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KMG Chemicals - Saying Goodbye

I am going to be perfectly open here, the only reason I investigated KMG Chemicals, Inc. (NYSE: KMG)is because I wanted to buy Koppers Holdings, Inc. (NYSE: KOP). I think Koppers is a better managed company than KMG but that aside, while Koppers makes wood preservative stuff just like KMG, Koppers sells lots of the stuff they make to the railroad industry. And since I like picks and shovels companies, well you get the idea.

So my gamble, and that is what it is a gamble, is that Cabot won't want to stay in the wood preservative business, meaning less competition for Koppers, the stock I own, which could lead to better price appreciation. Welcome to free enterprise.

Wax

KMG Chemicals, Inc.
KMG Chemicals manufactures, formulates, and distributes high purity and ultra purity wet process chemicals primarily to clean and etch silicon wafers in the production of semiconductors. The company also manufactures penta products used to pressure treat wood products, primarily for utility poles and cross-arms, to extend their life by protecting against insect damage and decay. In addition the company sells hydrochloric acid, a byproduct of penta production, for use in the steel and oil well service industries as well as manufactures and distributes industrial sealants and lubricants. Industry peers include include Koppers Holdings and Perstorp AB.

Short-Term Value
My short-term (3-6 week hold) target price for the stock is $79.00, with an initial trailing stop set at $74.15. With a current price of $75.28, upward price movement will find resistance at $78.05. Downward price movement will find support at $73.72 and $70.48, with final support found at $68.50.

Days to Cover
The most recent days to cover number is 1. The days to cover number is a measurement of the company’s outstanding shares that are currently shorted, expressed as the number of days required to close out all the short positions. The number is determined by dividing the number of outstanding shares currently shorted by the average daily volume. The days to cover number is sometimes used as a volatility precursor for a stock.

The Tax Act
It is import that investors understand the potential impacts of the Tax Act since changes mandated by The Act can distort earnings and consequently fair value.

The Tax Cuts and Jobs Act of 2017 makes broad and complex changes to the U.S. tax code, including, but not limited to, (1) reducing the U.S. federal corporate tax rate from 35% to 21%; (2) requiring companies to pay a one-time deemed repatriation transition tax (the “Transition Tax”) on certain earnings of foreign subsidiaries; (3) generally eliminating U.S. federal income taxes on dividends from foreign subsidiaries; (4) requiring a current inclusion in U.S. federal taxable income of certain earnings of controlled foreign corporations; (5) eliminating the corporate alternative minimum tax (“AMT”) and changing how AMT credits can be realized; (6) capital expensing; (7) eliminating the deduction on U.S. manufacturing activities; and (8) creating new limitations on deductible interest expense and executive compensation.

In the case of KMG Chemicals, recorded a net tax benefit of approximately $12.3 million for the re-measurement of net deferred tax liabilities as of December 31, 2017. In addition for the Deemed Repatriation Transition Tax (Transition Tax), which is a tax on previously untaxed accumulated and current earnings and profits (“E&P”) of certain of the company’s foreign subsidiaries, In addition, for the Deemed Repatriation Transition Tax (Transition Tax), which is a tax on previously untaxed accumulated and current earnings and profits (“E&P”) of certain of the company’s foreign subsidiaries, The company is able to make a reasonable estimate of the Transition Tax and currently estimate that it will not have a material Transition Tax obligation.

The company is also analyzing other provisions of the Tax Act such as potential limitations on the amount of currently deductible interest expense, and the limitations on the deductibility of certain executive compensation. As of July 31, 2018 and 2017, the company has recorded a valuation allowance of $0.6 million and $1.8 million related to some of the company’s European and Asian tax jurisdictions and certain state net operating loss carryforwards. In assessing whether a deferred tax asset will be realized, the company considers whether it is more likely than not that some portion or all of the deferred tax asset will not be realized. The company considers the reversal of existing taxable temporary differences, projected future taxable income and tax planning strategies in making this assessment. Based upon the level of historical taxable income and projections for future taxable income over the periods in which the deferred tax assets are deductible, the company believes it is more likely than not that it will realize the benefits of these deductible differences, net of the existing valuation allowances, as of July 31, 2018.

