The Beast From The East.

     In the year 2018, even as animal spirits were running wild on the bourses and the world was approaching the longest economic expansionary span on record, Europe was buffeted by one storm after another. With the Brexit hurtling towards an ugly finish, political and social unrest in France, a resurrecting Italian debt crisis and an EU-wide industrial production and consumer confidence slump, Europe’s economic engines were sputtering. Germany, by far Europe’s financial powerhouse, was facing mounting troubles of its own. Caught in the crossfire of a China-USA trade war and being the epicentre of a refugee crisis, its own slowing economy was doing it little favours. Over the course of the year, several German companies egged Angela Merkel’s government to loosen its purse strings to resuscitate an economy that was on the precipice of a recession. At the start of 2018, the cold wave dubbed ‘The Beast From The East’ had blanketed Europe in thick snow and sent both temperatures and consumer spending to new lows, with Germany being no exception. A few weeks later, the climatic Beast receded but the country’s troubles were only just beginning to snowball. Unknown to Germany, one if its largest and most iconic companies would soon be grappling with its own Beast, one that would shake the organization to its very core.

     The former Communist state of the Czech Republic is known for a thing or two to the rest of Europe. Glass and ceramic art, beer, castles, spas, Prague, Karlovy Vary (where a large portion of Casino Royale, the best 007 movie till date, was shot), Skoda cars (albeit under Volkswagen ownership) and the region of Bohemia are some of the most instantly recognizable symbols of the landlocked nation, which doesn’t feature prominently in Europe’s corporate landscape. After all, not too many Czech companies have made any moves that have either thrust them into the limelight or kicked up a storm in the larger scheme of things. All that changed earlier this decade when EPH, a Czech energy major, made its presence known in European corporate circles when it began snapping up assets all over Europe. And EPH’s buyout binge was masterminded by an evil genius.

     Daniel Kretinsky. Often known as a ruthless businessman with alleged Russian links (à la a certain American President who builds walls, bids for Greenland and makes too much use of a Sharpie), Kretinsky began his career in banking and then diversified into energy and media when the Czech Republic’s J&T Bank spun of its power assets, which Kretinsky took control of. Together with Patrik Tkac, Kretinsky began buying energy assets all over Europe by paying cents on the euro and taking advantage of the near zero cost financing that European banks were offering. With most European countries transitioning to renewable energy, dirty power assets such as coal-fired power plants were on a fire sale and Kretinsky swooped in, betting that most countries would overshoot their stated deadlines to take their dirty assets off the grid, providing enough time to squeeze value from those very assets. When most countries such as Germany ended up extending their ‘Energiewende’ (energy transition) timelines by as much as two decades, it was a plan that worked perfectly.

     Over the short span of less than a decade, EPH had built up a portfolio of energy assets all over Europe. But that wasn’t all. Kretinsky’s assets included the Sparta Prague football club and in a bid to diversify his holdings, the feared raider entered the media space by buying stakes in the holding companies behind Le Monde and Elle, two of France’s most popular media houses and publications. AC Milan and AS Roma too were rumoured targets at one point in time. But Kretinsky’s hunger for buying assets on the cheap was far from satiated and with Europe’s economy and business sentiment slowly deteriorating in late 2018, opportunities were aplenty. And this time around, Kretinsky had set his sights westward towards Germany and was gunning for one of Europe’s largest retail chains. His next target was once an acquisitive name in Europe’s retail ecosystem in its own right and a company that, through a series of missteps, had managed to upset its own shopping cart.

     Perhaps one of the best known global brands that emanated from Germany, Metro has been a stalwart player in the German retail landscape for several decades. While Metro had been growing via acquisitions and clocking healthy growth up until the Eurozone crisis, the subsequent years marked the beginning of turmoil for the company. For one, Metro’s balance sheet was stretched from all the debt it had taken on in the yesteryears. It had to sell one of its prized arms, Galeria Kaufhof, by far the main draw on any German high street. Its international expansion had burned cash and several of its overseas subsidiaries were mired in losses. Metro Russia, once one of the fastest growing arms, was one of the worst hit, bludgeoned by a falling Rouble and sanctions. Metro’s EUR 7bn hypermarket subsidiary, Real continued to struggle in the midst of an all-out discounting war in Germany and dragged down its parent’s margins. And to top it all, Metro itself was barely making money in its home market of Deutschland.

