KHD Humboldt Wedag: An Undervalued Winner

KHD Humboldt Wedag International (KHD) is probably the most under appreciated stock I know. This is a company in an essential industry, providing its service and products in the fastest growing parts of the world.  It has a growing backlog of orders and excellent margins. It also sits on a pile of cash that is half the market capitalization. Yet the stock sits near the bottom of the 52 week trading range. Later I will give my thoughts on why the stock is so undervalued. First, a recap of some numbers comparing the 2nd quarter of 2008 with the same quarter of 2007.

• Total revenue: $144 million, down 9%.
• Net income: $19 million, up 88%.
• Income per share: 63¢, up 85%.
• New orders: $320 million, up 105%.

• Order backlog: $1.3 billion, up 96%.
• Cash and cash equivalents: $445 million up $220 million.

Do not worry about the decreased revenue, the company is still well ahead of 2007 for the first 6 months of 2008 and has been able to increase its gross profit margin by over 4% to 19% in the last year.

KHD is an infrastructure company in the business of selling and installing proprietary concrete, coal and mineral processing equipment. The company’s business is focused in the growth areas of Russia, Eastern Europe, the Middle East and Asia. Recent growth initiatives have focused on increasing the range of services it offers its customers. (i.e.-it designs and completely builds a concrete plant rather than just selling and installing its own equipment.

The company's business lines plus its market area point to an almost endless supply of future business. Management has worked hard to ensure KHD gets its share of the most profitable projects. At this point growth is primarily limited by the company’s ability complete customer projects on a timely basis and it is controlling the addition of new business to not get behind on what it can deliver.

After listening to the conference call, I could write pages on the positive aspects of the management of KHD. The company is conservative in its bookkeeping and aggressive in pursuing new sources of revenue. I see no break in the growth trajectory for years to come.

I promised earlier I would give a few reasons why I think the stock price is lagging in relation to KHD’s growth and prospects:

1. Until about two years ago KHD was primarily a merchant bank with a sideline in industrial plant engineering. It has shed most of the financial business lines, but it appears the investing world has not yet discovered the new KHD.
2. The company is headquartered in Hong Kong and does a large amount of business from offices in Europe. There is almost zero western hemisphere exposure besides listing on the NYSE.
3. The stock is followed by one reporting analyst who just regurgitates the company’s overly conservative guidance.
4. KHD is a small (but very profitable) speck in the very large infrastructure market sector.
5. The name: KHD Humboldt Wedag, Ltd.

At this point the company stock is trading at around 13 times 2008 earnings while revenues and earnings are growing at multiples of the multiple. At some point management will put the cash hoard to work to further increase shareholder value. I will be holding my stock until it reaches multiples of the current price. KHD is a component of this site’s Special Opportunities Portfolio.

Note: I currently have a long position in KHD.

Comments

[buyitcheap:]

With cash at over $10/share,the core business is valued around $15 which, if we are to believe forecasts of $2.20(?) yields a very nice 7 PE for nicely positioned company that could be acquired or just ramp up its growth.

2008 Aug 14 06:57 AM

[UncleLongHair:]

Thanks for the write-up. I am also long on KHD.

The two concerns that seem to spook people are 1) KHD is in a cyclical business near the peak of its cycle, and 2) plants are being overbuilt in regions that don't have the economy to support them and demand will hit a wall (really just a variation on #1).

I don't accept this at face valuek, though I can't completely dismiss it because growth rates of 50-100%+ are not sustainable for any significant duration. The cement supply business (i.e. Cemex) is indeed cyclical, though it has never seen growth rates like this. The cement *engineering* business (i.e. KHD) may be different, but we don't really have enough data to know.

Anyay I wonder if you can comment on this.

On the flip side, the company has been making noises about acquisitions for several quarters now. Last quarter they said they almost closed something but it fell through at the last minute. This quarter they said they have hired an "experienced professional" tasked specifically with finding a deal and have initially earmarked $100m in US Dollars for investment purposes. Note that not all of the cash on their balance sheet is available for deals, since it is offset by deferred revenue liabilities.

I also think that Michael Smith has assembled a great management team. When MFC Bancorp initially took over KHD, he assumed all the executive positions, but one by one handed them off to other people, and the team he has put together really impresses me.

If you want to read some very colorful history of Michael Smith, read about his background at Mercer International and his former business partner Jimmy Lee. Lee still runs Mercer and Smith has been making activist shareholder noises with letters to the board.

2008 Aug 14 08:34 AM

[Tim Plaehn:]

By focusing on emerging economies it seems KHD can avoid the cyclical nature of the concrete business.

On the acquisition front, it seems they are following the same conservative practices. It would not break my heart if they decided to do a share buy back or pay a one time dividend with some of the cash instead.

2008 Aug 14 10:08 AM

[joe_btsfplk:]

So...who is buying KHD, and why don't international funds care? 47% is held by a few mutual funds and private investors: APIS (??), FMR LLC, and Renaissance Technologies are the "big" holders at a total of about 10%. Fidelity, through Fidelity North Star and Fidelity Low-Cost is the big mutual fund at 2% combined.

Is equity investment just not important enough to KHD that they court more funds, or is this area just more competently covered by another company and its stock?

2008 Aug 14 02:12 PM

[User 244953:]

Tim- please comment on the apparent self dealing that the company conducts? Smith is a Director at MFC and KHD. Instead of selling SWE Reit, he decides to spin it off (more below). 9 months later after a "shareholder vote" MFC has decided to acquire SWA in its entirety. Of course price will be determined after an independent valuation (my money is on the value of MFC being higher than market value and/or SWA being appraised below market value).

On top of that, the preferreds that KHD owns of MFC and being swapped into MFC shares. Seems like Smith is trying to find a way to increase the float and volume on MFC!!

You say that management is smart- I disagree. While they did purchase the KHD business for nothing and turned it into a huge business, Smith continues to do "dumb" things. Namely, spinning off businesses instead of selling them. The claim is that it is more tax efficient. Not really when you consider the illiquidity of the assets he spins off. Oh, by the way if he was selling the assets at a gain he would book at gain and it would actually increase non-operating revenues!

If you sell it and do not need the cash- issue a special dividend.

Smith is not going to find any quality businesses to purchase. He is always going to lose on price.

2008 Aug 18 10:10 AM

[InvestorCP:]

I am also long on this stock. I have focused on it for organic growth reasons specifically targeting the eastern european developing economies. Its a speculative buy to a great degree, but its currently has a nice margin of safety on the cash and probability of growth falling to levels that do not justify a better multiple is low. I do share the same concerns around overbuilding in emerging economies, and the management personalities involved here. Its a risk I have decided to accept given the potential of the target markets and KHD position within.

2008 Aug 20 02:00 PM