Another formerly written up opportunity that we find particularly attractive at the moment is KHDHF.PK. An updated analysis can be found below.
Deep Value + Special Situations = A Favorable, High Probability Outcome
An investment in KHD Humboldt Wedag International (KHDHF.PK) at or around the current price (~TBV), offers bargain hunting investors the chance to purchase a Fisher-esque growth stock, at a Ben Graham cigar butt price.
Notably, KHDHF.PK possesses nearly all of the qualities we look for in a great investment. In particular (1) an unsustainably low absolute and relative valuation (2) a good, fully incentivized management team (3) near to medium-term operating momentum (4) a promising long-term business model (5) a significant amount of recent non-economic selling pressure and (6) a variety of internal and external catalyst’s to bring about the convergence between price and value.
Given the company’s recent spin-off from TTT on March 31, 2010 (and the unique underlying dynamic/implications of this transition), and the fact that it’s in a cyclical business that is in all likelihood operating at a cyclical trough, we think it is reasonable to believe that KHDHF.PK’s underlying operating performance has stabilized and is poised to improve going forward. The bottom line here is that as the post-spin selling pressure abates and the company’s backlog begins to materially grow again, the market will eventually come to its senses and award this high quality company with a more appropriate multiple on much higher profits at some point in the coming months and years – driving returns of potentially 100%+ over the next 2-3 years with limited downside risk.
Spin-offs – A Secret Hiding Place of Stock Market Profits
Always cognizant of the typical post-spin trading dynamics that accompany the first few months of newly spun-out public company (i.e., the shareholder churn and significant noneconomic/short-term downward selling pressure that typically lasts for the first few weeks/months after the separation), we wrote that “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.” Luckily, almost six months after our initial write-up, we are thankful to say that our hopes have been realized.
So with that in mind, we would like to reintroduce investors to the idea and remind them that they will likely have a relatively short window of time to earn both low-risk and outsized returns relatively quickly (a year or so), assuming they are more than willing to (1) to take advantage of one of the market’s most exploitable inefficiency’s and (2) are comfortable investing in a relatively obscure German domiciled cement and engineering company that only reports twice a year, and with what seems like purposefully complex/confusing financials (which fwiw, is a classic hallmark of KHDHF.PK’s chairman, the enigmatic, value creating extraordinaire Michael Smith).
KHD Humboldt Wedag International Ltd. is a world leader in supplying proprietary technologies, equipment and engineering/design services for cement and minerals processing. The company 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.
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.
Going forward, KHD’s fortunes are largely tied towards the success of their operations in India and Russia/Eastern Europe (given the two countries currently make up the majority of the company’s existing backlog). In the near-term the company’s order intake will be driven primarily by strength in the Indian market, where demand for the company’s services remains robust (and fwiw should remain so for a long, long time).
With that said, a recent thesis we came across on the Distressed Debt Investors Club (hat tip to the author cparyse) framed the various issues and opportunities within the Indian and Russian markets perfectly (it is included in italics below).
India represents the second fastest growing market in cement only to China, and KHD has a growing presence with over $140mm of orders coming from India in 2009. Generally speaking, cement consumption in developing countries grows above the rate of GDP (historically this has been at a ratio of 1.7x). At current GDP growth rates in India, one would expect cement consumption to be growing at about 15% per year. Current cement capacity is around 230 metric tons; therefore, you would need about 30 metric tons of new capacity each year. This is equivalent to about 10-15 new plants. The following is a breakdown of the annual KHD market opportunity in India:
The average customized 2mm ton per year cement facility costs $425mm. The breakdown of the cost is:
KHD supplied equipment – $165mm
Pass-Through equipment – $130mm
Civil Construction – $100mm
Land Cost – $30mm
If 15 plants are built in India every year, that represents a $2.5B market opportunity. If KHD can capture 10% of that market that represents about a $250mm annual revenue opportunity. India is a structural growth story that in many ways could be analogous to China. While India currently has 230m metric tons of capacity, China has 1.4B. If India was ever to grow on the same plane as China, India would need another 800mm tons of capacity which would represent a $66B market opportunity over the long term”.
So, given that cement consumption/demand is considerably higher in developing nations in the process of undergoing industrialization than it is in mature or developed nations (as they are still in the process of building out the necessary infrastructure to support future growth) as well as that countries like India (and other developing nations) will likely continue on this path (i.e., that they will continue to grow in the future), then one must by implication believe that the demand for cement (and hence KHD’s services) will remain strong over the medium to long-term.
