Description

Pfleiderer Equity (€6.67)
 
Pfleiderer presents an opportunity to purchase high-quality, defensible assets driven by exceptional management at 30 cents on the dollar.  Due to extreme cyclical pressure and management's decision to force competition into capacity rationalization, and in some cases bankruptcy, Pfleiderer intentionally breached its debt covenants and is offered at just 4.4x normalized cash earnings. We believe that the share price will begin its reversion towards fair value once the details on its debt restructuring (with no impairment) to equity are revealed (We expect before year-end).
Description
 
Business and Industry Overview:
 
Pfleiderer is the second largest Particleboard (PB) and Medium Fiber Board (MDF) producer in the world with ~7,600 m3 of total capacity.  The Company employs 5,620 employees over 21 manufacturing sites.  The structure of the industry is significantly better than the US OSB or wallboard markets characterized by fewer players, higher cost of transport (business is local / regional - 500km economically feasible radius), and increased difficulty to open new capacity (capex of €150mm to build a new panel plant, environmental and labor issues).  Currently the average German spends €360 per annum on furniture versus €250 in the US and Western Europe, €16 in Poland and €8 in Russia.  Nearly 25% of the Company's sales are generated by Pergo, the laminate flooring division of Pfleiderer.    Laminate is a global business, and Pergo serves the high-end of the laminate floor market where brand matters. 
 
Company Exposures:
 
At Q2 2009, 51% of sales were generated in Western Europe, 31% in North America and 17% in Eastern Europe (Russia and Poland - down 41% yoy and generated a E2.5mm EBIT loss in Q2).  Pfleiderer's end markets by industry include Furniture (33%), Distributor (32% - largely flooring then construction and furniture), Others (17%), DIY (9%), Flooring (5%) and Construction (4%).  Costs to manufacture particleboard include wood (40% - prices set locally within a 200km radius and scale provides significant buying power), glue (25% - oil derivative), energy (15% - major advantage over peers given biomass co-generation facilities/backward integration), other fixed costs (15%) and personnel (5%).  Variable costs account for up to 80% of manufacturing costs, so clearly scale and plant efficiency are important. 
 
Market Update:
 
Most of Pfleiderer's assets are top quartile with the remainder falling into the second quartile.  As a result of market conditions, Sonae Industria, the third largest player in particleboard/fiberboard behind M&P Kaindl and Pfleiderer, is in the process of closing two large plants in Germany.  Sonae has reported six consecutive quarters of losses and is in significant financial distress.  Additionally, two small players are each removing facilities, which with Sonae's closures, should boost Germany utilization to the high 80s from the low 80s (est. >60% of W. European sales).  Pfleiderer will also likely close one or two facilities in Germany over the next 12 months, leading prices even higher.  Prices in Germany fell by 11% in Q2 driven predominately by actions taken by Pfleiderer to force higher cost players out of the market (strategy appears to be working).  The Company continues to take significant share in Germany with marginal declines in volumes yoy against a double digit decline in industry demand.  The Company estimates that prices would be about €10 higher if not for their long-term strategic decisions (would suggest 13% GROUP EBITDA margins versus 8%).  In Q3, Pfleiderer began raising prices in Germany and the industry followed.  North American volumes and pricing are both up slightly.  Poland demand is off significantly, but of the 40% reported decline in Q2, the fall was actually 16% in constant currency.  Industry utilization dipped below 70%, but is now slowly rising.  The Company has new, highly-efficient capacity entering the market at the end of the year, which management believes will earn double-digit EBITDA margins at current Polish prices and demand levels.
 
Brief History:
 
When the very capable CEO, Hans Overdiek, began at Pfleiderer in 2001 (named COO in 2003 and CEO in late 2007), exposure to Germany accounted for nearly 85% of group profits.  Through Hans' leadership, the Company sold and shut down several non-core assets, including Infrastructure Technology, which accounted for one third of sales in 2002.  Pfleiderer than began to diversify outside of Germany but stuck to its core competencies.  The Company purchased the laminate flooring business of Kunz in 2005, a Polish glue manufacturer in 2006 (backward integration) and Pergo, a global leader in laminate flooring in 2007.  Pergo was the largest acquisition at E308mm (<1x sales and 8x trailing EBITDA and very comparable to Mohawk's Unilin division in the United States).  While the acquisition was made at an unfavorable stage in the business cycle, the combination of the Kunz division and Pergo made strategic sense.  Subsequently, the Company has taken Pergo North American market share from 15% to 30% (>70% of Pergo sales and up 24% yoy in Q2).
 
