Investment actuary Rob Baker likes to paddle his own canoe. So after 17 years working for the man, he broke away in 2013 do his own investment analysis and share his thoughts via a subscription-based email service. It’s been going well enough for him to still be enjoying life in the independent lane. Here’s his latest effort, offered as a taster to those in the Biznews community who are looking for in-depth analysis of smaller stocks that are ignored by most in the investment community. – Alec Hogg  Â
By Rob Baker*
If you spend your time looking in areas which other informed investors aren’t paying attention to (mostly because of lack of liquidity), you have a greater chance of finding bargains (but also of finding rubbish!).  KayDav certainly falls in the set of illiquid shares.  Because a handful of shareholders own 88% of the company, the free float is tiny, and it’s common for a day to go buy without any KDV trades.
I think of KayDav as an entity which sources wood based panels from the likes of PG Bison & Sonae Novobord, carries out limited upgrades and is involved in the bulk distribution thereof; which usually includes the taking on of credit risk.  The wood-based panels are used inter alia in the furniture manufacturing, construction & shop fitting industries. Through their Packit Packaging acquisition, they have recently entered the packaging and packaging machinery distribution business.
The Group has been showing decent HEPS growth rates if one accepts that the industry settled on a new normal during 2008 and 2009 Â after the financial crisis and the implementation of the credit act. HEPS for 2008 was 6.8 cents thus compound growth of 15% per year since to the 16.3 cents of 2014.
Wood Based Panels 101
Wood based panels are manufactured through the compression of wood waste into a solid panel (KayDav is not involved in this) – either particle board (chipboard) or medium density fibre board (MDF).
Wood chips and formaldehyde resin are required to manufacture these wood-based panels. Particle board is made by mixing wood particles (flakes) with formaldehyde resin which is formed into a mat, and subjected to pressure and heat to form a stable board. The cured panel is then sent to a sanding line for calibration & finishing.  Particle boards can be used for internal components & can also be coated with a decorative surface for use in kitchens, bathrooms, bedrooms, office partitioning (where it competes with dry walls made from gypsum), furniture, shelving and coffins.
Formaldehyde resin, in turn, is produced from pure formaldehyde, urea & methanol. In a 2007 Competition Tribunal case, they estimated that Woodchem (now owned by KAP) had 63% of the market for making formaldehyde resin in South Africa, and Resinkem had 37%.
MDF is used in office furniture, kitchen industry, shopfitting, skirting boards, architraves, packaging material, doors, cabinetry and coffins.
Particle Board & MDFÂ board can be upgraded with various decorative surfaces for use in kitchens, offices, furniture & shop fitting, and manufacturing industries.
Supply & Demand of Wood Panels
Distributors, like KayDav, buy their products from PG Bison & Sonae Novoboard and then sell them onwards. KayDav’s direct competitors include:
- In the Western Cape :Citiwood Cape, Lansdowne Boards &Topworx.
- In KZN :Citiwood Natal, East Coast Boards, Melwood Kitchens,Pine Timber Board Express, Pine Board Builders & Simunye Board.
- In Gauteng :Board King Johannesburg, Board King Pretoria,Boardmaster, Timber & Board Express & Woodcentre.
Historically, local manufacturers suppled most of the chipboard (particle board) & MDF, with the shortfall
supplied by imports (MDF mainly). More recently supply from local manufacturers has exceeded demand (see KayDav’s 2014 Annual Report). Kaydav keeps buffer stocks on hand to ensure they are able to service the needs of their clients.
PG Bison & Sonae Novoboard are the dominant local producers of chipboard &  MDF. In a 2007 Competition Tribunal case (it’s dated, but better than nothing); it was estimated that market shares for particle board were PG Bison (47%), Sonae (39%), Magna (8%) and imports (6%). For MDF market shares were PG Bison (59%), Sonae (8%) and imports (33%). With the weakening exchange rate imports became more expensive, and it has become more important that PG Bison & Sonae Novoboard remain competitive (ie that they don’t merely set local prices equal to import parity prices).
