Description

"Long-term competitive advantage in a stable industry is what we seek in a business. If that comes with rapid organic growth, great. But even without organic growth, such a business is rewarding." - Warren Buffett

Kemet Corporation is a special situation, undergoing a substantial turnaround to return to normalcy from the brink of bankruptcy in early 2009.   Kemet operates in the passive semiconductor industry. This is a mature, near oligopolistic market with significant operating histories.  The recent economic downturn resulted in a perfect storm for the company, creating an excellent opportunity for new investors to participate in its turnaround.  Below, we present a long thesis as to why we think the company's stock could at least double from the current quote in the next 12 to 24 months.

Background

Kemet Corporation is a passive electronic component manufacturer that has been around since 1919.  Recent changes in the company's business are detailed in the Business section of the FY2009 Annual Report and serves as a lucid background to our write-up.  The company serves in all the major geographies and reports its activities in three distinct business groups:  Tantalum, Ceramic, and Film & Electrolytic (F&E).  To understand its current investment merits, we go back to 2007 when the company acquired the following businesses to diversify its product lines, at the risk of burdening its debt free balance sheet. 

The company's LT Debt zoomed from $80MM in FY 2006 (March 31 closing) to $365MM in FY 2009.  At the same time, the company's cash dropped from $164MM to $39MM as it financed its acquisitions.   The company's purchase of about 4 MM shares in FY 2008 at five times the current price drained its liquidity at possibly the worst moment.  The financial turmoil and subsequent economic distress towards the end of 2008 and early 2009 led the company to breach some of its debt covenants almost forcing them to file bankruptcy in first half of 2009.   The stock fell precipitously from $11ish in the spring of 2006 to eight cents last March.  KPMG, the company's independent auditor had expressed substantial doubts on company's ability to function as a going concern in its FY 2009 report.

Recent Actions

The acquisitions, excessively leveraged capital structure, and swift deterioration in its top-line placed Kemet's management under severe distress.   The operating cost structure was out-of-whack and the subsequent credit squeeze hindered the company's ability to refinance its debt.  The sell-off that occurred in company's stock during past 2 years was sharp and vigorous, thoroughly disrupting Kemet's operations.  In hindsight, Kemet would have been better off if they had not gone on an acquisition binge.  Even though these acquisitions were performed at reasonable multiples to diversify its product lines, their timing could not have been worse.  Driven to the brink disaster by the headwinds of the credit crisis, management responded with drastic measures to save the ship:

• Paying off $60MM to eliminate the senior notes.
• Reworking the credit facilities and reducing the current liabilities by moving the majority of the repayments to later years, thus providing the company with some breathing space.
• Selling off assets (wet tantalum capacitors) to Vishay for $35 million in cash and a three-year term loan for $15MM
• Operating costs, head count, and capex reductions
• Enforcing 10% wage reductions across the board and the suspension of employer-match to retirement accounts
• Rigorous A/R collection effort and implementing inventory reduction plans

At the beginning of FY 2010, the company's convertible debt was trading at about 10 cents on a dollar, suggesting a terminally distressed situation.  To reduce the debt load on its balance sheet and take advantage of distressed pricing of its convertible, the company purchased about 54% of its $175MM convertible debt at 40 cents on dollar with Platinum Equity's assistance, retiring approximately $93MM in debt.  The company reworked its debt covenants by delaying larger payments to 2013 and later.  Kemet issued 80MM warrants at $0.35 each for Platinum's assistance in restructuring.  While there will be 100% dilution when exercised, this transaction, along with the above listed actions, and helped the company pull itself out of looming bankruptcy in current debt environment.

