Funkwerk AG | Stock Analysis: Debt-free highly cash-generative german Market Leader within its Niche with a huge Growth Runway

9 Feb 2021

Dear Reader,

today I would like to introduce a special company. The company will not appeal to everyone at first glance, but it is absolutely newsworthy.

Funkwerk AG is a Capital Compounder worth reporting despite the low ‘capital market compatibility’

  • The German Funkwerk AG operates in the three business areas of train radio, passenger information, and video systems
  • In the train radio segment, which is a niche market, the company is the global market leader
  • Although all three segments show growth prospects as a result of technological progress and digitalisation in the railway sector, train radio is particularly exciting. Due to the conversion of train radio from GSM-R, which is still based on the almost medieval-looking 2G technology, to the new FRMCS standard, which will probably be based on 4G or 5G, Funkwerk is likely to benefit for years to come through retrofitting and upgrading the trains, as this development is still in its infancy. Besides, the rail network in Europe is being converted to ETCS, which also requires the trains to be modified. Funkwerk should be able to profit from these medium-term to long-term developments as a partial supplier in the next few years.
  • At the same time, the company has been earning a ‘pile of money’ since the successful turnaround, which cannot be hidden in the balance sheet and cash flow statement. In the P&L, however, the management constantly attempts to present the company as poorly as possible, and despite this, an EBIT margin of over 17 % has already been achieved in 2019.
  • The market capitalisation of €178m is offset by a cash position of probably over €40m  – almost a quarter of the market capitalisation, valuing the company at an EV/EBITDA(2021e) of just 7.3.

I would like to point out right at the beginning of this research report that the company has a low ‘capital market compatibility’. The company is listed on the OTC-Market of the Munich Stock Exchange, no quarterly reports are published, the company prepares its accounts according to the German accounting standards of the German Commercial Code and not according to IFRS, the financial statements are only published in German and the shares are not very liquid due to a low free float of only 22 % and as a result are not very easy for institutional investors to invest in.

But therein also lies an opportunity!

Long-term opportunity

All these aspects sound outdated and boring against the background of today’s fast-moving capital markets (think of GameStop). Since the company is only known to connoisseurs despite its outstanding operational development, it offers the opportunity to buy into the company at what I consider favourable prices.

The company valuation with my three scenarios forms the basis of this extremely asymmetrical investment case. With a growth rate of 0% (!), an EBIT margin of less than 15%, and, in a historical context, significantly higher Capex, a fair value of €21.30 per share is calculated, which is 3.2% below the current share price. The stock market is currently pricing the company as if it would not continue to grow. But this is anything but realistic. Depending on the growth assumption, the company’s value rises to over €35 with 10% growth (upside 62%) or almost €53 with 20% growth (upside 140%). As always, the truth will lie somewhere in between.

The disadvantages of the company outlined above, which may also be the intention of the major shareholder, in combination with the low familiarity as the company are mostly known by connoisseurs and by the reason of its ‘boring’ products (indeed, train radio is not sexy but it makes a lot of money), slow down the share price development. With a bit of luck, something happens on the shareholder structure so that this would act as a catalyst on the share price. If luck fails to materialise, this investment simply requires a bit of time. Because in the long run, the share price development correlates with the operational development.

Until then, I’ll just sit back (and hope that an activist investor, such as AOC (Active Ownership), will come around the corner and make some noise)!

Management summary of Funkwerk AG investment case

Funkwerk is a German company and operates in three business areas: train radio, passenger information, and video systems.

In the niche segment of train radio, which accounts for around 54 % of sales, the company is the world market leader in the development, manufacturing, supply, and implementation of GSM-R cab radios, which are necessary for communication in trains. European railways also need to keep pace with increasing demands and passenger volumes as well as digitalisation. Therefore ERTMS – a system for the management and control of rail traffic on the lines of the Trans-European Networks – is currently being developed. ERTMS in turn consists of the GSM-R standard and ETCS.

GSM-R to be replaced

The GSM-R standard is the current digital mobile radio system, which builds on the widely used GSM mobile radio standard, but has been extended for use on the railways. GSM, in turn, was introduced as early as 1990 and is also known as 2G. In times of 5G, this is an almost medieval technology. In this respect, it is not surprising that the entire train radio will be converted to a newer standard in the next few years. Presumably, it will be 5G. However, the changeover from 2G to 5G will still take several years, as not all details have been clarified yet. However, it is a fact that the hardware components installed in the trains will have to be upgraded or retrofitted. This should benefit Funkwerk as the market leader.

