Description

Volkswagon (VOW) is the best performing major automotive company in the world, with 5 year trailing revenue growth of 8% and EBIT growth of 15%.  VOW is also a cheap stock.  Porsche (PAH) controls VOW, and is close to being a pure play on VOW stock.  PAH is valued at 65% of the value of its stake in VOW, and currently trades at its largest discount to VOWs value.  Unlike many European holding company trades, PAH as a holding company has a plan to merge into VOW.  But a series of complicated legal liabilities need to managed down first, most likely.  PAH is a 65 cent dollar bill that owns another 65 cent dollar bill, and both PAH and VOW are growing in value.  The resolution of the liabilities is a catalyst for both PAH and VOW, as is the potential closing of a merger that is logical and has already been agreed to.  This note will discuss VOWs valuation; PAHs valuation; the series of transactions that have been agreed to between the companies; and the legal liabilities that stand in the way of value being realized.  The situation is complex in many ways, and we encourage independent research, verification of our work, and questions or comments.  We see upside of over 100%, as the value discounts close.  To lose money on the investment, you need to assume that the legal claims are paid out in full value (an assumption we find extremely implausible), and also that PAH trades at a permanent 20% discount to its NAV, despite the merger plan, and also that VOW does not go up.  If you assume a merger happens eventually, to lose money, you need to assume the claims are paid out in full, and VOW falls meaningfully in value.  The catalysts can take a while to play out, so mark to market risk is meaningful. 

VOW is a complex company, with a series of equity holdings and its bank comprising essentially all of its value.  Its ordinaries capitalize the company at E60B.  Its operating businesses are Volkswagon and Audi, and other brands whose revenue contribution is small.  These businesses generated E10B of consolidated EBIT in 2011, and are projected by sellside consensus to do E11B in 2012.  4x LTM EBIT implies E40B of value.  These businesses generated 7B in free cash in 2011.  VOW owns 63% of Scania and 71% of MAN, the trucking companies.  VOW intends to consolidate or merge these businesses, on terms to be determined, at some point in the future.  This will be a drain on cash, but will generate meaningful synergy.  The deal math is a guess, and one of the overhangs on the stock.  We value these businesses at 5x EBIT, less the minority interests, which is 12B net.  The market values of their stakes also equal 12B.  VOW owns a financial services business that does a 20% RoE and has book value of E11.5B.  Many analysts value the bank at 11.5B, which seems conservative.  VOW has the leading automotive company in China, which it owns half of in JV with Faurencia.  10x 2012 net income in China is worth E25B.  VOW owns E2.5B of Suzuki stock.  It has E22B in net cash, and pension provisions of E18B.  Finally, VOW owns 50% of PAH auto, and has the right to buy the other half for E4B.  VOW values its call option as having a value of E8B, implying a value for all of PAH auto of 24B (VOW's 50% is valued at 4B plus 8B); we value PAH auto at 3x EBITDA and 10x FCF at 10B, which seems conservative given its market position and growth rate.  At our valuation, VOW's 50% interest is worth 5B and its call option is worth 1B, or 6B total.  The values sum to 101B (40+12+11.5+25+2.5+22-18+6).  This sum of the parts value is unlikely to be attained given the complexity, and the overcapitalization of the balance sheet.  Those concerns are meaningfully overdiscounted at E60B.  At a 20% discount to the sum of the parts, VOW would trade at a value of 80B.  Instead, VOW trades at 60 cents on the dollar at 60B.  Most sellside analysts value the bank at book, China at 4x earnings, ignore Suzuki, discount the truck values, and say VOW has 25-30B of nonoperating assets, and an EV of 30-35B, and trades at 2.5-3.0x EBIT.  We find their valuation far too conservative--we think we are paying nothing for the operating businesses that VOW controls entirely--but are comfortable investing in VOW even at their multiples.  

PAH owns 50% of PAH auto's operating business, and 50% of the ordinary shares of VOW.  There are 0.49 VOW shares inside every share of PAH.  PAH has the right to put its stake in PAH auto to VOW starting in 2013 for 3.9B euros.  VOW has a call right starting around the same time for the same amount.  The call is in the money.  There is essentially no chance VOW will not exercise the call option, and if it does not, PAH can exercise the put.  Tax liability attaches to the party that exercises the option in 2013, but goes away in 2014.  We expect the option to be exercised in 2014, although many press reports say the parties are negotiating to amend the option agreement to allow its earlier exercise.  VOW has stated it will generate E500mm in synergies when it controls all of PAH auto.  PAH generates material cashflow, and we expect any earlier exercise of the option will lead to better terms for the option exercise for PAH.  In addition, PAH and VOW have a comprehensive agreement between the companies, which included an agreement to merge.  The merger terms were complex, and the comprehensive agreement between PAH and VOW has never been filed publicly.  The companies have both said repeatedly that the merger terms allow for a proportional merger of the companies, and have led analysts to assume the merger terms were at least equal to 0.49 VOW = 1.00 PAH.  The merger agreement had a termination date of 12/31/11.  In September 2011, VOW and PAH announced that the merger could not be completed, because of uncertainty tied to the size of the liabilites that PAH carries from legal issues surrounding the terrible, awful short squeeze of VOW stock in October 2008.  More on the liabilities below.  It is logical to merge the entities, as PAH controls VOW, and PAH only owns VOW and pro forma for the option exercise a small amount of net cash.  The parties say only that the merger has lapsed, and they don't expect the PAH discount to be wide once the legal liabilities are resolved, and the option is exercised.  This is the case because PAH will be a single stock holding company, with a simple balance sheet, in control of the entity whose stock it owns, and with a plan to merge that has lapsed.  In March 2011, PAH traded at a value equal to 0.55 VOW shares, or no discount to NAV, as the market assumed the merger would be completed.  Since September, the discount in PAH stock has grown from 90% of NAV to 65% of NAV.  Our PAH NAV is: 150mm VOW shares worth E19.5B; call option proceeds of E3.9B; year end 2011 net debt of E1.9B; sum is 21.5B.  NAV per share is E70.25.  PAH trades at 45.25.  If PAH traded at NAV, it would be 55% higher.

