Porsche Is a High-Quality, Special Situation Opportunity

(This is a highly-abbreviated version of a full SumZero report republished with the author's consent)

Contributor: Roy Sebag.
Firm: Essentia Equity. Hedge Fund.
Location: Tel Aviv, Israel.

Recommendation: Long Shares of Porsche Automobil (PAH3.DE)
Timeframe: Less than 3 Months
Recent Price: €39.00
Target Price: €75.00
Strategy: Special Event

Disclosure: The author of this report had an active position in this security at the time of its posting.

Quick Thesis:
Porsche Automobil Holding SE (PAH3) is a publicly listed holding company with two main assets:

A) 149.7mm shares (51%) of VOW GR (Volkswagen Voting Class Shares)
B) 51% interest in Porsche AG (The auto-mobile manufacturer)

Based on today's closing price of € 112.35 the VOW shares are worth € 16.8B while the 51% interest in Porsche AG is to be sold for € 4.5B Euros to Volkswagen under an existing put option that is to be exercised this year and with no taxes paid following an innovative solution with the tax authorities reached on June 9, 2012.

Legacy liabilities (post sale of Porsche AG) for PAH3 will be € 2.2B and include nearly € 2B of bank debt collateralized by the VOW stake. In other words, post the Porsche AG sale, PAH3 will have a simple balance sheet consisting of roughly € 5.0B in Cash and 149.7mm shares of VOW on the asset side with roughly € 2.2B on the liability side.

Following the sale of Porsche AG, PAH3 has tangible book value of € 58 per share using the current VOW price of € 112.35. Using analyst consensus estimates of € 160 for VOW, tangible book value for PAH3 rises to € 82 per share.

Legal Liabilities Overblown

Investors have been worried about the potential for lawsuits initiated by Hedge Funds in the US that shorted VOW in 2008 and suffered massive losses due to a major short squeeze. These professional investors, that acknowledged the possibility of losing more than 100% when opening margin accounts with their prime brokers, are of the opinion that somehow PAH3 is liable for their losses. After conducting nearly 2 years of research into the matter, I find the case to have an extremely low probability of success. My beliefs were confirmed today June 27 as the first hearing was held and Judge Stefan Puhle made it clear that the plaintiff’s case was extremely weak.

"There are high hurdles" to prove that the sports car manufacturer violated legal standards defined by Germany's top civil court, said judge Stefan Puhle after three hours of hearings at the regional court in Brunswick, northern Germany. "This is a tough act to prove," Puhle added

The idea that a short seller (by definition is a professional investment strategy available only to highly sophisticated investors through prime brokerage services) can sue a company for losses sustained due to a short-squeeze is one that I find laughable. The claims made by the short-sellers that Porsche did not disclose its intentions and misled them with press releases holds little credence as Porsche held over 40% of VOW since 2006 (almost 2 years before the squeeze) and it was known to any short-seller in VOW that there were significant FTD's and a very tight float. At the time Prime Brokers were charging in excess of 50% per annum for stock loans on VOW. Simply put, the short sellers played with fire by shorting VOW and they are merely blaming Porsche for their losses.

Investors are currently factoring in a legal liability of over € 6B or € 20 per share using the current VOW price of € 112.35. When using the analyst consensus target of € 160 the legal liability being priced by investors is over € 13B. This unfathomable amount if awarded to the plaintiffs would represent the single largest securities class action settlement, higher than Enron, WorldCom, or Tyco. Moreover such high damages would be awarded for a case where there was no accounting fraud, no bankruptcy, and no retail investor losses, rather a scenario where retail investors gained and where a stock price actually appreciated in value.

Following the sale of Porsche AG, PAH3 turns into a highly levered, easily modeled, perpetual call option on Volkswagen which I view as being attractively priced at only 3.08x trailing PE, 2.7% dividend yield and with the enlarged company being the strongest automobile manufacturer in the world consisting of the following brands: Audi, Bentley, Bugatti, Lamborghini, MAN, Scania, Seat, Skoda, Porsche, Volkswagen, Volkswagen Commercial, Ducati.

Our internal EBIT estimates for VOW in 2013 and 2014 are € 13.0B and € 14.0B respectively (Bloomberg EEO @ 13.6 and 15.4 respectively) leading to target prices for VOW of € 194 and € 208 respectively in 2013 and 2014 using a conservative 7X EBIT multiple. Moreover there are additional catalysts that would allow VOW to obtain an even higher multiple following the long-awaited marriage with Porsche. These include cost savings and the ability to focus on stock buybacks and dividend increases with its stable recurring stream of free cash flow.

In closing I offer three scenarios for PAH3 based on near term, medium term and long-term catalysts:

1) Near term target (Following the anticipated ruling on September 19, 2012) - by simply removing the legal liability halo and valuing PAH3 at its tangible book value (€ 16.8B for VOW + € 4.5B for Porsche - liabilities) I arrive at € 58.05 per share providing nearly 49% upside from the current price of € 39. This price should be reachable following the ruling of Judge Puhle on September 19 paving the way for the remaining suits to be thrown out.

2) Medium term target (6 -12 months) - Here I use the analyst consensus on VOW of € 160 but do not apply a 25% holding discount as the analyst community has done and arrive at tangible book value of € 81.22.

3)Long term target (12-24 months) - Here I apply a blended average of my 2013-2014 EBIT estimates for VOW as well as include future dividend flows from VOW arriving at projected tangible book value of € 100.78.

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