Saturday, November 8, 2008

Porsche Engineers a Financial Windfall

A potato-farming CEO and a Kafka-reading CFO engineer a stunning financial gain, playing the system, and outwitting hedge funds. The gains have been enormous. Hedgies got caught in a short squeeze, having taken big bets that VW stock would fall in value, and that they would reap huge gains. They were wrong, and lost big. Now they are crying foul. Porsche, meantime, is counting its money.

Porsche's profits on those trades totaled more than the current combined market values of beaten-down General Motors Corp. and Ford Motor Co. The outsize gains were scored by a potato-loving chief executive and his Kafka-reading chief financial officer. They teamed up with the offspring of the Beetle creator to engineer an audacious takeover bid – and outfox hedge funds at their own game.

Porsche made €8.57 billion euros, or about $10.9 billion in its just-ended fiscal year. 80% came from trading in options on VW stock. In Germany there is an instrument called a cash-settled option, which allows the option buyer to get cash, and not stock, when the option is settled. There is no requirement for the cash-option buyer to file regulatory notice of how much it owns. What Porsche did was to use the system to its greatest advantage: when hedge funds do such things their critics call it market manipulation and hedgies defend themselves by saying they are not doing anything illegal, simply using the system's rule to provide market liquidity.

Porsche's moves point to the resilience of Deutschland AG, the decades-old network of elaborate cross-holdings that kept companies in domestic hands but had been unraveling. Porsche's VW chase is a kind of corporate German reunification drama: Wolfgang Porsche and Ferdinand Piëch, the board chairmen of Porsche and VW, respectively, are grandsons of Ferdinand Porsche, who created the VW Beetle and founded Porsche before World War II.

The European Union does not allow for such nationalistic rules, aiming to break such down for the creation of a continental whole.

In April 2005, Franz Müntefering, the chairman of the then-ruling Social Democratic Party, called non-German financial investors "swarms of locusts" that land on companies and "strip them bare." Wendelin Wiedeking, Porsche's combative CEO, chimed in, telling a newspaper that Germany needed to stick to a "social market" economy that avoided putting shareholders' interests before those of customers, employees, and suppliers.

It is a matter of values, different ways of looking at things. In the US, shareholders's rights is held up as a core value and a most important way of making the free market work. Such are diametrically opposed to what Wiedeking calls the social market.

Mr. Wiedeking had helped steer Porsche out of trouble after taking the wheel in 2003 and pushed profit margins to industry highs. He slashed about a fifth of the work force and imported Japanese-style lean-inventory methods. Once, to drive home the point, he strode across a factory floor and smashed shelves bulging with spare parts. Mr. Wiedeking cultivates a populist persona, even as Porsche sells pricey cars such as the 911. The 56-year-old executive owns a working-class tavern and a small farm, where he harvests potatoes with the help of an old Porsche tractor, distributing sacks of potatoes to employees.

It is unimaginable that the CEO of a big US company would do such a thing. Porsche makes 100,00 cars a year, VW 6 million, yet Porsche has a name vastly larger than the physical size of its production level.

In September 2005 Porsche surprised investors by announcing it would buy a 20% stake in VW, becoming its biggest shareholder in a "German solution" that would avoid any foreign takeover. VW and its home state of Lower Saxony, which held a bit under 20%, welcomed the move by Porsche – which, significantly, didn't signal that it was interested in a majority stake.

Porsche can, perhaps, legitimately say that it was not then interested in a majority stake. Who can prove otherwise?

Behind the scenes, Porsche Chief Financial Officer Holger Härter was crunching numbers. An economist, Mr. Härter had joined the company in the 1990s after Mr. Wiedeking recruited him from a floor-products firm in a town where they both lived. Mr. Härter is known as a fan of Franz Kafka and Ludwig II, the 19th-century Bavarian king whose fanciful castles inspired Walt Disney. He also is the chairman of Stuttgart's derivatives exchange, and in the 1990s he developed sophisticated models to hedge Porsche's foreign-exchange exposure.

Härter knew his finances. An economist, chair of a derivatives exchange, a financial wizard.

Porsche began buying cash-settled options tied to VW stock in 2005, when VW's share price was below €100. If the price rose, Porsche could exercise the options and receive the difference between the lower strike price and the higher market price. It could then use the money to buy VW shares.

Porsche began buying cash-settle options. If it made money it could use it to buy more VW shares or options. That is investing at its best: using profits, not capital, to do more investing. Cash-settle options have one other important twist: Banks that underwrite them typically hedge their exposure by holding actual shares. That takes these shares out of circulation.

