Description

BALDA AG

I.                   Description of Balda

1. Core Business - Balda's historical expertise is in manufacturing plastic components. The core business has sales of around €150mm and is expected to be EBIT-
positive this year after modest EBIT losses in 2010. It currently has 3 divisions: Mobile Communications; Electronic Products and; Medical.

a. Mobile Com (China) - this was Balda's bread-and-butter business but has deteriorated into a hyper competitive business with negative margins. Basically
Balda manufactures plastic casings for mobile phone manufacturers. Sales have fallen from €150mm in 2008 to around €75mm in 2010 as the company has lost customers.
Currently, the division is overreliant on one customer (Sony Ericsson), and management is trying to win new business to improve capacity utilization and margins (full year
divisional EBIT is yet to be disclosed for 2010, but some analysts estimate a double-digit negative EBIT margin). Importantly, management has said repeatedly in the
past few months that the business is under close scrutiny and could be shut down in 2011 if it doesn't improve, which I believe would be positive for convincing
investors that the Board is conscious of maximizing shareholder value.

b. Electronic Products (Malaysia) - as a result of limited capacity utilization at its Malaysian factory which was historically used as part of the Mobile Com division, Balda
has moved that facility into the business of manufacturing various electronic products for OEMs, ranging from peripherals for mobile phones and MP3 players (e.g. headsets)
to digital cameras. The business has sales of around €40mm and is expected to be breakeven in 2011.

c. Medical (Germany) - in Germany, Balda designs and manufactures parts of plastic products for pharmaceutical, diagnostics and med tech companies. Products include
pharmaceutical packaging and throw-away products. This is a better business than the other divisions and is a comp to businesses like Gerresheimer (which has recently
been written-up on VIC), as well as Consort Medical in the UK, and West Pharma in the US, although in much smaller size. This business is expected to grow this year and
should be able to generate low double-digit EBIT margins. Management and the Board have made it clear that focusing on this business is their strategic priority,
and have intimated that some portion of the proceeds from any sale of their TPK stake could be reinvested in an acquisition in this space to gain scale / broaden the
customer and product portfolio.

2. Stake in TPK - some years ago, Balda invested in a Taiwanese startup called TPK which was founded by a Taiwanese entrepreneur named Michael Chung to focus
on the emergent market for capacitative touch screens. These are basically the glass touch screens now used in the Apple I-Phone and I-Pad, and other smart phone / tablet
products. At the time, the market was limited; now, however, the market is booming. TPK is the dominant supplier of touch screens to Apple for both the I-Phone and the I-Pad,
and sales have grown rapidly. Apple accounts for around 70% of revenues, and the company is actively trying to diversify its customer base to reduce concentration risk. The
business currently growing revenues at a rapid pace, gross margins are around 15%, and operating margins around 10% - which is what the company is targeting going forward.
Balda has progressively sold down its stake in TPK, and currently owns 16% of shares outstanding. TPK is publicly listed (Bloomberg ticker: 3673 TT), and currently has a market
cap of nearly €4.5bn. To make matters a little more complicated, the founder of TPK (Michael Chung) actually owns around 30% of shares outstanding in Balda, resulting in a
cross-shareholding that German investors find troublesome (I return to this fact in the Risks section below).

II.                Why is Balda mispriced?

The recent IPO of TPK in late October has provided a market-observable price for the value of Balda's 16% stake.  Since being publicly listed at T$250, TPK's stock has more
than tripled to over T$800 per share.  Marking Balda's stake to market, the value of its TPK holding is worth €720mm (Balda owns 36 million shares at T$818, converted at current
EUR:TWD exchange rate), versus its own market cap of €500mm, implying significant negative value for the core Balda business.  The huge price appreciation in TPK has been
driven by explosive growth in tablet and smartphone demand which has driven earnings and earnings expectations up during 2010 and early 2011.  In addition, locals speculate
that part of the price move has been due to an artificially low IPO price (according to TPK's investor relations officer, the IPO price was set early in 2010 before much of the sales
growth was observed, and apparently the company felt that engaging in the procedures required to amend the price was too cumbersome; also given employees in TPK continue
to hold a large portion of equity and haven't cashed out, they were always going to benefit from any subsequent price appreciation so their view was that pricing it at full value
day 1 was less necessary).   

