OTIS - thyssenkrupp: A Troubled Stock With An Exceptionally Low Graham Number

2023-05-01 21:30:39 ET

Summary

• thyssenkrupp AG is a German industrial and steel conglomerate which ranks highly among the world's largest steel producers.
• The company has a long and extensive history, with roots dating back to the early 1800s.
• Recently, the company's stock has become quite troubled as the coronavirus pandemic and the following escalation of the Russo-Ukrainian War took its toll on the German economy in 2022.
• To make matters worse, the departure of the CEO, Martina Merz, last week introduced more uncertainty and risk to investors.
• The stock has one of the lowest Graham numbers I have seen in recent memory, but I am putting the shares of thyssenkrupp in the "too hard" pile for now.

Investment Thesis

thyssenkrupp AG ( OTCPK:TKAMY ) is an extremely cheap, value stock with one of the lowest Graham numbers I have seen in recent memory. The company is well known, with roots dating back to the early 1800s, but in more recent years has run into various financial problems partly due to a failed steel merger, the coronavirus pandemic and the Russo-Ukrainian War. thyssenkrupp could be an interesting value investment opportunity for those looking to diversify more into cheap European stocks, but its 500+ subsidiaries make the conglomerate difficult to analyze. Still, the business centers around steel, which is a cyclical business and something which I admit is not my strong suit. For now, I am putting the shares of thyssenkrupp in the "too hard" pile, but would like to revisit the company at a later date once the current situation with management and the restructuring plan becomes clearer.

Introduction

I tend to like companies which have long histories of continued operations. Some of my favorites in this category are companies such as Otis Worldwide ( OTIS ), which has been in business since 1853. thyssenkrupp certainly is one of these rare businesses which has survived, in various forms, for over two hundred years (Krupp was founded in 1811). Similar in part to Otis, thyssenkrupp did have an elevator division, but was forced to sell the business in an effort to survive after experiencing broad financial hardship.

Despite the long history as a company, thyssenkrupp has become a troubled stock after over a decade of declining revenues, a failed steel merger, management issues, and major financial setbacks due to the coronavirus pandemic and the escalation of the Russo-Ukrainian War in 2022. It pains me to see such a prevalent company struggling during these times.

However, the company was seemingly on the up-and-up after Martina Merz became the CEO in 2019, bringing thyssenkrupp back nearly from the brink of collapse. It was through Merz's leadership during the coronavirus pandemic and in 2022 that a significant transformation occurred, and the company began improving in the midst of total devastation. Despite the stock's rebound from the bottom in late September 2022, the market still valued thyssenkrupp extremely cheap heading into the new year. With recent news just last week that the CEO is now leaving the company, the future of the turnaround plan is uncertain and the risks to the business could be substantial.

The all important question is; Could thyssenkrupp be a good investment now? The company currently trades at just 3.8x earnings and 0.3x book value, putting it firmly in the value category with an extremely low Graham number. Investors with a patient, value-oriented approach may find that thyssenkrupp is a good fit for their portfolios, especially if European stocks are the focus.

The Graham Number - Why thyssenkrupp Is Cheap

What do I mean by the "Graham Number," and what makes thyssenkrupp a compelling value stock? Some investors may attribute this term to a different number, but from my understanding and based on reading, the Graham number is basically the price-to-earnings ratio multiplied by the price-to-book ratio. In The Intelligent Investor , by Benjamin Graham, it is suggested that a "value" investor should not buy a stock with a Graham number over 22.5.

How did this number come to be the dividing line between a "value" stock and a "non-value" stock? It could be assumed that using an average price-to-earnings ratio of 15 and an average price-to-book ratio of 1.5, this brings us to the "average" Graham number of 22.5 as the cut-off point for determining a value stock.

However, just because a company may have a Graham number exceeding 22.5 does not mean that it is necessarily overpriced.

It may turn out that a given company has factors that set it apart from competition, or has high quality management, or is growing at an extremely fast rate with a long runway in front of it and deserves a high multiple.

Whatever the case may be, it is important to distinguish between value and non-value stocks, so one does not deceive oneself thinking they are buying value when they are not. Truth be told, a value investment is not just based on quantitative "cheap" numbers, it is simply paying less for a company than what it is ultimately worth in the long run. Growth stocks can also be value stocks, if you happen to pay a good price for them at an opportune moment.

When it comes to the curious case of thyssenkrupp, it is notable that the company has an extremely low Graham number of 1.14, but this depends on which year of earnings you use. We get this number by multiplying the P/E (3.8) by the P/B (0.3). Usually, what many market participants would consider "value" stocks have Graham numbers of 12, 15, or even 20. The lower the number, the deeper the value proposition tends to be, but it is also worth considering just why the number would be so staggeringly low.

