DEZ GY - Deutz

[roark1211]

Deutz is the world's #2 non-captive diesel engine producer, who just marked its 150th anniversary recently. Deutz's end-customers are large agriculture, trucks and construction machine manufacturers (e.g. largest one is Volvo).

 

Investment thesis: c.20% normalised FCF yield; margin should at least double in 2-3 years; net cash position; potential takeover candidate

 

1) Cheap stock even on trough margin

Even on headline multiples, Deutz looks very cheap on FY16 4x EV/EBITDA and 12x P/E - a typical cap good company should be on at least 7x EV/EBITDA. But the best part is, this is even on a trough margin and we believe the market significantly underestimate the margin expansion potential for Deutz.

 

During the past 5 years, Deutz invested significantly in R&D to bring its new generation of engines fully compliance with the new European emission standard (EU Stage 4). Having believed that the emission regulations will keep getting tighter, the company made one step beyond that and brought its entire fleet to meet even the Stage 5 standard, which will not be in force until 2019. At the moment, it's one of the very few engine manufacturers to be this far in the game and it's been winning market shares ever since it launched the new engines.

 

The interesting point is, the company conservatively accounted for the majority of these R&D as expenses in its P&L over the past 5 years, which made the margin significantly depressed. EBIT margin collapsed from 5.9% in 2011 to only 2.1% in 2014. Now, the painful investment period is basically done, and the company can start reaping the benefit. In fact, EBIT margin has expanded significantly in 1H15 to >3% and the company guided that 2015 margin should be around 3% with a "significant increase" in 2016.

 

Based on our discussion with the company, they believe 6% is a normalized EBIT margin (based on what they achieved in 2011), and they can get there fairly quickly due to the ramp up of sales without much cost associated. Internally, management's target is to reach 10% EBIT margin in the medium term (c.5 years). To help this, the company is also implementing a major cost cutting program which should provide a run-rate uplift to EBIT of c€10m p.a. - this may sound trivial but consider that 2014 EBIT was only €30m.

 

2) c.20% FCF yield on normalised earnings

Assuming Deutz reaches 6% EBIT margin and ~€1.6bn sales in 2017 (note: they had €1.5bn sales in 2014), that should give a normalised EBITDA of c€200m (D&A is about €100m p.a.). The company guided that gross CAPEX should be around €60-65m p.a. for the next few years (no need to spend here), taking out taxes and working capital need, we are looking at ~€100m FCF p.a. run-rate. On a market cap of €600m, that is about 17% FCF yield. If you are a bit more generous on the sales growth assumption (the company said they can grow sales by 10% a year and I assume only half of that), then 20% FCF yield looks very possible.

 

3) Tax loss assets worth 25% of market cap but not on balance sheet; plus net cash position

A very interesting hidden asset that Deutz has is its tax loss balance carried forward, which is about €1bn at the moment and not shown anywhere on the balance sheet. The only way you can see that is their low tax rate (guided ~18%) vs. official German tax rate of c30%. The German tax law allows company to carry forward tax loss indefinitely so there's no expiration date. We estimate the NPV of the €1bn tax loss balance is about €150m (it's much less than €1bn because you can not use the entire €1bn in one year), which is ~25% of the market cap.

 

On top of this, Deutz also has a super strong balance sheet with net csah position of €30m as at Q2-15.

 

Valuation/takeover

It's not hard to see Deutz is significantly undervalued and assuming a 10% FCF yield run-rate can see the stock double from here. But I believe Deutz is a great takeover target for another large manufacturer, namely Volvo who currently owns 25% of the company already. Volvo raised its stake to 25% in 2012 and the strategic fit between the 2 companies is pretty clear.

 

Risk

- Deutz has ~9% sales from China (c.25% on a pro-rata basis if including its China JV Deutz Dalian ). The construction market in China is in a recession and that could be a drag on the stock.

 

Disclosure: we are long DEZ

 

[LongHaul]

Thanks for posting.  I took a quick look. 

 

I always get nervous when I hear a company has huge NOL's as often they company has struggled to be profitable in the past. 

Situation specific though. 

 

Looks like they were EBIT negative in 1995 and 2009.  Looks like EBIT margins on average for the last ~20 yrs or so are much less than 6%.  Mgmt may be optimistic on the 6% normalized.  Seems risky to me.

 

I think the Engine business may be pretty brutal with price pressure from powerful OEM customers but would be interesting to hear from people on the board who know more.

 

 

 

 

[roark1211]

Hi LongHaul,

 

I am normally also very skeptical of the "this time it's different" thesis but a few data point makes me think they have a fair chance of getting there:

 

1) New management: It's fair to say that the company was mismanaged to some extent in the past but a new management team with very impressive background has recently come on-board. The Chairman/CEO has >20 years of experience at BMW and joined DEZ in 2008; the CFO has >20 years with Daimler and joined in 2009. From our discussion with management, they all have a very strong focus on profitability and efficiency.

