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Hat tip to mwhitman for doing all the heavy lifting

Thesis:

The Visteon Corporation is a classic post reorg/special situation with a large margin of safety and substantial near-term upside potential.

Brief Business Description:

Visteon Corporation is a global Tier 1 supplier of automotive products to original equipment manufacturers (OEM’s). Visteon is a market leader in each of its three core product groups: climate, electronics, and interior systems. Visteon is geographically diversified and is not overly reliant on any one particular OEM. The company’s three largest customers are Ford, Hyundai/Kia, and Nissan/Renault (which make up 29%, 27%, and 9% of the company’s revenues respectively).

Opportunity Overview:

Visteon’s shares are currently trading on a “when issued” basis at roughly 3x 2011 EBITDA, and after backing out the company’s significant ownership in high growth subsidiaries, we believe the core Visteon business trades for between 1.5x and 1.7x EBITDA. Given Visteon’s multiple internal and external catalyst’s, highly attractive absolute valuation and the outsized spread between the company’s “when issued” shares and the already depressed valuation’s of its global competitors, we think that the stars are aligning for bargain hunting investors to generate spectacular returns of 30%+ in a short period of time with relatively low risk.  Keep in mind that this isn’t “your father’s” Visteon, as the company will exit bankruptcy permanently improved and completely transformed, offering investor’s both a 1) quick, high-return, relatively risk-free arbitrage and/or 2) an inexpensive way to play any upturn in – or at least the stabilization of – global auto sales and economic activity in general.

The idea here is simple. As Visteon exits chapter 11, the near to medium-term upside will likely be driven by a combination of 1) a couple of imminent, high probability catalyst’s that should force the market to assign this company with a much more appropriate valuation on an absolute basis and relative to its peers and 2) various operational and financial enhancements that the company recently undertook while in bankruptcy should continue to yield visible and increasingly positive operating results for the foreseeable future.

Our expectation is that the initial roughly 30%+ will come almost instantaneously (within a month or so) as 1) the stock begins to trade regular way 2) equity analysts initiate coverage and 3) various institutional and index funds that have been unable to purchase the stock up until this point (due to restrictions on purchasing company’s in Ch. 11), begin buying in droves.  Notably, the return assumption above assumes that upon re-emergence the company trade’s at an incredibly non-demanding multiple of 3.75x EBITDA or, to put it another way, in line with the cheapest automotive suppliers within the industry as a whole.  Keep in mind that we think this estimate is very (almost unjustifiably) conservative given that on average Visteon’s peers tend to be considerably more levered, and typically possess both lower EBITDA margins as well as less attractive long-term growth prospects.

A Quick Primer on the Investment Attractions of Bankruptcy:

The primary reason we tend to be attracted to investments in distressed and/or bankrupt securities is because it is another “secret hiding place of stock market profits” or put another way, one of those areas of the market that consistently tends to mis-price assets, and hence tends to offer investors every now and again the opportunity to generate outsized returns, with very little risk.

Additionally, like all special situation investing, distressed and/or bankrupt securities 1) are often not very sensitive to fluctuations in the general equity and debt markets. This is important, as the behavioral characteristics of “when-issued” post-reorg equities are actually very much like merger arbitrage investments, as their price fluctuations are driven much more by the progress of the reorganization than they are by the vagaries of the overall stock and bond markets and 2) in bankruptcy investing, the emergence from the reorganization process usually serves as a high probability catalyst for the realization of underlying value.  We think an investment in Visteon at or around the current price provides investors with a short duration, non-correlated event-driven investment, where an imminent catalyst is more likely than not to unlock substantial value regardless of what happens in the stock and bond markets.

Why is it mis-priced?

Historically investors have tended to perceive securities of financially distressed and/or recently bankrupt companies as highly risky, and therefore as unwise and irresponsible investments for the risk-averse investor (or so the story goes). We think the reality here is considerably different than what the conventional understanding would have most investors believe (surprise, surprise). Again, the paradox here is that contrary to what most think, the facts actually tell a much different story – as numerous studies have shown that distressed investing (properly implemented of course), actually results in the opposite outcome – i.e., it subjects investors to less risk and volatility, while offering significantly higher returns in comparison to more conventional forms of investing (a rather nice combination, no?).