     Germany’s retail market had witnessed an all-out assault by Aldi and Lidl, two large discount retailers that tailored their stores to cater to regional product preferences and focused on private label brands (c. 80-90% of their total sales) with higher margins, vis-à-vis Metro’s largely undifferentiated approach and a comparatively low share of sales from private label brands at c. 15%. With its already low single digit margins coming under further pressure, Metro decided to pivot its business model towards food service by catering to the Hotels, Restaurants and Cafes (HoReCa) segment and shift away from general traders, a move that would lift the company to a higher margin profile. The only problem was that the change would take years to start showing a meaningful effect on the company’s financials. While Metro’s wholesale and cash and carry operations were seen as the more stable parts of the business, it did have a large chink in its armour. Metro’s consumer electronics retail arm had been walloped by Amazon’s entry and the brutal price war that had engulfed the German consumer electronics market.

     With its consumer electronics division being little more than dead weight, Metro decided to demerge itself into two entities – one that would focus on the wholesale and cash and carry operations and the other that would house its consumer electronics business. The former would be able to grow independently and pivot its business model towards food service while the latter would first consolidate and stabilize its operations and later return to a steady growth path. The demerger, after all, would simplify and reduce the conglomerate holding structure of Metro and enable shareholders to have holdings in both companies and subsequently choose which business model they wanted to invest in. Demergers, at the end of the day, are seen favourably by the markets and create value for companies and their shareholders. Or so sayeth the investment banker.

     In June 2017, Metro spun off its consumer electronics arm (Ceconomy, housing the Media Markt and Saturn electronic store chains) and rechristened itself Metro Wholesale Food Service (MWFS). While the markets initially cheered the demerger, all hell soon broke loose. A series of disappointing quarterly results and profit warnings from both companies ignited a race to the bottom. Both the Ceconomy and Metro scrips were heading towards Davy Jones’ locker and numerous announcements from both managements on business strategies and the small steps made towards them did little to allay the market’s fears. While Ceconomy, with its top level management exits and successive profit warnings, had been virtually written off as a basket case by the markets, Metro wasn’t about to be let off the hook easily. Its valuations were far lower than any food service player globally and even its European retail peers and with its share price dipping below EUR 10 (down from a EUR 18 debut at the demerger), its market capitalization had already sunk below the value of its real estate holdings. Investor interest in Metro had reached a nadir but in the midst of the carnage, Metro had caught the eye of an acquisitive Czech billionaire just east of the German border.

     Metro’s management, widely perceived by the investor community as reluctant to engage in any meaningful action, slowly awakened to the fire that was raging. Metro slammed the brakes on its international expansion and began selling and leasing back some stores to free up cash. Real was put on the block and names of several suitors, ranging from local rivals to Amazon, began doing the rounds. The press reported rumours of a retreat from several countries. But despite all the headwinds, Metro still had a lot going for it. It had a network of over 770 stores, some of which were prime real estate. Its transition to food service was slowly materializing and it had a loyal army of traders and HoReCa members globally. If the company could indeed ride out the storm, it was an attractive asset to board. When the Metro management tried to convince the markets of a recovery, the naysayers outnumbered the believers. With the markets undervaluing Metro and discounting its uncertain future, Kretinsky decided to move in for the kill.

