It’s That Time of year – Window Dressing and Tax Selling

A Danish poet wrote a poem many years ago saying that the year contains sixteen months and five of those are November! A not so subtle hint that darkness and cloudy weather is becoming the norm at this time of year and that time tends to become more of a drag.

My mother and I are less pessimistic. In fact it is a month where we indulge in our disorders and celebrate them. For her Christmas comes early. And those 107 Santa Claus characters populating every shelf in the house? Well, they are just not enough. And so as soon as the stores make new ones available she acts swiftly and decisively. With skills carefully crafted and perfected over many years she picks out the most spectacular ones before anyone else can get to them – and thus fulfills her cravings.

I’m also like that at this time of year except my disorder is more related to stock purchases. I load up on stocks I have had my eyes set on and I even buy on margin (4% currently and I will most likely boost it to 10% as I have done in previous years). Doing so makes me tense but I simply refuse to let those crumbs lie on the floor without picking them up when they are thrown around so carelessly by money managers clinging on to their jobs. You might say I have a mean streak in me because I don’t believe in leaving money on the table for my fellow man but when I see mispricings before my eyes without acting on them, I become physically ill. The stomach ache from buying on margin I can handle but not that other pain. Also, stomach ache is the constant companion of the bargain hunter so I get a bit of extra practise at the same time!

So what makes some money managers become so generous all of a sudden? Why do they act like amateurs and let small investors eat their lunch?

Window dressing

Some investment funds mislead their clients by selling badly performing securities before the end of a reporting period – month, quarter or year – and use the money to buy a rising security instead or to hold cash to buy back the securities they sold when the new period begins. By listing the stocks they hold at the end of the period the fund wants to appear to have performed better than it actually has. It is a despicable practise but it is a well-known fact within the industry that it occurs and it is most prevalent during the months of November and December.

Here is another window dressing technique that I witnessed in real time as I had an interest in buying a related stock at the time: Check out Wilhelmsen Holding’s A stock movement, ticker WWI, on October 30th, the last day of the month. In the last half hour of trading that day the price jumped 10% from 154 to 170,5 on low volume ochestrated by one buyer, CSB, who had been buying heavily in the previous weeks. The related B share hardly moved and in the following days the price came down by the same amount. This maneuvre is not legal but nonetheless it can often be witnessed in several illiquid stocks, especially on Dec 31st. The purpose is to inflate performance numbers at a relatively small price. It seems silly and if you or I did that it would be akin to pissing in our pants to keep warm for a few seconds. But perhaps you would also be tempted by sub par investment decisions if you had clients or bosses to report to?

Tax selling

In an overall rising year selling losing stocks to cancel out part of the wins can lessen the tax burden. For this reason you will often see stocks that have underperformed reach their lows in November/early December.

Be on the other side of the trade

You could call both of the above light forms of ”forced selling”. Any time you can be on the other side of a trade that isn’t driven by company fundamentals you want to be in that position – supposing of course that you want to own the particular stock in the first place. Note that what I am talking about here is the general odds of the above happening – you never know with absolute certainty who you buy from or what their motives are.

The January effect and small cap losers

Part of the reason January is often particularly good to small cap stocks that performed badly the year before can be attributed to the above practises. The market tends to correct itself and smooth out ineffeciencies but strangely this one has persisted and I will continue the uncomfortable practise of buying on margin for three months of the year and then gradually become non-leveraged come February/March until evidence says the market has erradicated it.

This bet doesn’t always turn out favorably, of course. In fact as late as 2014 I was not treated with any respect whatsoever by Mr. Market when I went for a leveraged oil play that turned sour as the oil price decline worsened. I won’t know for sure whether my bet was sound but I believe it was and therefore I would do it again. Investing is at heart a mathmatical undertaking where you attempt to estimate the likelihood of different scenarios happening:

Expected value = (Intrinsic value of the company in Scenario A * likelihood percentage) + (Scenario B * likelihood) + (Scenario C * likelihood) etc…

Dance like a butterfly sting like a bee

The above is a quote by Muhammad Ali to describe his boxing style: Non-dogmatic and opportunistic. When you see an opening: Pounce. I think this flexible attitude can also be applied by the enterprising investor even though check lists and hard rules are also a fine way to guard oneself against permanent loss. But to completely shut oneself off from action when circumstances are especially favorable is also a mistake in my book – mistakes can also be ones of omission as Charlie Munger puts it.

There is only principle I will not bend ever and that is the idea of a large Margin of Safety. The gap between what I perceive the value to be and the market price needs to be large for me to consider an investment no matter the circumstances.

The Cat is Out of the Bag – Part 2 (Arise Windpower)

The electricity market in Sweden has been very soft in 2015 due to a number of factors. The biggest contributing factor has been an abnormally wet year increasing the hydropower supply. Other factors: more wind capacity added to the system, a rather slow overall economic recovery, warmer than average temperatures and more than average wind conditions (reflected in the good operating results). In other words, when it comes to electricity prices 2015 has been hit by a perfect storm in almost all respects. In a normalized setting, power prices ought to increase – especially given the fact that four nuclear reactors – 13% of the overall supply – is in the process of being taken out of the system from now until 2020.

As a result Arise Windpower decided to write down their assets by about 10%. In my opinion a bit on the cautious side to do so given that they still have nice hedges in place until mid next year and thus plenty of time to see how the price situation plays out but it is after all a technicality and the market has already discounted the depressed conditions in the price of the Arise shares, which even after the write-down trades at 50% of book value despite a flow of high margin project sales.

Important to note also that about 70% of the production from their co-owned windfarms in Jädraås (about 40% of their overall production) have hedges in the 630-640 SEK/MWh range until the end of 2017 (compared to market prices, including e-certificates, of around 400 SEK currently) thus providing a nice cushion should electricity prices continue to be depressed.

Eolus Wind had written down their assets on Oct. 16th – their write-down was 15%, but I believe their assets are also older on average and thus bought at a time when wind turbine prices were higher. Other wind farm operators have chosen not to write down their assets but they may be forced to do so in the future.

I recently wrote a longer post about the e-certificate situation, thoughts on the future for ocean-based wind farms and possible project sales in the coming years for subscribers on and I plan to write a more in-depth post on the overall situation on there soon.

Meanwhile, let’s hope El Nino brings wrath to the Scandinavian winter… May we all suffer a cold and painful winter and may the winds blaze through our lands at violent speeds!

The Cat is Out of the Bag – Part 1 (Wilhelmsen)

Wilhelm Wilhelmsen and Arise Windpower both presented investors with shocks in their Q3 reports. The underlying results were solid as expected but provisions and write-downs shaved off significant amounts of their equity from their balance sheets.

In the case of Wilhelmsen, WWASA made provisions of 200 million USD for the anti-trust case, and the holding company, WWI & WWIB, another 50 million USD in impairment. It was known the company would be fined, but based on the settlements in Japan and South Africa I had estimated the global fines to amount to approximately 100 million USD, so it is fair to say I was surprised by the amount. Even though it isn’t the final verdict, it must be in that neighborhood since the company has been silent on a specific amount until now. The cases surfaced about 4 years ago so it has been a long wait that has contributed to uncertainty among investors.

It is important to note that the fine does not threaten the survival of the company at all. Their cash position and their easily liquidated share position in Hyundai Glovis (worth about USD 800 million, WWI owns 73% of this) insures that the liquitidy position is very solid. The decision to keep paying the biannual dividend also indicates that the company views their financial position as solid. What the provision means is that 13% of their equity was shaved off, compared to the 5% that I had estimated.

No market reaction

The market reaction has been non-existent. In fact, the stock trades 5% higher compared to one month ago (it is down 5% today, but this is set off by the 5% increase yesterday ahead of the report). That begs the question if the market, unlike me, expected the size of the fine to be as large as the company made provisions for today. That could be the case. It could also be the case that the market judges the provisions to be overly pessimistic.

