KSW, Inc., furnishes and installs high-end (> $3 million) heating, ventilating and air conditioning (“HVAC”) systems and process piping systems for institutional, industrial, commercial, high-rise residential and public works projects primarily in the New York City metropolitan area. The company also serves as a mechanical trade manager, performing project management services relating to the mechanical trades. It provides its services under direct contracts with building owners or subcontracts with general contractors or construction managers. To obtain jobs, the company bids against its competitors. However, on numerous occasions, it was able get work by directly negotiating with clients because of its value engineering assistance, under which the company’s staff recommends economical changes to streamline HVAC and process piping systems. This reduces costs, but still yields the same results as the original plans. During the current recession, value engineering comes in handy because the clients’ desire to save money is at an all-time high. Therefore, value engineering increases the company’s chances of getting work.
The company has experience with working on private and public projects. However, several years before the economic recession, it mainly focused on private work because it resulted in higher profit margins and required fewer administrative headaches. When the private work slowed down as banks curtailed their lending, the company started to bid on public projects again.
The Company’s History
KSW stands for Kerby, Sauders, and Warkol. The company was formed in 1994 after it acquired its existing assets and management from JWP Mechanical Services, a mechanical contracting business based in New York which consisted of three companies – Warkol Mechanical Corporation, Kerby Sauders, Incorporated, and Afgo Engineering Corporation. Each of these businesses was profitable with their own client base and particular expertise in the construction industry. Warkol Mechanical Corporation was founded by Floyd Warkol, KSW’s current CEO. Kerby Sauders specialized in mechanical work on large office projects. Afgo Engineering Corporation specialized in value engineering. Both Afgo Engineering Corp. and Kerby Saunders, Inc. had been in the mechanical contracting business in New York City for over sixty years. The combined entity became the largest mechanical contractor in the New York City metropolitan area.
New York City Construction Industry
KSW’s mechanical work represents only one component of the entire construction process. When the demand for construction is high, so is the demand for HVAC services, and vice versa. Therefore, it is important to understand the construction industry.
The New York City construction industry is enormous, fragmented, and decentralized consisting of thousands of small and medium-sized companies. It includes both public and private work projects. Public work projects are bridges, roads, tunnels, mass transit, schools, housing projects, airports, courts, jails, parks, government office complexes, and water supply and waste disposal systems. Major public builders include the Port Authority, the Metropolitan Transit Authority, and the Battery Park City Authority. Private work projects include single-family homes, retail properties, shopping centers, high-rise residential buildings and commercial buildings.
Before the financial crisis, the New York construction market was booming. Overall construction spending reached an all-time high of $32.4 billion in 2008, which represents an 11 percent increase over $29.1 billion in 2007. Construction employment was at its peak of 136,900 jobs in August 2008, which is 8 percent higher than 127,000 jobs in 2007. When the crisis hit, banks curtailed their lending activities in an attempt to preserve capital. Because construction activity is heavily reliant on outside financing, this put the brakes on private construction activity in New York City. At the beginning of the first quarter of 2010, the New York City construction employment dropped 22 percent to 106,500 from its peak in August 2008 as previously described. This was the worst employment data in nearly five years.
While private construction is down significantly, public construction is doing better reaching 60 percent of overall construction in 2009. However, public construction is not without problems. The State of New York is facing a $9 billion deficit on a $134 billion budget. On April 9, 2010, New York Governor David Paterson announced the suspension of payments on virtually all state-funded road work and other capital projects to conserve cash and keep the state solvent. The governor also announced that no new contracts would be awarded until the budget is resolved. He told reporters, “I think it would be easier for them to continue working because they will eventually get paid. We just don’t have the money to pay them right now.” This kind of funding freeze, if continued for a prolonged period of time, can have devastating consequences for the construction industry and the New York economy. It has the potential to affect 500 projects totaling $5 billion in contracts. Contractors can only sustain a negative cash flow for so long before they have to shut down projects and lay off workers. This is a foolish move by the governor because his funding freeze certainly guarantees more job losses. It will make the deficit even worse because construction workers will claim unemployment benefits, putting pressure on state’s financial resources even further. Some believe that this is a political move by the governor to pressure the legislators to finally approve a new state budget which was due on April 1, 2010.