Also, distressed securities are often illiquid, analytically complex, and typically require specialized knowledge to intelligently analyze, so most professional investors tend to be uninterested and/or reluctant (if not flat out unwilling) to put the requisite time in to understand and exploit this lucrative niche.

Other notable reasons for the mis-pricing include…

No Ticker Symbol – the company is currently trading on a when-issued basis and therefore does not as of yet have a ticker symbol and isn’t currently registered. This is obviously a temporary issue and we expect it to be at least partially resolved on October 1, when the company will receive a five symbol ticker listed on the pink sheets. Quickly thereafter (possibly as soon as November) the company should receive an NYSE listing, resolving the issue entirely. Fwiw, we think this is much more of a blessing than a curse given that most institutional investors cannot purchase when-issued stock, which in turn provides investors with the opportunity to essentially “front run” what will almost certainly be a large amount of institutional equity buying.

Economic Concerns/Fear of a Double Dip – another reason(s) for the current mis-pricing stems from concerns over the broader economy, but specifically worries about the potential for a double dip and the impact such an outcome would have on worldwide car demand. Clearly whether or not we actually experience a double dip is anyone’s guess, and the probabilities of such an outcome are open for debate – that said, we think that investors with longer-term time horizon (i.e., those who are interested in VSTN for more than just a quick arbitrage) are likely to do well either way, given we think the company’s current valuation already discounts a pretty unfavorable (and very unlikely) outcome. That said, it’s always possible to hedge most of the market risk here by simultaneously shorting Visteon’s more expensive peers.

Non-Economic Selling Pressure – a common problem/opportunity with investing in post reorg equities is the potential for a significant amount of non-economic selling pressure to take place once the company in question has been relisted and begins to trade again. This typically happens when the newly “equitized” former creditors cannot (due to institutional rules) and/or have no interest in (i.e., as former creditors they are just glad to get their money back) holding the new company’s shares upon re-emergence. So given this 1) ever-present reality and 2) the fact that so many of the recently listed post reorg stocks have traded down upon re-emergence of late, we think it would be foolish to completely discount the possibility. That said, we think any near-term downside volatility due to creditors selling would be a temporary issue and hence a non-concern. Fwiw, in Visteon’s case we actually think it isn’t likely to happen at all (or at least if it does, for any meaningful amount of time) given the oversubscribed rights offering and the fact that the current board/new shareholder base consists primarily of pre-petition bond holders who have every incentive to stick around and help bring about the continued realization of equity value. So given that, an enticing absolute valuation, and what we believe to be a considerable amount of pent-up demand from various sources this isn’t an issue that keep us up at night.

A Limited and Misleading Operating History – In our experience, any time a company’s future operating performance is unlikely to look anything like its past there is usually a good chance the market will mis-price the opportunity in question.  We think that’s definitely the case here.

For those of you who are unfamiliar, Visteon was the result of a poorly conceived spin-off from Ford in 2000, so the track record that does exist for the company is limited and (for reasons explained below) entirely unimpressive.  Much of the poor historical operating performance of the company wasn’t so much caused by permanent issues endemic to the business itself, but was more a function of both problems related to the spin (which have since been resolved) and other temporary, more macro orientated cyclical issues. For example, on the company specific side of things Visteon was originally spun-off with unprofitable Ford contracts, inadequate financial and admin systems, an overpaid union workforce and a debt load so large that the company never really had a real shot at viability, which actually almost got Ford sued for fraudulent conveyance after the fact. The only reason it didn’t was because by 2005 Ford essentially admitted as much and in an attempt to make amends ended up voluntarily agreeing to buy back a large chunk of Visteon’s money losing operations (and the large pension obligations, amongst other ongoing expenses/liabilities that came along with them) that were strangling the company to death at the time.

The reprieve was short lived though, as various macro/cyclical/financial issues facing their OEM’s began to overwhelm any of the relief that the 2005 restructuring provided. Like nearly all of the auto suppliers over this period, a few of Visteon’s bloated hugely indebted OEM’s began to squeeze them in a desperate attempt to stay afloat, which obviously had a negative impact on the company’s profitability over the period in question. For reasons discussed below, we actually think these issues won’t be nearly as large of a concern over the next few years, although it is undoubtedly something to keep a close, watchful eye on in the years ahead.