     In August 2018, post another disappointing earnings release from Metro, EPGC (Kretinsky’s acquisition vehicle in which he owned 53%, with Tkac holding the remaining 47%) announced that it had acquired a 17% stake in the company and had call options to buy another 15%, taking its total stake well over 30%, when it chose to exercise the options. This, in turn, would trigger the requirement for an open offer to Metro’s shareholders. The Haniel founding family of Metro, which had held on to the shares for generations (via the holding company Haniel) and had supported the company’s every move over the years, had now decided to tender some of their shares to Kretinsky and cash out at the bottom, a clear indication of the frustration with the direction that the company had taken under its new management. Ceconomy, which held a 10% stake in Metro, too had offloaded 9% to Kretinsky in a desperate move to raise liquidity post its own troubles of profit warnings, store closures and sales that trailed expectations in the months leading up to the FIFA World Cup. With EPGC already controlling a large chunk of Metro shares, the markets expected the Czech raider to make a bigger move. The Metro scrip crept higher, waiting for EPGC to strike. Kretinsky’s first salvo, by directly approaching the family foundations and Ceconomy for their stakes, may have been nothing less than a masterstroke but his assault on Metro was far from over.

     With a rumoured EPGC bid on the horizon, Metro’s management tried to win the market’s sympathy with successive outreaches and releases about the company’s move towards becoming a food retailer, selling Real, turning around its underperforming arms and repeated reassurances that it was saying its prayers and eating its vitamins every night. Metro’s biggest redemptive move was its planned sale of Real. The sale had attracted interest, although at a valuation of c. EUR 500mn, which was far less than the EUR 800-900mn number that had first been touted. For months on end, Kretinsky kept the markets waiting for his inevitable takeover bid, which finally came in 2019. EPGC launched a EUR16/share bid (a EUR 5.8bn offer in total) for Metro, declaring that the offer was void if it failed to cross a 67.5% shareholding at the end of the offer period. Not too far away was the coveted 75% DPLTA (domination and profit and loss transfer agreement) threshold, which under German takeover laws, would enable EPGC to take complete control over the direction and cash flows of Metro.

     Kretinsky’s offer though was far lower than what the markets had been expecting. While the bid had been delayed, Metro’s share price was already north of EUR14/share and the offer provided little incentive to tender. The family foundations (Meridian Stiftung and Beisheim) did not tender their remaining shares and EPGC only garnered a 41% stake, as against the 67.5% target. The offer turned out to be null and void, taking EPGC back to its 32%, which nevertheless ensured that it was still the largest shareholder. Kretinsky ruled out a revised or follow-up offer for the time being, stating that his EUR16/share offer was fair. The markets, however, thought otherwise and had given EPGC the cold shoulder. Metro’s management wasted no time in taking credit for the outcome, declaring that the markets had understood the true worth of the company by turning down the unattractive bid and that Metro’s transformation was gaining steam and would revolutionize the retailer. But Metro’s management may indeed be writing cheques that it may not be able to cash.

     While Kretinsky may have retreated in the near term, the Metro saga seems to be far from over. Metro’s turnaround is progressing but gains from real estate sales are repeatedly being used to pad its quarterly results and the company’s organic growth is weak with operating profitability continuing to be under pressure. With a stake of 32%, EPGC is currently the largest shareholder in the company and is vying for a board seat. The family foundations of Meridian Stiftung and Beisheim still control c. 20% of Metro and if Metro’s performance worsens, they may follow Haniel to the exit and sell out to Kretinsky. While Kretinsky may have built a power and energy conglomerate as well as a media conglomerate of sorts across Europe by buying different assets, he seems to be replicating the strategy in retail by picking up stressed assets. EPGC recently picked up a c. 5% stake in Casino, a large French retailer which, along the same lines as Metro, is struggling and is selling assets to pare down debt. Europe’s retail sector outlook is turning increasingly bleak, with store closures and wage costs on the rise and valuations on a slow but sure descent.

     With both Europe’s economy and the retail sector likely to head further south for the impending global economic winter, Metro may soon find itself trapped in a quicksand of a slowing retail environment, deteriorating results and a weakening stock price. With the stars aligning in his favour, Kretinsky may train his sights on Metro with another bid in the near future to gain the elusive control of the company. If… no, not if… when that happens, the once-iconic German retailer is likely to fall into the hands of the unrelenting Czech raider and the walls of Metro’s defence will come crumbling to the ground.