Why is KSW Still a Good Investment?
Banks do not want to lend and the New York Governor does not want to pay for construction projects. As a result, both private and public construction face pressure. So why would I think that KSW is a good investment?
While the current business environment in the HVAC and construction industry is bleak, the long-term outlook is favorable. This is a perfect storm for investors because Wall Street is giving companies such as KSW away because of short-term uncertainties while the long-term prospects seem pretty certain to me.
The questions that really matter are the following:
- Does the company provide a product or service that is essential?
- Is the company’s service going to be needed in 5, 10 or 20 years from now?
- Does the company possess a moat?
- Is the company run by competent management?
- Can the company stay in business despite a terrible business environment?
- Can the company’s stock be acquired at a reasonable price?
Does the company provide a product or service that is essential?
KSW furnishes and installs HVAC systems and process piping systems for institutional, industrial, commercial, high-rise residential and public works projects. HVAC systems are a part of every building, whether it is a single-family house or a high-rise office building. Because of the harsh temperatures in the winter and summer months, it is simply unthinkable to erect a building without any HVAC components. When HVAC systems work, we do not think much about them. It is only when they malfunction that we take notice. In the past, HVAC systems were a luxury, but today they are a necessity. Hotels, hospitals, and high-rise buildings would not be in business if they did not have these systems.
Is the company’s service going to be needed in 5, 10 or 20 years from now?
This is the same as asking: are we going to be breathing and experiencing hot and cold temperatures in 5, 10 or 20 years from now? The Internet may make some products or services obsolete, but this will definitely not be the case here.
HVAC systems impact our lives on daily basis. The long-term outlook for overall HVAC demand as well as HVAC demand in New York City is positive. The factors that positively affect the HVAC industry’s growth are population growth, aging property stock, pent-up demand, and the green revolution.
New York City has over 8 million people and the city expects an additional one million people by 2030. To accommodate the increase in population, the city will need to construct more buildings and expand its infrastructure, which will require HVAC systems. The governor may play his political games for a while by freezing construction funds, but in the end, New York desperately needs more construction and he will have to find money to pay for it. If he does not do it, the people will elect a governor who will.
New York City is also one of the oldest cities in the United States and therefore, has some of the oldest building stock in the country. Steve Cuozzo, in “Why we need 1 WFC,” wrote, “The fact is, New York is increasingly a city of obsolescent office buildings – an astounding 65 percent of our stock is at least 50 years old, compared with 24 percent that old elsewhere in the US.” HVAC systems that reach the age of about 50 years old need to be replaced and this fact ensures constant demand for HVAC services in the future. Building owners that choose not to upgrade will find that their properties are unappealing to existing and potential tenants. New York City has been the business center of the world. However, businesses are starting to demand newer buildings. Unless the demand for new construction is satisfied, other cities such as London or Shanghai will satisfy it. Cuozzo says, “Consistent demand for newly minted Manhattan office space explains why buildings erected ‘on speculation’ – that is without tenants signed in advance – almost invariably do get fully leased up within a year or two of completion.”
Based on my conversation with the company’s CEO, there appears to be pent-up demand in the New York City construction market. Some of the company’s clients have projects that need to be done but the only obstacle is the difficulty in securing bank financing. Also, there are more than 100 foundations that have been poured but currently do not have buildings on them. The work was stopped because of the recession. Whether it is banks or developers that are sitting on these work-in-progress lots, it is costing them money every day. Sooner or later, they will want to develop them which will create demand for HVAC work. Also, because banks are in the business of lending, it is only a matter of time before they resume lending because until then, they will not be making any money.
