I find it is an instructive exercise to re-visit file notes made in the past. The following post was from almost exactly two years ago:
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Korvest, and the industry in which it operates, would make for a fascinating MBA thesis on corporate and industry structure evolution.Go back 15 years, and Korvest was enjoying a pretty healthy and dominant market position, in which competition was limited and margins were decent and Return on Capital was high (denoted by "The Golden Years" in the charts below):
Then, from about 2005/6 the commodity boom starts to occur, and with it, the A$ rises, reaching over parity with the US dollar late in 2010, and it remains there for the next 3 years.This strong A$, combined with the unusual intensity of longevity of the commodity boom, and the related construction spending, makes Australia an attractive place of offshore players to do business. And many duly enter the Australian market, mostly by establishing distribution infrastructure and networks.Unfortunately, as is invariably the case with corporate behaviour, this occurred at virtually the top of the business cycle.What followed, as the commodity boom rolled over, was a period of excess capacity chasing too little work, and industry margins and returns were decimated ("The Bad Years").The trouble is, once new industry participants take root, it takes a long time for them to uproot themselves again (company executives don't like to act in a way that highlights their strategic errors).However, at some stage the rubber band of tolerance for losses becomes fully stretched and capacity is removed; indeed, over the past 12 months we have seen KOV competitors exit the space, ceding orders immediately to KOV.And I'll wager that, if it was tough doing business in Australia by importing products over the past two years, then the sharp and sudden fall in the A$ over the past 3 months will signal the death knell for companies that compete with Korvest via importing product.So I think this is an interesting example of industry economics in action, where capital flows into, and out of a particular economic sector, with the attendant impact on industry profitability. Not just that, but how the company that has the best fundamental competitive advantage is able to batten down the hatches and weather the storm, to emerge leaner and fitter and stronger when others have collapsed around it.Accordingly, in keeping with economic theory, I strongly suspect that a period of "Golden Years" [*] lie ahead of the company (until those future Golden Years once again attract new capital to the industry again, and the process is repeated).[*] For context, if the company gets back to generating ROE of 15% (nothing too outrageous in that assumption... it's the bottom end of the 15% to 22% range of ROE achieved during the previous "Golden Years" period) then on the $32m Equity Base, that translates to NPAT of between $4.5m and $5.0m, or Pre-Tax Profit (and EBIT given the company's interest income/expense line is negligible) is $6.4m to $7.0m.The company's current market cap is $34m, and it will end the year with net cash somewhere around $7m or $8m, leaving the EV at around $27m.So, that's an implied EV/EBIT in the vicinity of 4x.Now I don't know too much, but what I do know is that when KOV gets back to generating a 15% ROE (which, I'm 90% sure it will do), that it won's still be a $27m EV business at at that point in time.People don't instinctively associate KOV with being a beneficiary of a weak Australian dollar, because the impacts are not immediate and take time to impact competitor behaviour. But over a period of a few years, a strong A$ attracts imports and damages KOV's margins.The converse is true, when the A$ is weak.
And I think we have only just started to see the industry impact of that.Provided KOV board and management don't do anything dumb with shareholder capital, the next half-a-decade looks set to be a repeat of the Golden Years.Just a few weeks ago, I thought the opportunity to buy KOV risked slipping away.Now, an extraneous event has causes some seemingly indiscriminate selling, which is providing investors with a somewhat rare opportunity to buy shares in the company again, at what I consider to be a highly attractive valuation.The opening sentence of the above post, i.e., "
Korvest, and the industry in which it operates, would make for a fascinating MBA thesis on corporate and industry structure evolution." was valid at the time of that post and is even more valid today.
Because what happened in practice followed the investment thesis to a tee, but it increasingly appears that the investment thesis will not work going forward.
It's not often you get a stock in a sector where something happens with such predictability, but KOV is a really simple business to understand, operating in an industry which is readily easy to observe.
Starting with where the thesis worked:
In that post of two years ago, what was envisaged when the business re-entered its period of "Golden Years" was EBIT Margins reaching 10% or so and ROE of 15%.