PG Bison is owned by KAP, which is listed on the JSE. There’s the risk that PG Bison tries to expand more into the distribution of wood panels.  PG Bison describe their aim as to be “the leading board manufacturer & primary upgrader in Africa”.  BisonBord makes particleboard & SupaWood makes medium density fibreboard (MDF). Through their ownership of planted forests, they can supply themselves with the raw materials.  They describe themselves as being a “high volume, low cost manufacturer”. Whilst the risk that they may expand downstream into the distribution of wood panels cannot be ignored, recently the opposite has happened – PG Bison have moved upstream by closing various depots during 2012 (there are vague references to this in the Kap integrated annual report of 2013, page 17 – “Product & customer rationalisation strategy has resulted in the expected improved cash flows and margins”). This indicates that, at least in the medium term, the probability is low that PG Bison will move downstream.
Sonae Novobord is owned by Sonae Industria, which is listed on NYSE Euronext. In their 2014 report they divide their operations into Southern Europe, Northern Europe & Rest of the World (Canada & South Africa); with 8% of their customers based in SA. A total of 77% of their sales in SA are to the trade, which is far higher than in the other geographies in which they have a presence. Similarly to PG Bison, there’s the risk that they attempt to move downstream, which represents a risk to KayDav’s business model.  However, Sonae’s South African business has never had a downstream strategy in the wood panel market, and the inevitable backlash from resellers, should such a move be attempted, reduces the risk thereof in the short/medium term.
Factors impacting demand of Wood-based panels
Ultimately,  the industry is reliant on “consumer demand which in turn is impacted on by amongst other factors: personal debt levels, employment and the willingness of financial institutions to extend credit.”
Many of KayDav’s clients are “thinly capitalised businesses servicing the construction industry”, which turn to KayDav for financial support during times of depressed activity.  This can lead to a deterioration in the trade debtors’ book, and ultimately an impairment thereof.
KayDav are exposed to:
- Residential construction activity.
- Retail demand for domestic furniture & home improvement activity.
- Shopfitting activity
This exposure is reflected by KatDav’s writings in its 2008 interim results: “The Group faced considerable challenges during the period resulting from the general slowdown in the economy, rising interest rates, electricity supply issues and the effect of the National Credit Act on bank lending. Due to the contraction in business activity the Group has not achieved its growth forecasts.”
Credit Sales
About 75% of KayDav’s sales of wood based panels are made on credit. Credit control is exercised on a divisional basis with strict credit-granting criteria. All new account applicants are monitored by senior management. Industry knowledge & visits to potential customer premises assist in the decision to accept a new customer & the setting of credit limits.
Corporate Structure
The company was incorporated as Thornbird Trade & Invest 25 (Pty) Ltd on the 13th Dec 2006. On the 10th Oct 2007 its name was changed to KayDav Group Ltd, and was kept dormant until the business combinations occurred. On listing date 40m shares were placed at R1 per share.
Kaydav sells its products under the brands of “Kayreed Board & Timber“, “Davidson’s Discount Boards” and “Packit Packaging Solutions“.
Kayreed Board & Timber
Kayreed Board & Timber was acquired on 1 Sep 2007 for R107m, and it serves the Gauteng market.
Is a large-scale distributor of raw wooden board, with value-add limited to cutting facilities. The business targets high volume customers, primarily in construction & particularly the furniture, cupboard & kitchen manufacturing industries.  The Group works closely with local manufacturers to increase their national market share.
Davidson’s Discount Boards
Acquired on 1 Nov 2007 for R110m.  All the Group’s outlets, with the exception of Durban, have computerised beam saws and edgebanders. The factory used to be in Epping, but was moved to Ottery in the 4th quarter of 2014.  The manufacturing segment has historically been a small part of the Group’s business with turnover, before intragroup eliminations less than 10% of the total. Before the big losses of 2014 this segment impacted operating profit by 4% and 3% for 2013 and 2012 respectively. The big losses in the factory during 2014 has necessitated its relocation and restructuring to ensure it contributes rather than reduces the Group’s profitability. Note that whereever downscaling occurs, there are costs associated with it which impact negatively on Group profits.
Davidson’s Manufacturing is a focused manufacturer of veneer boards, foil boards, cabinet doors & post form tops- this production focuses on the application of various natural & synthetic decorative surfaces. The factory supplies upgraded wooden boards to the retail outlets. In addition to its boards, Davidson’s offers complementary products like fittings & accessories.
