Description

Investment Thesis: The current stock price provides investors with an opportunity to own a good & sustainable 18-22% ROIC cash generating business, with healthy competitive barriers and good (albeit somewhat cyclical) growth prospects for a valuation about equal to the value of the current cash and the monetized value of the order backlog. Thus, investors today can own the business for about what the company's cash position will be in about 18-24 months and get any future growth and/or cash flows from the business for free. The catalyst for the shares is an acceleration in revenue & earnings growth beginning in the current quarter tied to the recent jump in the company's backlog; historically a leading indicator of future revenue trends.

On multiple valuation metrics, the shares are very attractive for value investors with tangible downside protection. Given the earnings power of about $0.43 per share in 2010, based on the current near-record backlog, the shares trade at only a P/E of about 7.8x and a cash adjusted P/E of only 1.5x. From another perspective, the 2010 cash flow alone of about $5 million or more from the current backlog, when compared with the company's market cap of about $21 million and $5 million enterprise value, translates into an attractive cash flow yield on both of these valuations. Also, relative to the two closest publicly traded comparables (Emcor & Comfort Systems) KSW trades significantly below its peers (see table below) which shows that healthy upside in the share price is possible. The current net cash position of $2.54 and monetized value of the backlog should also provide adequate downside protection in the share price.

Since the stock peaked in July 2007 (at $8.34) the shares have underperformed the general market and are down about 60% from this level (versus a 10%-15% decline in the market indices). Noteworthy, most of the divergence relative to the market occurred post the December 2008 announcement of two major contract deferrals and the resulting drop in the order backlog. Hence, given the positive news that one of these orders is re-starting and the significant increase in order backlog to near record levels, I believe this divergence relative to the general market should narrow as revenue trends accelerate over the next couple of quarters. Adjusting for this divergence, the shares would sell in the $6.00-$6.50 price range. At this price the P/E would still be a reasonable 15x 2010 GAAP EPS, or a cash adjusted P/E of only about 7.5x.

Key Statistics:

Stock price: $3.37
52 week range: $ 1.79 - $4.94
Dividend/Yield: $0.10 / 2.9%
Market Capitalization: $21.2M
Enterprise Value: $5.2M
Net cash Position (@ 9/30): $15.9M
Net cash per share: $2.54
Debt: $1.1M
EPS 2009/10: $0.12/$0.43
FCF 2009/10: $1.0M/$2.7M

KSW was written up twice in 2008 and both pieces provide a fair amount of background for interested parties. As such, I will focus my write up on my view of why I believe this is a good sustainable business and why I believe it is a timely investment opportunity for value investors to consider at this time.

A well positioned & differentiated market position: By way of background, KSW is a heating, ventilating, and air conditioning (HVAC) mechanical engineering sub-contractor and provides project management services to many of the leading developers in the New York City metropolitan market. The company is one of the top HVAC mechanical contractors in the market, which gives it regional scale benefits. In addition, significant entry barriers exist. The New York City commercial construction market is dominated mostly by large builders and serviced with a unionized work force. It is very much a close knit industry where proven performance and long-term personal relationships are important to securing business, working with subcontractors and suppliers as well as securing a dependable and skilled workforce. The senior executives at KSW are well recognized industry veterans, with the company's CEO having almost 40 years of experience in the New York construction market. Having a healthy balance sheet to secure surety bonding is also a prerequisite for winning contacts on projects of the scale required in this market. This helps preclude smaller poorly financed competitors from competing for larger jobs on the same scale of the company. Many of the company's clients (the major builders) are repeat customers who value KSW's value engineering and trade management skills. As a result, many of the company's clients often bring KSW into a project during the design phase to leverage their proven expertise in reducing the cost of construction to be more consistent with their requirements. In fact, the company's reputation with developers in recommending significant cost saving changes to a project's design has enabled KSW to win a number of contracts without competitive bidding. Thus, this degree of expertise not only helps differentiate the company and creates a "stickiness factor" with its customers, but helps it obtain healthy operating margins.

A reversal in order trends, translates into a significant increase in backlog: KSW's business model is backlog intensive, with most projects running 12-24 months in duration. Thus, backlog is a good leading indicator of future revenue. As illustrated in the following table, KSW's backlog reached a record level of $139M in Q2 of 2008. Thereafter the backlog began to decline consistent with the downturn in the overall economy and the local New York market. In December of last year the stock took a big hit, declining about 45% following the announcement that two of the company's major projects in its backlog had been delayed. These delays were directly tied to the tightening in the credit market and the inability of the builder to get the necessary financing to complete the job. Management noted that in both cases the builder had indicated a desire to move forward when financing became available and that they had no desire to cancel or re-bid their HVAC contract with KSW. Nonetheless, this raised concern among investors that other contracts could follow suit and that if the company was not successful in winning new business it would deplete its backlog and become unprofitable. Management indicated at the time that there was still new business opportunities in its core private market (albeit things were moving slow) and that it had begun to investigate opportunities in the public market (where contracts were still being signed, but tend to be lower margin). The stock continued to decline further commensurate with trends in the overall stock market into the spring. While the stock has rebounded slightly it is still well off its 2008 highs and in my opinion is well below fair value. This contrasts with the fact that the tide has clearly turned very favorable relative to new orders and momentum trends in its backlog. Specifically, in the last few weeks KSW has: 1) announced two significant contracts in the private market, 2) shown its ability to capture some business in the public market (at margins that the company states that they are comfortable with) and 3) perhaps most importantly KSW announced that one of the two major projects that were delayed in December has been restarted and will move forward at a rapid rate. As a result of these new contracts the company's order backlog has grown significantly to $134.3 million at September 30, and is currently near record levels. I estimate that given the timing of the jobs, this order backlog alone will last the company well into 2011 to complete. Given some conservative estimates for profitability (assuming the public business is somewhat less profitable) translates into cash flow of about $5.0M-$5.5M, or about $0.80-$0.90 in future cash per share. Thus, I estimate that with no additional contract wins (not my expectation) KSW's future cash position will grow to about $3.55-$3.65 per share just from monetizing its current backlog.

