Kelso's Recent Decline: A Buying Opportunity

To give a quick overview, Kelso (KLS.TO, KIQ) is a provider of the best available tanker car equipment, namely pressure relief valves and manways (the hole on the top of tanker cars used to load and unload the oil or other liquids in the tanker car). They have two other products, the bottom outlet valve (valve on the bottom of the car which used to unload oil or other liquids quicker) and vacuum relief valve, which are both currently in field service trials. Their technology is light years ahead of the competitors' and has finally started to gain significant traction in the last few years. Their technology not only offers safer products, but economic advantages as well via less maintenance, faster loading/unloading times and less fines (e.g. typical manways have 8 eye-bolts compared to Kelso's one bolt, and each leaky bolt is subject to a $5000).

So why has the technology only gained traction in the last few years despite having been conceived 20 years ago and offering VERY compelling economic and safety advantages? It's because the railroad is a regulated industry so change is dreadfully slow and unwelcomed, and this industry is also the oldest big boy's club in the world. All products must go through a rigorous 2-year field service trial without the slighest hiccup and jump through numerous other hoops (e.g. obtain AAR vendor status, have sufficient capital for product liability insurance premiums, etc.). And if that wasn't hard enough to do, they also need to forge relationships with the 5 OEMs in the space who aren't receptive to newcomers. Furthermore, these OEMs are generally opposed to change so it's another challenge to have to convince them to adopt your products. The proof lies in the fact that pressure relief and manway designs have not changed in decades. The flip side, and major competitive advantage for a company like Kelso, is that the barriers to entry are ridiculously high. Their market dominance is virtually guaranteed!

In 2010, Kelso had a change in management and they were finally able to overcome all the aforementioned challenges over the next few years, leading to eye-popping revenue growth as seen in the following figures:

Q1 13' revenue: 2.014M
Q2 13' revenue: 2.660M
Q3 13' revenue: 3.555M
Q4 13' revenue: 4.902M
Q1 14' revenue: 5.480M
Q2 14' revenue: 5.648M
Q3 14' revenue: 5.936M
Q4 14' revenue: 6.752M
Q1 15' revenue: 6.871M

Q2 15' revenue: 4.596M **

So why is Q2 revenue down after numerous quarters of consistent sequential growth and why has the stock price fallen so much since it's 7$ high in 2014? The answer to that question is why I believe there's a great opportunity to pick up some cheap shares. In short, as most are already aware, there are new regulations that have come in place for the tanker cars due to the many derailments in past years, and some with major consequences like Lac Megantic. The problem is that OEMs did not know what the regulations would look like, hence they cut back on production which obviously affected Kelso's revenue. However, the cut back on production, created an all-time high backlog that will need to be worked through. That's on top of all the tanker cars in North America that will need to be retrofitted. Tanker cars have an average 50-year service life, therefore a good chunk of the cars in North America will be retrofitted instead of scrapped (exact figures slip my mind, but you don't need to know a man's exact weight to know if he's fat or not). That's the explanation for the soft Q2. Growth is expected to pick up in Q4 as per the MD&A: "The industry, although reluctantly, is realigning their business models to comply with the controversial new regulations in the fourth quarter of 2015 while legal matters are resolve". The pre-regulations revenue growth bodes extremely well for the post-regulations growth opportunity, especially considering that there should be 2 new products in the pipeline in 2016 and the much larger number of tanker cars (either retrofit or new ones).

Well since this post was longer than I intended to write, I might as well use it as the backbone of my formal write-up, and talk about other points like insider ownership and their financial situation.

Insider ownership:

Officers and directors combined own a bit over 10% of the stock. Ideally, I would of liked to see them own a greater amount, but it's sufficient to align their interests with those of shareholders. What's more, the officers are in their 60s and it's obviously not prudent for them to invest all their money in the company -- they need money for estate planning and they need to diversify their investments to a certain extent (not too much otherwise they wouldn't be as motivated to build shareholder value IMO) to insure their capital is protected.

Furthermore, they have credibility with regards to building shareholder value as they fixed the capital structure in 2010 via a stock rollback and PP raise, and have also brought the stock from a low of $0.10 to a high of 7$. They've also paid a dividend the last two years, $0.01 and $0.03 per share in 2013 and 2014 respectively.

That being said, I'd rather they use a money to do a share buyback program, which would help support the stock price and allow them to get a better a return on their capital. When share buybacks are done when the stock is trading below fair value, the company gets to buy back dollar bills for cents. The greater the discount to fair value, the greater the amount of shares they can buy with a certain amount of money, and the greater EPS can increase -- the holy metric for shareholders. 

Another issue I'm not fond of is the compensation issue. Management takes a 10% bonus of earnings before taxes and share-based compensation. This will need to be changed in 2016 and I know other shareholders are pushing for it. Management is aware and the compensation committee will rectify the situation in 2016. Thankfully the company has killer margins, so the bonus still allows the company to have impressive numbers.

Margins & financial situation:

The company's balance sheet is a solid as it gets. Prior to Q2, the company had near 10M in the bank and no debt. Cash decreased after Q2 because they payed out a 3 cent dividend and built inventory for the next quarters. The cash position is still very healthy coming at 4.5M.

As for the margins, prior to Q2, the company had a 40% gross margin and a ~24% operating margin adjusted for share-based compensation and unrealized forex loss (it's just a devaluation of their Canadian asset due to the weakening CAD). It's not every company that has killer margins like these, and that's part of the beauty of the pricing power that comes having market dominance in big market with few players. In Q2, gross margins declined to 30%, but that's a one-time event because they had higher product liability insurance premiums, more manway sales which is a lower margin product, and a pricing war for pressure relief valves with a competitor who is out of the market. First, the product liability insurance premiums are calculated at the beginning of the year and are based on what the company expects to sell throughout the year. Since Kelso initially estimated 36M in revenue prior to uncertainty created by the regulations, they're paying 50% higher premiums per month compared to last year when revenue has declined 33% YoY. Secondly, they had a larger blend of manway sales than previous quarters, therefore the overall margin took a hit. Manway margins will improve significantly with economics of scale. Lastly, as per the MD&A, a group out of England managed to sell non-certified pressure relief valves to one of the OEMs. It is my understanding that the engineers went behind management's back when ordering those pressure relief valves as they were cheaper. Upon learning this, they were fired and no more non-certified valves will be ordered again. There obviously could be major legal and monetary consequences when installing non-certified valves on a tanker cars, hence there's no real risk of it happening again in my view. Going forward, management expects margins to come back to their Q1 levels and improve in later years with economies of scale.

In conclusion, being able to purchase Kelso at these levels based on the projections for their business going forward is an opportunity that probably won't last too much longer.