2/22/10 Update: Spin Presentation
Note: We have reinitiated our position in KHD in the AAOI Portfolio
Deep Value + Special Situations + Options = A Favorable, High Probability Outcome
KHD Humboldt Wedag International (KHD) is a spin-off/special situation with multiple near-term catalyst(s), a tremendous margin of safety and substantial near term upside potential.
The January 6 announcement that KHD’s board had decided to restructure the company into two separate legal entities: (1) a mineral royalty company and (2) an industrial plant technology, equipment and service company was met with little fanfare by the market despite the fact that this transaction will likely unlock tremendous shareholder value over the next 3-6 months.
Our view is that the markets “under-reaction” regarding the value enhancing implications of this announcement coupled with last week’s sharp sell-off (and the spike in volatility that came with it), has provided opportunistic investors with (1) a short window to purchase KHD at a ludicrously cheap price and (2) created some attractive prices for those looking to sell volatility and skew the risk/reward equation further in their favor.
KHD Humboldt Wedag International Ltd. is a world leader in supplying proprietary technologies, equipment and engineering/design services for cement and minerals processing. KHD through its subsidiaries offers their clients all over the world engineering services, machinery, plant and processes as well as process automation, installation and commissioning. The services include staff training as well as pre- and after-sales services through to feasibility studies and financing concepts. This array of supplies and services includes, in particular, the modernization of existing facilities for capacity increases and, for reducing the specific energy demand and the burden on the environment.
The company operates in two segments: KHD’s largest subsidiary KHD Humboldt Wedag GmbH (“Humboldt”) was founded in 1856, and designs and builds plants that produce and/or process cement, beneficiated coal, clinker, base metals and precious minerals. The Company has more than 900 employees worldwide, and has operations in India, China, Russia, the Middle East, Australia, Africa and the United States. Its other segment consists of what will now be a new standalone mineral royalty company, which will change its name from KHD to Terra Nova Royalty Corporation (“Terra Nova”), and would continue to receive royalty payments from the Wabush Iron Ore Mine (the “Wabush”) in the province of Newfoundland and Labrador, Canada under a master lease that terminates in the year 2055. Wabush has been a producing mine since 1956, and currently has proven reserves of 75 million tons, representing approximately 15-year production based on historical production rates. Management intends to institute a dividend policy for Terra Nova shareholders. Going forward Terra Nova intends to focus on acquiring additional existing mineral royalties, providing capital for the exploration, development and construction of iron ore and other metals mines in exchange for royalties; monetizing metal by-product streams from either operating mines or projects under development; and providing acquisition financing to established operating companies in return for a royalty on acquired properties
How we are playing the opportunity…
By going long KHD common and short the 7/16/10 $15 calls/$12.50 puts in equal amounts, investors can create an options adjusted cost basis of $11.38. At $11.38, investors are essentially getting the royalty interest at an attractive price and the cement engineering business for free. This is absolutely nuts in our opinion as the cement engineering segment is a great business with predictable cash flows, a fortress balance sheet, a dominant competitive position and above average longer-term growth prospects. Granted, this is a cyclical business facing a relatively difficult near-term operating environment, and it may be a few years before things return to normal. But with that said, it’s important to note that it’s a matter of when business conditions normalize, not if…as cement companies cannot put off their cap-ex needs indefinitely, and it doesn’t necessarily take a genius to figure out that demand for their services isn’t going away anytime soon (this is a business that’s been around for 100+ years after all). Again, how often do investors get an opportunity to pay nothing to own a growing, capital light/high ROIC business, that as it stands today, should generate northwards of $25m in free cash in a “normal” year?
Investors interested in owning KHD pre-split may want to keep a little cash on the sidelines, as their will likely be a fair amount of non-economic selling in KID shares immediately following the spin (due to its German listing, its small size, etc.), which will likely create an even more attractive entry point. Our hope is it gets crushed so we get the chance to load up at an even better price.
Valuation – Sum of the Parts
The analysis below will show that the combined value of KHD’s core and non-core assets easily exceeds $25/share or well over 100% above the current market price (using historically conservative assumptions).
1 – KHD Humboldt Wedag International (KID)
An examination of the cement plant and engineering business indicates that KHD should be able to conservatively earn $400m in revenues and generate at least $25m in free cash in a normal year. Assuming $400m in sales and EBIT margins of 9% (which again, should be easily achievable if history is any guide) this business would generate roughly $36m in pre-tax profit. If we assume a 30% tax rate we are left with roughly $25m in net after-tax profit. With $30.3m shares outstanding that equates to$ .83 cents per share.