Green building is the practice of constructing structures that are environmentally friendly and use fewer resources. The green building revolution is taking place not only in the United States but also around the world. In 1993, the U.S. Green Building Council (USGBC) was formed. By 1998, it only had 150 member companies, but by 2007, the membership grew to 7,500, which represents a 50-fold increase. Green building offers different benefits to different groups. Environmentalists are pushing for change because green building saves the planet by reducing carbon emissions that contribute to global warming. Politicians favor it because they want to be seen as environmentally friendly in order to be elected to office. Builders, developers, and major corporations are more interested in the economic benefits of green building. They include reduced operating costs, increased building values, tax benefits, health benefits, and improved public relations.
Depending on the type and age of the building, it is not unusual to see energy costs run as much as 30 percent or more of total revenues from tenants. This is not going to get any better because the age of abundant and cheap fossil fuels is over. Today, about 90 percent of our energy needs are satisfied by fossil fuels – oil, coal, and natural gas. Over the past 50 years, the U.S. did not have much competition from other countries for energy resources. However, this situation changed in 2004, when China’s consumption grew faster than anyone expected. Today, China is the second largest importer of oil after the United States. But China is not the only country growing quickly because India is developing rapidly as well. Both of these countries and other developing countries are putting tremendous pressure on limited energy resources. In other words, the demand for energy is growing faster than the supply, and this is likely to keep upward pressure on oil and gas prices in the future. Years ago, people in less developed countries traveled primarily by bicycle. Now, they have better jobs and are upgrading to automobiles, and this trend is just in its infancy. By installing more efficient and more environmentally friendly HVAC systems, owners can reduce energy use and lower operating costs which leads to higher bottom lines which in turn, leads to higher property values.
Green building also offers tax benefits because federal and state governments have adopted policies that encourage it. For example, New York offers tax credits to builders who meet energy goals and use environmentally preferable materials.
Green building also offers health benefits for employees who work in these buildings. For example, new types of HVAC systems produce better quality air for people to breathe. When employees file fewer insurance claims, corporations benefit from lower premiums.
Just as politicians want to be viewed favorably by voters, developers, builders and major corporations want to be viewed favorably by the general public. Who wants to be viewed as a destroyer of the planet? For major corporations, a positive public image may translate into a higher stock price.
Based on all of these factors, the long-term demand for HVAC services looks promising. KSW’s business will be driven by the long-term demand for HVAC services.
Does the company possess a moat?
A moat is what gives a company a competitive advantage that allows it to generate and maintain high returns on capital by keeping competitors at bay. Based on my conversations with KSW’s customers, former employees, and other industry participants, it is clear that KSW’s moat stems from the company’s superior reputation. One of the customers told me that KSW’s contractors do excellent work and at the same time don’t create problems. They just get the job done and you do not even know that they were there. In addition, KSW provides value engineering which helps clients to make economical changes to streamline HVAC and process piping systems. This reduces costs, but still delivers the same results as the original plans. Another customer said, “value engineering is like having another set of consultants. They come up with solutions that designers did not even think of.” A former employee told me that value engineering is KSW’s biggest strength. It requires superior engineering knowledge and it is difficult for competitors to copy. One company tried to copy KSW’s value engineering and went bankrupt. As more and more customers experience KSW’s superiority, the company’s reputation keeps growing and this widens the company’s moat. Customers are so satisfied with KSW that many times, they don’t even give another company a chance to bid for HVAC work and they just negotiate with KSW directly.
From the customers’ perspective, having a good and reliable HVAC contractor is paramount. Getting a bad contractor may be the difference between profit and loss. Because complex projects are expensive, a developer may be forced into bankruptcy if a project fails. Construction is different from a typical industrial assembly line process in that the construction of a major project is custom made. There are many contractors and subcontractors working together and each of them plays a critical part in the entire construction process. Because there are so many moving parts, the construction process tends to be fragile. Delays and poorly performed jobs cost the owner money.
