Description

Energy conservation is a “hot” topic fervently debated by pundits around the world. There are plenty of strong arguments presented by all of the affected parties, including the energy consumers, the energy suppliers and the general public.  However, despite the lively discussions, there is one issue no one is contesting: the global movement towards achieving a cleaner, sustainable and a more balanced environment is irreversible.

A decade or two ago, most people would dismiss such a statement as a fanciful dream of a few “tree-hugging” environmentalists. The times have changed and so have the rules. It is hard to imagine an industry or a sector not impacted by stricter environmental regulations. A large number of countries have already adopted substantial legislative norms which impose gradually-rising reductions in CO₂ emissions. Throughout the US and Europe, the goals are set to decrease the level of “greenhouse” gas emissions by 20-40% until 2020, as compared to 1990, and by 80-90% by 2050.

The media attention has been largely focused on the energy suppliers. Pictures of coal-burning utilities’ smoking stacks have adorned many a pieces of pro-environmental propaganda. Clearly a lot of efforts are being made towards cleaning up such polluters’ acts.  However, equally important is to pay attention to the other side of the equation – energy consumption. Adopting policies that incentivize, or even force consumers, to alter their habits towards greater energy efficiencies has firmly taken place around the world. Here are some interesting, and perhaps little known facts.

• Approximately 33% of all energy consumption in the EU is used for transport. General industry consumes about 26% of the energy, while buildings use a “whopping” 41%.
• That is correct – residential and commercial buildings are the largest CO₂ emitters from the perspective of energy consumption. Most of such buildings’ energy consumption, about 2/3 of the total, is used for heating, cooling and ventilation.
• On average 50% to 75% of the required heat for a building is due to thermal losses via the building envelope.

As a consequence, the largest energy saving potential can be realized by insulating buildings and its envelope from the outside. Therefore, there are substantial efforts being made to increase energy efficiency and sustainability, which has led to the proliferation of “green”, “environmentally-responsible”, thermally-insulated buildings.

This investment recommendation Sto AG (“STO” or the Company) capitalizes on this strong secular trend. STO is a leading manufacturer of wall-insulation systems and products that provide for a significant reduction in a building’s energy consumption. The Company is well-known in the construction industry for its high-quality and innovative product offering. In fact, it was the first buildings products company that manufactured and sold external wall insulation systems. STO is a family-owned and managed business with a very solid long-term track record. Despite operating in a fairly cyclical industry it has demonstrated enviable stability in its financial results – its revenues barely budged during the last two recessions. The Company compounded revenues and earnings during the period 2000-2012 at a rate of 8% and 19% respectively.

We were attracted to the STO story not only because of its solid track record and the industry’s strong secular tailwinds but also because of its rock bottom valuation. The Company boasts a fortress balance sheet with net cash amounting to c. 21% of its market capitalization, while the gross book value of its land and real estate accounts for an incremental c. 30%. To us that provides a rock-solid margin of safety. Furthermore, STO trades at EV/EBITDA multiples in the 4x range and P/Es in the 10-12x range, which represents a 50%+ discount to its comparable companies. While the lack of liquidity in the shares, the stock’s minimal analyst coverage and the existence of a majority control by the founding family could partly explain the disparity, it is our firm belief that the shares are significantly undervalued and therefore we recommend investment.

