Description

KSB AG Vorzug is one of the world’s leading manufacturers and suppliers of pumps and valves and related services.  It is trading near its fifty-two week and within shouting distance of its five year lows despite no dramatic decline in revenues.  At first glance, the valuation seems to be a compelling 0.22x EV/Sales, 3.0x EV/EBITDA, and 4.9x EV/EBIT.  However, pension adjustments and minority interests introduce some complexity that call for adjustments.  It’d be reasonable to adjust the recent EV/EBIT (net of restructuring costs) to the neighborhood of 7.9x, which still has the beginnings of an attractive valuation.  However, it makes more sense to look the valuation on a P/E basis, adjusting the denominator for its excess cash.

Including these various adjustments for its excess cash, KSB3 trades for closer to 10.8x its trough earnings of €22.50/share (2014a), 5.5x its normalized earnings of €44.00/share (2016e = €40.39, 2017e = €48.31, while average of 2010, 2011, 2012 = €45.28), and 3.7x its cyclical high of $65.47 (2008 = €70.03, 2009 = €60.90).

In most cases, many value investors find it preferable to discuss valuation in terms of EV/EBIT, so please be patient with this Net Cash adjusted Market Cap in the numerator.  The explanation will be a bit further along in the write-up.  It seemed the most reasonable way to address the valuation in a way that came closest to the spirit of EV/ EBIT in stripping away some of the balance sheet complexities.

KSB has a solid balance sheet with a net financial position that is consistently near or above € 180M.  This is the amount I’m reducing its current market cap by in order to calculate its adjusted P/E.  KSB has € 385M in cash and equivalents, TTM revenue of € 2.28B, and expects 2015 revenues to be considerably higher than 2014 revenues of € 2.18 billion.  The company has over 16,000 employees.  

The company is 40% owned by the non-profit KSB Foundation through its ownership of 80% of the ordinary shares (ticker KSB GY, €369.00).  We are looking at the preference shares, which trade at a slight discount despite their higher dividend, higher EPS and greater liquidity (although neither has that much liquidity—combined daily volume is approximately €300k/day).

In the wake of last year’s disappointing results, KSB has enacted governance and management changes.  The company has initiated measures to reduce costs and expects these to have a positive impact on earnings.  Their recent strategic review has the company focused on higher profitability and sustainable growth.  These measures include a more intense focus on global material procurement and a reduction of the headcount in Germany.  While I wouldn’t compare this to zero based budgeting, the company updates describe every division in the company, quarter-by-quarter, doing full and thorough reviews.  Effectively, the company is trying to cut the costs of European production.  Thus far, this has involved closing their Homburg, Germany plant as well as the closure of three relatively small production and assembly units in Denmark, Switzerland and the UK.  Undoubtedly, there is a lot more to come from this company wide introspection and focus on costs.

KSB also changed the management structure to facilitate this review.  In 2014, these changes added up to € 30 million in non-recurring and restructuring costs.  It’s difficult to ascertain how much if any of that would flow to the minority interests, but if it does all flow through to the ordinary and preference shares, that would be €17.12 / share.  That adjustment alone could drive 2014’s trough earnings within 10% of the median and projected earnings mentioned above that describe an adjusted P/E of just 5.5x.

Regarding external forces, there is no doubt that weaker economic development has affected demand for pumps and valves, most notably in the energy sector.  In contrast, other sectors are less impacted.  Orders from the water and waste management industries as well as the construction sector have developed positively for KSB through the first nine months of this year.  This has resulted in sales being +6.2% YOY, but these results will lag weaker, as order intake is down -3.3% YOY through these first three quarters.  The difference between sales and orders has generally been a reflection of the pace of larger project commitments, and it seems natural that the economy has reduced some of the pace of these commitments.

For this year, KSB had been targeting €100M+ in EBT, their favorite measure, but has now guided that it will fall short of that, while still being significantly higher than 2014’s €72.6M.  Given the earnings attributable to non-controlling interests (mostly foreign subsidiaries cross-ownership stake), it isn’t clear how directly proportional their EBT guidance translates to EPS results, but it would be reasonable to expect that if EBT falls halfway between 2013’s and 2014’s results (which would be €96.0M), then EPS could likewise skew toward that two year average of €29.82.  That would be an 11.9x P/E ratio, or adjusted for the net financial position of €180M+ ($103/share), an adjusted P/E of 8.1x.

Here are some key historical figures:

While pumps and valves sound like fairly commoditized industrial products, their technical specs can still be quite demanding as customers demand reliability and energy efficiency.  For example, in their most recent annual report, KSB highlights three ground-breaking technical solutions.  These include an innovative non-chemical cleaning system for ballast water from container ships, energy-efficient mineral separation for mining applications, and the development of valves capable of withstanding temperatures above 700° C.  The latter are necessary in order to keep pace with fossil fuel burning power plants that achieve increased efficiency levels through higher steam temperatures.  In addition, KSB pumps and valves supply the following solutions:

• €30 million order to equip a Saudi power plant with high-pressure pumps

• 6,580 different gate, globe and swing check valves for the construction of an Indian steam power plant.