The legal liabilites surround PAHs attempt to purchase the much larger VOW in 2008.  The most meaningful claims come from hedge funds who were short VOW and were forced to cover when PAH disclosed it owned 54% of VOW stock through derivative contracts in October 2008.  The squeeze made VOW the most valuable company in the world for a brief moment, and came at the worst possible time for the hedge funds, given the market stress in late 2008.  The lawsuits generally accuse Porsche of manipulating the market with false statements.  There is little question that PAH was attempting to prevent investors from bidding VOW stock up as they tried to buy VOW stock.  PAH management was far from transparent and honest in their dealings with investors.  Smart and honest investors were deceived and lost a lot of money on their shorts.  As short sellers, we empathize with their meaningful pain.  That said, their legal claims have many flaws.  First, we do not think the US is the appropriate forum for their suits.  This is true both as a matter of federal securities law and as a matter of civil procedure.  The US courts that have ruled on the claims so far have thrown them out; appeals are ongoing; decisions are expected on the appeal in federal court in the coming months; there is a state court case in NY with a motion to dismiss and summary judgment ruling looming in coming weeks or months.  The forum matters a lot, because the German legal system is much less friendly to plaintiffs.  In the history of the German legal system, there have been few very large scale final damage awards for any plaintiffs, and none for securities plaintiffs. More than that, both in the US and in Germany, whether the law should act this way or not, the law does not operate to protect a defrauded short seller the same way it acts to protect defrauded investors.  There are many policy reasons for this, not that we agree with them.  But there has never been a large scale damages award to a short seller class in the history of the US legal system, not to mention Germany.  More than that, based on our extensive review of the record, we think the claim for fraud is weak; we wish we could sue management teams every time they told us less than the whole truth, or misled us; most successful fraud allegations involve explicit lies like fraudulent accounting; we have found few if any instances of explicit falsehoods allegedly said by PAH management in the record; fraud claims are especially hard for sophisticated investors to make, which the hedge fund plaintiffs are; the conduct alleged in the case involves obfuscating the truth by not answering questions completely; it does not involve a pattern of repeated lies.  It's not fraud when you answer questions stating facts accurately, but dodge the questions.  Also, German law places meaningfully more weight on the corporate veil than US law does, including in instances of alleged fraud; management liability may well not extent to the corporate entity; German investigators prosecuting the claims have focused on some individuals, but not the entity, so far.  Finally, the politics of the lawsuit in Germany are poor: American hedge funds are suing the largest employer in the country, and one in which the lower state of Saxony owns a meaningful stake, at a time of great economic stress in Europe, in part brought on by short sellers of financial instruments in Europe, on a claim based on short selling.  In our opinion, if the claims were litigated 1000 times, the plaintiffs would win a final judgment very few times.  Of course, the claims stand in the way of transactions that can generate material value for shareholders, and thus have some settlement value.  Settlement is hard, because the number of plaintiffs is large, and emotions still run high, while the legal merit of the claims is weak.  But we expect settlements eventually, especially if the claims do make it through the motion to dismiss and summary judgment stages in the coming months.  A total of E10B in claim damages have been asked for, the majority of that is in Germany, and in Germany, the claim bar date has passed.  Claimants cannot win more than once, so the duplicative US and German claims must not be counted twice.  The non overlapping claim amount is between 5 and 6 billion euros.  That is the best estimate of worst case damages from the claims.  That equals roughly E17/PAH share.  The discount in PAH stock is currently 25.50, again its all time wide.  The number of litigations in which securities plaintiffs receive what they are asking for in their complaints is very small.  

The best pushback we receive to our thesis is it can take a long time for the legal claims to be worked out.  This is correct.  However, settlement is logical, and should occur at some point.  In addition, both companies are growing in value over time, and generating free cash flow.  Finally, at the current discounts to value, we feel we are being adequately compensated for the timing risk.  The other pushback we receive is why not just own VOW.  VOW is attractively priced.  PAH prices in beyond the worst case liability discount to VOW, plus a permanent holding company discount.  We think the incremental risk reward in PAH is more attractive.  We are not investing to make money in the relative trade in the short term.  

Catalyst