How to profit from Germany’s coming takeover boom
It's tough to find even the most basic information on Germany's 900 listed firms. But this is why its equities are among the cheapest in the world, says Sven Lorenz. And with an obscure tax law about to spark a wave of takeovers in the country, smart investors could make a great deal of money if they invest now - here's how.
The UK is the easiest to access merger and acquisition (M&A) market in the world. Even bids for national institutions such as P&O or the London Stock Exchange don't arouse the least bit of protectionist opposition. Yet the world's most profitable deals aren't going to happen here, but in Germany. Sven Lorenz reveals how to make money out of the coming boom.
German tax laws are famously opaque, but getting to the bottom of them is nothing compared to trying to find out even the most basic information about its 900 listed companies. Of these firms, 80% aren't covered by analysts, disclosure laws are not quite up to the standards of those in other Western countries, and even if you know where the information you are after can be found, you'll only ever find it in German.
All these things have long meant that the German market has been particularly difficult to penetrate and that most investors have ignored it in favour of more straightforward pickings elsewhere. The result? German equities are still among the cheapest in the Western world.
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If you look at the country's leading stockmarket index, the DAX, you may not be immediately convinced about this (the market has risen about 150% since its March 2003 low), but during the same period, corporate profits have risen at almost exactly the same rate. In other words, the German market today is as cheap right now in p/e terms as it was at its absolute low. It's also still nearly 30% below its historic high of 8,064.
Still, just because a market is cheap doesn't mean that it isn't going to stay that way. So what makes me think that the German market is a good place for your money? The answer comes in the form of the little known UMAG law. You won't have heard of this, and neither have most German journalists, but UMAG which stands for Gesetz zur Unternehmensintegritt und Modernisierung des Anfechtungsrechts represents a far-reaching overhaul of German corporate law that could well be the thing that gets the German mergers and acquisitions (M&A) market moving and kicks off a rerating of the whole market as a result.
Until recently, Germany's antiquated corporate law meant that takeovers were never, ever straightforward. Shareholders were able to challenge crucial aspects of any bid in court, meaning that potential bidders eyeing the German market knew they were likely to end up facing large legal costs, long delays and a high risk of failure. So they just didn't bother: in 2004, German M&A amounted to just 4% of GDP, compared to 16% in the UK.
But UMAG, introduced in September 2005, has changed all this by moving German corporate law much closer to the Anglo Saxon model and hence lowering the barriers to takeovers. Add that to cheap valuations and impressive earnings and I'd say a wave of M&A is about to hit Germany, which means well-placed investors are going to make a great deal of money.
Let's look at just one example of a firm begging to be taken over, Wstenrot & Wrttembergische (WUW, €17.25), one of Germany's leading mortgage providers. Germany is currently seeing an influx of foreign banks trying to get into the mortgage business (ING and ABN Amro, for example), but this kind of market is tricky to get into, so buying a mortgage provider with existing distribution channels and brands has got to look tempting. The firm also has several insurance operations and is Germany's number-three savings provider a patchwork of businesses that should make it a prime break-up target for a large investor. Yet despite all these compelling attributes it is currently trading at just 0.66 times its book value of €27 per share.
German takeovers: what major shareholders mean for small investors
But W&W has another attribute that makes it look very interesting to me. It has one huge shareholder a trust that controls 65% of its votes. This is quite a common thing to find in the German market it's a legacy of the country's old corporate system, under which Germany's biggest banks and insurances companies effectively controlled the listed-company sector via an almost impenetrable web of cross-shareholdings.
For many years long after the system had outlived its usefulness these shareholdings remained intact, thanks to the fact that even thinking about the tax liabilities attached to selling them brought corporate Germany out in a sweat. Then, in 2001, the government brought in legislation to permit a tax-free sale of these stakes and German banks and insurance firms were finally able to get out of their stakes in non-financial companies. However, they tended to sell those stakes on in single blocks to new owners. So most German firms still have one dominant shareholder.
At first glance, this may look like bad news for small investors, but in fact it spells opportunity. Why? Because majority owners often want to remove minority shareholders and tend to be prepared to pay a premium to do so. Since 2002, legislation has existed that helps them do this, but in a way that favours minority shareholders.