Even after the construction process is finished, the mechanical components such as HVAC have to function properly. The mechanicals of major properties affect hundreds if not thousands of people. The owner of a high-rise office building would be at a huge disadvantage if the HVAC was not working properly. Tenants would leave and new ones would not want to lease space. Because real estate is heavily financed with debt financing, a loss of a few tenants can lead to negative cash flow which, if sustained long enough, can lead to foreclosure and possible bankruptcy.
A superior reputation is more important to get private work than it is for public work. For example, Donald Trump, who hired KSW for mechanical work, can choose whatever contractor he wishes without having to explain anything to anyone. However, public work is different because the government body distributes the work through the competitive bidding system which awards the job to the lowest responsible bidder. Because of the competition from other companies, public works tend to generate lower margins and the barriers to entry are lower than those to private work. In addition, contractors have to go through many more headaches and paperwork while dealing with the government. Several years before the economic crisis, KSW mainly focused on private work as the New York construction market was booming. When banks experienced heavy losses, they curtailed their construction lending activities stalling private construction in New York. KSW responded by shifting to do public work. What is nice about KSW is that when private market is slow, it can simply do public work. Because of its superior reputation and track record, when private market gets better, KSW will simply switch again. Competitors without this reputation and track record are not able to do it. The company’s CEO told me that because some companies are not able to stay in business, there will be more work for the survivors when the business environment improves.
Another important advantage that KSW possesses is its superior balance sheet, which has a significant amount of cash and very little long-term debt. At first, it might not be evident why this would be an advantage because in the end, why would a developer care of their HVAC contractor has a strong balance sheet? As long as the contractor gets the job done, it does not matter, right? In the construction industry, a contractor such as KSW has to get a surety bond to get work. This is important for private work, but it is even more important for public work. A surety bond is a guarantee that the contractor, such as KSW, will perform the obligation spelled out in the bond. It protects the developer or the owner from the contractor’s failure to deliver what the contract promises. If the contractor fails to perform, whoever provided the bonding (i.e. an insurance company) is on the hook. As a result, the bonding company is unlikely to provide a surety bond to a contractor that is in poor financial shape. Because many bonding companies experienced heavy losses during the current recession, similarly to banks, they tightened their underwriting standards. As a result, weak players have not been able to get bonding and therefore, have not been able to bid on jobs. This means less competition for KSW, which has no problems getting bonding.
Finally, the company’s knowledge and relationships in the local market gives it an edge over out-of-towners. Because contracting is a local business, it is based on local relationships. The barriers of entry differ depending on the size of the projects. For example, anyone can get into the single-family residential construction market because the work is done for the homeowners and the majority of the labor force is non-unionized. To get into large commercial projects is a completely different story. In this situation, sophisticated business owners, not homeowners, are the ones making the hiring decisions. Also, in large commercial projects, the majority of labor is unionized and New York City unions are extremely powerful. Unions have a monopoly over the workers required for highly complex construction projects and they decide who gets which workers. Relationships with union officials are key, otherwise the company might get unskilled workers for an important project. A poorly performed job almost certainly guarantees the loss of a client. Unions benefit from the network effect that occurs when the value of a service or product increases when more people use it. Workers want to join unions because that’s how they can get work. Developers and building owners want to hire construction companies that use union workers because they know unions control the supply of skilled workers. Construction companies want to use union labor because they know it will help them get work from developers and building owners. Also, New York is a democratic state and unions have substantial political support.
Is the company run by competent management?
KSW’s president is Floyd Warkol, who has 40 years of experience in the business. Based on the most recent proxy, he owns 12.2 percent of the company, which I believe aligns his interest with those of shareholders. Based on my telephone conversation with him, he seems to be very knowledgeable about the construction business and wise in choosing which types of jobs to accept. This is important because some construction companies under quote and take unprofitable jobs just to increase revenues. Warkol knows that revenues do not translate into profits unless a proper contract price is obtained. The president told me that he only takes jobs that he knows will make the company money.
