Korvest, and the industry in which it operates, would make for a...

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.