 
 
Long Merits
 
·         Visible and material upside:  3X ROI over 5 years with a 28% IRR in our base case
 
·         Superior managements:  CEO, Hans Overdiek, age 47, began his career as an auditor.  Overdiek then moved to a German metallic goods company (metal bending) where he became a Managing Director, borrowed and invested his entire net worth in the company, and sold his stake to become independently wealthy at 38 (1990).   Overdiek then moved to Robert-Zapp, a German steel company, where as head of procurement, marketing and sales, he grew sales from E300mm to E500mm by penetrating Europe organically and India through a JV.  PBT grew from break-even when he arrived to E50mm when he departed (1997).  Overdiek's next move was to Bohler-Uddeholm, a large steel company, where he ran the Lawn Products division with E300mm of turnover.  Sales grew, margins expanded and his division was acquired (2001).  Overdiek finally joined Pfleiderer's Executive Board in 2001, became COO in 2003 and CEO in late 2007.  Overdiek was responsible for implementing his structural cost-cutting strategy that he developed throughout his experience in the steel industry.  While his peers witness multi-decade lows in profitability margins as a result of plummeting demand, Pfleiderer's EBITDA margins troughed in Q2 at 8%, better than the weakest quarter in the 2002-2003 downturn (profitability for the industry troughed in 2003 and peaked in early 2001).  The Company is at the bottom of the cost-curve through this cycle as a result of shuttering non-core businesses and inefficient capacity, superior procurement efforts and building "mega-sites" in emerging markets (Poland and Russia). 
 
·         Incentivized alongside management:  Management collectively owns 6% of the company, and the CEO, Mr. Overdiek, who Pfleiderer investors refer to as a "rockstar", owns €800,000 worth of the hybrid bond and several million in common equity (not bad for Germany, includes options).
 
·         Family and PE dynamics: One Equity Partners and the Pfleiderer family own roughly 35% of common equity.  One Equity Partners is in year 2 of a 7-year investment and has recently added to its holdings at higher levels.  The family had capital gains of €300mm when it sold down some of its stake in 2003, and has indicated they would be supportive of a capital increase should it be required.  Having this level of support in the shareholder base should give investors comfort that the company will successfully refinance its debt and has supportive, long-term focused stakeholders.
·         Market Dislocation:  Due to the cyclical nature of the business, the shares fell from nearly €30 to the mid-teens at the outset of the housing/construction crisis.  Subsequently, the shares fell from the mid-teens to low-to-mid single digits driven by solvency concerns.  The market does not appreciate the primary driver behind the fall in profitability for Pfleiderer (Pfleiderer's decision to cut prices to force competitors to close capacity) and so estimates do not reflect the benefits of capacity closure against slowly rebounding demand.  Also, estimates do not reflect additional low-cost capacity in supply deficient areas, which we believe will add nearly E40mm of run-rate EBITDA on top of an earnings base of around E260mm (EBITDA).  Finally, the investment community does not appreciate the relationship of Pfleiderer with German banks and the option to finance with KFW, the German-owned bank with an explicit mandate to help companies that are struggling due to the financial downturn.  Once the major overhang regarding rights issue concerns or worse, insolvency, are resolved, and we believe the market will gradually start to revisit the Pfleiderer equity investment case, which has been all but forgotten by institutional holders, and the sell-side.  Additionally, we believe management's roadshow in early 2010 will add substance and comfort, as we view the CEO as highly credible and capable.
 
