Oerlikon’s story includes a new set of Russian shareholders, a hostile management buy-in, and an incredible amount of plastic surgery on its financial statements. While the intrigue may be fun for the time being, we think that this story ends in tragedy as we see at least 40% downside in the stock based on valuation alone, and much more if our concerns regarding revenue recognition are correct. Lucky for you, this company has a 6.6bn market capitalization and plenty of borrow is available.

Note: all numbers in Swiss Francs

 

 

Oerlikon’s 2005 financial statements, which purport to show a substantial YOY turnaround, actually provide evidence that there may be serious problems with the company’s revenue recognition policies. For instance, gross profit from percentage of completion projects swung from (77)mm in 2004 to positive 36mm in 2005, which looks great. However, this appears to be driven mostly through a change in percentage of completion costs included in the WIP account, which declined from 94mm in 2004 to 22mm in 2005. The accounting principals section of the 2005 annual report gives evidence of the changes in accounting policies when it says,

 

“In the financial year 2005, down payments received from customers have been offset with POC accruals. The effect of this offset as at December 31, 2005, amounted to CHF 53 million (see Note 17). The prior-year presentation was not adjusted because doing so at the individual project level is not practical for the consolidated accounts. Thus, the gross amounts are reflected for the prior-year.”

 

There are also three balance sheet accounts that give evidence of substantial beneficial changes from percentage of completion revenue recognition. First, between 2004 and 2005, the company reported a decline in inventories related to accrued sales under the percentage of completion method of 110mm and a decline in the WIP account of 25mm (net of a 71mm write-off due to the displays division). Second, the company reported an increase in receivables during this period of 60mm. Third, gross customer advances related to Percentage of Completion contracts declined from 228mm in 2004 to 137mm in 2005, of which 53mm was offset by accrued sales (see above), which results in lower costs recognized in the income statement. Such a decline is consistent with a company recognizing the cash received from customers as earned revenue rather than as a prepayment on future revenue.

 

While the H1 2006 accounts give less detail than the annual report, there are still a number of signs that suggest that the revenue recognition may be very aggressive. For instance, receivables adjusted for repayment entitlements for securities called increased by 15% while sales only grew by 12%. Likewise, customer advances declined by 10mm YOY. Unfortunately, there are no released numbers for revenues from percentage of completion accounting or for profits from percentage of completion accounting for H1.

 

 

Even if you believe the revenue recognition at Oerlikon, the quality of earnings at the company is horrible. For instance, in H1 2006, we estimate that the underlying EBIT on a constant accounting basis was 48mm versus reported EBIT of 126mm. The difference between these two measures of (78)mm comes from several one-time gains as well as two changes in accounting policies, all of which we believe the company took to reach their 15% EBIT margin targets set forth after their Q1 release in April. One-time gains included provision releases of 28mm, securities gains of 23mm, and real estate sale gains of 5mm. The company has capitalized 13mm of development costs, pursuant to recent changes in accounting policies with the introduction of IFRS. Oerlikon also had 4mm in lower depreciation from extending the useful life of its coating machines from 7 to 10 years.  The company also appears to have made a voluntary change to its accounting for interest expense related to its pension, such that it now appears below the EBIT line in 2006, which appears to boost year over year EBIT by about 6mm. Lastly, the company appears to have used twice as many provisions as it has taken during H1 2006 (12mm taken vs 25mm used).

 

Similarly, in 2005 the company recorded a number of non-recurring items in its EBIT. For instance, the company increased its depreciation period for Coating Systems machines from 7 to 10 years, which benefited 2005 earnings by 2mm. Provision reversals contributed an additional 59mm to EBIT in 2005. It also appears that income benefited from a net decline in doubtful account reserves of 4mm despite the aforementioned increase in accounts receivable.

 

 

In July, Vicotry sold just over 10% of Oerlikon in an off-market transaction to Renova, a Russian Holding Company at 290CHF, well below the market price at the time.

 

 

In 2006, Oerlikon was investigated for two separate instances of violating exchange rules. While the company said that they have been cleared, it appears that the company has actually been cleared of only one of the two investigations. Likewise from reading the insider filings, it is clear that insiders are trading the stock and options heavily in order to support the price when it is weak and liquidate in periods of strength. I have also spoken with several local brokers who said that much of the trading is actually just the insiders swapping stock back and forth at ever higher prices in order to try to drive the price up.

 

 

While Oerlikon would like investors to believe that it has affected an enormous turnaround based in its business, an examination of the cash flow statement would suggest otherwise. For instance, in FY 2005, the company reported (151)mm in FCF in comparison to FY 2004 in which it reported (36)mm in FCF. Likewise, in H1 2006, the company reported 10mm of FCF. To give credit where credit is due, this was a substantial improvement from both H1 2005 and H1 2004, when the company reported FCF of (155)mm and (55)mm.

