Description

This is a very simple idea, but should work with some luck and tenacity. 

Kadant was previously Written Up by Bismarck in 2018, so I shall not belabor you all with the (very helpful) business description, except to remark that we are in a highly similar situation as 2018, which creates a nice setup for underperformance, especially given that the stock has more than doubled since the start of COVID.

The summary

Kadant provides capital equipment and consumables for the linerboard industry, Kadant is also levered to housing starts/lumber via its wood processing equipment. 40% of sales are linked to pulp, paper and containerboard capex, with the remainder being linked to consumables.

Kadant trades at 20x earnings on peak earnings. EPS has more than doubled since pre-covid levels as EBIT margins have increased from ~13%(2019) to 19%(2022).

Consensus and a heady valuation assume that these margins and revenues will continue to be sustained.

But the current cardboard industry faces significant overcapacity, with utilization rates falling as consumer goods spending stalls.  

Why now?

Paper and pulp prices have already begun crashing as of last year, even as the consumer segment continues to deal with massive oversupply whilst consumers continue to protect their wallets. Many have been able to protect earnings as input costs have correspondingly dropped, but the excess capacity that has been built during COVID has resulted in meaningful levels of downtime. The excess capacity has created significant level of downtime in the US.

Furthermore, Chinese pulp and paper prices have also crashed correspondingly.

Valuation and room to downside.

Kadant trades at ~20x fwd earnings.

Kadant has expanded operating margins from around ~10-12% pre-2020 to around ~16% TTM. I expect these margins to come down as headline sales get affected by stalling pulp and paper capacity *(down HSD YoY by 2024), at ~40% decremental gross margins given the fixed cost base. For instance, an ~8% decrease in topline would be enough to drop EBIT to around ~140m,  ~170m ttm, or ~20%. Such a drop would probably also give impetus for multiple compression, perhaps to around ~15x (@ ~$8), which would imply a valuation of around $120, vs the ~$212 share price right now, or around ~40% downside.

Risks

Timing - it's getting rather hard to short some of these clearly overearning, high margin industrials- I recommend two options:

1. Wait until we see backlog numbers drop - bet on the slow bleed at the cost of some "bite" on earnings

2. Hedge with another similar, high margin industrial 

Catalyst

- stalling out capacity ( still has some backlog, ~4 months worth of revenue)

-further goods recession (currently seen from retail data, container shipping etc).