Has Korvest reached an inflection point? (ASX:KOV)
22/04/2019
Trav Mays
Continuing on our search for companies at inflection points, today we will be examining Korvest, they have been improving their results, but are they at an inflection point? Read on to find out.
Before we begin, this will be a flow on from my last post
covering XRF Scientific,
I highly recommend that you read that post first, it also gives a short summery
of Matt Joass’
article on inflection point investing.
Company
Korvest (ASX:KOV) is a combination of 4 businesses, their
most profitable is the EzyStrut cable tray manufacturer, but they also have a
galvanising business in South Australia and the Power Step and Titan
Technologies companies in Brisbane. Having listed in 1970, their results have
been similar to all businesses tied heavily to the expenditure cycle, up and
down as they ride the expenditure wave.
As the wave has been trending down in recent years, Korvest’s
results have followed suit, their troubles were further exacerbated by the rising
zinc prices (a key ingredient in galvanising). As you can see below (sorry
about the graph, not the cleanest ever done), the price of zinc
increased quite substantially between 2016 and 2017 (65.6%), whilst industry
expenditure stayed fairly flat, at levels 27% lower than 2 years prior. These
two forces culminated in the loss of 2017 and the ousting of the general
manager Alexander Kachellek, who had overseen the business for 10 years. Please
note that whist on the graph the zinc price has decreased in 2019, this is
only the price until Dec 2018, it has since trended higher to ~ US$3000/tonne
(As of 17/04/2019).
Korvest breaks their business up into two segments,
industrial products, which includes EzyStrut, Titan Technologies and Power step
and Production, which includes their galvanising business. When we look at the
individual segments, it’s clear that the lower expenditure is having a material
impact on both segments, with the rise of zinc prices hurting the production
segment even further.
As with XRF, Korvest has had some tailwinds in recent years,
helping to lift their profits higher. The main one is the increase in
expenditure, as the old adage states, “A rising tide lifts all ships”. Another
has been the decrease in zinc prices, helping to improve margins in the
production segment. The lower dollar also helped Korvest, making the cheaper
imported competitors more expensive.
Discussion
Within the XRF post, I referenced a Forbe’s interview with Peter Cuneo, in which he
stated “there are three elements to a successful turnaround, cost cutting,
organic growth and strategic leaps”. Unlike XRF, KOV doesn’t appear to be
ticking all the boxes, expenses as a percentage of revenue have decreased, but
revenue appears to have stayed fairly stable over the half, be it slightly
lower. KOV have stated that they have had a number of price increases in recent
years, pushing the higher zinc and energy prices onto consumers. These price
increases seem justified, especially when considering the wholesale price of
electricity in Adelaide has increased by 220% in 4 years (Dec 2014 31.5/MWh;
Dec 2018 101/MWh) and the wholesale price of gas has increased by 219% (Dec
2014 $3.25/GJ; Dec2018 $10.37/GJ). Whilst these increases are warranted, they
do however show that the slight decline in revenue must have resulted from a
disproportionate decline in sales volume.
Whilst sales volumes may have decreased, a quick look at the
expenses makes it appear that they have done well to reduce COGS, but the
actual decrease achieved by KOV has been heavily affected by the decrease in
Zinc prices. The other thing of note within the expenses, is that whilst
volumes may have decreased, distribution costs have increased; increasing by
8.9% pcp (Dec 2017 $2.11 mill, Dec 2018 $2.298 million). Which could be
attributed to larger and/or more difficult items to transport or rising
transport costs, it’s just something of note.
What about strategic leaps? Well, unfortunately KOV hasn’t
ticked this box either, but that’s not from lack of trying. In 2014, KOV
initiated a two part growth strategy; the first part was a further push into
the export market and the second part was focusing on growth through acquisitions.
To ensure they had ample manufacturing capacity to meet the predicted increase,
they sold off their less profitable Indax handrail and walkway business to free
up manufacturing space in their Kilburn plant for the more successful EzyStrut
business.
During 2015 and 2016, KOV continued to search for potential
acquisitions, their initial screen found 60 potential companies, 12 of which
they spoke to and of these 12, 3 were presented indicative offers, all were
unsuccessful. The 2 years of negotiating came to a total after tax cost of
$475K in 2016 and a declaration that all “M&A activity paused until
business conditions improve”.
During the search for acquisitions, they also focused their
efforts on expanding further into the New Zealand, Philippines, Singapore and
Hong Kong markets. During this time, they obtained DNV certification for their
products, allowing them to be used on offshore oil and gas rigs and installed a
local subsidiary in Singapore with representation. However the success of the
Singaporean subsidiary was not as expected and with the margins being squeezed,
KOV wrapped up the subsidiary just a year later (2017), saving ~$400K per half.
Along with these growth strategies, KOV initiated a cost saving initiative, one
of the areas of focus was the employee head count, reducing it by 18% in the
first half of 2016 (June 2015, 225: Dec 2015, 184) and 66% from their peak 6
years prior (2010, 306).
Despite the manager director’s best efforts, he was
unsuccessful in achieving the growth the board required and with the loss of
2017, it was only a matter of time before they called for his resignation.