Many investors are presumably unaware of the market value of TPK, and hence the undervaluation of Balda.  Investors who are aware of this pricing anomaly are still reluctant
to get involved because of the general perception that Balda is a "bad" company with a "bad" management team.  Much of this is to do with history.  Some investors may
remember the relatively unsuccessful attempts of activists to create value at Balda pre-crisis, while others may remember its proximity to bankruptcy in 2009.  Both situations
created a belief that the Balda management was shareholder unfriendly, either by design or incompetence.  What many investors are unaware of is that the management team
has changed since July 2009, and then again only a few days ago with the current CEO being replaced by the current CFO.  Admittedly the turnover is not great for credibility,
but as I discuss below in the Risks section, I believe this is insufficient to justify the extent of this pricing anomaly.

Finally, analyst coverage is limited.  There are 2 analysts who cover Balda, one of whom initiated only a few weeks ago.  Management has been extremely difficult to arrange
meetings with, and communication to the market is infrequent, resulting in limited investor awareness of the company.

III.             What is fair value for Balda?  

I believe the most appropriate way to estimate fair value for Balda is via sum-of-parts analysis.  Below, I show my base case SOP valuation.  Assumptions are described below.

(i) Holding in TPK - here I assume latest market value for the stake in TPK. I believe this is appropriate since I think management will try to sell its stake in coming
months so market prices are most relevant. People can form their own views on what TPK is worth, and I discuss potential downside associated with this in the Risks
section below. You could also sensitize Balda value for various realized sale prices in TPK - I've chosen not to show that analysis here, but given the extent of implied
negative value, you would have to haircut the stake in TPK fairly aggressively to see downside by investing in Balda at the current price

(ii) Net cash - giving full credit for this, pro forma for recent conversion of convertible debt

(iii) Core business - see the separate SOP below

(iv) Potential Tax Liability - conversation with management revealed that the company has sought tax advice and has been told that they are unlikely to pay any
capital gains tax on potential disposal of TPK shares as a result of the stake being held via a Singapore subsidiary

(v) Holding Company Discount - applying a 20% discount here in line with average European holding company discounts. In some respects, if management was to
sell its stake in TPK, you could probably argue for a narrowing of that discount, but to be conservative, I've retained it here.

On the back of these assumptions, there is over 60% upside to non-discounted breakup value, or 30% upside to a discounted SOP.  

For the core business value of around €45mm, here is my SOP:

(i) Medical- the business is expected to grow in 2011 due to a new dispenser contract awarded in 2010, so I assume €40mm of sales and a return to close
to 10% margins (the business did 15% margins on €35mm of sales in 2008 so this is not unreasonable). I assume an EV/sales multiple of 1x, with the comps trading
at around 1.2x-1.4x (Gerresheimer, Consort Medical and West Pharma).

(ii) Mobile Com - here I assume negative value of €5mm, mainly relating to shut-down costs. This is a very rough estimate of shut-down costs based on severance
payments the company had to make when it laid off a bunch of people in their Asian facilities in 2009/10. Keep in mind that the company has actually recently built
new facilities in Beijing that cost almost €6mm, so if they were to sell that for construction cost, this could help recoup much of the severance cost and reduce negative
value.

(iii) Electronic - I assume the business reaches breakeven this year, and use 0.2x EV/Sales to reflect fairly low margin potential of the business.

IV.              What catalysts could correct the mispricing?

The typical problem with holding company situations like these with a history of bad management is that the market applies severe discounts to NAV assuming value-
destructive capital allocation.  In this case, however, I believe that Balda will progressively sell down its stake in TPK with proceeds to be split between some form of
shareholder distribution, and some reinvestment or acquisition in the Medical business.

As part of the IPO, Balda is locked-up from selling any stock until late April 2011, when it can sell 50% of its stake, with the remaining 50% locked up until October 2011
(unless the bookrunners of the IPO were to grant Balda a waiver). The Board has made statements to the effect that it is considering what to do with its TPK stake, and
any decision will be in the interests of shareholders - see this press release (http://www.balda.de/investor-relations/press/detail/datum/2010/12/balda-ag-supervisory-
board-approves-further-steps-for-an-acquisition-in-the-medical-business-divisi.php?tx_ttnews%5Bday%5D=13&cHash=01f9e1f9d7fde378d6f13c545261e107)].  Since the
company has progressively sold down its stake from over 50% to the current 16%, I believe the Board views its holding in TPK as a financial, non-strategic asset and will
treat it as such. Conversations with the Investor Relations officer at the company have confirmed this view of the asset currently prevails.  In addition, the company has
engaged tax lawyers for opinions on the likelihood of capital gains tax on the sale of TPK shares - the fact that they have sought tax counsel suggests to me that they are
clearly considering selling their stake.

