Description

Short Geberit 

Company Description

Geberit is a Swiss manufacturer of sanitary products. The company is predominantly active in European markets. Geberit's products are mainly “in-wall” products such as flushing systems, waste fittings and traps, as well as building drainage and supply systems.

Geberit is known for its in-wall flushing system that allows the toilet tank to be placed inside the wall instead of sitting behind the toilet. Installation of Geberit’s in-wall system is rather complex and requires certified and trained plumbers. Geberit has trained over 30,000 plumbers mainly in Germany, Austria and Switzerland – its core markets. The high quality of the product, its reliability and the strong marketing directly to plumbers have made Geberit the go-to brand in the in-wall flushing systems niche. What is unique about Geberit, compared to other sanitary bathroom players, is that their main customers are the plumbers who choose the product and pass on the costs to the end user. The plumber is mainly focused on reliability and ease of install as he wants to do the job quickly and avoid at all costs the need to repair the system due to the complications of opening the bathroom wall.

Due to its unique business model, great execution and exposure to the markets that haven’t declined in the downturn (57% of sales in Germany, Austria and Switzerland and ~80% of EBITDA) the company has 27.5% EBITDA margins and ~32% ROIC.

Geberit has been a great performer in the past several years. In fact, it has been growing organically since 2010 which is extremely rare for European companies, especially in the building product space. Geberit’s growth has been due to a market share increase, introduction of a shower toilet product and exposure to strong markets such as Germany, Switzerland and Austria.

The Transaction

On 10/14/2014 Geberit unexpectedly announced its acquisition of Sanitec (SNTC SS) a Swedish manufacturer of bathroom ceramics. Geberit is offering SNTC shareholders SEK 97 which is a ~55% premium to prior day closing price. The offering price equates to ~€1.26bn in EV. Geberit announced that the company expects to achieve €45m of synergies (both cost and sales) by 2018. Geberit is buying SNTC SS at 10.3x consensus 2015 EBITDA ,13.5x EBIT (pre synergies) and 7.5x EBITDA and 9.0x EBIT (post synergies). Competitors are currently trading at an average of 6.0x 2015 EBITDA and 9x EBIT.

Sanitec in a Nutshell

Sanitec is a bathroom ceramic manufacturer and supplier of bathroom fixtures in Europe. Sanitec operates in various markets in Europe under several local brands (Twyford, Keramag, Sphinx, Allia, Pozzi-Ginori, Ifö, Ido, Colombo and Kolo). The company is expected to generate ~€705m of sales and ~€109m of EBITDA in 2014. Central Europe (Germany, Belgium, Holland) comprises 31% of sales, Northern Europe (Sweden, Denmark, Finland, Norway) 25% of sales, Southern Europe (France, Italy) 16% of sales, UK & Ireland 8% of sales and Other 3%. The company does not break down profitability by geography but I estimate that ~85% of the profits come from Northern and Central Europe.

Sanitec was acquired in 2005 by EQT partners, a Swedish Private Equity firm, from BC partners for €1.3-1.4Bn. At the time the company was generating €920m in Sales and had an EBITDA of €160m. EQT levered the asset substantially and during the financial downturn the company was on the verge on bankruptcy. EQT was able to reduce the debt burden by giving lenders an equity stake in the firm and the company managed to survive the downturn. In 2012, EQT ran a process to sell the company but did not receive bids that met its asking price (€1bn) and decided to end the process. The company was IPO’d in December 2013 with an EV valuation of ~€800m.

Thesis

Inflated Valuation

Geberit is one of the most expensive stocks in the industrial space. It currently trades at 16.2x 2015 EBITDA and 20.8x 2015 EBIT. Its European building product competitors trade on average at 6.4x 2015 EBITDA and 9.8x 2015 EBIT where the most expensive company in the comp group (Kingspan) trades at ~10x. Furthermore, I compared GEBN VX to a list of ~600 US and EU industrial companies and GEBN VX ranks as the 3^rd most expensive stock right after Tesla and Aerovironment. Consensus is expecting Geberit to grow annual sales by 9% on average in 2015 and 2016 and EBITDA by 9.4% while Tesla is expected to grow sales annually on average by 57% in that period and EBITDA by 120% and Aerovironment is expected to grow sales by 8% and EBITDA by 94% on average. Geberit is not a hyper growth stock, in fact its growth profile in 2015 and 2016 much more resembles the industrials space median (7% sales and 9% EBITDA). However, industrials 2015 EBITDA multiple is ~8.0x. Lastly, Grohe, a high quality German bathroom fixtures manufacturer with high margins and ROIC, was purchased last year for 11.0x EBITDA by Lixil of Japan.

