(Editors' Note: This article covers a stock trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.)
- Kewaunee Scientific (KEQU) trades at a distressed multiple as economic uncertainty surrounding state government spending results in a lack of near term visibility. However, many of the headwinds that limited growth over the past two years are gradually turning into tailwinds.
- Moreover, a focus on the lower top line misses the significant margin expansion and free cash flow growth driven by cost cutting, greater operational efficiencies and a return to a more sustainable capex run rate after the completion of a major facility expansion.
- Furthermore, company specific factors such as new products, increased market share as well as market and geographic expansion should provide revenue growth largely independent of any macro challenges.
KEQU designs, manufactures and installs laboratory, healthcare and technical furniture products primarily for pharmaceutical, biotechnology, industrial and research labs, educational institutions, healthcare institutions, governmental entities and manufacturing facilities.
The domestic segment primarily provides scientific and technical furniture while the international segment provides services including facility design, engineering, construction and project management.
Being a contrarian is easier when you're not alone: The case for better than expected growth
In the most recent 10-Q, management said the outlook for the second half of the current fiscal year would be challenging due to softer demand caused by overall economic uncertainty. This followed challenges in the most recent fiscal year (PDF alert) including higher raw material costs, weaker state finances due to higher unemployment and rising pension costs (resulting in fewer educational construction projects) and global macro concerns (e.g. European debt crisis, debt ceiling debate in the U.S.).
It is this negative backdrop and investor sentiment that creates compelling contrarian and asymmetric opportunities in the first place. However, the actual risk is significantly less than the implied risk for two key reasons. First, the 5x EBITDA multiple prices in most or all of this bad news (or more - see Valuation section below). Second, the outlook beyond the next six months may be better than expected by the market (and even management) as many of the previously mentioned negative factors are in the process of being resolved, if they have not been already.
For example, the domestic economic outlook continues to improve (e.g. unemployment rate at 6.6% from 7.9% a year ago, 4Q13 GDP at 3.2%) while the debate over the debt ceiling is over (and much quicker than expected). Moreover, recent value engineering initiatives should limit gross margin pressure caused by rising raw materials costs. Furthermore, the exponential increase in public employee pension obligations should begin to slow as all of the interested parties (e.g. government officials, unions, taxpayers, beneficiaries) realize that the current run rate is unsustainable and finally begin to make meaningful changes (e.g. Rhode Island took the lead in pension reform).
The outlook is improving from a micro standpoint as well. On the domestic front, management said at the most recent annual meeting that it now has the strongest dealer network in North America after strengthening the support structure. The strong reputation in the core domestic lab market and commitment to innovation provide the opportunity for new and repeat business (e.g. KEQU used the ownership change at a competitor to gain market share) as well as increased penetration into new markets such as long term care facilities driven by a dedicated website/sales team and direct marketing campaign.
On the international front, KEQU has a state of the art manufacturing facility in India as well as a strong support structure and dealer network, which should help gain market share in Asia and the Middle East. The extensive experience in the domestic lab market continues to generate international sales from existing customers looking to expand.
Investors should look past the revenue decrease in the mrq for three reasons. First, the decrease in domestic sales was expected due to the strategy to sell more lab projects through its dealer network (e.g. KEQU provides the products and the dealers provide project management and installation services).
Second, and more importantly, net income increased 12% despite this top line pressure due to a more favorable product mix, lower operating costs and the buyout of the minority interest in its international subsidiary. Manufacturing cost reductions implemented in FY13 are expected to provide annual savings of $2.5 million while all three manufacturing facilities exceeded productivity and efficiency goals.
Third, the rising operating cash flow and falling capex are driving free cash flow growth (yield of 11.3% on a ttm basis). For example, in the most recent six months operating cash flow increased >2.7x to $6.2 million while capex is expected to return to a more sustainable run rate of ~$3 million from $5.2 million in 2011 (due to the expansion and remodeling of its domestic manufacturing facilities). This cash flow provided the ability to raise the dividend 10% (PDF alert) in August 2013.
Improving balance sheet
The lowest net debt in more than five years shown in the chart below significantly reduces risk during this challenging period. For example, while the income statement typically provides growth, the balance sheet provides safety. Moreover, a refinancing in May 2013 extended term loan maturities to 2020 while capex is now being funded by operating cash flow rather than borrowing.
While the pension plan is underfunded by $5.3 million, the risk is less than it appears for three reasons. First, the plan was frozen in 2005, which significantly reduces the liability from that point forward. Second, the growth of the projected benefit obligation in excess of plan assets shown in the chart below is partly due to the discount rate decreasing from 7.04% in FY09 to 4.25% in FY13, which should eventually increase and provide a tailwind. Third, the strong equity market gains of 2013 are not fully reflected in the FY13 funded status (FY ends in April), especially given the 50% equity weighting. Furthermore, the contribution for FY14 should decline to $300,000 from $1 million in FY13, providing an additional boost to cash flow.
The low absolute and relative valuation shown in the chart below removes much of the risk of going long during this challenging period. While its peers may have a better near term growth outlook, KEQU is arguably the better investment given the low expectations implied by a 5x multiple. A stronger case can be made for a 1-2x turn increase in the multiple from this low level than from a higher one.
The following are the primary risks to the investment thesis, in order of importance:
- A deterioration in state finances may result in lower spending on educational construction projects while lower economic growth may result in lower overall construction spending.
- An increase in the cost of raw materials (e.g. stainless steel, wood, epoxy resin) would reduce gross margins.
- The market for furniture products is highly competitive and subject to competitive public bidding for projects.
- Although the rate of inventory growth slowed recently, the rising trend over the past five years from $7.8 million in FY09 to $13.2 million in the mrq may be a problem if not reversed.
The target price is based on a 1x turn increase in the multiple, which is conservative given the discount to the peer group, low absolute level and expected growth outlook over the intermediate term.
A stop loss should be placed below the 50 DMA ~4% below. The time frame is 12-24 months given the previously mentioned near term challenges and low visibility.