Well, today, at just the the early stages of the new cyclical upswing in earnings (i.e., JH2021) KOV's EBIT margin was already 12.5% and ROE was 18%.
And then in DH2021 things got really crazy with Op Margin and ROE reaching unprecedented levels:
View attachment 4226843Of course, DH2021 was truly extraordinary and management in January cautioned, based on the state of Covid at the start of the half, that "
JH2022 will look more like JH2021, than DH2021".
Well, given that the time of that caution, i.e., late January 2022, was about the time that Covid peaked in South Australia so it is unlikely that the company's operations will end up being too badly impacted for the rest of the half and besides, KOV ended Dec 2021 with record levels of inventories, being 55% higher than 31 Dec 2020 and 42% higher than 30 June 2021, so it is well provisioned to service demand in the current half, if it continues to be strong (which by all accounts, it looks to be the case).
So my money is on the current half result looking not merely similar to, but better than, JH2021 (for which NPAT was $3.2m), but certainly unlikely as good as DH2021 (NPAT of $6.2m)... maybe one-third of the way between the two results, perhaps, so
JH2022 NPAT of close to $4.0m would not be surprising.
So we are talking about a current
annualised NPAT run rate of around $8.0m.This would equate to ROE of 20%, based on the company's $41m Shareholder Equity base.
Which, in the traditional business cycle, as discussed in that initial post, has proven to be a sufficiently attractive a level of financial return to induce new entrants back into the industry, with the resulting fade in ROE for the incumbents.
So, if precedent is the guide, the cycle would be close to peaking currently, meaning the smart money should start selling KOV, feeding the ducks while they are quacking.
Well, that's what I was thinking as recently as a few months ago when the company announced its interim results. In fact, I had already commenced selling not long after the result announcement.
But I soon stopped when it occurred to me that "this time is different"
This is one of the most dangerous phrases to be used when it comes to investing, but there are a few readily observable things that are causing this time to be different.
And this is where the original thesis - the part where high industry returns will attract capital and capacity and induce the typical fade in ROE - looks like it will not work, due to the following:
During times of booms, most of KOV's competing product arises from increased imports, but this time imports are unlikely to feature for many years in any meaningful way due to:
1.) Energy cost differentials: Zinc galvanising and cable tray manufacturing is an energy-intensive business and while KOV has secured long-term gas contracts at comparatively competitive rates, the international energy situation (i.e., energy crisis) looks markedly different to any time in the past 30 years that I've been investing.
2.) Physically getting bulky goods around the world is currently very challenging; global supply chains have been seriously dislocated and it will take more than just a few quarters for things to normalise. KOV is also affected by this, but not nearly to the same extent as its competitors based offshore, since KOV can increase its inventory holdings onshore (which it has already done) to ensure supply to its customers.
3.) Supply chains are being "de-globalised", i.e., brought closer to home, meaning that KOV's customers, where they once would actively seek better terms from international suppliers that are competitors to KOV, are now going to prefer to partner with local suppliers in order to eliminate the supply chain risks.
So that's the changes that are evident in the structure of the
supplyside of the industry.
On the
demandside, and related related to point 3.) above, as the economic pendulum swings back over coming years from "global outsourcing to the max" to "domestic re-industrialisation", the demand cycle for KOV's products is going to be more protracted and enduring than the typical historical sort and sharp boom-bust type cycle.
And the $18bn allocation to road and rail infrastructure announced in last's night's Federal Budget certainly underwrites that robust demand outlook!
So in summary, I have gone a full 180 degrees in my thinking about KOV:
I went from starting to sell my KOV shares in early February, to now actually adding to my position.I'll revisit again in another two years' time to see if the original thesis was actually still the valid one, or whether this new thesis has indeed legitimately displaced it, but based on the discussion above, my mind's eye is now seeing a "stronger-for-longer" indicative profit profile for the company, at an NPAT level of around $8.0m to $9.0m:
