Metro AG’s proposed demerger should unlock significant value

·         Metro AG, the large German conglomerate, last week announced its intention to demerge its wholesale foods division (Metro) and its consumer electronics division (Media Saturn); the demerger is scheduled to complete by mid-2017.

·         The demerger makes perfect operational sense – both divisions have very little overlaps and hardly any synergies; a demerger should bring more focus and better execution in a highly competitive sector.

·         The demerger also makes sense for the shareholders – the current conglomerate is a hotchpotch of businesses trading at a discount to peers. The demerger, by creating two distinct pure-play sector leaders, should unlock significant value by removing the conglomerate discount inherent in price.

·         In my opinion the demerger should unlock significant value for the shareholders generating between 50% - 60% return in the next 12-15 months with little downside.

After significant fall in sales between 2012 and 2014, the group has managed to arrest the decline, with like-for-like sales recording a 1.5% growth in FY14/15. Media Saturn, is growing at just over 3%, with the whole sale foods division (Metro) growing at a negligible 0.1%. EBITDA margins have been consistent at around 4% for Metro and 3% for Media Saturn. Management have been upbeat and have shown confidence that the sales decline has been arrested and the positive trend in like-for-like sales should continue.

Consensus forecasts from the 35 analysts covering Metro indicate a conservative forecast with median FY16/17 sales for Metro showing negligible change and Metro Saturn sales showing a 3% growth. The conservative forecast is understandable given the shock analysts would have received when sales fell by 30% in 2013, and as is usual, it will likely take a while before they start correcting for the like-for-like trend. For my valuation purposes, I have used the conservative forecasts. 

Structure post demerger

The demerger is to be implemented by way of a spin-off of Metro, the whole sale food division, from Metro AG. Post the demerger, Metro AG will be left with the consumer electronics division, Media Saturn.

 Source: Metro AG

The demerger should create two distinct pure-play sector leaders – with Metro and Media Saturn. 

Below are select wholesale & foodservice sector players by sales. 

Below are select consumer electronics sector players by sales.

Source: Metro AG

Not only will Metro and Media Saturn offer pure-play in their respective sectors, they will also be sector leaders becoming the second largest players globally in whole sale foodservices and consumer electronics sector.

Valuation

Metro AG currently trades at just under 6 time enterprise value (EV) to earnings before interest, tax, depreciation and amortisation (EBITDA).

Metro trades a multiple which is significantly below its peers. A look at the multiples for the sector peers shows that the whole sale food services peers trade at a EV/EBITDA multiple of~12 and consumer electronics peers trade at a EV/EBITDA multiple of ~8.

A crude valuation for Metro which assumes that the demerged businesses will trade at EV/EBITDA multiple comparable to peers would should a share price for the combined divisions of €73, generating a 174% (2.74x) between now and post the demerger. See below.  

However, such a crude valuation would completely miss the point. Multiples cannot be compared in isolation of individual business fundamentals and key variables such as growth rate, return on invested capital (ROCE), cost of capital, and tax rate need to be factored in. Peers are a good starting point, but there are valid reasons why peers don’t always trade at the same multiples. Take the example of Sysco, the largest player in the wholesale foods services sector. It trades at EV/EBITDA multiple of over 12, and its business is fairly similar to Metro. But there are valid reasons why Metro shouldn’t trade at the same multiple as Sysco – Sysco has a higher growth rate, higher ROCE, and lower cost of capital compared to Metro. If enterprise value is a function of free cash flow discounted at cost of capital, then multiple should be consistent with this. In short, multiple should be a function of the following formula:

Using the above, we can see the difference between Sysco’s multiple and Metro’s multiple.

Using this methodology, I have calculate a multiple for Metro AG’s wholesale food services division of ~7.9 and for the consumer electronics division of ~8.1.

It is worth noting that the multiple for Media Saturn is similar to Darty, a peer with very similar characteristics as Media Saturn (i.e., both trade in similar markets and have a similar profile).

Using the above derived multiples to value the separate divisions gives a value per share of €43.2, a return of 62% based on current share price. 

Below, I have modeled share price and returns sensitivity to multiples.

As can be seen, there is very little downside, and significant upside. Metro AG already trades at a very low multiple, and with the improving trend in sales and the proposed demerger, upside is more likely than downside.

Risks

As with every thesis, there are risks involved. I have briefly discussed the key risks below.

Governance - Erich Kellerhals, the founder of Media Saturn who still owns 22 per cent of Media-Saturn, has had several run-ins with Metro in recent years. The main reason for the demerger to be structured by way of a spin-off of the wholesale foodservices business is to isolate that business from the legacy structure with Media Saturn in it. However, there is a risk that the Media Saturn business may continue to face problems with Erich Kellerhals. This was raised in Metro’s call with analysts last week when the demerger was announced. Metro’s management strongly believe that the new structure will not give rise to any governance issues (apparently Erich Kellerhals’ stake will be restricted to the subsidiary of Metro AG, and Metro AG will have full flexibility in running the Media Saturn business – e.g. make new acquisition, expansion etc. – without any hindrance. Management went on to state that in spite of media reports re issues with Eirch Kellarhals, the Media Saturn business has performed very well in recent years and management have full flexibility to run the operations. It is worth noting that a spokesman for Mr Kellerhals’ investment vehicle, Convergenta Invest, has said they did not see any issues with the proposed demerger. Even assuming that the market discounts 10% of value for this governance risk, I get a share price of €38.9 or a 46% return.

Tax, legal, commercial, and execution risks – Management have confirmed that they have undertaken detailed preliminary analysis of the key risks and no red flags or showstoppers were identified. In particular, indications are that the demerger should not be a taxable transaction.

Assignment of assets and liabilities between the divisions – Management have not yet made it clear as to how the assets and liabilities will be split between the two divisions. In particular the split of debt. This will be made clear as they work out the details – most likely in Q2 earnings call. That said, my valuation estimates should not materially be impacted by the chosen split.

Conclusion

Metro AG’s proposed demerger of the two divisions which have limited synergies is a great move and should be able to achieve management’s stated objective of creating two distinct pure-play sector leaders in the wholesale foodservices sector and consumer electronics sector. The move should also reward shareholders by unwinding the conglomerate discount.