On October 12th KMG Chemicals (KMGB), a global provider of specialty chemicals in carefully focused markets, reported its fourth quarter and full year results and continued to impress, with records in both revenues and net income (see earnings call transcript here). Revenues rose 9% to 208.6 million, net income rose 50% to 15.3 million or 1.34 per diluted share. This company has demonstrated an excellent ability to execute its growth by acquisition strategy, successfully integrate acquisitions into existing operations and realize expected synergies. The question is, should this small cap firm be valued as a growth company or as a value investment? Depending on which approach you take, the difference in valuation is quite large.
THE GROWTH ARGUMENT
Including the most recent fiscal year, KMG EPS has grown at a average annual rate of 27.35% over the last 5 years. The Average ROE over the last 5 years is 15.39%, Using the consensus mean estimate of 1.42 per share for FY 2011, Fridays closing price of 13.97 and the annual growth rate, the PEG Ratio is only .36. Despite a hefty Debt to Equity ratio of 65%, managements ability to quickly realize synergies has allowed EBIT to give an interest coverage ratio of 10.89, which is almost double last years interest coverage ratio of 5.77. The interest coverage ratio measures the number of times a company's EBIT could cover its interest payments. A higher interest coverage ratio indicates stronger solvency, offering greater assurance that the company can service its debt from operating earnings. This is a very important metric to watch when you are analyzing a company making a number of acquisitions over a short period as they are usually financed in part by debt.
THE VALUE ARGUMENT
KMG Chemicals grows its company through strategic acquisitions, however, the companies being acquired and the industries the companies compete in are mature industries that are not growth, but cyclical industries.
The acquisition of General Chemical in March 2010 gives KMG chemicals access to the 450M dollar asian market, which is 1.9 times the size of the US and European markets combined. However, the semiconductor industry is highly cyclical, with constant booms and busts in demand for products. The demand for KMG Electronic Chemicals will be affected by the cyclical nature of this business. Demand is determined by end-market demand for PCs, cell phones and other electronic equipment. When demand is high, companies like Intel (INTC) (10% of sales in 2008, 2009, and 2010) can't produce enough microchips to meet demand. When demand his low, times can be brutal.
Wood Preserving Chemicals
The portion of the wood preserving chemical market that KMG Chemicals serves is a mature market. KMG Chemicals manufactures and sells Penta and hydrochloric Acid, which is a by-product of the Penta manufacturing process and is sold in Mexico for use in the steel and oil well service industries. KMG Chemical is also a reseller of Creosote, which is used to treat utility poles and railroad cross ties. Railroad companies in the US and Canada purchase between 15M-21M railroad cross ties annually. The last several years have seen purchases at the top end of that range. Beginning in 2010, demand will be inline with the middle of the historical range. Penta treats and protects utility poles, which KMG estimates, is a market in which there are about 2 million utility poles treated each year.
Profitability in this operating segment is dependent on raw material inputs of chlorine, phenol and co-solvent needed to manufacturer Penta. Creosote is actually a finished product and price increases are passed on to the customer. There was a reduction in demand for utility poles and railroad cross ties in FY 2010 due to economic conditions. Management expects operating profit margins to decline to about 25% in FY 2011 in this operating segment.
The operating segment is also cyclical, with revenues being impacted by commodity prices. Higher input prices paid by KMG Chemical customers for items such as corn generally have a negative impact on sales when producers need to cut costs. Higher beef, poultry and pork prices allow KMG Chemical customers to purchase product without having a negative impact on their margins. Management is looking for a increase in sales and operating margins in FY 2011 as they expand their product offerings. This operating segment could be where the next acquisition is made in the 2013/2014 fiscal year.
A VALUE PLAY OR GROWTH OPPORTUNITY?
Unfortunately, on far too many occasions, we will see a valuation target based simply on the Industry Average P/E and the mean EPS estimate. In some cases this is appropriate, in most cases it isn't. Applying this method to KMG Chemicals we get 22.43 per share. This valuation is seemingly justified by management's outstanding performance with regards to successful integration of its acquisitions. If we really want to pull out the pom poms and run out on the field, we could use the PEG ratio. Using the growth rate and consensus EPS for FY 2011 we get a valuation of 38.83 per share. Really? Now that is just plain silly.
After returning from bubble land to earth and taking a serious look at this company on a value basis using a relative valuation model, I found that valuing the firm on either a price to sales or price to book basis would yield the most accurate valuation relative to other firms in its industry. On a price-to-book and price-to-sales basis based on the just closed fiscal year, my proprietary models value the firm is at 13.97 and 14.64, respectively. which is right around where the stock was trading on Oct 15th. If, based on information obtained in the conference call, we make a "very rough" estimate FY 2011 net sales at about 216M and net income at about 17M, or roughly 1.49 a share, without making any adjustment for share growth due to the exercise of stock options, on a price-to-book and price-to-sales basis I get values of 16.76 and 15.12, respectively. The 1.49 EPS estimate is in the middle range of managements growth expectations of single-digit to mid-teens from FY 2010 EPS of 1.34.
After adjusting for risk and taking the current over bought market conditions into consideration, I like the stock at around 13.50 per share. If I already owned it, I would hold my existing position and add if possible at lower levels than the Oct 12 price 13.97. It should also be noted that this stock has a very low trading volume, averaging about 65K per day. Therefore, patience is key with regards to obtaining the best price in your acceptable range. The market is valuing the stock as a value play and, in my judgment, that is what it is.
Disclosure: No ownership of KMGB stock by the author or any family members.