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Riding the Wind Behind Kaydon

Related Stocks: KDN

10/01/2007: Of all the industrial parts manufacturers, few are better positioned to benefit from the best segments of global growth than Ann Arbor, MI based Kaydon (KDN). At first glance the products manufactured by Kaydon may sound like an uninteresting commodity: bearings, shock absorbers, engine rings, fluid filtration systems. However, this company serves a booming high-margin niche where the money to be made is far from boring.

Kaydon builds specialty engineering parts for intense applications in the defense, wind energy, aerospace, petrochemical, and medical industries, just to name a few. Its customers demand durability and customization, and are willing to pay a premium for quality. Kaydon sustains some of the highest profit margins in the industry. For 2006 operating margins were 24.4% and gross margin at 41.4%, much higher than its peers in the Industrial Machinery sector.

Like other industrial companies driven by the strong global economy, Kaydon has a strong order book and is working to expand capacity. Since the beginning of the year, the order backlog ballooned by a third, from $151 million to $201 million at the end of the second quarter.

The best days for Kaydon may have yet to come. High governmental defense spending, growth in aerospace, and new innovations in energy should keep Kaydon busy for the next several years. CEO James O’Leary stated on the last conference call, “…the supply/demand imbalance is such that I don’t think you have to give up price to get volume. There is such a shortage and the needs of our customers are such that they’re not haggling on price about a key component…”

Even more interesting are the possible benefits from the rapidly developing wind power industry. As a manufacturer of wind turbine parts, Kaydon’s orders related to wind have exploded. According to the second quarter conference call, about $60 million of the $200 million backlog is for wind-related orders.

In anticipation for a growing wind energy market, Kaydon will be investing $25 million over the next 18 months to expand manufacturing capacity for larger 3-megawatt wind turbine parts. These larger windmills not only generate more energy, but tend to use more expensive parts - a benefit for Kaydon.

According to the American Wind Energy Association, the wind industry is expected to grow 25-30% per year for the next several years and the megawatt capacity per windmill has been steadily increasing. I believe that as utilities continue migrating to bigger and more efficient turbines, Kaydon will be ahead of the trend.

Financial Analysis

Kaydon looks appealing from a financial perspective. The company has been gradually repurchasing shares, but has only scratched the tip of its 5 million share buyback program. The $375 million stockpile of cash on hand also leaves many options for the company to enhance its stock price, including strategic acquisitions.

Given the cash reserves, I anticipate Kaydon will take steps for expanding capacity in Europe, where wind power is already vogue. On the first quarter conference call, management touched on the idea of opening a plant in Europe.

On a forward PE basis, the stock appears relatively expensive near 19X compared to its historic average in the mid-teens. However, the trailing EBITDA multiple of about 10 is in line, if not lower than similar industrial machinery companies. The PEG ratio near 1.5 also appears to be in line with other industrial machinery companies.

I think it is reasonable to go long this stock despite the inflated PE ratio because the analysts’ expectations of 8-10% revenue growth seem low considering the company’s competitive pipeline. It is my opinion that Kaydon is a good candidate for an “under-promise, over-deliver” earnings scenario.

As of this writing the stock price is off from its high, which may be a good opportunity to invest in Kaydon for the long term. Expect steady, consistent growth with a decent return for risk.

Possible Risks

The biggest risk to Kaydon is a slowdown in the global economy. During the conference call, James O’Leary cited a strong industrial market in the US and Europe as the backbone of the company’s growth expectations.

On September 26, the Wall Street Journal had a brief story about Germany’s Ifo business-climate index. According to the index, the recent credit market crisis has somewhat shaken business’ economic confidence in Germany. This is of particular importance for Kaydon because their distribution center in Germany has been a major contributor of sales growth.

Whether that index report turns out to be a leading signal of an industrial slowdown or a trivial statistic is yet to be played out. However, I consider it a brief reminder of the risk still lurking during good economic times.

Assuming that the global economy continues at full steam, expect Kaydon to have a strong wind behind it.

Full Disclosure: At the time of this writing, Winston is long KDN shares.