European Stock Updates
European Stock Updates
How some of our key portfolio holdings have played out over time.
Deutsche Börse – a case that has not played out as expected.
Our case on Deutsche Börse (DB) initially (March 2011) was built around the view that:
- The regulatory threat of having its monopoly position in derivatives trading opened up to competition would end up being toothless.
- The other side of the regulatory coin was that DB was set to benefit from additional clearing revenues, as regulators were forcing ‘over the counter’ (OTC) derivatives to be electronically traded and cleared from 2013.
- Trading volumes in that same derivatives business would continue to grow, albeit much slower than in the past. DB’s derivatives business had seen trading volume fall by 25% from peak levels post the GFC. Whilst the days of this being a 20% grower were over, we thought they could still grow at mid-to-high single digits from this low base going forward.
How the story has progressed
The regulatory side of the story has largely played out as expected. The European market regulator has indefinitely put on hold any prospect of forcing new competition in derivatives trading, and while new regulatory threats have emerged in the form of the European Financial Transactions Tax (FTT), the cost of this will likely be more than offset by revenue gains as OTC derivatives come onto exchange in 2013.
Where we have been wrong is the presumption of steady growth in derivatives trading volume. Post taking our position in early 2011, the story looked on track as trading volume in both DB’s equity index and interest rate futures continued to grow strongly in the second half of the year, finishing up 19% and 10% respectively on levels seen in 2010. However, 2012 has been a different story. Weak equity markets and a continuation of zero interest rate policies have seen DB’s equity index and interest rate futures down -15% and -23% respectively. Earnings for the company have fallen from €4.50 in 2011 to €3.70 in 2012.
Deutsche Börse is now trading at €46 versus our initial acquisition price in the €52-€55 range. Over our holding period we have received €5.40 in dividends, giving us a total return of -10%. A poor performer but not catastrophic.
So what do we do from here? Looking at the drivers of the business, from a cyclical point of view, volumes have bottomed in interest rate derivatives. Trading volumes in equity index futures and cash equities could fall further, but it is clear we are far closer to the bottom of the cycle than the top. Deutsche Börse offers an 8% earnings yield, with a management team that is returning the full 8% yield to investors (we receive 5% via dividend and 3% via share buybacks). Given the current 8% earnings yield is based on what are fairly depressed earnings, there is enough upside to continue to hold
The case is progressing as planned but it would have been nice to get the timing perfect!
When we evaluated Lloyds in June 2011, the market was primarily concerned that the bank:
- Would be required to raise additional capital.
- Had a high reliance on wholesale funding (Lloyds had a loan to deposit ratio of 160%), which would pressure profits as the cost of wholesale borrowing was going up.
On these issues we were less concerned. In respect to the need to raise capital, we concentrated on the fact that the company had already written off £70 billion of its loan book, and was making pre-provision profits of £12 billion. This meant that Lloyds had likely already seen the worst of the credit costs from borrowers defaulting on their loans, and had the ability to generate a lot of new capital each year through its profit base.
We agreed that the higher cost of wholesale funding would squeeze profits. But there were a number of reasons why the outcome might be better than feared, namely:
- The UK banking market had consolidated massively post the GFC, and we were now the largest player with 30% market share. In addition our competitors had a heavy reliance on wholesale funding as well. All of this meant it was more likely that some of the increased cost would be passed onto customers.
- Lloyds was aggressively shrinking its ‘non-core’ loan book (a collection of overseas and local large scale commercial loans). As this shrunk so to would the banks need for outside wholesale funding.
- With a combined workforce of 110,000 post their merger with HBOS, Lloyds had a lot of scope for cost cutting now that they were shrinking the size of the bank. Lloyds new CEO Antonio Horta-Osorio had performed similar cost cuts at competitor Santander UK, as was going to do the same thing for Lloyds.
How the story has progressed
From an operational standpoint Lloyds has done well, and management has done exactly what it said it would do. From 2010 to today, our deposit base has grown from £394 billion to £423 billion, whilst our non-core loans have fallen from £195 billion to £118 billion, with our loan to deposit ratio now at 120%, down from 160%.