Considering the qualitative and quantitative characteristics of this business I think one could make a good case this business deserves a market multiple at an absolute minimum (15x), but let’s keep it conservative and assign a multiple of 13x. That gives us a value on the operating business of $10.80/share. Add in the value of the company’s excess cash of $4/share, and we get a total value for KHD core biz post-spin of $14.80/share
Again, in our view the cement plant, design and equipment supply business possesses numerous attractive qualities, such as a (1) a capital light, high return business model (2) a fortress balance sheet (KID will hold nearly $4/share in excess cash post-spin) (3) a strong competitive position in a consolidated market – 3 players control roughly 90% of global market share due to intellectual property (KID holds nearly 500 patents and is third largest player with a 20% share) (4) a candid, fully incentivized management team with a long paper trail of value added capital allocation – notably, insiders collectively own roughly 30% of the outstanding common, and (5) attractive longer term growth prospects – this is a business that has a huge secular tailwind at its back as most of its business is derived from emerging markets (particularly India, Asia, The Middle East, Russia and Eastern Europe), where cement consumption is likely grow at an above average rate for a very long time. Why? When developing countries like India and China industrialize, they need huge amounts of cement to build out their infrastructure, it’s that simple.
Anyhow, taking all of the above into account a 13x multiple seems on the low side of reasonable.
Note: The excess cash amounts noted above are net of the cash needed to run the day to day business (due to a project-related deferred revenue liability)
2 – Terra Nova Royalty Corporation
The value of this segment can be broken down into its royalty interest in an iron ore mine and a pile of cash. Let’s start with the royalty interest. At the moment, this interest is valued on the balance sheet at $200m or $6.67/share. This is a conservative as it implies a price for iron ore significantly below the current spot price (the balance sheet valuation uses the following assumptions: an iron ore price of CAD $3.70/ton, 15 years, 5 tons/year, a 20% tax rate, an 8% discount rate, 2% escalations).
Next is the cash component which sits at $113m or $3.70/share. Cash is cash, so there is no need to make any further adjustments. Therefore, a conservative estimate of KID’s IV post-spin sits at $6.67/share (for the royalty interest) + $3.70/share (the value of the excess cash) = $10.37
We feel that the valuation above is very conservative for essentially three reasons. First, if one uses the current price of iron ore and similar assumptions, the per share value of the royalty interest jumps to $8.80/share. Our guess is that after the typical post-spin selling pressure subsides, the market will rerate the iron ore interest almost immediately and assign a multiple commensurate with current pricing. Second, management has stated that they intend to initiate a dividend policy as a newly standalone company. Our view is that after they do, it should begin to trade on a yield basis – resulting in the market assigning a higher multiple on the royalty interests existing cash flows and hence a higher valuation. Third, it doesn’t take into account the underlying supply/demand dynamic of iron ore and its relationship to global growth. We think it’s a safe bet that iron ore pricing will rise (potentially significantly) over the coming 10 years.
3 – Combined Value
The conservative sum-of-the-parts analysis above yields a combined value of roughly $25/share ($10.37/share for KID + $14.87/share for KHD).
In thinking about the value of the iron ore mine, we feel it’s helpful to keep a few things in mind. First, the income from the mine in any given year will closely correlate with iron ore prices, which are driven primarily by raw material requirements of the integrated steel producers. These requirements are in turn driven by worldwide steel demand. So the more steel needed in the world, the more iron ore needed to produce that steel. Also, and this is incredibly important, steel consumption/demand is considerably higher in developing nations in the process of undergoing industrialization (think China and India) than it is in mature or developed nations (think the U.S. and Western Europe), as they need to build out the necessary infrastructure to support future growth. Therefore, if one believes that countries like China and India (and other developing nations) will continue on the path of industrialization (i.e., that they will continue to grow in the future), then one must by implication believe that the demand for iron ore will remain strong going forward. To put it another way, iron ore is an investment that will increase in value as the underdeveloped world acquires the means to increase their standard of living.
Also, investors must always take three things into account when analyzing the attractiveness of an investment in a commodity itself and/or a commodity business (for example, you can’t have a thesis on a natural gas company without having a thesis on natural gas itself – at least if you know what you are doing). Those three things include (1) the current price of the commodity in question, (2) its medium to long-term supply/demand dynamic, and (3) whether or not the current price is low relative to where it should be given the supply/demand situation. In this case, our analysis indicates that (1) the current price of iron ore is very likely low (all things considered), and (2) that there will likely be a sustained bottleneck in the supply/demand equation for the foreseeable future – as upward pricing pressure should be significant as long as the developing world continues to build out its infrastructure and raise its standard of living. The evidence suggests that producers will simply have an very tough time getting the iron ore out of the ground fast enough to keep pace with the large and growing demand (by growing we mean over 5-10 year intervals, not next month or next year). In other words, elevated prices are likely to be around for a long time, as we are not of the opinion that China and India (to name just two) are done growing yet.
The implications regarding this particular investment are numerous. First, understanding the above makes it clear that the mine is a valuable, high quality asset that should grow in value along with the growth of the developing world. Second, the amount of cash that the royalty interest is likely to generate in an average year (currently sitting at roughly $20m+) is likely to grow meaningfully – or at the very least remain relatively stable for the foreseeable future (considering the supply/demand equation and the pricing dynamic that results). Third, it should strengthen your conviction that the above balance sheet valuation is conservative.