 

 

The company’s business strategy seems to lack both sense and consistency. From a strategic perspective, the company has recently announced that it will acquire Saurer. This makes no strategic sense, because Saurer has completely different businesses from Oerlikon – Saurer makes textile equipment and auto transmissions whereas Oerlikon makes vacuum pumps, coating systems, solar, and semiconductor equipment. The only way that this acquisition makes sense is that it is accretive to both EPS and to Oerlikon’s overall trading multiple. 

 

On the consistency front, I was particularly concerned with the company’s announcement at the beginning of this year that it would sell its semiconductor equipment business, at which time it announced an internal valuation for the business of 600mm. Since then, the company has said that the division will fetch around 500mm. Despite announcing its intentions nearly 10 months ago, the division remains unsold while its order book has deteriorated both QOQ and YOY, and there has been no recent news on it.

 

 

Oerlikon’s valuation suggests substantial downside on both a reported and an underlying basis. Looking at estimated 2006 PF EBITDA of 648mm including Saurer and estimated synergies of 20mm, the company trades at 12.1x EV/EBITDA vs its European peer average of 8.6x, implying downside of 35% to its average peer. (1)

 

When we adjust our EBITDA by the 78mm of one-time gains and income from accounting changes that are detailed above, we see 45% downside to the shares if they are to trade in-line with peers. (2)

 

Likewise, by valuing Saurer at its acquisition price, the expected annual synergies of 20mm (we are cautious here because we see no strategic overlap) at 8.5x EBITDA, and the core Oerlikon operations at 8.5x EBITDA, we see 52% downside to the valuation. (3)

 

From a FCF perspective, we think that breakeven is likely this year and we find little additional support from our pro forma EPS (excluding the one-time benefits detailed earlier) of 20.4 (P/E of 23x) because we believe that an artificially low tax rate is flattering the P/E. On a fully taxed basis, our EPS estimate would be 14.6, resulting in a P/E of 32x.

 

 

 

 

While there is nothing illegal or immoral about changing the name and reporting structure of a company, we tend to view these actions with skepticism given all of the other problems we see at Oerlikon. This year alone, the company has massively restructured its segment reporting to provide less visibility into each business unit and changed its name (previously Unaxis). From a practical perspective, these changes make it more difficult both to compare current performance with past years and to look at the history of the company.

 

 

Oerlikon also has a history of aggressive communication, both through its press releases and in its financial statements. On the press side, examples include the recent Q2 earnings release, which was entitled “The success story is only just beginning” and has the subtitle “Unaxis significantly beats expectations in first half of 2006.” Likewise, when Renova purchased a stake in the company below the market price, Oerlikon issued a press release with the title “Expansion of the strategic focus to Eastern Europe.”  

 

The company is similarly aggressive in the way it portrays its performance in its financial statements. For example, despite the obvious reasons behind the decline in inventories, the company misleadingly states “The decline in inventories from CHF 477 million in the previous year to the year-end 2005 level of CHF 237 million is attributable to improved inventory management and cost controls.” Yet as outlined earlier, we know that 181mm of the 240mm decline in inventories between 2004 and 2005 was due to changes in percentage of completion accounting and write-offs in the WIP account.

 

The above cited examples are only a few of the many examples of the aggressive communications strategy employed at Oerlikon. Over time, I have found that self-promotional companies are often trying to hide something or otherwise put an unrealistic slant on reality. While these actions provide no conclusive evidence, I view them as yet another warning sign.

 

 

The latest third quarter release only served to raise additional concerns, mainly on their ability to hit full year targets.  Q3 revenues of 432mm grew 5.6% YOY (10% YTD), well below full year revenue guidance of 15% growth.  Excluding ESEC (the semiconductor equipment business), which the company has stated it intends to sell, revenues grew at an anemic 2.5% YOY.  Against consensus estimates, Q3 revenues missed by 10%.  In the press release, Oerlikon made no mention of its 15% top-line growth targets, effectively pulling full year guidance. 

 

Furthermore, net income of 56mm (4.97/share) missed consensus estimates by 18%. 

 

The only thing Oerlikon was able to hit was its 15% EBIT margin target with 69mm in operating profit.  However, with no financials, it is impossible to assess true underlying EBIT since Oerlikon has said it will continue to recognize one-time gains in its EBIT figures.  In addition, Oerlikon lowered its 2006 EBIT margin target from 15% to “two-digit operating profit margin.”  Conveniently they’re able to cite the consolidation of Saurer, which will make a full comparison more difficult.

 

Lastly, the company provides a “operative cash flow” figure which improved from (72)mm last year to 150mm this year.  They make no effort to define “operative cash flow” and did not provide similar figures last year or last quarter. We still do not know what this figure represents and suspect it is meaningless.