As mentioned before, the construction business is local and therefore, local relationships are important to a company’s success. One of the company’s customers told me, “Somehow he [Floyd Warkol] keeps getting a lot of work. He knows everybody you know.” He currently sits on the Metropolitan Transportation Authority’s Blue Ribbon Panel on Construction Excellence which provides guidance to the MTA on how to spend its construction dollars. He is a past president of the American Subcontractors Association, an organization of 5,000 contractors throughout the country and a past president of the Subcontractors Trade Association of New York.
Can the company stay in business despite a terrible business environment?
The companies that go out of business are usually the ones that are not able to adjust their expenses downward with falling revenues. In other words, the companies with significant fixed costs are in danger of bankruptcy when revenues decrease. Companies with a significant amount of debt experience higher fixed costs because debt payments have to be made despite revenue levels. Because KSW has almost no debt, it does not have this problem. Companies that are capital intensive have high fixed costs. Because KSW does not require much capital to operate, it is able to adjust other operating expenses downward when revenues drop.
Because KSW has lots of cash on its balance sheet, carries almost no debt, and has a flexible cost structure, it should have no problem staying in business. Based on my telephone conversation with James F. Oliviero, KSW’s General Counsel, New York State’s funding freeze for construction projects has absolutely no effect on the company because all the public projects that the company is working on are either financed by the federal government or other agencies not supported by New York State’s funding.
Can the company’s stock be acquired at a reasonable price?
KSW can be the greatest company in the world, but it does not matter unless it can be purchased for a reasonable price. The current market capitalization of the company is about $23 million, but this metric does not take into account the company’s cash position, which is significant. Therefore, the enterprise value is a better metric to use. If you are not familiar with enterprise value, read my article “So What Is This ‘Enterprise Value?’”
The formula for enterprise value is as follows:
Enterprise Value = Market Value of Equity + Debt – Excess Cash
Market Value of Equity (Market Capitalization) = $23 million
Debt = $1.1 million
Excess Cash = $9.1 million
Enterprise Value = $23 million + $1.1 million – $9.1 million = $15.0 million
Every variable except excess cash is attainable without a problem. However, the calculation of excess cash in KSW’s case is tricky. Under normal circumstances the excess cash would be calculated in the following manner:
Total Current Assets (2009) = $37.7 million
Total Current Assets without Cash and Marketable Securities = $37.7 million – $14.8 million – $1.6 million = $21.3 million
Total Current Liabilities (2009) = $18.6 million
Because total current assets without cash and marketable securities ($21.3 million) would be enough to cover total current liabilities ($18.6 million), one can argue that cash ($14.8 million) plus marketable securities ($1.6 million) are not needed and therefore, are excess cash. If this is assumed, the enterprise value is calculated in the following way:
Enterprise Value = $23 million + $1.1 million – $16.4 million = $7.7 million.
Note: $16.4 million is simply the sum of cash ($14.8 million) plus marketable securities ($1.6 million).
However, I do not believe that the entire $16.4 million is excess cash because as I previously mentioned, the company chooses to have a significant amount of cash on the balance sheet in order to be able to get bonding. Therefore, the company is always going to have extra cash on the balance sheet. However, the company still carries more cash than it did in the past. Therefore, part of the $16.4 million is excess cash that we can subtract while calculating the enterprise value.
From 1996 to 2005, the company’s cash position was anywhere between 4.91 to 26.30 percent of total assets with an average of 17.94 percent. As of December 31, 2009, the company’s total assets were $40.5 million. Multiplying $40.5 million times 17.94 percent, results in $7.3 million, which represents the amount of cash that the company would need to keep on the balance sheet in order to get bonding. Anything greater than $7.3 million is excess cash.