But there is also a third option, which is embodied in the following quote by Franklin D. Roosevelt:

”We have nothing to fear but fear itself”

He said this in a famous speech in 1933 following the crash in 1929 and the subsequent uptake in the economy which had started to play out. It was true then and it is also true as a general concept for investing. Whenever there is uncertainty about a specific outcome investors tend to overreact. And for private investors with no bosses to report to (and therefore no way to get fired!), this provides a road to overperformance in a ”low hanging fruit” sort of way – provided, of course, the survival of the ongoing business of the particular company is not in question.

Historically cheap valuation

The long term potential in the case is very much intact. In fact it seems to me almost mindblowingly cheap considering that the company’s earnings power is strong compared to the market cap (P/E 4-5, excluding today’s one-off provisions) and has been for many years in spite of tough conditions with increased competition and the fact that the high margin high & heavy market (agriculture, mining equipment) is experiencing hardships, evidenced by reports by Caterpillar and John Deere (25% downturn). One ought to ask oneself what happens to the already healthy profit margins once that segment turns around… The other major segment – transportation of cars by sea – is almost certainly bright considering the growing middle class in China and India (and Africe further down the line) as well as the future replacement of gasoline driven cars towards more electricity/hybrid driven ones.

On a price-to-book valuation WWIB is priced at 0,49 and WWASA at 0,60. There is no reason why a dividend paying healthy business is priced at these levels and I continue to believe the price is based on irrational fear. If you think otherwise, please give me a holler!

Reaction to Arise Windpower’s write-downs

On Friday I will take a look at another company, Arise Windpower, where an almost identical scenario has played out following their report on Nov. 6th. Since I am writing about this company to subscribers at (I write about Swedish and Danish companies on there) I cannot go into too much detail, but I will lay out my general outlook.

Update on Wilhelm Wilhelmsen Holding

It’s been a long while since my last post, so I thought I’d give a short update on developments in Wilhelm Wilhelmsen Holding (listed in Norway) since my last post. Please excuse me if this post is a bit more hurried and less thorough than I normally aim for (fewer concrete numbers), but it is vacation time 😉

Wilhelm Wilhelmsen Holding

Bearish developments:

  • The Big Negative: Their shares in Hyundai Glovis have come down by more than 30% since my first post on WWH on March 18th. As this is WWH’s most important asset, accounting for NOK 4,1 billion (NOK 5,8 billion on March 18). This is a significant portion of the market cap, which is currently NOK 8,1 billion. The share price in WWH has increased 16% in the same period.
  • Hyundai and Kia have recorded declining car sales. I expect this to have a negative effect on Q2 as these two companies are major customers of the coowned company EUKOR. It is, by the way, the major reason why the Glovis shares have come down.

Bullish developments:

  • The Big Positive: The dollar is has recently come back to its highs from March and the oil prices have gone down once again meaning revenue is worth more and operating cost are coming down. Clearly favorable for WWH.
  • Much as I expected Q1 was a great quarter, primarily due to a strong dollar, a low oil price and cost cutting effects from 2014 that have started to have an impact.
  • The ClarkSea index is up.


In my opinion, the combo of Glovis being worth less while the WWH stock being priced higher makes WWH less of a no-brainer than it was four months ago. I still believe it to be a sound investment long term, but I think it is odd for the market not to react more negatively to such a sudden and heavy decline by their major asset and I fear that this could take place any time so I have decided to reduce my position by two thirds and put that money in more consumer related investments where I see more tailwind both short and long term. The discount to NAV is still favorable, which is why I am keeping one third and ready to increase again if circumstances dictate doing so.

Note: The price was 149,50 when I recommended the stock and it now sits at 171, an increase of 16% (when including 3 kr in dividend received in May).

Stay tuned for my next post on a subject I think is particularly important for investors having stocks in troubled industries, which is my favorite hunting grounds. The title is going to be Becoming Comfortable with Uncertainty.

Wilhelm Wilhelmsen Holding, the Bull Case

My last post on Wilhelm Wilhelmsen Holding, WWI, focused on the Bear Case, In this post I will present some bullish arguments. It will be shorter than my first two posts as some bullish arguments have already been discussed in those:

The Bull Case

  • Bottom of High & Heavy cycle?
  • High barriers to entry
  • Strong balance sheet
  • Strong dollar, cheap oil, opex cuts
  • Cheap share price, possibly based on irrational reasoning (see Bear Case)

As with the Bear Case, let’s look at each of the above.

Bottom of High & Heavy cycle?
For the last two years there has been a recurring theme in every quarterly report: ”Unfavorable cargo mix.” What that means is that the company would like a larger percentage of their cargo to be in the High & Heavy-segment, which is more profitable than the car carrier segment.

The reason for this unfavorable mix is that mining and agriculture companies have been holding back on capex spending, ie. upgrading old equipment or buying new due to depressed prices in those sectors. The good news is this cannot continue for much longer. At some point in the not to distant future they will have to make these investments. A good indicator of when this shift occurs is to keep track of reports of manufacturers of that type of equipment: Caterpillar and John Deere.

I list this as bullish since we want to be investing in cyclical companies when they are near the bottom of their cycle instead of near the top. When High & Heavy starts to improve we can expect better margins. Since the stock is already cheap based on current earnings, I expect this to have a strong impact on the share price once it kicks in.

The car carrier segment seems poised for continued growth as former poor countries lift a larger portion of their citizens into the middle class.

High barriers to entry
Investments into the car carrier sector is capital intensive and it takes years from purchasing a vessel till it is delivered. In other words, the economic moat around the sector is quite wide. This makes increased competition less likely in the foreseeable future and profitability more likely to be durable.

Strong balance sheet
When investing in depressed markets, a strong balance sheet is essential in making sure that companies can weather potential storms for longer than their competitors. An additional benefit of having cash on hand is potential opportunities to buy competitors in trouble or their assets. Having an equity ratio of 48% for the holding company, WWI, and 51% for the daughter company, WWASA, Wilhelm Wilhelmsen is in a strong position. Also noteworthy is the interest WWASA is paying on their bonds: 2-3,5%. In other words, they have access to cheap money and are not bogged down by large interest payments.

Strong dollar, cheap oil, opex cuts
In the near term there are a number of external factors that WWI will benefit from.

The strong dollar contributes to stronger earnings as revenue is mainly in dollars and only to a lesser extent on the expense side.

Cheap oil reduces transportation costs – although some of those savings are likely to land in the pockets of customers in the form of cheaper prices. At least that has been the case in some of the shipping and transportation companies that I follow.

During 2014 Wilhelm Wilhelmsen undertook operating expenditures cuts that will start to have a positive impact in 2015.

Cheap share price based on irrational reasoning (see Bear Case)
All of the above bull arguments mean very little if the share price is overly expensive. In my post on March 19th, the Bear Case, I noted some possible reasons for the cheap price, some of which are clearly irrational.

Future posts on WWI
My three posts on WWI have focused mainly on qualitative aspects. I will probably revisit the case and post one that is more numbers driven (free cash flow) in the coming months.

Let me know if you have any questions or additional thoughts that can shed more light on the case.

Wilhelm Wilhelmsen Holding, the Bear Case

In my first post on W. Wilhelmsen Holding published yesterday,, it was established that the stock is exceptionally cheap right now, based on both Price/Book and Price/Earnings.

Why is it cheap? The Bear Case
This question ought to be the main focus when we dig into the fundamentals of a company, which on the surface appears to be especially cheap. There is always the risk that it is a value trap and that the market knows about things that we don’t. As we slowly peel the onion that is the company and get closer to the core of it, reasons will start to appear. The main question is if those reasons are rational or not.

