Kentz (LSE:KENZ) is a construction company which constructs specialist plant and equipment for the oil & gas industry and the mining sector. It was formed a hundred years ago and has a long reputation and vast experience of developing equipment in the harshest conditions. With the earth’s oil resources being constantly exploited companies are now having to look at the more difficult oil stores and developing complex extraction techniques. For example a construction project in Canada the Kentz is working on involves building in temperatures of -40 degrees. This is why specialist and expert companies like Kentz are needed.
This may sound like a pretty boring industry, but perhaps if I mention that Kentz earns returns on equity of 25% it will spark your attention. What about if I mention they have no debt, and have over a quarter of their market cap ($181m) in cash? What about a PE ratio of 9, the lowest it has been since 2009. Ok now you’re interested!
Their business is separated into 3 segments which are well described from this diagram in their 2012 annual report (click to enlarge).
Ok, so it’s not actually well described, it’s full of management talk, but hopefully you get the idea!
Most of their contracts (47%) are on a cost reimbursable basis, that means their customers pay for the materials as they’re building. This kind of contract involves huge amounts of working capital (large trade receivables and payables) and explains their huge cash buffer of $181m (this is just their own cash, total cash on the balance sheet is larger). But it also means they don’t need much in terms of fixed assets and can earn those impressive 25% returns on shareholders equity.
70% of revenues are from the oil & gas engineering sector. This industry report gives some overview of the industry from a US perspective. The key points are:
- The level and direction of oil and natural gas prices are key indicators of performance for the industry
- Since demand for such fuels fluctuates with the economy, oilfield services stocks are considered cyclical.
Positive qualitative factors
Kentz backlog has been increasing for years and shows no signs of stopping. They are projecting double digit growth in earnings for the year ahead and the strong order book supports that view.
Kentz also has a large shareholder, Kerbet Limited who have a representative as chairman of the board. The background to this deal can be found here. In simple terms, they rescued the company from going bankrupt in the 1990s and have transformed the business.
Remuneration and bonuses are based on EPS growth exceeding the average of the peer group. They are also based on a return on equity target.
The table below shows the historical accounts of Kentz.
There are 3 main things to take from this report
- Revenue and earnings growth has been strong, even throughout the crisis. Diluted earnings per share has grown at 18% compounded annually since 2006.
- Operating margins are relatively stable and the latest years earnings are neither abnormally high or low on an historic basis
- The company has strong free cash flow generation. In aggregate since 2006, 84% of reported earnings have come through as free cash flow.
Their balance sheet is also strong, which you can see here. They have negligible debt and cash of $223m, although only $181m is theirs, the rest is prepayments for projects under construction. That is 26% of their market cap (£458m). The only thing that is of any possible concern is the pension deficit of $17m, with assumptions of a return of 4.2% on assets and a discount rate of 4%. But this is small change in relation to their cash and profits.
Every company has risks and it would be negligent to ignore them. These are the biggest that I identified from the 2012 annual report
- The risk in many projects lies with the physical construction of the asset and Kentz has its own construction workforce that has developed the skills and experience to successfully build these assets. But if its projects fail it has gross exposure of over $300m to claims against it.
- Kentz also operates in emerging countries, and labour disputes like this are common. So far its margins have been relatively stable however.
- Approximately 72% of the Group’s revenues are derived from its top ten customers and the loss of major customers could have material impact on the business.
- The contract business is reliant on continual awards of contracts and future revenues are far from certain. Sudden falls in revenues are not unheard of.
- A major downturn in the oil and gas industry would have severe consequences for Kentz
I’ve always felt UK annual reports are very light on risks compared to US companies 10-K filings. But by checking on Hoovers for a US competitor here, I found Fluor Corporation (NYSE:FLR) as a good source of risk details. Their 10-K here gives a much more detailed list of risks for companies in this industry but I wont note any additional ones here. As an aside it useful to note that Fluor’s margins are half those of Kentz’, but it trades on a PE of 17 and its profits are not as consistent, or growing like Kentz are.
I’ve also been through and checked Kentz against my Investment Checklist and found nothing amiss. Even analysts are universally rating this stock as a strong buy.
Valuation & Conclusion
Historical earnings growth has been 18% per year on a diluted per share basis. This may not be sustainable going forward but I think at least 10% is achievable for the next 5 years. This fits with their guidance for double digit earnings growth next year. Operating margins have been consistent for the last 7 years with only 2011 standing out as the year of lowest margins.
Using my PE ratio tool and a 10% growth rate for 5 years followed by another 5 years of 5% growth, I calculate a PE ratio of 17 as suitable at a 10% discount rate. However, only 84% of profits are free cash flow, so I will discount this to a PE ratio of 14.
But that doesn’t include their cash on the balance sheet, which amounts to $1.51 per share. So in total I believe the shares are worth 1.51 + 14 x 0.60 = $9.91 per share (£6.50). With today’s price of £3.91 that represents a 40% margin of safety.
Not only that but this company reinvest earnings at a high rate of return and is a great candidate for a long term investment. With a return on equity of 25% the more this company reinvests the better. Some people may ask what is this company doing with all this cash-flow? That’s an important question. The answer is, at the moment, nothing! That is why we have such a large cash amount on the balance sheet. Sooner rather than later the board will hopefully return this to shareholders, that should be a catalyst for waking the market up to their value. Of course, there is the chance that they squander it on an expensive acquisition but with today’s margin of safety in the share price I think investors are somewhat protected from this. Also management have shown no precedent for this kind of behaviour and with a major shareholder as chairman this should reduce the risk.
I consider this a fantastic long term holding with a good margin of safety. I’m now long LSE:KENZ with a position size around 8%.