What We Like About STO

• Strong Secular Tailwinds for Insulations Materials Industry: In the prior section we already made the point on the longevity of the trend towards higher energy efficiency and conservation, which should benefit companies like STO. Here are some additional metrics on the industry:
  • According to Rockwool, one of the leading industry players, The European insulation market is estimated to be €6.5bn, while in the USit is €4.2bn. The Chinese market is currently smaller but growing at solid rates given the low penetration –> consumption of wall insulation materials in Chinais nearly 1/6^th of that inGermany.
  • The industry will continue its growth due to several factors: 1) urbanization – currently 50% of the world’s population lives in cities with that figure expected to reach 70% by 2030, 2) Buildings’ generated CO₂ emissions are estimated to increase by 50% by 2030, driven by greater demand for heating / cooling, 3) A number of countries are behind their scheduled emissions’ reductions’ targets and hence the pressures on construction developers will intensify.
  • German legislative organs are currently discussing new energy legislation (EnEV2013) which may provide certain incentives to developers of energy efficient new constructions and likely for those engaged in the renovation of existing buildings. Furthermore, higher energy efficient targets are likely to be adopted.
  • According to Rockwool, such tightened new building codes will increase the need for insulation material inGermanyby 100-300%, STO’s major market, due to increased thickness requirements of insulation material used in roof and exterior walls.
  • Stability of Operations and Financial Performance: STO has demonstrated the consistency and stability of its operations during the last several recessions. Its revenues declined merely c.2% in the crises’ trough, 2001 and 2009, respectively, despite operating in the notoriously cyclical building materials industry.
    • STO derives c.50% of its revenues from the German market, which has been significantly more stable than other residential and commercial constructions markets around the world.
    • Furthermore, the Company has a substantial exposure (c.55%) to the renovation and repair market, which has demonstrated historically a much lower volatility than the new construction market.
    • Lastly, STO has been increasingly diversifying its geographical exposure which further contributes to the stability of its operations. This was particularly evident last year. In 2012, despite a temporary slowdown inGermany, the Company’s international operations, particularly Asia andAmericas, performed strongly, contributing to the overall growth.
  • Leading Provider of Thermal Insulation Component Systems: STO is the leading thermal insulation component system producer inGermany andWestern Europerenown for its innovation and expertise.
    • In fact it was the pioneer in the field being the first company to manufacture and sell external wall insulations systems in the 1960s.
    • With its strong focus on R&D and innovation as well as its expertise in façade technology, STO has emerged as one of the top solution providers for thermal-efficient buildings’ envelopes inEurope.
    • The company has set standards in the energy consumption of buildings by using special facade solutions. The general certification of new buildings regarding energy efficiency inGermany(“Energiepass”) was influenced by STO’s ideas and blueprints at the beginning of the last decade.
    • The Company is a trendsetter and closely linked to architects, planners and facility managers inGermany.
  • Growth Opportunities Through New Distribution Channels: The Company has built a captive direct distribution network targeting architects, construction engineers and facility managers. The existence of such strong direct relationships with the consumers that have been built over a long period of time provides a powerful edge over the competition:
    • However, the Company is also selectively looking into expanding its distribution through developing the retail and wholesale channels for certain of its products thus broadening its end market.
  • International Expansion:STO has more than doubled its international operations over the last eight years with significant expansion in Northern and Eastern Europe as well asAmericas andAsia.
    • Over the last eight years the international operations grew at a CAGR of 11%, while the domestics operations grew at 7%.
    • Over the last year the international operations provided a solid offsetting effect to the temporary decline of the German Operations in 2012 – while Western Europe was flat year-over-year, Asia/Americas and Northern/Eastern Europe grew at 31% and 5% respectively.  
    • STO has significant potential in Emerging Markets given its ability to provide for both cold and hot weather insulation.
  • Owner-Operator Model:The Company was started by the Stotmeister family in 1936 via an acquisition of an existing lime and cement business. Since then the family has controlled and managed the business.
    • The Stotmeister family controls c.56% of the equity via sole ownership of the Company’s preference shares.
    • The top two STO executives are members of the Stotmeister family, which has led the Company for three generations.
    • The Company has been increasingly making special dividend distributions paying out a larger amount of net earnings to shareholders.
  • Cheap Valuation and Rock Solid Balance Sheet: STO is trading at 50% discount to its peers, as well as its history, despite better historical track record and having c.65% of its market cap consisting of cash and unlevered real estate. We believe that this discount is unjustifiably low given the prospects for the Company and the industry.

Risk Factors

• Dependence on European Economies:  A large portion of STO's business is dependent on the European construction markets. Approximately 50% of the Company's sales are generated in Germany while an additional 35+% are derived in other parts of Europe. WhileGermany's construction markets have demonstrated resilience over the last decade, STO's operations in Spain and Southern Europe have detracted in recent years. In 2012, the Spanish and Eastern European operations declined, whileNorthern Europe offset that by growing mid-single digits. The Company is actively pursuing international diversification to mitigate such risks.
• The Building Materials Industry is Cyclical:  The Company's products target the residential and commercial construction industries and as such are exposed to the cyclicality of their end markets. An example of that was the '95-'05 slump in the German construction industry, which followed the real estate boom post-reunification. This period was characterized by intense competition and deteriorating prices as a result of high levels of surplus capacities.
  • STO withstood this crisis better than most other players as it has a relatively large exposure to the renovation and repair market, which is characterized by lower cyclicality than the new-built market. This aspect of STO's business combined with the strong secular industry tailwinds should help mitigate future cyclicality.
  • Competition:  STO is a leader in integrated facade systems inGermany and parts ofWestern Europe, however there are a few large competitors who produce the insulation components that go into these integration systems. These larger companies are looking to expand their presence in value-added products / complete solutions. These companies include Knauf, Rockwool, Kingspan, St. Gobain, BASF and Uralita that are the leaders in the production of stone wool, glass wool and specialty insulation plastics, three of the key components for insulation systems.
  • Raw Materials Price Pressures:  STO uses raw materials such as marble and quartz sands, cement, silicates, silicones and aqueous dispersion agents in the manufacturing of its facade and coating products. Furthermore, the production of the Company's paints uses oil by-products as well as titanium dioxide, both of which have seen significant price fluctuations.
    • STO mitigates such raw materials pressures by entering into long-term supply agreements, diversifying its procurement partners and focusing its R&D efforts to optimize the use of raw materials.
  • Dependence on Weather Conditions / Seasonality:A large part of STO's products are used for exterior insulations. As such, installation and application of these products is dependent on the weather. The Company took some steps a number of years ago to reduce this dependency, but these measures had limited success. Consequently, a long and hard winter or constant rain, as was the case in 2012, can still negatively impact turnover, the effects of which may be only partly recouped in the following period due to limited processing capacity. Such weather-induced declines in business volumes could lead to potential large losses in earnings.
    • As a result of this weather dependency the business is seasonal with lower activity in the first few months of the year, resulting in heavier use of working capital during that period, while the summer months generate the majority of the excess free cash flow.
  • Dependence on Regulations: The Company depends on regulations that govern the environmental impact of building construction and in particular wall insulations. Any changes to such regulations, including reductions or elimination of subsidies encouraging energy efficiency, could have an impact on the business. During 2012, it was expected that new regulations will be adopted in the following two years which impacted demand as customers postponed purchases in anticipation of the new rules.
  • Product Liability:STO's products are subject to product liability and recall risks. So far the Company has not witnessed any major such incidents driven by product defects. However, there have been active discussions in the press about the recyclability of insulation materials, their fire resistance and monotonous look. STO produces a diverse set of products that addresses each of these issues.
    • Potential  liabilities could arise not only from the sale of products themselves, but also from the consulting services that STO provides to construction engineers and architects alike, with respect to project bid tenders or buildings' design and development.

