Humboldt: When Cash Is Not Always King

KHD Humboldt Wedag (KHD) is an international industrial engineering and equipment supplier for the cement processing industry. Thanks to reduced demand for its products due to the recession, the company is pretty close to just breaking even. However, the company has negligible debt and a cash position of about $350 million, yet it trades for just $273 million! Sounds like a steal, right?

Perhaps not. The strangeness of this company's name is matched only by the strangeness of its balance sheet: If one were to remove that net cash balance, the company would have negative equity of about $100 million! Meanwhile, the company is trying to sell its fixed assets in order to raise even more cash. What gives? Can shareholders expect a massive payment?

It would not appear so. KHD appears to operate in such a highly cyclical environment that not only is it not sufficient to not have any debt (as we've discussed is important for cyclical companies), but it needs an extremely large cash buffer to boot!

To understand this phenomenon, we have to understand the cash conversion cycle for this company. When a company contracts KHD to design/build a plant, it makes a large chunk of the payment upfront. KHD doesn't get to count this as revenue yet, since it hasn't performed any services. But using these funds, KHD will pay its suppliers, workers and other expenses associated with performing its end of the contract.

When a cyclical downturn hits, however, not only does it hit hard (order intake in the second quarter was a full 90% lower than that of the year-ago period), but it means there's no cash coming in! Even though KHD will be booking revenue in future quarters as it fulfills its backlog, it won't be receiving cash, but will still be spending cash on its costs.

The highly cyclical nature of this business combined with the fact that cash is paid upfront means there can be long periods of low cash intakes for this company. But during these long periods, the company still has to perform on its end of the contracts. As a result, the company has to maintain a large cash hoard just to stay in business, even though shareholders might think the cash can be paid out! It would appear that sometimes cash is not king: Do not automatically believe that companies with strong cash positions offer a margin of safety.

Disclosure: None

Comments

[stefaith:]

KHD does get a large cash deposit on signing a contract, but not the entire amount. Hence when working down the backlog, KHD receives further payments making the process cash flow positive or neutral, not negative as your article implies.

Aug 19 04:26 AM

[geofisher1:]

It would have been informative to have split out current deposits from business working capital. I have seen this number in other reports, but it is outdated. A few months ago, it was something like $4-5 a share in non-deposit cash, with the balance project deposits. I'm sure its less today.

Aug 19 10:00 AM

[Gwyn:]

KHD operates in a highly-cyclical, high fixed-cost industry. However, as an engineering company, KHD has a scalable, low fixed-cost business model. Essentially, it requires only FTE (engineers) and office space to operate. It did experience a negative cash flow in the current quarter (3/31) of $28mm. However, at that burn rate, their cash-on-hand would last over three years. Order backlog is still good at $730mm - approximately 1x annual revenue. You could certainly expect order intake to take a hit in the recent quarter due to the worst global economic slowdown in a long time. However, we are already seeing positive growth in many parts of the developing world. Likely, order intake will be on an upswing.

This company is definitely a long-term "buy" with limited downside. The question is how long will it take to see improvement in demand?

Aug 19 03:18 PM

[KFC007:]

WAS A SOLID COMPANY. IS IT SO SOLID NOW? MAY BE.

Sep 22 12:20 PM