Wilhelm Hertzog: Steinhoff shares a “coin toss” – bonds, prefs much better bet

On this week's Rational Radio show, Wilhelm Hertzog gave us his impressions of the long awaited Steinhoff Investor Presentation which he attended yesterday. In this insightful contribution, the co-founder of money manager Rozendal Partners also explains why those paying anything for Steinhoff's JSE-listed shares – even at 124c – are engaging in a gamble that's akin to a "coin toss". Those wanting a bet on an eventual recovery should rather investigate the company's bonds or even its preference shares. – Alec Hogg.Wilhelm Hertzog on the line with us now, Wilhelm, when did you start your own business?.___STEADY_PAYWALL___.About two years ago. Prior to that I spent ten years with Piet Viljoen and Jan van Niekerk at RECM. They were good years filled with great experiences and I learnt a lot. But after ten years I thought it was time to move on. So myself and two partners set up Rozendal Partners in early 2017 and that's where I am today, as a portfolio manager and analyst..Yesterday you went along to the Steinhoff Investor Presentation. The first since the bombshell hit in 2017. Are you a Steinhoff shareholder?.No, we're not Steinhoff shareholders and nor are our clients. Our clients own bonds of Steinhoff, two different Euro denominated bonds and the Rand denominated preference shares. We own various instruments in the greater Steinhoff capital structure but we don't own any ordinary equity..Just explain why you would go for bonds rather than ordinary shares?.Given the state of affairs in the group, the profitability and the way the businesses are operating, there's just too much uncertainty and risk attached to the ordinary shares. Bondholders obviously have a preferential claim on any cash flows the company generates, and the South African preference shares are quite secure in terms of the assets which service the South African preference shares, which eventually flow through preference share as dividends and to shareholders. There are different rights and obligations attached to each of these instruments and in our analysis and assessment of the situation, the Euro denominated bonds are a safer investment proposition. There is so much uncertainty attached to the equity, that to our mind it's a coin toss whether there's any value in the ordinary shares or not. That is not a risk reward profile we were comfortable with..But those bonds, are they actually receiving interest?.No. Interest has been accruing since the lockup agreement was signed in mid 2018, but interest hasn't been paid. Yesterday Steinhoff announced that the CVA process has concluded and the restructuring agreements have now become effective. So those Euro denominated bonds have now been converted into new low notes which are also PIK notes, "Payment In Kind". They do accrue interest but the interest doesn't get paid out in cash. When these bonds mature the bond holder will receive an amount greater than the face value of the bonds, which amounts to the value of the bond plus accrued interest. But you don't actually receive any interest while the bonds are outstanding for the next two and a half years..So I presume you get them at it at a pretty good discount..Correct, yes..So specifically the 2023 convertible bonds issued by Steinhoff Finance Holdings, which is a European entity in the Steinhoff structure. Those bonds were trading at a very deep discount to their face value and have been ever since the events of December 2017. That reflects the fact that those bonds specifically also sit in a vehicle in the Steinhoff structure where it has almost a second-to-last claim to any cash flows that the businesses generate. They rank just ahead of equity in the greater capital structure. The other tranche of bonds issued by Steinoff Europe AG have a better position in the capital structure, so they almost sit on top of Pepkor in Europe, and also Conforama, which are valuable assets and generate good cash and earnings. The Steinhoff Euro bonds have always been trading at a higher price relative to their face value, than for instance the Steinhoff Finance Holdings convertible bonds, and that just reflects the different places in the entire capital structure where those bonds are sitting and their preferential claims to cash flows or otherwise..That's interesting. Thanks for unpacking all of that for us. I think clearly that's where the smart money would be going, but there were a lot of smart people there yesterday presumably at the presentation, more than 300 people who went in through the webcast, so what did you make of proceedings?.I think the proceedings were a succinct summary of events and helpful in terms of getting an overview of where the company is. There were some interesting comments made about the future direction the group will be taking under the current board and management team. There was very little "value" relevant information that was disclosed, such as the trading performance of the underlying companies. It was a nice overview but not much relevant information was disclosed..There was a question about whether Markus Jooste would be going to jail..Yes, there was a great deal of public interest in that affair, but of little relevance from an investor's point of view in Steinhoff Capital structure instruments..When is the next time you're going to hear from these guys, presumably at the annual general meeting. What would you expect them to tell you then?.The AGM