So far I have spotted the following possible reasons:

  • Antitrust investigations
  • Uncertainty about contract renewal
  • Fear of increase in local car production?
  • Conglomerate discount
  • Shipping market discount
  • Norwegian market discount (following the current oil crash)
  • The founding family controls more than 50%
  • Dividend payout ratio is low (12%)
  • No share buyback
  • Cyclical, low liquidity, boring

Let’s look at those one by one.

Antitrust investigations
WWASA and three Japanese competitors are all being investigated for price fixing from 2008-2012. The investigation started in the fall of 2013 and has already led to fines from Japanese authorities. Two Japanese competitors have also been fined by US authorities and it is expected that WWASA will be fined as well. It is also expected that the EU, Canada, Mexico and Chile will seek to fine the major of players in the industry. This creates uncertainty in the market. But it can also be a source of opportunity and lead to mispricings if that fear is irrationally overblown. WWASA expects a clearer overall picture on this issue during 2015.

Having spoken to analysts who have followed the process more closely, the expectation is that the total fines for WWASA will be in the USD 100-120 million range, and USD 200 million being a worst case scenario, in their opinion. Translating those numbers to the balance sheet of the holding company means a reduction of between USD 70-140 million in equity. If that turns out to be the case the effect will be in the 0,02-0,03 range in terms of Price/Book, ie. it will jump from 0,49 to 0,51/0,52 – still a far cry from P/B 0,84 of 2013 and 2012. In other words, while a serious matter, this alone cannot be the reason for the heavy discount – if we suppose investors are rational.

The liquidity position of WWASA is solid enough to counter fines of this size. On top of that WWASA has a 12,5% share in the logistics company Hyundai Glovis, and that share is currently worth approximately USD 1 billion. So if things get tough, they can sell a portion of that.

Uncertainty about contract renewal
Eukor, which is 40% owned by WWASA, has a contract renegotiation with Hyundai and Kia coming up in 2016. Eukor currently transports 60% of Hyundai’s and Kia’s exports and there is uncertainty whether this will continue or whether it will drop into the 50% or 40% range. WWASA has stated that they expect volumes to remain the same. Perhaps the market views this as overly optimistic.

Fear of increase in local car production?
I have not been able to find information on whether there is a trend in this direction currently. But if it is indeed the case, or if it happened in the future, it would result in a smaller market, so it is a potential threat to keep in mind and to look out for.

Conglomerate discount
There has always been a discount compared to a sum-of-parts valuation in WWI. As I wrote in the first part of this analysis, I don’t completely agree with it, but it will probably stay that way in the foreseeable future. Should the company decide to spin off some of their holdings, this will come down and the share price will go up.

Another reason for the discount might be a very simple one. Both WWI and WWASA consist of a myriad of companies and joint ventures, which makes it harder and more time consuming to analyze. Perhaps many potential investors stay away for that reason. However, none of those two reasons address the increasing discount gap.

The general shipping industry has been hit hard
The Baltic Dry index, which measures the transport activity of commodities by sea, is at an all time low – due to a combination of overcapacity and declining demand. As a result of that many players in the shipping industry are struggling. However, WWI’s main operations are in the car carrier and high & heavy markets, which are both unrelated to Baltic Dry. The revenues for the Ship Service part of the group has declined slightly – but profits are up and EBIT-margin a healthy 10%. However, these numbers are relatively small compared to the overall numbers for the group.

You could argue that if the market is viewed to be in a slump now and the current P/E is at 3,4 what happens to the share price once profits start to really take off?

Norwegian market discount
Norway is to a very large extent synonymous with the oil and shipping industries. As both have witnessed brutal declines recently some investors in the region may have withdrawn funds from the overall stock market out of fear regardless of the industry that the individual companies are in. A lot of stocks on the Oslo stock Exchange are traded at historically cheap prices. For some the fear is warranted, for other much less so. I believe the latter to be the case for WWI.

The founding family controls more than 50%
Some investors don’t like to be at the mercy of one group controlling 50%+ of the outstanding shares. However, it is very well documented that founding families tend to be more focused on long term value creation than your average CEO. And generally speaking, you get rewarded handsomely for owning shares in family owned businesses. However, there is also another side to this story and that is that the company (Tallyman), which controls the majority of shares in WWI, is owned by about 15 family members, I am told (as a side note, many of those are on this list of Norway’s richest people, among them the group CEO, Thomas Wilhelmsen: What happens if there are disagreements with regards to the overall strategy within that group. Can it hamper decisive action?

Low dividend payout ratio
WWI is expected to pay out NOK 3 to shareholders in May and NOK 2 in November, this equates to only 12% of earnings (3,3% dividend yield). Compare that to the more normal 50% payout ratio of other companies. I think this is one reason why WWI is usually cheap compared to its earnings power. In the current low interest environment the market is hungry for dividend yield so I have no doubt the share price would explode if the company suddenly decided to payout 50% of its profits. Very unlikely to happen though. The company does not strike me as one that changes its strategies to satisfy the market.

No share buybacks
If the primary aim of a company is to increase shareholder value one expects that company to invest its profits in ways that maximizes the return. New capex investments might be expected to produce a return on investment in the 10-15% range. However, there is another low hanging fruit waiting to be grapped now that the company’s asset are for sale at only 49 cents on the dollar and that is to buy back its own stocks. If Price/Book were to increase to the more normal (but still cheap) levels of 2012 and 2013 the stock would increase by about 70% in value. That seems like a no brainer investment to make. And personally, I would much rather see this happen than increased dividends.

I don’t believe it will happen though. The company has no history of doing so and it may prefer an organic growth strategy. If that is the case, perhaps the stock market is punishing the company for preferring empire building rather than shareholder maximizing initiatives.

Cyclical, low liquidity, boring
I don’t care in what shape or form they present themselves but I like value propositions. Paying much less than the expected value of an asset is all that interests me. But many investor groups need an investment to fit into a certain box in order for them to invest and in many ways WWI doesn’t fit the bill.

Dividend investors tend to be defensive and shy away from businesses that are cyclical in nature, which WWI certainly is.

Institutional investors want a minimum of liquidity otherwise their very buying and selling will move the price too much to be worth it for them. On many days the volume in WWI is less NOK 1 million, which is surprising for a company of this size.

Gamblers want bigger day-to-day movement than WWI provides, being in a mature business segment and with a low gearing ratio and solid balance sheet. The later also scares away growth oriented investors.

Personally, I am indifferent to those reasons. I just want the gap between price and value to be huge. I also don’t mind volatility from year to year as long as value is created and compounded over time.

Bear Case conclusions
Of the above mentioned 10 possible reasons for the discount, I believe the first three are somewhat rational. I am the most uncomfortable with the second and third reasons as I find those the hardest to assess both in terms of the likelihood of them occurring as well as the possible impact they can have. The rest are not really rational in my book.

I hope there are skeptical investors out there  who would like to share their thoughts if they have found holes in my analysis or have additional information or questions/thoughts to bring to the table.

You can read the third and final part, the Bull Case, here:

Wilhelm Wilhelmsen Holding – Quality at Bargain Prices?

Everyone and their neighbor has been participating in a mad rush to buy quality companies (earnings wise) for the past year or so. This has led to bloated, pumped up prices and I want no part in that race even though the participants have been rewarded nicely – so far. Value investors typically look a little dumb in the latter stages of bull markets, but Seth Klarman and the like often remain with their clothes on unlike many others investors a couple of years later. As I have said repeatedly in my blog: Quality is not a safe haven. Price is king when it comes to evaluating risk, not quality. But, if I can have it both ways, I am open to suggestions!

I might just have stumbled upon such a company: Wilhelm Wilhelmsen Holding, listed on the Oslo Stock Exchange, stock ticker WWI. It has in fact been on my radar for some time I just hadn’t gone down and dirty with analyzing it due to its complexity which meant it would be a time consuming exercise if nothing came up. Below is a diagram of its structure:

WWI overview

The 25% drop in share price since July has triggered my curiosity and I thought it would be an excellent time to take a closer look and dig into whether the drop was warranted or whether it has provided an opportunity for investors. Especially since the share prices of the three main competitors have gone up in the same period of time, indicating a low probability that it is the future prospects of the market they are in that is at fault.

