KEMET (“KEM” or “Company”) is a long investment opportunity that has strong potential for 50% or more in upside in two years or less.  The idea for investing in KEM has been submitted to VIC three previous times and it’s worth reading each submission for some historical context.  The attractiveness for contemplating investing in KEMET again is driven by the Company’s recent restructuring actions on the operational front coupled with the Company’s recent strategic actions.  Numerous insiders agree as evidenced by nine management members and directors spending over $425,000 in aggregate to purchase shares during May at prices well-above the current price, at $5.38-5.77. 

Although KEMET and its peers do sometimes trade below tangible book value (KEM’s TBV is currently $5 per share) and KEM’s TBV could be vulnerable to some near-term decline, the discount to TBV doesn’t typically last too long, in the absence of severe leverage, and I believe it offers some downside protection at KEMET.  The Company is currently leveraged at less than 2x LTM EBITDA and debt matures in 2018. 

Some context of current valuation is shown below.

• Based on its fiscal year ended March 2012, KEM is trading at ~3x EBITDA and ~4.5x EBIT
• After the most recent quarter which was abysmal, with sales down 23% and EBITDA down 75% from the prior year quarter, KEM’s LTM valuation is ~5x EBITDA and ~9.5x EBIT
• Based on the Company’s average reported FCF over the past three fiscal years, the equity FCF yield is over 20% 
• Based on fiscal year 2014, KEM’s P/E is ~5x; this compares to peers AVX at ~13x and VSH at ~9x.  I view this fiscal year as a transition year towards much improved performance in fiscal year 2014 and beyond.   
• As of March 31, 2012, the Company had U.S. net operating loss carryforwards for federal and state income tax purposes of $275M and $410M, respectively. 

As will be described more below, there is also substantial “option upside” potential based on the recently announced Joint Venture with NEC-Tokin which also provides KEMET with the option to acquire all of NEC-Tokin’s tantalum capacitor business by May 31, 2018.  The transaction could ultimately prove to be transformative for KEMET.  The “option upside” should materialize if the Company, assuming a combination with NEC-Tokin, were to achieve management’s guidance for generating $1.7-1.9 Billion in sales and $300-400 Million in EBITDA by fiscal year 2016. 

KEMET, founded by Union Carbide in 1919, is a global manufacturer of tantalum, ceramic, film, aluminum, electrolytic and paper capacitors.  Since capacitors are pervasive in anything that turns on and off, its customers are global leaders in electronic product design, manufacturing, and distribution and includes nearly all of the world’s major electronics OEMs, EMS companies and ODMs.  Among its customers are Apple, Avnet, Boeing, Boston Scientific, Cisco, Dell, Delphi, Ericsson, Flextronics, Hewlett-Packard, IBM, Raytheon, Richardson, Siemens, and TTI. 

KEMET offers 95% of all possible dielectric solutions, covering more than 99% of applications.  Capacitors come in various shapes and sizes with a myriad of technical specifications, and are required in anything that has an electric current (from iPods and iPads to flat screen TVs to giant windmills).  They are numerous in some devices, with over 3000 utilized in some flat panel TV's and over 700 in some smartphones. Capacitors are typically used to filter out interference, smooth the output of power supplies, block the flow of direct current while allowing alternating current to pass and for many other purposes. Generally, ceramic capacitors are more cost-effective at lower capacitance values, and tantalum capacitors are more cost-effective at higher capacitance values.  Since capacitors are a fundamental component of electronic circuits, demand for capacitors tends to reflect the general demand for electronic products, as well as integrated circuits, which although cyclical, continues to grow.

KEMET operates in three business segments: Tantalum, Ceramic, and Film & Electrolytic (“F&E”).   The Tantalum business comprises the largest mix of sales, at 42%, followed by F&E, at 36%, and Ceramics, at 22%. 

According to a March 2012 report by Paumanok Publications, a market research firm focused on the passive components industry, the global capacitor market generated almost $18B in sales across 1.6 trillion units for the year ended March 2012.  During this same period, KEMET generated $985M in sales across 32 billion units.  Paumanok forecasts that sales will grow at a CAGR of 6.4% and units will grow at a CAGR of 8.5% over the next five years.  The demand for smaller and more complex electronics products will continue to drive robust demand for capacitors.  However, there is ongoing pressure on average unit selling prices and therefore manufacturing efficiency is a critical driver for success.  KEMET’s management believes its manufacturing facilities in Mexico and China are among the most cost efficient in the world. 