Davidson’s has branches in Brackenfell (a satellite branch in George was opened in 2012, which is managed by the Brackenfell branch), Durban (opened in October 2012), Montague Gardens (downscaled in 2009), Ottery, Pretoria (Silverton) and Strand. This is complemented by franchises in Bredasdorp, Gansbaai & Hermanus.
Packit Packaging
On 1 Aug 2014 KayDav acquired a small packaging distribution business for a maximum of R15.2m (final price is still being determined). The business “is primarily involved in the distribution of packaging materials and to a lesser extent in the sale of packaging machinery. The business has characteristics which they claim are similar to those of KayDav’s existing businesses, namely: 
- The nature of operations is wholesale and retail distribution.
- Marketing is done business to business via sales representatives.
- Working capital management is a key driver of success.
- Gross profit and net profit margins are similar”
There is a geographic presence in Honeydew (Gauteng) and Maitland (Cape Town).
I don’t see many similarities between Packit and KayDav’s wood-based panel business. Whilst the start looks promising, it’s early days and it must be borne in mind that KayDav’s previous move out of their comfort zone (the Castle Timbers start up in 2008) wasn’t successful (in fairness though, that was a start-up and not an acquisition).
KayDav have indicated that the acquisition of Packit Packaging is the 1st step in their strategy of diversification.  Things can easily go wrong in acquisitions, and this space needs to be closely watched.
Castle Timbers – a brief post mortem
In September 2008 Kaydav’s new business, Castle Timbers, started trading. The factory was in Cape Town. The business was new to KayDav, as it focused on solid wood products instead of their traditional wood-based panels.
Mangement based their decision to set up Castle Timbers on the “availability of a highly skilled management team with the necessary expertise to implement the new venture”.
It was set up to process rough solid wood into solid wooden mouldings, skirtings & associated products. These products would then be distributed via merchants & retail building chain stores.
- In the 2008 annual report they described themselves as “optimistic” regarding the prospects of Castle Timbers.
- In the 2009 annual report they said market share grew significantly, but “trading losses were incurred during the year in reaching optimum turnover levels”.
- In Dec 2010 they divested from Castle Timbers. “It became clear during the year reported on that Castle was underachieving on budgeted goals. An expansive strategy was created for Castle in terms of which levels of turnover & profitability were to be reached. These were not realised. One of the main reasons for the underachievement was the poor performance in the residential construction industry. Management resolved that it would be best to extricate from Castle given the quantum of losses incurred & future funding required. The business was sold as a going concern.”
Abscondments
Is it so difficult to get a job in South Africa that having one is treated as a prized possession? Not judging by the fact that there were 39 abscondments of KayDav staff in FY2014 (out of 476 staff). In fact, KayDav say that they “believe that the high rate of employees leaving voluntarily has to do with the mobility of labour.” 
Share Price History
Kaydav was listed on the main board of the Johannesburg Stock Exchange on the 15th November 2007. Â The placing on listing in 2007 was at 100c a share.
In 2008, along with the massive impairment of goodwill, the share price plummeted down to 21c.
In the second half of 2014 I picked up KDV’s at 105c, and at the time of writing the last trade was at 190c.
Share Buy-backs
- In 2009 R18m was used to buy shares back at 30c each.
- In 2010 R15m was used to buy shares back at 30c each.
- In 2011 R5m was used to buy share back at 35 to 44c each.
Calculating Sustainable Owner Earnings
My assumptions included:
- Board Distribution revenue in FY2014 was taken as equal to what is sustainable.
- 80% (thumb suck) of revenue from manufacturing was assumed to be sustainable (“The manufacturing segment, which consists of one operation, performed disappointingly during 2014 and consequently a decision was taken to restructure the unit. Unfortunately the process of downscaling and relocating the manufacturing division, which was completed during the period, had a further negative impact on the Group’s results for the year under review. This operation has now been successfully incorporated into the Davidson’s Discount Boards Ottery outlet and management is confident that it is in a position to positively contribute to Group results.”)
- The revenue from Packit Packaging over the 5 months to 31 Dec 2014 was annualised, and 90% of the annualised number was assumed to be sustainable (to take account of possible seasonality).
