Value Investors Club / KHD Humboldt Wedag (KHD)

Description

KHD is a fast-growing international cement engineering company capturing booming industrial growth in several emerging economies. Under the brilliant control of Michael Smith (of MFC Bancorp fame), it produces extraordinary positive cash flow with minimal assets. Growth has been enormous over the past 4 years, and while growth rates have slowed somewhat, visibility into future growth has improved. KHD also has substantial surplus capital and non-core assets that will be catalysts as soon as Q1 2008. A misunderstood quarter provides an excellent buying opportunity into this multi-faceted investment that is sure to have a bright 2008.

KHD is the latest creation of Michael Smith, chairman of both KHD and MFC Bancorp. Smith has been a frequent topic of writeups on VIC, please review the write-ups of MFC Bancorp and Sasamat Capital for more information. Other affiliated companies you may have heard of are Mass Financial, Cathay Merchant Group, and Blue Earth. Smith has a long and successful career involving buying, improving, and spinning off businesses with a focus on building shareholder value, not to mention somewhat arcane tactics and paying little in the way of taxes.

KHD took its current form when Smith took over the company through his merchant banking holding company MFC Bancorp, then trading as MXBIF, in 2005. The acquisition was structured as a reverse takeover with MXBIF changing its name and symbol to KHD's current monikers. I believe this structure was intended to maximize tax benefits. This transaction brought a hodge-podge of different assets into the combined company, including iron ore royalty interests, industrial real estate in Germany, a Swiss bank, some merchant banking operations, and equity interests in affiliated companies. Most of these assets have subsequently been spun off, though some spin-offs are still pending. More on that in a minute.

Since the acquisition, Smith completely replaced management at KHD, refocused the business to value-add engineering and service activities targeted towards international emerging economies, cut costs, rationalized redundant expenses, improved positive cash flow, and lightened up the balance sheet. The transformation has been nothing short of amazing, evidenced by KHD's financial performance and stock price since then. Despite this fantastic performance, I believe there are a few more years of juice left in the core business, with frosting on the cake provided by the non-core assets.

Core Business

KHD's core business is providing cement engineering services and equipment to customers internationally who are building or improving their own cement plants. This should be distinguished from a cement manufacturer which is a heavy industrial business with high fixed assets and costs and typically a regional reach. Key growth drivers in the cement engineering industry are general broad industrialization and demand for cement, and the need of companies and governments to make their plants more efficient and environmentally friendly.

KHD business dates back more than 150 years and KHD is considered a leader and innovator with their own proprietary products and processes. As part of the transformation process led by Smith and MFC, KHD began focusing more on the value-add, technology, and service components of the business which are lighter in assets, higher in margins and produce more cash than other aspects of the business.

KHD's business revolves around customer contracts and there is a bid, proposal, and completion process for each job. This provides an intake, backlog, and revenue pipeline which provides some visibility into KHD's future business. We have discussed KHD's revenue recognition policies in detail to ensure that revenues are not improperly front-loaded, and are satisfied that their policies are fair and even tend to back-end a substantial portion of it. Revenue is booked on a percentage of completion basis and the backlog tends to turn into revenues over about 12-18 months, so the backlog figures provide about 4-6 quarters of visibility. They also announce large deals when they are closed, providing additional visibility.

In March 2007, KHD announced an exclusive cooperation agreement with CITIC, which is "the largest mining machinery manufacturer and one of the largest heavy machinery manufactures in China specializing in cement, mining, metallurgical process, nonferrous, power generation and environmental equipment." We believe this will provide KHD with a solid entry into the Chinese market as well as additional opportunities outside of China.

KHD management knows that their growth figures are surprising and acknowledge that they are riding a wave of booming cement demand that won't last forever. They have addressed this in several ways, one of which is to provide the intake and pipeline operating statistics so shareholders get some visibility into their business. They have also started expanding into the coal and minerals processing industries in an attempt to diversify away from a sole focus on cement. Coal and minerals represented about 16% of their 2006 revenue stream, and over the past 2 years has grown faster than their core cement revenues, but they still have a ways to go to really decrease their dependency on cement.

