Description
Executive Summary:
KHDH is an undervalued investment with high quality cement and minerals engineering businesses that service the growing infrastructure demands of the worldwide market. Formerly known as MFC Bancorp, the company spun off its finance component earlier this year to focus on its core engineering businesses. Giving consideration to the current cash on hand and several non-core assets owned by the company, the core engineering business that remains is trading at 4x earnings. We believe this investment offers an opportunity to double your money as the company transitions to a pure play with a strategy focused on growing higher margin revenue and continues to announce large and profitable new contracts. KHD completed the spin-off of its financial subsidiary, Mass Financial, in early 2006 so second quarter results will provide further clarity on the standalone results of the engineering business. The following facts make this special situation investment complex and therefore even more compelling – KHD is incorporated in Canada, headquartered in Hong Kong, the stock is listed on Nasdaq, the engineering team historically was predominantly German but is now expanding rapidly into India, and the company presents its financials in Canadian dollars while giving forward guidance in US dollars but prices many contracts in euros. Jim Busche, the recently hired CEO, operates out of the Hong Kong office and, as far as we are aware, the management team currently spends no time with current or prospective investors which appears to have turned off many new investors from taking a close look at the opportunity.
Company Overview:
For a good overview of the business and strategy, take a read through the company’s 2005 20-F
KHD is a leading industrial plant engineering company serving two sectors, the cement industry (89% of revenues) and the metals and mining industry (11% of revenues). The company is an engineering business specializing in the design, manufacture and sale of equipment used in cement production, coal beneficiation and minerals processing. KHD’s customers include large cement manufacturers like Cemex, Holcim and Lafarge. The company has a long and successful track record, having built more than 450 cement plants worldwide and supplied equipment to more than 140 coal plants.
Specific services provided by KHD include plant design, equipment design and development, engineering services and automation services. Within the cement group, KHD’s product range focuses on grinding and pyro-process technologies, which represent approximately 55% of the equipment value chain of a typical cement plant. Within coal and minerals, the company focuses on grinding, sorting and dewatering technology applications.
KHD’s largest competitors include FLSmidth and Polysius (owned by ThyssenKrupp) which both have full-scale engineering operations. Industry pricing is competitive, but it does appear to be a rational as only three players (FLS, Polysius and KHD) are generally in contention to win large cement projects outside of China which is a self-contained and distinct market.
China is far and away the largest consumer of cement worldwide, demanding almost 45% of total worldwide capacity. Sinoma dominates the China market, which is fragmented and has many small, inefficient competitors. While Sinoma has been aggressive in attempting to expand outside of its home market, they have achieved only moderate success as they have minimal technology expertise and very low environmental standards, two very important criteria in the bid process.
Investment Merits:
- Strong and growing end market demand – an investment in KHD offers one of the cheapest means of taking advantage of the growing worldwide infrastructure demand. Cement usage typically follows a country’s process of urbanization, industrialization and growth in economic wealth. With a dramatic commodity bull market in recent years, many resource rich countries are spending huge sums of money on further development.
Cement consumption per capita is significantly lower in regions of the world like Asia (excluding China), South America and Africa than in Western Europe and America. It is interesting to note the significant gap that exists between China and many other emerging economies; China consumes approximately 750 kilograms of cement per capita versus 175 in India and 225 in South America. We believe many rapidly developing economies such as India will require significant incremental cement capacity to upgrade their transportation systems and facilities if they are to continue strong rates of growth and elevate their worldwide competitive status.
Cement Consumption per Capita (Kg)
Africa 117
North America 403
South America 226
China 741
Asia excl China 187
Eastern Europe 268
Western Europe 513
Middle East 479
Total 346
Total excl China 242
In the near term, India, Russia, North Africa, Vietnam and the US are expected to have the heaviest cement kiln capacity expansion. In the US market, 25% of cement demand has historically been imported but significantly higher freight rates have made this more of a challenge. Additionally, a strong non-residential build cycle and the recently implemented US Highway Act are driving demand for significant new cement capacity. KHD signals its substantial end market demand in its public filings: “Our engineering capacity is currently substantially below demand and this requires that we outsource certain engineering services. Given the present high level of order intake, the company expects this capacity gap to continue for the foreseeable future.”
- Valuation gap with key competitors – KHD trades at approximately 1.5x book value versus 4-5x for its closest peers. FLSmidth is considered by most to be the leading service provider in the industry, and trades at approximately 9x 2007 EBITDA and 17x 2007 EPS, substantial premiums to where KHD is currently trading.
- Focus on predictable, higher margin business – new management has shifted the company focus away from turn-key erection and commissioning business towards its core strengths of design, engineering, manufacturing, erection and commissioning of plants worldwide. These higher intellectual property projects afford the company better predictability and should reduce the likelihood of future cost overruns typically associated with civil contract work on labor and soil management issues. Additionally, the company is transitioning a significant portion of its engineering staff to low cost labor sources in India and China, which should drive future operating margin improvements. The company is seeking niche tuck-in acquisition opportunities that will complement its current service offering and give KHD a better probability of success in future bid processes.
- Tremendous growth in the coal and minerals segment – while the coal and minerals business represents a small percentage of overall sales today, end demand for KHD’s services are growing dramatically. In 2005, order intake in the sector grew 128% as the company has a strong reputation in the large and growing markets of China, India, Russia, Australia and South Africa. Backlog in this business has grown almost 3x in the past year as current high prices for many commodities justifies capex on new mining development projects.