Basically, the current law in Germany requires that a bid to buy shares is based on the fair value of the business. So if a bid is made to take a business private (ie, a big share holder wants to buy out all the smaller shareholders), and the smaller shareholders aren't happy with the price, they have the right to ask a court for an independent appraisal of the business. But here's the good bit: the price can only be appraised upwards!
This creates an opportunity for small investors to reap a virtually risk-free profit there's upside but no downside so it's one of the main areas I'm currently keeping an eye on: if you can find the firms that have big shareholders that want to go private, you can probably find yourself a profit too.
Share tips: small and medium-sized firms
So where should we look for this kind of firm? I suspect that once the M&A market really gets going, you'll be able to find candidates even at the very top of the market (Italy's Unicredito already owns 95% of Germany's number-three bank, HypoVereinsbank, for example), but for now, I think the best potential is among medium and small-sized firms.
Beru (BZL, €73), a world-leading manufacturer of diesel cold-starting technology, with major customers such as BMW, GM/Fiat, Renault and Ford, is a good example. It has a new majority owner in the form of US automobile part supplier Borg Warner (NYSE:BWA). In February 2005, Borg Warner bought a 70% stake in Beru, leaving 30% as a free-float, and you can be sure it's soon going to want to buy out the free-float (in a clear indication that it wants to own the whole firm, it's already changed Beru's fiscal year end to fit with its own).
But when it has a go at doing so, it's going to have to pay up. Currently, you can only force remaining outside shareholders to sell up when you already own a 95% stake. That means professional German investors will already be building 5% stakes so as to increase their bargaining positions (if you look at the share price chart, you can see they're already moving in).
So what are they going to bargain for? Well, Beru and Borg's products complement each other perfectly, so there are likely to be multi-million dollar synergy effects and they are going to be looking for a price that reflects this. Beru shares are currently trading at €74, and I reckon they could fetch €90-€95 by the summer.
Offering a similar, but I think even better, opportunity than Beru, with the share price having much higher potential, is Klnische Rueck (KRV, €99.15), or Cologne Re, one of the world's largest reinsurance firms. Currently, 91% of the firm's shares are controlled by General Re, which is in turn owned by Warren Buffett's holding company, Berkshire Hathaway and as far as General Re appears to be concerned, that's soon going to be 100%. Cologne Re doesn't even have a website of its own anymore. Instead, anyone looking for information needs to check the German language section of www.GenRe.com.
During the first nine months of 2005, Cologne Re earned €7.59 per share. With an estimated 2005 result of €10-€11 per share and a share price of e101, you can currently buy into the firm at a p/e of just ten. When it looks like Buffett is about to make his move, that is highly unlikely to continue to be the case: if you buy now, odds are Buffett is going to pay a lot more than ten times profits to make you go away.
Again, professional investors are likely to play a key role in getting as high a price as possible here. Some sophisticated money managers have already started to pile into Cologne Re, in order to gain control of enough shares to negotiate a better offer from Buffett.
These professionals know what they are doing. Three months ago, they made a killing when French insurance giant AXA SA announced a plan to take its German subsidiary, AXA, fully private at €129.30 per share. Before the price was announced, anyone could have bought AXA shares on the open market for just €80. And having valued them a few years earlier at €120, many investors had done just that, prompted by the fact that AXA SA has been seen buying additional shares in its subsidiary itself a move akin to publicly announcing that it intended to take it private.
This was as close to a no-brainer of an investment as you'll ever get and a lot of savvy early-bird investors made a fine return on the deal. Some of the money they earned then is now being piled into Cologne Re.
Share tips: gas meters priced to go
My third candidate is Kromschrder (KRO, €32.60), one of the world's largest manufacturers of gas meters. Germany's engineering sector has always had a reputation for precision and reliability, and the idea that something is "made in Germany" still has its pull, which may have been a factor in attracting a consortium, including UK private-equity house CVC, to Kromschrder: since June 2005 it has owned more than 95% of the shares and it has since made an offer to buy the rest of them from the remaining smaller shareholders at €27.90 per share (the shares were trading at only €15 in early 2005).