KHD enjoys a favorable tax situation, based in part due to the structure of the takeover with MFC. Smith is adept at making use of tax assets and net operating losses, and is familiar with the tax codes of various governments, in an effort to minimize taxes. We don't believe there is anything untoward or shady going on here, and effective tax planning is a necessary part of any international business. The Q3 press release says, "at KHD we consider taxation as an expense like any other warranting proper and effective planning in consideration of the company's fiscal responsibilities to its shareholders and host governments." The upshot is that their consolidated tax rate has been in the 5-10% range and they guide for 20%, though we believe they'll come in closer to 15% for a while longer until their enormous profits eat up their tax assets.

KHD's gross margins have been both a pleasant surprise and a point of contention among analysts as the company has grown. Gross margins were about 13.5% in 2005 and 15.6% in 2006. During 2007, the margins have varied from over 20% in Q2 to 11% in Q3. Due to the growth, KHD's business is somewhat lumpy, and the results in a given quarter can be skewed significantly by the timing of deals closing or one-time items. We view 20% as unsustainably high while 11% is too low, and margins in the 13-15% range seem normal and sustainable.

As an aside, we feel that KHD is extremely receptive to analysts and shareholders, and being fairly new at shareholder communications on several fronts, are eager to answer questions and tailor their disclosures to what investors want to see. We have had excellent access to management and IR has been very responsive.

We feel that misunderstandings about gross margins and the timing of events in particular quarters are being misunderstood as an "earnings miss" this quarter, which is what is driving the stock down 10%+ at the time of this write-up. The lumpy core business combined with various non-core assets and divestures frustrates analysts who want smoothly progressing quarterly figures in their spreadsheets. We find that analyzing the company over rolling 3-5 quarter periods smooths out these bumps and provides a more accurate view into the business.

In 2006, 30% of order intake came from the emerging Asia/Pacific region, 30% from Russia and Eastern Europe, 23% from the Americas and 8% from the Middle East. KHD is focused on emerging economies around the world, and is fairly well diversified geographically. The currency situation is fairly complex. The company is currently incorporated in Canada (an offshoot we believe of the takeover), but does an immaterial amount of business in Canadian dollars. They report in US dollars but derive a minority of their business in that currency. Trading on the NYSE and reporting in dollars, we believe they are helped by the falling US dollar since they earn overseas, but it is difficult to model or predict this impact.

Strategically, we believe that KHD is in roughly the 3rd year of a roughly 5 year plan orchestrated by Smith to acquire KHD using his investment vehicles, overhaul KHD to maximize shareholder value, and then make an exit through various spin-offs. We noted that Smith started out holding various operating positions including CFO, all of which have now been turned over to qualified execs (who without exception have impressed us favorably). We feel that Smith is now free to focus on his post-KHD efforts which likely will be carried on with the various entities that have been and will be spun off, including the preferred shares of MFC Bancorp.

Those familiar with Smith and his history will recognize this modus operandi, plus the highly international and somewhat arcane structure of the various companies and entities. This is a potential risk factor since we may not own the right company at the right time or may end up on the short end of a stick. But in the case of KHD, we believe it is still in the heyday of its turnaround and there will be time to analyze the future spin-offs to time an exit.

Historical Analysis

A quick look at KHD's annual report or 20-F for 2006 will show the strong growth in revenues, earnings, and cash flows over the past few years. The historical data is well presented there so I will just hit the highlights. Dollar figures are in US$ millions, and the EPS figures have been adjusted for the recent stock split.

                Revenues     Pretax Income    Net Income          EPS
----------------------------------------------------------------------------
2004       155.7            12.6            10.6              0.39
2005       329.4            30.9            23.8              0.87
2006           393.5            45.4            31.8              1.05

The growth here is evident, with revenues increasing 250% and earnings increasing about 270% in just 3 years.

Starting in mid-2007, comparisons to prior periods start to be complicated by non-core operations. One non-core operation (SWA real estate holdings) with earnings of about $3M per year was spun off in Q3 and those earnings are not present thereafter. Another non-core operation is royalty interests in an iron ore mine, the annual earnings of which were less than $5M in 2006 and are on track for about $16M in 2007 and will probably increase in 2008. Let me discuss 2007 and 2008 figures after discussing the spin-offs.