Investment Merit Today

While we do not profess to be experts in the passive semiconductor industry, we believe that this business has substantial barriers to entry for new competitors.  This is clearly evident from the fact that the sector has been an oligopoly, which has been dominated by 3-4 players for decades.  Compared to the semiconductor industry as a whole, this sector has historically been predictable, with relatively low margins and less IP value. High capital expenditures have inhibited competition from entering this space.  The company was caught by the devastating credit crisis, followed by severe downturn in the economy. This presented an excellent opportunity for Platinum and other opportunistic investors, who recognized this as a temporary setback.  Since their invention 18^th century, capacitors have been used in various applications and their use has steadily increased.   A simple google search on "capacitors" will help understand how pervasive company's products are in the electronics industry.  Below is a list of salient factors which lead us to believe Kemet is a unique investment opportunity today:

• Bad acquisitions followed by extreme selloff caused by macro events in late 2008 and early 2009 have enticed previous holders to sell their stock at any price. This sell-off has presented value investors with a great opportunity.
• Platinum's involvement and financial wherewithal have provided solid support as the interests of new investors at the current price are completely aligned with Platinum.
• Excellent cash generation quarter after quarter clearly indicates the company's early stages of turnaround. Net debt has been reduced from $300MM to $197MM for a company with diluted market capitalization of less than $250MM, a good chunk of it from the cash generated from internal operations. With Platinum's support, the company has opportunistically retired approximately 54% convertible debt at 60% discount.
• Strategic migration away from low margin business is evident from the improved operational metrics. We believe, at present, the turnaround is just beginning to take affect and majority of the turnaround will be visible in next 12 to 18 months.
• Migrating to current global strategy minimizes risks associated to currency and reduces overdependence on revival of any single economy. Additionally, the company will be more attractive to businesses seeking global exposure.
• The company's stock is currently traded on OTC Bulletin Board, even though it was previously on NYSE for over 30 years. Management has expressed a desire to see it traded once again on one of the major exchanges. Per their recent conference calls and investor presentation in November 2009, the company would like this to happen due to its own merit without any intervention like reverse-splitting the stock. The company's stock will be eligible to be traded on NYSE Amex when it trades over $2 for 10 days, expanding its reach to larger institutional share holders.
• We believe, like our earlier write-up on Intellon, the most likely catalyst for current shareholders will be an acquisition by a local or foreign competitor. A quick peek at Platinum's historical modus-operandi and its 50% ownership of diluted company supports our speculation.
• Due to its proprietary manufacturing process, global positioning, and large portfolio of patents, Kemet's assets have value to a prospective acquirer. We believe Kemet will trade above its book value like its competitors - Vishay and AVX.
• Company has guided a modest turnaround in its F&E division constituting approximately a third of its sales. Any quicker turnaround, quicker than company's projections will be icing on the cake. We are optimistic that such a scenario will arise based on the company's practice of under-promising and over-delivering, as evident past four quarters. Also, a recurring restructuring charge reported every quarter indicates persistent revival of the F&E business.
• A major revamp on their cost structure listed in Recent Actions section has helped the company lower its breakeven point to approximately $160MM from $210MM run rate per quarter one year ago. Low inventory levels at the company's major customers suggest a sustained recovery, producing gobs of cash in the following quarter.
• Purchase of the company's shares at current prices by the top management at the first available window after the recent major capital transformation corroborates our thesis.
• There are practically no sell-side analysts. We believe that when the company returns to trading on a major exchange, increased analyst coverage will occur.

Financials

Below, we present a list of key operating metrics over the past eight quarters.  During the quarter ending March 2009, the top-line declined 29% from previous quarter, one of worst declines recorded in its history.  At this stage, customers backed off from their orders, as the imploding balance sheet cast doubt on the company's survival.  Significant doubts were raised as to whether the near-term debt maturities would be met.  Even though several cost reduction measures were put in place, none of them could counter severe declines in revenues.

Kemet's management worked diligently to restructure the short-term facility.  With its stock price less than a dime, it was fruitless approaching public markets for immediate liquidity requirements.  Additionally, they proactively worked with new partners, Platinum Equity, in retiring 54% of the convertible debt at 40 cents on dollar.  Large NOL carry-overs ensured minimal to no taxes on the gains from the transaction.  It should be noted that the convertible is now trading north of 85 cents on dollar. 

