Cheaper isn´t always less expensive

In times of volatility, Mr. Market (using Benjamin Graham´s lingo) tends to offer bargains for the stoic investor. Much has been said about the benefits of stoicism on investing, and I will not be as arrogant as to think I can add to what others have brilliantly already said, but will just quote what Ben Graham said in 'The Intelligent Investor' on what our temperament should be towards constantly changing price quotations:

"The true investor … is free to disregard the current price quotation. He need pay attention to it and act upon it only to the extent that it suits [him], and no more. Thus the investor who permits himself to be stampeded or unduly worried by unjustified market declines … is perversely transforming his basic advantage into a basic disadvantage. That man would be better off if … stocks had no market quotation after all, for he would then be spared the mental anguish caused him by other persons’ mistakes of judgment."

If you follow the financial media, you know that the stock market has been a bumpy one over the last few weeks. Some have even described it as a "kangaroo" market. As an example, just a few weeks ago, on 11 June 2020, emotional investors and speculators experienced one of the most difficult days in history, as the Dow suffered its fourth-largest point decline on record.

Of course, the points alone do not tell the whole story. Points drops and gains get larger as the index grows. The second-largest percentage decline in the Dow’s history—a 21% drop back in 1914—came on a gigantic (at the time) 15-point loss.

But still, even on percentage terms, the drop on 11 June 2020 (6.9%) did qualify as one of the 30 largest drops on record. Days like that theoretically happen only about 0.1% of the time, but since March, days like that have happened about 4% of the time. That is to say we are going through one of the highest volatility periods in history.

Volatility begets volatility (creating unrest even to the trained professionals) but (or precisely because of that) it also provides the window of opportunity that Ben Graham referred to when he said "[intelligent] investors need pay attention to price quotations and act upon them only to the extent that they suit them".

For the long-term investor (that is, the net saver who is not near retirement), price drops like these are a sign that we are in the middle of hunting season. Warren Buffett brilliantly commented on this in Berkshire Hathaway’s 1997 Annual Report:

"A short quiz: If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef? Likewise, if you are going to buy a car from time to time but are not an auto manufacturer, should you prefer higher or lower car prices? These questions, of course, answer themselves. But now for the final exam: If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the “hamburgers” they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices."

If you have cash available to save and you see stock prices fall, be grateful for you are being invited to hop on a train that will take you uphill if you choose wisely. What's more, you should be glad to see the price of your stocks go down, even if that creates the psychological illusion that you are losing money, as that is just an invitation for you to increase your share of the future profits at a potentially advantageous price.

A sharp decline in the quotation price of METRO AG (B4B:XETRA) is what caught my attention in early March. As rapid expansion of COVID-19 made clear social distancing and lockdown measures were inevitable, shares sharply declined from €11.98 on March 5 to a low of €6.41 on March 18, after having lost approximately €2.00 in the first two months of the year. That is a 46% drop in just nine trading days, or 54% in less than three months. All this only a few months after the majority of METRO shareholders rejected an offer of €16.00 per share from Czech billionaire Daniel Křetínský. What an unfortunate turn of events for METRO!

During the lockdown weeks that followed, I grew tired of pessimists predicting a new era of isolated people too afraid to eat out and mingle with others in bars and restaurants. And yet, when I talked to "real" people, the first thing they wanted to do as soon as the restrictions eased would be to go out and have lunch and dinner with friends and family. Knowing that Mr. Market is one of the most famous manic-depressive characters in history (only after Inside Out´s Riley when Anger, Fear, and Disgust assume control of her personality) I set out on a quest to understand what is the true value of METRO AG's shares.

In 2010, METRO was the fourth-largest retailer in the world measured by revenues, after Wal-Mart, Carrefour and Tesco. However, growth was below expectations and as soon as Olaf Koch, current CEO, took the reins of the company in 2012, he embarked on a journey to transform METRO from a conglomerate into a pure wholesale business. The restructuring of the group took time and consumed a lot of energy and resources. Under Olaf's tenure, METRO spun-off from Ceconomy (the consumer electronics retailer), reduced its debt by around €5 billion and, more recently, divested its hypermarket business Real and sold a majority stake of its Chinese retail operations (METRO China). While simplifying the group structure, METRO expanded its core business, wholesale, with a consistent focus on the two core customer groups HoReCa (hotels, restaurants and catering companies) and Traders (independent grocery stores). METRO also serves Service Companies and Offices (SCO), professional service companies and organisations, such as offices and institution. While management does not consider this to be a strategic customer group, sales to SCO customers are meaningful. METRO´s share of revenue generated from each of these three customer groups in FY 2018/19 were as follows:

• METRO: 48% (H) | 22% (T) | 30% (S)

• Germany: 46% (H) | 13% (T) | 41% (S)

• Western Europe (w/o Germany): 65% (H) | 16% (T) | 20% (S)

• Russia: 16% (H) | 30% (T) | 54% (S)

• Eastern Europe (w/o Russia): 37% (H) | 31% (T) | 32% (S)

• Asia: 40% (H) | 31% (T) | 28% (S)

Note: (H) = Horeca; (T) = Trader; and (S) = SCO

Today, METRO has some 24 million customers around the world. The majority of METRO wholesale customers are small and medium-sized companies as well as sole traders who can choose whether to shop in one of their large-format stores (METRO and MAKRO brands), order online and collect their purchases at the store or have them delivered. In addition, METRO offers a range of services to these traders, restaurants, hotels and caterers to strengthen their competitiveness and increase customer retention over the long term and to become the preferred partner for HoReCa and Traders customers. Before COVID-19, METRO showed results that this strategy worked and in FY2019 (12 months ended 30 September 2019), METRO wholeshale reported like-for-like revenue growth rate in constant currency terms of 2.4%, the highest in the last decade.