Wilhelm Wilhelmsen Holding, WWI, has an immaculate value creation record since 1861. In the last 15 years WWI has returned 12% annually (semi-annual dividends + increase in share price) to their shareholders, which equates to 4,5x their money, beating the general market by a wide margin.

The company’s biggest asset is the daughter company WWASA (to the left in the diagram above), of which it owns 72,73%. The company’s primary market is transportation of cars and so called “high & heavy” equipment (mainly mining and agricultural machinery) by sea. They also have a lot of subsidiaries and joint ventures in related markets. In other words, it is a conglomerate, and investors typically crave discounts for those. However, unlike many other conglomerates WWI’s businesses intertwine creating synergies, so perhaps it would be more appropriate to award a premium to the share price instead. This probably won’t happen any time soon. However, it is my belief that the current discount will come down as it is rather large.

Key valuation figures, WWI (holding company)

Today 2014 2013 2012
Price/Earnings 3,4 4,2 5,9 4,1
Price/Book 0,49 0,55 0,84 0,83
Solvency ratio 48% 48% 46% 42%

Key valuation figures, WWASA (daughter company)

Today 2014 2013 2012
Price/Earnings 7,3 8,2 7,6 4,9
Price/Book 0,80 0,79 1,22 0,77
Solvency ratio 51% 51% 48% 45%

At the time of this analysis the price for WWI was NOK 149,50 (for the B share, the A share was slightly higher at 150,50 – if I was buying, I’d buy whichever is cheaper on the day). Price/Earnings is extremely low at 3,43 based on 2014 numbers and the company guides for 2015 to be similar to 2014. Price-to-Book is at 0,49, down considerably from 0,84 in 2013. Curiously, in the heyday year of 2007 Price/Book was at 2,2 (4,5 times higher than today).

These first two numbers generally don’t go together. Either you have excellent earnings and pay a high price-to-book for it, or you have poor or negative earnings prospects and are compensated by getting what is on the balance sheet at a discount.

What’s the catch?
Why both? What are the dangers lingering out there in the horizon? Well, according to my analysis there are a few but in my opinion they are relatively minor in proportion to the heavy discounts the market is providing.

  • Antitrust investigations
  • Uncertainty about contract renewal
  • Fear of increase in local car production?
  • Conglomerate discount
  • Shipping market discount
  • Norwegian market discount (following the current oil crash)
  • The founding family controls more than 50%
  • Dividend payout ratio is low (12%)
  • No share buyback
  • Cyclical, low liquidity, boring

Follow-up post
In my next post, I will take a closer look at each of those bear case arguments and following that I will then proceed to the bull case arguments:

Polarcus – the Story has Darkened

Since I posted my analysis on Polarcus on Nov 18th and a follow-up on Dec 8th the price of oil has come down dramatically to reach USD 45 (Brent) at its low point. Judging from the number of tenders and the current day rates in the seismic industry, Big Oil has essentially freezed their seismic capex spending. During December oil companies reported they would reduce capex by 20% on average. Since seismic players CGG and WesternGeco were quick to reduce their seismic fleet my thinking has been that the balance between supply and demand would not take as large a hit as was reflected in the seismic share prices. However, the tender activity in January was down 50%, and in the North Sea there has been 5 tenders while there is usually 20-25 this time of year. This development is especially unfortunate for Polarcus because of their strained balance sheet and poor backlog for Q2 (45%) and Q3 (55%). Since January 7th there was no new orders until March 4th. And PGS CEO has recently said that there is still 15% overcapacity in the industry and as long as this gap exists this will naturally have an adverse effect on day rates.

Two problems in the horizon
There are two problems in the horizons. The immediate (but less serious) one is loan covenants. In order not to be in breach of those Polarcus needs USD 150 million EBIDTA on a 12-month rolling basis for Q2 (they need USD 50 million in total for Q1 and Q2). I believe they will reach that but it isn’t a certainty if the backlog for Q2 doesn’t build up very soon. A bigger issue is Q4 2015 where the total EBIDTA needs to reach USD 172 million on a 12-month rolling basis and where the equity issue in Q3 2014 does not count in the equation any more. In light of developments the last couple of months I don’t see that happening. But this has happened before and has only led to insignificant fines so it may not be a big issue after all. Then again, it might…

The overshadowing issue, though, is the refinancing of the bond that is maturing in April 2016 where they need to pay USD 104 million. Free cash flow will not cover this amount and given the current yield-to-maturity of their bonds (in the 40-50% range) a new bond issuance seems extremely unlikely unless the market turns sharply upwards in less than a year’s time. So that leaves four other options: The sale of a vessel, new cash injection through equity placement, debt restructuring or liquidation – the latter I think is very unlikely unless oil collapses completely, I assign less than 5% to the likelihood of that scenario. Shareholders will root for the first option as the other three options will almost wipe them out. Sovcomflot has an option to buy the V. Tikhonov vessel, which is currently on bareboat charter. If this happens the share price will almost certainly shoot dramatically upwards (except in the case of a fire sale price). I don’t see this as particularly likely though. My guess is that Sovcomflot is as capex spending focused as the rest of the industry, and if they decide to buy they have a lot of leverage when it comes to pricing given Polarcus’ situation.

The need for cash
That leaves us with cash injection from a new equity issue and debt restructuring. The low share price has made the first of those options less likely. The market cap is now around USD 40 million and Plcs needs at least USD 100 million. In other words, we are looking at a dilution of current shareholders by at least 70%. On top of that, it might only be a shortterm solution as it doesn’t address the bigger issue, which is that there will still be a large amount of debt left which is difficult to service in the current environment. For that reason, I think a debt restructuring is the most likely scenario and one that bond holders will be pressured to go along with. For shareholders this will be bad news as debt restructurings usually wipe out 90%+ of their value.

Sold Polarcus shares, bought Dolphin
For the above reasons I decided to sell my Polarcus shares and buy Dolphin instead. I believe in the longerterm outlook for the industry but right now I believe the risk/reward has become less attractive in Polarcus, even though the stock has gone down significantly in the last two weeks.

Polarcus – lessons learned
I took a loss of 22% (average buy price 0,76, average sell price 0,59) and even though this isn’t the first time that has happened this one has been particularly painful due to the size of my position. I have no problem with the buy and sell decisions themselves. Macro events are impossible to forecast and I would do the same again every day of the week given the situation as it was, and especially once the pension funds started selling out. However, I will probably think twice about the sizing of my bet in a risky proposition such as Polarcus in the future. I am not ready to admit that there may have been an element of hybris involved due to large bets having paid off very well in the past since I previously have only made big bets when the downside was very well protected. The mental anguish involved, however, has been an eye opener. I have followed the developments of the stock price too closely which has led to less research on other possible investments. That has been the main lesson and I cannot allow that to happen again. Overall, the experience has reinforced my belief in taking contrarian positions.

Next article
In the near future I will post an article called “The Sizing of a Bet” where I will go into this subject in more detail as it is one I am fascinated with.

Arise Windpower – a Quantitative Analysis (Part 2)

Back in October I wrote a qualitative analysis on Arise Windpower ( – before reading this quantitative follow-up I recommend that you read part 1 first.

I have been hesitant making calls on future electricity prices due to political uncertainty regarding a possible re-election. Since it has now been cleared up that there will be no re-election I feel somewhat more comfortable making these estimates. However, it is important to realize that there still is a lot of uncertainty in the assumptions below.