But here's the odd bit. The shares are trading well above the offer price at e31. Why? The answer is simple. Using the publicly available balance sheet and profit-and-loss statement, professional investors have probably done the numbers and realised that if they appeal against the bid in a courtroom, they can probably push the offer price to €40 or so. The shares are now guaranteed not to fall below the €27.90 that's already been offered, but a threat of a court case might see them rising much, much higher.
Getting someone else to do the work
Buying into Klnische Rueck is easy, even for UK investors any UK broker capable of trading on the Frankfurt market can buy this relatively liquid share for you. But obviously, not everyone is going to have the time consistently to search out such complex investment prospects.
For starters, quite often the legal documents involved run to hundreds, even thousands, of pages. During a recent case involving Allianz, a staggering 4,696 pages of legal documents were sent out, along with the invitation to the firm's annual general meeting. Yet anyone who really wants to make money out of the whole thing has to read all the documents on offer, attend all shareholders meetings and closely watch court cases. It's a bit like detailed detective work. Good news then that there is an easy route in, too.
It is little known, even among German investors, but there is a vehicle that specialises in pursuing such opportunities. Hamburg-based Falkenstein Nebenwerte (FAK, €50), which listed on the Frankfurt exchange in 2003, has been in this game since 2001.
Those who bought in early have done extremely well indeed. In spring 2003, the shares changed hands at €16. Today, they are hovering around €50, thanks to a rapidly rising net asset value. The Falkenstien managers were early into AXA shares, for example, as anyone can easily see from their 2004 annual report, buying in as low as €30 per share. And they have lots of other good opportunities on their radar too. The firm is involved in a whole range of lawsuits that could lead to a retrospective (and substantial) payout from holdings that it has already sold to bidders, but it's also actively looking for new deals.
One I really like the look of at the moment is biofuels producer lmhle Hamburg. The story of this stock starts in the UK. Quite often, an upcoming transaction in Germany can be anticipated after a similar deal has already occurred in the UK. In other words, where UK investors lead, German investors often follow and this is exactly what has happened here.
In 2003, the leading American agricultural giant, Archer Daniels Midland (NYSE:ADM), bought 100% of listed UK firm Pura. ADM was keen on increasing its exposure in the biofuel market and Pura's rape-seed production offered an easy way to do just that. ADM's biofuel acquisition trail then took it to the windy port-city of Hamburg in northern Germany. There, too, the American agro-giant bought into a local rape-seed producer. However, in the case of lmhle Hamburg, it didn't manage to get its hands on 100%. The US firm currently owns 95.18% of the German company, but has been involved in a long and drawn out struggle against the remaining small shareholders. Once this case has been resolved, an offer for the remaining 4.82% of shares is more than likely.
lmhle Hamburg has annual revenues of €1.3bn and is working on doubling its existing biofuel capacity. Once finished, its expanded oil mill in Hamburg will be the largest such facility in Europe. In Germany, it is already compulsory to add 5% biodiesel to any kind of diesel fuel, but given the sky-high oil prices, demand for cheaper fuel alternatives, such as those made by lmhle Hamburg,will continue to grow, even without government prompting. When ADM took over Pura, it offered a 67% premium to the last share price, based on a p/e of 26. lmhle shares have the potential to make holders at least that much once ADM initiates a bid.
The bad news is that you are unlikely to be able to get in on this deal by yourself the shares are very illiquid but there's good news too: it looks like the cunning managers at Falkenstein have had this one on the radar for a long time. Yet another example of how well it can pay to have someone else do the work for you.
Falkenstein's CEO, Christoph Schfers, points out that his portfolio has had an extremely low beta factor over the last few years. This means that his returns have been largely independent of market volatility and Falkenstein also profits from yet another bit of advantageous German legislation that makes much of the company's profits tax-free.
Still, what with the many opportunities coming on to the market, I think the best may be yet to come for Falkenstein. It's current market capitalisation of €26m makes it a minnow with a tiny float, but it's the small size that gives it the flexibility quickly to turn positions in order to maximise gains for shareholders. By the end of 2007, I wouldn't be surprised to see the shares hit 100.
Sven Lorenz is a German-born fund manager. He will soon launch an Aim-listed offshore fund specialising in such German corporate action opportunities. He, or the funds advised by him, may hold positions in the firms he discusses. Contact: s.lorenz@innomega-ag.de
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