Description

Gesco A.G. is an aggregator of niche German industrial businesses. By aggregator, I mean a company that holds of portfolio of related industrial businesses and grows both through organic growth in those businesses and reinvesting the operating cashflows of those businesses in related industrial businesses (through acquisitions). Gesco was the brainchild of Willi Back, who served as CEO of the company from 1990-2004 and as Chairman of the Board of Directors from 2004-2011. The culture he imbued onto the business is one of a conservative management and being long-term oriented.

Since floating in 1998, Gesco has generated a TSR of approximately 13% p.a. (10% stock price appreciation and 3% through dividends).

The overall business can be segmented in a few ways. Several ways below:

Segmentation by Standardized vs. Customized Products

One key question is the mix between standardized and customized products that Gesco sells. The mix at Gesco AG is roughly:

a)      Standard:            35%

b)      Customized:       65%.

Segmentation by Business Area/Application

The largest areas by revenue:

a) Automotive                                               21%

b) Industrial components                            17%

c) Steel & Metallurgy                                    13%

d) Others                                                      49%

    Total                                                        100%

Segmentation by Region

Gesco is heavily dependent on the Germany industrial base:

a) Germany                                                                         65%

b) Europe ex Germany                                                       19%

c) Other                                                                              16%

    Total                                                                                100%

Overall, the business is run in a decentralized fashion. It has nothing to do with Berkshire Hathaway, but the way it is run is similar in that the HQ is very lean (only 15 people last time I checked) and each sub-business, of which there are about 20, is led by business MDs who have a large degree of autonomy and responsibility in running their businesses. HQ is involved only in monthly meetings to give an outside objective perspective, and yearly meetings with the local management teams to establish budget targets and corporate strategy or to sign off major investments.

As the Gesco business is decentralized, a few words about the biggest sub-businesses.:

I. Dörrenberg Edelstahl GmbH (in Engelskirchen)

Dörrenberg accounted for ca. 40% of the revenues of the Gesco group. It is involved in several activities:

a)      Steeltrading – this is the largest part of the business and describes a business involved in the trading of specialty steels for the German industrial manufacturing base. Their sweet spot is in the steels used for tools manufacturing and their main value to customers is reliability and having inventory.

b)      The second part of the business is specialty steels manufacturing – a forge

c)       The third business is a foundry business. From interviews conducted with such companies for Vesuvius plc, they are capital intensive but if niche and focused on critical components can be good businesses.

d)      The last business is a metals treatment business like Bodycote plc in the UK. It’s an okay business. I originally thought commoditized but there is some regional density requirements, that made it better than I originally thought.

Overall, the target EBIT margin in this business is 10%. NWC are average, so this is not a bad compounder over time. The large number of cstomers shows that this business serves the small clientele, which is less price sensitive. Most competitors are small regional German companies in the Ruhr-area.

II. SVT GmBH

Another sub-business is SVT GmbH. It employs 180 personnel.

SVT manufacturers loading arms for loading/unloading LNG fleets. This is a specialty market and includes equipment sales, service, and aftersales. There is also an element of software that is used for controlling the loading arms. This sounds like a good business but,

Roughly 20% of revenue comes from aftersales and spare parts. That is okay.

The named competitors were:

a)      FMC Technologies (USA)

b)      Niigata (Japan)

Again, this is a global niche business.

III. MAE Maschinen-und Apparatebau Götzen GmBH

Another super German sounding company, this one claims to be the world market leader for automated “Richtmachinen”. A Richtmachine is very roughly an automated machine that places an object (metal tube for example) at an exact position so that other types of very accurate treatments can begin.

Again this seems to be a business with soft and hardware, and likely spare parts and service.

The named competitors were two Italian companies: Galdabini Spa and Officine Meccaniche Spa.

The purpose of showing these 3 businesses is really to give you a feel for what Gesco AG is: principally an owner of numerous niche industrial businesses that are involved in the German manufacturing base and businesses that tend to be generally have decent returns on capital and not face rampant competition. In many cases, the businesses are in oligopoly situations.

Investment Case

Historically, Gesco AG has been a decent, but not great compounder. Its ROCE has been about 12% (lower in 2016/2017), based on a 6% EBIT margin. There aren’t a ton of comparable businesses like Gesco AG, but there are some in Europe, which try to do the same thing of aggregating niche industrial businesses. The best 5 examples in my opinion would be Addtech and Indutrade in Sweden, and Diploma plc, Halma plc, and Spectris plc in the UK. I urge you to do your own research on those companies, but the gist of the thesis is that for an well run industrial aggregator with decent niche businesses as Gesco AG owns, the return on capital should be > 15% rather than the 12% Gesco achieved historically or the < 10% ROC they have now. Similarly the margins should be a bit higher than their current 6% EBIT level and 4% net profit level profitability.

Just a very basic comparison:

A business like Gesco AG, which is a mix of a distribution and manufacturing businesses of niche components that are for the most part customized, simply should have both higher margins and lower capital intensity than shown by Gesco AG in the last few years. Margins used to be higher and capital intensity lower, and we suspected for years that the management team had gotten complacent. We believe there are simple wins in NWC as well as inventory management on the capital intensity front.

What has changed?

We have known the Gesco A.G. business for the last 5 years along with its management team. Very simply put, we didn’t want to invest in them not because we didn’t think the business wouldn't continue to be successful as they had in the past, but because we thought the management team could not make it a great business, which is what we are after. On the sales side, we felt the concept of value based pricing was absent in areas where it should not be absent. On the PPE and NWC front, we felt the organization generally got very lazy.

When comparing the management teams at the other “peers” mentioned above, for example at Addtech of Diploma, we saw a world of difference. We felt like we could easily understand the difference in financial performance although the underlying businesses were closer in quality than the financial performance would suggest.

Last summer Dr. Eric Bernhard was appointed as a the new CEO of Gesco AG. With this management change, we feel like there really is an opportunity to realize the gains that we think are possible with this business. Although I would seldom have an opinion on whether a manager with a long McKinsey pedigree would be positive or negative for a business, from our meetings with him, we feel like he does understand the easy wins that could be had on the capital intensity front and the concept of returns on capital.

In this aggregator business model, if we can increase the amount of free cashflow from the business and/or free up cash from inefficient capital management, we could directly increase the growth through hopefully prudent bolt-on acquisitions.

Whereas the historical Gesco business with single digit returns would not be interesting to us, if it could materialize the gains we think can be had and provide returns on capital above >15% like the companies I think it is similar to then certainly this is an attractive investment at this time.

It is trading at roughly 15x this year’s earnings, which I think is unassuming if you believe it can achieve the margin and capital intensity improvements I think are possible. 

Catalyst

Management change.