Description

Kemet, the 2nd-largest capacitor manufacturer, is a normalized-earnings story with excellent growth potential. KEM and its competitors are hugely out of favor due to the temporarily rotten conditions in their end markets. Earnings will decline from this year to next year, possibly substantially. What one needs to realize as a potential investor is that KEM has grown rapidly (albeit in a lumpy fashion) over the last ten years, and there is no reason to believe that the growth drivers will disappear anytime soon, current conditions not withstanding. . The stock at around $18 is trading at about 4xEV to Mar. 2001 earnings and about 1x revenues (conf. call will be on 4/23, Co. has announced they should meet consensus, or about $3.93), <2x book, and at about 10x normalized (depressed) March 2002 earnings. 2001 earnings were inflated by very favorable but unsustainable pricing, and the industry is now experiencing an inventory correction along with the general malaise in tech. However, the industry is riding strong secular growth trends that should continue for some time.

Kemet has a #1 market share (25%, up from 23% last year) in tantalum capacitors and a #4 share (8%, up from 7%) in ceramic capacitors, the two fastest-growing and most widely used types. Estimated market size is about $10B, with new products potentially adding $6B to the addressable market. Capacitor consumption has grown substantially over the last ten years, and KEM has outpaced the industry somewhat growing unit shipments on average approximately 26% and sales 19% annually. Capacitors are basic building blocks in every electrical circuit, and ANY electrical device, from consumer electronics to computers to automobiles to industrial equipment is chock full of capacitors. Better yet, as chip use grows and chips become more complex, circuit designs require more capacitors. 10 years ago, every chip required an average of 3 capacitors. That number is now 6. Thus, capacitor growth is a proxy on the growth of electronic device utilization of all kinds.

To provide additional growth, KEM is introducing a new line of high-performance solid aluminum surface-mount capacitors. While Al capacitors have desirable price/performance characteristics, in the past their limited heat tolerance has prevented automated ("wave") soldering. KEM's new solid product allows for significant cost savings for manufacturers as they are wave-solderable. There is only one other small (Japanese) supplier of these components now, and the market is nascent. However, to the extent this new design can penetrate the existing Al market, KEM's addressable market is potentially increased substantially

KEM's management are industry veterans. CEO David Maguire has been at the company 41 years, while the rest of management averages 25 years of service. Management believes they maintain a sustainable competitive advantage via long-term "preferred supplier" agreements with top OEMs, distributors and contract manufacturers (a veritable tech who's who). KEM's worldwide network of manufacturing facilities allows them to deliver any component anywhere in 72 hours or less, and they claim the highest on-time delivery record in the industry at >90%. High performance capacitors are difficult to manufacture (another barrier) and KEM believes it is low-cost producer in its specialty products. They meet with all major customers annually to review expected needs for the coming year. Capacity additions are then made based on this data. Capital spending is judicious, as anyone proposing capital spending projects must be able to demonstrate at least $2 of revenue in the first year for every 1$ spent before Maguire will even listen to them. There is a share buyback plan in force for 4M shares, with 2M remaining to be purchased.

The main competitors are AVX and Vishay. Both of these companies are worth a look, as they currently trade at similar valuations to KEM. However, I prefer KEM for the following reasons: KEM is a pure play, both AVX and VSH have diversified into other components. AVX is majority owned (~70%) by the Japanese company Kyocera, which I consider a negative. VSH's CEO is known for making risky acquisitions, some of which have turned out miserably. While you could consider any one of these positives, I look at them as adding additional risk with uncertain reward.

KEM has a strong balance sheet with ~$2 of net cash per share. ROE is typically at least high-teens, and cycles much higher. Company sources indicated to me that normalized net margins are around 10-12% (much higher recently). If we assume that industry growth over time remains robust, and KEM just maintains share rather than taking share as they have consistently done, then the revenue growth should easily continue in the mid-teens long-term. Management is sticking by a $3 or greater EPS target next year, but street estimates have moved down around $2. Normalized earnings off of FY (Mar.) 2001 revenues should be about $150M or $1.68/share. Next year's revenues should be at least 10% higher (mgmt. guidance) barring economic collapse. At mid-teens growth, we can get $3 in normalized earnings by FY 2005. At typical historical mid-teens multiples the stock could be at $45 to $50 in about 3 years. Historically the stock has traded at 6x EV/EBITDA. Normalized EBITDA margins should be about 20%, giving valuations in the $40/share range 4 years out with mid-teens growth. Maintenance capex levels are about 4% of revenues, making FCF before capacity additions about equal to earnings. My 10 year DCF models put current intrinsic value between $30 and $35 at 12% WACC. At $18, the stock is currently discounting about 3% long-term growth on a DCF basis. Bottom line, this company is very cheap any way you look at it. Clearly, the new catch-phrase "no visibiltity" applies near term, but KEM's earnings power should be realized over time and prospects for robust growth look excellent.

Catalyst

Tech sector fundamentals improve, inventory correction works itself out, Surface-mount AL sales kick in, earnings growth returns, market looks for lower-risk value-based ways to play tech growth, and slight chance company is sold as there are some rumors out there it is in play.