KAI - Kadant Backlog Demand Increases Due To E-Commerce Sales Increase; Appears Undervalued

Summary

• Kadant Inc. appears well-positioned in the field of engineering services and structural solutions.
• Further improvement in the company’s backlog will likely bring more revenue growth from 2023.
• I am quite optimistic about the recent increase in high mill activity and demand for capital equipment reported in the last quarterly report.

Kadant Inc ( KAI ) recently reported an impressive increase in backlog demand driven by global increase in e-commerce sales and packaging materials. Besides, analysts out there are expecting significant free cash flow generation, and I believe that the risks from competitors and supply chain can't explain the current stock price. In my opinion, KAI appears undervalued.

KAI: Significant Demand And Geographically Diversified

With the management of residual materials from industries and a business model divided into three large areas that include the control and management of flows for industries, industrial processing, and the management of materials for large constructions, Kadant Inc appears well positioned in the field of engineering services and structural solutions.

Among the information received in the last presentation in November, there are a few great reasons to research KAI today. First, management reported that growing demand for sustainable materials and the wood industry will likely bring sales growth.

In addition, packaging demand is increasing at a large pace driven by recent increase in the e-commerce activity. With e-commerce sales increasing at close to 20%, I believe that KAI's fiber-based packaging materials will likely experience significant growth in the coming years.

Finally, KAI enjoys global presence with revenue coming from North America, China, South America, and Europe among other regions. In my view, considering KAI's geographic diversification, the company could navigate better economic recessions or other crises.

Balance Sheet

As of October 1, 2022, the company reported cash worth $72.936 million along with accounts receivable of $128.253 million, inventories of $156.567 million, and total current assets of $400.993 million. The total amount of current assets is close to two times the total amount of liabilities, so I wouldn't expect relevant liquidity any time soon.

With an asset/liability ratio close to 2x, in my view, the balance sheet appears quite solid. Non-current assets include property worth $105.439 million, intangible assets worth $173.707 million, goodwill of $372.966 million, and total assets of $1.106 billion.

Liabilities include accounts payable worth $53.495 million, accrued payroll worth $35.912 million, and customer deposits of $69.394 million. Accompanied by other current liabilities of $44.688 million, total current liabilities are equal to only $213 million. Finally, long term obligations stand at $208.114 million, with long term deferred income taxes of $34.926 million and other long term liabilities worth $41.309 million.

Market Expectations Include A Median Sales Growth Close To 4%, An EBITDA Margin Of 20.36%, And Operating Margin Of Around 16%

Analysts expect 2024 net sales of $940 million accompanied by a net sales growth of 4.21%, EBITDA of $204 million, and an EBITDA margin of 24.70%. 2024 operating profit would stand at close to $163 million together with an operating margin of 17.30%. Analysts also foresee a pre tax profit of $159 million with a net income of $117 million.

In my view, the best financial figures were reported in the cash flow statement. Market analysts believe that the company will likely report 2024 FCF of $103 million with a FCF margin of 10.96%. Considering these figures, I assumed that using a discounted cash flow model for assessing KAI's valuation makes sense.

My Bullish Case Scenario Includes Further Improvement In Demand For Parts And Consumables As Well As More Acquisitions

I believe that once more and more investors have a look at the most recent quarterly report, equity demand will likely increase. Let's keep in mind that the company continues to see strong demand for parts and consumables. Besides, further improvement in the company's backlog will likely bring more revenue growth from 2023.

We continue to see strong demand for our parts and consumables, down slightly from record demand in the first half of 2022. We ended the third quarter of 2022 with a consolidated backlog of $350.3 million. Source: 10-Q

I am quite optimistic about the recent increase in high mill activity and demand for capital equipment reported in the last quarterly report. In my view, further improvement of market conditions will likely bring more revenue growth than expected. In this regard, I believe that investors may want to read the following lines from the report:

Increased demand for our wood processing business products, for both capital and parts and consumables products, principally in North America, was driven by high mill activity, which resulted in increased capital investment and higher parts consumption. In addition, increased demand for capital equipment at our stock-preparation businesses, primarily at our European and Chinese operations, due to improved market conditions compared to early 2021. Source: 10-Q

Considering the company's balance sheet, I believe that new acquisition of businesses and technologies is quite possible. Management has cash in hand available, and the net debt/EBITDA ratio appears in good shape. Besides, the company already noted that it continues to pursue acquisition opportunities, which could, in my view, bring KAI's FCF growth north. Finally, I would be expecting successful integration of recent acquisitions of East Chicago Machine Tool Corporation and The Clouth Group of Companies.