Upgrading to ETCS

Besides, there is the retrofitting and upgrading through ETCS. ETCS is the new ‘European Train Control System’ that is to replace the national train control systems. As a result, trains can travel easily across national borders. ETCS also replaces the mobile block sections, in which only one train is allowed to run at a time due to the long braking distances. As a result, the capacity on the rails can be noticeably increased, which will have a positive side effect on the overloaded rail networks. To achieve this, however, the rails, signal boxes, and railway switches must be digitised on the one hand, and the trains must also be made ETCS-capable on the other. Funkwerk is a subsystem supplier for this and should therefore also benefit from this lighthouse project.

Other segments Funkwerk operatines in

In the area of passenger information, Funkwerk supplies stationary visual and acoustic passenger information systems such as display boards or public address systems. In the field of video systems, the company supplies complex video surveillance systems including the corresponding evaluation and analysis software.

The company expects future growth potential from digitalisation in all segments.

Turnaround and takeover bid

After the company almost slipped into insolvency a few years ago, Ms. Schreiber (sole executive board member) restructured the company to make it fit for the future. After the restructuring was completed, the major shareholder Hörmann, which held around 52 % of the shares at the time, made a takeover offer at € 2.55 in 2014, which corresponded to a premium of around 10 %. Not surprisingly, only about 17 % of the outstanding shares could be collected. Further purchases on the capital market have since brought Hörmann’s shareholding to around 78 %.

The shareholder group may be responsible for the slowed-down share price development despite gaining +1,100 % during the last 6 years. Operationally, Funkwerk has developed very well since 2014, especially in terms of earnings, with a significant increase in the EBIT margin from 5.4% (2015) to 17.1% (2019).

At the same time, Ms. Schreiber is trying to make Funkwerk look as poor as possible. By allocating provisions, which according to Ms. Schreiber will have to be released at some point in the future, and as a result, there will be a cash outflow, it was possible to depress the result somewhat. Without these measures, the margins would have been noticeably higher. But the balance sheet and the cash flow statement are not so good at disguising true profitability. The company is debt-free, while the assets side shows €40m cash by 30.06.2020 – this corresponds to about 22.4 % of the market capitalisation. That values the operating business at an enterprise value (EV) of about €140m. As of today, I expect an EBITDA of €19.3m for the current year, so that the company is currently valued with an EV/EBITDA of 7.3.

Let’s get back to the balance sheet again: If the provisions are considered as equity, the equity ratio would be 85%. It is always argued that there will be a release at some point. And in fact, the company also releases provisions every year, but through other operating income, which means that the provisions from previous years were set too high. At the same time, however, a higher amount is added again, so that the provisions increase every year. The annual revenue and profit forecast is also VERY conservative and has been exceeded by more than 50 % on average in recent years.

Of course, Hörmann did not have a crystal ball in 2014 to predict the future when they made the takeover offer for € 2.55. But I would argue that Hörmann would have fared much better if they had paid a premium of 50% at the time and taken over Funkwerk completely. Today, unfortunately, it is not known what Hörmann still intends to do with its 78 % stake in Funkwerk (which may be the most valuable asset in the Hörmann Group); this uncertainty will certainly not cause leaps of joy on the capital market as long as the motive remains unclear.

It is not entirely unlikely that Hörmann is (deliberately) putting the brakes on the capital market orientation, although the reason for this is not clear to me. Let me give you a few examples:

  • Funkwerk does not prepare its accounts according to IFRS but according to the German accounting standards HGB and exercises discretionary decisions in such a way that the result is reported as low as possible. The guidance is communicated too low every single year.
  • The company is only listed in the OTC-market of m:access mid-market segment of the Munich Stock Exchange. Unfortunately, there is no XETRA or Frankfurt listing.
  • As a result, the company reports only once every six months (i.e. no quarterly reports) and only in German.
  • There is only one participation in a small capital market conference each year (MKK in Munich).
  • The financial calendar is usually updated very slowly, or only when I write to the company and ask for an update.
  • Due to its low free float, the share is illiquid and practically uninvestable for institutional investors.

Of course, all this goes down extremely well with investors [irony off].

I assume that the company is worth significantly more than what you have to pay for it on the stock market today. With a bit of luck, Hörmann could provide a catalyst that drives the share price more quickly toward its fair value. If luck fails to materialise, Funkwerk will simply require patience (who still has that on the stock market today?), because in the long term there is a high correlation between operating performance and the share price.

Author’s ownership disclosure: At the time of publishing this research report I hold shares in Funkwerk AG

P.S.: On 3 December 2020, I published a research report on IVU Traffic Technologies AG. The company also operates in the public transport sector. If you missed this research report, just click here.

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