Description

I am recommending the purchase of KSW, Inc.  This company was written up on VIC in February of this year. The author of the earlier piece gives a very goodover view of the company and its business.  I point you to that write up for a fuller business description.  But in short, KSW is a mechanical contractor that designs and, as general contractor, installs HVAC systems for predominately New York City high rises.  It is a backlog sensitive business.  Backlog typically moves through the income statement in 12-18 months.

I am writing it up again because I believe the market is over reacting to two pieces of admittedly bad news which I will go into below.  But the over reaction has created an opportunity to invest in a true “net-net”.  Net-nets, of course, were a favorite of Benjamin Graham and until the recent market chaos virtually didn’t exist in current times.    In short a net-net occurs when a company’s market capitalization is less than the sum of their cash and a fraction of their accounts receivable and inventories, less their total liabilities.  In KSW’s case, it becomes even more attractive because the company is solidly profitable and will continue to be solidly profitable even given recent events.

First I will tell you about the bad news that has the stock about 50% in the last two weeks.  Over the last week the company has issued two 8-k’s stating that two projects which represented significant backlog have been “delayed”.  I stress the word “delayed” because when I spoke to management they were very sensitive to the fact that I originally referred to it as “canceled”.

As of the their most recent Q for the quarter ended 9/30/08 bac log stood at $117 mm and they disclosed that they had another contract for $24mm entered into backlog after the quarter ended.

 The first 8k issued on the 16^th this month stated that a project at 56 Leonard street had been postponed.  This is the aforementioned $24mm contract.  Interesting, this is collateral damage of the Madoff scandal as the general contract of this project was personally heavily invested with the infamous money manger.

The second 8k issued yesterday after the close states that a project at 42^nd and 10^th, worth $32 mm of backlog, has been delayed.  KSW management stated, and it is hinted at in the 8k, that the developer is trying to renegotiate with the unions given the current financial climate which has led to the delay.  The delay is expected to be 3 months and the KSW is hopeful this contract will be able to go back into backlog.

Clearly it is not good news that the company has lost nearly 40% of their backlog with these two delays.  But my thesis relies on the fact that history indicates that even with significantly lower levels of backlog this company will remain substantially profitable.  And the stock is trading at Graham’s legendary metric of a net-net.  Net nets in recent times have been about as common as unicorns and when a company did trade at these depressed level it was often a train wreck of a company that was very quickly on its way out of business.  That is not the case at all with KSW.

Now for the net-net calculation!  KSW has 6.8mm shares outstand and as I type is tradeing a $2.25 for a market cap of $15.3mm.  KSW has no debt. 

Cash                                        $17,395

Marketable Securities               $1,561

Total Cash                                $18,956

Accounts Receivable                $20,128

Retainage Receivable                $9,197

Total A/R                                 29,325 * 75% = $21,993                                

Cash plus adjusted A/R =  $40,494     

Liabilities

Accounts Payable                     $17,159

Retainage Payable                    $5,210

Accrued Payroll                        $1,962

Accrued Expense                     $241

                                                $24,572

Net – Net =                             $15,922 > 15,300 Market Cap

So in short, KSW is cheap even by historic valuation metrics used during the great depression.  But there is more.  Even at the reduced back log levels I think it is very likely that KSW continues to be significantly profitable.

So if we are to estimate the current backlog we would stare with the $141mm where it stood in October.  Subtract the two lost contracts ( $56MM) and burn off an additional $25mm for this quarters revenue.  This ignores the relatively minor contracts that were added to backlog in this quarter which management states were relatively insignificant in the low single digit million range.  So my estimate is that backlog stands at $60mm.

When we explore the company’s history about how backlog translated into revenue and net income we can see that current backlog still translates into high profitability.  In 2004 the company reported backlog of $36mm.  The following year they reported $53mm in revenue and $2.51 in EPS.  In 2005 the company had $82mm in backlog which generated $72mm in Revenue and $2.77 in EPS.

Current backlog is right in the middle of the backlog in those two years and both were significantly profitable years.  I asked management if there were any changes in cost structure from those times which would make the company less profitable.  The answer to that was a resounding “no.”

Obviously, if the country goes into a deep recession or another depression, it is likely that more backlog will fall out.  So basically, as with any long, bets are pretty much off if the economy grinds to a halt.  But I am somewhat comforted by the fact that the Net-net investment method was used very successfully during the great depression.  So, obviously the economy is in some rough straights.  But using a valuation method that worked very well during the 1930’s is probably a good downside protection to this company’s valuation.

In summary, the company is cheap using the most conservative valuation method that Graham used during the great depression.  If the economy does better than that, the backlog that was delayed is likely to come back.  Even if it doesn’t, the company should be significantly profitable next year; profitability that only improves the net net valuation of this company at such absurdly low multiples.  This market is brutal, but the brutality is opening up investment for traditional value investors.  As most small caps, this isn’t immune to the selling pressure.  But I think when we look back in a year, this will be a great opportunity

As I side note, as I have been typing, the company has announced a $1mm buy back and the stock price has improved marginally.  The management seemingly sees value at these levels as well.

Catalyst