Value stocks with Graham numbers of 5 or less are exceedingly rare. What would have to happen for a stock to trade with a Graham number below 2, or even below 1? To get a Graham number of 1 or below, the company would have to trade at 5x earnings and have a price-to-book value ratio of 0.2 or less. This is beyond what I would consider the "normal" range of a value stock, and could fall into the category of deep value, or perhaps even the dreaded "value trap." Companies that screen with such low multiples are best to be avoided entirely, and I do not think that investors should favor lower Graham numbers over higher ones simply because they are low.

In my opinion, the price-to-book value ratio makes the most difference in the calculations of the Graham number. The bigger the discount to book value, the more likely it is that the Graham number will be quite low, as is the case with thyssenkrupp.

Above all else, the quality of the business must be assessed and factored in when considering different value investments with low Graham numbers.

Do I think that thyssenkrupp is a particularly high quality business? Honestly, I do not think the stock would be trading at the multiples it currently is if it were, but I am not an expert on the steel industry. The business seems good, but the stock seems troubled. Do I think that the business is durable? Yes, as the company has survived in various forms for over two hundred years. However, thyssenkrupp probably used to be a better business than it currently is, but there have also been extreme and unforeseen events in the last few years (Covid-19, invasion of Ukraine) which have weighed on the company and its future prospects. Is the company going away anytime soon? I would hope not. The stock is very, very cheap, but there are good reasons that it trades at a Graham number of just above 1.

CEO Departure, Risks, Inflation

On April 24th, 2023, thyssenkrupp's CEO, Martina Merz, abruptly quit and caused the largest intraday drop for the stock price since August of 2020. Merz, having joined as the CEO in 2019, was supposedly turning the company around with a restructuring plan after a rough period, and instilled a lot of confidence in investors.

It was reported that Merz "only last year received a new contract to lead the submarines-to-car parts group until 2028, but lack of progress in plans to hive off the company's hydrogen and steel division led to growing criticism ." It seems as though the turnaround for thyssenkrupp has run into a brick wall, and the CEO departing after a few years on the job does not make me confident in the near-term prospects for the company. The future prospects for the conglomerate may be better than some are fearing, but the uncertainty at this point in time is at a high level.

Merz's plan involved making thyssenkrupp a less complex, smaller business, as it would divest or entirely shut down subsidiaries and establish a group of companies similar to a holding structure, in which the parent company would own stakes but would not control the individual businesses. This sounded like a great plan, but now that Martina Merz is leaving the company with no particular reason given, there are real questions as to when or if this plan will finish strong.

One thing I will note as a positive is that the company has returned to paying dividends, and pays a decent yield at 2.23%. This is an indication that Merz's turnaround plan was working and that the company is in better financial shape than in previous years. Still, with such a large number of subsidiaries, thyssenkrupp is a difficult company to analyze, and making the conglomerate less complex would perhaps invite more analysts to cover the stock. I would like to revisit the company at a later date, once the restructuring plan and issues with management become clearer.

Further risks for investors to consider are higher costs for the company, increased competition, and persistently high inflation in Europe. Steel is a cyclical business, so one must be aware of the cycles and also the current landscape for demand. Buying thyssenkrupp going into a recession does not seem like the right move, but coming out of a recession, the stock could perform well - especially if the Graham number moves up more into the "normal" value range and the market reprices the stock in future years. It all depends on one's time horizon. For me, the biggest risk in the near-term is that thyssenkrupp could face more headwinds from high inflation and lack of a trusted leader could discourage investors from believing on the follow-through in a great turnaround story.

Conclusion

My view on thyssenkrupp is rather neutral at this moment in time, but I would like to revisit the company at a later date once the status of the turnaround plan becomes clearer. Martina Merz's decision to leave the company comes as a shock to me and many other market participants, and introduces a great deal of uncertainty into the mix. The company has a long and extensive history, but has fallen out of favor with investors in recent years. The stock is troubled, and has an extremely low Graham number which could indicate that the shares and deeply undervalued. However, with over 500+ subsidiaries, thyssenkrupp is difficult to analyze and for this reason, I am putting it in the "too hard" pile for now. The risks of higher costs, increased competition, and high inflation combined with uncertainty about management make me wary. I currently view the shares of thyssenkrupp as a Hold, as the stock is cheap, but I would like to revisit the company at a later date in the hopes of giving it a Buy recommendation.

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