• Numerous technical advances and awards for compact desalination systems, low power consumption motors, cooling system pumps durability, and automated safety valves to protect pumps, water turbines and piping against pressure surges.

• Approximately 60% of all LNG tankers used in the world are outfitted with KSB valves.

The decline in 2014 sales revenue and earnings had been the trigger that led KSB to introduce a series of measures to address profitability and growth.  Revenue had declined by 2.9% in 2014, and EBT had fallen from € 119.4M to € 72.6M.  Granted, as indicated above, KSB indicated that non-recurring and restructuring costs in 2014 accounted for € 30 million of that reduction.  More to the point, the quick reaction of KSB and their previous earnings expectations suggests that they are recalibrating the company to produce € 100M+ EBT going forward and current efforts will probably help to raise the floor under earnings for the next demanding economic cycle.

The company does face growing competition from Asian suppliers, and KSB reports “more and more contracts being awarded to local manufacturers, with China being a prominent example.”

By segment in 2014:

Pumps : € 1,524 million
Valves: €    407 million
Services: €    390 million

Europe: € 1,427 million
Middle East / Africa: €    123 million
Asia: €    357 million
Americas / Oceania: €    415 million

A few more footnotes about KSB’s share count: The share capital of KSB AG is divided into 886,615 ordinary shares and 864,712 preference shares.  Approximately 80 % of the ordinary shares are owned by Klein Pumpen GmbH, Frankenthal, the majority of shares in which are held by KSB Stiftung [KSB Foundation], Stuttgart. The remaining ordinary shares and the preference shares are free float.

Finally a word or two about the pension obligation and the defined benefits obligation (DBO).  As KSB puts it: “The payments linked to pension obligations are paid from our liquid assets, without the need for specialist investment strategies to cover pension plan obligations.”

In both 2012 and again in 2014, KSB significantly reduced the discount rate for its DBO and is now using a 2.2% discount rate in Germany:

Were the discount factor to increase by 100 basis points, the DBO would fall by € 93 million.  The DBO for KSB is mostly centered around its German workforce, with retirees accounting for roughly half the amount.  As recently as the start of 2012, the PV of the DBO was € 280M.  At year-end 2014, it had jumped to € 562M.  This is where it pays to start making adjustments to the EV/EBIT metrics.  For a more complete picture, here’s the DBO table (we can ignore their other pensions as they are current):

And:

And:

As shown, the annual expected payments are not onerous, but the € 562M is a bit intimidating.  Let’s go back to that initial description that attempted to provide a properly adjusted EV/EBIT ratio.  If we took the Bloomberg calculation of € 500M EV (yes, that probably needs adjusting—but enough already) and add in the € 562M, that would be € 1,062M.  The EBIT of € 88.8M should likewise be adjusted higher for the € 16M of benefits payments and to additionally net out the restructuring charges, another € 30M—making an adjusted EBIT of € 134.8M and an adjusted EV/EBIT of 7.9x.  Undoubtedly, that’s piling a few adjustments on top of each other, but it seems a reasonable way to address the problem.

With actuarial assumptions moving DBO pension liabilities around by close to € 100M per 100 bps, I’d prefer to stick with my hybrid adjusted P/E ratio, but in the interests of walking through another way of looking at this, it is valuable to do both sets of analysis.

Keeping in mind, of course, that these pension liabilities will always be messy and it is completely understandable if an investor wants to simply steer a wide berth of any such obligations.

As for comps, there are some similar industrial companies out there.  Here are their respective valuations:

Granted, the above table doesn’t make the adjustments across the board.  Nonetheless, KSB stands out as cheap to other industrial companies that have a presence in the pumps and valves market and similar industrial niches.

The discussion of the accounting adjustments is more complex than the business.  Year after year, KSB manages to produce over € 2 billion of pumps, valves and related solutions.  They are on board 60% of the LNG tankers in the world.  They are instrumental in massive build-outs of infrastructure, and they keep improving their products.  They have a global presence, German engineering, and a renewed focus on efficiency.  Both historically and recently (net of restructuring costs) and also by most reasonable estimates going forward, they seem more than capable of a baseline run rate of better than €40/share in EPS falling to the shareholders. They have a net financial position of just over €100/share and an investor can make any adjustment to their recent € 355/share close that they care to in order to accommodate that.  Their preference shares trade at a discount to their ordinary shares, and have returned to the bottom of their one year and five year range at €355/share.  Net of any reasonable adjustments, this is a well-established company trading at a single digit P/E, which represents a compelling valuation on a risk-adjusted basis.

Catalyst

General recovery in industrial shares.

Earnings recovering from restructuring charges.