Spin-Offs and Non-Core Assets

Since MFC's acquisition of KHD in 2005, several spin-off transactions have been completed. KHD spun off shares of Mass Financial (Jan 2006), settled its ownership of Sasamat Capital (March 2007), spun off SWA REIT (Sept 2007, not fully complete). These transactions are not relevant to buyers of KHD today, though these do muddy comparisons to past periods somewhat, and I mention them in case any readers were familiar with those transactions.

The three primary non-core assets remaining as of Q3 2007 are the iron ore royalty interests ("Resource property"), the preferred stock of MFC Bancorp ("Investment in preferred shares of a former subsidiary"), and surplus cash.

The royalty interests in the iron ore mine were carried into KHD from MFC. The increase in earnings from 2006 to 2007 is explained by an increase in iron ore prices, and I believe successful renegotiation of the terms of the royalties. Management has said that they expect these earnings to increase further in 2008 based on iron ore prices and operational changes at the mine. I don't believe that these interests will be spun off, however, because they are carried with a zero tax basis and the spin-off would have unfavorable tax implications. So while these are non-core assets, I believe that these will remain within KHD for at least a few more years.

The preferred shares of MFC Bancorp are I believe what is left of the original company that initiated the reverse takeover. According to management, these will be spun off at a valuation neutral to KHD, which is to say their carrying value of $91M. I don't believe KHD derives meaningful operating income from this asset. Management has said that they intend to spin off these shares in Q1 2008.

The surplus capital on the balance sheet is substantial, approximateily $285M at Q3 2007, up from about $209M in Q3 2006 and $239M at the end of 2006. This increase demonstrates the company's cash generation. The company is entirely self-funding and substantially cash flow positive, so this cash is surplus and management has indicated that they intend to use it for acquisitions, joint ventures, or other initiatives to diversify and expand the business. Given Smith's historical success with savvy acquisitions and building tremendous shareholder value, we view this as a strong positive. Management said that they will be specific about the uses of this cash by the end of Q1 2008.

Incidentally, looking over the balance sheet and excluding these items, we see that the company is delightfully devoid of both non-current assets and liabilities -- once the current planned spin-offs are complete, it will be almost exclusively working capital and a strong cash flow engine.

Valuation

Adjusting for these non-core assets and changes, we have a company with a current market cap of about $1 billion and debt of just $11 million for an EV of about $1 billion. Net earnings for 2007, including core operations and iron ore mine royalties, but excluding discontinued operations, are expected to be about $52M (i.e. management guidance of $1.70-1.75 per share with about 30.5M shares). Backing out $285M in surplus cash and $91M for the preferred shares of MFC, we are left with an EV of about $634M for a EV to net income multiple of about 12 in 2007, for a company that is on track to grow net EPS by about 450% over the 4 years ending 2007.

Given the growth rate, positive cash flow, asset-light balance sheet, premier status in their markets, penetration into the world's fastest growing emerging economies, and clear opportunities to continue their growth, I believe a multiple of at least 15-18x is on the low side of reasonable. Assuming earnings growth of 15-20% per year for 2 more years (approximately half the rate of growth of the past 4 years), this puts the 2009 valuation of the core business at $1030-1350M. Adding the $376M of non-core assets to be deployed or spun-off in Q1 2008, and you have two-year upside of 40-73% from today's prices. Increases from successful deployment of the cash would present upside beyond that. My earnings increase estimate may well be low if the new joint ventures and initiatives bear fruit.

Risks

KHD is still highly dependent on the cement industry and a majority of their future growth will have to come from there. Repeating the growth of the past 4 years is probably not likely, and it is also likely that they are in an up cycle that will turn at some point. Predicting this will likely be difficult despite the backlog figures. That said, we don't think they are nearing a cliff, though the picture may be different 4-6 quarters from now.

Catalyst

Deployment of $285M surplus capital;
Continued growth and re-perception of the company with low multiples once the spin-offs complete in Q1 2008;
Wider recognition by analysts and investment community

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			2007	2008
Price:	32.67	EPS
Shares Out. (in M):	0	P/E
Market Cap (in $M):	1,030	P/FCF
Net Debt (in $M):	0	EBIT	0	0
TEV (in $M):	0	TEV/EBIT