We want to quickly note that unlike China, where the requisite infrastructure that is needed to support the county’s near to medium-term economic growth prospects is already in place (and then some to be honest); the situation in India is radically different. Currently India’s national infrastructure is not only not overbuilt, but woefully inadequate – so much so that it essentially acts as a heavy tax and drag on economic growth (ironically the same is true in China but for the opposite reasons). Whether we are talking about power, transportation, ports, you name it – their infrastructure situation is dire, which is why the government is directing an increasingly huge amount of spending (along with courting foreign direct investments) towards remedying the problem. Keep in mind that given India’s above average GDP growth, the gap between the infrastructure they need vs. what they currently have continues to grow. Equally as noteworthy from an investment perspective is that given India’s positive labor force trends, significantly lower levels of national debt, immense foreign currency reserves, and a consumer sector that is still in its infancy, they can actually afford it. Our point is that given India’s above average growth and the governments continued spending on national infrastructure, cement consumption is poised to grow in the double digits for the foreseeable future almost regardless of the economic health of the world at large.
With the above in mind, is it any surprise that the Indian government can and will spend hundreds of Billions of dollars over the next 10 years or so to alleviate the current bottleneck? Or for that matter that KHD will continue to benefit from this spending/emerging megatrend for a long, long time to come? A prime example of the above mentioned investments is the Indian governments plan to invest almost $400B in road infrastructure projects by 2012 (notably the use of concrete in road building in India is a nascent trend). Initiatives such as this are not only not really discretionary at this point, they are actually fundamental to India’s continued economic growth and prosperity. The bottom line here is that with a large and growing need for more roads, housing, and various other forms of essential national infrastructure, cement consumption should continue to accelerate in the short, medium, and long-term. Again, investors should keep firmly in mind that the industrialization/urbanization of India is just beginning and that this fact is tremendously bullish for KHD’s long-term prospects.
On Russia/Eastern Europe (from the same write-up)…
As previously mentioned, the opportunity in Russia/Eastern Europe is now more medium term in nature due to financing issues in the country emanating from the credit crisis. In this region of the world, there is a significant need for new cement kiln technology. Eighty percent of production capacity here is wet kiln capacity which is 50% less efficient that dry kiln. There is two year payback by switching technologies. Based on discussions with management, I believe that there is about 52mm tons of capacity that needs to be replaced. Assuming $165mm in equipment per 2mm ton plant, this could represent a $4.3B market opportunity. If KHD can capture 20% share (old market share when Russia was strong), that could represent $858mm of backlog.”
As the above makes clear, KHD’s order intake within the Russian market may continue to remain subdued in the near term due to the lingering effects of the credit crisis – although management recently stated that they are seeing tentative signs of improvement there (which is certainly a positive data point all things considered).
The way we see it is that regardless of the company’s immediate prospects, looking out a couple of years their Russian operations offer significant potential given KHDHF.PK’s dominant competitive position and the countries significant need for new (i.e., much more modern and efficient) cement kiln technology.
Note, we are using a USD/Euro value of 1.27 for all calculations below
Valuation wise, not too much has changed since our last write-up. An examination of the business indicates that KHD should still be able to conservatively earn 400m in revenues and generate at least $22m in free cash in a normal year going forward.
According to the August 17th mid-year update, the company currently has a backlog of $397.57m (E 313m). Per management, we can expect to recognize roughly 80% of that as revenues over the next 12 months, or roughly $318m. Add in the $75 to $100m in service revenue the company expects to earn this year and the company’s total revenue’s should fall somewhere between the $393and $418m range (or roughly $400m). Assuming $400m in sales and EBIT margins of 8% this business would generate roughly $32m in pre-tax profit. If we assume a 33% tax rate we are left with roughly $22m in net after-tax profit. With $32.9m shares outstanding that equates to .68 cents per share.
Given the qualitative and quantitative characteristics of this business I think one could make a good case this business deserves a market multiple (15x) at an absolute minimum, but let’s keep it conservative and assign a multiple of 10x. That gives us a value on the operating business of $6.8/share. So after we add in the value of the company’s net working capital (an approximation of the company’s excess cash) of roughly ~$7/share, we get an intrinsic value of ~$13.8/share or well over a 100% upside from today’s prices.
