Heads I win; Tails I don’t lose much

"Heads I win; Tails I don’t lose much" is Mohnish Pabrai´s approach to investing and one that has made him very rich, allowing him, for example to successfully bid $650,100 with Guy Spier for a charity lunch with Warren Buffett.

This catchphrase reflects the idea that certain situations in life (including but not limited to investing) offer a substantial upside, accompanied by limited downside. A very good example of this is being nice to others. Try being nice to everyone and wonderful things will start happening to you. Sooner or later, something positive will come out of having this attitude that will more than outweigh the inconveniences of being nice to a few idiots.

Applied to the realm of investing, it means that you should invest in a business only if you have a high conviction of success and you do not expect the downside to be too bad if your investment thesis proofs to be wrong.

And when Monish Pabrai talks, I listen.

That is what an investment in Sonae SGPS (SON) at current prices (as of 28 May 2020) can do. SON is a multinational holding company managing a diversified portfolio of businesses in retail, financial services, technology, shopping centres and telecommunications.

It operates through the following business segments: Sonae MC, Worten, Sonae Fashion, Iberian Sports Retail Group (ISRG), Sonae FS, Sonae IM, Sonae Sierra and NOS.

• Sonae MC is the largest food retailer in Portugal. It owns and operates Continente, Continente Modelo and Continente Bom Dia (hypermarkets, supermarkets and proximity stores, respectively); Go Natural (healthy food supermarkets and healthy fast food restaurants in Spain and Portugal); Well´s (health, well-being and eye-care para-pharmacies and dental and aesthetic clinics); Arenal (network of pharmacies and perfumeries in the northwest region of Spain); franchising proximity stores Meu Super; Maxmat (do-it-yourself, construction, bath, and garden stores); and the operational assets of Sonae RP (management of Sonae's retail real estate portfolio, mainly stores that operate under the Continente brand and under other brands of Sonae).

• Worten is a network of stores for electronic products.

• Sonae Fashion is a network of owned and franchising stores for sports and clothing products.

• Iberian Sports Retail Group (ISRG) is a partnership between JD, Sprinter and Sport Zone with network of sports stores in Spain and Portugal.

• Sonae FS offers financial services in Portugal, with the Universo credit card (third credit card in Portugal by market share, with 13% in payments with credit cards); and insurance brokerage, with MDS (largest insurance broker in Portugal; and in the top five insurance brokers in Brazil).

• Sonae IM is the investment arm of Sonae, aimed at building and maintaining a portfolio of technology-based companies related to retail and telecommunications.

• Sonae Sierra develops and manages shopping malls.

• NOS is telecommunications company in which Sonae has a 23.4% ownership through Zopt. NOS is a publicly traded cable TV operator, internet and mobile service provider and cinema distributor. It produces several TV channels and distributes movies in Portugal. It is, on its own merits, an interesting investment that I may discuss in the future.

Quite a complex structure, isn't it? That is what makes SON a unique investment opportunity, as it discourages most portfolio managers from buying the stock. Also not helping is the fact that the company restates its financial statements at least every couple of years to reflect changes in the structure (for example, Sonae RP used to be a separate business segment before it was included under Sonae MC business segment). This makes it difficult for analysts to track the performance of the different business units over time. For complex holding structures such as SON, the easiest way to value the company is by estimating the value of each business unit separately and the adding the sum of the parts. It is therefore understandable that many investors pass on the opportunity to buy SON´s shares, even if they trade at a significant discount. But for the hard working analyst that is willing to make the effort, there is a fantastic investment opportunity awaiting.

SUM OF THE PARTS ANALYSIS

Sonae MC

Sonae MC (excluding Sonae RP) generates Earnings Before Interest, Taxes and EBITDA (EBITDA) in excess of €350 million per year (that is, after implementation of IFRS 16, which became effective on 1 January 2019 and increased reported EBITDA metrics as lease expenses started being effectively capitalised and flowing through the income statement as a depreciation and finance charge). Considering that Sonae MC is the market leader in Portugal, an Enterprise Value (EV) to EBITDA multiple of 5.0x is conservative, even factoring in the competitive pressure that Sonae MC will have to face as Mercadona and Dia (large food retailers in Spain) make their move into the Portuguese market. As a reference, Carrefour trades at approximately 6.0x - 7.0x EV/EBITDA and Jeronimo Martins (owner of Pingo Doce, the second largest food retail network in Portugal) trades at approximately 8.0x EV/EBITDA.

