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Key Technology, Inc. (NASDAQ: KTEC) designs, manufactures and sells process automation systems. The company’s primary market is the food industry, where the company specializes in potatoes, and more specifically french fries produced in North America. This market is mature, but demand still exists for equipment that increases yield. The company’s efforts to diversify its revenue stream has led it into other food categories including fruit and vegetables, as well as non-food industries such as tobacco, pharmaceuticals and neutraceuticals.

The company is (as of the time of writing, 11/8) trading at a market cap just shy of $71 million, yet the company has $26 million in net cash, is profitable and generated $10.8 million in free cash last year (for an ex-cash yield of 24%!).

The company’s historical returns have been highly volatile, though largely positive.

Key Technology, Inc. - Historical Returns, 1995 - 3Q 2011

Key Technology, Inc. - Historical Returns, 1995 - 3Q 2011

As noted above, the company carries a high net cash balance. This is generally true for the company, at least for most of this decade. For this reason, it is important to focus on the ROIC figures (Recall that ROIC uses Average Invested Capital in the denominator, which is the sum of equity and debt less cash, so a company is not penalized for holding a lot of cash). In the chart above, we see that ROIC outperforms the other returns metrics. Over the last decade, ROIC has averaged 11.2%, which isn’t spectacular.

I omitted the company’s CROIC from this chart because of its even greater volatility, which dwarfed the scale of the returns shown here. We’ll look at free cash flow separately below, but first let’s look at the company’s revenues and margins.

Key Technology, Inc. - Revenues and Margins, 1995 - 3Q 2011

Key Technology, Inc. - Revenues and Margins, 1995 - 3Q 2011

Here we see somewhat excessive volatility in the company’s margins. This is partially due to the nature of the company’s business, in that cost overruns for certain projects can be the KTEC’s burden, and with relatively few projects completed in any given year an overrun or two can have a big effect. We see this in the difference in gross margin from Q2 and Q3 of this year, which swung 698 bp as a result of cost overruns. Given the volatility in the company’s margins, it is important to not place too much emphasis on outliers and instead consider the company’s long-term normal margins. We’ll take this into account when valuing the company.

On the topic of revenues, it behooves us to consider the source of revenues. Here we find one potential worry, in that the company’s top three customers (McCain Foods, J.R. Simplot and Frito-Lay) account for around 35% of sales. Additionally, independent sales representatives account for 20 – 30% of revenues, which adds some further riskiness due to the reliance on these third parties.

One more thing to note is that the company has a significant number of patents, though at least one expires this year. The company says in its 10-K that it does not believe this expiry to be material.

Now we’ll move on to cash flows.

Key Technology, Inc. - Cash Flows, 1995 - 3Q 2011

Key Technology, Inc. - Cash Flows, 1995 - 3Q 2011

Here we see that, except for 2009, for the last decade the company has earned cash flows around $5 million and up. The average, excluding the 2009 outlier, is $7.8 million. Recall that the company’s market cap less net cash is just $45 million, so using the long-term average (which does not take account of the growth in revenues since 2007), we have a very healthy free cash flow yield.

While on the topic of net cash, let’s take a look at the company’s capital structure over time.

Key Technology, Inc. - Capital Structure, 1995 - 3Q 2011

Key Technology, Inc. - Capital Structure, 1995 - 3Q 2011

Here we see that the company’s cash balance he been swelling over the last eight or nine quarters, and that debt is held at a conservative level (and of the small amount of debt the company does have, the bulk is not due until beyond 2015). This all bodes well for an investor.

Everything we’ve seen here has been historical, but in order to value the company, we need to assess its prospects. Thankfully, the company publishes its backlog each quarter, which can give us an idea of how revenues in the (near) future will stack up. This is a fuzzy process, whereby we’ll compare the historical backlog to historical revenues, and then draw a conclusion based on the current backlog.

Key Technology, Inc. - Order Backlog, 1995 - 3Q 2011

Key Technology, Inc. - Order Backlog, 1995 - 3Q 2011

The last two quarters can be confusing, with Q2 reporting the highest backlog in the company’s history, followed by Q3 which showed a backlog almost as low as the depths of the recession. The Q3 conference call sheds some light on this, whereby management suggested that the debt ceiling crisis in the US had caused many customers to delay capital investments. In the short-term, I don’t think there is a clear trend from which to draw conclusions.

Given the volatility of the company’s performance and its backlog over the recent past, it important to look at normalized margins. When predicting future revenues, the investor’s best bet is to look at a number of revenue scenarios and get a feeling for what the market is pricing in, and then assess whether this is a realistic prediction. My assessment reveals a company that is undervalued. I think a more realistic price is in the high teens, suggesting significant upside.

What do you think of KTEC?

Disclosure: No position.

Source: Key Technology: Look Past The Volatility