- FY2014 had a cyclically low gross margin of 29% (over the last 8 financial years the gross margin has been remarkably stable, varying from 29% to 31%, averaging 30%). The last time this happened was in 2010, and we saw a nice pickup in profit in 2011 when the gross margin increased to 31%. I’ve assumed a gross profit margin of 30%. You might argue that different gross margins should be assumed for the 3 business segements, and you’d be right – however I’ve assumed equal rates to keep things simple, because I don’t have enough data to accurately split it, and because I think it more or less averages out, with poor margins on manufacturing balanced by large margins on Packit Packaging.
- What you gain on the swings you lose on the roundabouts…whilst the gross margin in FY2014 was lower than usual, operating expenses were higher than usual (-23%, compared to the average and assumed -25%).
- Because I included a full year’s revenue from Packit Packaging, I must include a full year’s finance costs. I also adjusted finance costs (as well as finance income) by shocking it by 3%, in line with my thoughts as to where interest rates are heading (and my inherent dislike for debt-fueled profit).
- I have assumed a 28% average tax rate.
- Kaydav would benefit from any decrease in fuel prices, as vehicles are used to distribute the wooden boards. However, I think it would be a short-term gain, as the margins in this business have been fairly constant through previous fuel price changes.
Taken together, I have current sustainable earnings at R27m p.a.
Valuing KayDav
Besides the assumptions made in estimating the sustainable earnings, we need to make 2 vital assumptions about the risk discount rate required (in excess of risk free returns) and the real growth in earnings. 
Risk Discount Rate
Theoretically, KayDav is better diversified as a result of the Packit Packaging business being added into the mix. However, I’m not going to credit them for that, as I’m concerned about new business risk.  I see a range of fair risk discount rates from 6% to 9%.
Real growth in earnings
I see a range of real growth of earnings being from 1% to 4% (more gut feel than science).
Conclusion
I could be wrong, but I see fair value of KayDav as being in the range from 140c to 340c. This is quite a wide spread reflecting my uncertainties. Interestingly enough, the share also traded in a wide range during 2014 (low of 73c, high of 215c).
Investor service
AÂ hat tip to KayDav, for them getting back to me quickly when I requested feedback.
Seasonality
Is the wood-based panel industry seasonal (seasonality means extra care needs to be taken when looking at interim results)? Probably:
- In their 2008 Interim Results KayDav said that “Historically the second half of the year accounts for the larger part of the full year operating profits.”
- In their 2009 interim results KayDav changed this to: “With the exception of the 2008 financial year, historically the second half of the year accounts for the larger part of the full year operating profits.”
- In their 2010 interim results KayDav  changed this to: “Historically, the second half of the year contributes the larger portion of annual profi ts. During 2008 and 2009 this was not the case due to the economic downturn and the effect of losses from start-up businesses.”
- In their 2011 interim results KayDav said: “Save for structural changes in our industry, for example industry wide gross margin changes, the second half of the financial year normally generates the greater contribution to annual operating profit.”
- In 2012 nothing was said about seasonality.
- In 2014 interims nothing was said about seasonality.
Owners of KayDav
88% of the shares are held by the 5 biggest shareholders:
- 42% by David Brouze Trust
- 33% by Davidson Family Trust. The most recent director-related trade was on the 5th September 2014, when the Davidson Family Trust bought R1.8m at 180c.
- 8% by Gary Davidson
- 5% by Craig Dawson
With such a small free float, KDV is extremely illiquid, and it’s common for there to be no trades in a week. It’s not a big step from here to buying out minorities & delisting (just saying).
Info Sources
- 2007 Annual Report
- 2008 Interim Report
- 2008 Annual Report
- 2009 Interim Report
- 2009 Annual Report
- 2010 Annual Report
- 2012 Interim Report
- 2013 Annual Report
- 2014 Interim Report
- 2014 Annual Report
DISCLOSURE: I own some KayDav
* Rob Baker is an investment actuary. He worked in traditional roles for 17 years before breaking out on his own. Rob is an active investor on the Johannesburg Stock Exchange, and runs a niche subscription service with a private reader base, sharing his focused investment thoughts. He is offering the subscription to Biznews.com community members at an initial R2500 for 5 years. rob@investsouthafrica.