 

2) Efficiency program: first time ever Dez has a major efficiency program. They launched that program earlier this year and already made the first step towards it (see here: http://www.deutz.com/press/press_container/deutz_lays_foundation_stone_for_new_shaft_centre.en.html). Remember that Dez made only €32m of EBIT in 2014 while the efficiency program aims to deliver €10m run-rate; even if they can only deliver half of that €10m, it's a 16% increase in EBIT

 

3) Peers: their closest competitor who is publicly listed is Cummins (CMI). CMI's EBIT margin in the engine division is 12%. Certainly, this is a scale business and CMI should have a structurally higher margin than Dez due to their sheer scale, but it's also not a stretch to imagine Dez getting to at least half of CMI's level of profitability.

 

In terms of pricing pressure from OEM, I'm more relaxed. The company is not really competing on pricing and evidently, in 1H15, ARPU was up 8%.

[LongHaul]

roark1221,

 

Interesting counterpoints that could prove right over time. 

Thanks for the reply.

[mateo999]

Thanks.  I'm sorry for the lazy questions, but: 1) ~what % of engines does Volvo source from non-DEZ suppliers?; 2) ~what % of DEZ sales are to Volvo?; 3) can the NOLs survive a takeover?

 

Thanks again.

[roark1211]

Mateo999,

 

1 & 2) Dez's revenues from Volvo is around €280m p.a., which is around 20% of the group's revenue.

 

Unfortunately Volvo does not disclose the % of engines sourced from Dez either in the AR or on the call with us. But given that Volvo's cost of sales is >€20bn, I think the sourcing from Dez is pretty insignificant.

 

3) As far as I understand, the basic rule is that the tax loss will be cancelled upon a full merger. There are some tricks to get around this a bit but I'll work with the assumption that it will be gone.

[mateo999]

Holy moly.

[roark1211]

Today was by far the most frustrating and painful to us this year. DEZ issued a profit warning last night and the stock collapsed. Management was shocked by the reaction so they organised a last minute conf call before market close. They remained confident that sales will grow next year and margin should expand significantly but that was too little too late.

 

In short, what happened was order intake has been much weaker than expected, especially in China and U.S. so they now expect to be break even on EBIT rather than 3% margin this year. It puzzled us because the CFO just reiterated all their guidance last Friday at a sell-side conference.

 

There's not much I can say here other than we got this so wrong, at least in terms of timing. Hope it has not caused any pain for anyone reading this.

 

 

[mateo999]

Sorry to hear.  No involvement, but was digging.  For what it's worth, i'll now be digging a little faster.  Have a drink!

[farbelow]

No involvement and just digging too. Does anybody have insight if Deutz lost revenue to competitors, or is business for all suppliers weak?

[roark1211]

CEO confirmed on the conf call that they have not lost market shares. It's the weakness in their customers' market overall that caused problems. Customers have been holding back orders and/or built up inventories in light of the weaker end market. Typically they should see a pick up in order around August and September but it didn't happen this time. Based on what they’ve seen, Q4 will also be weak, which make them think that they can’t reach the guidance for this year. It's worth bearing in mind though that the lead time from order and revenue is very short i.e. growth/decline in order will show up in next quarter' revenue already

 

For FY15 they still expect +ve FCF and will end the year with net cash despite the tough condition. For FY16 they do not have much visibility now although they said that 2016 should be better than 2015 ("minimum is stable" and "very disappointed if not grow more than 10%") and margin should expand due to cost cutting and better mix. Long term, they do not believe they will remain at this level of low margin.

 

For what it's worth, CFO bought 10,000 shares today.

 

[mateo999]

Management was shocked by the reaction so they organised a last minute conf call before market close.

 

Bloomberg is showing nothing for DEZ under its events function.  I also don't see any webcast/dial in information on the Deutz website, or any mention of a call.  Do you happen to have a URL or replay dial in info?  Or better yet, a transcript?

 

Thank you!

[roark1211]

The funny thing about Dez is that none of their quarterly calls or events are recorded on either their website or Bloomberg, and of course no transcript either (which I absolutely loved). The only way to participate in their future calls is to contact IR and ask them to put you on their distribution list.

 

Alternatively, you can contact brokers who cover Dez to ask for feedback. Kepler Cheruvrex is quite close to the company (they organised the roadshow last month).

[mateo999]

Yeah I've found that is somewhat common in Germany.  Rheinmetall comes to mind.  Thanks, hopefully IR gets back to me soon.  They usually have mp4 copies of these things.

[whistlerbumps]

How are people thinking about the pension liability here... The stated liability increases the pre pension EV by ~50%.. While it is almost certainly higher than the actual economic liability due to the German discount rates, I think its clear that it needs to be included in some fashion...

 

If we say discount BS liability by 25% and then the EV increases from ~380mln to ~520mln which is ~7x EBIT at 6% normalized margins... Not sure if that is cheap enough given then long-term profitability and cyclicality of this business...