Sonae MC EV = €350 million EBITDA x 5.0x = €1,750 million

Sonae RP

We do not have a lot of information to value properly Sonae MC´s real properties or the real estate porfolio owned by the holding company, but we can make a conservative assumption that the value of these properties is not lower than 80% of their book value. This is probably too conservative but it serves me well in demonstrating that SON´s current share price is significantly undervalued.

Sonae RP NAV = 80% of invested capital at book value as of 31 March 2020 = €712 million

Worten

Worten is a network of stores for electronic products that apparently makes money in Portugal, but has struggled to break even in Spain for at least the last three years. It may have some value but I personally do not see a great future for this business trying to compete with online retailers like Amazon. For the purposes of this analysis, I am giving it no value.

Worten EV = conservatively assuming no value

Sonae Sierra

The rise of e-commerce has put pressure on shopping malls in recent years. While Sonae Sierra reported a foot traffic increase of 5.0% year-on-year during the first 6 weeks of 2020, foot traffic is generally being driven away from shopping malls by online retailers and video-on-demand platforms (do you go to the cinema as often as you used to?). Under this environment, successfully operating a shopping centre is all about location and occupancy ratios. In regards to both of these factors, Sonae Sierra is a great business with prime locations and occupancy ratios above 95%.

However, the coronavirus pandemic has created yet another set of difficulties for the sector.

As of June 2019, Sonae Sierra owned 18 malls in Portugal, 9 in Brazil, 6 in Spain, 2 in Italy, 1 in Germany, 1 in Romania, 1 in Greece and 1 Colombia. In most of these countries the pandemic has hit so hard the malls have stayed shut down for weeks. That means more debt is being or will be added that the business will have to service, and less value for the equity holders. Even as malls begin to open their doors again as countries lift lock-down restrictions, consumers will not immediately return to shopping the way they did before the pandemic.

Many consumers are still concerned about the danger of coronavirus infections in public spaces, and millions have lost their jobs. At the same time, some stores have imposed restrictions of their own (allowing fewer people to enter to allow for social distancing, or reducing operating hours). All these measures discourage impatient shoppers like me. That means even more debt.

That said, not everything is negative for Sonae Sierra. There are some positive developments too. On 29 February 2020 Sonae Sierra announced they had diluted its shareholding in six core assets, through the creation of Sierra Prime, a new retail real estate JV with APG, Allianz and Elo. According to the press release, "this was a key milestone in the company’s capital recycling strategy, enabling very significant cash proceeds for Sonae while ensuring that Sonae Sierra retains the management of these assets". This provided liquidity at a time when it was very much needed.

That said, with investment gurus like Howard Marks and Warren Buffet calling for caution, I will not be as arrogant as to pretend to know what the precise impact of the pandemic will be on the value of the business. I can try, however, to make some high level and very conservative assumptions to put a floor to the value of the business.

As of 31 March 2020 the Net Asset Value (NAV) of Sonae Sierra was €715 million. While this NAV included an €18 million provision for the impacts of the pandemic, I would not be surprised if further write-downs occur in following quarters, as the main impacts of the pandemic are expected to hit harder in the last three quarters of the year. Therefore, in my analysis, I have assumed some level of value destruction for Sonae Sierra. For this, let´s imagine three scenarios:

• Scenario A: Enough tenants go out of business or have difficulties to fulfil the payment of their rents to drive Sonae Sierra's loan to value (a measure of the indebtedness relative to the value of the properties) to unsustainable levels, forcing Sonae Sierra to declare bankruptcy. This would essentially transfer economic value from the shareholders to the debtholders. In this situation, I would assume no value for shareholders like me. I give a very low probability to this scenario, given their significant liquidity position (€200 million as of 31 December 2019, not counting with the cash proceeds of the Sonae Prime transaction) relative to their fixed expenses, which I don´t have enough information to estimate, but have to be less than the total (fixed plus variable) expenses of €120 million for the 12 months ended 31 December 2019.

Sonae Sierra NAV in Scenario A = conservatively assuming no value

• Scenario B: the higher debt, lower rents and lower occupancy ratios result in a destruction of value of around 50% of NAV. This would imply a value of:

Sonae Sierra NAV in Scenario B = €357 million

• Scenario C: the higher debt, lower rents and lower occupancy ratios result in a destruction of value of around 25% of NAV.

Sonae Sierra NAV in Scenario C = €536 million

Again, while even Scenario C may be overly pessimistic, it helps me demonstrate, as we shall see, that SON´s current share price is significantly undervalued.

