions have prompted concerns among the large French construction companies (whom are GEA customers) that further government spending cuts may adversely impact public infrastructure budgets. The overall consensus expectation among these companies however is that while growth in 2014 may be negligible, they do not expect the domestic economy to be any worse off than 2013. To counteract the domestic challenges, construction firms (and GEA customers) Bouygues, Vinci and Eiffage have focused on generating orders overseas and concentrating on high-margin domestic projects. So where does this leave GEA?
With France representing approx. 60% of GEA’s order book, its prospects are closely tied to the activities of the large French construction companies. However, as part of these customers’ efforts to source new, high margin projects domestically, it has been reported that three of GEA’s key customers (Vinci, Eiffage and Sanef )have been in negotiations with the French government regarding a new €3.6bn motorway stimulus plan, which would involve the upgrade of the existing motorway network. There is political buy-in for this plan as it would provide a significant boost to unemployment numbers across the French construction industry for Francois Hollande’s socialist government. Furthermore, and significantly for GEA, the French government has reportedly stipulated that 55% of the upgrade work must go to small and medium businesses that are not subsidiaries of Eiffage, Vinci or Abertis (the owner of Sanef) – this would appear to bode well for GEA as preferred supplier to each of these entities. The French government has submitted this stimulus plan for EU approval, which is expected later this year. Should it be approved, the likelihood is that GEA should win new multi-year contracts to provide electronic toll equipment and software to each of these customers over the next year or so, given its long-standing relationships and track record of delivery for these customers.
On the international front, export sales to foreign markets were approximately 40% of GEA’s order book at the beginning of FY14. In the H1 FY14 update management noted some challenges with regard to these markets but did not explicitly detail what these challenges were. GEA’s exposure to overseas contracts is largely dependent on the activities of its French construction customers in foreign markets. Given that these customers are looking to developing economies to grow their businesses, GEA should benefit from motorway construction projects undertaken.
In terms of the overall electronic toll industry, a recent report from research firm Markets & Markets projects that the global electronic toll collection (ETC) market will grow at a CAGR of 11% between 2014 and 2020, to a value of $9.5 bn. Within this market globally, North America is expected to deliver the strongest growth, followed by Europe.
Given GEA’s track record, customer relationships and status as market leader for supplying ETC equipment in France (which has the largest road network in Europe), I believe GEA’s prospects remain very positive. The current year slowdown is symptomatic of a cyclical lull in activity, attributable to the completion of growth phase in France between 2009 – 2013 for motorway development, and present domestic economic challenges in France. The prospect of a new significant motorway upgrade programme led by three of GEA’s key customers is very positive for the Company however, and should see GEA grow revenues and earnings again in the medium term given its competitive positioning.
While GEA has experienced a slowdown, this is has been the experience generally across motorway-construction related sectors, with both Vinci and Eiffage for example reporting slowdowns in motorway construction, prompting expansion into new segments (e.g. Vinci has expanded into operating airports) and focusing on overseas markets. As a niche supplier to this sector, GEA’s present slowdown needs to be read in the context of this wider industry environment, which appears to be a cyclical slowdown rather than a secular deterioration.
While not a pure comparable, perhaps the most comparable listed French company to GEA is Thales Group (Ticker: HO), which provides ETC equipment as well as aerospace, defence and related systems. Thales reported a H1 FY14 decline of 3% in revenues and 12% in orders in its Transport division. While this decline is not nearly as severe as GEA’s, it must be remembered that Thales’ Transport division includes a number of revenue lines in addition to ETC, including railway and public transportation information systems and line signalling systems, which obscure its ETC performance. Thales do not break out their ETC business results within their financial reporting, however at a high level the results support the trend reported by GEA, which is that revenues and orders have declined in France.
While not a direct competitor, Kapsch TrafficCom (Ticker: KTCG) is a broadly comparable company based in Austria, which also reported a mediocre FY13/14 in its annual results released in June (relating to March ’14 year-end). Revenue was flat on a YoY basis, with a focus on overseas markets including South Africa, Poland and Belarus to grow revenues and offset sluggish growth in the Euro Area. Again it should be noted that Kapsch is not a directly comparable business, and its results include disparate segments not comparable to GEA’s offering. However, the recent experience of Kapsch broadly resembles that of GEA and others’, in that developing overseas markets are seen as a means of off-setting sluggish domestic/European growth, with generally negligible or negative YoY growth experienced by all in 2014 to date.
This confirms to me that the recent negative YoY results reported by GEA do not appear to be symptomatic of a fundamental flaw in its business model. I believe GEA remains on a sound footing, with the recent negative results simply reflecting the timing in the cycle, temporary domestic economic headwinds and the contract nature of its revenue cycle, rather than any flaw or weakness in its underlying business or prospects.
3. Investment thesis and risk of capital impairment
In light of the above industry factors, GEA’s customer relationships and its highly competent management team (as evidenced by GEA’s excellent financial track record), I believe that my original investment thesis remains intact – FY14 is unlikely to be representative of GEA’s normalised earnings power given the industry and business prospects as summarised above. Therefore GEA’s business fundamentals remain sound and its investment attributes very appealing. While current year Worst Case FY14 revenue and EBIT estimates may be weaker than I previously expected, I do not believe this compromises my original investment thesis – I continue to take a long-term view in terms of realisation of intrinsic value. The slowdown experienced in the current year appears cyclical and is in line with the experience of related businesses across the motorway construction and tolling sectors, and therefore I believe FY14 outturn is not reflective of the sustainable earnings power for GEA.
On this basis, I believe the EBIT range €12.4m – €16m.1 as outlined in my original valuation analysis continues to be a reasonable expectation of long-term, normalised earnings power. With this is mind, the current price represents a bargain, equating to an EV/EBIT multiple of just 1.5x – 2.0x EBIT:
With greater visibility to FY14 outturn, it is also worthwhile revisiting potential downside risk, on the assumption that the price could drop further if the market takes a short-term mind-set and re-prices GEA based on current year EBIT. An analysis on this basis would indicate downside risk a further decline to approx. €57 per share, assuming that the long-term multiple of 3.0x EBIT is applied:
A price of €57 indicates downside risk of 18% from current pricing, and 32% from my original purchase price:
Taking my original normalised EBIT range of €12.4m – €16.1m to reflect sustainable earnings power for GEA, my estimated intrinsic value range of €128 – €149 implies upside of 85% – 114% from the current share price. This indicates that the upside to investing in GEA common stock remains a multiple of the downside risk (in the order of 4.7x – 6.4x) over the medium term.
Finally, the current price is near the most recent 52 week low of €67, which combined with the reward/risk ratio gives me further comfort.
To conclude, I believe the recent share price decline offers an opportunity to increase my interest in an excellent business with positive prospects at a significant discount to intrinsic value. In most market environments, it is a rare thing to find a company that meets all the key investment criteria – good prospects, very attractive economics, highly competent management, possessing a competitive advantage, and available for purchase at a compelling valuation. In the present QE-juiced market, it is almost impossible to find such investments.
I remain long GEA and am considering increasing my position to 20% of my portfolio.