Financial Projections and Valuation:
KHD has demonstrated tremendous top-line growth in the past several years and has a strong and growing pipeline of signed contracts and potential new orders that provide good visibility into future earnings. In 2005, order backlog and intake both grew by more than 40%. 2005 order intake was split geographically as follows: Asia - 43%, Middle East - 32%, Americas – 19%. America and India have grown recently as a percentage of the overall backlog (America grew from 2% of backlog at the end of 2004 to 12% in 1Q06; India went from 7% in 2004 to 20% in 1Q06). Our conversations with cement manufacturers and several major new announced orders by KHD in recent months give us confidence that backlog and revenue will continue robust growth through at least 2008.
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2004 |
2005 |
2006E |
2007E |
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Revenue (C$) |
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$199 |
$398 |
$478 |
$550 |
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% Growth |
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100% |
20% |
15% |
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EBT (C$) |
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$13 |
$30 |
$36 |
$47 |
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% Margin |
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6.7% |
7.5% |
7.5% |
8.5% |
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Backlog (US$) |
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$225 |
$318 |
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Q106 Backlog |
$352 |
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% Growth |
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41.5% |
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Order Intake (US$) |
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$281 |
$394 |
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Q106 Intake |
$95 |
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% Growth |
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40.5% |
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Following the Mass Financial spin-off in January, KHD essentially consists of a core engineering business, a royalty interest in an iron ore mine, land in Eastern Germany and a preferred ownership position in Mass Financial. As shown below, we have valued KHD in separate components. The company has a considerable cash balance of >$200mm. KHD also owns a 50 year royalty interest on the Wabush Iron Ore Mine in Newfoundland, Canada. We have conservatively valued the royalty based on the minimum guaranteed payment to KHD of $3.25mm/yr despite the fact that KHD netted more than $6mm/yr from 2003-5. Additionally, the company owns approximately 680 acres of land in Eastern Germany that is zoned for industrial usage and which it intends to sell. Finally, KHD owns preferred stock in Mass Financial that is valued on the balance sheet at approximately $75mm. The preferred stock was granted to KHD in return for its common stock ownership position essentially to preserve the tax-free status of the spin-off. After deducting the value for the above-mentioned items, the core industrial and engineering services business trades at approximately 4x 2006 earnings, which should grow by north of 30% in 2007.
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Mkt Cap (a) |
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$441 |
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Less: Net Cash |
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215 |
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Less: Iron Ore Royalty DCF |
29 |
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Less: Real Estate Value |
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44 |
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Less: Preferred Mass Fin Shares |
76 |
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Less: PV NOLs |
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10 |
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TEV |
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$66 |
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2006 Core IES Earnings |
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18 |
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Earnings Multiple Paid |
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4x |
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(a) |
Assumes 0.5mm shares issued to buy-in Sasamat stake. |
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One interesting potential catalyst for the stock is an on-going legal dispute between KHD and Cleveland-Cliffs, the operator of the Wabush Mine. KHD believes that CLF has underpaid the true economic terms of the royalty agreement, as the payments were structured based on prices printed in a commodity publication that changed ownership and no longer updates current transacted iron ore pellet pricing levels. We believe that there is a strong likelihood that KHD will receive a make whole payment from CLF (which could be sizable given the spike in pellet pricing in the past 4 yrs) and will re-structure the royalty payment terms to achieve the originally intended percentage of sales generated by the mine.
We believe KHD should trade for a low teens earnings multiple, implying a per share valuation in the mid $40s. Given the conservatism in each of our valuation assumptions, the upside opportunity could be dramatically higher if the engineering business continues to grow as we would expect and if iron ore prices remain at high levels. In a more bullish scenario, we ascribe a 16-18x earnings multiple on our expected forward earnings (excluding cash interest income) and assume that the company is successful in its royalty arbitration process, in which case the royalty stream would be worth nearly 3x our conservative value from above and a make whole payment of approximately $10mm is achievable. Under these assumptions, KHDH would offer greater than 100% upside potential.
Investment Risks:
- Emerging market risk – the majority of KHD’s revenues are generated from projects in emerging economies. While the company requires a significant upfront payment and insures against certain political risks, the projects are subject to a high degree of financial, political and legal risk.
- Cyclical business with high fixed costs – the commercial and industrial sectors generally experience long demand cycles that are highly correlated to the general economic environment, and the global market for new cement production capacity has experienced a high level of activity for the past three years. Furthermore, KHD has a high degree of operating leverage and the majority of its revenue is one time in nature.
- Low perceived barriers to entry – while cement engineering is perceived to be a basic technology, conversations with industry experts indicate that there is a very long learning curve in this business. Furthermore, significant capital and size are required to successfully bid for world scale projects. It is interesting to note that small Chinese competitors have tried unsuccessfully to copy successful engineering and design innovations made by industry leaders, making them uncompetitive in large project orders particularly in areas with strong environmental standards.
DISCLOSURE: We and our affiliates are long KHD Humboldt (KHDH), and may long additional shares or sell some or all of our shares, at any time. We have no obligation to inform anybody of any changes in our views of KHDH. This is not a recommendation to buy or sell shares.
Catalyst
Catalysts:
Clarity around company structure and earnings power of engineering business
Continued strong infrastructure growth in worldwide markets