Value Investors Club / Pfleiderer (PFD4 GR)

Description

Pfleiderer 7 1/8% hybrid perpetual bonds, trading at 51c on the dollar, represent a compelling value opportunity where we believe patient investors can triple their investment over 5 years. The market dislocation exists for three reasons: (1) the violent 2008 selloff in high-yield debt markets post Lehman's demise took the bond down with all similar bonds; (2) management recently (August) exercised its option to suspend coupon payments on the bond, which is permissible if management eliminates the dividend on the common equity; and (3) earlier this year, due to the broad economic climate (outside of management's control), and a proactive strategic decision by management to apply pressure on marginal competitors by enacting significant price cuts, Pfleiderer violated its covenants on its senior debt (3.5X net debt/ebitda covenant). The Company is currently renegotiating its covenants with a consortium of private German banks, including the government, and we are confident that a favorable resolution, without restrictive covenants or any implications for retirement of the hybrid in 2014, will be accomplished and communicated to the market within the coming weeks. Without any clear view as to whether the coupon payments would resume in the short term, yield-focused bond funds were forced to exit their positions. Importantly, similar to the now somewhat obsolete savers share concept, these bonds carry an accumulated coupon, so that when the company resumes coupon payments, all coupons in arrears are immediately due as well. Below we depict two scenarios, a bull/base case and bear case, all of which we feel offer an attractive risk/reward. Our analysis of Pfleiderer's business structure, market positions, profitability, competitive landscape, and supportive and deep-pocketed shareholder base, give us comfort that the company's risk of bankruptcy is extremely remote to non-existent. In addition, we believe management of Pfleiderer has been personally purchasing the bond, and are therefore significantly aligned with fellow bond holders.

Why are we confident that management will retire the bonds at par in 2014? First, management owns the bonds. Second, the cost of the bonds will change from a fixed 7.125% to floating EURIBOR + 423bps. We believe this spread will be quite onerous to comparable instruments, and we believe, as does management given that they have been buying the bond both at the corporate and personal level, that EURBIOR will be significantly higher than where it is today (0.73% - near historic lows).

Bull/Base Case: IRR of 28% and a multiple of investment of 2.8x through 2014

We assume the industry recovers and Pfleiderer reinitiates its long-standing dividend policy, and therefore resumes coupon payments on the hybrid, in 2011.

Bull Case	2009	2010	2011	2012	2013	2014
(Investment) / Redemption	(1,000,000)	-	-	-	-	1,960,784
Coupon	-		419,118	139,706	139,706	139,706
Total	(1,000,000)	-	419,118	139,706	139,706	2,100,490
IRR	28%

Bear Case: IRR of 13%

We assume that refinancing occurs (as discussed in detail later, which we believe is question of when an announcement will be made and with what parties as opposed to whether the debt will get refinanced or even the general cost. We assume that coupon payments resume in 2011 triggered by the initiation of a small dividend to shareholders (private equity involved and management owns both stock and bonds), but that a) the bonds are not called in 2014 and b) 3-month EURIBOR stays near historic lows at 0.77%. This mean that coupons are paid into perpetuity, but convert from 7.125% fixed to 3 month EURIBOR + 4.23% in August 2014.

Bear Case	2009	2010	2011	2012	2013	2014	2015
	(1,000,000)	-	-	-	-
	-	-	419,118	139,706	139,706	139,706	98,039
	(1,000,000)	-	419,118	139,706	139,706	139,706	98,039
IRR	13%
Payback Period	5.73 years

Business and Industry Overview:

Pfleiderer is the second largest Particleboard (PB) and Medium Fiber Board (MDF) producer in the world with ~7,600 m³of total capacity. The Company employs 5,620 employees over 21 manufacturing sites. The structure of the industry is significantly better than the US OSB market characterized by fewer players, higher cost of transport (business is local / regional - 500km economically feasible radius), and increased difficulty to open new capacity (capex of E150mm to build a new panel plant, environmental and labor issues). Currently the average German spends E360 per annum on furniture versus E250 in the US and W. Europe, E16 in Poland and E8 in Russia. Nearly 25% of the Company's sales are generated by Pergo, the laminate flooring division of Pfeliderer. Laminate is a global business, and Pergo serves the high-end of the laminate floor market where brand matters. Pöyry Group and RISI are solid resources to get up to speed on the wood products industry.