A Classic Low-Risk, High-Reward Investment Opportunity

Whether or not the company actually trades higher upon re-listing, we think it’s pretty hard to lose money (under nearly any outcome we can imagine) purchasing VSTN at $48/share or roughly 3x EBITDA when its margins are expanding and 2/3rd of its revenues are coming from Asia. After all, Visteon is an established and fast growing market leader with rapidly improving fundamentals and a sticky and above average customer base. Granted this isn’t the best business in the world, but given the nature of how the industry operates (LT contracts, etc.), the company does have a pretty defensible niche – especially given its improved financial position, revamped operations and its diversified client base (who are for the most part healthy and growing ). Again, the current price is simply way to cheap all things considered.

Granted, most investors familiar with the company probably think of the company as it was in its pre-bankruptcy days – where the company had a bloated cost structure, a large amount of debt, a more concentrated customer base, and the majority of its business was derived from slower growth, lower margin U.S. and Western European markets. But that was then and this is now and as of today (i.e., post bankruptcy) the company is a very different animal as it possesses (we don’t think it ever hurts to reiterate it one more time) a lower “lean and mean” cost structure, a net cash position, a stronger, more diversified client base and best of all, the majority of the company’s business is now derived from rapidly growing, higher margin Asian markets.

The bottom line here is that the company is cheap, its fundamentals have clearly stabilized and it’s growing, margins are improving, and barring any worldwide catastrophe we think these trends will in all likelihood continue for at least the next couple of years. If not, the sizable margin of safety embedded in Visteon’s current price will likely ensure investors do okay regardless. The way we look at it is that if things get better, the upside from here should be spectacular. If they’re okay i.e., both economic conditions and global vehicle sales purely stabilize, we will likely still do very, very well. If they get worse, we will probably at least get our money back (or maybe even lose a little). All in all we like the risk/reward here.

Valuation:

We agree with MWhitman that the most appropriate way to value Visteon is on a Sum of the Parts basis, given the majority of Visteon’s current EV consists of a 70% interest in Halla Climate control (a publicy traded company in Korea) and a 50% interest in Chinese JV Yanfeng Visteon. In order to do that, one needs to separate the cash flows between the company’s Asian interests from the rest of the company and then apply an appropriate multiple to each piece. That way we can add up the pieces and adjust the balance sheet for the sources and uses of cash associated with the reorganization and hence, get an idea of what the consolidated company’s total value is at our base case multiple of 3.75x EBITDA (i.e., the low end multiple of Visteon’s comps).

Let’s begin with the value of the non-Asian segment. With consolidated 2011 EBITDA of roughly $675m, we need to subtract the 92.2m & 26.2m in net income from the Yanfeng and other JV’s. After that, we will need to add back 100m associated with the minority interest deduction and then last but not least, subtract Halla’s 325m in expected 2011 EBITDA. If we do the associated math, we find that our adjusted non-Asian 2011 EBITDA comes to 331m, which, if we then apply our chosen multiple of 3.75x 2011 EBITDA we will get a TEV of $1,243.7 for Visteon’s non-Asian assets.

As far as the values of the Asian assets are concerned, we think it makes sense to value Visteon’s 70% stake in Halla Climate at market, or roughly $1.1B. Probably due to the stigma associated with having a bankrupt parent, Halla trades at only 10x its 2010 after-tax earnings which is cheap from an absolute standpoint but especially so given Halla’s competitive position, above average growth prospects and improving profitability. Keep in mind that the health of Halla is a function of the health of Hyundai, which notably has a long history of steady growth and market share gains (which we expect to continue).

