KHD: A Promising Value Stock

A little company background info

KHD designs and builds plants that produce and/or process cement, beneficiated coal, clinker, base metals and precious minerals. On the product side the company supplies its customers with machinery, plant and processes as well as process automation, installation and commissioning. They also provide other services such as staff training, pre- and after-sales services, feasibility studies and financing concepts. The company’s focus is on the modernization of existing facilities for capacity increases and reducing the specific energy demand and the burden on the environment.

The company’s main focus is on Asia, Russia and Eastern Europe, and the Middle East. This can be clearly seen in the backlog breakdown where current $731.7mn of backlog is in Asia (38%), Russia and EE (44%) and 13% Middle East, with the rest of the world standing at 5%.

The company had $638mn of revenues in 2008 and generated operating profit of $56mn (there was a 31mn adjustment for terminated contracts). The company’s order intake took a big hit with the financial crisis and the end markets have since been relatively morbid thanks to a large hit to construction and the initial scare around emerging markets. The main customers, cement producers, are still laden with debt and trying to repair their balance sheets following a period of increased leverage. In this period, the company has not been winning any new considerable business and thus has been eating through its backlog (coming down to $731 from a peak of 1.2bn).

So is it all gloom and doom?

Despite the current gloomy end markets, the rebound in emerging markets, where the company has its greatest exposure, is encouraging. The likes of India will continue to need cement throughout their development stage. This is obviously a very cyclical industry, where the company makes outsized profits during the boom years. In fact the company reckons that there are currently 70 projects out there worth $1.5bn (admittedly about half will never come through thanks to problems in securing financing).

But the main issue lingering in the minds of the investors is the company’s ability to survive the “quiet” periods.

The first thing that pops up is the company’s large cash position which stands at $355mn as of Q209. Of this amount there is a $146mn liability offset as progress billings to customers and $12mn of prepayments, leaving the company nearly $200mn of net cash position on the back of $300mn market cap (this is about $6.7 of cash per share on current price which is $10.25). Note that the cash is 60% in Euros, 20-25% in USD and rest is in Rupees, leaving company exposed to large FX fluctuations. This obviously did not help in Q409 and Q109 when investors were flocking to the USD but has been a positive contributor in Q209 and with the current rates, should have another $5-10mn positive impact for Q309.

The second “haven” on the face of things is the relatively large order backlog that stands at 731.7mn at the moment. This compares to the latest quarterly revenue recognition of 106mn that, at the current rate, should keep the company limping along for another 7 quarters. However, the backlog is not pure. Currently about $130mn of this backlog is classified as at risk (down from $164mn in Q48). Looking at the details, about 60% of the backlog at risk is having issues with scope while the remaining 40% is having issues from financing.

Third is the company’s ability to run the business at a cash break-even level despite this catastrophic period. Despite a -$28mn cash flow from operations printed in Q1 and Q2 2009, we should be re-adjusting for the cash outflow due to declining liabilities of progress billings. This is a natural outflow for a company that is working through its backlog and we are already adjusting for this given that we are already netting off these numbers in the calculation of the net-cash position. Of course there will be real cash burn of this amount if there are no project wins after 6-7 quarters (and then we are burning real cash and dipping into the $200mn cash reserve).

The fourth bright light at the end of the tunnel is the company’s efforts in restructuring. Currently the company is seeing a ballooning in SG&A due unutilized engineers (their time not being charged to projects, i.e. COGS, but to main office, i.e. SG&A, as they are not physically working for clients). The company reckons that around 40% of the engineers are unutilized. To address this problem, they have been active in taking steps to reduce headcount. Sale of coal division reduced 333 employees and the company had also guided to a reduction of 124 employees during H109 (this compares to 1,270 employees as of Dec 2008) so the headcount must have been reduced to around 800, a 35% reduction, which should reduce the company’s ongoing cost base. The company’s 18 month target is to reduce the workforce by 50%.

Let's talk valuation

So what do all these imply for the valuation? Cash accounts for about 65% of the share value. Another kicker for the company is their iron mine which is operated by CLF (supplies going to Cliff, Mittal (MT) and US Steel (X)). The company has a 100 year lease and 16 year mine life on the property. KHD received a base price per ton plus adjustments. Currently the operation levels have been cut by 60 (plus price hits) but in 2008 the royalties amounted to around 27mn. The average quarterly amount since the crisis is around $2mn of royalty income (annualized would mean 8mn per annum). At a 10% discount rate, the 16 year cash flow from the property should mean about $60mn of value added for the company (probably longer as at current production levels, the mine life should extend above the 16 years). That is another $2/share of value, which leaves the remaining business valued at around $1.6/share, or at around $50mn. Of course with higher prices, the value of the property would increase significantly.

Digging out some material from the heydays of the bull market, FLSmidth was speculating that (and they still stick to this number) the expected future average of cement kiln capacity add per year should be around 60-75mty ex-China (50% new capacity and 50% replacement). KHD’s order intake in 2008 was $550mn on a market of c120mty with 7% market share while order intake in 2007 was $761mn on a total market of c130mty with 12% market share. Assuming a 10% market share and 67.5mty market size, the company could book around $350mn of orders. With gross profit margins at 20% (pretty steady during the boom and the crisis) this would imply a 70mn gross profit. Now with $56mn SG&A in 2008 and $516mn in COGS (of which 7-8% is engineering) total staff costs should have been around $95mn. A 50% workforce reduction would mean expenses of around $50mn for SG&A. Adding these two findings should yield an EBIT of around $20mn for the company, implying that the pure engineering portion is trading at round 2x EBIT. At 10x EBIT, this would give a 50% upside to the company valuation. Of course if all is back to normal and the expectations are geared back to higher growth, the kiln capacities would move up to 80-100mty (another 20-50% revenue upside potential for a couple more years), helping the co to make some more supernormal profits along the way.

Disclosure: Long KHD

Comments

[kozanack:]

I am long KHD. I received it as a spin-off from another stock, and sold it during the boom. I like the company and bought it back. If you like KHD, you might also like Mass Financial Corp (MFCAF.PK), which is the remnant of the company that spun-off KHD.

If you like KHD, you might also like India Globalization Capital, Inc. (IGC).

Oct 14 09:59 PM

[MagicDiligence:]

Great job, thanks.

Oct 16 12:54 PM

[Stone Fox C...:]

Don't see how the capacity will be down from 07-08 levels in the future. Countries like India are just now starting to build out infrastructure.

Oct 20 11:45 AM