Sonae Fashion

Sonae Fashion used to generate EBITDA north of €40 million per year. This is another sector that has been hit hard by the pandemic (who needs new and fancy clothes if you are working from home?). In addition, this is a very competitive sector in which Sonae Sierra has no competitive advantage over Inditex, Uniqlo or H&M. Still, an EV of €230 million for a business that can generate €40 million in a normal year is not difficult to see. Note that this would imply a multiple of 5.5x EBITDA, relative to the sector´s historical average of 7.0x if you ignore Inditex and H&M.

Sonae Fashion EV = €40 million EBITDA x 5.5x = €230 million

ISRG

While ISRG is similar to Sonae Fashion in that it sits outside SON´s circle of competence (food retailing), it is a different story as in this case SON participates in the business through a JV with sports clothing retailer JD Sports. This partnership is in my view a more appropriate way of diversifying into other retail spaces and something the market would like to see with Sonae Fashion as well. But let's go back to the question at hand. What is the value of SON´s 30% stake in ISRG? We do not have a lot of information on this JV either, but we know it used to generate revenue of approximately €676 million before the pandemic, with double digit growth and with an EBITDA margin of approximately 10%. According to SON´s management, the financial investment in ISRG as of 31 March 2020 was €181 million. In my analysis, I estimate the value of SON´s share in ISRG at €136 million, a 25% discount to the financial investment to reflect the impact of the Covid-19 crisis.

SON's interest in ISRG = €136 million (25% discount to SON´s financial investment)

Sonae FS and MDS

These are two relatively small businesses that would require a significant amount of time to analyse as well as information that SON simply does not report. I am therefore ignoring them and assuming they have no value.

Sonae FS and MDS = conservatively assuming no value

Sonae IM

Sonae IM´s investment portfolio is comprised of about 28 companies. SON´s management reported a NAV for this portfolio of €272 million as of 31 March 2020, allegedly based on the multiples method for the controlled companies and cash invested or recent transactions for the minority stakes. To properly value Sonae IM, we would need access to the financial statements of the 28 portfolio companies, and evaluate their performance relative to their peers, something that is simply not possible. Luckily for me, I do not need to make a precise estimate of value, as I am only evaluating whether SON's current share price offers more upside than downside. I am therefore assuming a 50% discount to the reported NAV.

Sonae IM = €122 million (50% discount to reported NAV according to SON´s management)

NOS

NOS is an interesting investment opportunity on its own merits, and one you can invest in directly as it is publicly traded in the Lisbon stock exchange. Many smart people I have talked to believe there is a lot of upside on its stock, which has rallied 10% in the last seven days. I may do a post on this in the future, but for now, and just to prove how we can play the "heads I win; tails I don’t lose much" game with SON, I will use the share price as of 28 May 2020.

SON´s stake in NOS = NOS share price x shares outstanding x 23.4% = €390 million

Holding structure

SON´s holding company provides certain services to the underlying businesses and creates value by sharing knowledge between the portfolio companies, by realising group synergies or by leveraging the existing assets and its comprehensive view of various markets to build new businesses. All of these benefits come at a cost of approximately €40 million per year. In the same way we valued most of the portfolio businesses based on multiples, you can also put a value to the holding structure by using some sort of weighted average multiple. A multiple of 6.0x to 7.0x would be more conservative than the actual weighted average of the EV/EBITDA multiples I have used to value each of the parts (which would be closer to 5.0x-5.5x).

SON´s holding structure = €40 million x 7.0x = €280 million

Net debt and non-controlling interests

As of 31 March 2020, SON´s net debt and value of non-controlling interests is approximately €1,318 million.

SUMMARY

The following table summarises what the equity value of SON would be with the assumptions explained above:

As I write this post, the stock trades at €0.68. If I buy at this price I become an owner (at least partially) of a wonderful food retail business including significant real estate, a few not so great clothing retail businesses, a promising sports clothing retail business and a bunch of other businesses (Sonae FS, MDS, Worten) with nothing but upside. In addition, I get to participate in the NOS story, where chances are that it will provide a lot of joy to the shareholders, and have no downside at all in the Sonae Sierra challenge. Since I have used very conservative assumptions, if everything goes well, the stock price could rise even higher than €1.14. If things go terribly bad, I still own a business worth €0.87 for which I have paid only €0.68.

All of this with a capital allocation policy that some would qualify as suboptimal (because, wouldn´t it be nice if SON focused on the businesses they know or if they repurchased more shares given the wide gap between price and intrinsic value?).

As I said at the beginning of this post, "heads I win; tails I don’t lose much".

IMPORTANT DISCLOSURE

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