We take a similar tact with Visteon’s 50% stake in Chinese JV Yanfeng Visteon. With Yanfeng, we apply a multiple of only 9x after tax earnings or $829.7m – which again we feel is almost unjustifiably conservative given the qualitative and quantitative characteristics of this business (after all, JCI didn’t try and steal it in bankruptcy for nothing). On a relative basis, Yanfeng is also very cheap as all of its Shanghai, Japanese, and Hong Kong traded comps currently trade hands between roughly 10 and 15x after tax earnings.  Anyhow, if you are not as of yet sufficiently convinced with the conservatism of our valuation, did we mention that Yanfeng is a global industrial powerhouse with a diversified client base and 70 production facilities in China and elsewhere around the world (which explains why the company is currently ranked #4th out of 100 of China’s automotive component businesses)? How about the fact that it has been growing at over 60%? Now no business can grow that fast over the long term, but given the absolutely gigantic runway still ahead of it and the structural tailwinds firmly at its back, 15x after tax earnings certainly seems like a more rational multiple all things considered – but for conservatism’s sake, we will stick with or original 9x estimate. The only other piece of the puzzle in this regard is adding in Visteon’s 50% interest(s) in their other JV’s – and again, for conservatism’s sake we valued these additional JV’s at a conservative 5.5x after tax earnings (or $143.9m).

Last but not least we want to point out that the valuation below (again for conservatism’s sake) assumes 1) the billion plus NOL’s the company has are worthless, and 2) that the company doesn’t benefit from any future working capital releases associated with the restoration of trade terms. Obviously both should generate considerable amounts of value for shareholders.

Sum of the Parts

Non Asian Visteon EV = $1,243.7

70% Stake in Halla Climate = $1,122.1

50% stake in Yanfeng = $829.7

Other JV Interests = $143.8

TEV = 3,339.3

Exit Cash(1)= 785

Less: Cash at Halla = (100)

Warrant exercise Proceeds = 114.2

NOL (2) = 0

W/C Source of Cash (3) = 0

Exit Debt = (500)

Other Debt = (143)

Equity Value = $3,495.8

Shares Outstanding (mm) = 54.2

Value Per Share = $64.45

(1) See sources and Uses of Cash

(2) Book value of NOL’s were $1.6B as of 12/39/09

(3) There will be a material amount of cash from restoration of trade terms

Sources & Uses of Cash

Sources:

Equity Right’s Offering  = $1250

Cash 6/30/2010 = $1160

New Term Loan Proceeds = $500

Additional Cash Generated since 6/30 = $60

Total Sources = $2,970

Uses:

Prepetition Term Loan = $1659

Cash on B/S on Exit = $785.3

Administrative Claims = $105

ABL Claims = $ 127.2

DIP Facility = $75

Priority Tax Claims = $5.3

Other Claims = $5.4

Cash to other UnSec. Claims $83.4

Backstop Fee’s @3.50% = $43.8

Other Fee’s and Expenses = $80.5

Total Uses = $2,970

Thoughts on the Rearview & the Road Ahead:

We think that one of the silver linings of the turmoil of ’08 and early ’09 – and the restructuring’s and bankruptcy’s that followed – was that it caused many of the biggest OEM’s to fix their balance sheets, wring out unnecessary costs and rationalize their excess capacity, all of which have set the stage for a period of significantly improved profitability (for both the OEM’s and indirectly, the auto supplier group as a whole).  This is important as this new reality should make OEM’s considerably less likely to try and squeeze their suppliers (and hence depress their profitability), at least over the next few years or so.

Additionally (as odd as it may sound), the secondary effects of the great recession turned out to be even more positive for Visteon, as bankruptcy forced it to lower its cost structure, right size its capital structure (post reorg the company has zero net financial leverage) and revamp and transform its operational footprint, all of which should result in permanently improved operating performance and significantly better long-term growth prospects. We don’t think it’s a stretch to say that for all intents and purposes old Visteon and new Visteon are essentially completely different companies. We want to also quickly mention that it’ likely no small thing that for the first time since its arrival as a public company nearly a decade ago, the company as well as a significant amount of its customer’s/end markets are simultaneously healthy (or at least healthier).

So in sum, given the above in conjunction with the fact that global auto production has stabilized and that – at least for the moment – appears to be solidly growing again, it may be that Visteon’s next few years will actually be quite bright. In fact, we think the next few years likely will be, barring of course any sort of scorched earth scenario where global growth in vehicle production falls of a cliff. Again, Visteon is a materially better business today than it has ever been (and should trade at a materially higher valuation than an examination of its history would suggest), as the company should not only generate higher margin cash flows, but it should actually be able to grow those cash flows at a much faster clip given the large and faster growing runway ahead of it.

