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Consilium: A Cash Shell With a Small Loss-Making Business Attached Is Trading at a Discount

GuruFocus.com

Investment thesis

Consilium AB (OSTO:CONS B) is a family-controlled company currently trading at a discount to its net current asset value. The company recently sold its major business area, Marine & Safety, which left it with a large pile of cash on the balance sheet.

The smaller business area, Safety Engineering, is the remaining operating business within Consilium, which has been struggling to reach profitability for the past couple of years. A smaller-than-expected special dividend disappointed shareholders, leading to an interesting entry point for investors with a belief in the capabilities of management to deploy the cash in an accretive manner.


When fire safety matters

Consilium is a Swedish company that went public in 1994 and has operations in eight countries worldwide with almost 93% of sales outside Sweden. The company provides fire safety products and services used to protect lives, material values and the environment.

The customers are companies in various niches of the energy market where safety requirements are high and the environments complex. The solutions protect objects with high protection values, for example, refineries, tank farms, oil drilling and production platforms, petrochemical factories and power plants. The solutions extinguish fires using water, foam and gas.

Sale of Marine & Safety business

On Dec. 20, 2019 Consilium entered into an agreement to sell the Marine & Safety business area to Nordic Capital, a leading private equity firm in Northern Europe, for a purchase price of 3.0 billion Swiss krona ($346.4 million) on a debt-free basis. The transaction was approved by Consilium's shareholders on Jan. 27. The transaction also required formal approval by regulatory authorities, which were granted in March 2020.

The transaction was completed on March 31, and a preliminary payment of 2.6 billion krona was received. The sale results in a preliminary capital gain of 1.53 billion krona. The final settlement was expected to take place in June. The rights to the name "Consilium" are attached to the business area Marine & Safety. This means that the remaining business will change its name in 2020.

Marine & Safety had before the sale been a part of Consilium since 1985. The motivation for the sale of the company was that continued expansion of the business unit would require substantial capital resources, which were not available to the company. With the sale of the business area, the remaining business has greatly improved access to financial resources as well as management resources. Remaining operations are expected to develop positively in the coming years with the experience built up within Consilium, and with a very strong financial base. Group-wide costs for management will be adapted to the new group structure, which implies cost-savings.

The remaining business

Looking at the performance of the Safety Engineering segment over the past decade, it is obvious that the business has been struggling recently:

Safety Engineering - 10 year revenue and operating profit
Safety Engineering - 10 year revenue and operating profit

Safety Engineering generated about 280 million krona in revenue during 2019. Ebit excluding discontinued operations and impairments was 6.5 million krona. Ebit including these items was -225 million krona. The operations in the Middle East and India have experienced a major restructuring. The balance sheet looks clean going forward, with only 17 million krona in remaining goodwill. Hopefully, this means that no more impairments will be necessary.

Construction contracts generated 93% of revenue in 2019, with the remaining 7% being generated through after-market sales. The largest geographical market is the Middle East, which generated 46% of total revenue in 2019 followed by India at 30%. The total number of employees is around 180.

The development project Optronics has not yet generated any revenue. Optronics develops optical gas detectors for various industrial applications, primarily for the oil and gas market, the marine market and the mining industry. The first product is expected to be ready for launch in the second half of 2020. According to management, the product is considered to have great market potential. This is an interesting business, but it is difficult to ascribe value to it currently.

To summarize, there is limited visibility as to future profitability prospects for the remaining business. The company is a small player in a big market.

Capital allocation after the sale

About 150 million krona of cash and cash equivalents has been used for amortization of interest-bearing liabilities during April and May 2020. A dividend of 17 krona per share was paid on June 3, which amounts to 198.9 million krona in total.

The company has initiated structured asset management of the remaining cash received from the sale of the Marine & Safety business area. The intent is to generate a long-term return on the company's capital that ensures future financing of both organic and acquisition-based growth. The aim is to develop a new industrial group around concepts for security systems and security products. The asset management will be executed in close collaboration with a number of major reputable asset managers and the investments include both bonds and stocks. Approximately 900 million krona has been invested in bonds and interest-bearing instruments.

Valuation indicates upside potential

Since the cash balance is substantially larger than the value of the operating business, a balance sheet-based valuation approach is reasonable.

When valuing the company based on the balance sheet, it is important to consider the hybrid bond loan, which is classified as equity. The reason for this classification is that the hybrid bond loan has a perpetual maturity. The hybrid bond loan amounts to 200 million krona, with three months STIBOR, currently at about 0.03%, plus 6% until November 2021.

The hybrid bond loan can be repaid on Nov. 1, 2021 at the earliest. Since this is a rather expensive financing option considering the available cash on the balance sheet, management should consider repaying the hybrid bond loan at the earliest date possible. When valuing the company, it is more conservative to reclassify the hybrid bond loan as a non-current liability.

When adjusting the balance sheet from March 31 for the amortization of interest-bearing liabilities, the special dividend and the hybrid bond loan, the net current asset value per share is 104 krona. In comparison with the current stock price of 80 krona, the shares trade at a discount of 23%.