Valuation and Investment Recommendations

The construction materials sector suffered deeply during the last global financial crisis and the subsequent real estate bust. During that period, the US markets were the "canary in the coal mine". On the way down, they led the rest of the world into the abyss and on the way up they were the first ones to show signs of resurrection and recovery. Indeed, the USconstruction industry has enjoyed a solid run upwards both in operational and stock market performance. Subsequently, investor sentiment has improved, consensus earnings estimates have been on the rise and valuations have normalized.

STO did not experience the declines that other building products companies did for reasons we have outlined above. As its earnings did not go into a trough, it also did not see the same massive consensus estimates upgrades thatUScompanies did. Its earnings’ profile was characterized by greater stability. Furthermore, as explained in the risk factors above, temporary events such as inclement weather and regulatory uncertainty, led to a relatively flattish 2012 in terms of revenues relative to the 10-year track record. As a result, STO's listed shares are trading at a steep discount to its history and peers. While the lack of analyst coverage and the low liquidity could partly account for that, we believe that this discount is unjustifiably large.

We have derived the Company's valuation using the following three metrics: EV / Sales, EV / EBITDA and P / E ratios.  To establish our valuation framework we have looked at both historical metrics and comparisons to peers. The following two charts compare STO's average trailing twelve months P/E to an aggregate composite of its peers. We have included in this index of comparable companies Rockwool, Saint Gobain, and Kingspan. We used these three companies as they have significant exposure to the wall insulation markets. We did not include data from a few other competitors such as Uralita, Owens Corning or Steico as their historical information was not fully available or was not meaningful.

Similarly we have compared the earning trajectory of the Company over the last decade vs. that of its peers. We have looked at STO’s rolling twelve months’ earnings growth since 2003 (up nearly 10-fold) vs. that of the composite of peers (up less than 2-fold). While STO's earnings have been more stable and have experienced much higher growth, the multiple has not reflected the quality of its operations..

In addition to an earnings-based valuation we have done a sum of the parts (SOTP) analysis. We have valued separately each of STO’s four business segments based on the sales multiple of the comparable companies. We have also added excess cash and the gross value of the real estate to come up with a SOTP of €224.

Our earnings based approach produced a lower target of c. €196 per share as it applies a blended multiple. We believe that our estimates are conservative as our projected sales growth, in the base case, is only a third of STO’s historical growth and our margin assumptions rise very modestly to reflect the on-going expansion in theAmericas, Asia andNorthern Europe. We believe that 2012 and 2013 were “transitional” years for STO as they were marked by some temporary factors that impacted results. The consolidating stock price reflects that. It is our firm view that the long-term prospects for STO are bright.

Here is a summary of our three cases - bull, base and bear as well as a "recession" case.

Bull Case: Our bull case is predicated on the top line growing at 5.5% which is lower that the Company’s ’00-’12 CAGR and in line with the ’07-’12 CAGR, a period that included a global recession. In this case we assume that margins expand by about 100bp per year and reach prior peak margins in 2014. Lastly we assume that the EV/2015 EBITDA is 7x and P/2015E is 12x, a modest discount to its peers. The resulting price is Euro 258.

 Base Case: Our base case is predicated on the top line growing at 3.1% which is lower that the Company’s historical growth. In this case we assume that margins expand by about 50bp per year and reach prior peak margins in 2015. Lastly we assume that the EV/2015 EBITDA is 6x and P/2015E is 11x, a large discount to its peers. Our target price is Euro 195

 Bear Case: Our bear case is predicated on flat top line which is lower that the Company’s historical growth. In this case we assume that margins do not expand. Lastly we assume that the EV/2015 EBITDA is 5x and P/2015E is 10x, a large discount to its peers. Our resulting price is the current price of c.E140

Our weighted average target price is: E196

 Conclusions and Investment Recommendations

Catalyst