It is clearly evident, the company's operational efficiency improved substantially in the face of the economic turbulence the company went through since latter half of 2008.  Now that the company has returned to profitability, customer confidence has also returned.  Hence, sales have been ramping up since March 2009.  In spite of improved metrics, the company is still trading below its diluted book value.  The company has indicated new operating margins are here to stay, and we believe, they will undergo larger improvements to the upside as a few more quarters roll on. 

The table below shows how the Tantalum and Ceramic divisions have improved their margins in the past two quarters.  The F&E division is gross margin negative, but, here lies a significant catalyst that should play out in the succeeding quarters.  The restructuring costs, a majority of which are attributable to this division, should improve, resulting in gross margins in the 24%-26% range and operating margins over 10%. 

We believe this transformation will occur sooner than company's forecast of 15 months to 21 months.  QE June 2010 and Sep 2010 should reveal a majority of this improvement. 

As mentioned earlier, Vishay and AVX operate similar businesses to Kemet.  In the table below, you will see how Kemet majority stockholding in comparison to its competitors (assuming Platinum's warrant exercise).

We believe, Kemet is available at current price at relative discount due to investors' hang-over of the distress experienced after their latest acquisitions.  With the bankruptcy risk eliminated and evolving capital structure, Kemet will eventually trade like other companies in the sector at a premium to their book value.  Recent economic distress has forced out fixed costs permanently out of passive semiconductor industry as confirmed in management calls.  In all three of its divisions, Kemet is within the top 3 or 4 manufacturers in market share.  The trough in top line sales was mainly due to costumer concerns as to whether the company would survive the economic upheaval.  Improving margins across the industry, fading survival concerns, and market leadership will provide tailwinds for improved performance going forward.

Kemet's operating margin will improve every quarter for next several quarters, as the F&E division's turnaround takes effect.  Per the investor's conference in November 2009, management has suggested that the company's operating income margin would reach  10% or greater at quarterly revenues of around $215 million once the F&E restructurings are in place, which is still not baked into price of its stock. 

Valuation

Our thesis here is more about returning to normalcy than resuming growth.  In this new normal, we believe, the company will operate lean, with more of top line transferred to the bottom line, benefitting company common stockholders.  With three observing directors on board from Platinum, significant margin improvement will be noticed.  Currently, the company is operating at 70% of its capacity.  If the economy continues to recover, they can operate additional capacity without any significant capital requirements.  Also, company's management, and especially the CFO, is performing an excellent job in disseminating company's story.  In fact, he scheduled our first telephone conversation while on vacation.  Below is our base case operating forecast for next three fiscal years. 

Our intrinsic value of the company based on modest recovery and WACC of 12% yields $ 2.78 per share.  For WACC range of 9%-15%, our estimated value per share is $1.9 to $4.2 per share.  Large operating history in oligopoly markets provides a adequate margin-of-safety for our investment.

Risk Factors

• A major downturn in the economy may be by far the main risk to Kemet's performance. Even though the breakeven point was lowered significantly, a global downturn of the magnitude seen in late 2008 and early 2009 in the near term may delay the company's turnaround.
• Prolonged distress in credit markets may hurt company's plan to refinance its debt. Couple of weeks back, company was in the market offering senior secured note. Sudden contraction in credit markets due to events transpired in Greece and EU have prompted company to pullback its offering temporarily. From our sources, we learnt that while offering was well received by investors and demand for the issue was robust, the pricing was not agreeable to the management and the company is not in a position of having to accept any price. S&P has proposed convertible rated at 'B' and corroborated with our conclusions we deduced on margin improvements and improved cost structure. Management may offer its debt once again when the market stabilizes and if the yield ranges somewhere between 9% and 10%.
• Decline in gross margins either due to inflation in raw material prices or finished product pricing pressure.
• Turnaround in company's divisions especially F&E take longer than our estimates.

Catalyst