·         Margin of safety: EBITDA margins troughed in Q2 at 8%.  The Company could generate cash if growth capex is deferred (plant in Russia could be deferred until 2011; North Carolina addition will be completed in Q4 2009).  Capex could fall to as low as E40-50mm in 2010, providing ~E100 million of unlevered pre-tax cash flow.  Pfleiderer is adding capacity in regions that are either short supply or where current prices support >15-25% EBITDA margins for new capacity due to high-cost competition.  By 2012, the Company should be able to generate E2bn of sales on 15% EBITDA margins, suggesting E300mm of EBITDA and E170mm of unlevered after-tax free cash flow against a current enterprise value of E1.4bn (this includes over E400mm of equity value positioned below us).  The 9x unlevered FCF multiple implies at least a 50%+ margin of safety.  This business is characterized by regional oligopolies due to transportation and capital barriers.  As a result, the industry is much more similar to cement than to most hard commodities.  EBITDA margins for Pfleiderer over the past 10 years have averaged 12% (this includes margin dilutive businesses through 2004, which are no longer part of the Company) with a fairly narrow range of 8% (8.4% in 2003) to 14% (13.6% in 2007).  The Pergo acquisition should be long-term margin accretive, given its brand equity and market positioning (25% of sales).  We believe the Company is structurally better now than at any point in over the past 10 years, which should permit the Company to earn superior margins and a return on capital above its WACC.

 

E in mm, FYE Oct-	2007	2008	2009	2010	2011	2012
Revenues	1,801	1,736	1,399	1,497	1,871	2,002
Organic Growth	27.3%	-3.6%	-19.4%	7.0%	25.0%	7.0%
EBITDA	244	215	143	180	253	300
Margin	13.6%	12.4%	10.2%	12.0%	13.5%	15.0%
D&A	112	126	115	117	120	120
Total EBIT	132	88	28	63	133	180
Margin	7.3%	5.1%	2.0%	4.2%	7.1%	9.0%
Interest Expense	(46)	(52)	(55)	(80)	(79)	(72)
EBT	86	37	(27)	(17.4)	54	108
Taxes	(24)	(10)	8	5	(15)	(30)
Rate	28%	28%	28%	28%	28%	28%
Minority Interests	(14)	2	4	2	(7)	(14)
Total Net Income	48	29	(15)	(10)	31	64
Average Shares Out.	53	51	51	51	51	51
EPS	0.92	0.57	(0.30)	(0.20)	0.61	1.25
Cash EPS	(0.00)	0.05	(1.65)	0.75	0.90	1.53
Growth		-13272.3%	-3449%	-145.3%	20.1%	71.0%
Total ROCE (unadjusted)	3.6%	-3.6%	-7.6%	-4.7%	1.2%	5.8%
Cash Flow	2007	2008	2009	2010	2011	2012
EBIT	132	88	28	63	133	180
add: Depreciation	99	110	100	104	108	109
add: Amortization	13	16	15	13	12	11
less: Interest Paid	(46)	(52)	(55)	(80)	(79)	(72)
less: Taxes Paid	(24)	(10)	8	5	(15)	(30)
less: CapEx	(179)	(163)	(210)	(50)	(100)	(100)
Total FCF	(5)	(10)	(115)	54	59	98
Total FCFS	(0.09)	(0.20)	(2.26)	1.07	1.15	1.92
Multiples
Levered Cash Flow	nm	nm	nm	27.6x	25.6x	15.4x
Unlevered Cash Flow	nm	nm	nm	6.2x	5.8x	3.5x
P/E	nm	nm	nm	8.9x	7.4x	4.3x
EV/EBITDA	6.1x	7.0x	10.5x	8.4x	5.9x	5.0x

 
 
 
Long Risks
 
·         Credit markets and equity markets collapse over the next few weeks and the consortium of German banks that make up Pfleiderer's lending group decides to force administration and run a wood products business. 
 
·         Perfect storm: demand declines by an additional 10-20% and industry capacity closures are insufficient to recover pricing, while oil and energy prices spike (PPI inflation against CPI deflation or stagflation causing the entire industry goes bust).  
 
 

 

Catalyst

 
Catalysts
 
·         Debt refinancing details disclosed
 
·         Further capacity closures with potential of Sonae Industria going bankrupt
 
·         Evidence of price increases and trough profitability (quarterly reports)