Now is the time to buy; next week is critical; cash flow should continue to flow as our club revisits this old idea - Kemet Corp! Let’s start from the beginning for the ones not too familiar with the story. KEM is based in Simpsonville, South Carolina is one of the world’s largest manufacturers of capacitors which are found in virtually all electronic applications and products. In 1987 Union Carbide divested 50% of its holding in the company to an LBO group led by KEM’s management team, GE Capital and CitiGroup Venture (who still holds a board seat). The company completed its IPO in 1992.
Regarding its products, capacitors store, filter and regulate electricity as it flows through a printed circuit board. KEM focuses on the two key segments, tantalum and ceramic, which represents 60% of the US market and 40% of the world market. Tantalum and ceramic capacitors are widely the materials of choice for advanced technology devices. Key customers include telecom, computer, automotive companies, etc. The worldwide capacitor industry is approximately $15 billion. The tantalum market is currently ~ $3.5 billion. There are 8 major tantalum capacitor producers in the world. The top three are Kemet Corp. with ~25% share, AVX Corp with ~23% and Vishay with ~22% market share. Nearly 35% of KEM’s growth (in good times) was due to hand set sales of PDAs, cell phones, and alike.
KEM's management team comprises of industry veterans and is known as the best operators in the industry – as evidenced by the fact that during this horrible environment, the operators have been able to generate substantial free cash flow in the business. CEO David Maguire (who led the 1987 LBO) has been at the company for over 40 years, while the rest of management averages 25 years of service. With an attractive track record as stewards of shareholder’s capital, one can be confident in management’s ability to manage during this cyclical down-turn and create shareholder wealth.
The challenge in this exercise is to “price” the business correctly based on my appraised value of the business and the downside protection. Telecom-related companies collapsed in July of 2002 and KEM hit a low in the mid-single digits… which is about where its shares are trading today. KEM however, is worth about $17 per share based on the private market value, price-to-book and historical earnings assessments.
Let’s look at each in further detail. Regarding private market values, I tried to reasonably ascertain what the private-equity group paid for such an enterprise after a careful review of the 1987 management buyout. Given the cyclical nature of the industry and the fact that the company has virtually no debt and that capex would be minimal going forward (hard capacity utilization is at 35% while labor utilization is at 65%); I used a “normalized” EBITDA numbers in my valuation for the buyout analysis. EBITDA is reasonable to use because capex is very small for this business and addition to expand will be minimal given the capacity situation (most of the equipment that have been moth-balled are practically brand new). Peak EBITDA for the company was nearly $650 million. I concluded that $200 to $300 million would be a reasonable EBITDA number based on my demand assessment of the industry (taking into account the fact that the good times are unlikely to even close the what they where). Based on prior transactions in similar companies, I concluded that the private market would likely pay between 5x and 6x EV/EBITDA for the business. Taking a mid-point multiple of 5.5x on normalized EBITDA gets me around $17.40 per share for the first of the three values I will use to triangulate to get a final value.
As for my book value assessment, I think it is reasonable to buy a solid, adjusted book value particularly during these uncertain times. Unlike its competitors (AVX, VSH), KEM has very little goodwill on its balance sheet and has nearly $285 million of cash and $100 million of debt -- net cash of just over $2.00. Tangible book value is about $9.00 per share ($9.30 if you were to include goodwill). The company however, has high inventory levels which they have been successfully working down in the past few quarters. One should expect this to continue when the report. I’d like to give them credit for this effort. However, while there is no obsolescence risk with the company’s inventory which is mainly raw tantalum power, I nonetheless, wrote down the inventory value by 50% to get to my “adjusted” book value of $8.00 which is my buy price for KEM’s shares. To get to fair value, I reasoned further that I will get an opportunity to sell the company for at least 2x my adjusted book value (or 1.7x reported book value) given that the company has traded for as much as 5x book. By comparison, KEM is currently trading at 90% of my adjusted book value and 80% of reported book value. 2x book gives me a value $16.
Regarding assessing historical earnings, normalized earnings numbers (given that during these times there is no “e” to speak of (they will lose $0.04 this fiscal year ending in March and make $0.07 to $0.10 next year). Peak fiscal year earnings for KEM were $4.00 per share. This number is gone for good. Evidence suggests that a number closer to $1.50 is more reasonable on a going forward basis (yep, not even half of peak). Despite KEM trading at very high P/Es during up markets, one can suspect that an exit multiple near 12x normalized earning numbers would be reasonable which would generate a fair value for the company of $18.00 per share.
In sum, averaging the values from my private market, price-to-book and historical earnings assessments I get a fair value for Kemet Corp. of around $17 per share. This would generate a +113% upside potential on an acquisition price of $8 per share.
This assessment seemed reasonable, but my approach and analysis took me a bit further. I performed a liquidation value of the enterprise to assess my margin of safety levels, i.e., my down side protection. After taking a closer look at the assets and liabilities of the firm, I assigned the following liquidation values: cash: 100%, AR: 80%, Inv: 80% on my significantly reduced, adjusted number, PP&E: 50%, debt: 100%, etc., gets me to a liquidation value of about $6.50. I know this is pretty rough, but seems very reasonable. Therefore, downside in KEM is roughly -18%.
In the final analysis, it is hard not to like the business of Kemet and its managers. We are afforded such a price in this cyclical tech environment because KEM (like other similar companies) are not “in favor” at the moment despite it being a cyclical company with a reasonable downside protection in its stock. Needless to say, one can get comfortable with what the enterprise is worth and the reasonable safety level to minimize loss of capital… Since I am buying for size (e.g., an option to average down), 18% downside and 113% upside is good enough for me here. Some may what a 5% downside. Clearly, Kemet Corp. is a long-term investment in a solid business run by capable managers, at a price that is heavily based on a downside assessment value in case of a prolonged drought in the cycle. The focus continues to be on “buying right” which I believe I have done.
Given that this is a highly cyclical industry, I understand that “time” may be the most potent catalyst. This will come about due to the supply/demand equation. Based on channel checks and industry surveys, unit declines seem to be moderating a bit which typically precedes any moderation in average selling prices. I do not know when the cyclical will rebound. Accordingly, I priced this uncertainty into the appraisal.