Since October, there has been some interesting developments:
1) A project with a capacity of 46 MW was sold to BlackRock, one of the largest money managers in the world. The company will receive a healthy profit of SEK 46 million as well as management fees going forward.
2) Due to the current low electricity prices the company has decided to reduce risk by selling three wind parks with a total capacity of 25 MW (total portfolio is 266 MW). They expect to sell these wind parks at prices above book value. On December 3rd the first of those were sold at a price that was 15% above book value. It was the small Stjärnarp wind park with a capacity of 5,4 MW which was sold for SEK 83 million and which had a book value of SEK 72 million (cost 75 million, depreciation 3 million).

Projects sold above book value, while the stock is traded at a 48% discount
The above sales show that even in the current challenging environment where electricity prices are at historically low levels, customers are willing to buy at prices that are above book value. This is not reflected in the current stock price, which is selling at a 48% discount to book value. After these sales the risk in the stock has been reduced significantly and the upside ought to be apparent for investors.

Let’s now take a closer look at the net present value of future cash flows and convert the number to price per share. Below are my assumptions.

Discounted cash flow analysis – assumptions:
– The previous expansion strategy has been put on hold due to lower electricity prices and therefore I will assume no building of new farms. This means Arise will rely on the cash flows generated from existing wind farms as well as projects sold to external parties. Should total energy prices rise to above 700 SEK/MWh it can be expected Arise will again look into expansion. This is an added upside but also one that is impossible to quantify, and so for this analysis I will focus on the current strategy only.
– Arise has sold 5,4 MW recently and aims to sell 20 MW more at a price above book value. This will lower debt from SEK 1,6 billion to around SEK 1,2 billion. Whether or not these sales will materialize, it will not affect the intrinsic value of Arise Windpower by much. It might be slightly higher if these sales do not materialize, however, the investment will also be somewhat riskier.
– Yearly average production: 715 GWh (current) – 87 GWh (sale of 25 MW) = 628 GWh after sale of 25 MW.
– Life span of a wind farm is 25 years. E-certificates are received for 15 of those years. On average Arise’s total wind farm capacity has been in operation for 3 years. That means on average they have 12 years left to receive E-certificates. For the remaining 10 years only elspot prices will be collected.
– For 2015 we already know Arise will receive around 600 MSEK/MWh due to forward price hedging. Very little is hedged after 2015.

– From 2016 and onwards I make the following assumptions as to prices and the likelihood of them occurring:
Scenario 1: Total elspot + E-certificate prices from 2016 and onwards: 450 MSEK/MWh. 2% price increase per year. Probability: 15% (No e-certificate hike + prolonged lower e-spot prices)
Scenario 2: Total elspot + E-certificate prices from 2016 and onwards: 650 MSEK/MWh. 2% price increase per year. Probability: 60% (normalized e-certificate prices + slightly higher e-spot prices but still below historical average)
Scenario 3: Total elspot + E-certificate prices from 2016 and onwards: 800 MSEK/MWh. 2% price increase per year. Probability: 25% (global recovery above expectations)

In terms of free cash flows my estimates for a normal year are as follows – based on previous years and based on a price of 650 SEK/MWh:
Screen Shot 2014-12-28 at 23.03.22

– On top of revenue from own wind farms Arise expects project sales of 75 MW on average per year. After the BlackRock deal this seems a reasonable assumption. Total profit after tax for those sales is estimated to be SEK 35 million. Added to that approximately SEK 5 million in management fees per year per project. We don’t know for sure whether Arise will succeed in making these project sales, but due to the recent sales I estimate there is a 75% chance of this happening – so for the numbers I have discounted with this factor.

Given an 8% discount rate, I have calculated the intrinsic value per share to be as follows:

Scenario 1: 13,60
Scenario 2: 31,50
Scenario 3: 44,20

Weighing the different outcomes I arrive at the following numbers:
Intrinsic value: 13,6 x 0,15 + 31,5 x 0,60 + 44,2 x 0,25 = SEK 32,00 per share

The current share price is 16,90. And the current book value per share is 34,90. In other words, the above estimate is still below book value. Considering what recent customers have been willing to pay for Arise’s wind farms it is possible my guesstimates are too conservative. I’d be interested in hearing yours.

Note that when it comes to discounted cash flows it is a case of garbage in, garbage out. And since there is a lot of uncertainty in almost all of these numbers, take it for what it is: Lots of guesses as to possible future outcomes.

Polarcus Revisited

Has a special situation presented itself?

I went into some detail on Polarcus three weeks ago ( when the price was NOK 0,99. Now, following the OPEC meeting on November 26th, it is at NOK 0,64. A loss of 35%, while competitors Dolphin (0%), PGS (-5%), TGS (+8%), EMGS (+20%) and CGG (+1%) have pretty much stayed put. Has Polarcus become that much more risky in comparison with their competitors in that short time period or can the reason be found elsewhere? I believe the latter to be the case.

Forced selling?
This post is not about the longterm value of Polarcus. Instead it is born out of what seems to me a special situation that has developed. The newest major shareholder list,, reveals an interesting fact: Since Nov. 14th there has been heavy selling, possibly forced selling, by two Finnish Pension funds, Elo Pension and Varma Pension. None of the other major shareholders have reduced their holdings in the same period. Pareto Securites has sold 19 million shares since November 14th and so it seems to me the only possibility is that they are selling on behalf of Varma Mutual Pension fund and that they now have fewer than 7 million shares left.

For an investor this is significant for two reasons. One, they are soon out of shares, most likely within a few days (Pareto sold 2,8 million shares on Friday) – and there have been no other heavy sellers at these price levels, which makes a near term upwards rise in the share price quite likely in my opinion. Two, if a fund sells large amounts of shares without regards to valuation and estimates of risk/reward, great opportunities can arise.

Why would a fund sell at large discounts?
Possible reasons:
Risk profile. Being pension funds their risk profile may be such that they are forced to avoid companies where risk is seen to have increased without regards to price and an overall judgment of risk/reward.
Market cap considerations. Some funds are known to have internal rules that require them to sell stocks in companies when the market cap of the company falls below a certain threshold.
Tax/window dressing. At the end of the year some funds are known to sell their loser stocks for tax or for window dressing reasons. Some managers don’t want to be seen investing in stocks that underperform significantly for job security reasons or fear of customers withdrawing funds, so they erase the loser stocks from their listed investments before the end of the year.

There is of course the possibility that the two Finnish pension funds have found a hole in the case that other investors, such as JP Morgan, Goldman Sachs, BlackRock and Erik Henriksen, have not. Personally, I view that as highly unlikely. Pension funds are typically not considered to be the sharpest knives in the industry.

While it is not at all certain that Polarcus will make it through the current turmoil in the oil business without new infusion of capital when the USD 104 million bond expires in April 2016, I question if this as catastrophic as the current market price indicates.

Market cap NOK 428 million, equity NOK 4 billion!
Suppose the expired bond cannot be refinancied with a new bond at an attractive interest rate and the company needs to issue new equity that will see a 50% dilution, the Price-to-Book will still be in the neighborhood of the 0,20-0,25 range (currently 0,11) – in other words, still very cheap. Consider also that the largest shareholder, One Equity Partner, owned by JP Morgan, is financially strong and has put up NOK 78 million only two months ago along with NOK 26 million by other insiders.

The current price also makes a takeover bid for the company by a capital strong competitor or a private equity fond a very real possibility, especially considering the recent bid on CGG by Technip and the merger between Halliburton and Baker Hughes. Curiously, CGG is traded at P/B 0,54, while Polarcus is traded at P/B 0,11, even though Polarcus’ EBIT-margins are much healthier. CGG’s equity ratio is slightly better than Polarcus’ at 45% vs. 42%.

I believe the market has made a serious probability misjudgment based on irrational fear in relation to upside potential. However, it is never wise in these above normal risk/high reward situations to put too much of one’s capital at risk. Staying in the game should always have the highest priority.

As for the oil price, with a sharp downward move like we have seen in the past few months, I am betting on mean reversion in the not too distant future rather than a prolonged downturn – even though it may decline further in the near term. China and India are still growing rapidly and the low oil price ought to raise demand.