We think the above multiple is almost absurdly conservative considering this is a competitively entrenched, high return business with (1) an incredibly strong balance sheet (2) predictable, high margin cash flows and (3) 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, we believe that it’s important to note that it’s a matter of when business conditions normalize, not if – as cement companies, can’t put off their cap-ex needs indefinitely and it doesn’t necessarily take a genius to figure out that demand for their services (1) should be strong going forward as India continues to industrialize and Russia/Eastern Europe goes about modernizing their existing production capacity and/or (2) isn’t going away anytime soon – after all, this is a business that’s been around for 100+ years.
Another important point to keep in mind here is that the valuation above assumes 0 growth going forward in KHD’s backlog, which seems almost impossible given their focus on (and competitive position in) growing emerging economies with large and growing infrastructure needs. Notably, in the company’s August 17 interim report, management stated that they have seen a significant improvement of late order intake wise, and that in their opinion the 2nd quarter of 2009 was almost certainly the bottom of the current business cycle (from an order intake perspective). So given KHD (1) appears to have reached an operational inflection point, where results are almost certainly poised to improve going forward and (2) possesses a strong competitive position in various growing emerging economies that desperately need to expand/modernize their existing infrastructure, one could argue that the 0 growth assumptions made above are indefensibly conservative over the long-term.
It’s hard to say exactly what KHDHF.PK is worth at the moment, but with its current TBV marginally below the current price it’s pretty easy to conclude “a lot more than the current price!” Paraphrasing Buffett, you don’t have to know a man’s exact weight to know he’s fat! Anyhow, we want investors to ask themselves how often they get an opportunity to pay essentially nothing to own a durable, capital light/high ROIC business generating cash flows of over $20m today, and what amounts to essentially a growing royalty stream on the continued growth of the developing world tomorrow. Again, potential cyclical headwinds aside, this is a great business that continues to have a huge secular tailwind at its back as most of its business is derived from emerging markets (particularly India, Russia, The Middle East, and Eastern Europe), where cement consumption is likely grow at an above average rate for a very long time – the current price implies the opposite.
The bottom line here is that the current valuation simply makes no sense unless one believes the company is likely to burn cash for the foreseeable future – considering the company’s variable cost structure and growing backlog, such an outcome seems highly unlikely at this point (at least for any material amount of time). Note: Revenues would have to drop beneath $300m before KHDHF.PK would come close to burning any cash, so taking into account the current valuation and given the top-line should remain comfortably above that number we believe such concerns are wildly overblown all things considered.
Downside Protection (Margin of Safety)
Considering today’s environment and the myriad of risks/headwinds that still face both the public and private sectors of our economy, we think it makes sense to look for investments with significant downside protection as well as certain defensive characteristics that will likely ensure the business in question will do well under any reasonable future outcome we can imagine. With that in mind, we feel that KHDHF.PK fits this bill beautifully, as it possesses numerous attractive qualities that taken together go a long way towards ensuring a positive outcome regardless of what the future has in store for the general equity market as whole. Again, the combination of (1) an attractive absolute and relative valuation, (2) a fortress balance sheet (3) a durable, high return, capital light operating business with above average long-term growth prospects (4) numerous internal and external catalysts that should help bring about the realization of value and (5) a proven, high quality management team that is absolutely committed to increasing shareholder value by maximizing return on capital and growing the business at an appropriate rate.
The long and short of it is that given the current valuation, the quality of the business/the management team and the secular tailwinds that underlie their long-term growth outlook 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 BS/financing risks to worry about given how the company continues to maintain a strong balance sheet with significant liquidity and financial flexibility, nor any exogenous type risks – think political and/or legislative risk. Management is candid, fully incentivized, with a history of capital discipline and remaining focused on all the right things. Also, given Chairman Smith’s long paper trail of savvy acquisitions and building shareholder value through buying, improving, and spinning off businesses, the risk of the company doing anything stupid with their excess cash is very low, at least over the long-term. Granted, it’s entirely possible that short-term cyclical headwinds put pressure on KHD’s near-term results, but as long as (1) developing countries don’t stop industrializing (2) cement remains humanity’s building material of choice and/or (3) companies and governments don’t stop wanting to make their plants more environmentally friendly and efficient – any near-term operating weakness will almost certainly be a temporary issue…so there isn’t a lot of business risk in the short or long-term. There is certainly market risk in the near term, but given (1) the presence of multiple catalysts and (2) the fact that we are being incredibly well compensated for taking it, not only do we not think this is an issue, we are thankful for it.