Based on Paumanok research from fiscal year 2010, ceramic capacitors are the least expensive capacitors in the industry, with an average cost of $0.006 per capacitor, aluminum capacitors are also inexpensive, with an ASP of $0.03.  By comparison, tantalum capacitors cost nearly $0.10.

The largest segment of the capacitor market is Ceramic, at 49% of the total market, followed by Aluminum, at 24%, Paper and Plastic Film, at 12%, and Tantalum, at 11%.  The Tantalum market segment, where KEMET maintains a leading market share position, is forecasted to grow most quickly followed by the Ceramic market segment.  Paumanok forecasts growth of Tantalum at a CAGR of 11.8% and growth of Ceramic at a CAGR of 6.6% over the next five years.

Based on the Company’s net sales, management believes that KEMET is the largest manufacturer of tantalum capacitors in the world and one of the largest manufacturers of direct current film capacitors.  The Company also has a significant position in the specialty ceramic and custom wet aluminum electrolytic markets.  According to market research firm Paumanok, KEM has ~20% of the tantalum market followed by AVX at ~20%.  The third largest maker of tantalum capacitors is KEM’s future JV partner NEC-Tokin with ~15% followed by Sanyo (12%), Vishay (12%), Hitachi AIC (7%), and Nichicon (4%). 

The aluminum electrolytic market is the most fragmented.  The top five industry players of the aluminum electrolytic market comprised 56% of the market segment in 2010.  This compares to the top five within ceramic at 77% and top five within tantalum at 78%.  The overall capacitor market is relatively fragmented as evidenced by the top five companies comprising 39% of the industry in 2010.  Since ceramic capacitors comprise the bulk of the capacitor market, the largest suppliers of capacitors are primarily the top ceramic capacitor makers.  The top ten overall players were Murata (11%), AVX/Kyocera (9%), Samsung (7%), Taiyo Yuden (6%), Nippon Chemi-Con (6%), TDK (6%), KEMET (5%), Nichicon (5%), EPCOS (5%), and Panasonic (4%).  Within the ceramic category, the top five shares were as follows:  Murata (25%), Samsung (15%), Taiyo Yuden (14%), TDK (12%), and AVX (11%).  KEMET ranked eighth in ceramic share at 3%. 

Over the past three fiscal years, KEMET generated an average of ~$913M in sales, ~$132M in EBITDA, ~$83M in EBIT, and ~$51M in FCF.  Shown below is a financial summary by business segment for KEMET over the past three fiscal years followed by a ten year financial summary:

KEMET’s most recent quarter was abysmal as evidenced by the significant decline on a year-over-year basis in sales, EBITDA, and operating income.  The cyclical end markets that KEM serves compounded by the high fixed cost nature of the business can lead to significant swings in profitability.  The most recent quarter (the first fiscal quarter) was a good example of negative operating leverage when sales declined by 23% year-over-year and EBITDA declined by 75%.  In contrast, the first fiscal quarter in 2011 compared to 2010 was demonstrative of favorable operating leverage when sales grew by 19% and EBITDA increased by 25%.  This should make it clear that KEMET’s results can be volatile on a quarterly basis.  This isn’t too different from the semiconductor industry in general. 

A key barometer that is monitored in the short-term is the book-to-bill ratio.  This measure was guided as being relatively strong, specifically 1.3 in the tantalum segment and 1.2 overall, during the last earnings call, thereby implying better momentum in the current quarter than is typical.  Despite my comments about the recent quarter and the current quarter, the investment thesis is not a short-term perspective.  I mentioned earlier that I deem this fiscal year being a transition year towards much improvement in fiscal year 2014 and beyond.  Among the reasons I envision that results will improve in the longer-term for KEMET are the following:

Substantial margin improvement is anticipated in the tantalum segment from the Company’s recent vertically-integrated supply chain

The cost of tantalum powder is the most important input cost for tantalum capacitors.  Tantalite ore is used to make tantalum powder.  Getting back to simple economics, there are two reasons that the cost of tantalite ore has been increasing:  demand is increasing and supply has been reduced.  On the demand spectrum, the capacitor industry consumes ~50% of the world’s tantalite ore.  The remainder is used as an alloy with other metals for cemented carbide tools for metal working equipment, for surgical instruments and medical equipment, and for super alloys in jet engine components.  On the supply side, tantalite ore comes from mines in Africa, Australia, Brazil, Canada, and Ukraine.  Over the past few years, supply has been reduced because several mines have been closed in Australia, Canada, and Mozambique.  Furthermore, in addition to fewer mines, there are several mines in the Congo region that have been deemed to be engaging in illegal activities such as mining in environmentally-protected areas and using child labor.

In March 2012, KEMET closed the acquisition of Niotan, a leading manufacturer of tantalum powders and previously a supplier to KEMET, for $75M plus $10M in royalty payments ($45M of the $75M will be paid over a thirty-month period).  KEMET was Niotan’s most significant customer and the relationship is now all captive. 

Pursuant to the Niotan acquisition, KEMET is now the only completely vertically-integrated tantalum capacitor manufacturer of any appreciable size in the world.  Management believes its supply chain control will provide the Company with an advantage by enabling technology developments to address customer and market needs.  More specifically, management envisions a reduction in raw material costs that will yield a benefit of $10-15M in FY2013 and $40M in FY2014.  The majority of savings in this fiscal year are envisioned being achieved during the second half of FY2013.  The $40M of raw material cost savings would have improved FY2012 EBITDA by over 30%.

Conflict-free tantalum powder is in tight supply and KEMET will benefit as the largest vertically-integrated provider of tantalum capacitors. 

During fiscal year 2012, management achieved its objective for securing a “close pipe, conflict-free, vertically-integrated tantalum supply chain”.  This occurred towards the latter part of the fiscal year and therefore few of the expected strategic/operational/financial benefits have materialized in the Company’s recent performance. 

On August 22^nd, the Company issued a press release that noted the following:

KEMET welcomed the SEC's ruling on the Conflict Minerals Provision 1502 of the Dodd-Frank Wall Street Financial Reform Act. While all of the details are yet to be understood, the promulgation of this law is a big step in creating supply chain transparency through reporting requirements for those publically traded companies that use conflict minerals in the manufacture of their products.

"KEMET's tantalum capacitors are conflict free. As the world's largest user of tantalum, KEMET took an early leadership position in the industry on the issue of obtaining certified conflict free minerals," stated Dr. Daniel F. Persico, KEMET's Vice President of Special Projects. "Strong conflict minerals reporting requirements means an enhanced quality of life for the people of the DRC and a more stable supply of conflict free capacitors for our customers," continued Persico.

The plan was completed by acquiring Niotan (now called KEMET Blue Powder) and obtaining sole rights to Tantalite Resources, an ore processor located in Johannesburg, South Africa.  These actions support management’s vision to be the most reliable supplier of tantalum capacitors in the world and they also make KEMET the largest vertically-integrated tantalum capacitor manufacturer in the world. 

As noted earlier, there are several mines in the Congo region that are deemed to be engaging in illegal activities such as mining in environmentally-protected areas and using child labor.  There are numerous customers who are appropriately sensitive to their social corporate responsibilities and therefore will not conduct business without assurance that all components of the supply chain meet the highest degree of proper labor treatment operating in a conflict-free environment.  In addressing this issue, management developed a program called “Making Africa Work.”  This program focused on sourcing conflict-free tantalum from the Katanga Province of the Democratic Republic of Congo.  The Company committed $1.5M to social responsibility and sustainability programs at the mine site and local village.  KEMET’s “comprehensive socially and economically responsible supply chain is the only example of its kind in the industry.”  KEMET’s leadership in the tantalum market should be reinforced by its ability to guarantee that its capacitors are manufactured from conflict-free tantalum.

Ongoing turnaround in the Film & Electrolytic Segment should yield significant operating and financial improvements over the longer-term. 

During the past couple of years, management has successfully restructured much of the Tantulum and Ceramic segments.  This was largely accomplished through the reduction of headcount, the renegotiation of unfavorable sourcing contracts, raising prices, relocating manufacturing to lower-cost regions, and discontinuing product line losses.  However, the F&E business, primarily acquired from the Evox Rifa and Arcotronics transactions, continues to dilute Company results. 

The F&E business segment generated a margin of negative 19% in the latest quarter, down from a positive operating margin of 12.5% in the prior year quarter.  Sales in the F&E segment declined by ~42% from the prior year quarter; operating income declined by ~$25.5M.  Over the past three fiscal years, the average operating margin and EBITDA margin generated in the F&E segment was -5% and 0%, respectively.  This compares to an average operating margin of 10% and 17% in the tantalum segment, respectively, and an average EBITDA margin of 17% and 21%.  The average three year gross margin in the F&E segment is 10%; this compares to 25% in the tantalum segment and 31% in the ceramic segment.  Management believes it can improve operating margins at the F&E segment to mid-teens, similar to its Tantalum and Ceramic businesses. 

KEMET has been pursuing a restructuring of the F&E segment, with the goal of completing it by the end of FY2012.  That initial timing goal has not been achieved.  The plan included improving yields, deploying new Oracle software systems, developing new manufacturing technologies, moving production to lower-cost regions, and focusing on specialty and emerging segments.  Specifically, the restructuring plan involved moving 42 of the Company’s manufacturing lines, or roughly 40% of total F&E lines, from high-cost locations in Europe to lower-cost sites in Mexico and China.  Although there has been some improvement as evidenced by gross margin which improved from negative 1.7% in fiscal year 2010 to over 15% in both of the recent fiscal years, there is ample opportunity for better results which should materialize pursuant to the ongoing restructuring actions.

As described in the shareholder letter in the annual report, the Company completed the first phase of the F&E restructuring plan during fiscal year 2012 and management is now pursuing the second phase which will include a new manufacturing facility in Skopje, Macedonia to fulfill its objective of reducing the cost structure of this business segment.  Among the challenges that management has confronted in the F&E segment is the manufacturing footprint located in Italy.  The F&E segment has thirteen manufacturing facilities and three of them are located in Italy.  It was finally in November 2011 when management reached an agreement with labor unions in Italy to consolidate three existing plants into a single new facility.  As described in the 10K, management expects its restructuring plan to result in ~$6 Million of lower costs in Europe in fiscal year 2013.  Furthermore, during fiscal year 2015, management expects to realize the full potential of its restructuring plan, achieving total annualized operational cost reductions of $25-30 Million compared to fiscal year 2012.  This amount in potential savings would more than double the EBITDA generated in the F&E segment during the past two fiscal years and be a meaningful improvement from the negative $25M that was generated in FY2010.

Transaction with NEC Tokin provides the potential for substantial longer-term benefits and value creation

During March 2012, KEMET announced its intention to acquire a 34% economic interest with a 51% voting interest in NEC Tokin, plus two call options that would result in KEMET owning 100% of NEC Tokin.  Its revenue was $755M for the fiscal year ended March 2011.  Its EBITDA margin was slightly more than 10%. 

The full combination will make KEMET the market leader, at 35%, in tantalum capacitors, the fastest growing capacitor category.  NEC created the standard for polymer capacitors used globally.  Capacitors represented 40% of NEC-Tokin’s revenue during fiscal year 2011.  In addition to capacitor technology, KEMET would also be acquiring NEC Tokin’s electro-magnetic capabilities which represented 35% of revenue and is comprised of inductors, choke coils, ferreters, transformers, and EMI shielding materials.  The remaining 25% of NEC Tokin’s revenue comes from electro-mechanical devices, piezoelectric ceramics, and access devices. 

This transaction could ultimately prove to be transformative for KEMET.  There is “option upside” that could materialize if the Company, assuming a combination with NEC-Tokin, achieves management’s guidance for generating $1.7-1.9B in sales and $300-400M in EBITDA by fiscal year 2016, assuming the full option is exercised by then.  For illustrative and simplistic purposes, if an investor were to apply a multiple of 5x to $300M in 2015 and conservatively assume that no FCF is generated between now and then, KEMET would be worth ~$17.65.  Note that in making this simplistic calculation, I apply the current net debt plus an additional $350M for the NEC-Tokin transaction and an additional $45M for Niotan that is to be paid over the next thirty months.  

The obvious consideration is how management intends to generate ~$300M of EBITDA on ~$1.7B of sales.  Management has not provided a bridge yet, this is only a target that they communicated but I think it is reasonable.  KEMET generated ~$920M in sales for the LTM and the data we have for NEC-Tokin is $755M for the twelve months ended March 2011.  Assuming sales at NEC-Tokin declined by 10% since then, the LTM combined sales total ~$1.6B.  To arrive at $1.7B in FY2016, that would imply just ~1.5% CAGR in sales.  For context, this is most likely very conservative in comparison to the forecast of a 6.4% CAGR (through FY2017) as provided by research from Paumanok.  The combination would achieve the $1.9B target at ~4.5% CAGR.  Moreover, the tantalum category, in which KEMET and NEC-Tokin combine for a substantial market share leadership position of 35%, is forecasted by Paumanok at an 11.8% CAGR.  As for achieving $300M of EBITDA, this implies achieving a margin of 15.8-17.6%.  Since KEMET has only achieved this range or more once in the past ten fiscal years (in FY2011, KEM generated a 19.3% margin), this management target might appear overly bullish.  However, when one considers, on a standalone basis, the $40M of tantalum savings and the $25M of F&E savings, as described above, that KEM management expects to achieve coupled with the recent operating margin improvement actions, described below, that are expected to generate another $25M of savings, I ascribe a higher level of management achieving its $300M target.  Based on KEM’s FY2012 EBITDA of $128M and NEC-Tokin at ~$75M plus the aforementioned $90M of expected standalone savings, one can gain some comfort.  There are obviously numerous cost savings and “synergies” from the JV and full combination.   Nevertheless, my investment thesis is not premised on the NEC-Tokin combination but I do envision it can provide much “option upside”.

It’s important that KEMET is focused on the potential downside of combining these two companies and therefore engaged in pursuing the transaction through a three-step process.  This enables KEMET management to methodically learn/integrate/preserve flexibility as it pertains to ultimately combining with NEC Tokin.  In the first step, the consideration paid for the 34% economic interest is $50 Million.  KEMET’s two options expire August 2014 and May 2018.  The first option (i.e., second step) is to increase its economic ownership to 49% for an additional $50 Million.  The final step would make NEC Tokin a wholly-owned subsidiary of KEMET.  In the third and final step, KEMET would pay 6x LTM EBITDA, or an additional $250 Million, whichever is greater (i.e., if 6x LTM EBITDA is more than $350M, then KEMET will pay the resulting valuation measure less the $100M that would have already been paid).  The Company has not discussed how it would fund the third option but the first and second options can be paid with the current cash available.  The bond market was receptive to KEMET earlier this year with 10.5% Senior Notes maturing in 2018.

The JV is pending regulatory approval which is expected soon (i.e., a near-term catalyst).  During July, the Company received regulatory clearance from the European Commission but the transaction remains subject to satisfaction of customary closing conditions, including receipt of required regulatory approval in China.  Management has communicated an expectation for closure this quarter, by the end of September. 

Although the sales organizations will remain separate during the JV, management envisions they will benefit from the leverage of procurement, logistics, IT, finance, and HR to optimize costs and systems towards improved service to the combined customer base.  KEMET management believes that the JV and ultimately the full ownership of NEC-Tokin will catapult KEMET’s presence in Asia, especially in Japan, where the Company is under-indexed.  APAC represented 34% of total sales for KEMET during FY2012.

Valuation Considerations

I mentioned my expectation for a potential return of 50% or more in two years or less.  This level was reached in early May.  There are numerous moving parts subject to execution risk with the four most significant items being i.) achieving the $40M expected from vertical integration of the tantalum supply chain; ii.) achieving the $25M expected from phase two at the F&E segment; iii.) achieving the additional $25M expected from incremental operating margin improvements announced on July 26^th; and iv.) the JV with NEC-Tokin.  Furthermore, KEMET’s end markets are cyclical and a looming slowdown to the global economy creates numerous challenges as evidenced at KEMET in previous down-cycles.  I believe management has appropriately taken the actions described to reduce the sales breakeven level and be prepared for the exogenous challenges it faced only a few years ago.  As described above, Paumanok envisions that capacitors will grow at a 6.4% CAGR through FY2017 and more importantly the tantalum segment will grow at an 11.8% CAGR.  In thinking about valuation, I embrace a multiple of 5x FY2015 EBITDA that I apply in 2014.  I am not ascribing any additional value to NEC-Tokin which I described above as yielding potential “option upside”.  For purposes of simplicity, I am ignoring NEC-Tokin and assuming that the $100M that KEMET pays for the first and second options is equivalent to the value ascribed by the market.  I am simply expressing a high likelihood of KEMET executing the $90M of savings noted above and if I ascribe just 60% of it being achieved (i.e., $54M) and add such to the LTM EBITDA, which was notably abysmal because of the recent quarter and implies the Company is under-earning its potential, I arrive at $140M.  I assume there is no FCF generated in the next two years and include the $45M owed for Niotan in addition to the $165M of current net debt (note I have included the warrants and therefore the associated cash).  Based on 53.3M fully-diluted shares, this simple illustration yields a price of ~$9.20.  One can obviously make numerous assumptions and I offered just one.  I do not think the market is ascribing much likelihood that KEMET will execute effectively on the $90M of savings described above and instead is focused solely on the recent abysmal quarter.  I think the vertical integration of tantalum is highly strategic and financially rewarding over time but the market is ascribing little value to it.  This part of the anticipated savings is probably the most likely since the transactions are complete and management has communicated being ahead of plan.  I have not included any FCF generation although KEMET has averaged ~$51M in the past three fiscal years and ~$13M in the past five fiscal years (the Company did incur significant losses during the financial crisis with negative FCF of ~$25M in FY2009 and ~$64M in FY2008).  There is additional value associated with KEMET’s NOLs.  As of March 31, 2012, the Company had U.S. net operating loss carryforwards for federal and state income tax purposes of $275M and $410M, respectively.  Net/net, I think there is much opportunity for KEMET’s stock price to rise as the benefits as described become more transparent within operating and financial results.

Selected Risk Considerations

• The cyclical end markets that KEM serves compounded by the high fixed cost nature of the business can lead to significant swings in profitability.  The most recent quarter (the first fiscal quarter) was a good example of negative operating leverage when sales declined by 23% year-over-year and EBITDA declined by 75%.  The first fiscal quarter in 2011 compared to 2010 was demonstrative of favorable operating leverage when sales grew by 19% and EBITDA increased by 25%.  It should be noted that management is taking decisive action based on the weakness exhibited in the most recent quarter.  Concurrent with its earnings, KEMET issued another press release that described selected operating margin actions which included a 4% headcount reduction.  The Company expects to achieve cost savings of ~$16M in the current fiscal year and an annual run rate savings of $25M as it exits the current fiscal year.
• Substitution of tantalum by other dielectrics given its high relative cost.
• Inability to realize benefits from the F&E restructuring program and other restructuring initiatives which have been recurring in each of the past ten fiscal years.
• Execution risks, there are numerous avenues management is pursuing to improve its profitability but there are always execution challenges and especially with a global enterprise like KEMET.

Selected Catalysts

• Margin improvement from vertically-integrated tantalum supply chain to achieve $40M of raw material cost savings in FY2014
• Benefits that accrue from having the largest source of conflict-free tantalite ore
• Effective execution of phase two of F&E restructuring to achieve $25-30M of savings during FY2015
• Effective execution of recent operating margin improvement action which is expected to yield ~$16M in savings in fiscal year 2013 and an annual run rate of $25M by the end of this fiscal year
• Closure of first step in JV with NEC Tokin, coupled with increased clarity regarding strategic and operational benefits derived from the JV and the timing of financial benefits
• Potential growth in tantalum as forecasted by Paumanok at 11.8% over the next five years