will be the next time there will be public interaction from the company's side with investors and shareholders. I would expect for more aggressive questions being put to management, as it is typically the AGM forum where disgruntled shareholders air their grievances. That was certainly the experience at the 2018 AGM. It was a far more aggressive and almost antagonistic forum than what was experienced at yesterday's investor presentation. I expect management to be under more pressure at the AGM than yesterday's presentation. I don't think new value relevant information will be disclosed around the ongoing litigation as the company can't say much at this stage..Having a look at the people they've brought onto the board and even the chief executive himself, it looks like it's lawyers running the place now..Yes and that is what is required at this stage. The big uncertainty hanging over the whole group is the quantum of any damages that will be awarded by a court in these various court actions that are ongoing. So priority number one for shareholders and bondholders is to ensure that all value in the group does not go to claimants in this litigation and that there is value left on the table for bondholders firstly, but then also for ordinary shareholders potentially. So it's very much top of mind and they need to throw all resources at ensuring that the best possible outcome is negotiated in these litigation cases..So in essence what you've got here is a is a bunch of assets, some of them very valuable, which have been acquired through funding that was raised on inaccurate financial information and now those who provided the funding are starting to fight, saying they want that money back. Depending on how much money they settle for, there might be money left in the pot for people who own Steinhoff, or there might not be..Correct and one has to take a view on the outcome of this litigation if one wants to get a view on the value of the bonds or shares. We've done our own research and liaised with various legal experts on the matter and there is some legal precedent in Europe as to the quantum of damages awarded in such claims. Based on that, we have taken a view but there is a great deal of uncertainty attached to what the eventual quantum will be and also over what time period Steinhoff will have to settle these claims. There is a big difference between having to settle hundreds of millions of Euros on a specific day or whether they are given a number of years to settle these claims. So all those kinds of factors will influence either way how much value accrues to existing Steinhoff bondholders and shareholders..I guess the good news is that you've got two guys who were and are intimately involved with the litigation against Lehman Brothers. So they certainly have been playing in the Premier League..Correct. The legal advisers that were pulled in to advise creditors, they are the premier league of global restructuring law firms and hence the massive legal fees one sees floating through Steinhoff accounts for the past 18 months but they certainly pulled in the top names in the world..Just to give us an understanding, to buy Steinhoff bonds or prefs today, in other words to go a little higher on the capital structure than the ordinary shares that are traded on the JSE. What kind of a discount would you get to the supposed underlying value?.The last traded price of the Steinhoff preference shares on the JSE before they were suspended was R44 versus R100 face value. It is a bit tricky to buy those these days because they're not publicly traded anymore. Regarding the bonds, they are now converted to these new PIK notes, which have not started trading yet so there's no proper price set for them. The more senior bonds, the Euro bonds were trading at 70 to 75 cents in the Euro or 70-75% of face value and the more junior 2023 convertible bonds were trading in the order of 45-50cs of face value, so deep discounts to face value and to what they supposedly were worth when they were issued..If you're getting bonds which are so much higher up in the food chain at 40 percent, what are the ordinary shares actually worth?.If Steinhoff had to close down today and sell off the assets and settle the bonds and creditors, I think there's little prospect of shareholders recovering much. In my estimation it would be close to zero. The shares are trading at a positive value because it is effectively optionality on a recovery. So if something happens along the lines of Steinhoff selling Pepkor in Europe for an exorbitant price or Conforama turning around its trading performance and generating high levels of EBITDA, or something similar happening to Pepkor Holdings in South Africa, then there is an off chance of the ordinary shares having value but that is pure optionality value. Steinhoff today in simple terms, the group has about €10bn of debt, carrying interest at roughly 10%, so they need to service interest albeit non-cash interest, but its interest nonetheless of about a billion Euros per year. Most recently they reported generating EBITDA in the order of €440m for a six month period. If you annualise that, you get around €900m of EBITDA. They can't service the interest on the existing debt from the EBITDA the group generates which indicates the interest bill is slowly but surely eating up all equity value in Steinhoff. Some very positive development needs to happen for us to be confident of any value being left for ordinary shareholders.