Share Price: 14.3 Euro
S/O:6.4M
Debt:74.3M
Cash: 46M
Pension Liability: 70M Euro
Adjusted EV: 190M Euro

Summary:

Bavaria Industriekapital is an obscure German investment company with a highly specialized and interesting business model run by a capable CEO with 67% ownership in the company. As you would expect given his ownership, he is entirely focused on the business vs. raising the company's profile, and it took me several attempts to have a phone conversation with him which he cut off at exactly the half hour mark. Furthermore, he views dividends as his prime mechanism of creating value for himself, and the historical dividend rate has been as high as 3 Euro per share (vs. current share price of 14 Euro). As the thesis play outs, we foresee substantial dividends which can serve as a hard catalyst even if the company continues to be broadly neglected. Finally, in addition to the future value creation that we think will occur due to the interesting business model and capable/incented management, you can buy into Bavaria's current portfolio at less than 4x 2011E EBITDA.

Business Model:

Bavaria focuses on highly distressed non-core businesses of large German and European conglomerates. In their typical deal, they pay less than 1 Euro for the business and put the acquired company in its own legal entity with no recourse to Bavaria the hold co. Bavaria's CEO previously was a Managing Director at a leading German distressed private equity firm, and his team is heavily operationally focused with significant training in Toyota Production System (TPS) methods. Going into an acquisition, Bavaria has a 90-180 day plan to stem the bleeding as quickly as possible, which is often done through hard-nosed dealing with German/European labor unions. It is much easier for Bavaria to play tough vs. a large conglomerate that has many plants across Europe and therefore has to negotiate with labor collectively. In addition, large conglomerates operate at a much higher level of publicity, have to be concerned with political backlash, etc. As such, Bavaria frames itself not only as an investor but as a service provider to large conglomerates - e.g., we will take a problem off your hands.

Upon acquisition, Bavaria has a clear operational strategy as discussed previously but also a financial strategy where Bavaria will fund losses for a certain period of time to see whether the turn-around is working. If the losses cannot be stemmed, the company is shut down. Bavaria hold co does not assume material liabilities or guarantees with the op cos. Often times, Bavaria will liquidate assets such as equipment, excess land, etc. to fund the losses, reducing the investment to a nominal amount.

As such, you have a company that essentially creates a stream of options each year. Acquisitions often have several hundred million Euro in revenue, so Bavaria's enterprise value relative to its turnover is miniscule. If any type of positive EBITDA margin is achieved sustainably, the deal is a homerun. In the CEO's words, Bavaria is essentially a venture capital company but with no acquisition price, operating losses often funded by monetization of the portfolio company's own assets, and an equal or higher probability of hitting a home run than an early stage start-up. As Bavaria grows, its average deal size has grown and the optionality increases.

Management:

We have conducted several reference checks on Reimar Scholz, Bavaria's CEO. The universal response was that he is very hard-charging to the point of being brusque and hard to work with, but that he is highly capable and has strong integrity. His salary is very reasonable (Bavaria's entire Executive Board was paid 1.1M Euro in 2010), there are nominal options, and there are no typical private equity fees of 2 and 20, all of which is not surprising given his 67% ownership. He told me explicitly that he views dividends as his way of creating wealth for himself, and the history of Bavaria is filled with extraordinarily large dividends relative to the share price. As exits occur, minority investors can feel comfortable that the proceeds will be distributed to them relatively quickly (Reimar wants to get his). Given the 1 Euro purchase price for many acquisitions, re-investment needs are relatively contained, which is of course what has allowed for such large dividends in the past.

Valuation:

Bavaria's accounting is no doubt challenging. Bavaria buys for less than tangible book value, often considerably so, which helps them fund operating losses during the turn-around through monetization of hard assets. However, per German accounting, any acquisition done for less than book value is considered negative goodwill which can be booked as profits. As such, it's important to get into the footnotes to determine operational EBITDA.

Per this metric, Bavaria did 20M Euro in EBITDA in 2010 and given 1Q performance, could do over 40M in 2011. Bavaria's portfolio is heavy in highly cyclical industries such as auto part manufacturing that are rebounding and Bavaria is benefitting from the associated operating leverage. For example, in 1Q11, Bavaria's sales grew strongly and operational EBITDA went from break even in 1Q10 to 9M in 1Q11. Note that operational EBITDA includes the losses of the recently purchased companies that are still loss-making. As these will be shut down if they don't at least break-even, EBITDA could be viewed as the EBITDA of the turned-around companies. If we use this, operational EBITDA was 29M Euro in 2010 and our 2011 estimate would be nearly 60M. While there will always be loss making EBITDA companies given Bavaria's strategy, a sum of the parts would value these losses not as ongoing but as the NPV of funding operating losses until wind-down.

Bavaria has a pension liability of 70M. In the auto parts space, analysts typically add the pension liability to EV and then add back pension expense and get an adjusted EV/EBITDAP ratio. This may be theoretically right, but I view pension expense as an operating expense and to be conservative I adjust up the EV for the pension liability but not make any add-backs to EBITDA. On this basis, Bavaria is trading at 6.5x 2010 EBITDA and 3.3x 2011 EBITDA (adding back the loss-making companies' losses as discussed).

The vast majority of Bavaria's EBITDA currently comes from the auto parts division. Commodity auto parts supplier companies trade at 4.5-6.5x 2011 EBITDA, so using a 5.0x I arrive at a 31 Euro share price vs. the current quote of 14 Euro.

Our favorite type of investment is buying into a top tier business model and management team at a meaningful discount to hard asset value, so you make out both on the closing of the value gap and on the future long-term value creation of management. The real value here in our opinion is not the auto part companies Bavaria owns today but the enterprise itself and its CEO. What Reimar has done is remarkable - with nominal initial equity (initial founding in 2003 and tiny IPO in Jan 2006), he has created significant equity and enterprise value despite paying out dividends already in excess of equity invested. His track record in the space is clear, he has created 60M in EBITDA out of very little, and as he grows his business the average deal size of his acquisitions will only grow. There is terrific future optionality you are being paid to receive.
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As noted previously, the CEO distributes cash routinely. As the thesis plays out, it is possible that investors get their initial investment back in 3-5 years from dividends and continue to own their stake in this intriguing company.

As previously discussed, Bavaria's portfolio is heavy in highly capital intensive, highly cyclical industries. As such, we are exiting a period where a distressed investor makes investments and entering one where it harvests them. We would expect to see some exits among Bavaria's portfolio in the ensuing years.

Finally, the mispricing may partially exist due to Bavaria's recent decision to cut its dividend to zero. In our view, this is entirely understandable with even a cursory examination of Bavaria's cash flow statement. In a time of rising sales, the working capital investment becomes meaningful, especially for a company with as low of an enterprise value as Bavaria relative to its sales. We view this as being prime evidence for the improving fundamentals of the business and any technical selling based on the dividend cut is a good opportunity for long-term investors to acquire shares.