update, page-3

"Madamswear could you please give us an update on your predictions re korvest,s potential for increase in performance 1/8/18. They would appear to be on track,but how much further do you think they will go before a downturn. "

@snosrap ,

Apologies for the slow response, but I have been away from my computer for the past week.

I'm not sure what your reference of "1/8/2018" means, but if you are asking for my view of what demand for KOV's products and services will look like in the future, I'm afraid I don't have any faith in my ability to accurately predict economic cycles, so what I do instead when it comes to investing in KOV is to value the business on its underlying, mid-cycle earnings (that way, I don't need to have to attempt to predict the future).

On that score, the charts below show KOV's operating earnings (proxied by EBITDA and Pre-Tax Profit) over time:



As you can see, the company is emerging from an horrific crunch in earnings, some of it self-inflicted, but the majority of it due to a confluence of unique, extraneous factors that caused a once-a-generation slump in profitability.

As you can also see, apart from the extraordinary FY2016/17 periods EBITDA ranges from $3m pa at the bottom of the cycle to $10m during boom times. And, accordingly, my sense from that financial history is that $6.5m to $7m represents a mid-cycle level of EBITDA for this company.

Now the important question is what valuation multiple one might reasonably ascribe to that level of mid-cycle EBITDA for a company like KOV (given its longevity, durability and cash flow generation, but also considering its operational warts and organic limitations).

Personally, I could not countenance ever paying as much as 8x EV/EBITDA for a business such as KOV. Even 7x is too rich for me. I think that an EV/EBITDA multiple somewhere around 6x (Corresponding EV/EBIT multiple is ~8.0x, and a FCF yield of ~9%) is fair and reasonable.

Capitalising my "mid-cycle" EBITDA of $6.5m at that 6x yields an Enterprise Value of around $39m, or a Equity Value of $43m (equivalent to $3.90/share) given the company's $4m-ish net cash position.

So that's my "fair and reasonable" valuation for KOV and which is the price around which I base my portfolio positioning.

Of course, if you don't buy into that kind of "mid-cycle" valuation methodology (and not many people do) and are wanting to "play the cycle", then the insights I am able to offer you are limited to the following two points (one with possible near-term implications, and the other of more medium-term relevance):


1. Short-Term Challenge (Possible):

The second-half of the past financial year saw EBITDA of $3.2m, up 71% on pcp and up 36% on the first half. A large part of this strength was due to the company being very busy supplying one or two major infrastructure projects. This work is expected to taper off sometime in the current half which could result in DH2019's result being comparatively softer (and especially JH2020's result, as the company cycles off the strong JH2019).

During the past reporting season, some companies in the infrastructure space (eg. SRG, BLD) have reported a bit of a hiatus in infrastructure-related demand because of delays in some projects in NSW.

So FY2020 might not be as strong a year as FY2019 was, depending on what work KOV wins (noting that a meaningful competitor in Victoria, which serviced the eastern states, has recently ceased operating and has withdrawn from the industry).

While I think it is a bit of a waste of time and energy, some people like to invest around their perceptions of these sorts of 6-monthly ebbs and flows in financial performance, so I'm putting it out there that if you are sensitised to short-term share price movements, the results for FY2020 might not be as strong as the market might be expecting, after the impressive FY2019 performance.


2. Medium-Term Outlook:

I'm sure you've seen this chart is some or other form over recent months.



I'm sure that outlook - particularly the extent of the 2022/23 peak in infrastructure spending plans - will prove to be less than 100% right, but even if it is remotely accurate, I fully expect that KOV will, at some stage over the next 3 or 4 years report close to boom time earnings once again (recall, KOV has the capacity to generate in excess of $10m in EBITDA if sufficient demand exists for KOV's products).

6x EBITDA of $10m equates to an EV of $60m, and Equity Value of $65m, so $5.75/share

And, of course, as we know when things are booming the market, in its infinite wisdom, sometimes applies higher multiples to the elevated earnings during boom times.

So, there is a chance that the market applies an 8x multiple as it buys into the infrastructure "narrative". Which would imply an $80m EV, $85m Equity Value ($7.50/share)

Now I'm not for a minute saying this boom share price is certain to eventuate, but I do think that there is a fair chance (50% probability) than KOV will generate peak cycle type operating earnings over the coming 2 to 4 years. And if that happens, that there will be a 25% probability that the EV/EBITDA valuation multiple re-rate to where it was at the previous cycle peak, namely 8x.

Therefore, the way I view KOV as an investment proposition is on the following probabilistic terms:

Base Case Scenario = $3.90/share (50% probability outcome)
Boom Earnings, Mid-Cycle EV/EBITDA multiple (6x) = $5.75/share (40% probability)
Boom Earnings, Peak-Cycle EV/EBITDA multiple (8x) = $7.50/share (10% probability)

So, when I derive a crude price objective by weighting each individual price by the probability of such a scenario eventuating I get - quite conveniently - a nice round number of $5.00/share


As for your seeking an explanation for the recent share price movements, specifically why the share price has fallen from $3.84, to wit:

"Are the sellers just profit takers or is there some other reason for these in some cases
big hits on the sp now down 15% from the high of $3.84"

I like to believe I know why share prices do what they do over the longer-term, but who knows why share prices do what they do over the short-term, i.e., from day to day or even week to week?
(I mean, in the few short weeks before the company fell 15% it rose by around 40%, so....)

You'll almost never know for sure why share prices tick, tock and twitch over short term time frames, and I think you'll end driving yourself spare trying to know (and even if you were somehow, on the odd occasion, able to know, what would you be able to do about it, given it would have already happened?)

Rather focus on businesses and their performance than on share price movements, I say.