KSW (NASDAQ:KSW) furnishes and installs heating, ventallation and air conditions (HVAC) systems and processing pipes for high-rise and public works projects. The company does not actively pursue projects worth less than $3mm. In this post, I hope to demonstrate the company is significantly undervalued on a variety of metrics and demonstrate an investor at today’s prices picks up a company with a decent moat with a significant margin of safety.
What they do
As mentioned above, KSW focuses on installing HVAC systems for high-rise and public work projects. They have also begun providing project management services for new construction projects. What this means is that on a large and complex project (generally one with a mechanical portion over $10mm), a construction manager can hire them for a fixed price and they will hire and manage subcontractors to perform the work. This is beneficial for the construction manger as it allows them to accurately judge the price of this portion of the project before signing on to build a building and allows them to lock in the price of this portion of the project, reducing the risk of cost overruns or time delays.
How we got here
The company derives all of its revenue from the New York City market. As you can imagine, with a complete reliance on the New York market, revenue and backlog have been crushed during the current recession, and the stock price has been hammered as well, dropping from the $5 to $7 range to the current $3 to $3.5 range. Also, the CEO began exercising and selling some stock options that expired at the end of this year, which has helped to keep the price depressed.
The company’s moat
The company actually has a pretty significant moat. The company has a great reputation within the NYC market. Additionally, the company is willing to work with managers and help design the HVAC system while the building is being drawn. This allows them to design creative solutions that can help customers design building that cost less money and are more energy efficient. It takes a long time for a company to build a reputation that will allow them to partner with construction managers and aid in building designs.
To sum it up, this basically means the company designs systems that are critical to the building (who would live / work in a building without air conditioning and heating!) and represent a relatively small part of the building cost (a skyscraper can easily cost over $300mm, and the company’s designs can represent less than 10% of this). With such an important and cheap project, a contract manager is not likely to take the risk of hiring a no name contractor or saving a few bucks by hiring a contractor with a shaky reputation. They are much more likely to pay a premium for a partner they can trust and who will work with them to save them money. (Another company I like that has a similar advantage is GHM, but the significant run up in price over the past six months has taken away a big part of their margin of safety.)
However, the financial crisis has frozen most of the private construction market. As the company notes, they would much prefer to work private contracts, but due to the freezing of the market, they have shifted to the public market. However, many of their advantages don’t apply to the public construction market. They can’t offer their value engineering services, and they must go through a complicated bid process that can significantly reduce margins (a private company will hire them for a premium to get their value added and trust worthiness, but in most cases the govt. must hire the lowest cost bidder).
Combined, this has created a perfect storm for the company. They are in a hated industry (commercial real estate construction in New York City). The selling by the CEO has weighed down on the stock. Finally, most of their revenue currently comes from government projects, and the finances of the state of New York and New York City has investors nervous that there will be big construction cost cuts in the future, reducing revenue. Add the three together, and you get a company with a significantly depressed price. However, with the CEO’s selling complete, commercial real estate showing signs of life, and the company’s ability to switch from between private and public markets make these concerns short to medium term problems, and should not subtract from the long term investment story.
In the past five years (fiscal 2005, 2006, 2007, 2008, 2009), the company has earned operating income of $2.8m, $5.4m, $6m, $6.8m, and $2m. ROE was 28%, 24%, 21%, 21%, and 6%. Pre tax ROIC, by my calculations, ranged from 30 to 40% before falling to 10% in 2009. The significant drop off in all metrics 2009 is due to some cost over runs and the lower margin projects from working in the public sector. However, even during the biggest financial crisis in the past 75 years, and probably the worst time frame for commercial real estate construction as well, the company managed to turn a decent profit.
Currently, with a share price of $3.45, the company has a market cap of $22m. However, the company has over $17m in cash and short term investments and just over $1m in mortgage debt, for a net cash position of about $16m. Not all of this can be considered excess cash, however. In order to meet bonding requirements and for customers to feel comfortable giving them work, the company must maintain a significant level of cash. How much? It’s impossible to be complete accurate, but in 2005 they had revenue of $54m and a net cash position of $6m. In 2006 and 2007, they had revenue around $77m and net cash of about $12.5m and $17m. This year, they are on pace for around $70.
Given those figures, I’m inclined to say they need around $10m in cash to run their business and meet bonding requirements. While this is likely pretty conservative, given the still shaky state of today’s capital markets, I always like to build in a margin of safety. This suggests excess cash of about $6m, and a true enterprise value of around $16m.
So for $16m, you get a company with significant competitive advantages, a history of strong returns on equity and capital (ROIC above 30% with a significant excess cash position!), and an ultra conservative capitalization (remember, they still have $10m, they just need to keep that in the bank to meeting bonding requirements), trading for under 8x times trough operating income!
Additionally, in the first nine months of this year, the company has earned $2.7m in operating income. In other words, they are trading for less than 7x just nine months of operating income for this year! That’s less than 5x full year operating earnings, and the company is still nowhere near what I would consider normalized levels.
Finally, the company has some likely catalysts coming up.
First, backlog and revenue are both increasing, and the company mentions they have another contract which they have already won but have not booked to backlog because final pricing has not been determined. As backlog and revenue continue to rise and the economy continues to strengthen, the companies earning will follow.
Second, the removal of the CEO’s option exercise / sale overhang, which has both weighed on the stock and created some uneconomical selling that has dragged the stock down.
Third, continued return of capital to shareholders. The company has a strong history of both paying a dividend and, to some extent, buying back stock. While I’d much rather them buy stock back hand over fist at these prices, it’s always nice to have managers act like owners and return capital to shareholders instead of investing it in unprofitable empire building.
At today’s prices and with the recent extra dividend (which seems like it could become a recurring thing, as the company announced it as a regular dividend, not a special dividend), the company yields 5%, so shareholder’s are definitely being “paid to wait.”
Finally, the company’s tax rate has crept up towards 50% in some years, which is absolutely insane. Implementing some tax reduction strategies, or even moving headquarters from New York City to somewhere close by could significantly reduce their taxes. I have seen some talk that the company might pursue the later strategy, but this would only be a bonus resulting in likely additional dividends / buy backs.
It’s difficult to set a price target on this stock. It’s definitely cyclical, and, to some extent, the moat relies on the continued service of the CEO. However, just because it’s difficult to set a price target doesn’t mean the stock isn’t obviously cheap.
Taking a stab at a price target, I would estimate normalized operating earnings at $5m. Note that this is less than the company earned in 2006, 2007, and 2008. Applying a 7 multiple to these earnings (which seems reasonable for a company with low capital reinvement needs and high ROIC, but somewhat dependent on the services of the CEO) would yield an enterprise value of $35m. Adding back $6m of excess cash gives us a market cap of $41m, and a stock price of $7.15, or more than a double from today’s prices.
What I really like about the investment is the strong upside potential with limited to no downside risk. Worst case scenario, the company has $16m (only 25%ish below today’s stock price) to deal with any problems / liquidate to shareholders if business drags to a halt. My price target represents a fairly low multiple on a conservative normalized earnings number. I would say the risks to both the earnings number and the multiple are much more heavily weighted to the upside than the downside. Best case scenario, both of my numbers were too conservative, and the stock is closer to a triple than a double.
Disclosure: I am long KSW.