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KMG Chemicals (KMGB) recently reported 4th quarter and full year earnings for its 2010 fiscal year, ending 7/31/2010. The full year earnings were a record, at 1.34, but the 4th quarter, while it reflected strong revenues, also had below average margins. The stock ran up prior to earnings, to 15.00, but has been as low as 13.69 since reporting. The market is getting this one wrong, and the stock is a good candidate for accumulation over the next few quarters.

I got the idea from an article by Marc Gerstein here on Seeking Alpha, and did my own analysis before buying.

Overview

KMGB is a small cap specialty chemical maker, growing successfully by acquisitions, having done eight during the past eight years. The strategy seeks niches, too small for larger companies, where KMGB can become a dominant player and achieve satisfactory margins.

There are three segments: Electronic Chemicals (57%), Wood Treating Chemicals (37%) and Animal Health Solutions (6%). Growth has been rapid, 28.7% CAGR on revenues for the past 5 years.

According to a recent presentation, the company has a healthy pipeline of future acquisitions.

Debt and Cash Flow

Total debt at 70% of shareholders equity as of the end of the 4th quarter is high, and would constitute a reservation. However, the company made money every quarter going through the recession and cash flow over the past 10 years has averaged 1.67 X reported earnings. I think the debt load is manageable.

From a discussion on the earnings press release, John V. Sobchak, CFO of KMG, commented:

As of July 31, 2010, working capital increased to $43.4 million, including $4.7 million of cash, from $29.7 million one year earlier. Included in our total debt of $59.3 million is $20.0 million borrowed on our $50.0 million revolving credit facility, which was used to partially fund our most recent acquisition. We expect to use cash flow from operations to significantly reduce outstanding revolver balances by the end of fiscal 2011. We closed the year with shareholders' equity of $84.8 million, up 19% from $71.0 million one year earlier. Cash flow from operations was $14.9 million for the year. It is worth noting that this figure was reduced by the approximately $13.0 million used to fund the working capital requirements of the business acquired in March.

Guidance and Estimates

Again from the earnings press release:

Assuming the continued gradual recovery in the economy, we anticipate that net income for the 2011 fiscal year will increase modestly over fiscal year 2010. We expect the results for the first quarter of fiscal 2011 to be in line with the most recently completed quarter, with a small sequential decline in the subsequent quarter, consistent with our historical seasonality. The year-over-year earnings growth for fiscal 2011 is expected to result from increased profitability in the second half of the fiscal year, with the acquisition's integration driving the increase in earnings for that half. The completion of the integration project should provide further year-over-year earnings growth for fiscal year 2012, as we will benefit from a full 12 months of having the business completely integrated. We are also using this time to identify our next consolidation platform and to set our sights on concluding a transaction in the 2013 to 2014 timeframe.

The consensus estimate for 2011 is 1.43. Noting that the press release includes 2010 pro forma operating results for KMGB including its most recent acquisition completed in March, halfway through the fiscal year, of 1.46, current estimates seem conservative. I'm using 1.39.

Valuation

Forward P/E, using the 1.43 consensus, is 10.

This is a growth story. However, my usual 5 year average EPS methods are workable here. Using 4 years actual, and adding a 2011 estimate of 1.39, projected 5 year average EPS is .99: applying a historical average multiple of 20.5 develops a target of 20, within one year. To illustrate this line of thinking graphically, here is a chart:


(Click to enlarge)

Serial Acquirer

A strategy of growth by acquisition has its perils. However, KMGB has successfully integrated previous acquisitions, including the most recent. Management is active in pursuing acquisitions, as witness the discussion of the pipeline. The statement that they are setting their sights on concluding a transaction in the 2013 to 2014 timeframe is reassuring: it allows time to pay down debt and displays a patient attitude.

Tactics

Beta is 1.8, and the the share price been volatile in recent years. Performance has been consistent, under difficult economic conditions. With current market conditions uncertain, this stock can be expected to fluctuate, providing buying opportunities. I have opened a starter position and plan to accumulate while monitoring progress quarterly with EPS and listening to the conference calls, not neglecting to check progress reducing debt.

If 2011 earnings and revenue perform along the lines suggested by guidance, modestly beating 2010, then over time I look for share prices to appreciate toward a target of 20.

Disclosure: Author long KMGB

Source: KMG Chemicals: Growth by Acquisition in Specialty Chemical Industry