Polarcus – a Short Analysis

P/B: 0,17. Equity ratio: 40%. 2013 P/E: 2. An unlikely combination and too good to be true?

Polarcus is a company that trades on the Oslo Stock Exchange. It is in the seismic industry supplying oil companies with geophysical maps of the underground to aid their search for oil. To do this Polarcus has a fleet of specialized ships with streamers attached that pick up the data like in the illustration below.


The industry is dependent on the Exploration & Production budgets of oil companies. Those have been hit hard recently by a combination of shareholders wanting to cut costs and return more to shareholders via dividends – as well as the decline in the oil price. As a result almost all seismic stocks have taken a hit – and in the case of Polarcus to an extreme degree: 78% down since the beginning of the year.

Price-to-Book, Nov 18th
()=May 30th
Stock performance
since Jan 1st
Polarcus 0,17 (0,60) -78%
Dolphin 0,77 (1,34) -32%
PGS 0,77 (1,15) -39%
TGS 2,36 (2,50) 11%

I believe the extreme differences in those numbers relate to the market’s view of the riskiness of their balance sheets. Polarcus has the newest fleet in the industry and thus has higher leverage while TGS is an asset-light company in that they don’t own any ships.

A closer look at the balance sheet

Currently you can buy shares in the company for 0,99 NOK while the Price-to-Book value is 5,72 NOK per share. This is insanely cheap and indicates that the market believes there is an imminent risk of Polarcus going bankrupt or in need of large injections of cash. If this risk is low and Polarcus survives the current downturn in the industry the upside potential is very large, possibly in the 200-400% range. The stock traded in that range only five months ago.

When analyzing the balance sheet we see that the loan-to-book ratio is 55%. For a bank that would seem a safe loan. Now there are market participants, Fearnley Fonds among others, who argue that as there are no buyers of ships in the current market this ratio is irrelevant. I personally don’t understand this logic. 1) You want to look at the whole business cycle and not just at a moment in time when the market is depressed. 2) With a margin of safety of 55% loan-to-book ratio would the banks not want to extend the loans if Polarcus’ cash position gets into troubling territory? I would think so.

Debt Service Ratio-terms

There is also another aspect of the financing that needs a closer look and that is the Debt Service Ratio-terms that Polarcus has agreed with the banks. In 2014 Polarcus has been in breach of covenant twice and this has resulted in some minor fines of USD 15,000 so it hasn’t been a big issue in the past. However, it is never nice to be dependent on the good will of banks as that can change. With a loan-to-book ratio of 55% it does seem to me that the banks have an interest in keeping the relationship afloat though.

The DSR is defined as EBIDTA/debt service (ie. interest+loan repayment). For Q4 this is 1,6x, Q2 2015: 1,75x and Q4 2015: 2,0x. The debt service on Polarcus’ books are at USD 86 million on a 12-month rolling basis and so for Q4 the EBIDTA needs to be above:

Q4 2014: 86 x 1,60 = USD 138 million on a 12-month rolling basis

Q2 2015: 86 x 1,75 = USD 150 million on a 12-month rolling basis

Q4 2015: 86 x 2,00 = USD 172 million on a 12-month rolling basis

EBIDTA for recent quarters have been as follows:

Q1 2014: USD 40 million

Q2 2014: USD 50 million

Q3 2014: USD 43 million

Q4 2014: ? – probably below USD 20 million given company guidance (lots of multiclient work this quarter)

Note that on Oct 6th Polarcus launched an equity private placement where they secured USD 35 million – probably pushed through by the banks in exchange for better DSR terms. In the DSR agreement the proceeds counts as EBIDTA. Therefore Q4 is no problem in this respect. Fearnley Fonds, who have been selling the stock heavily for the last 30 days, have argued that there is risk of covenant breach in Q2. To me that seems very unlikely. For that to happen the three quarters of Q4, Q1 and Q2 combined would have to be below: 150-35-43 = USD 72 million, which translate into an average of only USD 24 million per quarter and the company has already secured a large backlog for the coming quarters. For Q4 of 2015 it will be trickier. And if the current market conditions persist for much longer I think a breach of covenant is likely in Q4. The question is how much it matters. That we don’t know. So far there have been no serious consequences.

Here is Polarcus’ backlog as of mid November (the numbers in parenthesis are for the same time last year):

USD 325 million (USD 150 million) backlog:

Booked capacity Q4 2014: 100% (75%)

Booked capacity Q1 2015: 70% (30%)

Booked capacity Q2 2015: 45% (20%)

Booked capacity Q3 2015: 50%   (?)

Booked capacity Q4 2015: 25%   (?)

It is worth noting that the CEO has said that Polarcus has been aggressive in their price bidding recently. But now, given the record high backlog, it would seem to me that to fill the rest of the backlog they don’t need to be as aggressive going forward possibly resulting in higher margins.

Future earnings and conclusion

So far I haven’t even touched on what drives stock prices: earnings and cash flows. While very impressive in 2013 they are much less so for 2014. The bottom line will probably result in a small deficit. The free cash flow will be positive though – for the first 9 months it was at USD 18 million adjusted for changes in working capital (market cap USD 98 million) – and after loan repayment and interest.

2015 will no doubt be a challenging year with regards to earnings. But if Polarcus can get through the current depression in the market reasonably intact, the 2013 results showed that the company has fine earnings potential.

As I believe the market is being too pessimistic with regards to Polarcus’ financial health and is giving too good a price for me to pass up, I have chosen to invest in the company. I do not recommend for others to do so if they are risk averse, however. And for those who do, a bet on the smaller side might be a wise option. In other words: don’t risk the house on Polarcus – it could come crumbling down!

Ego Protection – a Source of Major Mistakes

“Take no thought of who is right or wrong or who is better than. Be not for or against.” – Bruce Lee

Imagine for just one moment that you and your ego are two separate entities. Ok? Now imagine yourself as a boxer and your ego as a punching ball. Is the image planted firmly in your mind? Good… Now punch!

Did it hurt? Unless you are Buddha or someone who dances in nirvana land on a regular basis the answer is probably yes. Separating ourselves from our ego is just not that easy to do. However, it is my thesis that if we become proficient at it good investment decisions will follow much more frequently than if we let ourselves become slaves of our irrational ego. The hopes and fears of our ego can block the view of what is actually true about a situation.

Ego taking over the control
Ok, so we have done a thorough analysis on a company and have decided to invest. The stock goes up and we feel quite good about our stock picking skills. It still has a long way to go before it reaches its intrinsic value (according to our analysis) but nonetheless we decide to lock in the gains and sell on the grounds that “no one ever lost money from taking a profit” – a surprisingly common saying even among professionals who ought to know better. In reality we have committed a crime against our wallet in order to satisfy our ego’s need to book a win. In that moment we gave in to shortsighted sugar craving when it would have been wiser to develop the patience and thick skin and toughness of a Mongolian warrior waiting through the long and cold winters for the prey to arrive – ie. for the stock to finally reach its fair value. Easy thing to say, not always easy to do – hence the spiritual warrior metaphor.

Other examples
The same is true when we exit a stock that has fallen because our ego cannot stand to see the red figures in our account. When we start buying at absurdly high prices for fear of missing out on a rally everybody and their neighbor is seemingly a part of. Or when we become so attached to a stock that we keep holding on to it even though the fundamentals have changed in a major way so that the intrinsic value is now below the price of the stock. (Note, I’m not talking about the minor inevitable bumps that all companies experience on a regular basis. Selling on minor bad news can be costly when it comes to transaction costs in and out of a stock. I’m talking about game changers that fundamentally change the future prospects of a company.)

