KEQU - Kewaunee Scientific's Share Price Hasn't Caught Up To Results
2023-12-18 19:17:15 ET
Summary
- Temporary pandemic issues led to poor operating performance.
- Pass through of higher input costs have led to dramatic margin improvement.
- Improved earnings have not been fully reflected in share price.
Kewaunee Scientific ( KEQU ) is a leading manufacturer of laboratory furniture with manufacturing facilities in North Carolina and Bangalore, India. They make fume hoods, workstations, benches, safety cabinets and other products designed specifically for the laboratory market. End customers include industrial labs, higher education facilities, and pharma/life science facilities. The company has had staying power operating for over 100 years. Revenues are roughly 70% in the United States, with the remainder international.
There is an opportunity here due to a reversal of temporary margin headwinds associated with contracts taken during the pandemic, and a change in business model that is allowing them to focus on their core competency which is manufacturing products for the laboratory space. The company is showing a strong backlog, robust sales and escalating earnings while trading at an extreme discount. Near term earnings comparisons should show dramatic year over year improvements which I would expect to lead to a re-rating of the company shares as a best estimate of near term prospects suggest the company will be trading for a forward PE under 6 as temporary pandemic headwinds fully flush out of their backlog. At roughly $24 per share, KEQU seems to be a bargain.
As an aside, this is actually one of my favorite kind of setups. You have a company getting past temporary headwinds with easy earnings comparisons near term, strongly improving operations, and what should be revenue visibility due to the outstanding order book. I don't tend to look more than 6-12 months out so few of my recommendations are looking at 3 year or 5 year trends or long term durable competitive advantage. My general view is the outlook for any company 3 years from now is completely shrouded in mystery, and trying to guess the swirling impact of billions of variables over longer time frames is a mugs game. What I do know is companies growing quickly and trading at discounted multiples generally see share price appreciation. I'll worry about 2025 as 2025 nears.
So with that said here is what is attractive about Kewaunee. The company was utterly decimated in 2020-2022 due to some temporary issues related to covid. Specifically their orders for laboratory furniture were booked at fixed prices with orders filled over a period of 12 months or longer. What happened in 2021 is the costs of their input prices for things like wood, steel, and resin went through the roof while they were obligated to deliver orders based on prices that were agreed on prior to the massive inflation we saw in 2021/2022. Predictably their bottom line collapsed along with the share price. Gross margins dropped from over 20% in the year ended April 2018 and troughed at under 10% in October of 2021. Operating margins went from a positive 6% to -7% in that same time frame.
The problems here were simple. They booked contracts based on input prices that saw an unprecedented ramp up. They addressed those problems in the obvious way by increasing product prices to match the reality of their own costs. The problem was this process took time with over 100 million dollars in backlog on the books those old contracts had to be worked through to get a better picture of what the business would look like in a normal operating environment. These problems were not unique to Kewaunee, but I think it's fair to say they didn't anticipate the issues or handle them well. At this point that is water under the bridge and adjustments have been made. As that low margin backlog has worked its way through the order book the operations have improved accordingly. The changes to pricing were announced as part of their earnings release in July of 2021.
We have taken steps to implement surcharges on new orders to offset broad based price increases for basic materials including steel, aluminum, hard woods, and resin products. The impact of these surcharges will lag what has been an immediate impact of rising commodity prices.
In addition the company employed a direct selling model to US customers in certain areas that included product installation. That direct selling model combined with installations was a not very profitable distraction for the company, and they decided to focus on their manufacturing operations, and instead sell through distributors that they had a successful relationship with in other regions. They would sacrifice some revenue for improved profitability. They announced the change to move to a distributor model in January of 2022.
From the release
While Kewaunee's direct business has grown, it has also created inefficiencies that have adversely affected the profitability of the business.
Kewaunee Scientific Corporation Announces Changes to Domestic Channel Strategy
With these two changes in hand, one to pass on the price increase for materials, and the other to exit unprofitable areas of the business, the company was in wait and see mode as the old unprofitable contracts rolled off the books and were replaced with higher margin work. Those changes do seem to have in fact worked. Gross margins have rebounded all the way to 26.7% and Operating margins have improved to 10%. Earnings have surged to $0.93 cents per share in the most recent quarter, and that is with a one-time tax expense in India of approximately $500,000. Normalized earnings would be more like $1.14 per share.
The loss of product installation revenue has reduced the topline year over year by about $4 million, however operating income is up 55% and earnings per share up a whopping 578%.
Per the most recent 10Q
The decrease in Domestic sales was predominantly related to the reduction of installation revenue related to the Company's decision to no longer sell directly to end users, which typically included installation services.
The obvious conclusion to draw here is that the combination of business model change and price adjustment have both worked in massively improving operations. The company currently trades at a normalized fully diluted trailing PE of 9.92, and EV/EBITDA of 5.87. These are trailing numbers and include quarters from early 2023 when older contracts were still working through the backlog. Margins going forward should build on these numbers and as weaker quarters from early 2023 roll off the book's valuation should be even more compelling.
Using lumber and stainless steel tubing prices as a proxy for input costs it appears costs have been coming down. This is important because the terrible feedback loop that led to 9% margins in 2021 may be reflected by the inverse in 2024 namely input prices falling as contracts on the books were bid at higher prices when input costs were greater. There may in fact be some margin improvement ahead and at the very least it's reasonable to expect margins will remain elevated.
The company overall is driven by capital investment in laboratories. When labs are built they need equipment and the furniture Kewaunee supplies. There is some fiscal impulse here as well. The Inflation Reduction Act allocated $1.5 billion for laboratory construction, and as mentioned earlier, this construction is a driver for the company's business.
It's hard to quantify the extent to which this spending will impact the company, but a combination of federal money, and a general onshoring trend certainly doesn't hurt.
And of course as always there are risks
- Capital spending is directly tied to interest rates. While backlog has held up that might not be the case if financing remains expensive. Possible rate cuts next year would obviously be helpful.
- As any infrastructure tied business is cyclical economic conditions are going to have an outsize effect on the business.
- Raw material costs have been volatile and the virtuous cycle of lower costs could reverse.
Overall I see this as an inexpensive company with a series of easy comparisons on deck. If they continue to execute as they have the company should re-rate significantly higher.
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Kewaunee Scientific's Share Price Hasn't Caught Up To Results