Description
KHD Thesis:
KHD is an attractive event-driven play with clear catalysts over the next three months that should unlock 33-67% upside. This morning they announced the spin-off of their industrial plant technology, equipment and service company from what will be the parent company leaving a royalty mine interest and significant cash at the holdco.
http://finance.yahoo.com/news/KHD-Humboldt-Wedag-prnews-1079435258.html?x=0&.v=1
The stock is up on the news, but I believe it is a significant under-reaction because it separates the core and non-core assets and removes a corporate governance overhang (discussed on VIC boards from previous write-ups). I think the event driven aspect justifies a new write-up.
Business description:
KHD Humboldt Wedag International Ltd. operates as an industrial plant engineering and equipment supply company. The company supplies technologies, equipment, and engineering services for cement and coal and minerals processing industries. The company's products and services for the cement industry include plant design, equipment design and development, engineering services, and automation services; grinding technologies for use in raw material, clinker and finished cement grinding; and pyro-process equipment comprising pre-heaters, kilns, burners, and clinker coolers. Its product and services for the coal and minerals processing industries consist of jigs, centrifuges, float cells, and flocculant products; equipment and plant components for crushing, grinding, and separation of ore and minerals; chemicals for sorting materials by floatation; and coal floatation reagents. KHD Humboldt Wedag has operations in India, China, Russia, Germany, the Middle East, Australia, South Africa, and the United States.
The core of their operations are in India, Middle East, Russia, and Eastern Europe. Order intake has been soft (hitting a trough in Q2) because financing dried up for large projects and demand fell, but is quickly coming back (esp in India). However, reviewing cement producers commentary confirms demand for capacity expansion in India, North Africa, and the Middle East and replacement plants in Russia and Eastern Europe. Most orders right now are for repair/replacement of components, not greenfield projects. There is an energy efficiency improvement from upgrades as well.
Valuation:
(1) Terra Nova Royalty Corporation
- a. Mine valued on the balance sheet at $200m ($6.67/share)
- i. Kicker #1: Using the recent price of CAD 5.00/ton, the value of the mine is worth approximately $8.80/share (8% discount rate, 2% escalations, 20% tax rate, 5m tons/year, 15 years)
- ii. Kicker #2: Potential to get a better cap rate. The mine will institute a dividend policy and probably get valued based on yield. If that's the case, the discount rate I'm applying might be high. Hard to argue for a "greater fool" valuation, but royalty interests/MLPs often capitalize on this.
- b. Cash of $112m ($3.70/share)
- c. Resulting in $10.37/share
(2) KHD Humboldt Wedag
- a. Cement plant design and equipment supply
- b. Consolidated market (three operators control ~90% market share ex-China) because of intellectual property (patents) - this is what makes it a quality business
- c. Increasing emphasis on service/repair contracts to leverage installed base.
- d. Very cyclical, but:
- i. Normalized revenue of $400m (kiln capacity expansion in-line with 2004; 2006-2008 averaged >700m order in-take; backlog of $626m takes them through mid-2011; Q3 order intake of $76m in difficult environment)
- ii. EBIT margin of 9% (in line with historical)àpretax profit of $36m
- iii. Tax rate of 30% à after tax profit $25.2m
- iv. Shares: 30.3m à$0.83/share
- v. Multiple of 13x à $10.80/share (current backlog is probably worth $2/share at historical margins)
- vi. Excess cash at industrial group: $4/share
- vii. Value: $14.80/share
(3) Combined
- a. Combined value of $25/share (67% upside from $15)
- b. Haircutting that 20% for cyclicality, future listing in different places, etc: $20/share (33% upside).
Management:
- (1) Chairman Michael Smith has a record of value creation through M&A with an eye towards tax avoidance. He owns ~9% through trusts.
- (2) Peter Kellogg owns >20% and has been a long term investor. He is not involved in the business, but could act as a check on any self dealing by management.
- (3) CEO seems fine, but he's relatively new. His emphasis is on increasing service revenues from the installed base.
Catalysts:
- (1) Company doing road show in February
- (2) Split off in late March
- (3) Small re-IPO in Germany to get coverage of industrial group (Smith won't want to sell at a bad price)
- (4) Initiation of dividends at Terra Nova
- (5) Q4 #'s in late Feb / Early March - they wouldn't proceed and remove the cash from the industrial business if order intake were not improving.
- (6) Removing overhang of corporate governance concern (cross holdings with MFCAF and concern over use of excess cash)
- (7) Potential for ADR in US to mitigate holding restrictions
Why is this opportunity available?
- (1) This is a small cap stock that has one analyst (lightly) covering it
- (2) Under reaction to significant news event
- (3) Listing of new "KID" will be in Germany - as this moves from mutual fund holders to special sits managers, I think valuation improves.
- (4) Historical corporate governance overhang
- a. They always held a lot of excess cash and had cross holdings with Mass Financial (MFCAF). The concern was that value would be siphoned away from KHD holders for the benefit of MFCAF holders. This has been clearly resolved and the cash will be used to fund dividends / mine royalty purchases at Terra Nova. There will be less excess cash at the operating unit KHD.
Tradings Dynamics:
The listing in Germany is certainly a wrinkle. If investors can't hold German stocks, they can't invest and might be forced sellers. One could argue it's better to wait for the KID spin to get a more attractive entry point, but I think you are creating it very cheaply here already. The effective market cap of that segment is ~$125m (30.3m shares * (14.50 - 10.37 for the mine segment)), but there is approximately that much excess cash in KID (pro forma), so I think the downside is very limited.
Catalyst
Catalysts:
- (1) Company doing road show in February
- (2) Split off in late March
- (3) Small re-IPO in Germany to get coverage of industrial group (Smith won't want to sell at a bad price)
- (4) Initiation of dividends at Terra Nova
- (5) Q4 #'s in late Feb / Early March - they wouldn't proceed and remove the cash from the industrial business if order intake were not improving.
- (6) Removing overhang of corporate governance concern (cross holdings with MFCAF and concern over use of excess cash)