Excess cash = $16.4 million – $7.3 million = $9.1 million
Therefore, I believe that the enterprise value is equal to $15.0 million as calculated by the previously shown formula:
Enterprise Value = $23 million + $1.1 million – $9.1 million = $15.0 million
Enterprise value per share = $15.0 million / 6.3 million shares = $2.38 per share
Enterprise value represents what the company is currently trading for after taking excess cash and debt into consideration. The next step is to determine whether it is cheap or not.
|Costs of revenues||57,484||80,910||66,771||67,155|
|Selling, general and administrative expenses||4,964||5,283||4,427||4,511|
|Interest income, net||34||359||569||317|
|Gain on sale of marketable securities||0||11||113||44|
|Total other income||34||370||682||361|
|Income before provision for income taxes||2,080||7,204||6,750||5,823|
|Provision for income taxes||810||2,965||3,088||2,715|
|Earnings per share||0.20||0.67||0.59||0.51|
Note: Figures are in thousands except per share data.
In 2006, 2007, and 2008, the company’s earnings per share were $0.51, $0.59, and $0.67, respectively. The average earnings per share between these three years is $0.59. If we assumed that KSW can earn $0.59 sometime in the future, then the corresponding enterprise value of $2.38 per share would be cheap based on a price over earnings multiple of 4. Applying a conservative multiple of 10 could make the stock’s price more than double. However, the big question is whether KSW can earn this much in the future – I believe that it can earn even more.
KSW’s business is driven by a backlog, which the company describes as anticipated revenue from the uncompleted portions of awarded contracts. In other words, a backlog is a pipeline of projects to be completed within the next 12 to 24 months. Thus, the backlog is a good leading indicator of what the company can make in the future. In 2005, the backlog was at $82.2 million, which translated into $77.1 million of revenues and $0.51 of earnings per share in 2006. In 2006, the backlog was at $110.2 million, which translated into $77.3 million of revenues and $0.59 of earnings per share in 2007. In 2007, the backlog was at $111.3 million, which translated into $93.0 million of revenues and $0.67 of earnings per share in 2008. In 2008, the backlog was only at $62.5 million, which translated into significantly lower revenues of $64.5 million and $0.20 of earnings per share in 2009.
As of December 31, 2009, the company’s backlog totaled to approximately $121.5 million, which is double the backlog from 2008 backlog and greater than the backlog from 2005, 2006, and 2007. If 2007’s backlog of $111.3 million translated into $0.67 of earning per share, it is not unreasonable to assume that the 2009’s backlog of $121.5 million can translate into $0.67 or even more in 2010 or 2011. Remember that the enterprise value we previously calculated was $2.38 per share and the multiple of enterprise value to $0.67 of earnings per share would yield 3.55. This is really cheap.
How is KSW able to have a backlog that is higher than the backlogs from previous years at a time when the construction industry in New York City is not in great shape? One reason is that there were some projects that were delayed in 2008 because of the economic crisis and were reinstated later. Also, the company shifted its strategy from purely private work to a combination of both public and private work. Finally, the New York construction industry is a $30 billion per year industry. KSW’s 100 million annual revenues represent less than 1 percent of the total industry. When the total construction spending decreases, the weaker players are the ones that do not to get any work. KSW is one of the major league players that will always be able to get work ahead of the less reputable companies. If all the NBA teams shut down their operations, Kobe Bryant would not have any problems signing with a foreign basketball team. There will always be work for the best of the best.
KSW, Inc., is a company that provides an essential service to general contractors and building owners, possesses a moat to protects its revenues from competitors, and is run by competent management with skin in the game. Even though the short-term business outlook for the construction industry does not look promising, the company is able to get work and stay profitable despite the current weak economic conditions. Because the company does not get much coverage by analysts, it is not on Wall Street’s radar and therefore, the current trading price offers significant upside potential to investors who are willing to establish an investment position in the company.
I, or persons whose accounts I manage, own shares of KSW, Inc. at the time of this report. This report is not a solicitation to buy or sell securities. Neither Mariusz Skonieczny nor Classic Value Investors, LLC, is responsible for any losses resulting from purchasing shares of KSW, Inc. You are advised to consult your financial advisor or conduct the due diligence yourself.