Description

With the VIC value meter seemingly stuck on low and 52-week highs outpacing 52-week lows by wide margins, it has become harder to find slam-dunk value plays. Key Technologies (KTEC) provides an opportunity to buy a solid company at a cheap price for investors with the patience to wait for a rebound in the food processing industry.

KTEC manufactures process automation solutions for the food processing and tobacco industries. Its automated systems deliver labor cost savings and improved yields resulting in a payback of less than a year. The largest markets for the Company's products have been processors of potatoes, vegetables and snack foods, although the Company believes there are many additional applications for its systems beyond the food processing industry. The principal potato market served by the Company's systems is french fries. Current investment in new french fry processing facilities has declined relative to historical levels, largely in response to changing consumer preferences, such as low carb diets.

KTEC has three segments: 1) automated inspection systems, which detect and remove defects during product processing, 2) process systems, which convey, sort, separate and grade products, and 3) parts and services, which provides spare parts and post-sale field support. The company’s automated inspection systems are its most sophisticated products. The detection process is performed using cameras that can detect shape, size and color of products. Each of the cameras scans the product streams (product streams move at 5 to 20 feet per second) at the rate of 1,500 to 4,000 times per second and can identify defects as small as 1/16 of an inch in diameter. In fiscal 2004, the Company introduced a new vision engine called G-6, which will be used in its optical sorting systems. The G-6 will be sold as part of new systems sales, but can also be sold as an upgrade to existing optical sorting systems. The G-6 has significantly more software content than previous vision engines, which allows customers to perform more powerful analysis than was previously allowed. KTEC expects the software to be a strong selling point to customers and at the same time provide a higher gross margin in the automated inspection systems segment.

The company’s story for F2004 was one of project deferrals. The food processing industry is going through a tough period and thin margins are expected to keep a lid on capex in 2005. The industry as a whole is delaying new plant construction and is instead focusing on increasing automation and finding ways to improve cost effectiveness with quick payback products. While a free flowing capex environment would clearly benefit KTEC, its products are well situated for an environment with a focus on quick paybacks. The following quote from a trade magazine article sums up this point: “Automation is one obvious solution to quickening the pace of both production and changeovers. While the food industry still lags some other industrial sectors in this area, automation is becoming a significant investment item on the shopping lists of most food companies. In our own annual Manufacturing Trends Survey [January 2004] respondents ranked automation the third most important issue facing them this year, behind perennial concern food safety and in a virtual dead-heat with labor issues. Ninety percent said they were in the process of automating some component of their manufacturing processes.”

The problem is that even with a demonstrable ROI, the sales cycle has proven to be longer than expected and backlog has decreased from $20.1mm at the end of F03 (fiscal year ends 9/30) to $12.7mm at the end of F04. There are a couple of reasons to believe that the company’s slide in sales will subside in F05:

--The company has significant exposure to the french fry industry, which has been on the wrong side of the low-carb trend. The market has seen signs of a reversal of the low-carb diet trend, and I expect the trend to gain momentum as people inevitably lose motivation with their low carb diet and remember how good french fries taste.
--The company estimates that the installed base of systems has an average life of 5 to 7 years. Projects can be deferred for a while but eventually need to be replaced, even with proper maintenance. Company feedback from its sales teams suggests that project deferrals have been due to a trend among customers to allocate capital to projects aimed at reducing the effect of higher steel costs in their canning operations. I expect project deferrals from F04 to translate into sales towards the end of F05. If this thesis does not materialize, however, the parts and services segment will continue to see improvement (up 17% in F04) in the meantime. This segment carries a relatively high gross margin of 36% compared to the process systems segment, which has a gross margin of 22% and was down 13% in F04. This trade-off should help cushion the blow on profitability if project deferrals continue for longer than expected in F05.
--The new G6 vision engine will enable KTEC to increase sales to its installed base of customers, and will yield a higher margin due to the increased software component. A European french fry manufacturer visited the WA plant recently to evaluate the G6 and said that KTEC has moved significantly ahead of competitors in terms of software. The company expects to see payback revenue from G6 in 2nd half of F05.
--The company has established a sales office in Mexico to serve the South American region and plans to open a sales office in China based on encouraging results from Asia. The Company has already generated significant amounts of international sales (44% in F04) and is focused on international opportunities. KTEC expects sales to materialize from the Mexican sales office in first half of F05.

Valuation
Using diluted shares of 5.2mm and net cash of $3.7mm, I get an EV of $44.6mm at the current share price. F04 EBIT was $5.4mm, plus depreciation of $3.2mm less capex of $1.2mm yields an EV/EBITDA – capex of 6. This does not give effect to the fact that KTEC is expecting improved margins from the increased component of software in future automated inspection systems. The company has also been focusing on controlling costs and it reduced headcount across all divisions in Q4F04. This headcount reduction is expected to reduce costs by $2mm annually. If these savings had been present in F04, EV/EBITDA – capex would have been 4.7.

In terms of relative value, most of the company’s direct competitors are private. The only public comp is FMC Technologies (FTI), which is of limited comparison value since it has a large energy systems segment. It trades at a trailing P/E of 27 and an EV/EBITDA of 12.5. I don’t place much weight in this thin comp analysis, but it is nevertheless a data point. For the sake of argument, if KTEC traded at an EV/EBITDA of 10, it would yield a stock price of over $17.

The thesis here is that you believe while sales cycles have been longer than expected, project deferrals will subside in the later half of F05 and F06 and at the same time deliver richer margins through higher software content. While waiting for this rebound, we have an entry point at EV/EBITDA-capex of 6, with a solid balance sheet. The company has excess cash of $3.7mm, and a ratio of current assets to total liabilities of 2.1 to limit risk.

The bear case is that KTEC peaked in F03 and is on a steady decline. Even though it looks cheap on a trailing basis, the depressed stock price is justified given sliding revenues, declining backlog, and a disappointing rollout of its new product (the G6). My counterargument goes as follows: while backlog is decreasing, the backlog figure only captures the longer lead time projects such as process systems and inspection systems and does not reflect the growing parts and services business. As the parts and services segment carries a gross margin of 36% compared to 22% for process systems, this decrease in backlog is not as painful as it first appears. If projects continue to be deferred, the company will essentially be trading systems sales for parts and services revenue. Admittedly, it is not an even trade in terms of revenue, but given the high margins on parts and services, it is not a bad alternative while investors wait for project deferrals to turn into sales. In terms of valuation, I can offer the following analysis as a benchmark assuming operations do not improve in F05: Annualizing Q4F04 results, with pro forma adjustments for $2mm cost savings due to headcount reduction and assuming historical EBITDA and capex, I get a forward EV/EBITDA of 7.5 and EV/EBITDA-capex of 9.4. This is still cheap, especially considering backlog heading into Q1 F05 has improved slightly from last quarter, and Q1 is typically the company’s worst quarter. To give an idea of how cheap the stock is if fundamentals improve in the food processing industry, it is trading at only 3.8 EV/EBITDA-capex based on record F03 results.

Given that the company expenses all R&D and product development costs and its capex has historically been very low (less than $1mm annually), I believe the company will start to accumulate significant excess cash going forward, even without a rebound in the food processing capex landscape. I have a call into the company as to whether they would be open to share repurchases or dividends and I will update this posting when I get a response.

Catalyst

--penetration of G6 vision engine, expected in the second half of F05.
--conversion of F04 project deferral into sales.
--reversal of the low carb trend, which will translate into higher sales in the potato and french fry industry.