Description

K-Tron International

"Ed (Cloues) is like Warren Buffett - if it isn't a fat pitch, he won't swing" - Preston Athey, T. Rowe Price.

Investment Thesis

K-Tron is rapidly growing company with 14% FCF yield on trailing twelve month basis with low capex and exceptional and shareholder friendly executive management.  The current stock market sell-off has offered this high ROC business at an extreme discount based on price to diluted EPS since 2000.  The following evidence demonstrates what management has achieved:

• Top line growth of greater than 25%
• FCF growth of greater than 60%
• Excellent balance sheet
• Highly opportunistic and disciplined acquisition strategy

I believe the company is well positioned to get through the current economic crisis with a stronger and larger market share globally.  When the market returns from its risk aversion, I believe, K-Tron will quickly revert back to the midpoint of its valuation range, providing an opportunity to significantly outperform general market.

The Company

K-Tron International, through its predecessors has served diverse industrial markets including detergent, pharmaceutical, electric utility, coal and mining, plastics, cement, food processing, aluminum, and chemicals for more than 100 years.  The company operates in two separate business lines:

• Process Group: Feeding and pneumatic (air transport) conveying group.
• Size Reduction Group (SRG): Size reduction equipment, conveying systems, and screening equipment.

K-Tron's products are utilized in applications such as:

• Achieve appropriate mix of marsh mellows in General Mills Lucky Charms
• Saudi Basic Industries (formerly GE Plastics)'s polymer pellets
• Accurate composition of various constituents in Merck's Vioxx
• Uniformity of millions of Starbust chews produced by MasterFoods (Mars)
• Pulverization of coal in our local thermal power plant etc.
• Amount of baking soda in P&G's Pampers

While not a pure play on consumer staples, K-Tron's equipment is vital to the production of many consumer staples, offering a backdoor play into the sector.  Serving in the background, K-Tron's products have been utilized for decades, in some cases, since 1900 in some of the most popular consumer brands, due to their diversity and emphasis on accuracy.  Below is an excerpt from The Philadelphia Inquirer that describes about K-Tron's products:

"Pharmaceutical companies need K-Tron to make their pills.  The food industry would crack and chemical companies would come unglued.  All of them use raw materials that need to be measured.  Now, the coal, pulp and paper industries are customers of K-Tron too." - The Philadelphia Inquirer, June 2007

While the company does not divulge its revenue distribution between its two business lines, I estimate it is evenly distributed.  Of this, I believe, approximately 50% of its revenue is replacement parts business, most of it from SRG.  Company is uniquely benefiting from the replacement business, as it is the only source of digital drawings of various components of mechanical equipment sold over period of greater than 100 years.  Hence, as can be imagined, the margins on this business are substantially higher.  With right mix of new products and replacement parts, the company has successfully weathered several boom-and-bust economic cycles.  I believe the company will come out much stronger than earlier cycles, as it has one of the best senior management, which I will discuss in the Management Section.

History and Transformation

K-Tron, under this name, started its operations in 1949 manufacturing pneumatic scales, slowly migrating to digitally controlled feeders. This follows a similar strategy used by the process control equipment manufacturers in the 1950s thru 1970s.  The company has grown its business since inception either organically or through acquisitions.  However, the company's survival was in question in mid 1990s due to an expensive acquisition triggering a change of guard at the top in 1998.  Since then, the business was transformed into a lean-and-mean operation and the turnaround was spectacular, as shown in the comparative study of its annual results below:

Since present management has taken over, the EBITDA margins have improved from the 10% range to the 18% range.  Also, the cap ex per revenue decreased from greater than 300bps to the low 100bps.  The company attributes this performance improvement to the previous downturn, which helped the company focus on the bottom line.  A new enterprise resource planning system for worldwide operations was introduced during the 2000-2002 recession, resulting in company wide operating efficiencies.  Also, the company sold unprofitable businesses and focused on improving return on invested capital.

The operating margins discussed above have clearly flowed to the company's bottom line, as can be seen below comparing 2003 to 2008 TTM metrics.  While the top line has grown approximately 150%, EBITDA growth and EPS growth were recorded at 350% and 505%, respectively.

The backlog increased by 327% as larger part of the revenue is due to recurring orders for replacement parts, mostly in SRG.  The replacement business is similar concept to Gilette's razor-razorblade model, providing the company with stable revenues and higher net margins.  This sustained improvement over the years can be attributed in part to its organic growth, but for the most part due to company's opportunistic acquisitions that are accretive within a short time period.

Recent Acquisitions

Since the beginning of the transformation, the management team has grown the company organically and through acquisitions.  The table provided below discusses the acquisitions performed under the watch of current management.  All acquisitions have been accretive within a year of acquisition.  Also, the long-term success of an acquisition seems to be the main driver and is never sacrificed to gain quick short-term benefits.  Even though in an unrelated sector, the management strategy mirrors growth through acquisition strategy pursued by EBIX (written up in VIC by tim321). Patiently waiting for "fat-pitch" acquisitions, with future cross-selling opportunities, seems to be a great recipe when performed by shareholder friendly management.

As in case of EBIX, acquisitions like Colormax and Pnuematic Conveying Systems have provided K-Tron a quick backdoor entry into the UK markets.  Even though the company was selling in the People's Republic of China earlier, the Wuxi acquisition has provided K-Tron with local and capable management, and a conduit to cross-sell its products at an accelerated pace in a still growing economy.  The management is constantly looking for accretive acquisitions with long-term benefits, and now is an opportune time for management to buy businesses cheaply.

