Key Knife, Inc. (KAI) Earnings Call Transcript & Summary

Ladies and gentlemen, thank you for standing by. Welcome to Kadant's acquisition of Key Knife's conference call. [Operator Instructions] Please be advised that today's conference is being recorded. I would like now to turn the conference over to Michael McKenney, Executive Vice President and Chief Financial Officer. Please go ahead.

Okay. Thank you, Michelle. And before I read the safe harbor, I'd just like to apologize for the delay, and you should now be able to access the slides. So with that, I'll go into the safe harbor. Good afternoon, everyone, and welcome to Kadant's conference call to discuss its acquisition of Key Knife. With me on the call today is Jeff Powell, our President and Chief Executive Officer; and Michael Colwell, Vice President and industrial processing sector head. Before we begin, let me read our safe harbor statement. Various remarks that we may make today about Kadant's future plans and expectations, including the expected benefits of the acquisition of Key Knife, forward-looking statements for purposes of the safe harbor provisions under the Private Securities Litigation Reform Act of 1995. These forward-looking statements are subject to known and unknown risks and uncertainties that may cause our actual results to differ materially from these forward-looking statements as a result of various important factors, including those outlined at the beginning of our slide presentation and those discussed under the heading Risk Factors in our annual report on Form 10-K for the fiscal year ended December 31, 2022, and subsequent filings with the Securities and Exchange Commission. In addition, any forward-looking statements we make during this webcast represent our views and estimates only as of today. While we may elect to update forward-looking statements at some point in the future, we specifically disclaim any obligation to do so even if our views or estimates have changed. With that, I'll turn the call over to Jeff Powell, who will discuss the acquisition. Following Jeff's and my remarks, we will then have a Q&A session. Jeff?

Thanks, Mike. Hello, everyone, and thank you for joining the call today. As you read in our press release last week, we've completed the acquisition of Key Knife. Today, we will provide more information about this acquisition and give you an opportunity to ask questions about this new addition to Kadant. As many of you know, we have specific attributes we look for in an acquisition, namely strong market position, high revenue percentage in parts and consumables, a product offering that is complementary to Kadant's portfolio and strong financial performance. I'm pleased to say that Key Knife has all these attributes, and we are very excited to welcome them to the Kadant family. I'll start by providing an overview of the company and the transaction. Key Knife is a manufacturer of engineered knife systems used in custom chipping, planing and flaking applications. Founded in 1986, Tualatin, Oregon-based company has built a reputation of quality and custom solutions that helps its customers improve productivity and reduce operating costs. Today, Key Knife holds a strong market position in the wood processing industry, one that we are quite familiar with. The revenue for the trailing 12 months that ended September 30, 2023, was $65 million, with approximately 95% of that being from aftermarket parts. The purchase price was approximately $156 million in cash. Key Knife has developed a deep product portfolio of engineered knife systems that are customized for specific applications and processes. Many of these systems are used in the primary breakdown area in wood processing, and this is one of the critical areas within the production process. As you can see on Slide 5, Key Knife offers unique chipping and planer systems used in sawmills, pulp mills and chip plants and other applications. In addition to its product offerings, the company provides comprehensive field service and product-specific training programs to help its customers maximize their operating effectiveness. The company's leading position in disposable knife systems and its highly complementary offerings to Kadant's Wood Processing products make Key Knife an excellent fit with Kadant. We have worked with Key Knife for many years and collaborated with them on specific development projects, including a disposable knife system for our stranders used to produce oriented strand board. We believe there were opportunities to collaborate across our other wood processing businesses in the future. Key Knife has an experienced management team, and they will continue to lead the business as part of Kadant. They have done an excellent job of building a strong customer-focused culture and their financial metrics and market position reflect this. As we look ahead, there are many potential opportunities made possible by our collaboration. One of the more compelling opportunities in developing new markets, where Kadant has existing relationships that can be leveraged to provide Key Knife with growth opportunities in underserved markets. With the addition of Key Knife's products and systems to our existing offerings, we are able to offer an even broader product portfolio to support our customers' critical applications. Our shared focus provides opportunities to expand our solutions to help our customers improve fiber recovery and product quality, maximize production and reduce overall mill operating costs, which we believe strengthens our respective positions in wood processing industries. Consistent with our decentralized operating model and past practices, Key Knife will continue to operate as a stand-alone business under Kadant. We look forward to quickly integrating Key Knife into our Industrial Processing segment and begin exploring opportunities for collaboration and sharing the best practices soon after. With that, I'd like to now turn the call over to Mike to discuss the key financial metrics.