On 18 February 2020, Luxembourg-based financial investment firm SCP Group entered into an agreement with METRO AG to acquire 100% of Real from METRO AG. As of 19 June 2020, METRO management expected to close the transaction over the summer, which will generate net proceeds of approximately €0.3 billion.

On 23 April 2020, METRO completed the sale of a majority stake in METRO China to Wumei Technology Group in exchange for net cash proceeds of more than €1.5 billion.

Before the divestments of Real and METRO China, the company operated in 36 countries and employed more than 150,000 people worldwide. Excluding Real and METRO China, in financial year 2018/19, METRO generated sales of €27.0 billion and EBITDA of €1.7 billion, including €339 million from real estate transactions. These are earnings mainly linked to project developments and sale and lease backs. While management believes a sustainable amount of real estate earnings of €100 million can be generated every year, this is a extremely volatile source of earnings. For reference, real estate earnings were €175 million in FY2017 and €128 million in FY2018, while for FY2020 real estate earnings are not expected to be higher than €10 million.

Excluding the proceeds from the Real and METRO China divestments (which should strengthen the balance sheet, increase liquidity reserves and improve optionality for organic investments as soon as the economic recovery begins) net debt as of 30 March 2020 was €7.5 billion, more than 5x FY2019 EBITDA. Considering that EBITDA in FY2020 is likely to be lower, debt levels are heavy. Even if the full proceeds of the METRO China divestment were to be used to reduce debt, debt coverage ratios may be put to the test, since the negative impact of COVID-19 on EBITDA is likely going to be large.

How large?

That is, again, the million-dollar question. The uncertainty around the impact of the restrictions have caused METRO to withdraw guidance for FY2020. They just shared the following illustrative table showing how the restrictions impacted each of the three customer groups.

We can see that the HoReCa business, as expected, is under significant stress. This is the largest customer group for METRO (48% of revenue in FY2018/19) and, while it is not going to disappear (people will eventually go back to their previous habits), extended restrictions can cause a lot of harm. Just from 1 January to 31 March, METRO's operations burnt cash in excess of €700 million. This was mainly a working capital issue, and a big chunk of this cash outflow will be recouped when sales pick up. In any case, METRO estimates that each additional month with the current restrictions will lead to a decline in sales of approximately 2 percentage points compared to the same period of the previous year and very limited ability to counteract the negative impact on EBITDA and earnings. That is €540 million per month in revenue and a significant portion of it directly hitting the bottom line (probably €200 million to €400 million per month). Not only this is a really vague and uncertain estimate, but it does not even account for the length of the restrictions and the likelihood of a second wave.

Rather than trying to guess the specific impact the pandemic will have on cash flow, I find it easier to backsolve for the impact the current share price is implying. If you know what the value of the business was before COVID-19 and you know the price the market is currently paying for METRO AG´s shares, you can make an estimate for the number of months investors think the restrictions will last.

An analysis of value using the Discounted Cash Flow (DCF) method can be helpful given METRO´s ongoing restructuring plans. This method would capture the value associated with the after-tax cost savings of efficiency measures METRO is developing as part of its transformation into a pure wholesale business. Using the guidance provided by METRO management, and certain conservative adjustments and assumptions (10.5% discount rate, 1.0% long-term growth rate), the value per share of METRO AG before COVID-19 can safely be estimated to be at least €13.00 to €14.00 (remember that the shareholders rejected an offer for €16.00 in August 2019).

This value would imply a 7.3x to 7.6x multiple on EBITDA, which does not seem to give much credit to the company´s growth in the wholesale business, and would make METRO a fantastic target for US competitors looking to expand into Europe. Of the three largest US food wholesalers, Sysco (ticker: SYY), US Foods Holding (USFD), and Performance Food Group (PFGC), Sysco is the most likely acquirer. In March it was even rumoured that both companies were in talks, but not much credibility was given to the story. Still, Sysco´s CFO touched upon the idea during Sysco's Q2 earnings conference call when he said: "We remain convinced that Europe will be a growth opportunity for the company in the years ahead." With or without Sysco being part of the transaction, there is no doubt that METRO would be an attractive target at a €13.00 to €14.00 price range, absent COVID-19, that is.

At a price of €8.5 today, the market is telling us that investors price in the impact of COVID-19 restrictions on METRO at an amount of at least €1.6 billion. If you think these restrictions cost METRO €200 to €400 million per month, it follows that the market expects 4 to 8 months of additional restrictions. Whether the market is right to make this assumption remains to be seen. Your guess is as good as mine. For a conservative investor like me, I would rather wait to see how things play out. In a few weeks, METRO will report earnings for Q3 and we will be able to reassess the situation. In the meantime, as it relates to METRO, it would be wise to hold on to your wallet and proceed with caution.

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