Miscellaneous:

JCI Bid/Potential Asset Sale’s – Given that Johnson Controls has publicly stated that it is essentially chomping at the bit to make an offer for the company’s interior’s and electronics businesses (JCI recently mentioned that they are simply waiting until after the Visteon’s emergence from bankruptcy to re-start talks), we wouldn’t be at all surprised to see a significant amount of the company sold in the near-term.

Difficult Industry/Global Sales Decline – At the moment the rebound in global SAAR is a tailwind, but obviously if there was any significant decline in global vehicle sales from where we are at it, Visteon’s OEM’s would suffer and hence so would Visteon. Investors who intend to own the company for the long-term should always keep in mind that Visteon operates in a difficult industry. The auto parts industry is a cyclical, brutally competitive industry that is both labor and capital intensive. That said, given their position in the industry, any uptick or unexpected strength in global vehicle production should quickly benefit the company’s bottom line.

Management Incentives/Recent Sandbagging – As with all reorganizations, it’s helpful to have a solid understanding of the incentives of insiders/management when analyzing the opportunity. So given their options and the current global economic uncertainty, we don’t think it’s at all surprising that they have been grossly low-balling estimates over the course of the reorganization and will likely continue to do so at least for the near future (fwiw, this reality provides us with further confidence in the conservatism of our valuation).

When Issued Eligibility – In our opinion, given the cleaner arbitrage associated with the when issued shares, we think they are the ideal way to exploit the current mis-pricing. The problem though – at least for funds with less than 100m in AUM – is that smaller funds can’t effectively take advantage of it. For those of you without the requisite size and who are also attracted to the opportunity on a longer-term basis, one can always purchase the old equity (VSTNQ.PK). Interestingly the old equity will receive 1m shares and 1.57m warrants with a $58.80 strike price upon the newco’s relisting, so although not as cheap as the “when-issued” shares, at the current $0.52 they are still attractive. It’s important to know though that the trading dynamics of the old equity will likely be a lot different (i.e., less efficient, more volatile, etc.) than the new equity. Below is a sensitivity table regarding the trade-offs between the new and old equity.

SENSITIVITY ANALYSIS: IMPLIED ABSOLUTE RETURN
NEW EQUITY/WHEN ISSUED SHARES @ $49
VISTEON CORE EBITDA MULTIPLIER
28% 2.5x 3.0x 3.5x 4.0x 4.5x 5.0x
HALLA P/E 8.0x 5.5% 11.8% 18.0% 24.2% 30.5% 36.7%
10.0x 15.4% 21.6% 27.9% 34.1% 40.3% 46.6%
12.0x 25.3% 31.5% 37.8% 44.0% 50.2% 56.5%
14.0x 35.2% 41.4% 47.6% 53.9% 60.1% 66.3%
16.0x 45.1% 51.3% 57.5% 63.8% 70.0% 76.2%
OLD EQUITY SHARES W/ WARRANTS @ $0.515
VISTEON CORE EBITDA MULTIPLIER
0.026393 2.5x 3.0x 3.5x 4.0x 4.5x 5.0x
HALLA P/E 8.0x -22.8% -18.2% -13.6% -4.2% 7.5% 19.2%
10.0x -15.5% -9.1% 2.6% 14.4% 26.1% 37.8%
12.0x -2.2% 9.5% 21.2% 33.0% 44.7% 56.4%
14.0x 16.4% 28.1% 39.8% 51.5% 63.3% 75.0%
16.0x 35.0% 46.7% 58.4% 70.1% 81.9% 93.6%

Via Morgan Stanley/Arnaud Mares

DNA/Vivek Kaul Interview

H/T to Corner of Berkshire and Fairfax

Howard Mark’s latest (brilliant as usual)…

Via Bloomberg

For more on Burry and another great read check out Tariq Ali’s (of the fantastic Street Capitalist) latest post on the interview.

Daniel Loeb’s latest…

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

The Opportunity

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).

Business Description:

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.

Revenue Driver’s

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

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)…

Russia/Eastern Europe

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.

Valuation

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.

Catalysts

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.

Miscellaneous:

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

http://www.khd.com/financial-reports.html