Being too attached to a stock
This last example can be especially difficult to deal with if we have put in lots and lots of time studying a company and now feel we need to get paid for that time. Unfortunately, the market is completely insensitive to our petty needs! It doesn’t deal with what is fair or unfair, only with what is true about the intrinsic value – or rather, it fluctuates around it, usually with a pull in that direction, like a yo-yo always returning to home. Another danger of being attached to a stock we have bought is that we can become so blinded by the upside that we don’t analyze news in a cool and unbiased fashion but instead shift the truth of the situation and instead see it in the light that we prefer.

Why do it?
Obviously, all of the above can be devastating to long term returns. So why do you, me – everybody! – do it so often? I think there are a few things that can come into play – and it isn’t at all impossible to cut down on their frequency.

1) We don’t separate ourselves from our ego

When we are not monitoring our own thought processes in an unbiased, “from the outside” sort of way and instead go on autopilot and react to situations in a non-reflecting way, our ego can easily dominate our actions. To prevent that it can be helpful to view our ego and ourselves as separate entities like in the exercise above. Daily meditation can be very powerful in this respect, as in every other part of our life. The Buddhist nun Pema Chödrön has described her view of meditation as the image of “sitting in a garden, watching children play with an attitude of nothing left to do”. With children being a metaphor for our thoughts – ie. watching them in a calm and free way without interfering – and becoming like water:

Within the finance world there are many proponents of meditation, which isn’t surprising given how much people are burdened with constant streams of information. One is top fund manager Ray Dalio, who attributes all of his success to this practice, which he has been at every day for 43 years.

2) Protecting our ego is more important to us than spotting mistakes

When protecting our ego from getting hurt becomes more important than making money we are in a bad situation as investors. The result is that we travel the comfortable road we are used to, which is to make sure we blame mistakes on external factors rather than looking inwards. And here I’m not talking about mistakes as being equal to having losing positions and winning positions being mistake free. That is “after the fact”-thinking, which is worthless and something to toss out the window. We act on the information we have in the moment we make the decision. We cannot look into the future so a mistake is not necessarily the same as an outcome that turns against our particular stock. What I am instead talking about is our reactions to events. That is what needs to be scrutinized, not our results – I don’t believe anything can be learned by studying our results.

3) Analytical work makes our heads cooler

It is much easier to react with a cool head if we have done the analytical work. If we don’t know the approximate value of something through analysis (and here I’m not talking about analysts estimates…) we can be swayed easily like the wind whenever a talking head says something in the news or whenever there is a minor positive/negative company event that doesn’t really do much for the long term value but we react by buying or selling nonetheless.

A note on intrinsic value
Now, I know I talk about intrinsic value – the present value of all expected future net cash flows – as if a number exists that could be agreed upon by all analysts. And if we all had godlike, omniscient knowledge of all available information and were able to calculate the millions of possible outcomes, yes, such a number would exist. But as investors we don’t live in theory land and so the intrinsic value of a stock will always be based on fallible estimates and is therefore not a number set in stone. However, it is the closest thing we have to uncovering the true value of a stock and therefore we have no choice but to rely on our own estimates more than anything else. If we give in and trust the volatile price movements of Mr. Market more than our own estimates, we become speculators instead of investors. And 99% of speculators don’t win.

There is, of course, great uncertainty when performing discounted cash flow analyses. The future is usually very hard to predict. But that doesn’t mean we shouldn’t try. If not for anything else but to see how the value is affected by different outcomes. And that means we can better interpret the results as they appear.

Ego – peace not war!

Is ego all bad and something that needs to be destroyed in order to achieve good results? No.The ego can often tell us where we want to go. But it needs to be supervised. We need to make sure that it isn’t taking charge of the ship that is us. Because it is a very bad captain.

But, we are humans – not machines. Our ego will take charge from time to time and it will lead us into making bad decisions in the future. The way to reduce the damage is to become aware of the ego’s influence the moment it takes over. Not an easy task, but one that can reap huge rewards the more we work on it. Ignoring it is not the answer. Instead we ought to monitor it like a mild grandfather watching his grandchild play!

I’d love to hear your experiences…

Arise Windpower – Traded at a Historically Large Discount, part 1

(Note to the reader: What follows is an analysis of Arise Windpower. Part 1 will contain a qualitative analysis – the why without a lot of numbers, while part 2 will focus more on the quantitative aspects of the case, ie. the numbers in the annual reports, discounted cash flows, etc. If it is too long winded for you there is a summary at the bottom of the page.)

As an investor I am always on the lookout for stocks that are traded at a discount to their intrinsic value. Bargains in other words. Those have become harder to find in the current market where optimism is running rampant and stocks have risen sharply the last five years in spite of a rather bleak world economy. So I have started looking in depressed sectors out of the spotlight of most investors. One such sector is the wind power industry in Sweden. This sector has been hit by low electricity prices the last few years as can be seen here:

2008 2009 2010 2011 2012 2013 2014
Elspot SEK/MWh 491 392 542 378 280 340 320
E-certificates SEK/MWh ? 317 255 187 167 196 180
Total SEK/MWh 709 797 565 447 536 500

The bolded numbers, Total SEK/MWh, are what renewable energy producers (such as wind power producers) receive per MWh and the Elspot prices are what conventional energy sources (such as nuclear power producers) receive per MWh. The prices change every day, so these are averages.

These are unsustainable levels if Sweden is to renew its energy base since very few producers of energy are willing to make the necessary investments in the sector at these prices since they are all bleeding money (except those that have hedged prices in advance when times were better, ie. 2009 and 2010). As a consequence stock prices in the sector have been hit hard since the summer of 2011. Some perhaps way too hard. I believe Arise Windpower, listed on Swedish Stock Exchange in the small cap category, is such a case. Below we can see the development of the Price to Book Value from 2010 when Arise was listed on the Stock Exchange to today, October 9th 2014.

2010 2011 2012 2013 2014
Equity per Share 38,99 37,18 34,46 37,09 34,91
Share Price (yearly average) 48,80 39,70 31,40 24,30 17,20 (cur)
Price to Book Value 1,25 1,07 0,91 0,66 0,49

At the time of writing, Oct 9th 2014, the share price was 17,20. 

“For the price of 49 SEK you are currently getting 100 SEK of value”

The market cap of the company is currently priced at 585 mio. SEK while the book value of equity is at 1,167 mio. SEK. Discounts this large are not unusual for companies in declining industries where the company shows deficits year after year slowly (or in some cases, quickly!) depleting its assets. However, Arise has actually shown a combined profit in the tough years from 2011 to 2013 of 60 mio. SEK. And the cash flows from operations are approximately +200 mio. SEK per year. This is mainly due to successful hedging of prices though and not results that can be expected longer term if electricity prices remain subdued at current levels for the long run.

So what gives? Well, before I get into possible reasons for the large discounts (and whether I think the heavy discount is warranted), let’s take a look at what Arise Windpower actually does…

Arise Windpower’s business model
This is their own brief description of their business model found on their website, “Arise is a leading player in the Swedish wind power market. The company’s business idea is to operate as an integrated wind power company managing all stages of the value chain, from project development to sale of green electricity from company-owned onshore wind turbines. Arise´s target is to have completed construction of and manage 1,000 MW of onshore wind power by 2017, of which 500 MW is owned by the company.”

At present wind farms in operation are at 368 MW (of which 102 MW are co-owned), which is quite far from their 2017 goal. The original goal for 2014, set back in 2009 when electricity prices were significantly higher, was to have 700 MW in operation. However, new investment decisions were put on hold because of market conditions. When prices rise above 600 SEK/MWh the company has stated that the expansion plans will resume.

The developments in the energy sector in recent years and the political situation
As of 2013 the total electricity production in Sweden was 150 Terawatt hours (TWh). The power sources were as follows:
Nuclear power 42%
Hydro power 41%
Wind power 7% (9,9 TWh)
Other energy sources 10%

In only a few years wind power production has gone up quite dramatically from 2% to 7% of the total national production. This is due to decisions by the political establishment relying less on nuclear energy and instead shifting more towards renewable energy. The E-certificate system is the instrument the politicians have available to make investments in the sector more attractive.