Unrelated Income
Income unrelated to a company’s day to day operation, such as income tax benefits or income from other sources will distort a company’s earnings and consequently its fair value. Investors should always explore the sources of a company’s earnings to better understand potential valuation impacts. For KMG Chemicals none of the company’s operating income came from income tax benefits or from other sources.

Insider Transactions
The SEC classifies insiders as the “management, officers or any beneficial owners with more than 10% class of a company’s security.” Insiders are required to abide by certain rules and fill out SEC forms every time they buy or sell company shares. In addition, to prevent insider trading, or benefiting illegally from material non-public information that their positions give them access to, the law prevents insiders from deposing of shares within six months of their purchase. This effectively bars insiders from profiting from quick trades based on their “insider” knowledge.

In the past 12 months, the company has reported 139 insider trades involving 1,120,557 shares of stock. Of those 139 insider trades, 40 were Buys involving 351,350 shares of stock, and 99 were Sells involving 769,207 shares of stock, creating an insider buy to sell ratio of 0.5 to 1.

Mergers/Acquisitions
There were no company mergers or business acquisitions during fiscal 2018.

Divestitures/Dispositions
There were no company divestitures or business dispositions during fiscal 2018.

Subsequent Events
Subsequent Events are material events that happen after the closes of a company’s fiscal year but before the company has filed its most recent annual 10-K reports. For KMG Chemicalson August 14, 2018, the company entered into a Merger Agreement with Cabot Microelectronics, providing for the acquisition of the company by Cabot Microelectronics which would make the company a wholly owned subsidiary of Cabot Microelectronics, with each outstanding share of the company’s common stock automatically converted into the right to receive $55.65 in cash and 0.2000 shares of common stock of Cabot Microelectronics. The Merger Agreement and the Merger have been unanimously approved by the boards of directors of the company and Cabot Microelectronics.

Year-Over-Year Metrics
Several year over year metrics that are of interest to many investors are revenue growth, free cash flow growth, earnings growth, debt growth, price growth, and year to date price growth. For KMG Chemicals, revenue increased by 40%, earnings increased by 37%, free cash flow increased by 54%, debt decreased by 45%, and the stock price increased by 29%. Year to date the stock price is up 5%.

Future Value
My future (5 year hold) target price for the stock is $171, which is an average annual return of 25%. A prior five year hold of the stock (FY2014- FY2018) would have returned an average of 44% per year. Past and future gains are based on actual and anticipated earnings, actual and anticipated dividends, and actual and anticipated price appreciation. Any investment has the potential for loss, and past performance is no guarantee of future results.

Baseline and Fair Value
As an on-going concern, my current baseline valuation for the company is $44. Baseline valuations are based on free cash flow value, net current asset value, book value, and tangible book value. My current fair value estimate for the stock is $62. The fair value estimate is my current valuation for a stock based on earnings, earnings growth, and the current 5-year yield of a AAA rated corporate bond. Value investing initiate, reduce, and terminate targets are derivatives of fair value.

Other Value Considerations
Other value considerations include the PE Ratio, the PEG Ratio, Return on Assets, Return on Equity, Return on Capital Employed, Return on Invested Capital, Cash Flow From Invested Capital, and Tangible Book Value. For KMG Chemicals, the PE Ratio is 14, the PEG Ratio is 0.6, the Return on Assets is 9.9%, the Return on Equity is 19.6%, the Return on Capital Employed is 11.3%, the Cash Flow From Invested Capital is 18.4%, and the Tangible Book Value is $(7.60).

Fair Warning
Fair warning means that the time for bidding has ended and an exchange is about to be concluded. KMG Chemicals, Inc. (NYSE: KMG) – FYE 07/2018 – FAIRLY VALUED The stock is currently trading at levels in line with my most recent $62 fair value estimate. Please See Linked PDF Worksheet

Financial Data
Financial data used in this report was taken from the most recent SEC 10-K filing as reported to the U.S. Securities and Exchange Commission on 10/01/2018 at 17:31:15 HRS.

Disclosure
I hold no shares of KMG Chemicals, Inc.. I hold shares of Koppers Holdings, Inc..

Disclaimer
I am not a licensed or registered investment professional, nor am I qualified to provide investment advice. As such, always consult a licensed and registered professional investment advisor before investing any money.
Copyright © 2018 Wax Ink
Posted on 10/07/18

Disclosure: I am/we are long KOP.