Tuesday, August 18, 2009

Humble Humboldt

KHD Humboldt Wedag (KHD) is an international industrial engineering and equipment supplier for the cement processing industry. Thanks to reduced demand for its products due to the recession, the company is pretty close to just breaking even. However, the company has negligible debt and a cash position of about $350 million, yet it trades for just $273 million! Sounds like a steal, right?

Perhaps not. The strangeness of this company's name is matched only by the strangeness of its balance sheet: if one were to remove that net cash balance, the company would have negative equity of about $100 million! Meanwhile, the company is trying to sell its fixed assets in order to raise even more cash. What gives? Can shareholders expect a massive payment?

It would not appear so. KHD appears to operate in such a highly cyclical environment that not only is it not sufficient to not have any debt (as we've discussed is important for cyclical companies), but it needs an extremely large cash buffer to boot!

To understand this phenomenon, we have to understand the cash conversion cycle for this company. When a company contracts KHD to design/build a plant, it makes a large chunk of the payment upfront. KHD doesn't get to count this as revenue yet, since it hasn't performed any services. But using these funds, KHD will pay its suppliers, workers and other expenses associated with performing its end of the contract.

When a cyclical downturn hits, however, not only does it hit hard (order intake in the second quarter was a full 90% lower than that of the year-ago period), but it means there's no cash coming in! Even though KHD will be booking revenue in future quarters as it fulfills its backlog, it won't be receiving cash, but will still be spending cash on its costs.

The highly cyclical nature of this business combined with the fact that cash is paid upfront means there can be long periods of low cash intakes for this company. But during these long periods, the company still has to perform on its end of the contracts. As a result, the company has to maintain a large cash hoard just to stay in business, even though shareholders might think the cash can be paid out! It would appear that sometimes cash is not king: do not automatically believe that companies with strong cash positions offer a margin of safety.

Disclosure: None


balans said...

Good insight, but it would be interesting to know where you found this out. From the annual report (if so where), or from some other source? It is a good insight, but if you could help me generate similar insights by myself it would be even better.

Pov said...

On the latest earnings conf call, the company disclosed that their ‘net free cash balance’ is ca $200m. You need to subtract the following liabilities from the nominal cash figure to arrive at true cash balance:
Progress billing above costs and estimated earnings on uncompleted contracts ($145.8m)
Advance payments received from customers ($12.0m)

Having said that, it still might be a decent investment opportunity. At $9 per share their EV is about $122m, incl pension liabilities. 2008 EBITDA was $86.8m. Now, even if we assume that a normalised EBITDA is only 25% of 2008 level, we have a normalised EBITDA of about $22.7m, so 5.6x EV. While not looking rock bottom cheap, I reckon it provides a relatively good margin of safety given that EBITDA will probably not fall by that much. Also, the cash balances are clearly excessive and the management is probably being overly conservative by not returning anything to the shareholders. Would be interesting to hear some views on the management and more qualitative aspects of the company, if someone has been following the company for some time.

Saj Karsan said...

Hi Dan,

It's not written in the annual report, it's just something I can see from the financial statements, including the line items Pov referred to specifically.

Akwon said...

hey saj, I was looking at a company that does Health Insurance thru mainly government sponsored programs such as medicare and medicaid. The company is called Molina Health care (MOH). It has a lot of cash, but like this current post, it receives their payments up front, then distributes it in forms of payments to private physicians, pharmacy, its own clinics, etc. The company has been expanding recently to new states, however, their profit margin has been shrinking mainly do to California's unexpected healt care claims. What I'm wondering what do yo feel about the risk and upside of this company? As it continues to expand they can generate more money, however as more of the baby boom are retiring and getting sicker, health care costs could skyrocket. Thanks.

Saj Karsan said...

Hi Akwon,

I'll let you know if I find anything interesting.