We expect that a significant driver of our growth over the next several years will be the acquisition of businesses and technologies that complement or augment our existing products and services or may involve entry into a new process industry. We continue to pursue acquisition opportunities. Source: 10-Q

In the third quarter of 2021, we also acquired East Chicago Machine Tool Corporation for $53.5 million, net of cash acquired. Source: 10-QIn the third quarter of 2021, we acquired The Clouth Group of Companies for $92.9 million, net of cash acquired plus debt assumed. Source: 10-Q

Under the previous conditions, I included 2030 net sales of $1.267 billion with net sales growth of 5.10%. In addition, 2030 EBITDA would stand at $255.9 million together with an EBITDA margin of 20.20%. I also expect 2030 operating profit of $256 million, 2030 free cash flow of $212 million, and the FCF margin of 16.70%.

If we use a WACC close to 8.30%, the net present value of future FCF will likely be around $947 million. I also included an EV/EBITDA multiple of 15.7x, which implied 2030 terminal value of $4.018 billion with a net present value of $1.960 billion. With these figures, the total enterprise value would stand at $2.907 million. Besides, with cash of $73 million and debt of $251 million, the equity would stand at $2.7 billion. Finally, with a share count of 12 million, the fair price would be $234 per share, and the internal rate of return would stand at 4.06%.

My Bearish Case Scenario Would Lead To A Valuation Of Almost $125 Per Share

The development of products of better quality and lower price as well as the variety of their applications in terms of the energy transition of different industries play a critical role in differentiating Kadant's value from its competitor companies. Although this is accentuated in its industrial processing and waste management segments, since it competes with a large number of smaller companies in each region, it does not happen in relation to its flow management and administration model, since it is one of the companies globally positioned leaders. According to statements by the company, its main difference lies in its knowledge and technical expertise as well as its specific knowledge of the market and the innovation of its products as compared to its competitors. Under this case scenario, I assumed that the company's technical expertise would be enough to compete with peers. As a result, I would expect a decrease in the company's revenue and FCF.

The company, due to its good brand globally, must maintain high quality and innovation in its products as well as a good relationship with its customers. If quality lowers, I believe that fewer clients will be working with KAI, and KAI's brand equity would lower. In such a scenario, I believe that less investors would acquire shares, and the stock price would lower.

Kadant's 10-k states that the sale or acquisition of new machinery and assets of the magnitude of this industry are difficult to calculate, especially in moments of economic uncertainty. An error in this sense could compromise KAI's FCF and consequently the state of its operations at a global and national level.

Similarly, when it comes to its acquisition strategy, Kadant could make poor assessments of the projections about the companies to be acquired as well as the inability to retain its largest clients or difficulties integrating the new acquisition into its model business.

Other relevant risk factors that the company accuses have to do with specific areas of its business model. For example, in the provision of wood, it directly depends on the growth of the construction market, especially for industrial uses. Also, much of its materials management segment is supported by coal mining. Changes in this sense could directly affect the KAI's calculations.

Finally, in addition to the logical factors related to unforeseen economic or inflationary crises such as supply chains, the growth of digital industries is affecting Kadant's operations. Under this case, I assumed that further supply chain issues could lower free cash flow growth, and lower KAI's fair price.

Under these conditions, I estimate that by 2030 KAI will likely report net sales of $1.172 billion with a net sales growth of 3.75%. Besides, 2030 EBITDA would stand at close to $228.6 million accompanied by an EBITDA margin of 19.50%. I also expect an operating profit of $229 million and 2030 FCF of $158 million along with the FCF margin of 13.50%.

If we include a WACC of 9.50%, the NPV of future FCF would be close to $767 million. Besides, with an EV/EBITDA multiple of 8.5x, the terminal value would stand at $1.94 billion. With these figures, I obtained an enterprise value of $1.625 billion. If we also include cash of $73 million and debt of $251 million, the equity valuation would be $1.448 billion. Finally, with a share count of 12 million, the fair price would be close to $125 per share with an IRR of -3.72%.

Conclusion

KAI benefited from the recent increase in e-commerce sales and demand for packaging materials. Management appears to have a lot of expertise in the M&A markets, and appears to acquire new targets from time to time. Besides, with many analysts expecting significant free cash flow generation and the backlog increasing in 2022, future business performance will likely be successful. I obviously see risks from competitors, supply chain, and quality control. With that, in my view, KAI remains undervalued at its current market price.

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