Shareholder structure and management incentives

There are two share classes, but only the class B shares are publicly traded. The class A shares have 10 times the voting power of the class B shares. Both share classes carry the same right to a share in the company's assets and profits.

Platanen Holding AB controls 53% of the capital and 72% of the votes. This is a holding company run by Carl Rosenblad, the previous chairman of the board who retired at the end of May. His son, Carl Adam Rosenblad, is now CEO.

MCT Brattberg is the second-largest shareholder, controlling 19% of the capital and 11% of the votes. The company first appeared on the list of major shareholders in 2006. The company operates in the same industry as Consilium.

Rosenblad also runs Platanen AB, from which Consilium buys management services. Platanen provides administration and accounting services to Consilium as well. The company also operates through Fastighetsbolaget Henriksborg HB, which is a real estate company renting property to Consilium. According to the annual report, management services and rent from related parties are paid on market terms. This is difficult for an outside investor to assess. The following table summarizes the purchase of goods and services from related parties for the last 10 years (Swedish krona in millions):

2010

2011

2012

2013

2014

2015

2016

2017

2018

2019

Platanen AB (management services)

3.5

3.5

3.5

3.8

3.8

3.8

3.8

3.8

3.8

3.8

Platanen AB (administrative services)

0.3

0.3

0.3

0.4

0.4

0.4

0.4

0.5

0.5

0.5

Fastighetsbolag Henriksborg HB (rent)

5.4

3.9

3.7

2.6

2.6

2.6

2.6

3.0

3.0

0.7

Sum

9.2

7.7

7.5

6.8

6.8

6.8

6.8

7.3

7.3

5.0



Related-party transactions are important to watch since they can indicate that value is taken out of the company to the disadvantage of minority shareholders. In Sweden, in comparison to the U.S., the chairman of the board is generally much less involved in the day-to-day activities of the business. Compensation paid to the chairman is thus typically lower in Sweden as compared to the U.S. The direct compensation of the chairman has been in the range of 150,000 to 175,000 krona per year over the last 10 years. Since Rosenblad has taken a more active role than what typically is the case, it is reasonable that he has been additionally compensated through the payments to Platanen.

Executive pay seems reasonable, with a yearly salary of about 2.6 million krona for the CEO for the past two years. No bonus payments were done. To reward the key people involved in the sale of Marine & Safety, the AGM approved a maximum one-off bonus payment of 10.7 million krona. It is not unusual to reward key people when executing a major deal like this. When the deal was announced, the market cap of Consilium increased by 890 million krona overnight. A key-person bonus of 1.2% of this amount seems fair.

Management has demonstrated that it is capable of developing businesses and creating growth. Marine & Safety grew revenue by eight times over the last 20 years, from 200 million krona in 2000 to 1.6 billion krona in 2019. Shareholders benefited from the sale of Marine & Safety at a price substantially above what the stock market valued the company at.

A family-controlled company is a double-edged sword. There is no possibility for an activist investor to gain much influence on how the company is run. On the other hand, the Rosenblad family will most likely do its best to keep the company in business in order for it to eventually be handed over to the next generation. The family can also afford to take a long-term view of the business, which is more difficult in a company without a long-term majority shareholder. The market didn't appreciate the value of Marine & Safety correctly ahead of the deal. A similar future scenario could lead to the stock staying undervalued for a long time.

Risk factors

With a lot of cash on hand, it may be tempting for management to start acquiring other businesses. Performing larger acquisitions carries significant risks of overpaying or buying businesses that can't be easily integrated with the existing business.

In the short term, the company's continuing operations will be affected by the Covid-19 pandemic. Management has adapted the business to the current situation, with layoffs, work from home, etc. The large amount of cash held provides a strong foundation for the company to ride out the storm, even though in the short term, the business will likely experience a downturn.

As for the Safety Engineering business, the customers' willingness to invest is affected to a relatively large extent by the price development of oil and gas. Oil and gas prices dropped significantly during the spring, which may negatively affect sales of safety systems to the oil and gas industry going forward. There is also an increased risk of suffering losses due to customers struggling to pay or going out of business.

Status quo is a risk in itself when the remaining business is loss-making. If the company doesn't manage to deploy cash in a value-creating manner, there is a risk that the remaining business continues to lose money and burn cash.

Potential return drivers

The financial position of the company is very strong, which opens up for acquisitions at potentially depressed price levels. If these are successfully integrated into the existing business, this could drive growth and profitability going forward.

Oil and gas prices have rebounded from the lows seen during the spring, but are still far below previous all-time highs. If prices continue to rise, the customers of Consilium are likely to invest more and expand.

The company is trading below net current asset value. When buying a stock at such a depressed valuation, the odds of good returns simply due to revaluation are good.

Conclusion

Consilium is a family-controlled company with a long history. Even though Covid-19 and low oil and gas prices cloud the near-term outlook, the low valuation is attractive. The stock trades at the lowest price since the sale of its Marine & Safety business was announced. The current valuation is attractive enough to warrant an investment.

Disclosure: The author is long Consilium.

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This article first appeared on GuruFocus.