Favorable Growth Trends In the New York Construction Market Not Discounted In The Share Price: Looking at historical data (i.e. nonresidential construction, construction spending, construction employment and public infrastructure spending) from various sources on the New York City construction market shows it to be a growth industry, but cyclical in nature. The industry tends to be a lagging economic indicator with spending trends in the public and private market somewhat offsetting each other. Input from a number of the major commercial private developers suggests that they continue to believe there are interesting opportunities for them in this market in the future. For example, recent press reports indicate that in the New York metropolitan market there are over 100 foundations that have been laid in advance of future construction activity and before the June 2008 expiration of 421-a tax abatements. In addition, data suggests that about 65% of all commercial buildings in New York City are over 50 years old. Noteworthy, recent data also shows that most of these buildings are not up to code relative to current HVAC standards and will likely need to comply with code in the future. In addition, with the support of the major of New York, Michael Bloomberg, about one-sixth of the city has been re-zoned for development. This suggests a solid amount of new construction activity in the private market will commence sometime in the future. Noteworthy, approvals are in place and developers selected for a number of major local construction projects including: the World Trade Center, Atlantic Yards (Brooklyn), Hudson Yards and the former Con Edison eastside facility. In addition, major institutions that have significant expansion plans include: Columbia University, St. Vincent's Hospital and the United Nations. While construction activity has slowed in the private market due to economic and credit issues, there appears to be a healthy amount of construction work continuing in the public market. Consistent with the trends in the market with more business opportunities in the public sector, KSW has broadened its focus and has been successful in wining a number of significant contracts in the public sector. This wins include the recent partnership on the former World Trade Center site as well as a number of hospitals. After not doing any public projects in the last few years, this sector has been one of the reasons behind the recent jump in the backlog. While management does not break out the mix of the backlog, I estimate that public projects now account for approximately 30% of the backlog. A major driver of growth in the New York public market is from the government sector, which includes New York City and State, as well as entities such as the Port Authority and the Metropolitan Transportation Authority. In addition, while there has been only a limited amount of government stimulus funding flowing into the market to date, there is a lot of opportunity for this spending to continue to fuel healthy growth in the public sector. The important point here is that by all indications with construction activity and opportunities for KSW likely over the next few years, the current valuation of the shares does not appear to appreciate this, giving investors the opportunity to participate in this growth for free.

Significant Relative Valuation Gap Illustrates Upside Potential: The two closest publicly traded comparable for the company are Comfort Systems and Emcor. While not exact comparables to KSW, they both are in the construction and services business and all are closely tied to the broad trends in the construction business and related economic factors. Emcor is a larger company with worldwide operations and broader construction services. Comfort Systems provides HVAC installation and services in a number of mostly secondary markets in the US. While some may argue that KSW deserves a valuation discount as a result of its smaller size, others could argue that it has regional scale and geographic focus. Nonetheless, the valuation differences are significant and in my opinion illustrate that there is significant upside in the share price. In addition, for investors who are attracted to more growth oriented stories, of the three companies, only KSW is projected to show an increase in both revenues & EPS in FY2010 (and KSW's revenues will likely set a new record).

Q3 Represented the Trough in Revenue & Earnings During The Current Cycle: Historically the backlog has proven to be a leading indicator of future revenue trends. If one were to graph the relationship between the trend in backlog and revenues on a quarterly basis over the last few years, this point would be clearly illustrated. Given the significant jump in backlog over the last couple of months, this bodes well for an acceleration in revenue and earnings over the next couple of quarters. Noteworthy, the recently reported Q3-09 period should mark the trough in revenues during the current down cycle. Reading through the recent 10Q, management projects that $119.6 million of its $134.3 million backlog is not reasonably expected to be completed this fiscal year. Thus, management is projecting about a 12% sequential revenue increase in Q4. In addition, given the timing of some of the company's larger project work beginning to ramp up in early 2010, revenues should grow further from Q4 levels.

The table below highlights some historical trends as well as my projections for the company. I conservatively assume that only about 60% of this backlog will be booked as revenues in FY 2010. This implies that KSW will need a revenue contribution of only about $12 million from new orders to reach my revenue projection. In addition, I assume gross profit margins near the low of the company's historical range during periods of healthy revenue growth to account for the possibility of some lower margin public contracts (no sign of this evident yet) and a greater mix of trade management business. 

Catalyst

• sequential growth in Q4 revenues, indicating the trough has passed in this current cycle.
• an acceleration in revenue & earnings from beginning to work through the backlog.
• future growth in cash flow and net cash per share.
• the announcement of additional new contracts.