Description

KSB is a German pumps and valves manufacturer. Written up by Beethoven in 2021 (who has done an amazing job keeping the board updated), shares have almost tripled since then, yet we believe substantial upside remains and hope to add detail on some aspects of the thesis below, namely sustainability of margin gains to date, remaining growth potential, and a near term catalyst in the form of a merger of the preference and ordinary share classes which should improve liquidity.

Stable business driven by aftermarket and replacement demand. A first look at KSB would perhaps show a cyclical low margin industrial manufacturer, but closer inspection shows it derives 83% of LTM EBIT from attractive and recurring aftermarket, including maintenance services through its extensive branch network and spare part sales.

Founded in 1871, the company is the global #3-4 in a surprisingly attractive and stable industry – pumps are critical elements of various industrial processes and generate extensive aftermarket (typical 20-year useful life). In addition, most demand is currently replacement-driven, especially in developed countries, and in recessions the longer use of existing pumps drives stronger aftermarket, which has much better margins. Most peers have been around for centuries (e.g. Sulzer founded in 1834, Flowserve dating back to 1912, etc) and trade for high single digit / double digit EBITDA multiples, highlighting this stability. There is valuable IP, as many of these are highly engineered and complex pumps. Finally, the industry is at the confluence of multiple structural growth vectors highlighted below.

Contrary to peers, on our numbers KSB trades at c. 4x 2024E EV/EBITDA, 8x 2024E P/E and 8% 2024E FCF yield despite a positive growth outlook, due we believe to governance challenges that are in the rear view and low share liquidity that we see improving.

Aftermarket growth vector. Aftermarket revenue carries a ~19% EBIT margin (vs 0-3% for original equipment) and is growing strongly (14% 21-23 order intake CAGR), as the company is focused on capturing a greater share of its underpenetrated installed base. In fact, KSB currently taps ~33% of annual aftermarket demand from its installed base, which compares with our estimates of ~60-70% for peer Flowserve and ~30-40% for Grundfos per interviews we conducted. This is despite, especially in the case of Grundfos, these peers focusing on less aftermarket-driven standard pumps. 

Competitors interviewed highlighted KSB’s extensive service network of 190 service centres and 3,500 technicians – especially in Europe –, and the company’s focus on personalized, highly-engineered pumps as key factors that should allow increased penetration. This strong footprint should support a greater penetration rate, as should KSB’s bias towards end markets that are typically linked to greater aftermarket, such as energy generation (especially nuclear, where regulation regarding use of non-OEM aftermarket suppliers is often tight), mining (which generates a lot of wear and tear on pumps, driving shorter replacement cycles, as can be seen in mining-focused peer Weir), and other heavy industry applications.

The mix impact from growth in higher margin aftermarket driven from growing penetration should suffice to reach management’s targeted 10% EBIT margin:

Structural tailwinds. The company is at the centre of multiple structural tailwinds, serving mainly the water (28% of LTM order intake), industrial (26%), building services (15%) and energy (13%) markets. The energy market is, we believe, a strong margin contributor due to tight regulation of aftermarket sales in pumps used in nuclear power plants, a niche sector where KSB has a strong position. After a “lost decade” for nuclear since Fukushima, the company is seeing strong growth as India and China (both countries where KSB has JVs in place to produce locally) increase nuclear investments. Water is also a long-term growth vector, as water security and renewal of ageing wastewater infrastructure become top of mind. Across other end markets, the company is also well positioned – pumps are a key element in removing mine slurry water (with growing electrification mineral-driven utilization) and in reducing energy usage of industrial processes through flow optimization, while non-nuclear energy generation is also seeing investments.

We believe these structural drivers, together with the opportunity in KSB’s installed base, provide strong foundation for the company’s stated target to grow sales at GDP + 1% per year until 2030.

Improving governance and catalysts. This growth and stability would warrant a higher valuation for KSB, but the company has a checkered history with investors, detailed in messages to Beethoven’s write-up – culminating in a 2017 article in the German press highlighting some self-dealing favouring members of the founding family during 2014. In addition, the foundation set up by the founders controls KSB through a corporate structure (KGaA) that is almost synonymous with poor governance in Germany.

We have seen this however changing since the arrival of new CEO Dr Stephan Timmermann in 2017. Potentially due to interest from the foundation in monetizing its stake in the future, or perhaps as a backlash from the 2017 article, management has been strongly focused on improving governance and transparency – e.g. starting earnings calls, hosting an inaugural investor day, conducting roadshows – and revitalising the company through an ambitious growth and margin improvement plan, centred on a more market-centric organizational structure and growing the aftermarket capture rate. We visited the company’s headquarters in 2023 at the CMD and were positively impressed with the executive team’s drive and interest in hearing shareholders’ views on how to further unlock value.

An additional stage of improvement would be a merger of the preference and ordinary shares, which would increase liquidity and reduce asymmetry between the KSB Foundation and minority shareholders. This was mentioned by management in the last earnings call (which we found surprising and very encouraging - a sign of transparency with shareholders and continued willingness to explore additional ways to support the share price, which we had seen in person at the CMD already.

20% IRR possible without significant multiple expansion. We believe that at the current valuation there is strong upside if KSB continues to execute. At a relatively constant exit multiple of 5x EBITDA (in line / slightly below historical levels), current cash generation (8% FCF yield 2024E) and growth (~7% EBITDA CAGR 24-28 expected, driven by above-GDP topline and growing margins from aftermarket) generate a 20% 5-year IRR in our base case, as shown below.

Of course, IRR would be much greater in a more aggressive scenario where this continued growth and governance improvements finally materialize in an exit multiple in line or close to peers (or if the Foundation indeed decides to sell the business).

Cycle exposure and margin sustainability potential risks. The key risk to our thesis is, we believe, the business turning out more cyclical than we think, and operational improvements seen to date being given back as a result once we see a downturn in the industry. 

A bear could raise two points supporting this possibility - first, the business did see significant margin contraction during the last downcycle (although revenues were stable). Secondly, many peers are reporting record revenues and margins similar to KSB at the moment (e.g. see Flowserve or Xylem’s recent earnings calls).

To quantify this risk, we believe we could see 20-35% maximum EBITDA contraction in such a pessimistic scenario, applying long term median and worst-case margins, respectively, which could come with an additional 5-10% revenue decrease.

As a mitigant, we regularly track market conditions through calls with competitors so far show these show continued strength in end markets, despite a slight deceleration year-to-date. We believe at least a good part of this industry strength is the result of the multiple positive long term trends highlighted above, rather than just a cyclical top.

Benchmarking KSB’s performance to the competition also strengthens our view that past underperformance was a result of under-optimization at KSB rather than economic conditions, as is the fact that the company’s revenue was stable throughout the post-GFC period, with EBITDA downside having been driven by lower margins (which management indicates were in turn driven by misquoting of projects and high raw material inflation, although they were not present then). Something that supports this is the fact that peer margins were more resilient during the last downcycle, again pointing toward the conclusion that KSB’s margin problems were self-inflicted.

Further, the company is now certainly less cyclical, with lower exposure to mining & energy (20% of revenue vs 33% in 2008) and a higher share of aftermarket. A final headwind in the 2010s was likely the downfall of nuclear after the Fukushima disaster. As mentioned, this sector is now instead a tailwind for the company and we believe it might be one of the crown jewels in KSB’s portfolio, given its very high attach rate on aftermarket due to regulation.

Catalyst

Share class merger