Investment Structure (w/Options)
Leg 1) Purchase 1000 shares of KHD common @ $12.26/share
Leg 2) Sell 10 July 10 $15 Calls @ $.50/share
Leg 3) Sell 10 July 10 $12.50 Puts @ $1.50/share
Cash outlay = $12,260 (common stock)
Cash inflow = $2,000 (option premium)
Total net cash out of pocket = $10,260
Expected Scenario’s (potential range of outcomes):
If shares rise to at least $15 buy July 16, 2010
(1) The $15 calls will be exercised
(2) You would sell your shares for $15,000
(3) The $12.50 puts will expire worthless
(4) You will have no further obligations
(5) You will hold no shares and $15,000 in cash
In the best-case scenario investors would earn a total return of 44% ($4,740/$10,260) in roughly 6 months (assuming the shares trade north of $15 by July 16 of this year). Due to the variety of upcoming catalysts over the next three to six months, our view is this is the most probable outcome.
What’s the downside?
If the shares are less than $12.50 on July 16, 2010:
(1) The $15 calls will expire worthless
(2) The $12.50 puts will be exercised
(3) You would be forced to purchase another 1000 KHD shares
(4) You will need to lay out an additional $12,260 in cash
(5) You will end up with 2000 KHD shares
(6) You will have no further obligations
Assuming the “worst case” where the stock closes below $12.50 and the investor ends up being “put” an additional 1000 shares, he/she still wins – as they would get a chance to double down on an incredibly attractive opportunity at a better price.
Note: Since the Spin is a pro-rata distribution, for the sake of simplicity I have left the ‘put’ scenario above as it would have been pre-split.
What’s the breakeven on the whole trade?
On the original 1000 shares it’s the $12.26 purchase price less the .50/share call premium = $11.76/share. On the “put” shares it’s the $12.50 strike price less the $1.50/share put premium = $11/share. Breakeven on the whole trade is the average between the two or $11.38 ($11.76/share + $11/share/2). Notably, with the stock at $12.26, the stock can rise, stay static, or fall a bit from today’s level and one would still walk away with a profit on the trade.
Downside Protection (Margin of Safety)
The combination of (1) a ridiculously attractive absolute valuation, (2) a fortress balance sheet(s), (3) the inherent quality of the underlying assets, (4) numerous near-term catalysts, and (5) a proven, high quality of management, provides investors in KHD with tremendous downside protection. Also, the utilization of attractively priced options in our view skews an already attractive risk/reward equation even further in our favor, as it not only lowers our cost basis but allows us to profit under a wider range of outcomes.
The long and short of it is that it truly is difficult to figure out how one could lose money looking out 2-3 years and beyond, as there simply isn’t much that could upset the applecart so to speak. There are no balance sheet/financing risks to worry about, nor any exogenous type risks – think political and/or legislative risk. Management is capable, fully incentivized, and focused on all the right things and given Chairman Smith’s long paper trail of savvy acquisitions and building shareholder value through buying, improving, and spinning off businesses, the risk of them doing anything stupid with their excess cash is very low (odds actually favor the opposite outcome). Also, considering KHD has a couple of year’s worth of business in its backlog (which provides significant earnings visibility), business should be decent for the next few years at minimum – as long as developing countries don’t stop industrializing, cement remains humanity’s building material of choice, and/or companies and governments don’t stop wanting to make their plants more environmentally friendly and efficient, there should be more than enough business to keep them busy…so there isn’t a lot of operational risk in the short or long term. There is certainly market risk in the near term, but our use of options and the presence of multiple near-term catalysts make’s this less of an issue.
Also, in light of the large amount of credit creation, quantitative easing, and dollar printing that has been taking place in the U.S. and around the developed world, it is reasonable to be concerned about the future buying power of the dollar, the prospect of higher interest rates, etc. Luckily the effects of these negative outcomes on the cement engineering business should be minimal, as this business (1) earns most its profits globally (over 90% of its earnings are foreign sourced) and (2) due to both its market position and asset-light business model, it should have the pricing power to be able to preserve its real earnings power in both an inflationary and/or deflationary world. Obviously the iron ore interest would benefit in an inflationary environment as well.
The bottom line here is that KHD is a classic low-risk, high-return fat pitch – offering investors who get in around the current price the chance to make a considerable amount of money under any reasonable future outcome/scenario we can imagine. And better yet, sooner rather than later.
Upcoming road show
Spin on 3/22
Initiation of dividends at Terra Nova
Spin-off press release
We recommend reading Leucadia’s primer on iron ore (which discusses the variables that drive supply, demand, and pricing, etc.) from their April 2008 letter to shareholders for more color on the issue (pgs. 2 – 4).
Recent Business Week article provides some recent commentary on current pricing