Kelso Technologies Inc. (KLS-TSX): Regulatory play, undervalued stock
Recommendation
I recommend taking a
long position in Kelso Technologies Inc. (KLS-TSX), a railroad equipment
supplier, which currently trades at $ 4. 26 per share, because it is
undervalued by at least 40%.
The company is experiencing increased growth on account of
increased demand for safety in the transportation of flammable liquids by rail
in North America. Additionally, the rail
safety equipment industry has significant barriers to entry, which would help
the company to protect its market share. Lastly, the company has and continues
to develop additional products which are expected to contribute substantially
to the future financial growth of the company.
The US Department of Transportation passed new requirements
on May 1, 2015 for rail tank cars used in the transportation of flammable
liquids by rail. These new requirements will contribute significantly in the
growth of the company. Additionally, the company continues to demonstrate
strong growth year over year, has a cash of $7.3 million and has no debt on its
balance sheet, allowing the company to continue its strong growth.
Key investment risks include the fact that the company is
dependent on a small number of customers and that the company’s production
facilities may not be large enough to handle growing market demand for the
company’s products if demand is beyond projected levels.
We can mitigate these risks via put options after taking a
long position in the company’s stock.
Company Background
The company is a railroad equipment supplier which produces
tank car components to reduce risk and improve reliability in the transport of
hazardous commodities in North America. The railroad industry has been slow in
adopting new technologies and the technology designs have not changed in
decades even though environmental sensitivities, human safety issues and
regulatory engineering problems continue to challenge the railroad industry. This
provides Kelso with its ongoing opportunities to use its engineering creativity
to provide unique technology services to the railroad industry and grow a
successful multi-million dollar business.
Investment Thesis
I believe
the stock is underpriced due to the following reasons:
1.
The
rail road industry is entering a boom period due to the rapid growth of crude
oil shipments in North America. Additionally, the rail road industry has been
slow in adoption of new technology and has not taken any significant steps
towards the transportation of hazardous materials in over 70 years. However, the social liabilities,
environmental sensitivities and worker safety issues have increased government
pressure and spurred new regulations in both Canada and United States. These
factors combined will prompt the transportation industry to adopt new
technologies at a much faster pace providing Kelso with a solid foundation to
grow a sustainable, profitable business.
2.
The
company operates in regulatory environment, wherein lengthy qualification
process to achieve regulatory compliance, patent protection and production
infrastructure provide significant barriers to entry for market penetration. Therefore,
this positions the company for a solid growth without fear of new entrants
taking share of the industry.
3.
The
company has many products in the pipeline that are currently patent pending.
These products address additional safety concerns for the loading, unloading
and transportation of hazardous materials. The company’s strong growth year over
year is a testimony to increased concerns over safe transportation of hazardous
materials, and these additional products are expected to contribute
substantially to the future financial growth of the company.
These
reasons are significant and even if one of these factors ends up making an
impact, there is a significant upside in taking a long position in this stock.
Catalysts
Key catalysts
in the next 6-12 months include, (i) regulatory developments supporting product
adoption, (ii) railroad and regulatory alliances and influences, and (iii)
creation and acquisition of new or established products that can grow new
markets.
1. Catalyst # 1 is important as the
company reported on May 1, 2015 that Transport Canada (TC) and Department of
Transportation (DOT) of United States passed new rail tank car regulations.
These new rules govern the retrofit of existing rail tank cars and production
of new rail tank cars and will play a significant role in ensuring Kelso’s
strong growth in the future years. The fact that there significant barriers to
entry in this industry as discussed above will also lead to continued growth in
future.
2. Catalyst # 2 and # 3 are important as
Kelso already has business and engineering alliances in place with other companies
for some of its additional products. For example, it entered into a strategic
alliance with Saferack (a leading expert in crude oil and liquid natural gas
terminal engineering, procurement and construction services for the railroad
and trucking industry), for incorporating its KKM technology as an integral
part of a new generation of high-capacity crude oil loading terminal systems
designed and provided by Saferack. These alliances and additional products
developed/being developed by Kelso will lead to additional sources of revenue
in the wake of society becoming more socially and environmentally conscious.
Valuation
I performed a DCF calculation for FY 2015 E to FY 2019 E
using a multiples method. I made the
following operating assumptions in doing my DCF analysis:
*Operating assumptions derived from prior period actual financials and company MDA.
On the basis of these operating assumptions I made the following Cash Flow Projections:
For the DCF analysis I performed a sensitivity analysis
wherein I choose a Discount Rate (WACC) ranging from 10% to 16% and Terminal
EBITDA multiples for a range of 5.0x to 10.0 x. These numbers were selected by
me on the basis of comparable companies.
Based on the above analysis I got a range of values, which
allowed me to conclude that the minimum share price above is $5.98 and since
the current price is $4.26 the company is undervalued by at least 40% in the
worst case scenario.
Risk factors and how to
mitigate them
1. The Company is dependent on two major
US corporations as customers. Although, the customers have displayed a pattern
of consistent product orders over the past 24 months and timely payment of
amounts owing, there is no guarantee that sales to these customers will
continue at current levels, or that these customers will continue to satisfy
their payment obligation to the company in a timely manner. The company does
not have any formal agreements for long term, large scale purchase orders with
these customers and only sells to them when purchase orders are received. The
company expects that these customers will continue to represent a substantial
portion of its sales for the foreseeable future. The loss of any of these
customers could have a material negative impact upon the company and its
results of operations.
2. The company’s production facilities
may not be large enough to handle growing market demand for the company’s
products if demand is beyond projected levels. This may have a material
negative demand on the company’s ability to maintain existing customers and
expand its customer base, and its ability to generate revenue at current and
projected levels.
We can mitigate these risks via put options.
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