That completes the circle: shares underlying cash-settle options are set aside by banks that lend the money for the options, lessening the total number of shares in public float. As Porsche was buying cash-settle options on VW stock, the number of shares of VW available publicly went down.

By March 2007, Porsche had boosted its stake in VW to 30%. That triggered a German rule requiring it to make a full tender offer for VW shares. The company said it wasn't interested in a takeover of VW. Forced to make a tender offer, Porsche offered the legal minimum price the law let it offer, which was €100.92 for each voting share. Only 0.6% of the remaining VW shares were tendered.

Expert move: Porsche said it didn't want to buy VW, and the market believed it. The tender offer didn't work, something which, in retrospect, would prove to be what Porsche wanted.

That November, Porsche announced that for the fiscal year ended July 31, 2007, it had booked a pretax profit of €5.86 billion, including €3.59 billion from "the very positive effects" of VW options. Compensation for Porsche's six-person management board more than doubled, to €112.7 million. Mr. Wiedeking pocketed more than half of that.

So the social market did not prevent the CEO from making more than 50 million Euros. A nice enough payday.

This past March, Porsche's supervisory board gave the green light to take the VW stake above 50%, and this goal was announced. For the six months ended Jan. 31, Porsche disclosed a pretax profit that included €850 million from "hedging transactions in connection with the acquisition of the VW stake." But Porsche denied growing talk that it was gunning for 75% of VW. In a news release, the company said the possibility of that was "very small indeed" and dismissed it as "speculative mind games of analysts and investors."

Porsche owned 30% of VW, and made another 850 million Euros in profit on VW options.

In mid-September, Porsche disclosed it had raised its VW stake to just above 35%. At the Paris Auto Show in early October, Mr. Wiedeking told reporters a 75% stake was a "purely theoretical option." On Oct. 24, a Friday, VW's share price closed at €210.85 on Frankfurt's stock exchange.

Another 5% of VW added. Porsche had begun to buy VW stock when its price was under € 100; by now it was more than twice that. Note the difference in language of Wiedking's statements: from a "very small" possibility of Porsche going for 75% of VW stock, it went to a "purely theoretical option."

On Friday October 24, VW stock was €210.85.
On Sunday October 26, Porsche dropped a bombshell.
On Monday October 27, all hell broke loose.

Porsche's bombshell: In a news release, the company disclosed that it owned 42.6% of VW's shares as well as cash-settled options linked to an additional 31.5% of the shares. Porsche also said that it planned to acquire a 75% stake in VW.

All hell broke loose: funds that had borrowed VW shares and sold them, expecting no takeover offer and betting the stock would decline, raced to purchase shares to unwind the bets. There weren't enough to go around. Part of the reason is that underwriters of cash-settled options typically hedge their risk by owning the shares of the company involved. The shares they owned, combined with those Porsche had acquired, added up to 74.1%, and Lower Saxony state owned 20.1%The result was that while some 12.8% of VW shares were on loan, mostly to short sellers, those that for practical purposes were in circulation amounted to only 6% of VW shares.

74% of VW shares were owned Porsche and banks hedging their lending for cash-settle options, 20% by Lower Saxony, leaving 6% in public float. Yet there were short sales for nearly 13% of VW total stock, meaning 7% of VW stock sold could not be replaced. Little wonder all hell broke loose.

As hedge funds fought for the remaining VW shares, they drove the stock's price ever higher – deepening their losses. At the height of the short squeeze on Oct. 28, VW stock briefly topped €1,000, nearly five times as high as on Oct. 24, making VW the biggest company by stock-market value for a few hours.

Porsche had begun buying VW stock at less than € 100. On Friday the price settled at € 398.21 in Frankfurt.

How Porsche did it, and exactly what it did, are now matters of speculation. Some investors complain that Porsche and Schaeffler have crossed the line of fair play, taking advantage of disclosure rules that are too loose and regulators that are too tentative.

Schaeffler is a German auto-parts supplier pursuing a campaign similar to Porsche's (aimed at Continental AG).

"We need a different approach, with efficient supervision,'' says Christian Strenger, a board member at DWS, the asset management arm of Deutsche Bank AG, Germany's biggest financial group.

When financiers win, they call it the free market at work, and label their actions advantageous for the free market's liquidity; when they lose they call for a different approach, and even for efficient supervision.


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