The use of proceeds is less clear, but again, based on conversations with the Investor Relations team, I have reason to believe that the company is considering using part
of it in a special dividend, with the other part to be used in an acquisition in the Medical business.  The intent to beef up the Medical business is apparent in previous press
releases and comments in the Company's annual reports.  The intention to return some cash from a TPK proceeds to shareholders is less obvious, but even the mere
monetization of some or all of TPK shares at around spot value should force the market to value the resulting cash at a narrower discount. 

V.                 What are the risks?

Key risks are:

• Management / corporate governance / shareholding structure - clearly management needs to decide to sell the stake in TPK for the mispricing to correct.
  In addition, they would then have to return part of that to shareholders as opposed to engaging in some large, badly thought out acquisition in Medical. An additional
  complication is the cross-shareholding structure of Balda / TPK. Michael Chung, the founder of TPK, owns around 30% of Balda through Yield Return Investments (a
  shareholding vehicle). If he wanted a poison pill for TPK, he could demand that Balda not sell its stake, and given his level of shareholding in Balda, he could potentially
  get what he wants. However, there are a couple of things that make me believe this is less likely. First, Balda has already progressively sold down its stake in TPK.
  Second, they have engaged tax counsel and begun thinking about how to sell the stake, so it suggests that Chung has not objected to a potential sale. Third, there
  was a recent management change that suggests Chung may not control the Board - CEO Michael Sienkiewicz, who was apparently introduced to the company by Chung,
  resigned and was replaced by the current CFO, Rainer Mohr. The fact that the Chung-appointed CEO was ousted by the Board (apparently due to poor progress at the
  Mobile Com business and the desire to hold him accountable) suggests that the Board may actually be acting in the interests of all shareholders, rather than just Chung.
  In any event, I believe the current discount to SOP value shows that the market is already pricing in the risk that management either does something stupid or nothing
  so you win if they do something remotely shareholder friendly.

• Decline in value of TPK - is stock price inflated? - given how much value is accounted for by the holding in TPK, a decline in the value of that business will obviously
  impact fair value for Balda. It is tough / impossible to hedge out this risk by shorting TPK because of limited /no borrow since it has just recently been listed and inventory
  of borrowable shares is low. I admit that TPK is an expensive growth company, and as value investors, I assume that few people on VIC would ever invest in it outright.
  Having said that, the growth in touch screen usage has been extraordinary, the I-Pad 2 is rumored to be coming out, the company has dominant technology and customer
  relations, and there is an investor base very happy to pay the current multiples for TPK to get exposure to all of those things. I believe this risk is also mitigated somewhat
  by the fact that the lockup for the first 50% of Balda's remaining TPK stake expires in April, at which point I expect them to sell, so the length of time for which one is
  exposed to market fluctuations in TPK's stock price is relatively limited - at least for the first half of the remaining stake. Finally, the magnitude of upside to non-discounted
  SOP value (over 60%) suggests some margin of safety - even if the price of TPK was to decline, there is enough of a mispricing here that capital should be protected.

• Cash burn in the core business - cash burn in the core business could erode value here. I take some comfort from the fact that the new CEO (former CFO) came out
  and said that the core business should be EBIT positive this year, suggesting that operating losses (and hence major cash burn) should be limited.

• Payment of special dividend impeded by technical minimum equity requirements - a recent research report suggested that the company could face some impediments
  to paying out a special dividend to shareholders because of minimum equity requirements at certain operating companies that have been historically loss-making. This could
  very well be true, but would probably only delay a cash return to shareholders or force it to be structured in instalments, rather than making it impossible. If the company
  was to even articulate an intention to pay out some of the TPK proceeds over time, I think that would be sufficient for the market to re-value the equity, even if one was
  to discount back those proceeds for time value of money. Alternatively, the company could do a buyback instead of a special dividend - that would require shareholder
  authorization at an AGM, but I suspect most (rational) shareholders would approve the monetization of an expensive asset and a return of resulting proceeds.

Conclusion

Catalyst