September 2017 was when he handed the reigns over to the interim CEO Chris
Hartwig, who was then appointed the CEO in February. Chris has been within the
Korvest group since 2006, starting off as the general manager of the
galvanising business before moving to the EzyStrut business where he worked as
both general manager and executive general manager.
Despite the troubles Korvest has had over recent years, they
have managed to continue to pay a dividend, mind you, nothing like what they
paid out in 2014 (2014 includes the 100% franked special dividend of $1.00 per
share). If we were to price Korvest on their dividend alone and assuming they
continue to pay a second half dividend of at least equal to the first half,
usually higher, but to keep it conservative, we will assume they keep it the
same, Korvest has a current dividend yield of 6.67%, pretty good. Using the
Gordon growth model with a growth rate of 5% and cost of equity of 12%
calculates a price of $2.57 a 4.76% drop from today’s prices.
Given that we are (roughly) at the start of the upward phase
of the expenditure cycle, is a growth rate of 5% realistic? Not really, between
2003 and 2011, Korvest increased the dividend at an average rate of 11% per
year. We are however starting from a higher dividend then in 2003 (2003 .125;
2019 .18), so using a more realistic/conservative growth figure of 7, we come
to a price of $3.6 a 33.33% increase on today’s price.
Evaluation
Looking at the half year value metrics, it’s clear that
Korvest has posted their best half since 2014. EPS has more than doubled when
compared to 2017, not only that, but they are getting a better return on both
equity and assets and they are trading at an EV/EBITDA not see since 2012.
Along with the increased return on both assets and equity,
margins have continued to trend higher.
When we look at the segment PBT margin, both have increased
quite considerably, production by 2% and industrial products almost doubling.
Whilst still not close to the PBT margins of yesteryear, due to the changing
market, I believe these types of margins have gone the way of the dodo. The
increased competition across all businesses and reduced expenditure, has
resulted in an abundance of unutilised production facilities, further squeezing
margins. As a local manufacturer, they have had a distinct advantage against
international competition, the low dollar. However, as Korvest doesn’t
typically service the low cost market, this tail wind is having less of an
impact than expected.
To price Korvest, along with the Gordon Growth model above,
I have tried to calculate the price at the top of the coming cycle. Korvest has
achieved a FY EBITDA over $7.5mill in 3 of the last 12 years and an EBITDA over
$6.5mill in 8 of the last 12 years, I have therefore used these values in my
valuation as they are achievable. Using these and the 12 year average EV/EBITDA
multiple of 5.8, we arrive at valuations of $4.3 and $3.73, which using today’s
prices, results in a gain of 66% and 43%. Quite large gains. Given that
investors typically attach higher multiplies at the top of cycles, these
figures are most likely, still somewhat conservative.
Conclusion
If I was to invest in Korvest, it would not be as an
inflection play but as a cyclical one. Whilst they have tried to decouple
themselves from the Australian expenditure cycle, they have unfortunately
failed. Rising fixed costs have squeezed margins in recent years and whilst
some of these costs have been pushed on to consumers, an increase in the level
of competition means we won’t be seeing margins similar to those seen just a
few years ago anytime soon. Another thing I’m concerned about is the increase
in the prices, these increases were done at a time when the Aus dollar was depressed,
if/when the dollar rises back to its highs during the last cycle top, will they
still be able to keep their margins and compete with the cheaper imported
products? I have no idea, but my gut tells me it will be hard.
Due to all of this, and my inability to predict the cycle,
let alone the top, means that I have no idea how long it will be before we see
the 66 and 43 percent gains calculated above and then when you add to that the
time value of money, I believe I can find better investments elsewhere, XRF scientific for
example. If however you are more experience with cyclical investing, this is a
good place to start your own review, worst case, you receive a pretty good
dividend whilst you wait for those gains.
If you’d like to read more about inflection investing, I
recommend Matt Joass’ article titled “The hidden power of inflection points” and for a
company currently at or near an inflection, check out my article on XRF Scientific. I am on Twitter Follow @MaysTrav and Linkedin 
if you’d like to connect, feel free to send me a msg, it’s always great to meet other ASX investors, especially those who have a different view point.
if you’d like to connect, feel free to send me a msg, it’s always great to meet other ASX investors, especially those who have a different view point.
Sources:
- Gas and electrical information gathered from https://www.aer.gov.au
- https://www.forbes.com/sites/robertreiss/2011/08/22/why-9-of-10-turnarounds-fail/#697aff6a3f5d
- https://mattjoass.com/2018/11/10/inflection-point-investing/
The author is not a current owner of a portion of Korvest, they may however still be subject to one or a number of biases, more specifically anchoring and/or confirmation bias. This article is neither general nor personal advice and in no way constitutes specific or individual advice. The website and author do not guarantee, and accept no legal liability whatsoever arising from or connected to, the accuracy, reliability, currency or completeness of any material contained on this website or on any linked site. This website is not a substitute for independent professional advice and users should obtain any appropriate professional advice relevant to their particular circumstances. The material on this website may include the views or recommendations of third parties, which do not necessarily reflect the views of the website or author, or indicate its commitment to a particular course of action
Location:
Brisbane QLD, Australia
