5.1% grossed up divvy yield for 6 month period, page-18

While the full-year result doesn't quite reflect it, the June-half was weak.
(That the full-year result came in where it did is attributable to a monster Dec 2019 half, in which Revenue was up 25% on pcp, and EBIT was 130% higher).

With a hiatus between projects, JH2020 Revenue was down 15% on pcp which, as can be seen below, is a big reduction in the context of KOV's history:




For added context, the half-yearly Revenue shows that the company is still operating well below its notional $75m pa Revenue capability:



...and EBIT is running well below historical peak capability of ~$9m pa




KOV is clearly a cyclical business, and looking at historical data such as this provides some indication of what kind of earnings KOV might be able to generate at the next peak of its earnings cycle which the following indicates it is heading into, via a very strong upswing in demand.



The upswing currently underway is not only significant in magnitude, but its duration also looks impressive.

And this graphic was derived from a presentation made in February, pre-Covid. I fully expect the federal government to commit a raft of new infrastructure projects in order to repair the damage to the economy.


The logical question then becomes, what could/should KOV earn under such a mouth-watering demand profile?

Based on history, one might say peak earnings are:

- around $9.5m in EBIT, representing ~12.5% margin on $75m in peak Revenues.


However, I think there are a number of reasons to believe that peak Revenue and Earnings in the coming cycle peak will be meaningfully higher than the levels achieved at previous peak (which was driven by a boom in commodity prices, whereas the upcoming boom will be driven by government infrastructure programs):


1. The production factory is better-prepared, operationally and from a mechanical availability standpoint. Like many sectors,of the economy, the sheer speed and the extent of commodity boom took most service providers by surprise. KOV had spent just $4.5m on capex in the 5 years leading into 2008, the start of the commodity boom; by comparison, it spent over $3.2m in FY2020 alone.

KOV has spent a lot of money during the past several "lean" years to make operating improvements to the factory to improve efficiencies and drive out costs.

2. KOV now has two additional businesses, together generating Revenues of around $4m/$5mpa, which were acquired subsequent to the peak of the past boom.

3. Driven by commodity prices, the A$ went to above parity with the US dollar in the last peak, and stayed there for several years; this made it economical for offshore-based manufacturers to distribute into the Australian market. By comparison, today, not only are offshore operators less present in the market, but there has been a removal of some competition domestically. The competitive landscape is reportedly a lot more benign today.

4. Moreover, also related to the commodity boom, zinc is a key raw material in the galvanising process applied by KOV, and during the commodity boom, the zinc price went from $1,000/tonne, to $4,000/t in the space of 12 months, which adversely impacted KOV's gross profit margins (they fell by 350bp betweeen 2006 and 2011). Today the zinc price is around $2,000/t.


Putting all this together points to a business which is today better placed to capitalise on the coming cyclical upswing, not just in terms of output, but in terms of product pricing outcomes, as well as operating cost performance.

So, whereas $75m @ a 12.5% EBIT margin was the optimal level of performance in the previous period of peak demand, I think this time the cyclical peak will see the company generating closer to $85m in Revenue at an EBIT margin in the 14-%15% region, i.e., around $12m in EBIT.


Valuation-wise, applying a modest 6.0 to 7.0 x EV/EBIT multiple (equivalent to a FCF Yield pf 10% to 12%), that yields an Enterprise Value between $70m and $80m, i.e.,, Equity Value of $75m and $85m.

If my assessment is correct, that suggests between 50% and 70% share price upside still remaining, even after the strong performance of the share in recent two years.

That is, a target share price in excess of $7.00 in two or so years' time.

And during the wait, shareholders are likely to receive close to 70cps in fully franked dividends for the privilege of doing so.

The JH2020 result was the one to get out of the way; somewhat surprisingly, that has happened without the market so much as blinking.

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