Geberit has gained its multiple due to good execution, consistent growth, low earnings volatility and high return on invested capital. I estimate Geberit’s ROIC at ~32% in 2014 vs. comps at 11%. Numbers are somewhat skewed due to comps exposure to European markets that are at trough volume levels, however, other US or European best in class competitors with high growth or high ROIC trade at much lower multiples.

Sanitec – Business in Turmoil

When Sanitec was purchased by EQT they appointed Bengt Pihl, a 15 year veteran at ABB, as the CEO. Bengt was an admired CEO and guided SNTC through the financial crisis. In 2008, EQT appointed Peter Nilsson as the Chairman of the company. Nilsson is an aggressive, egocentric, controversial manager that drove out both the former CEO, Bengt Pihl, and the former COO, Walter Koch in 2010. During that time, he took over as CEO. Both Pihl and Koch confirmed to me they left because of Nilsson’s leadership and his plans for the company’s future. Since then, EVERY single regional head has left the company, in fact Nilsson drove out 2 consecutive heads of the UK during his tenure.

During my research I spoke with over 10 former managers who worked at Sanitec and Duni (Nilsson’s former employer) and surprisingly I got the exact same messages from them:

1. Under Peter Nilsson the business has been significantly mismanaged and underinvested

2. The bathroom ceramic industry is a relationship business and the current regional heads are sub-par compared to the team that left

3. Management team lacks credibility

   1. In 2012 the company tried to sell itself. KKR who was looking at the asset had 8 EU companies with exposure to Sanitec’s end markets. However, Sanitec’s estimates were the only ones that forecasted growing sales and EBITDA for 2013. In fact, Sanitec was forecasting at the time (mid 2012) – 2014 Sales of €977m and EBITDA of €174.7m. Sanitec is expected to generate this year sales of ~705m and EBITDA of ~€109m.

   2. Sanitec has been implementing the former management’s team “One Sanitec” restructuring program in the past several years. The program was constructed by the former COO Walter Koch. Sanitec claims that EBITDA rose from €50m in 2009 to €100m in 2013 due to the program. Nilsson has been communicating to investors that the company has only completed half of the “One Sanitec” program since the IPO. In fact, Geberit purposefully mentioned this point during their merger announcement call - “According to management, the company is about halfway through the One Sanitec journey”.

Every single person I have spoken to, including the people that came up with the program, Walter Koch and Bengt Pihl, do not think the company can cut another €50m of costs. In fact, most believe that the company cannot even cut half that amount and if they do, the effects on the company will be disastrous as it will effect core competencies of the company.

Sanitec – Underinvested Business

Sanitec has been owned by private equity firms since 2001. Both BC partners and EQT did not invest in the business. In fact, annual depreciation for the company has been around €30m for the past ~4 years, but the company has spent on average ~18m on capex or 2.4% of sales during this period. Further, when looking at data from 1998-2001 (the previous time Sanitec was public) we can see that Capex averaged ~€40m or 5.3% of sales. If we analyze Villeroy & Bosch they have been spending in recent years ~3.5% of sales on capex. Further, in recent years a good portion of the capex spent has been on “One Sanitec” – Sanitec’s cost cutting program. R&D spend has also been cut significantly – from an average of 1.9% between 1997-2001 to 1.2% between 2011-2013. Sanitec has also been underinvesting in Sales & Marketing in the past several years, there has been a 30% decline between 2013 and 2011.

The reduction in investment has caused a reduction of SKUs, deterioration of relationships, decline in brand equity and market share losses for Sanitec.

Market share is a controversial subject with Sanitec. If you speak with the company – they would argue that they are leaders in most of their markets and that they have not lost any share in recent years. However, conversations with prior insiders suggest that the ceramics industry is fragmented and tough to analyze. There is no industry organization that gathers data and market share data is anecdotal at best. When speaking with industry contacts and distributors – most suggest Sanitec has lost market share in recent years.

Sanitec’s Brands

In contrast to most European ceramic manufacturers, Sanitec has different brands for different countries. They operate with the Ifӧ brand in Sweden and Denmark, Ido in Sweden and Finalnd, Keramag in Germany, Sphinx in the Netherlands, Twyford in the UK, Alia in France, Pozzi Ginori in Italy and Colombo in Ukraine. All of Sanitec’s brands are middle-market brands, meaning that their ability to capture share is limited without significant marketing investments. Higher end brands such as Duravit, Grohe and Villeroy & Bosch operate under one cohesive brand and their brand equity allows them to capture share and volumes in a stagnant European environment. Sanitec has identified the competitive disadvantage that results from having local brands, noting that it prevents the company from growing into new markets especially high growth ones. Sanitec considered investing in Keramag, its German brand, in order to elevate it to a higher end pan-European brand. However, when the company realized they would most likely need to spend €100m to do so it backed down.

Why is Geberit Buying Sanitec?

Geberit listed the following reasons for the acquisition:

1. Creation of the EU leader in the sanitary products industry

2. Expansion of Geberit's addressable market in bathroom ceramics and ceramics complementary products

3. Combination of behind- and in-front-of-the-wall products and know-how to facilitate the development of integrated system solutions

4. Direct access to end users, e.g., via showrooms and Sanitec’s established regional brands

5. Combination of two organizations highly regarded by customers with outstanding reputation for product quality and reliability, service and innovation

6. Achievable synergies with an objective of at least EUR45mm run-rate in the medium term through continuous productivity improvement and a lean functional organizational structure

There are three main points I want to highlight that illustrate why this transaction is a red flag and will lead to a blow to Geberit’s reputation, counter most of Geberit’s transaction rationale and cause the multiple to contract:

1. Change in Strategy - What changed?

For years Geberit has been communicating to the street that it has no intention to expand to the front of the wall as its expertise is behind the wall and their relationships are with installers. In the past, Geberit also rejected large acquisitions noting their ability to grow organically and that with 30% ROIC it is impossible to find acquisitions that actually increase shareholder value. In fact, during Geberit’s Q2 2013 call the company was asked about its priorities and listed large acquisitions as its last priority for cash deployment:

: Okay. I mean - and are you able just to comment? Historically, you've always said that your priority for the balance sheet has been, I think, kind of dividends, share capital return, share buybacks. And then big acquisitions will be your last priority. Does that still remain the case in your list of priorities?

: This has always been in our list of priority, and nothing has changed.

Further, going through some of my notes from prior meetings with Geberit – the company went above and beyond to explain why a move to in front of the wall does not make sense given the different marketing / brand investments between front of the wall and behind the wall products. Geberit is a technical product that is marketed to installers. Their brand equity within the consumer market is limited. Sanitec’s brands are consumer brands where the products are usually chosen by the end user. The sales/marketing synergies are minimal at best. Further, Geberit reiterated to me in several meetings they will only make acquisitions in order to grow.

I believe the reason for Geberit’s move relates to comment the company shared during its Q1 2014 call –

“Regarding the competitive environment we are facing competitors like Duravit, European player. We have TOTO from Japan trying to penetrate the market. Grohe is also in the market with one product. And we see more and more, I would say, ceramic manufacturers trying to enter the shower toilet business. So the competitive environment is increasing with more and more players, both from Europe and also from Asia.”

Competition is intensifying from Grohe, Roca, Toto and others. Further, all the macro indicators for Germany, Geberit’s core market, have been coming in below expectations. Geberit is desperate for growth and believes they need to acquire it.

In the recent Q3 2014 call Geberit was asked specifically about the “change in market conditions” but the company was unable to come up with a coherent message to explain its change in strategy.

(Andre Kukhnin - Credit Suisse – Analyst) – “ I think you mentioned on that call, which we did listen carefully, that there were changes in market conditions that led you to pursue this deal. Because this logic and this rationale that you've just presented on the call, that existed I think a year ago as well, and two years ago. So really curious to find out what's changed in the market, what's evolved in the market to -- for you to pursue this now? Is it maybe development within AquaClean that you're seeing, is that converging the front of the wall and behind the wall, or is there anything else? Because the decision-makers are still difference for ceramics and for your technical products that are called Geberit?”

(Albert Baehny - Geberit AG – CEO) – “ We believe that, on a long-term basis, to maintain the competitive advantages of Geberit, to maintain our strong market position, we need to include the ceramic business into our current portfolio. In markets where you don't have educated and skilled plumbers, the end users are the main decision makers for all the sanitary products including front and behind the wall. If you don't have a brand dedicated to the end users you don't have strong access to these end users. We want to improve our access to the end users in the so-called European emerging markets where the design brands play an important role”

There are two reasons why the CEO’s answer is not satisfactory:

1. If the purpose of the acquisition is for emerging EU growth – why pay ~€1.3bn for ~110m of sales in Eastern Europe with operating margins in the low single digits?