In February 2014 the Swedish Energy Agency put forth a recommendation for the adjustment of the E-certificate system which would result in higher prices if an agreement is made among the parties in the Swedish Parliament. A decision will be made in 2015. There is usually agreement across the aisle to follow recommendations of the Swedish Energy Agency.

Since the Social Democratic Party and the Green Party came to power the pace toward renewable energy has become even more pronounced. Before the election last month Sweden’s stated goal was to reach 25 TWh from renewable energy (currently at 18 TWh) by 2020. Now the left leaning government has raised the bar and proposed a new goal of 30 TWh by 2020.

Nuclear power
At the same time there are proposals from the government for extra taxes on nuclear power making a shut down of one or two nuclear reactors (of a total of ten) within the next four years a possible outcome. This would increase the spot prices of electricity as there will be less supply.

There are lots of ifs and buts in the discussions so the overall picture is not entirely clear. The right wing parties, along with many industry associations, are sceptical of the pace of which the new government wants to phase out nuclear energy. They fear unstable energy supply and higher prices.

One key question is whether the Green Party can survive as a party and as a member of the government unless they get a win in this, for them, major issue. Before the election they promised voters that at least two nuclear reactors would be shut down if they came to power. Having followed the debate quite closely (from the outside, admittedly), it looks to me like an almost certainty that the E-certificate prices will be raised, possibly by double what it is now (ie. in the 350 SEK/MWh range) as a few independant energy experts have called for. Perhaps the right wing would accept this in exchange for a slower phasing out of the nuclear reactors than what has been proposed.

Being comfortable with uncertainty
A lot of guesstimates and uncertainty here but isn’t that what always comes along with the investment territory? Being comfortable with uncertainty and being able to perform unbiased, coolheaded calculations of different scenarios is what investing is all about after all. Perhaps the best sources of opportunities lie in the fact that most would rather steer clear of uncertainty even when the odds are stacked in their favor?

Back to Arise
Now let’s get back to Arise and the possible implications for the share price for each scenario.
I first became aware of Arise back in May of this year when I learned that Peter Gyllenhammar had bought a stake worth 13 million SEK in the company. I had read a great deal about him in the book Free Capital by Guy Thomas and he is someone who likes to go for deep value (there is an excellent portrait of him in Swedish by a fellow blogger here:

However, I never got down and dirty with the annual reports figuring it would take too much time to really figure out the inner workings of this complex industry to be worth my while. Since then the Arise stock has plummeted a whopping 35% from 26,00 to now 17,20. I started reading more about the company in September when the price was around 18,50. At the time it looked like a certainty that the red/green side would win the election which would possibly be giving tailwind to the wind power industry and so I started digging for reasons that stock had tanked so heavily.

So far I have not found anything that could justify shaving off 285 mio. SEK from the market cap. Sure, the numbers in Q2 were a bit worse than expected mainly due to less wind in the quarter and the refinancing of loans might have been a tad more expensive than the market expected but again we are talking very small numbers in comparison to the dive.

No change in long term story
From my perspective the long term story has not changed in any significant way and so the 35% dive seems unjustified. After all, electricity is not a product that is ever unsellable. You don’t need a marketing department, and once wind turbines are erected there is little capex maintainance. So there is a certain safety attached to the investment.

The only major issue that I can see is the uncertainty of the price of electricity and while this is a huge one, and one that fluctuates quite wildly, electricity is tied to the survival of the nation. A bit like the too big to fail banking sector in 2008. If prices dip even further the long term supply of electricity is threatened. So when investments in the sector start to dry up, I believe the politicians will wake up and press a few buttons in order to make investments attractive again.

A few numbers
First, let’s take a look at the downside. I tend to focus on potential catastrophes first. Preservation of capital is vital in the long run and much more important than chasing that extra percentage here and there.

According to my calculations, the point at which cash flow from operations goes in the red occurs when the total price (elspot + E-certificates) falls below 400 SEK/MWh. Net income would be -100 mio. SEK. Even two years like that would spell trouble when it comes to refinancing their loans. Arise might have to liquidate some of their assets at discounts that are larger than the current price indicates. For that to happen two things would have to occur simultaneously. 1) No political agreement is reached on adjustments of the E-certificate system and 2) the economy enters into a recession. The chances of both happening at the same time is extremely low in my opinion.

The point at which Arise net income goes in the red occurs when prices are below 570 SEK/MWh. Still cash flow from operations would be +100 mio. SEK. Due to Arise’s current price hedges 2014 and possibly 2015 look like years in that price range. Not great years at all, and not ones that make Arise overly attractive as an investment. The reason to enter would be because of what, in my opinion, is almost bound to happen from 2016 and beyond.

Political decision in 2015
Parliament will have made energy decisions reaching well ahead into the future in 2015 and the new adjusted E-certificate prices will come into play from 2016 and onwards. I don’t see the combined prices falling below 650 SEK/MWh as that could jeopardize the overall investment plans. And it is quite possible that prices will be a lot higher than that. At 650 SEK/MWh cash flow from operations will be 140 mio. SEK and profit after tax around 40 mio. SEK. At 800 SEK/MWh cash flow from operations will be 220 mio. SEK and profit after tax around 120 mio. SEK.

I will dive deeper into the numbers from the reports and perform a cash flow analysis in part 2. I expect to post it shortly (probably within a week or two after the Q3 report).


The Bull Case
Significantly higher E-certificate prices on the horizon according to experts. Judging from the political debate it seems almost a done deal across the aisle. Arise, with its portfolio of projects, is well positioned for a quick expansion plan if this was to occur.

– It is difficult to imagine the price of electricity fall below what it is now if Sweden is to reach its long term renewable energy goals. Investments in the sector has come to a halt as a consequence. This cannot go on for much longer and judging from the political debates it won’t.
– 100 SEK of book value is currently selling at 49 SEK. This is historically low. If Price to Book increased modestly from 0,49 to 0,70 as is more normal in the sector currently, the Arise share price would be in the 25,00 area – an increase of 45%. If electricity prices were to rise to average levels a share price around book value seems within reach, which would double the price from current levels. The long term potential is much higher.
Insiders are buying. The CEO bought 60,000 shares (amounting to 1 mio. SEK) in September around the time of the election. Board member Peter Gyllenhammar added to his 500,000 shares position by buying another 250,000 shares on Oct. 2nd (4,3 mio. SEK).
– Will the Green Party survive as a party if nuclear reactors are not being shut down in the near future? If reactors are shut down, the price of electricity will be boosted.

– BlackRock, the world’s largest asset manager, recently entered into an agreement to purchase Bohult windpark (46 MW). This can prove to be very beneficial relationship for the years to come releasing capital to either lower debt, pay out dividends to shareholders or for new projects.

Less important and more short term, but factors nonetheless:
– The water supply for hydro power is below the historical mean currently. Short term this ought to support the elspot prices.
– Will Russia increase the pressure in Ukraine by cutting the gas supply when the winter comes? This could potentially raise elspot prices in Sweden.

The Bear Case
– Forward prices of E-certificates do not agree with my assessment that we will see significantly higher E-certificate prices going forward ( in which case the current price to book discount is fair.
– A worsening of the world economy would put pressure on the demand for electricity potentially driving elspot prices down even further. It is my belief though that E-certificate prices would provide a cushion, at least to some extent.
– A reversal in political sentiment towards nuclear power. I really don’t see that coming – the momentum away from it seems way too strong on both sides of the aisle. But perhaps the market sees this question differently than I do, hence the low stock price.
– Rising interest rates at or around the time the loans are to be refinanced. The flip side to that is that it would indicate a stronger world economy and thus almost certainly higher elspot prices.

Part 2 of my analysis can be found here: