KSW, ePlus Look Like Bargains

Needless to say, I think there are some terrific bargains all over the place right now.  Just look harder if you’re not seeing them.  Remember that these are just leads, though.  I don’t own any of them yet, besides the companies I’ve already written about.  If you’re interested, keep digging away, because without the facts in your head, you will eventually lose the courage of your convictions.

There are some other companies I’ve been looking at, generally good companies selling at cheap prices or undergoing change.  I still have much work to do on most of these, and don’t own any of them quite yet.  I’ll probably only buy one of ‘em, maybe two.

KSW, Inc. (KSW)

KSW is a magic formula stock which I’d glanced at earlier this year and passed on.  After a recommendation by a friend and further consideration on my own, I’m snooping again.  KSW is a mechanical contractor and trade manager.  They install HVAC systems in new buildings and public works projects, and also act as a project manager on all the mechanical and electrical work done on these buildings.  They no longer compete for bids, as you’d think a traditional contractor would, but rather their work is offered to them or found through personal sources.  This isn’t immaterial, as it shows they have at least one unique element that competitors may lack.  Market cap is $31mm, EV is $12.5mm, 6mm shares out.

The compelling points are such:

• KSW uses very little to no capital conducting its ongoing business.  Returns on capital are almost non-calculable because they use so little capital.  Last year, pre tax ROIC was 250% under my calculations.  (IC = Net working capital + net PPE - excess cash)
• KSW has been able to grow their revenues from $26mm in 2004 to over $80mm in the trailing twelve months.  Admittedly, they did very poorly in the last economic slowdown. However they’re doing great in the current one, as their project backlog is at all time highs and the last quarter, was their strongest ever.  This bodes well for their prospects.
• With a $31mm market cap, KSW has $18mm in cash and no real debt.  EV is ~$13mm.
• On valuation, the company trades for about 2x EV/pre tax earnings, defined as EBITDA - maintenence capital expenditures (which are obviously almost nil).  It’s worth at least 8x based on the quality of the business and some growth.  Also trading around 15%  EV/Sales.
• CEO and Chairman Floyd Warkol owns 12% of the company.
• They paid a .20 dividend in Q1, on a $5 stock, so that’s amounts to an annual yield of about 16%.  The question here is whether they will keep paying that dividend.   At .80/yr, that’d be ~$4.8mm, which is doable but a little high (remember $4mm in annual free cash flow $18mm bal. sheet cash).

So obviously the thesis is viable at first glance.

Risks?  Well, I’m having a little trouble deciding how solid those earnings truly are.  We’re paying a premium to liquidation, so it’s an obvious concern when searching for a margin of safety.  If the earnings are sustainable this is a home run investment, a real no-brainer.  What if KSW hits trouble and can’t find new projects?  What happens in the backlog gets cancelled?  What will they do with all that cash?  What are the probabilities of these scenarios? These are the (somewhat) unanswered questions for me at this point.  Any clarity from a reader with an interest in the company would be terrific.

So, the thesis: High ROC company, terrific price, shareholder aligned management, sparkling balance sheet, growing revenues and backlog.

ePlus, Inc. (PLUS).

ePlus is an IT company, for all intents and purchases.  From what I can glean so far, they buy equipment from large tech companies (Cisco, Microsoft, et cetera), and lease it out to middle market companies along with proprietary software and, obviously, support systems ranging from installation to troubleshooting.  They take on non recourse debt, which means the worst case scenario is that the lessees could seize the collateral assets, but can’t go after ePlus.  This is another company that trades at a seemingly unbelievable price.  Market cap is about $107mm, EV$48mm due to $59mm in cash and no recourse debt.  8.25mm shares out.

The points:

• ePlus is tainted.  I like taint.  They’ve gone through legal troubles and an options related restatement in the last 3 years, and this has obviously hurt the stock price big time.  The legal issues have been good and bad for ePlus.  On the bad side, they had to pay out $10mm to Bank of America (BAC) and GMAC relating to a company called Cyberco that was fraudulent.  Cyberco had leased equipment from BoA and GMAC, with ePLUS as an intermediary, but it was a scam and they went bankrupt.  BoA and GMAC went after ePlus for what looks like material misrepresentation, and they were awarded a victory.  On the plus side, ePlus successfully sued SAP (SAP) for patent infringement and received $37mm.  Then, last year, ePlus made an agreement to license out these patents to SAP legally and got another $17.5mm there.
• Re: stock options, the company has had to restate a few years' worth of financials and this process has eaten up a chunk of cash.  The company is finally up to date on their filings, but lost their Nasdaq listing in the process.  They trade OTC, but should be re-listed very soon now that they are up to date.  This presents a viable catalyst.
• Earnings have been masked by the legal issues and  accounting and lawyer fees due to the restatement.  Once you pull those all of those gains and losses out, earnings have showed a steady rise over the past 4-5 years along with revenue.  I estimate that EBITDA - maint capex was about ~32mm in the last fiscal year.  This is a little shaky, I’m still figuring out maintence capex, but if true, EV/ EBITDA - maint. capex is a whopping 1.5x.  If anything, my maintenance capex is overstated so that’s a relatively conservative number.  I think 5 or 6 is a better multiple, which would value the company at $26/share or so (adding back cash), with shares currently around $12.  These are normalized earnings.
• Tangible book value is $137mm or so.  With a market cap of $100mm, PLUS trades at 72% of tangible book.  This is mostly cash and lease paper, very solid assets.
• Insiders own 35% of the company, and a financial focused hedge fund with board members owns another 15%.  This keeps alignment intact and dials down my worry regarding the legal issues and options restatement.
• Revenue has grown consistently YoY for the past 5 years, and they’ve had only 1 operating deficit in their history, to my knowledge.  In fact, even when tech was smashed in 2000-2002, business held up and they stayed profitable.
• ROC is not high.  If my free cash number is right, ROTC is only about 12% after tax.  The lease paper they hold sucks up a lot of capital, but the good news is that ROTC [net PPE + Net Working capital + lease investments - excess cash] is now less than in 2003, and returns have been rising in that same period as well.
• They’ve shown the willingness, before the options trouble, to buy back stock in hordes.  They just announced a small buyback program last week.

Here’s a company where I see multiple safety margins (very, very cheap on both annual free cash flow and salable assets, with a solid balance sheet).  I see a growing business with a very viable model, tainted by scandal and general malaise over tech stocks right now, with identifiable catalysts in a Nasdaq re-listing, uncovering of real earnings, and growth.  I need to dig here, though, to straighten out their future prospects, some accounting aspects (try and understand their cash flow statement, I dare ya), and look closer at comps.

There are some great Value Investors Club write ups on ePlus, so I’d recommend reading them if you’re interested.  Here’s one.

Other names I’ve considered but not done any work (or much work) on yet:

• Trident Semiconductor (TRID).  Selling at net working capital right now, less than net cash, beaten up stock, formerly very profitable.  Main questions come from cash burn and future profitability.
• Borders Group (BGP).  Very cheap looking at sum of the parts, cheap on past free cash flow, possibly selling below liquidation value. Pershing Square is their major owner, one highly incentivized to push them towards value creation. They’ve put themselves up for sale and won’t go for less than $8 I believe (Pershing owns 15mm warrants at $7/share).  Another catalyzed investment opportunity.
• Office Dept (ODP).  Depressed, beaten up, cheap.  Selling for only a few times fully taxed normalized FCF.  Again, a look at their competitive position is really needed to make sure not too much permanent damange has been done to normal free cash flow.  ROC is high (on a normalized basis) for ODP as well, and their CEO is a former Autozone CEO adept at capital allocation.
• IAC (IACI).   Splitting into 5, count ‘em 5, units via spinoff.  I figure at least one of these things is going to come out cheap, but it will take some serious work to value all these parts and pick one that is very cheap.  I bet the work will be rewarded, though. You’ve got Ticketmaster, which is a great franchise, Home Shopping Network, and a few other units.  The spinoffs should occur in a month or so.
• Clear Channel (CCU).  By December their much publicized buyout should be complete.  The interesting part? There will be publicly traded stock in the LBO. You get to participate, tit for tat, with the buyout firms.  The more interesting part? Management is staying on and participating, not only operationally but financially. Two top managers are getting options on 4% of the company, each, plus exchanging many of their current shares for shares in the LBO. The risk here is extreme leverage to the tune of 8.5x EBITDA I believe. That’s big time debt.
• American Express (AXP).  American Express hasn’t seen these type of multiples in a long, long time.  Even if profitability is a little on the high size, normalized earnings still come out with a 13 or 14x after tax multiple.  This is a terrific worldwide franchise with years of 8-10% growth ahead and a fantastic manager in Ken Cheanault.  See VIC write up.

Well, I’m exhausted.  This is the current crop of ideas I’m considering, and I’m confident that at least of a few of these companies are going to see their stocks double and triple, and a few will be duds even though they look great at first glance. 

One more note: I’d recommend trying to ignore all this noise going on right now.  There is prognostication left and right in the financial media, economic forecasting, talks of bottoms, etc.  Pick a few cheap and good companies and buy them.  It’s in times like these that even smart value investors forgot how bad human beings are at forecasting the future of a complex adaptive system such as the stock market.  The only prediction I can confidently make is that most of the commentators in the media and in the money management world will be wrong.  

There are unforeseen events that we cannot predict, ones that will alter our thinking and even cause us to believe we predicted them. You can either try to predict when and where the rain will fall or build a nice big ark just in case.  I’d go with the latter.

Comments

[DaveinHacke...:]

Jeff,

That wasn't a quarterly dividend, it was an annual one. There are no plans, as far as I know, for KSW to initiate a regular quarterly dividend.

2008 Aug 06 08:36 PM

[palu77:]

Jeff,

Couple of comments of KSW. Your evaluation is right on as far as I can tell. However, I disagree with you about margin of safety. They have $18MM in cash and $140MM in backlog. If that isn't margin of safety I don't know what is. Not to meantion that the backlog is not with one project.

1) I think is safe to say that the work resonably expected to be complete by the end of the year ($50MM) is safe. That will bring in an additional $2.2MM in earns this year or ($0.35/share).
2) The company has a floor of ~$2.90 based on the $18MM is cash on hand. Furthermore a majority of the $2.2MM in potential earnings for the rest of the year should go directly into the current cash holdings.

As for dividend, I wouldn't expect a quarterly dividend from KSW. They stated in their 10k that the companies dividend policy is set annually based on annual performance.

Overall if you look at is from a risk versus reward stand point. Your max risk is $2.13/share if KSW trades at cash. But even if KSW stops growing it will not trade at cash so lets say it trades at 3x's EPS(ttm) plus cash or $4.3/share or $0.70/share downside.

Your potential reward is $0.7*15 = $10.5 or $5.50/share upside, assuming a 15x's P/E on 2008 expected earnings.

That translates into a 7.8:1 Reward to Risk ratio. Not bad.

Good Luck

Paul

2008 Aug 07 07:47 AM

[Jeff Annello:]

Dave,

I figured as much, that's why I mentioned my uncertainty. Thanks for the comment, I appreciate it.



Paul,

Good assessment, and I tend to agree. I am already very impressed based on the numbers and reading I've done so far. I just want to be sure.

I'm not worried about a stoppage of growth, however. What I'm worried about is an earnings collapse. I understand that the next year and a half, maybe two are pretty much covered by the current backlog of projects. I'm also trying to understand what could possibly happen to that backlog. As I said above, if the earnings are stable, not even growing, the margin of safety is a monster. If the earnings are subject to a collapse (very small company, not a recurring revenue business model i.e. they must always be receving new projects)), the margin of saftey is current cash plus future cash on already backlogged items that will be completed in the next few years. If we assume they do generate 2.2mm in cash this year, that leaves them with $20.2mm, or ~$3.35/ share.

My point is, downside risk is there in that if they lose new revenues, prices keep rising without the ability to pass them through, or there is a blip in their operations, there won't be much to add to existing cash for a full valuation.

While I'm not saying this is likely, all risks must be considered to find a true margin of safety.

Any other comments or thoughts I would appreciate.

2008 Aug 07 09:30 AM

[palu77:]

Jeff,

Agreed you must consider all risks when developing a margin of safety and you are right to point out that they don't have a recurring revenue model. Still when developing an investment thesis it is important to consider risk vs. reward and using your assumption of a cash floor at $3.35 puts the risk at $1.65 per share. Where the reward with continue growth is ~$10/share, upside of $5. That is a sufficent risk to reward ratio for me as an investor.

So with that said, I don't care to pour into the day to day activities and know them intimately or else I would apply to work at the company. I put some level of trust into a managment team that has performed admirably to date and combine that info with a healthy balance sheet and develop my buy decision. Now it is in Mgmt's hands and all I can do is hope that my anaylsis is on target and modify as new information is revealed.

If I am wrong I sell when I realize I am wrong. If I am right I add to my postition when the time is right and wait to sell. I have owned KSW at $6/shr and my ananlysis still indicates that I am making a smart investment so I am adding to my position at this level.

Good luck to you in your investment decision.

Paul

2008 Aug 07 01:20 PM

[Jeff Annello:]

Paul,

I was thinking about that yesteday as well, the risk/reward ratio. Indeed if the stock is worth maybe $3.15 in the worst case, the risk reward ratio is still over 3 based on what I really think it's worth. I'm not trying to know the company better than management, I believe it's a fallacy that you can really do so, I want to know everything I can from an outside perspective.

Cash is cash until they starting burning it, which is another risk in an "earnings collapse" scenario. When looking at R/R, the entire downside case must be considered. So if I say to myself "ok, what else?" in the case of an earnings collapse that might be cash burn. See TRID, which I mentioned above, for this scenario.

While these are not "probable" scenarios, they cannot be glossed over, not least of all for a small company without recurring revenues or a wide moat.

Your analysis, for the most part, is right on though. The investment is no doubt a smart one at these prices.

-Jeff

2008 Aug 08 09:24 AM

[zacjones:]

I agree with you on KSW with so much in cash and such a solid backlog and high ROIC and now bidding on a number of new projects this is a very attractive investment.

2008 Aug 08 02:26 PM