Company Exposures:

At Q2 2009, 51% of sales were generated in Western Europe, 31% in North America and 17% in Eastern Europe (Russia and Poland - down 41% yoy and generated a E2.5mm EBIT loss in Q2). Pfleiderer's end markets by industry include Furniture (33%), Distributor (32% largely flooring then construction and furniture), Others (17%), DIY (9%), Flooring (5%) and Construction (4%). Costs to manufacture particleboard include wood (40% - prices set locally within a 200km radius and scale provides significant buying power), glue (25% - oil derivative), energy (15% - major advantage over peers given biomass co-generation facilities/backward integration), other fixed costs (15%) and personnel (5%). Variable costs account for up to 80% of manufacturing costs, so clearly scale and plant efficiency are important.

Market Update:

Most of Pfleiderer's assets are top quartile with the remainder falling into the second quartile. As a result of market conditions, Sonae Industria, the third largest player in particleboard/fiberboard behind M&P Kaindl and Pfleiderer, is in the process of closing two large plants from Germany. Sonae has reported six consecutive quarters of losses and is in significant financial distress. Additionally, two small players are each removing facilities, which with Sonae's closures, should boost Germany utilization to the high 80s from the low 80s (est. >60% of W. European sales). Pfleiderer will also likely close one or two facilities in Germany over the next 12 months and then lead prices higher. Prices in Germany fell by 11% in Q2 driven predominately by actions taken by Pfleiderer to force higher cost players out of the market (strategy appears to be working). The Company continues to take significant share in Germany in Particle Board with marginal declines in volumes yoy against a double digit decline in industry demand. The Company estimates that prices would be about E10 higher if not for their long-term strategic decisions (would suggest 13% GROUP EBITDA margins versus 8%). In Q3, Pfleiderer began raising prices in Germany and the industry followed. North American volumes and pricing are both up slightly. Poland demand is off significantly, but of the 40% reported decline in Q2, the fall was actually 16% in constant currency. Industry utilization dipped below 70%, but is now slowly rising. The Company has new, highly efficient capacity entering the market at the end of the year, which management believes will earn double-digit EBITDA margins at current Polish prices and demand levels.

Brief History:

When the very capable CEO, Hans Overdiek, began at Pfleiderer in 2001 (named COO in 2003 and CEO in late 2007), exposure to Germany accounted for nearly 85% of group profits. Through Hans' leadership, the Company sold and shut down several non-core assets including Infrastructure Technology, which accounted for 1/3 of sales in 2002. Pfleiderer than began to diversify outside of Germany, but sticking to its core competencies. The Company purchased the laminate flooring business of Kunz in 2005, a Polish glue manufacturer in 2006 (backward integration) and Pergo, a global leader in laminate flooring in 2007. Pergo was the largest acquisition at E308mm (<1x sales and 8x trailing EBITDA and very comparable to Mohawk's Unilin division in the United States). While the acquisition was made at an unfavorable stage in the business cycle, the combination of the Kunz division and Pergo made strategic sense. Subsequently, the Company has taken Pergo North American market share market share from 15% to 30% (>70% of Pergo sales and up 24% yoy in Q2).

Visible and material upside: 3X ROI over 5 years with a 28% IRR in our base case

Superior management (especially for Germany): CEO, Hans Overdiek, age 47, began his career as an auditor. Overdiek then moved to a German metallic goods company (metal bending) where he became a Managing Director, borrowed and invested his entire net worth in the company, and sold his stake to become independently wealthy at 38 (1990). Overdiek then moved to Robert-Zapp, a German steel company, where as head of procurement, marketing and sales, he grew sales from E300mm to E500mm by penetrating Europe organically and India through a JV. PBT grew from break-even when he arrived to E50mm when he departed (1997). Overdiek's next move was to Bohler-Uddeholm, a large steel company, where he ran the Lawn Products division with E300mm of turnover. Sales grew, margins expanded and his division was acquired (2001). Overdiek finally joined Pfleiderer's Executive Board in 2001, became COO in 2003 and CEO in late 2007. Overdiek was responsible for implementing his structural cost-cutting strategy that he developed through his experience in the steel industry. While his peers witness multi-decade lows in profitability margins as a result of plummeting demand, Pfleiderer's EBITDA margins troughed in Q2 at 8%, better than the weakest quarter in the 2002-2003 downturn (profitability for the industry troughed in 2003 and peaked in early 2001). The Company is at the bottom of the cost-curve through this cycle as a result of shuttering non-core businesses and inefficient capacity, superior procurement efforts and building "mega-sites" in emerging markets (Poland and Russia).