2. Levering Sanitec’s brands to sell Geberit products in markets where end users are the main decision makers makes a lot of sense. But in order to do so – Geberit will have to offer its products under Sanitec’s brands. Geberit specifically said, during their M&A call, that they will keep the Geberit products under the Geberit brand.

Further, in Geberit’s Q3 2014 report growth rates in the company’s core markets have slowed (see below). The company also came out with cautionary end market guidance. Geberit has decided to purchase growth and is doing so at the expense of its shareholders in hopes that acquired growth will keep its multiple elevated

2. Poor due diligence - Sanitec needs investment

As I covered earlier, Sanitec’s management has underinvested in the business in the last decade. The company needs investment in sales force, products, R&D and infrastructure. Contacts I have spoken to estimate the level of investment needed between €100-200m.

Geberit admitted in their M&A call and in a private conversation with me that they only used publicly available data for their due diligence.

: So what level of due diligence were you able to do?

: This is the due diligence we can do when you buy a public company. There was restrictions and we want to respect and we'll respect these restrictions. You can only have access to public information. This is the rules and we respected that. We try to read between the lines, but at the end of the day we had only access to public information. This is how it works.

I believe Geberit is not aware of the hisdtorical underinvestment in the asset, the internal turmoil caused by Peter Nilsson and the challenges it will face realigning the business.

3. Poor return on investment in the transaction– higher cyclicality and drop through

Geberit paid €1.2bn for Sanitec. Sanitec is expected to generate €82m of EBIT in 2014 and €91m in 2015. Pre-taxes and pre-synergies returns are 6.8% for 2014 and 7.6% for 2015. Post synergies the returns are 10.6% for 2014 and 11.3% for 2015. However. If we assume the Geberit will need to invest €100m into the business, due to the underinvestment, pre-taxes and post-synergies returns will be 9.8% for 2014 and 10.4% for 2015. These returns are significantly below Geberit’s 32% ROIC.

The low return on investment in this transaction should lead to a reduction in Geberit’s multiple. Sanitec’s high cyclicality, due to its high fixed cost basis, and high drop through (30-40% vs. Geberit’s 20-25%) should also lead to a reduction in the multiple as Geberit’s earnings volatility is likely to increase significantly.

4. Different customers

Geberit’s customers are the installers while Sanitec’s customers are the end users. Geberit will try to create sales synergies between both companies but the market where these synergies can happen (Germany – where the installers are informed and Sanitec has a good presence) is already saturated. Keramag (Sanitec’s German brand) has 20-30% market share in Germany and Geberit has 90% of the concealed in wall toilet systems in Germany and 50% of the overall market. Opportunities for further market share gains in Germany are limited. In other markets like Scandinavia or Poland where Geberit hopes to gain market share – Sanitec will add limited resources to doing so. Education of customers about concealed systems will take years and relationships with local installers is not an asset that Sanitec brings to the table. Therefore, sales synergies are going to be tough to accomplish.

To summarize the points in the context of Geberit’s transaction rationale:

• No clear benefits of a combination of behind and in-front of the wall systems

  • Especially if the post synergies return result in ~10%-11% return

  • Different customers for behind and in-front of the wall products mean that sales and marketing synergies will be hard to achieve

• Geberit’s ceramics and ceramics complementary products, most specifically, the shower toilet are expensive and high end and do not fit with Sanitec’s middle market brands

• Access of Geberit’s core in-wall products to Sanitec’s showrooms will have marginal effect as the Geberit brand has limited effect on end users.

• Sanitec is not a high quality business and needs significant investment

• I believe that €45m of synergies in 3 years will be a tough number to accomplish without end market growth especially where significant part of the synergies are sales synergies.

Catalyst

In conclusion, I believe the Sanitec acquisition will be a catalyst that will cause the stock to underperform and the multiple to contract. Geberit decided to make a business transforming transaction even though it has been communicating for years that they were not going to do such transactions especially moving beyond the wall into ceramics. The issues noted throughout this analysis are going to surface in the next several quarter and will raise the levels of uncertainty and cause Geberit’s multiple to contract. In an environment where core markets are contracting and the company is resorting to a significant low quality and low return investment made with poor due diligence Geberit should not be trading at 16.0x 2015 EBITDA.