Another way to analyze and slice the data when evaluating the probability of permanent capital loss regarding KHD is to drill down on the qualitative characteristics of the business. Attractive qualitative characteristics that should help safeguard KHD’s current intrinsic business value both in the short-term and over time include (1) significant earnings visibility – again, KHD’s backlog has not only stabilized, but order intake has actually improved significantly over the first half of the year (up 86% over the prior period). The takeaway is that business should be at least decent for the next few years at minimum as they continue to work through their existing backlog (2) low capital intensity (i.e., asset light business model) – With an asset heavy a business, an owner needs to continually re-invest considerably more money into his company to keep earning a profit than an owner of an asset light business. In KHDHF.PK’s case, most of the FCF generated from their operations simply piles up on the balance sheet (i.e., not much of its book value is needed to generate the company’s profits) (3) a variable cost structure – KHD’s primary cost is people, which gives them the ability to more quickly/effectively react to any significant deterioration within the company’s fundamental outlook, and hence to preserve profitability much more easily than your average business over the full cycle and (4) a strong competitive position in a consolidated market – essentially four players control roughly 90% of the worldwide market due to intellectual property. KHD holds roughly 500 patents and is currently the fourth largest player with a roughly 6% share. Keep in mind that their % share was 20% a very short time ago, and their current share is temporarily depressed due to the significant drop off in activity within their core markets (in particular Russia, Eastern Europe, and the middle east). In time we think KHD’s market share will return to a more normalized level as they win new business and activity in their bread and butter markets returns.
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.
The bottom line here is that KHDHF.PK at or around $5.76 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.
Value – current valuation is simply way too cheap given the quantitative and qualitative characteristics of this business.
Improving Operating Performance – given the myriad of macro concerns currently haunting the market and the lack of a standalone operating history, our guess is that it the company will need to have a few quarters of decent results under its belt before the market begins to realize (1) the company isn’t likely to burn any cash going forward due to the strength in the company’s order intake and their growing stream of service revenues (and that the company may in fact be entering into a cyclical upturn) and (2) to fully understand the standalone company’s permanently improved economics (as operating margins post-spin should be permanently augmented relative to what a historical examination of their results would suggest). This is due to a variety of factors, including a higher % of revenues being generated from the companies higher margin service division, the sale of the lower margin coal and mineral division and various other restructuring initiatives the company has taken on in the recent past (like their switch to a 100% outsourced model, etc.). As these changes begin to show themselves in KHDHF.PK’s results, the valuation should normalize.
Improving disclosure/general investor understanding – Post-spin, KHDHF.PK was a near complete “black box,” and the myriad of post-spin information that was released was incredibly confusing (for example, some of the reported revenue numbers didn’t include any of the company’s newly added divisions nor any of the servicing revenue as part of its projections). In fact, it was so confusing that in all honesty it was a significant factor (fwiw, the primary reason had to do with worries on the TTT side of the spin) that ended up causing us to sell out of our original position not long after our original write-up. We were convinced that we had either (1) seriously messed up our work, i.e., we flat out didn’t understand the business in the first place and (2) that management had lied to and/or had intentionally mislead us. Turns out the latter wasn’t the case (and to an extent, neither was the former), and that we had actually been “generally correct” about most of our key assumptions. In retrospect, we simply ended up being “shaken out” so to speak by the classic shenanigans that Michael Smith is so well known for (another lesson learned). Anyhow, the recently released (August 17) interim report and improving disclosure in general from the company over the next year or so will likely lead to better general investor understanding and hence a more appropriate valuation in time.
The Bonding line is renewed (November 10, 2010) – the second the company’s bonding line is renewed, management will likely begin putting the company’s excess cash to work for the benefit of shareholders. We feel this is a near certainty given the company’s present financial strength. Given management’s capital allocation savvy and the current stock price, our guess is that most of the company’s free cash will go towards what would be massively accretive stock repurchases (but they could always go towards acquisitions and/or a dividend of course).
Analyst Coverage – the company has been doing road shoes and attempting to get some decent analyst coverage.
More of the company’s stock should be spun out at the end of the month (8/30/2010), which as always could put some additional short-term downward selling pressure on the stock. Although the longer-term upside to this is that it will also make the stock more liquid. Regardless, both issues are temporary concerns that shouldn’t worry the long-term investor.
The August 17 interim report can be found here