Incentivized alongside management: Management collectively owns 6% of the company, and the CEO, Mr. Overdiek, who Pfleiderer investors refer to as a "rockstar", owns 800,000k worth of the hybrid bond and about 1mmE worth of common equity (not bad for Germany).

Family and PE dynamics: One Equity Partners and the Pfleiderer family own roughly 35% of common equity. One Equity Partners is in year 2 of a 7 year investment and has recently added to its holdings at higher levels. The family had capital gains of 300m euros + when it sold down some its stake in 2003, and has indicated they would be supportive of a capital increase should it be required. Having this level of support in the shareholder base should give investors comfort that the company will not face bankruptcy risk and the bonds are "money-good".

Market Dislocation: Due to the mandates of many institutional bond funds, the value of Pfleiderer's perpetual bonds fell precipitously on the back of a covenant breach in Q2 and suspension of the coupon payment (August 2009). The sell-side does not appreciate the primary driver behind the fall in profitability for Pfleiderer (Pfleiderer's decision to cut prices to force competitors to close capacity) and so estimates do not reflect the benefits of capacity closure against slowly rebounding demand. Also, estimates do not reflect additional capacity, which we believe will add nearly E40mm of run-rate EBITDA on top of an earnings base of around E260mm (EBITDA). Finally, the investment community does not appreciate the relationship of Pfleiderer with German banks and the option to finance with KFW, the German-owned bank with an explicit mandate to help companies that are struggling due to the financial downturn. While we think it is somewhat unlikely that the Company will resort to KFW financing, the impact to the equity and the perpetual bonds should still be positive as a major overhang will be removed from the bonds and shares and go-forward effective interest will likely be around 7% (manageable).

Margin of safety: E406mm of equity value below us as well as E208mm of cash and available credit lines. At 8% EBITDA margins (trough quarter), the Company could generate cash if growth capex was deferred (plant in Russia could be deferred until 2011; North Carolina addition will be completed in Q4 2009). Capex could fall to as low as E40-50mm in 2010, providing ~E100 million of unlevered pre-tax cash flow. Pfleiderer is bringing on capacity in regions that are either short supply OR where current prices support >15-25% EBITDA margins for new capacity due to high-cost competition. By 2012, the Company should be able to generate E2bn of sales on 15% EBITDA margins, suggesting E300mm of EBITDA and E170mm of unlevered after-tax free cash flow against a current enterprise value of E1.4bn (this includes over E400mm of equity value positioned below us). This business is characterized by regional oligopolies due to transportation and capital barriers. As a result, the industry is much more similar to cement than to most hard commodities. EBITDA margins for Pfleiderer over the past 10 years have averaged 12% (this includes margin dilutive businesses through 2004, which are no longer part of the Company) with a fairly narrow range of 8% (8.4% in 2003) to 14% (13.6% in 2007). The Pergo acquisition should be long-term margin accretive given its brand equity and market positioning (25% of sales). We believe the Company is structurally better now than at any point in over the past 10 years, which should permit the Company to earn superior margins and a return on capital above its WACC.

Take-out provisions: in the event of a take-out, the bonds can be redeemed for par or face an incremental 5% per annum interest penalty (>12% cost of debt).

Long Risks

Credit markets and equity markets collapse over the next 4 to 6 weeks and the consortium of German banks that make up Pfleiderer's lending group decides to force administration and run a wood products business. Additionally, KFW steps away and withholds financing.

Perfect storm: demand declines by an additional 10-20% and industry capacity closures are insufficient to recover pricing, while oil and energy prices spike (PPI inflation against CPI deflation or stagflation causing the entire industry goes bust.

Long Merits

Description

Pfledierer 7 1/8% Undated Subordinated Fixed to Floating Rate Securities (51c)

Catalyst

Debt refinancing (October/November 2009
Further capacity closures with potential of Sonae Industria going bankrupt
Evidence of price increases and trough profitability (quarterly reports)

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			2009	2010
Price:	51.00	EPS	-$0.73	$0.35
Shares Out. (in M):	0	P/E	nm	nm
Market Cap (in $M):	260	P/FCF	nm	nm
Net Debt (in $M):	890	EBIT	30	60
TEV (in $M):	1,261	TEV/EBIT	42.0x	21.0x