Management

Per my conversations with the senior management, I came away with an impression of the top management including CEO Ed Cloues and CFO Ron Remick as shareholder friendly and trustworthy stewards of shareholder capital.  They have a long-term investment horizon and are not looking for short-term results.  As mentioned in the introductory quotes, Ed Cloues is wired in running the business similar to Warren Buffett.  Below is an excerpt from Forbes to demonstrate K-Tron's management's prudent acquisition strategy:

"Penn Crusher turned down K-Tron's offer of $23.5 million.  Cloues didn't back down, and didn't up his bid.  Two years later Penn Crusher agreed to the deal because the majority shareholder was getting on in years and decided to do some estate planning.  K-Tron revenue immediately jumped 39%" - Forbes, October 29, 2007

Management does not conduct any conference calls or issue guidance.  Also, management does not seek any exposure to prop-up the stock.  They focus on shareholders and are not disturbed by short-term fluctuations in the stock.  Ed Cloues has not sold any stock and has steadily accumulated stock. He now owns approximately 10% of the company.  Also, management has ensured minimal dilution of outstanding shares since 2000.  During past 9 years, the outstanding shares have increased a meager 8%. 

I hear Ed Cloues has no plans for retirement.  In the past, Ed spurned Jack Welch's offer to join GE Plastics, as he enjoys his current job and did not want his family to relocate.

Valuation

I believe, based on recurring nature of major part of the revenue, the predictability of future cash flows is relatively high.  Also, looking at historical data and the fact the stock has sold off more than 60% from its peak, suggests we may have a good entry point at the current quote.  While its participation in industries like chemicals, plastics, etc, where downturn may have not yet taken its course, business may be affected negatively. We may be more close to a bottom as far as stock price is concerned.  Even though the company does not provide guidance, the backlog numbers suggest business-as-usual for the fourth quarter.  Most of the backlog is consumed in less than 120 days; hence, a generally tough economic environment for most businesses is not a suspect in case of K-Tron for FYE 2008.  My conversation with the management leads me to believe that to some extent the macro environment may affect the business.

Since January 2000, the company has generated approximately $100 MM in cash, with most of it either reinvested in complimentary businesses or used to pay down debt.  More than half of this cash was generated in 2007 and first three quarters of 2008.  This was the result of organic growth but more importantly successful acquisitions tabulated in the "Recent Acquisitions" section.

The management has consistently grown the intrinsic value of company as evidenced by substantial growth in bottom line and top line, with minimal change in share count.  Current management has never used equity for acquisitions that would dilute the stake of its long-term holders.  In fact, Ed Cloues has steadily increased his ownership in the company to present 10% and has never sold a share.

The tables presented below provide the company's financials since FYE 2000.  The PE ranges suggest that the company is trading at its lower range at the current quote.  Also, the company has ended with its highest cash balance in its history with no net debt, which will help it weather the current credit crisis and economic slump.  In fact, this environment may present the company with an opportunistic and accretive acquisition in the short term.

I estimate the FCF for year 2008 at $31MM.  The company has grown FCF greater than 25% for the past 3 years.  However, if the company experiences no growth for 2009 and nominal growth for 2010, I estimate the FCF to be $32MM and $33MM respectively.  At a low range  PE of 9, I expect a base valuation of $300MM or $105 per share.  However, with solid management steering the K-Tron ship, and a return to normal valuations, the stock price could easily double from the current quote of $71 per share.

The company is trading at low end of its book value range, while growing the top line more than 25% and growing FCF more than 60% over the past two years.  While the company may not be completely immune to the current downturn, conservative management will safely navigate the company through this turbulent time.  In a normal environment, it is hard to identify why the company will not cross its old highs.

Quick Note on the Balance Sheet

Below are some balance sheet details and metrics at the end of 2008Q3.

Working Capital:  $62MM

Shareholder Equity:  $ 116MM

Cash and Cash Equivalents:  $ 34MM

ST Debt/Current Portion + LT Debt:  $26MM

Inventory Turnover:  7

As can be seen from the key balance sheet metrics and its historical balance sheets, even though the management operates the business conservatively, the company has focused on optimal utilization of cash.  All the acquisitions in recent history were funded with cash from operations.  The fact that company has never accumulated cash on the balance sheet or collected money from public markets signifies the confidence the management has in its business to generate cash internally.

While the company has no net debt, the company has utilized a revolver in the amount of $23MM, which is due in 2011.  Even though the cash and cash equivalents on hand of $ 34MM nicely offsets this amount, it is important for me to mention that some of the cash is available local to the company's operations outside of United States.  The management seems comfortable with available cash to weather the current credit storm. 

Risks

Below are the risk factors associated with owning this stock.  However, I feel none of these can easily affect the long-term health of the business.  As mentioned earlier, some divisions of the business have withstood several booms and busts over the past 100 years.  With an excellent balance sheet, I believe, the company will ride through the current downturn.

• Better disclosure of company's financials based on business lines and geographies served. An increased interaction with investor community helps investors evaluate K-Tron story.
• Exposure to chemicals and plastic industries.
• Even though thermal power plants were around for centuries, effect of Obama administration's view is not deterministic. Rhetoric next few months may provide some direction on the subject. Any negative impact on K-Tron's coal business may be somewhat neutralized by its biomass business.
• No succession plans yet. Even though the current CEO is at the helm for about 11 years, he is still 61 years. Hopefully, the board will chalk-out a succession plan in couple of years.
• Low trading volume.
• Protracted global economic slump.

References

• http://members.forbes.com/forbes/2007/1029/102.html
• "A Measure of Success" - Article from the Philadelphia Inquirer, Date June 29, 2007
• SEC Documents
• Chairman Letter, Annual Report, 2003-2007

Catalysts:

• Economy returning to better footing
• Value situation with superior management may help the company rebound quicker than general market.
• Accretive acquisition in the short-term.

Catalyst

• Economy returning to better footing
• Value situation with superior management may help the company rebound quicker than general market.
• Accretive acquisition in the short-term.