Thanks, Jeff. I'd like to provide you with some additional color on the financial metrics associated with this transaction. The purchase price was approximately $156 million, subject to customary adjustments. And on a trailing 12-month basis, as of September 30, 2023, the business generated approximately $65 million in revenue and $15.8 million of adjusted EBITDA which translates to an EBITDA multiple of 9.8x. I would note that Key Knife's revenue is almost all from parts and consumables. So a strong recurring revenue stream and this transaction has very favorable tax attributes, which are not captured in the EBITDA multiple. It's important to note that we were able to treat this as an asset deal for tax purposes which means we'll be able to take a tax deduction for the step-up in basis for the acquired assets, including goodwill and other intangible assets. Being able to deduct the amortization of goodwill and other intangible assets will provide a significant cash benefit of approximately $24 million over 15 years. This benefit is worth approximately one turn on the EBITDA multiple. And when it's factored in, the multiple is 8.8x. We value businesses on their after-tax cash flow. While EBITDA is a nice quick way to think about pretax cash flow, it does not capture the very favorable tax attributes here. I'd also note that Key Knife is an asset-light business with low CapEx requirements. We used some cash on hand to fund the transaction and borrowed $148 million from our credit facility. We estimate that our leverage ratio, as defined in our credit agreement will still be relatively low, and as a result, absent any changes from the Fed, we expect our borrowing rate to be approximately 6.4% to 6.7%. While we are still working on the valuation of the intangibles that will be amortized for book purposes, our current estimates are that we will have a high level of noncash intangible amortization expense. We estimate this in combination with the interest expense will make this transaction slightly dilutive in 2024 on a GAAP EPS basis. However, free cash flow should be quite good. As always, we will work hard to delever and drive down the interest cost in 2024. I'm going to now turn the call over for questions. But before we start, I should mention that the Q&A session is specific to the Key Knife transaction as we are currently in the year-end 2023 closing process and cannot comment on our 2023 results or our guidance for 2024 until we have our upcoming earnings call in mid-February. With that, we'd be happy to take your questions. Michelle?

[Operator Instructions] The first question comes from Gary Prestopino with Barrington Research.

Could you just very -- I know, Jeff, in your prepared remarks, you just discussed what these products are used for within the various segments of the wood processing. But could you just maybe just go over that again, just so we get -- I can get an idea of where they are in the process of the wood production?

Yes. So there -- in the sawmills, if you think of dimensional lumber in particular, they're in the very -- they're right after our debarkers, you basically have to square off that log before you start to cut up. And so this system does that. It basically squares that off. And if you think of that waste wood that comes from squaring that off, it typically gets chipped and then goes into often into pulp mills or other applications. And so this technology does it right outside of our debarker, it will square it off. They also do -- make chipping knives for the chipping industry, be it again, pulp mills or wood pellets. They make [ planer ] systems. They make systems that if you think about the 2x4, you'll notice the 2x4 the corner is always rounded. It's not a complete 90-degree sharp angle. On 2x4 they make the system, they do that rounding. So it's throughout the sawmill operation that they provide their knives and their technology. But it all starts with it right out of our debarker with the squaring off of the log or rectangular, whether squaring or rectangular, essentially kind of taking the round radius off of it.

Okay. That helps. And then could you give us some idea of what like the top line growth of this company has been through the last couple of years?

Yes. Gary, from 2019 through '23, it has grown at 5.6%.

Okay. And then two more quick ones. In terms of all of these products, I mean, how often do they have to be changed within the capital equipment usage? I mean, is it -- are these things good for a month? Are they good for 6 months? I mean, give us some idea since it's a lot of recurring revenue, how that works?

Well, of course, Gary, you're familiar with the knives that we use in the OSB market, and those get changed out every 8 to 12 hours. And these applications could be similar. It's kind of hours to days.

Okay. All right. So there's a lot of change...

Yes. If you think about it, these are very, very harsh environments, running at very high speeds. And so these knives dole out very quickly.

Okay. And then it just looks like your this will -- just based on the numbers you gave us, this is accretive to your industrial processing adjusted EBITDA margin even without the tax benefit, how many basis points would -- if you could comment on that with what you're figuring out with the amortization, how many basis points of accretiveness off of that 24.3% would you expect? Or is that something you can't answer right now?

Yes, we're still working through the numbers here, Gary, because as you know, at a private company, they kind of look at things a little bit differently. So we're still aligning them to Kadant. But specific to the EBITDA margins for the numbers I gave, you would have come out with an EBITDA margin around 24%. And that's currently accretive for the Industrial Processing segment, which I think year-to-date was a little under 23%. But -- and then for Kadant overall, of course, we're running a little over 21%. So it will be accretive for Kadant.

The next question comes from Kurt Yinger with D.A. Davidson.

I'm just curious how would you kind of characterize Key Knife's market share and kind of their key product line or 2? It sounds like some of the knives aspect is very similar to Carmanah, which is obviously mostly focused on the OSB side, but this sounds a little bit more skewed to lumber mills. So just kind of curious how you would kind of slice and dice that market share.

Yes. So we think they're #1 in the market in the Americas. They're principally focused in the Americas, North America and Central and South America, not quite as much in Europe or the rest of the world. But in those markets -- and by far the -- if you think of disposable knives, in America, maybe 40% of the market uses those, where in Europe right now, it's maybe only about 5%. So Europe is yet to kind of adopt this disposable knife process. So while there's still substantial conversion opportunity in the Americas because it's about 60% that still uses knives that are resharpened and Europe there, it's a substantially bigger opportunity for us. But they're #1 in the Americas, which is where the majority of the market is for disposable knives right now.

Is it fair that it's kind of complementary in terms of lumber versus OSB focus of Carmanah?

It is. It broadens our offering. I think you heard in the comments that they actually worked with us in developing our disposable knife, so they have great expertise in knife technology, but they haven't focused on the OSB market. That's kind of a market that we have extremely high, nearly 100% market share on the OSB side. These guys are #1 in their market, but there is a major European competitor that they compete with.