The higher cost of wholesale funding has hit profits, with our net interest margin (the difference between the interest the bank earns from its loans, and has to pay for its funds or deposits) falling from 2.21% to 1.93%. This has been somewhat offset by lower costs, with our operating expense falling from £13.1 billion to £10.1 billion. The bank has continued to build capital via its own profits, and did not need to raise extra funds through a share issue as feared.
This steady operational progress was masked by some truly incredible swings in Lloyds share price, and the last 18 months has been a great lesson on the irrationality of the share market when it is panicked by fear.
We started building our stake in Lloyds in late June 2011 at a price of 44 pence. At that point the stock had recently fallen 37% from its previous trading range of 70 pence and offered a valuation of 0.7x book and a 6x earnings multiple of what it could earn a few years out – good value we thought. However, shortly after, the share price of Lloyds went on a wild roller-coaster ride, with the price eventually bottoming five months later at 22 pence, a further 50% fall!
The main reason for this collapse was simply the panic over the European sovereign crisis which peaked in November 2011. Whilst the stock prices of the whole European banking market saw heavy falls, puzzlingly despite almost no direct Euro-zone exposure, Lloyds was one of the worst performers. At the bottom, Lloyds was valued at 0.3x book and 3x P/E, even the Spanish banks never got that cheap!
We continued to add to our position as the stock kept falling and at a current price of 50 pence, Lloyds has been one of the best performing stocks for the Fund in 2012.
Amadeus – It Has Been A Smooth Flight.
When we made our initial investment in Amadeus it was a classic example of a stock that was not really on investor’s radar screens. Our investment case was very simple. Amadeus was an extremely high quality business that offered predictable sales and profit growth but was priced like a no-hoper on 11x earnings.
The driver of the growth was two-fold. Firstly, Amadeus’s air ticket Global Distribution System (GDS) business by virtue of its leading position in every market outside of the US would continue to tick along at a 5% growth rate driven by growing demand for air travel in Asia, Latin America and the Middle East. Its second business, the Altea software suite, was going through a huge growth phase. Altea allows airlines to outsource their critical IT functions around ticketing, inventory control and departure management to Amadeus. Demand for IT system outsourcing was booming, driven by the IT complexity of air-travel and Amadeus had already signed up 110 of the world’s leading airlines to shift to its system.
How the story has progressed
So far the revenue and profit growth at Amadeus’s two businesses have been very much to plan. As advertised, the GDS business is growing at 6%, fuelled by the growth in air-travel bookings in the emerging markets. The Altea airline software business has been very strong; revenue and profits are growing at 15% as the new airlines progressively migrate onto its system. Cathy Pacific, Scandinavian, and Singapore Air have made the shift to Altea in 2012, and the company has signed up another 12 airlines to take the Altea software, taking the total number of airlines contracted up to 122.
The significant new news is the inroads Amadeus is making expanding its business in the US. The US remains the largest single travel market in the world, but for historical reasons Amadeus has had little business in the US, with the market being dominated by Sabre and Travelport. But there are signs this is changing, with a number of recent milestones:
- Southwest Airlines, the largest US domestic carrier signed up to use the Altea software for its international flight bookings, with the expectation that in time Southwest will also shift its US flights onto Altea. This is a major prize, as despite providing IT for global giants like British Airways and Qantas, Amadeus had yet to sign up any of the major US carriers.
- Expedia, the largest US online travel agent, have agreed to use Amadeus to process its US air ticket bookings. Previously Expedia had used Sabre exclusively in the US.
- Kayak, the world largest air travel search and price comparison website, announced that Amadeus will now provide the data feeds to power their website in the US. Amadeus is now Kayak’s main source for pricing and flight data on a global basis.
Overall the prospects for Amadeus continue to look promising. The stock has performed well, with the price up roughly 40% from our average entry point. Amadeus is now trading on a valuation of 14x earnings, still relatively modest compared to similar businesses in the service sector, and we are happy to hold as the company continues to grow.
 Think about the new system demands that have been introduced around code sharing with airline alliances, frequent flyer points and charging for ancillary services like checked bags when booking a ticket. These new requirements have stretched the capability of the airlines legacy mainframe systems.
DISCLAIMER: The above information is commentary only (i.e. our general thoughts). It is not intended to be, nor should it be construed as, investment advice. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. Before making any investment decision you need to consider (with your financial adviser) your particular investment needs, objectives and circumstances.